What is Forex and how it works

The offer to become a currency trader and earn on speculation can be found everywhere. The Internet has long been full of bright banners with a beautiful bill, moreover, even offline you can find offers to start earning. Brokers use a lot of instruments to attract our attention. And they do it very well because the number of traders is growing before our eyes. That is why in today’s article we will try to tell you in simple language what Forex is, who its participants are, as well as compare it with the no less popular among investors, the stock market.

Forex is an abbreviation of the phrase Foreign Exchange, which is translated from English as currency exchange.  It is a general term for all over-the-counter currency exchange transactions, the sale and purchase of currencies by one or another of its participants. It is important to note that Forex is often directly associated with the exchange, due to some technical similarity in the conduct of forex trading. But if the stock market has exchange floors, Forex is a decentralized currency trading system, without a single-center, where orders and cash flows would accumulate. That’s why the currency market functions 24 hours a day, five days a week, with liquidity providers playing the main role. To put it as simply as possible, Forex can be compared to a market where participants do not trade commodities, but currency by exchanging them with each other.

History of the birth of the Forex market

Many historians tie the birth of the modern foreign exchange market to the collapse of the Bretton Woods system when the dollar was directly linked to gold. It happened in 1971 due to the economic reform of then U.S. President Richard Nixon. In December of the same year, the limit of the dollar fluctuation was changed from one percent to four percent for major currency pairs and nine percent for cross rates. Such an international agreement let the world currency free float, where the real exchange rate began to be regulated by supply and demand.

But to be completely objective, Forex in one form or another has existed since the emergence of interstate economic relations between nations. Neighboring countries interacted with each other perfectly, paying for loans or other services in different currencies, not just gold. Economic globalization and technological progress were the main reasons for the emergence of this over-the-counter market.

Trading volumes on the financial market Forex

One of the fables that circulate in the world of speculators says that big players can move the currency rate as they want. Under this hypothesis trading strategies are created, where the main task is to find the volume and move in its direction. To put it simply, to trade and be guided by the logic of the big banks. However, if you study the statistics of daily trading volume by years you will see that this concept is a myth.

Experts estimate the average daily turnover on the currency market in 2020 to be in the range of $10 trillion. Naturally, to influence the market in any way, except for supply and demand, a major player has no chance. The only exception may be the Central Banks, which are responsible for the stability of their national units.

Bidders at the currency exchange

Forex is not just speculation and making money on exchange rates, as many people think! Completely different participants in the Forex exchange market can pursue their own goals and objectives, but at the same time influence the exchange rate. Among the participants we distinguish the following:

• Individuals;
• Central Banks;
• Commercial banks and financial institutions;
• Institutional investors;
• Brokers.

It should be noted that physical persons became participants of trades not so long ago, and their activity can be carried out exclusively through brokerage companies. This category includes private traders and investors. First of all, it is related to the amount of capital, since the absolute majority of them have no opportunity to open 1 standard lot equal to 100 thousand units of currency. That is why with the help of brokerage companies providing the lacking sum in the form of leverage, nowadays everyone can buy currency and earn from the difference of rates even from 100 US dollars.

Central banks ensure the stability of the national currency and fulfill the tasks assigned to them by the government. They can buy foreign currency to keep it in reserve or sell it to keep it within a certain price range.

Commercial banks can speculate on exchange rates, but they can also carry out their operations by exchanging money for clients or acting as intermediaries in large transactions, where currency exchange is needed.

Institutional investors are also participants in the Forex market, as they either invest in currency directly or buy different securities: bonds, shares, during the initial public offering.

Forex in Russia and CIS countries

The Forex market in Russia and the CIS operates based on three popular schemes:

• Direct withdrawal of transactions to the liquidity provider;
• Internal clearing;
• A mixed variant.

Direct withdrawal to the interbank market is a transparent scheme when all clients’ orders and transactions come directly to the liquidity provider, namely to a group of banks that act as counteragents. This scheme does not have the most important thing – a conflict of interest. It is important to note that this scheme is implemented not in all brokerage companies in Russia, but only on certain types of accounts – ECN, STP, or NDD.

Internal clearing – is a scheme in which your trades are combined with other traders’ transactions within the company or the broker acts as a counterparty. This is pure fraud because in front of you is a classic bookmaker’s office, which is not interested in traders to earn. It is this scheme of work of some companies which are disguised as a pure brokerage service, undermined the credibility of Forex in the entire post-Soviet space, and especially in Russia.

The mixed variant is used more often, and its peculiarity is the fact that the broker withdraws large positions or the total volume that is not covered internally by the traders on the liquidity providers.

It is worth noting that in Russia, unlike other CIS countries, there was an attempt to regulate the currency market with a special law. However, the practice showed that the current legislation strongly narrows trading opportunities for beginners and considerably increases the entry threshold. That is why instead of providing services on transparent conditions a great number of brokers registered in the offshore zones and bypass all restrictions. That’s why you should choose a brokerage company with which you plan to open an account with caution.

Forex as an alternative to the stock market

The stock market is a great opportunity to invest in underlying assets: stocks, bonds.  However, in practice, it is not so easy to do. The reason is the high entry threshold because the value of some assets starts from several hundreds of dollars. Taking into account that margin trading on the stock market is available only to certain types of traders or to qualified investors, for normal trading at least several thousand dollars are required. On the futures market, the situation is simpler, to trade in futures you need only a few thousand rubles to open one position.

Also do not forget that the stock exchanges are localized, namely, to invest in U.S. stocks or to get full access to the vast number of ETFs you need to pay double commission or open an account with a foreign broker with all the implications. Although it should be noted that since 2019, the average investor has had access to a much larger number of instruments on the Moscow and St. Petersburg exchanges than was the case before.

One way or another, Forex can be a quality alternative. In addition to trading currencies, traders have an opportunity to use derivative assets – CFDs on stocks, indices, and raw materials. It allows earning on currency rates difference, but with much bigger leverage. Moreover, within one account different groups of securities are focused. Thus, it is possible to try oneself in trading CDF or indices from as little as $100. Starting deposit for cent accounts may be as low as $1.

Advantages and disadvantages of the Forex market

As with any market, Forex has both strengths and weaknesses. If we talk about the weaknesses, there are only a few of them:

• Lack of full-fledged regulation;
• A limited number of trading assets;
• Leveraged trading is highly risky;
• No possibility to study the real trading volume, and as a consequence, to see the full picture of supply and demand;
• High volatility of trading assets and poor predictability.

If we talk about the strengths, we can highlight the following:

• Low entry threshold (from 1 dollar);
• Developed infrastructure and intuitive platforms (with MetaTrader4 and MetaTrader5 even a schoolboy understands);
• The huge number of trading solutions that can be downloaded for free: strategies, indicators, advisors, scripts;
• Ability to trade different assets without reference to any particular section or exchange;
• The currency market operates 24 hours a day, allocating four main trading sessions;
• Small commission and a single scheme of its calculation (spread and trade turnover);
• Developed services for the copying of successful traders, as well as a passive investment;
• The developed investment infrastructure (PAMM, MAM), allowing to involve safely and transparently means of investors;
• No restrictions on the potential yield. Everything depends only on you.

Conclusion

The Forex Exchange is a place where millions of people can conquer a new profession and start earning right now. However, we should not forget that investing involves risk, so for every beginner, there is a difficult path to master a new profession – that of a trader. Hard in the learning, easy in the fighting!