How the FX market works

Pay for a coffee in Tokyo with a UK card and a currency trade happens behind the scenes. Add up every such trade, from tourists to central banks, and the currency market is the largest financial market in the world. Yet many people misread its prices, because each one is written as a pair.

The foreign exchangeForeign exchange: the market where one currency is swapped for another. (FX) market is where currencies are swapped. A French carmaker sells in the US and turns dollars into euros. A Japanese pension fund buys Australian bonds and needs Australian dollars. A tourist buys Swiss francs at the airport. Each is an FX trade.

Where it happens. There is no single FX exchange. Almost all trading is over the counterOver the counter: traded directly between two parties, usually with a dealer bank, rather than on an exchange.: between banks, and between banks and their clients, by phone, chat and electronic platforms. Because some centre is always open, trading runs around the clock on weekdays: it opens on Monday morning in Wellington and Sydney, moves through Tokyo, Singapore and Hong Kong, then London, and closes on Friday evening in New York. London is the largest centre, followed by New York.

Who trades. Large dealer banks make prices and take the other side of clients' trades. Their clients are companies paying for imports or receiving export income, asset managers and pension funds buying foreign assets, hedge funds taking views, and central banks managing their reserves. The US dollar is on one side of almost nine trades in ten, so it acts as the hub of the market.

Reading a quote

Every currency has a three-letter code: USD for the US dollar, EUR for the euro, GBP for the pound sterling, JPY for the yen, AUD for the Australian dollar, CHF for the Swiss franc. A quote names two of them. In EUR/USD = 1.0849, the first currency is the base currencyThe first currency in a pair. A quote is the price of one unit of it. and the second is the quote currencyThe second currency in a pair, also called the counter currency. The price is in units of it.. The number is the price of one unit of the base, in units of the quote: one euro costs 1.0849 dollars.

Which currency goes first? The market has a fixed order, by convention rather than logic. The euro comes before everything, then the pound, the Australian dollar, the New Zealand dollar and the US dollar. So traders write EUR/USD, GBP/USD and AUD/USD, but USD/JPY, USD/CHF and USD/CAD. Check the order every time: a quote of 150 makes no sense for EUR/USD but is normal for USD/JPY.

Two prices, not one. A dealer shows a bidThe price at which a dealer buys the base currency from you. and an askThe price at which a dealer sells the base currency to you. Also called the offer., such as 1.0848 / 1.0850. Both are prices of the base currency. The dealer buys euros from you at the lower price and sells euros to you at the higher one. The gap is the spreadThe gap between the ask and the bid: the dealer's margin for making a market., measured in pipsThe smallest usual price step: 0.0001 for most pairs, 0.01 for pairs quoted in yen.: here 2 pips. The mid, halfway between, is 1.08490.

Stronger and weaker. If EUR/USD rises, one euro buys more dollars: the euro has strengthened and the dollar has weakened. If USD/JPY rises, the dollar has strengthened against the yen. The currency that goes up is the one in front.

When the money moves. A spotA deal for delivery soon after the trade, normally two business days later (T+2). trade is agreed today but settled, with both currencies actually paid, two business days later for most pairs (written T+2). US dollar against Canadian dollar settles one business day later. Agreeing today on a rate for a later date is a forward, the subject of the next lesson.

Direct and indirect. You will also see quotes described from one country's point of view. A direct quote gives the price of one unit of foreign currency in home currency: for an American, EUR/USD 1.0849 is direct. An indirect quote is the flip: how much foreign currency one unit of home currency buys.

The arithmetic is short, but signs and sides are easy to mix up, so here it is written out. Let $S_{A/B}$ be the price of one unit of currency A in currency B.

Flipping a quote. The rate for B in A is the reciprocal. With a spread, the sides swap:

So EUR/USD 1.0848 / 1.0850 becomes USD/EUR 0.9217 / 0.9218.

Cross rates. Where a pair trades thinly, banks build its price, the cross rateAn exchange rate between two currencies worked out through a third, usually the US dollar., through the dollar. The dollars cancel:

Percentage moves. The change in the base currency's value is the new rate over the old rate, minus one. The change for the quote currency is not simply the opposite, because it is measured from a different starting value:

Convert EUR 10,000 into dollars, then switch “You hold” to USD. Next, flip the quote to USD/EUR and check that the answer does not change: the trade is the same, only the way it is written is different.

A furniture importer in Chicago owes a German supplier EUR 250,000, due by spot settlement. Its bank quotes EUR/USD 1.0848 / 1.0850. How many dollars will it pay?

The same bank also serves a Dutch client that buys machine parts from Japan and wants a euro-yen price. The bank quotes USD/JPY 149.80 / 149.83 and builds the cross through the dollar:

The cross bid multiplies the two bids because a client selling euros for yen is, in effect, selling euros for dollars and then dollars for yen, hitting the bid both times.

Most FX trading is not governed by a single rulebook. Since 2017, central banks and market participants have backed the FX Global Code, a set of voluntary principles on ethics, fair pricing, information handling and settlement. Many banks and asset managers publicly sign up to it. Supervisors also expect banks to control settlement risk: the danger of paying one currency and not receiving the other (see the first Spark).

Looking ahead: banks hold capital against their open currency positions under the Basel market risk rules, covered in later levels.

• FX is a mostly over-the-counter market that trades around the clock on weekdays, with the US dollar on one side of most trades.
• BASE/QUOTE = x means one unit of the base costs x units of the quote. Market convention fixes which currency goes first.
• Dealers buy the base at the bid and sell it at the ask; the spread, measured in pips, is their margin.
• To flip a quote take the reciprocal, and swap the bid and ask. Cross rates are built through the dollar.
• When a quote rises, the base currency has strengthened. Spot trades usually settle two business days later.

Foreign exchange (FX)

Foreign exchange: the market where one currency is swapped for another.

Over the counter

Over the counter: traded directly between two parties, usually with a dealer bank, rather than on an exchange.

Base currency

The first currency in a pair. A quote is the price of one unit of it.

Quote currency

The second currency in a pair, also called the counter currency. The price is in units of it.

Bid

The price at which a dealer buys the base currency from you.

Ask (offer)

The price at which a dealer sells the base currency to you. Also called the offer.

Spread

The gap between the ask and the bid: the dealer's margin for making a market.

Pip

The smallest usual price step: 0.0001 for most pairs, 0.01 for pairs quoted in yen.

Spot

A deal for delivery soon after the trade, normally two business days later (T+2).

Cross rate

An exchange rate between two currencies worked out through a third, usually the US dollar.