The Foreign Exchange (Forex) is the largest and most liquid market in the world. Investors, companies, and individuals worldwide participate in the Forex, executing millions of transactions, which amount to approximately US$5.3 trillion daily. This article explores the dynamics of the Forex, the market’s major players, and gives an outlook into its future.
Investment and the Foreign Exchange Market
The Forex market is highly decentralized and, therefore, it serves as one of the best mechanisms to gauge the strength of an economy as well as the politics of a region. In theory, all of the world’s currencies participate in the Forex; however, merely a dozen of them dominate the vast majority of the market. Throughout the 20th century and into the 21st, the United States dollar (USD) has dominated as international currency.
The Forex market is made up of currency exchange pairs. For example, USD:EUR means that the dollar is exchanged against the Euro. Therefore, the strength of specific currencies within the Forex is measured as a percentage out of 200 basis points because there are two currencies are involved in each transaction. Today, the USD is present in 84.9% of all Forex transactions worldwide. This means that the overwhelming majority of currency transactions involve the USD. Since its creation almost two decades ago, the Euro (EUR) has quickly become the second most popular currency in the Forex, participating in approximately 39.1% of all transactions. These two top currencies are by far the dominant actors within the Forex and the international economy. The third most exchanged currency, particularly dominant in Asian markets, is the Japanese Yen (JPY) at approximately 19.0% of transactions, followed eventually by the British Pound (GBP) and the Australian dollar (AUD).
A particularity of the leading currencies within the Forex is that they are all floating. This means that none of them is backed by precious metals, such as gold or silver, and that their value fluctuates daily based on market sentiment. Certainly, these currencies are managed by their respective central banks and backed by the good faith of their governments. However, in the end, the value and demand of a specific currency is determined mainly by the sense of security that the market feels towards it. Another factor that makes of the USD and the EUR dominant world currencies is that international debt obligations are most often managed in these denominations. These obligations include loans from institutions such as the World Bank, the International Monetary Fund (IMF), and even private sector banks. Similarly, the bonds issued by the governments of the United States and the European Union as well as the large amounts of trade involving these regions, make of their currencies popular and inevitable for any international investor.
In spite of the financial dominance of the USD and the EUR, it is fair to wonder whether this scenario will change in the future, particularly given the coming of the so-called Asian Century. The fact is that, even though China has become an economic leader in the 21st century, the Asian Giant has so far held back from an expansionist monetary policy. However, as China undergoes an economic transformation, it has taken actions that seem to challenge Western hegemony in economic matters. Today, the main barrier for China to become a leading economic player is the internationalization of its currency, the Yuan (RMB), as a denomination for debt obligations worldwide. The new financial institutions brought forward by China over the last several years are the start of an international policy to issue RMB denominated loans and debt obligations into developing markets. Beijing expects this policy to be the beginning of an internationalized Chinese currency.