What is forex?
“Forex” is a financial term used to describe trading foreign currencies. The word “forex” is an amalgamation of “foreign” and “exchange,” and it’s sometimes abbreviated as “FX.”
Businesses, banks, and traders involved in forex are constantly swapping fiat currencies. Unlike the stock market, there’s no physical building where brokers meet each day to fulfill orders. Instead, all forex activity happens “over-the-counter” (OTC) on online trading platforms. Forex trading takes place 24/7 on Mondays through Fridays.
Although forex doesn’t have a central exchange like the New York Stock Exchange, it doesn’t mean it’s unregulated. Every nation has institutions that constantly monitor currency trading. For instance, in the U.S., the Commodities Futures Trade Commission (CFTC) and the National Futures Association (NFA) oversee forex activity.
What is forex trading, and how does it work?
Whenever people buy or sell different foreign currencies, they’re trading in the forex market. Even if you swapped a few USD for Danish krone at a Copenhagen kiosk, you’re participating in forex.
While any currency exchange qualifies as “forex trading,” this phrase is more closely associated with institutions or investors that use online forex brokers to execute large currency trades. Traders can directly trade between fiat currencies or use derivatives representing an underlying foreign currency.
Companies often use forex trading to secure a specific exchange rate for international business. However, the most common reason banks, institutions, and retail investors trade forex is to speculate on future price movements. Forex traders can buy or sell foreign currency pairs to take advantage of the changing exchange rates.
There are hundreds of currencies available for trading in forex markets, but a few of the most common include the following:
- U.S. dollar (USD)
- Euro (EUR)
- Japanese yen (JPY)
- British pound (GBP)
- Canadian dollar (CAD)
- Australian dollar (AUD)
- New Zealand dollar (NZD)
- Chinese renminbi (CNY)
- Swiss franc (CHF)
For most of the 20th century, only large institutions, businesses, and high-net-worth individuals could take advantage of forex trading. However, it’s now possible for retail traders to participate in the foreign currency exchange, thanks to online forex brokers such as TD Ameritrade, eToro, and Interactive Brokers.
Anyone can set up a forex account similar to signing up for a centralized crypto exchange (CEX) or a stock brokerage account. Most forex trading platforms offer similar features to exchanges that offer other assets, including limit orders, market orders, and leverage trading.
Once you log into a forex trading site, you’ll see numerous currency trading pairs with the current “exchange rate.” This number demonstrates how much of the “quote currency” equals one “base currency.” The base currency is on the left.
For example, the GBP/USD pair has an exchange rate of 1.12 (at the time of writing), so you’ll need 1.12 USD to buy 1 GBP.
You can place buy or sell orders on a forex trading platform as you’d buy stocks or cryptocurrencies. However, your orders may take a few days to clear on the forex market. In exchange for filling out your order, your brokerage platform will charge a “spread fee,” which refers to a slight premium in the exchange rate.
Three types of forex markets
Forex trading can be as simple as transferring one currency to another. However, there are more complex ways investors can speculate on forex price movements without touching foreign currencies. The three most common ways to trade forex are as follows:
Spot market
Most people think of the forex spot market when they envision forex trading. This is where traders buy and sell currency pairs with the help of an online broker. Since the spot market deals directly with fiat currencies, it’s the most active and liquid forex exchange.
While trades on the forex spot market are settled in real time, it sometimes takes a few days for funds to appear in a trader’s account. Since there’s no central exchange for forex trades, all spot transactions take place in the OTC market.
Forward market
In forex, the forward market refers to a set of private agreements related to the future value of a currency pair. Two parties will exchange a “forward contract” on the OTC market with a set of conditions to buy or sell a currency at a predefined rate on a date in the future.
Forwards are a type of “derivative” because their value comes from an underlying asset. In other words, a forward contract only has value due to the underlying foreign currencies. Businesses, banks, or institutions often use forwards as a strategy to protect their current currency holdings.
Futures market
Like forwards, forex futures are derivatives that require contract holders to buy or sell a currency at today’s exchange rate on a future date. However, forex futures contracts aren’t handled in the private OTC market. Instead, investors trade these contracts on regulated futures exchanges like the Chicago Mercantile Exchange (CME).
The benefit of using forex futures is that they’re more transparent and highly regulated than forwards. However, futures have less flexibility than forward contracts. Futures traders must abide by the established futures trading requirements set by authorities like The Commodity Futures Trading Commission.
Forex vs. crypto
Traders on the forex and crypto markets both trade currencies, but there are significant distinctions between these underlying assets. The fiat currencies in forex are tied to sovereign nations, whereas cryptocurrencies like Bitcoin are non-sovereign.
Although El Salvador and the Central African Republic recognize Bitcoin as legal tender, not every country accepts it as a valid form of currency. Indeed, many countries ban all forms of crypto transactions. Plus, no government can claim ownership over the Bitcoin network.
Instead of relying on centralized authorities like banks or governments, cryptocurrencies use blockchain technology, distributed ledgers, and consensus algorithms to validate transactions. While supply and demand determine the prices of crypto and forex, the former doesn’t have centralized institutions crafting monetary policies. Also, cryptocurrency is more prone to speculation than established national currencies.
Not only is cryptocurrency more experimental than forex, but it’s also far less liquid. While the crypto market surpassed $1 trillion in 2021, forex routinely has a trading volume above $6 trillion. There are also fewer derivatives opportunities for trading cryptocurrencies than foreign currencies.
The relative lack of liquidity, high speculation, and experimental nature of cryptocurrency make it more volatile than forex.
Can you trade crypto on forex exchanges?
Although the crypto industry is relatively new, some forex platforms allow traders to deposit and trade Bitcoin. Since Bitcoin has the longest history and the highest market cap, it remains the most trusted cryptocurrency. Brokers willing to offer crypto services to traders will likely only focus on Bitcoin due to its higher liquidity and longer track record.
While some forex platforms offer Bitcoin services, most crypto traders rely on exchanges that specialize in digital assets. Centralized crypto exchanges (CEXs) like Binance, and Coinbase have high trading volumes and liquidity. While high-profile CEXs abide by KYC (know-your-customer) and anti-money laundering policies, there aren’t central crypto-focused institutions dedicated to monitoring their operations.
There are also dozens of decentralized crypto exchanges (DEXs) on blockchains like Ethereum. Instead of relying on centralized market makers, DEXs use smart contract-based “liquidity pools” to provide users with trustless peer-to-peer token swaps. While not as popular as CEXs, DEXs like Uniswap, Curve Finance, and PancakeSwap have become integral to the DeFi (decentralized finance) space.
Wrapping up
If more governments and businesses recognize cryptocurrencies, forex markets will likely include digital assets in currency trading pairs. However, dozens of countries are now working on CBDCs (central bank digital currencies) that can compete with decentralized cryptocurrencies, especially stablecoins. If more nations adopt CBDCs, forex markets may focus on these tokens rather than Bitcoin, Ethereum, or privately issued stablecoins like USDC.
While it’s unclear how crypto will influence the future of forex, central banks can no longer ignore disruptive technologies like blockchain. At Worldcoin, we believe cryptocurrencies will play a crucial role in the globalized economy. We aim to ensure everyone has equal access to digital assets, which is why we’re putting a share of our crypto in everyone’s hands for free. We’re also airdropping free DAI tokens to anyone who downloads our app. Subscribe to our YouTube channel to learn more.
