by Gautam Samel
The forex market is a shining example of global collaboration. Should we look at it as inspiration for the future?
Currencies are as old as the civilizations of ancient Egypt and Mesopotamia and have been a central part of human financial transactions. Going from barter and other similar majorly flawed systems to the use of currencies as money was a major step in humanity’s globalizing behaviour – and it has subsisted in the way currencies behave with each other in our modern financial market. Currency is traded by various banks, nations and even individual traders today in what is called the “foreign exchange market”. The foreign exchange market is by valuation and trading volume the largest financial market in the world. This is even larger than the credit market, which might come as a surprise to many.
First, it is essential to understand the need for a foreign exchange market. Financial transactions within a sovereign territory rely on the said territory’s currency itself, but what happens when one wishes to transact across borders? While rules and regulations over international trade are regulated by trade treaties and other similar rules, we’ll assume basic market conditions for international transactions for the sake of simplicity. Suppose a farmer in Portugal wishes to sell his grown potatoes in his neighbouring country Spain. Assuming that laws and treaties allow him to do so, either the buyer of his potatoes or the farmer himself will have to exchange currencies to directly transact with each other. To do this, the easiest way is for the buyer to convert his money to Portuguese currency and pay the farmer with it. Contrarily, the farmer can receive Spanish currency and exchange it for Portuguese currency. But when we say “convert” or “exchange”, what do we mean exactly? Any random person will not have the means to convert currencies directly or have a “stock” of various currencies to transact with, which is why the need for a global, interconnected market arises. This global market allows such willing participants to exchange currencies with each other i.e partake in such international transactions, which is the primary objective of a foreign exchange or forex market. People have started to use this market, like many others, to turn a profit through trading.
The biggest transaction participants of foreign exchange are undoubtedly banks – especially those of the multinational kind. These banks rely on several other firms that trade foreign exchange in large quantities. Very often these other firms are also other banks, which have had this foreign exchange market dubbed as the interbank market since the majority participants would be banks. These organizations transact currencies on a very large scale on a pair-to-pair basis, which means there is no one absolute value. Values in the forex market are determined on a relative basis, by comparing one pair to another (for example, one of the most famous pairs is the Euro to the US Dollar, known as the EUR/USD pair). This is a uniqueness of the forex market, as most other financial markets value their assets on an absolute basis of their sovereign currency.
Another uniqueness of the forex market is its interaction with geographic time zones. Since the market is international, it is not based in one single place but rather tied to multiple major financial cities – the biggest examples being London, New York, and Tokyo. The transaction times are twenty-four hours with the exception of weekends, which is another uniqueness of this market, compared to other markets, which are active only during working hours or even lower. These hours fuel the massive volume transactions undertaken in this market. As
mentioned once before, a popular transaction pair is the Euro to US Dollar. Euro is the currency of the Eurozone, while US Dollars are the currency of the USA, therefore trading in the EUR/USD allows for businesses in the Eurozone to transact with those in the USA, and vice versa. This allows for a lot of highly valued business transactions to take place across continents without a hitch in the currency aspect of the whole thing.
Now that we have talked about the basic and more technical functions of the forex market, we can move on to the more subjective functions of it. The forex market is a global over-the-counter or OTC market, meaning there is no centralized regulator or clearing house for settlements. And given that the forex market is such a large, globalized network, we have quite strong grey areas surrounding how forex is regulated around the world. Some countries are more liberal than others, while a lot many are rigid in their regulations – some have no regulations at all. The forex market poses quite a difficult question to regulators – how is something that collaborates on such a grand scale regulated in a national jurisdiction? There is probably no proper solution to this, which is both a boon and a curse. Let’s talk about the curse aspect first.
The forex market is highly liquid – most retail trading occurs using derivatives called “CFDs” or contracts for differences. CFDs are an asset class that are highly leveraged – making them very popular in retail traders intending to make a quick buck. This high leverage often forms
a voluntarily created problem for traders – most lose their money very quickly. This makes regulators disinclined to liberalizing retail forex trading – they fret about the financial security of retail traders.
However, retail traders sometimes do not quite come into the view while talking about such regulation. The forex market is vast and massive, which in itself is a virtue that makes it difficult for regulators to exert any proper influence over foreign exchange markets. While nations obviously control the values of their respective currencies through monetary policy, it is obvious that they cannot possibly control the values of the currencies of other nations. This restricts the sphere of influence of regulatory organizations to monetary policy and to control over the brokers engaging in the market. This poses a threat to the true and final credibility to regulatory organizations.
But the modern world is evolving. We live in a world where we transact globally, where our Instagram posts and Tweets are seen globally, where we get products shipped internationally day in and day out, where one stock market affects the other. In short, we live in a globalizing world that is moving rapidly with innovations like cryptocurrency, decentralization and more. Such innovations, while new, are still trivial compared to the grand scale of the forex market which in essence would be fairly similar to a “decentralized market” that cryptocurrency advocates are striving for. The forex market has long been ignored as a source of regulatory inspiration for a global interconnected market. Maybe we need to stop looking at the forex market as shady and dubious from the traders point of view, as unregulated and threatful from the regulator’s point of view, and start looking at it as the magnificent global collaborative system it truly is.
Gautam Samel is a second year law student at the Jindal Global Law School