Unlike other financial markets such as the London Stock Exchange, the forex spot market does not have a physical location or a central exchange. Instead, it is an Over-The-Counter (OTC) or ‘interbank’ market that is run electronically within a network of banks around the clock. In this market, participants determine who they want to trade with based on on trading conditions, prices, and the reputation of the trading counterpart.
The US Dollar is by far the most traded currency on the forex market, given that it forms one half of every major currency pair, and three quarters of all forex trades involve the major pairs. There are several reasons for its dominance. The US economy is the largest in the world, with the biggest and most liquid financial markets. The US has a stable political system, and the US dollar is the world’s main reserve currency. Also, the dollar is the medium of exchange for many cross-border transactions, such as those involving oil. If, for example, a Spanish company wanted to buy oil from Dubai, they would have to buy it with US dollars, and if they didn’t have any, they would have to sell their euros and buy US dollars in order to place the order.
While commercial transactions of this type are a large part of the forex market, the majority of currency trading is speculative, and most of the $4tn daily volume comes from traders that buy and sell based on intraday price movements. It is estimated that speculative trades account for over 90% of the trading volume. The scale of speculation on the forex markets means that liquidity, which is the amount of buying and selling volume at any given time, is very high indeed. This makes it very easy for traders to buy and sell currencies, as there are always lots of people willing to buy your currencies, or sell their currencies to you.
From the investor’s perspective, liquidity is very important because it determines how easily price can change over a given time period. A liquid market allows huge trading volumes to happen with very little effect on price. Over the course of a trading day, the market depth for any given currency pair fluctuates, which makes the timing of your trades important.