Structure of Foreign Exchange Markets, Types of Transactions & Settlement Date
Last updated on 09/12/2021 0 By indiafreenotesThe structure of the forex market is rather unique because major volumes of transactions are done in Over-The-Counter (OTC) market which is independent of any centralized system (exchange) as in the case of stock markets.
The participants in this market are:
- Major commercial banks
- Central Banks
- Investment banks
- Corporations for international business transactions
- Speculators
- Hedge funds
- Pension and mutual funds
- Insurance companies
- Forex brokers
Market Participants
In the above diagram, we can see that the major banks are the prominent players and smaller or medium sized banks make up the interbank market. The participants of this market trade either directly with each other or electronically through the Electronic Brokering Services (EBS) or the Reuters Dealing 3000-Spot Matching.
The competition between the two companies; The EBS and the Reuters 3000-Spot Matching in forex market is similar to Pepsi and Coke in the consumer market.
Some of the largest banks like HSBC, Citigroup, RBS, Deutsche Bank, BNP Paribas, Barclays Bank among others determine the FX rates through their operations. These large banks are the key players for global FX transactions. The banks have the true overall picture of the demand and supply in the overall market, and have the current scenario of any current. The size of their operations effectively lay down the bid-ask spread that trickles down to the lower end of the pyramid.
The next tier of participants are the non-bank providers such as retail market makers, brokers, ECNs, hedge funds, pension and mutual funds, corporations, etc. Hedge funds and technology companies have taken significant chunk of share in retail FX but very less foothold in corporate FX business. They access the FX market through banks, which are also known as liquidity providers. The corporations are very important players as they are constantly buying and selling FX for their cross-border (market) purchases or sales of raw or finished products. Mergers and acquisitions (M&A) also create significant demand and supply of currencies.
Sometimes, governments and centralized banks like the RBI (in India) also intervene in the Foreign Exchange market to stop too much volatility in the currency market. For instance, to support the pricing of rupees, the government and centralized banks buy rupees from the market and sell in different currencies such as dollars; conversely, to reduce the value of Indian rupees, they sell rupees and buy foreign currency (dollars).
The speculators and retail traders that come at the bottom of the pyramid pay the largest spread, because their trades effectively get executed through two layers. The primary purpose of these players are to make money trading the fluctuations in the currency prices. With the advancement of technology and internet, even a small trader can participate in this huge forex market.
Currency pair
If you are new to the forex market and have just started trading Forex online, you may find yourself overwhelmed and confused both at a time by the huge number of available currency pairs inside your terminal (like the MetaTrader4, etc.). So what are the best currency pairs to trade? The answers is not that straightforward as it varies with each trader and its terminal window or with what exchange (or OTC market) he is trading. Instead, you need to take the time to analyse different pairs of currencies against your own strategy to determine the best forex pairs to trade on your accounts.
The trade in Forex market occurs between two currencies, because one currency is being bought (buyer/bid) and another sold (seller/ask) at the same time. There is an international code that specifies the setup of currency pairs we can trade. For example, a quote of EUR/USD 1.25 means that one Euro is worth $1.25. Here, the base currency is the Euro (EUR), and the counter currency is the US dollar.
Commonly Used Currency Pair
The most traded, dominant and strongest currency is the US dollar. The primary reason for this is the size of the US economy, which is the world’s largest. The US dollar is the preferred base or reference currency in most of the currency exchange transactions worldwide. Below are some of the most traded (high liquidity) currency pairs in the global forex market. These currencies are part of most of the foreign exchange transactions. However, this is not necessarily the best currency to trade for every trader, as this (which currency pair to choose) depends on multiple factors:
- EUR/USD (Euro – US Dollar)
- GBP/USD (British Pound – US Dollar)
- USD/JPY (US Dollar – Japanese Yen)
- USD/CHF ( US Dollar – Swiss Franc)
- EUR/JPY ( Euro – Japanese Yen)
- USD/CAD (US Dollar – Canadian Dollar)
- AUD/USD (Australian Dollar – US Dollar)
As prices of these major currencies keep changing and so do the values of the currency pairs change. This leads to a change in trade volumes between two countries. These pairs also represent countries that have financial power and are traded heavily worldwide. The trading of these currencies makes them volatile during the day and the spread tends to be lower.
EUR/USD Currency Pair
The EUR/USD currency pair is considered to be the most popular currency pair and has the lowest spread among modern world forex brokers. This is also the most traded currency pair in the world. About 1/3rd of all the trade in the market is done in this currency pair. Another important point is that this forex pair is not too volatile. Therefore, if you do not have that much risk appetite you can consider this currency pair to trade.
The Bid-Ask Spread
The spread is the difference between the bid price and the ask price. The bid price is the rate at which you can sell a currency pair and the ask price is the rate at which you can buy a currency pair (EUR/USD).
Buy Limit
A pending order to buy a currency at a lower price (whatever price trader wants to buy) than the current one.
Buy Stop
A pending order to buy a currency at a higher price (whatever price trader wants to execute) than the current one.
Sell Limit
A pending order to sell a currency pair at a higher price (whatever price trader wants to sell) than the current price.
Sell Stop
A pending order to sell a currency pair at a lower price (buy high, sell low).
Leverage and Margin
In this chapter, we will learn about leverage and margin and how these influence the financial market.
Hedging
Hedging is basically a strategy which is intended to reduce possible risks in case prices movement against your trade. We can think of it with something like “insurance policy” which protects us from particular risk (consider your trade here).
To protect against a loss from a price fluctuation in future, you usually open an offsetting position in a related security. Traders and investors usually use hedging when they are not sure which way the market will be heading. Ideally, hedging reduces risks to almost zero, and you end up paying only the broker’s fee.
To open a position in an off-setting instrument
The offsetting instrument is a related security to your initial position. This allows you to offset some of the potential risks of your position while not depriving you of your profit potential completely. One of the classic examples would be to go long say an airline company and simultaneously going long on crude oil. As these two sectors are inversely related, a rise in crude oil prices will likely cause your airline long position to suffer some losses but your crude oil long helps offset part or all of that loss. If the oil prices remain steady, you may profit from the airline long while breaking even on your oil position. If the prices of oil go down, the oil long will give you losses but the airline stock will probably rise and mitigate some or all your losses. So, hedging helps to eliminate not all but some of your risks while trading.
To buy and/or sell derivative (future/forward/option) of some sort in order to reduce your portfolio’s risk as well as reward exposure, as opposed to liquidating some of your current positions. This strategy may come handy where you do not want to directly trade with your portfolio for a while due to some market risks or uncertainties, but you rather not liquidate part or all of it for other reasons. In this type of hedging, the hedge is straightforward and can be calculated precisely.
Stop Losses
A stop-loss is an order placed in your trading terminal to sell a security when it reaches a specific price. The primary goal of a stop loss is to mitigate an investor’s loss on a position in a security (Equity, FX, etc.). It is commonly used with a long position but can be applied and is equally profitable for a short position. It comes very handy when you are not able to watch the position.
Stop-losses in Forex is very important for many reasons. One of the main reason that stands out is no one can predict the future of the forex market every time correctly. The future prices are unknown to the market and every trade entered is a risk.
Forex traders can set stops at one fixed price with an expectation of allocating the stoploss and wait until the trade hits the stop or limit price.
Stop-loss not only helps you in reducing your loss (in case trade goes against your bet) but also helps in protecting your profit (in case trade goes with the trend). For example, the current USD/INR rate is 76.25 and there is an announcement by the US federal chairperson on whether there will be a rate hike or not. You expect there will be a lot of volatility and USD will rise. Therefore, you buy the future of USD/INR at 76.25. Announcement comes and USD starts falling and suppose you have put the stop-loss at 76.05 and USD falls to 75.5; thus, avoiding you from further loss (stop-loss hit at 66.05). Inversely in case USD starts climbing after the announcement, and USD/INR hit 77.25. To protect your profit you can set stop-loss at 77.05(assume). If your stop-loss hit at 77.05(assume), you make profit else, you can increase your stop-loss and make more profit until your stop-losses hit.
Functions of Foreign Exchange Market
Foreign Exchange Market is the market where the buyers and sellers are involved in the buying and selling of foreign currencies. Simply, the market in which the currencies of different countries are bought and sold is called as a foreign exchange market.
Types of Foreign Exchange Transactions
The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies. Simply, the foreign exchange transaction is an agreement of exchange of currencies of one country for another at an agreed exchange rate on a definite date.
Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their payments within the two days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-day period, which means no contract is signed between the countries. The exchange rate at which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.
Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate. The market in which the deals for the sale and purchase of currency at some future date is made is called a Forward Market.
Future Transaction: The future transactions are also the forward transactions and deals with the contracts in the same manner as that of normal forward transactions. But however, the transactions made in a future contract differs from the transaction made in the forward contract on the following grounds:
The forward contracts can be customized on the client’s request, while the future contracts are standardized such as the features, date, and the size of the contracts is standardized.
The future contracts can only be traded on the organized exchanges,while the forward contracts can be traded anywhere depending on the client’s convenience.
No marginis required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept as collateral so as to establish the future position.
Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two investors. Here one investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off the obligations denominated in a different currency without suffering a foreign exchange risk.
Option Transactions: The foreign exchange option gives an investor theright, but not the obligation to exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date. An option to buy the currency is called as a Call Option, while the option to sell the currency is called as a Put Option.
Settlement Date
The settlement cycle in stock markets refers to the time between the trade date, when an order is executed in the market, and the settlement date, when participants exchange cash for securities or shares. Sebi has given the option to exchanges to adopt T+1 based on their readiness from year 2022. The Sebi circular states that if the stock exchange wants to opt for the T+2 settlement cycle in between, it will have to give notice one month in advance.
Dematerialised settlement
NSE Clearing follows a T+2 rolling settlement cycle. For all trades executed on the T day, NSE Clearing determines the cumulative obligations of each member on the T+1 day and electronically transfers the data to Clearing Members (CMs). All trades concluded during a particular trading date are settled on a designated settlement day i.e. T+2 day. In case of short deliveries on the T+2 day in the normal segment, NSE Clearing conducts a buy in auction on the T+2 day itself and the settlement for the same is completed on the T+3 day, whereas in case of W segment there is a direct close out. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded. The settlement schedule for all the settlement types in the manner explained above is communicated to the market participants vide circular issued during the previous month.
Rolling Settlement
In a rolling settlement, for all trades executed on trading day. i.e. T day the obligations are determined on the T+1 day and settlement on T+2 basis i.e. on the 2nd working day. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE holidays, Saturdays and Sundays are excluded.
Activity | Day | |
Trading | Rolling Settlement Trading | T |
Clearing | Custodial Confirmation | T+1 working days |
Delivery Generation | T+1 working days | |
Settlement | Securities and Funds pay in | T+2 working days |
Securities and Funds pay out | T+2 working days | |
Valuation Debit | T+2 working days | |
Post Settlement | Auction | T+2 working days |
Auction settlement | T+3 working days | |
Bad Delivery Reporting | T+4 working days | |
Rectified bad delivery pay-in and pay-out | T+6 working days | |
Re-bad delivery reporting and pickup | T+8 working days | |
Close out of re-bad delivery and funds pay-in & pay-out | T+9 working days |
Limited Physical Market
Settlement for trades is done on a trade-for-trade basis and delivery obligations arise out of each trade. The settlement cycle for this segment is same as for the rolling settlement viz:
Activity | Day | |
Trading | Rolling Settlement Trading | T |
Clearing | Custodial Confirmation | T+1 working days |
Delivery Generation | T+1 working days | |
Settlement | Securities and Funds pay in | T+2 working days |
Securities and Funds pay out | T+2 working days | |
Post Settlement | Assigning of shortages for close out | T+2 working days |
Reporting and pick-up of bad delivery | T+4 working days | |
Close out of shortages | T+4 working days | |
Replacement of bad delivery | T+6 working days | |
Reporting of re-bad and pick-up | T+8 working days | |
Close out of re-bad delivery | T+9 working days |
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