Forex Market Panorama: A Beginner's Guide to the World's Largest Financial Market

How Does the Forex Market Work? Understanding Its Unique Market Structure

Forex Market (short for Foreign Exchange Market) is the largest financial market in the world, with an average daily trading volume exceeding $6 trillion. Unlike centralized exchanges such as the New York Stock Exchange, the forex market is a decentralized over-the-counter (OTC) market with no unified trading venue.

The market operates smoothly thanks to its internal hierarchical system. Imagine this system as a pyramid—at the top are the world’s most powerful big banks, in the middle are various institutional investors, and at the bottom are retail investors. Each layer has different trading conditions and entry barriers.

The top of the pyramid, the interbank market, is composed of the world’s leading banks, including Citibank, JPMorgan Chase, UBS, Barclays, Deutsche Bank, Goldman Sachs, HSBC, and Bank of America. These banks trade directly with each other, either via phone communication or through electronic brokerage platforms. The two most prominent electronic brokerage platforms are EBS Market and Thomson Reuters Matching—they hold a position similar to Coca-Cola and Pepsi in the beverage industry, each occupying different market shares.

Currency quotes are not fixed; EBS Market tends to have higher liquidity for currency pairs like EUR/USD, USD/JPY, EUR/JPY, and USD/CHF, while Thomson Reuters Matching has an advantage in pairs like GBP/USD, AUD/USD, and NZD/USD.

A key point is that all banks in the interbank market can see each other’s quotes, but whether a trade occurs at those prices depends on the credit relationship between the trading parties. Similar to applying for a bank loan—banks with good credit records and high reputation can obtain more favorable exchange rates and larger transaction limits.

Hierarchy of Participants in the Forex Market

The second tier consists of hedge funds, importers and exporters, trading companies, and retail market makers. These institutions do not have close credit ties with the interbank market, so they must transact through commercial banks as intermediaries. As a result, their exchange rates are usually slightly higher than the rates in the interbank lending market.

At the very bottom are ordinary retail investors. In the past, retail access to the forex market was extremely difficult, but with the proliferation of the internet and mature electronic trading technology, retail brokers emerged, greatly lowering entry barriers. Today, ordinary people can participate in the forex market.

Who Drives the Forex Market?

Large international banks conduct massive daily forex transactions to meet their own position needs and to serve clients. They provide buy and sell quotes based on supply and demand, effectively determining global exchange rates.

Multinational corporations participate in forex trading to settle international trade transactions. For example, when Apple purchases electronic components from Japan, they need to exchange USD for JPY—that’s corporate-level forex trading.

Governments and central banks participate through market operations, international payments, and foreign exchange reserves management. More importantly, when central banks adjust interest rates to control inflation, exchange rates often fluctuate accordingly. Some central banks (like the Bank of Japan) also intervene directly or verbally in the currency market to influence exchange rate trends.

Speculators look for currency price fluctuations, buying low and selling high to profit from the spread. Since exchange rates are constantly changing and difficult to predict accurately, traders seek profit opportunities amid this uncertainty.

How Did the Forex Market Reach Its Today’s State?

After World War II, major Western countries established a system to stabilize the global economy, leading to the Bretton Woods Agreement. This agreement pegged the US dollar to gold, with other currencies linked to the dollar, creating a fixed exchange rate system.

However, as the global economy developed at different speeds, contradictions arose in this fixed system. In 1971, the Bretton Woods system collapsed, replaced by a floating exchange rate mechanism—where rates are determined by market supply and demand. Initially, the market struggled to find “fair prices,” but with advances in communication and computer technology, the market gradually stabilized.

From the 1990s onward, the computer and internet revolution changed everything. Banks began building their own trading platforms, and traders developed internet-based trading tools for individual investors. Retail forex brokerage emerged, making participation in forex trading accessible to ordinary people.

The Two Main Models of Forex Brokers

Market Maker Model involves brokers setting their own bid and ask prices. For example, a bank might quote EUR/USD at a bid of 1.2000 and an ask of 1.2002, with a spread (difference) of 0.0002. Although seemingly small, when millions of trades occur daily, this spread becomes a significant profit source for brokers.

Electronic Communication Network (ECN) Model aggregates the best bid and ask prices from interbank markets and automatically matches client orders. Traders can quote their own prices, and ECN brokers typically charge lower commissions. Compared to the wider spreads of market makers, ECN brokers offer lower spreads and smaller commissions, making trading costs more transparent and favorable for traders.

This multi-layered structure and diverse participant ecosystem make the forex market the most liquid and highest volume financial market.