The current system of flexible (or
floating) exchange rates has been in place since
1972, when the fixed-rate system of currencies established
by the Bretton Woods Agreement in 1944 broke
down under inflationary pressure.
Foreign exchange market is the generic
term for the worldwide institutions that exist to
exchange or trade the currencies of different countries.
There exists no single trading center, and the market
operates 24 hours a day. "Foreign exchange" is often
shortened to "forex", or "fx".
The foreign exchange market is loosely organized
in two tiers: the retail tier and the
wholesale tier. The retail tier is where the
small agents buy and sell foreign exchange, orienting
themselves to the reference rates of such
agencies as Reuters which are adjusted round-the-clock
to actual events in the market. The wholesale tier
is an informal network of more than 1000 banks and
currency brokerage firms that deal with each other
and with large corporations. When the financial
press talks about the foreign exchange market in
general it refers to the wholesale tier.
The spot market is the exchange market
for payment and delivery today. In practice,
"today" means today in the retail tier and two business
days in the wholesale tier. The forward market
(or "futures") involves contracting today for the
future purchase or sale of foreign currency. In
a forward transaction the settlement date is deferred
much further into the future than in a spot transaction,
and no cash moves on either side until that settlement
date.
Dealers and brokers, when acting
as market makers, provide two prices: a
bid and an ask. Once given, the quote
is binding (for a few seconds), i.e. the market
maker will buy foreign exchange at the bid quote
and sell at the ask quote. The arithmetic average
of the bid rate and the ask rate is called the
mid rate (or middle rate, or midpoint
rate). The difference between the bid and the
ask is the spread. Market makers make a profit
from the bid-ask spread. Bid-ask spreads can usually
range between 0.03% and 0.07%, which is significantly
lower than spreads in other financial markets, but
which is compensated by the high volume in the foreign
exchange market (about ten times the volume of international
trade in goods and services).
Commercial banks account for the largest proportion
of total trading volume. About three quarters of
all foreign exchange trading is between banks. These
transactions are called interbank or direct
dealing transactions. Direct dealing saves the
commission charged by brokers.
The primary clearing system for international
transactions is operated by SWIFT (Society
for Worldwide Interbank Financial Telecommunication).
The electronic transfer system works in a very simple
way: two banks involved in a foreign currency transaction
will simply transfer bank deposits through SWIFT
to settle a transaction.
The daily reference (or "information",
or "nominal") exchange rates published by
financial institutions, newspapers, central
banks and providers such as those which can be
accessed by Currency Server
are usually either based on an analysis of a high
volume of foreign exchange trading during the previous
day, or on concertation procedures which occur every
day at a certain time between central banks. In
the first case the providers analyze, over a period
of time, bid and ask currency prices provided in
real time by suppliers such as Reuters, Bloomberg, Tullett & Tokyo, etc. This raw data is validated with consideration
to frequency, unusual peaks, possible errors, etc.
The average of these filtered bid and ask prices
over a certain period of time is called median
price. Usually only the mid rate of the median
price is provided. Where bid and ask rates are provided
instead, the mid rate can easily be calculated (Currency Server does this automatically, depending
on the data it receives).
Outside the foreign exchange trading community,
"interbank rates", "reference rates", "nominal rates",
"wholesale rates", "swift rates", "spot rates",
and "cash rates" are often used to mean the same
thing. Depending on the context, "cash rates" can
however refer either to spot market rates (opposed
to those of the forward market), or to rates which
apply when a customer goes to the bank to exchange
cash from one currency to another (opposed to interbank
rates). Similarly, "retail rates" is also often
used to refer to the exchange rates offered to customers
by banks and exchange agencies, and not the rates
of the retail tier of the foreign exchange market.
"Cross rates" usually refers to exchange rates that
do not involve the US dollar, but more in general
it can also be used to indicate direct exchange
rates between two currencies which usually use a
third currency as a reference.
During their respective euro transition
period (1999 to 2001, for a first group of
currencies), national currencies of European Economic and Monetary
Union (EMU) member states are considered sub-units
of the euro currency unit, and are converted to
and from each other and the euro using constant
conversion rates (whereas the term "exchange
rates" usually implies independent and floating
units) and special triangulation and rounding
procedures (which applications like
Currency Server
support).
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