FX 101: Understanding the basics of the foreign exchange market
FX 101: Understanding the basics of the foreign exchange market
Global trade was built on foreign exchange. Cultural, scientific, and intellectual exchange has shaped and enriched our world and experience immeasurably.
The foreign exchange market is the largest and most liquid in the world. More than USD$7.5 trillion is exchanged daily by banks and foreign currency traders across the globe. The currency market trades 24/6 and rates can move constantly.
The FX market is described sometimes as an ‘imperfect’ market. Participants may include speculators, global financial institutions or Fintechs, investors, governments and supra-nationals, day traders, travelers, cross-border businesses, or retail operations, among others, and all are there for different reasons.
Consider manufactured goods, solar panels or technologies from China, machinery, commodities, foods, medical technologies from Europe, commodities, fuels and rare earths from Africa and Latin America, agricultural products and commodities from Australia, Canada, New Zealand, energy products and aerospace technologies from the US: we’re barely scratching the surface.
Nevertheless, it can be challenging for businesses operating cross border (or aspiring to!) to navigate the intricacies of the foreign exchange markets. Our guide will provide a basic overview that can help you get started.
And if you feel we’ve missed anything, please reach out.
THE BASICS
What is foreign exchange? If you have payment obligations or receivables in a currency other than your local currency – if you’re making cross-border payments, or a need to manage currency risk – you’re taking part in the foreign exchange (FX, or FOREX) market. Many businesses around the world need to buy or sell currency in order to pay suppliers, make payroll payments, receive funds, or otherwise hold funds in foreign currencies.
How does FX pricing work? As with any market, pricing is primarily determined by supply and demand. Some currencies are more widely traded than others (more ‘liquid’), and pricing can be more changeable for some currencies than others. Currencies are priced in currency-pairs: if you hold euros and need to buy British pounds, your EUR/GBP rate will be based on that differential. If you search online for a price, you will likely see the interbank rate: the base pricing for large banks trading currencies amongst themselves. Commercial rates will typically involve a higher spread/margin (less ‘favorable’) than the ‘interbank’ rate. Further to that, the rate for a business transaction is usually dependent on the currency pair, the amount and frequency of trading. A multi-national enterprise making lots of high-volume payments will likely enjoy a more favorable rate than a business making a handful of trades a year. When you’re considering working with an FX provider for the first time, or when you’re embarking on an FX journey with your bank or FX provider, it’s wise to get a quote for the currency pair you’re exchanging, and check to make sure it’s competitive.
MAKING FX TRANSACTIONS
How do I make FX transactions? You can disburse outgoing payments, as well receive funds, through a number of different settlement methods. These include Wires, Electronic Bill Payments, Electronic Funds Transfers, Automated Clearing House, Direct Debit, BPay (Australia), DEFT (Canada), and Drafts, among other forms of ‘good funds’. With many providers, your outgoing transaction is processed after they receive your funds for settling the payment. You should always expect be furnished with a transaction confirmation as a receipt. Some providers may also offer you the ability to maintain ‘funding balances’, or credits, in various currencies for later disbursement or conversion.
TYPES OF TRANSACTIONS
What kinds of transactions can I make? Types of FX transactions vary, but the basics are spot transactions, limit orders, and forward exchange contracts.
Spot transactions: An agreement to buy or sell currency at the then-current exchange rate, with provider typically building in a markup of spread/margin into the price that the provider quotes. Generally, spot transactions are undertaken for an actual one-time exchange of currencies and delivered same-day, one day, or two days in the future, depending on the client’s location and the currency pair.
Limit orders: A limit order—also called a rate order or market order—allows you to buy or sell currency at a specified rate within a given time frame. Limit orders can be beneficial when you need to exchange funds at a particular budgeted rate in order to satisfy internal cash flow needs or future payments. You specify the currency and the amount, the rate you want to achieve, and the expiry date for the order. A limit order is not guaranteed to fill. If the currency reaches your targeted rate before expiry, it will automatically fill, and you will need to settle the payment at that time. If your target rate is not reached during the term, the order expires, and you can execute your transaction at the current market rate. To find out whether a spot transaction or a limit order would better suit your business needs, get in touch with a reputable foreign exchange provider and they can help you weigh pros and cons of each of your options.
What is a forward contract? Forward contracts are the most common type of FX hedging tool on the FX market today. Simply put, a forward contract, or forward exchange contract, is an agreement to buy or sell funds for delivery on a specified future date more than two business days in the future. The forward contract locks in an exchange rate for the term of the contract. Bear in mind, though, that forward contracts commit you to the purchase or sale of the currency at the agreed rate, no matter where the market stands at the drawdown or expiry date. You may be required to post, as security, an initial margin amount (of around 5%) with the FX provider when entering a forward contract.
How are forward contracts structured? There are two main types of forward contracts. The Closed Forward Contract is structured for you to make your payment, or take delivery of the currency, on one specific future date. The Open Forward Contract is more flexible as it allows you to make multiple payments (drawdowns incrementally reducing how much of the forward is left to use) over a series of dates up to an agreed expiry date. Forward delivery tenors (the term-length of a specific forward contract) can be as short as three business days, or as long as two years, depending upon factors like the currency pair.
DATA AND SYSTEMS SECURITY
What should I be thinking about in terms of security? Look for a provider who demonstrates rigorous measures for mitigating security-risks re foreign exchange and payments. You will want to ensure their systems security and data protection protocols meet or exceed all relevant industry standards, and that they are monitoring security-risks on an ongoing basis. Check with your provider to ensure that their measures for safeguarding or protecting client assets is aligned to any and all applicable regulatory regimes where clients are located. You’ll also want to ensure that the provider’s business practices and licenses are up to date, and that they haven’t been subjected to any recent fines or penalties for fraud, breaching sanctions programs (such as, for USA clients, OFAC’s), or compliance failures. If you’re planning to use your provider’s online trading platform, it would also be wise to ensure it complies with the latest hacker testing, encryption, and authentication standards.
CHOOSING A PROVIDER
What should I look for in a provider?
Capabilities and Tools Whether you’re an SME exploring cross-border expansion, or an established corporate on an international growth trajectory, you’ll want to ensure your provider is well-equipped to provide you with the tools you need. The best way to do that is get in touch with them – a good provider will be able to scale their solutions to meet your needs. Perhaps you need a netting manager solution to consolidate subsidiary payments, or a self-serve online platform. You may want a wide range of currencies, or the most efficient pricing. You may wish to lock in exchange rates for the future, to better manage your budget and longer-term obligations. Or perhaps you just want a human at the other end of the phone.
Size and Reach Many companies shopping for a provider (or looking to replace their existing provider) prefer working with a broker with a track record and positive reputation in the industry – which almost always allows them to have established a large and efficient network of global partners (of correspondent banks and other payment rails) to help facilitate client transactions quickly and affordably. The size of a broker is also important – too big, and you may get lost in the shuffle. Too small, and they may not have the buying power to provide you with favourable pricing, or efficiently track lost payments. Transactions are kept flowing when your broker has deep banking relationships, which could reduce delays and intermediary banking fees. Often, a large FX turnover means they’re both well-staffed and experienced.
Responsive Service If you’re new to foreign exchange, you might consider a broker who offers personalized service even if you plan to do all your transactions online. The human element can add a great deal to your experience. A proactive broker will take the time to help you understand many of the market risk factors specific to your business’ needs, and potential effects of currency volatility on your business’ profitability. Plus, they will check in with you on an ongoing basis to help you keep everything running smoothly, make you aware of any new tools available in the market, and furnish you with educational resources.
Ease of Use No one has time to waste, so it can be smart to find a foreign exchange partner who understands that. For example, an efficient onboarding process should take no more than 3-5 business days, and you should receive one-on-one support to guide you through the process. Ease of use doesn’t just apply to the account opening. An experienced provider will help to ensure your day-to-day transactions are straightforward and hassle-free, which includes cutting out the jargon in favor of plain language.
Self-Serve Technology Most providers offer an online trading platform, and of course, it should be customizable to your needs. What are you looking for in an online platform? Do you may need a scalable approval model to allow your accounting team to have different levels of access? Perhaps you struggle with verifying payment formatting details for your beneficiaries. Or, you need real-time tracking of time-sensitive payments. Is an efficient mobile app a must-have? Perhaps your heart’s desire is an uncluttered dashboard and visibility into details of your payments and balances.
Consider what’s most important to you when choosing a provider: chemistry and common goals matter, even in a digital age.
Can’t I do these transactions through my bank? A good starting point can in fact be first exploring the pros and cons trade-offs of sending or receiving the foreign funds you require through your bank. Many established foreign exchange brokers also have close-knit relationships with Tier One banks in order to help facilitate the movement of funds around the world, as banks tend to be integral to the process. Foreign exchange and global payments providers can complement your banking relationships, adding value and expertise, without necessarily replacing established processes. A provider can be of service in many ways: the most important might include favourable and transparent pricing, and a team of responsive FX market professionals at your beck and call.
At the end of the day…
Just as no two companies are alike in their missions or values, no two approaches to managing foreign exchange needs are alike. A smart FX partner will help you discover what you need, and will offer a solution tailored to you.
To learn more, get in touch with Corpay. We’ll get to know your business, give you FX quotes, provide access with guidance to FX tools that could benefit your business and connect you with ongoing currency research that can help keep you up to date on market movements… even if you aren’t our customer…yet!
Check out some of out other resources:
Why Currency Markets Move, and What you Can do About It
The SME Guide to Foreign Exchange