FX Transactions- An Overview

As my first post eluded there isn't really a great overview of the FX space from a technology perspective anywhere on the internet. While equities is a fairly "lit market" in terms of not only trading but technology, FX is almost a complete black box. In this post I'm going to cover some of the basic fundamentals for understanding an FX transaction and in later articles I'll cover the technology behind it.

Notes:

The information I will describe is not of my own IP, the information you will read is a combination of information available on the internet and through my own experience in eFX.

Words that are in Bold will have a high level explanation at the end of the article.

FX Transactions

At a very high level a foreign exchange transaction, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on agreed upon date.

The simplest way to think about this is the following example, for conversation purposes we will call Person 1. Vanessa.

Vanessa requires Euro's for her upcoming trip to Germany. In order to purchase these Euro's Vanessa will need to go to a foreign currency exchange. This can be a local bank, a small business that specialises in currencies or another financial institution.

Now Vanessa is a smart person, she's been watching the Euro rate against the US Dollar (USD) (the currency she will be exchanging for Euros in this example) and she see's that she can purchase 1 Euro for $1.30 USD.

This transaction is probably the most common one that anyone reading this article. who doesn't either run a small business or is involved in financial markets. will make.

Vanessa's transaction is considered a "cash" rate. That means the money she is exchanging today at her venue of choice, lets say her local bank, is settled at the counter and shes provided the Euros' right away. (we'll go over a "spot" transaction in a moment.)

The bank has now agreed to purchase (Buy) USD with their Euros and Vanessa has agreed to buy her Euro's in exchange for USD.

Vanessa USD (Sell) ----> Euro (Buy)
Bank Euro (Sell) < ----> USD (Buy)

Now you might have noticed I said Vanessa was smart and she was watching the exchange rate prior to entering the Bank. Something to note is that the exchange rate you see as a consumer on TV or online (google finance, xe.com etc) is never going to be the exchange rate you receive at a financial institution. Why you ask? Simple, that rate is a consolidated rate of various known FX market makers. Those participants are spending millions of dollars, sometimes billions, and you're most likely spending a few hundred or thousand. In general the minimum quantity a bank or financial institution can purchase is $50,000 to $100,000. In order for them to offer a rate to you as the consumer, they need to add some margin (can also be called a risk premium) , for taking on such a small position they need to purchase a large amount of that currency. Now this can be done up front by the bank or at the time of purchase. In this example since we're physically exchanging cash, the bank has purchased those Euro's well in advance and is actively maintaining inventory in it's branches. There is a cost to doing so, call it the cost of doing business, and this is eventually in some form or fashion passed onto you.

Now earlier I mentioned the transaction that Vanessa made was a cash transaction, meaning it settles today. a spot transaction actually settles in the future, usually T + 2. T being the date of purchase and 2 being the number of business days added to the transaction date.

Example: An Spot transaction occurs for the same transaction Vanessa made , for conversation purposes lets say she did this on a Monday.

Monday (T --the transaction date-- ) ---> Wednesday (assuming no holidays).

Ok, that's it for today folks, If you have any feedback let me know!

Glossary

Lit Market: This means the market is transparent, we can see all the transactions that a occur and the value of those transactions.

eFX: Electronic FX, this is the means of how currency's are exchanged, usually this done via system and not over the phone.

Market Makers: These are participants, such as Citi Bank or JPM, who actively exchange currency's to with the goal of keeping a liquid market. A liquid market means we're always able to receive and exchange our currency's.