§ 1 Overview

1.1 Definition

The foreign exchange market（FX）or currency market，is where foreign exchange be traded.It is by far the world's largest financial market，in which there is no bear market.Currencies are constantly traded，regardless of prices of stocks or bonds.FX trader's profit or loss stems only from changes in the relative value of the currencies being traded，not the value of stocks，bonds or other commodities.

The foreign exchange market was initially designed for firms or banks to buy and sell foreign currencies for international trade and investment purposes，individuals usually take part in the market through brokers or banks.The foreign exchange market is generally a worldwide Over-theCounter（OTC）financial market，that is，the foreign exchange market could be a decentralized market without a central physical location where market participants trade with each other through various communication modes and with advanced technologies such as liquidity aggregation and algorithmic trading techniques.All the traders and the market participants worldwide deal directly with each other，there could be no central exchange at the foreign exchange market.Financial centers around the world function as anchors of trading between buyers and sellers.According to Bank for International Settlement（BIS）report，the top 5 trading centers in year 2022 are London，New York City，Singapore，HongKong SAR，and Tokyo，among which London is by far the biggest foreign exchange trading centre .It is more cost-effective to centralise counter party and credit relationships，or technical and legal infrastructures，in a handful of hubs than to spread them across many countries.FX trading has been increasingly concentrated in financial centres.

1.2 Features

Foreign exchange market has dynamic market participants，high daily transaction volume，worldwide around the clock of the trade，little regulation and shows a trend of consolidation.

1） Dynamic Market Participants

The foreign exchange market is one of the largest and liquid financial markets in the world.The main market participants in foreign exchange market are international commercial banks，central banks，large investment firms，multinational commercial companies，hedge funds，mutual funds，insurance companies and retail foreign exchange brokers，etc.

Foreign exchange market is divided into levels of access that are determined by the size of the“line”（the amount of money with which they are trading）.The top-tier access is the interbank market，which accounts for more than half of all transactions.Central banks，commercial banks and large investment banks are market makers in the top-tier，and they stand ready to make a market in FX.In the interbank market，the standard size trade is 10 million U.S.dollars，and the stakes are high.

At the next level there are smaller investment banks，followed by large multi-national corporations，large hedge funds，pension funds，and some of the retail foreign exchange brokers.

Although some activity in foreign exchange market is driven by real commercial needs，most of the FX participators get involved in FX for hedging，speculative and arbitrage transactions.

The following table shows the top 10 foreign exchange dealers in 2020，where large commercial banks dominate FX trading.

The above table provided by Euromoney survey shows a very competitive market.Ranks change year after year，although Deutsche Bank，UBS and JPMorgan dominate the foreign exchange market for now.

Part of the interbank trading among international banks involves adjusting the inventory position banks hold in various foreign currencies.However，most interbank trades are speculative or arbitrage transactions，where participants attempt to judge the future direction of exchange rate movement.

FX brokers match buy and sell orders and charge commission fees，but they do not carry inventory.The international banks serve the bank customers，in the conduct of international commerce.The bank customers include multinational companies，money managers，and private speculators.

In order to maintain exchange rate regime，the central bank intervenes in the FX market in an attempt to influence the price of its currency against that of a major trading partner or a country that it fixes or pegs its currency against.The central bank is the only market participant who is not driven exclusively by profit.

Although interbank trade dominates foreign exchange market，widespread use of high technology provides easier access for more market participants to get involved in this market.The availability of new dealing technologies has redefined the roles of each of the major foreign exchange market players.Electronic trading in general and retail-oriented trading platforms in particular have provided FX market access to a broader range of end users and favor a more active participation of non-dealer traders.

2） Large Size and High Liquid

Foreign exchange market is the biggest market in terms of trade volume.It is also one of the fastest growing segments in the financial world because that the currency trading has become more influential as an asset class and the fund management assets as hedge and pension funds increase.Up to 90％ of the daily volume of trading activity in the foreign exchange market is a result of speculator activity，with the balance primarily made up of commercial hedging transactions.

Trading in foreign exchange market averaged＄6.6 trillion per day in Apr.2019.It reached to＄7.5 trillion pey day in Apr.2022 according to Triennial Central Bank Survey 2022 by BIS among which the U.S.dollar remained the dominant vehicle currency.

The above summary table shows that foreign exchange activity is concentrated in 3 “major”currencies in trades against the USD：EUR，JPY，and GBP.

This concentration of liquidity in a few currency pairs reflects the importance of the underlying financial and physical product markets denominated in those currencies.

（1）The U.S.Dollar（USD）

The USD is the world's dominant currency，being on one side of 88.5％ of all FX trades.The economic and political significance of the U.S.makes the dollar the world's most heavily traded currency.

The scale，diversity and sophistication of financial instruments available in U.S.markets attract foreign investors.The USD is the most widely used currency for global investors so far.Generally，for any country has its currency be widely used，it must meet 7 conditions：

① The currency should be prudently managed；

② A robust legal system is required to safe-guard contracts；

③ The Treasury bill market is deep and liquid；

④ Money markets are readily tapped for borrowing purposes and are safe for investment；

⑤ The government bond market is deep and liquid；

⑥ Private sector bonds and equities provide a wide range of investment opportunities；

⑦ Each cash market is mirrored by deep，liquid derivatives markets which offer efficient hedging tools and speculative position-plays.

The U.S.has met the above conditions and attracts the central banks to hold the majority of foreign currency reserves in U.S.T-bills.It also attracts the entire range of private investors，from the risk-averse，holding U.S.Treasury bonds，to the most speculative players looking for high returns from growth stocks，high-yield bonds and open futures and options positions.

According to BIS survey，in Apr.2022 88.5％ of the transactions in foreign exchange markets involve the dollar.It took a long way for USD to obtain the achievement.Before the establishment of the Federal Reserve System in 1913，various currencies were issued in the U.S.

In the late 18th century and during the American Revolution，the Continental Congress printed its first paper money，known as continentals.But inflation was rapidly increasing and continentals were becoming worthless quickly.

The First Bank of the United States established in 1791 was the first attempt to central banking，which was not well-received by agrarian electorates.When the bank's 20-year charter expired in 1811，votes in Congress were not enough to renew it.

The Second Bank of the United States of 1816 had a similar story.The Free Banking Era（1836 1865）had state-chartered banks and unchartered “free banks，” issuing their own notes，redeemable in gold or specie.Following the financial panics of the late 19th and early 20th century，the American public was ready for a central bank.In 1913，President Woodrow Wilson signed the Federal Reserve Act into law.The U.S.dollar came into being.

（2）Euro（EUR）

Euro takes over from the German Deutschmark（DEM）as the world's second largest trading currency.

Before the advent of the Euro，the DEM accounted for 25％ of all FX transactions，with USD/DEM being the most liquid and traded pair.Euro has expanded on this.Not only does Euro also take in the German Deutschmark and 18 other European currencies，it is also expected to stimulate the growth of the EMU's Euro-denominated debt and equity markets，that have the potential to rival U.S.financial markets in terms of depth and liquidity.

Introduced in 1999，as stated in Chapter 1 section 4，Euro became the second highest-traded currency in the world with a 30.5％ share in daily transactions.Introducing a new common currency and a central bank that oversees this currency was not an easy task.Since the early 1960s，the central banks of the European Economic Community（EEC）had been trying to coordinate their monetary policies and promote price stability.The Maastricht Treaty of 1992 put a long-contemplated idea on paper：a common currency.In 1998，the European Central Bank was established.

（3）The Japanese Yen（JPY）

With a share of over 16.7％ of the daily currency transactions，the Japanese Yen ranks No.3 in spot market.This third most traded currency is primarily active against USD and EUR.Liquidity is substantially reduced against other currencies.The Japanese demand USD for investment purposes，to service USD debt and to import oil，gas and commodities.

Japan's domestic financial markets are difficult for foreign players to access.As such，demand for JPY is predominantly from Japanese companies repatriating trade profits，investment returns and debt capital.The Japanese yen is particularly sensitive to the profitability of these companies and to the domestic property market.

The history of the Japanese yen goes back to 1871 when it was adopted officially as the Japanese currency by Japan's Meiji government.In 1882，the Bank of Japan was established under the Bank of Japan Act as the country's central bank.

The Bank of Japan was reorganized in 1942 according to the new Bank of Japan Act.The Act of 1942 states the objectives of the Bank of Japan as regulating the currency as well as controlling and facilitating credit and finance to enhance the country's general economic performance.

The Act of 1942 was amended several times after World War Ⅱ and was completely revised in 1997 to reflect the modern principles of central banking：transparency and independence from fiscal authority.

（4）British Pound（GBP）

The British pound has a share of 12.9％ in daily currency trades according to BIS Triennial Central Bank Survey.It is most heavily traded against USD and EUR and over half of these trades are through London，the major FX center.

The city of London and the GBP were at the center of all FX activity before the rise of the USD.Britain and the U.S.maintain a historic two-way investment relationship，with many U.S.companies investing and operating in the UK and vice versa.

As the British economy is now far smaller and has been far less fundamentally stable over time than the U.S.and Germany，it has made for highly volatile currency pairings with the USD and EUR，giving London dealers in particular，many opportunities for speculative position plays.

The official name of the currency is pound sterling which is mainly issued by the Bank of England.As one of the oldest central banks in the world，the Bank of England was founded in 1694 to act as the government's banker and debt-manager.It began issuing notes the same year，where notes had a few lines of engraved text，promising to pay a specified sum at the bank's premises with spaces for a handwritten date，number，signature，and the name of the payee.In 1734，the Bank of England moved to Threadneedle Street in London and is still located there today.

（5）the Australian Dollar（AUD）

This currency has 6.4％ share in daily currency transactions.Prior to 1911，private trading banks were issuing currency in Australia.

In 1911，legislation established the Commonwealth Bank of Australia.However，at that time the bank was just like a commercial bank and did not assume the responsibilities of a central bank.Then，the Australian Department of the Treasury was in charge of issuing notes.In 1924，the Commonwealth Bank Act was amended and the bank was given control over the note issue.From this time until 1945，the Commonwealth Bank of Australia gradually evolved its central banking activities.

In 1959，part of the Commonwealth Bank of Australia was renamed as the Reserve Bank of Australia（RBA）to fulfill the functions of a central bank.The commercial banking functions were kept by the Commonwealth Bank of Australia.

（6）The Canadian Dollar（CAD）

The Canadian dollar ranks as the No.7 currency with 6.2％ share in daily currency transactions in the world.Until the early 19th century，a number of different currencies，British，French，and local currencies，were used in the Canadian provinces.In the years leading up to the Confederation，most of the country was organized as small rural settlements spread over a large area，which made branch banking a practical approach.

During the 18th and early 19th century，the branch banking worked well.Then，bank runs reduced confidence in the system，and the idea that government should issue currency started gaining support.In 1871，the dominion government passed the Uniform Currency Act.

The Great Depression of the early 1930s convinced policy makers to establish a central bank.In March 1935，the Bank of Canada（Banque du Canada）opened its doors as the central bank.

（7）the Swiss Franc（CHF）

With 5.2％ of daily currency transactions，the Swiss franc takes the 8th spot.Until the mid19th century，cantons（states or provinces is Swiss）and other entities were producing their own currency.After the first Federal Constitution went into effect in 1848，the Federal Coinage Act was passed in 1850.

Between 1876 and 1901，three agreements were passed to ensure and facilitate the reciprocal conversion of banknotes without any charges.While several attempts were made to establish a central bank，either the motion didn't pass in the parliament or，if it did，it was rejected by voters.

Finally，the Swiss National Bank was established after the introduction of the Federal Act on the Swiss National Bank in 1905.In 1910，the Swiss National Bank received its monopoly position in issuing money.

（8）Chinese RMB（CNY）

From the above Table 2-2 one can find that in 2022 the RMB share rose to 7％，making it the 5th most traded currency（ ω _p from 8th place in 2019 with a 4％ share）.CNY trading increased in line with aggregate market growth.To become a truly international currency，Chinese currency still need to remove impediments such as the low liquidity outside the CNY/USD pair，capital controls，the wedge between the offshore and onshore exchange rates.etc.

FX contracts trade similarly to stock markets and most technical analysis methods work with currency markets exactly the same as with other stocks and commodity markets.There's only one exception：currency contracts tend to trend substantially more than most stocks and commodity markets.Currency contracts trend about 55％ of the time，while other financial markets such as stock indexes，precious metals and bonds only trend about 30％ on the average.

3） Worldwide and Around the Clock

The legacy of Britain's historic dominance of international trade has placed the City of London at the center of the world's time zones.Since the 1960s，the big American banks have moved into the City of London to operate offshore USD business，reinforcing London's historic dominance.Nowadays London is still the world's biggest FX center.New York，as the center of domestic U.S.finance，ranks the second biggest FX trading hub.

Geographically，the FX market spans the globe with prices moving and currencies trading every hour of every business day.As shown in Figure 2-1，major world trading starts each morning in Sydney and Tokyo，then moves west to China's Hong Kong and Singapore，continuing to Europe and finishing on the West Coast of the U.S.Most active trading takes place when European and Asian centers overlap or American and European centers overlap.

Markets fully closed from Friday New York Closing to Monday Auckland Open，but still some trade on Saturday and Sunday in middle-east.

4） Few Regulation

Because of the sovereignty issue，when involving two currencies，FX market has little（if any）supervisory entity regulating its actions.Some countries do regulate FX brokers through governmental and independent supervisory bodies.For example，the National Futures Association（NFA）and the Commodity Futures Trading Commission（CFTC）in the U.S.，and the Financial Conduct Authority（FCA）in the UK act as watchdogs for their respective markets and provide financial licenses to organizations that comply with local regulations.

Other supervisory institutions are listed in Table 2-3 for reference.

5） General Trend of Consolidation

Foreign exchange dealing has become steadily more concentrated among a handful of powerful dealing banks as the development of electronic trading has materially altered the nature of the foreign exchange market.Although trading in foreign exchange has been growing，the number of banks doing large-scale foreign exchange trading has been shrinking.The growth rate of reporting dealers is not high comparing with that of other financial institutions as one can find from Figure 2-2.Electronic trading has resulted in reporting dealers now trading less with other reporting dealers and more with other financial institutions.

1.3 Currency Intervention

Because of its huge trading volume，high liquidity，geographical dispersion，continuous operation and low margin of profit，FX market has been referred to as the market closest to the ideal of perfect competition if not for currency intervention by central banks.

Currency intervention，also known as foreign exchange market intervention，is a monetary policy operation.It occurs when a government or central bank buys or sells foreign currency in exchange for domestic currency，generally with the intention of influencing the exchange rate.

Policy makers may intervene in FX market in order to advance a variety of economic objectives：controlling inflation，maintaining competitiveness，or maintaining financial stability.

Nowadays FX market intervention is largely used by the central banks of developing countries，and less so by developed countries.Generally，there are four groups that stand out as frequent currency manipulators：longstanding advanced and developed economies，such as Japan and Switzerland，newly industrialized economies such as Singapore，developing economies，and oil exporters.

Since 1989，China's central bank has devalued CNY by buying USD with CNY，which caused higher supply of the CNY in the foreign exchange market，thus increasing the price of USD.In 1994 China began its currency intervention.By the end of 2014，China's foreign exchange reserve holds more than ＄3.8 trillion，making it the highest foreign exchange reserve in the world.58％ of this reserve was composed of U.S.government bonds and debentures as shown in Figure 2-3.

Scholars have different opinions on China's currency intervention.

Paul Krugman argued in 2010 that Chinese currency devaluation helps China by boosting its exports，and hurts the U.S.by widening its trade deficit.The U.S.was suggested to impose tariffs on Chinese goods.Greg Mankiw，on the other hand，asserted in 2010 the U.S.protectionism via tariffs will hurt the U.S.economy far more than Chinese devaluation.Jin and Choi（2014）have computed the annual and cumulative accounting profits since 1994 when China began its currency intervention，and have found that profits initially were positive but China has suffered a massive loss from the currency market since 2007 .

Another typical currency intervention is the Swiss franc.CHF has good reputation of stability.As a safe-heaven currency with nearly zero inflation rate and strong gold reserves，CHF had been getting even stronger since 2008 financial crisis.Its central bank，the Swiss National Bank（SNB），devotes itself into exchange rate management.When a sharp appreciation of the Swiss franc arose in 2011 due to European Debt Crisis，SNB quickly introduced a minimum exchange rate of 1.20 CHF per EUR.This minimum exchange rate supported Swiss exporting with a cost：by purchasing large amount of Euros its foreign exchange reserve rocketed to 495 billion by the end of year 2014 almost 3 quarters of Swiss national output.

As one can find in Figure 2-5 Switzerland holds large amount of EUR.The the European Central Bank signaled a quantitative easing program which would depreciate SNB's eurodenominated reserve even more.To relieve the appreciation pressure on CHF，SNB set a negative key interest rate，as－0.25％.But it did not effect much.Bringing more depreciating euros into its reserve is not a sustainable way to maintain the minimum exchange rate of EUR/CHF.Besides，CHF would over-depreciate against USD with the peg to EUR，and would be listed on the U.S.Treasury Department's Monitoring List as the foreign exchange polices bear close monitoring.

On 15th Jan.2015，SNB unpegged the CHF from the EUR，which resulted in a large and sudden exchange rate appreciation on CHF.CHF then soared by nearly 30％ against EUR.

The Swiss Franc shock brought huge losses to FX retailing brokers.Even FXCM，the world largest listed retailing broker，encountered difficulty in compliance with the regulatory capital requirement as its clients shorting CHF suffered equity shrink.Other smaller brokers such as Alpari，a British-based broker，simply filed for bankruptcy right after the SBN announcement.The Swiss Franc shock addressed issues about capital buffer and leverage regulations on FX brokers. H235rYgsSfPkffkqoJFGjNdPH6sfQkE1mGHmSj6dc6ANJedGb9AyPZbCsTBhyt72