This question some might find too embarrassing to ask and yet it is going around on forums and being asked by beginners. We thought we’d take the embarrassment out of it and answer it here for all beginners to benefit from without actually having to ask someone.
The short version of the answer is: from the traders. If that makes sense, you may move on with your day now. If, however, you would like some detail you may read the rest.
Understanding the currency pool
Every trader who participates in forex adds to the pool of currency. In other words, your trade capital is going to add to the liquidity of that currency.
In this way, all the various participants of the forex market make up the 5.1 trillion dollar the market boasts.
When we say that forex is an OTC market, meaning it is Over The Counter and there is no central exchange, we are basically saying that the traders are the market. The money that goes around in the market is theirs and the market sentiment and rise and fall of prices is their doing too.
With that background in place, let’s take a look at who these participants and market players are:
The parties that make up the currency volume
- Central Banks
- Commercial Banks
- Individual Traders
1. Central Banks
Governments participate in the forex market to stabilize and regulate their currencies and to maintain foreign reserves.
For example, if a country’s currency value is dropping, the Central Bank might buy large amounts of its own currency to balance out the supply and demand and raise the currency value. Similarly, in case of unsustainable rise in value, the Central Bank of that country might sell their currency so that the supply exceeds the demand and the currency value drops.
2. Commercial Banks
Commercial or investment banks are private banks that trade on behalf of their clients and with other banks. Therefore, when they provide their services they are adding to the currency pool too.
In fact, these banks contribute the highest volume to the market.
The Inter bank market is the biggest in forex. The trading between banks is done to manage interest rates and exchange rates. When they trade on behalf of their clients they also work to diversify the portfolios of big investors.
There are management services in place whose entire business revolves around managing investments of their clients and investing on their behalf.
This includes hedging, trading futures and even day trading. The job of these investment management services and consultants is to add profit to their clients’ accounts- in other words expand them.
They form the second largest group of contributors in the forex market (after the commercial or private banks). They trade bigger sums of money like the private banks, managing retirement funds etc.
For the smooth functioning of businesses, foreign exchange will play a role at one point or another.
For example, any manufacturer of a product will need to import an ingredient or part from another country. Raw materials are searched and bought from wherever the most cost effective option can be found. A lot of times this means importing from another country. When a company in country A buys a product from a supplier in country B, they will exchange their own currency for that of the supplier’s and make the purchase then. This means trade between the two currencies in the forex market.
Traders are essentially investors. They might be short term investors, if they are day traders for example, but the principle is the same. They put in some money in a trade and hope to make some profit off of it. Those are the rules of investing.
So day traders, scalpers, swing traders, position traders, futures traders, all make up this category. The volume that is contributed by these individuals is quite small compared to the bigger players but it does add value to the market.
These traders are speculators mainly who are looking to make smaller profits (as compared to commercial banks for example) from the minor market fluctuations.
All these elements come together to form the forex market. This is where the money comes from and where it goes. There is no single party that benefits from it, but a multitude of different ones.