A comprehensive guide to the foreign exchange market: from beginner to expert

What is the Forex Market? Starting with the Market’s “Pyramid”

Forex Market (also known as the foreign exchange market) may seem complicated at first glance, but if you imagine it as a pyramid structure, it becomes clear. Unlike centralized exchanges like the New York Stock Exchange with uniform quotes, the forex market is decentralized — meaning the same currency pair may have different prices from different traders.

It sounds chaotic, but in reality, the market has its own order. It is divided into three layers from top to bottom:

Top Layer: Interbank Market — This is where the players operate. The world’s top banks (Citibank, JPMorgan Chase, UBS, Barclays, Deutsche Bank, Goldman Sachs, HSBC, Bank of America) conduct massive forex transactions daily. They trade directly via phone or electronic broker platforms. EBS Market and Reuters Matching are like the “Coca-Cola and Pepsi” of this circle, dominating liquidity. For example, popular currency pairs like EUR/USD and USD/JPY have the strongest liquidity on EBS, while GBP, AUD, and others are more active on Reuters.

The interbank market has a hidden rule: you can see others’ quotes but may not be able to transact at that price — because exchange rates largely depend on the credit relationship between trading parties. Banks with good credit can negotiate the best rates and credit limits, similar to applying for a loan.

Middle Layer: Institutional and Market Makers — Hedge funds, large trading companies, retail market makers, and ECN brokers operate here. They lack the close credit relationships with banks, so they must go through commercial banks as intermediaries, resulting in slightly higher rates than the interbank market.

Bottom Layer: Retail Traders — Individuals like you and me. Before the internet and retail brokers emerged, retail traders couldn’t access this market at all. Now, the barrier has been greatly lowered, but the trading costs are higher than those at the top tier banks.

Who Determines Exchange Rates? An Overview of Market Participants

Large Banks: The Rulers of the Forex Market

The world’s largest banks — Citibank, JPMorgan Chase, UBS, Barclays, Deutsche Bank, Goldman Sachs, HSBC, and Bank of America — conduct enormous forex transactions daily. They trade for themselves and on behalf of clients, constantly adjusting bid and ask prices based on supply and demand. Simply put, they hold the pricing power in the forex market.

Corporations and Commercial Banks

Multinational companies like Apple need to settle international trade. For example, buying electronic components from Japan requires converting USD to JPY before paying Japanese suppliers. These companies’ trading volumes are much smaller than the interbank market, so they usually work with commercial banks.

Central Banks and Governments

Central banks (Federal Reserve, European Central Bank, Bank of England, etc.) and governments often participate in the forex market. They do so through market operations, international trade payments, and managing foreign exchange reserves. Interestingly, when central banks adjust interest rates to control inflation, it often triggers chain reactions in the forex market. Sometimes, certain central banks (like the Bank of Japan) directly intervene by buying or selling large amounts of a currency to influence its value — although not regularly, their impact is significant.

Speculators

These traders buy a currency hoping to sell it at a higher price later. Because exchange rates fluctuate constantly and no one can predict them accurately, traders have opportunities to profit from these movements.

The Evolution of the Forex Market: From Fixed to Floating

Bretton Woods System Era (Post-WWII to 1971)

After WWII, major Western countries realized the need for a stable global economic order and reached the Bretton Woods Agreement. This treaty pegged the US dollar to gold, and other currencies to the dollar, creating a fixed exchange rate system.

However, as the world’s major economies developed at different speeds, contradictions in this system became apparent, eventually leading to its collapse.

Floating Exchange Rate Era (1971 to Present)

In 1971, the Bretton Woods Agreement was abolished, replaced by a floating exchange rate system. Since then, exchange rates are determined by market supply and demand, no longer fixed by governments or international agreements.

Initially, this caused some chaos, but with advances in computer technology and improved communication, the market gradually found balance. Especially after 1990, with the rise of the internet, banks began building electronic trading platforms, and some traders launched online platforms for retail investors — known as retail forex brokers — greatly lowering the barrier for ordinary people to enter the forex market.

Two Main Types of Forex Brokers

Market Maker Model: They Set the Prices

Market makers decide their own bid and ask prices. For example, if you travel to the US and need USD, you go to a bank to exchange. The bank (acting as a market maker) might tell you: EUR/USD bid is 1.2000, ask is 1.2002.

The 0.0002 difference is the market maker’s profit — called the spread. It seems small, but considering millions of forex transactions daily worldwide, this spread can accumulate into huge profits.

Market makers usually offer high liquidity and fast execution; however, their spreads tend to be larger.

ECN Brokers: Transparent Matching Mechanism

ECN stands for “Electronic Communication Network.” Their approach is entirely different. ECN brokers gather the best bid and ask prices from multiple interbank institutions and automatically match client buy and sell orders.

Since traders can quote their own prices, ECN brokers typically earn less from spreads and instead charge commissions. The result is lower trading costs, but traders need to be more proactive in managing their trades.

Start Your Forex Journey

Now that you understand what the forex market is, how it operates, and the roles of various participants, the next step is to choose a suitable broker, learn about risk management, and start practicing. The forex market is constantly changing; continuous learning and adaptation are key to success.