Forex Trading Complete Guide: From Historical Evolution to Practical Operating Mechanisms

What is Forex? An Introduction to the World’s Largest Financial Market

The forex market is the largest and most liquid financial trading venue in the world, with daily trading volumes reaching trillions of dollars. Unlike centralized stock exchanges (such as the New York Stock Exchange), the forex market operates on a fully decentralized structure, meaning that currency prices are not determined by a single institution but are set collectively by countless participants.

You might wonder, since there is no central authority controlling it, isn’t the market chaotic? Not quite. Although decentralized, the forex market has formed a clear hierarchical system, from the top interbank market, to the middle-tier institutional investors, down to retail traders, each layer has its distinct roles and status.

The Pyramid Structure of the Forex Market: From Banks to Retail

Tip of the Pyramid: Interbank Market Dominates

At the top of the forex market are the world’s largest banks, which conduct direct transactions via phone or electronic broker platforms. EBS Market and Thomson Reuters Matching are the two major electronic brokerage systems that dominate the market, with influence comparable to Coca-Cola and Pepsi in the beverage industry.

These banks hold advantages in different currency pairs. For example, EUR/USD, USD/JPY, and USD/CHF are the most liquid on EBS Market; meanwhile, GBP, AUD/USD, and NZD/USD are more active on Thomson Reuters Match.

It’s important to note that while all participants in the interbank market can see each other’s quotes, whether they can trade at those prices depends on other factors. Exchange rates largely depend on the credit relationships established between trading parties—higher credit ratings lead to more favorable quotes and larger borrowing limits, similar to commercial bank loan approvals.

Middle Tier: Institutional Investors and Market Makers

The second layer includes hedge funds, trading firms, retail market makers, and ECN brokers. Because these institutions are not tightly connected to the interbank market, they must transact through commercial banks, which means their quotes are slightly higher than those in the interbank market.

Bottom Tier: The Gateway for Retail Traders

The bottom layer of the forex market consists of vast individual investors. Before the internet era, retail traders had almost no access to this market. However, with the advent of electronic trading platforms and retail brokers, trading barriers have been significantly lowered. Today, anyone with an internet connection can participate in forex trading.

Who Drives the Forex Market? An Overview of Participants

Major Investment Banks: Pillars of the Market

Key participants include top global financial institutions such as Citibank, JPMorgan Chase, UBS, Barclays, Deutsche Bank, Goldman Sachs, HSBC, and Bank of America. These banks execute large volumes of trades daily, constantly adjusting quotes based on supply and demand, effectively acting as the price discoverers of the forex market.

Multinational Corporations: Operational Demanders

Companies like Apple purchase components from Japan and need to exchange USD for JPY, while Starbucks collects revenue in various currencies worldwide and needs currency conversion—although their trading volumes are smaller than banks, their international trade and M&A activities also propel the forex market.

Central Banks and Governments: Market Regulators

Central banks such as the Federal Reserve, European Central Bank, Bank of England, and Bank of Japan often participate in the forex market. They manage foreign exchange reserves through market operations and control inflation by adjusting interest rates—these policies often have profound effects on exchange rates. Sometimes, central banks directly or verbally intervene in markets; Japan’s central bank, for example, is known for this. When a central bank perceives its currency to be mispriced, large-scale buying or selling can instantly change the trend.

Speculators: Seeking Opportunities in Volatility

Traders buy and hold foreign currencies, hoping to sell later at higher prices for profit. Because currency prices are continuously fluctuating and unpredictable, this uncertainty creates profit opportunities for speculators.

How Did the Forex Market Evolve into Today’s Form?

Bretton Woods System Era (1944-1971)

After WWII, major Western countries realized the need to establish mechanisms for a stable global economy. In 1944, they reached the Bretton Woods Agreement, which pegged the US dollar to gold, with other currencies fixed to the dollar. This system initially worked well, but as economies grew at different speeds, its flaws became apparent.

The Era of Floating Exchange Rates (1971-Present)

In 1971, the Bretton Woods system was abandoned, and the international monetary system shifted to floating exchange rates. In this new system, rates are determined solely by supply and demand, making the market more flexible. Although this transition initially brought uncertainty, advances in computer technology and communication gradually helped markets adapt to the new operational paradigm.

Retail Forex Era (1990s-Present)

The 1990s saw the widespread adoption of the internet and personal computers, which revolutionized the forex market. Banks began building their trading platforms, and savvy traders developed online systems for retail investors—what we now call retail forex brokers. This development transformed forex from a “professional finance game” into a market accessible to everyone.

The Two Main Models of Forex Brokers

Market Maker Model: Setting Their Own Prices

Market makers set their own bid and ask prices. Imagine exchanging dollars at a bank, where they tell you the exact rate—you either accept or reject it—that’s how market makers operate.

For example, a bank quotes EUR/USD at a bid of 1.2000 and an ask of 1.2002; the 0.0002 spread is the bank’s profit. While this spread seems small on single trades, with millions of trades daily, this accumulates into significant revenue.

ECN Model: Transparent Trading with Lower Costs

Electronic Communication Networks (ECNs) operate differently. They source the best bid and ask prices from the interbank market and automatically match orders for clients. Traders can set their own prices, and ECN brokers usually earn less from spreads and more from commissions. This model offers narrower spreads and lower costs, making it attractive to cost-conscious traders.

Starting Out in the Forex Market

Now that you understand what forex is and how the market operates, you have the basics covered. Embarking on trading only requires three simple steps: register and fill out your information, deposit funds through various channels, and place trades to find opportunities and execute orders quickly.