The Beginner’s Guide To Financial Markets: Foreign Exchange

In our previous instalment of the beginner’s guide to financial institutions, we took a brief look at the history of the City and some of the main market participants. Over the next few weeks, we’ll bring you beginner’s guides to the various markets, starting with foreign exchange (FX).

Buying and selling

Imagine you’re going to the Bureau de Change to get your holiday money. On the wall there’s a board with red neon numbers in columns next to a list of currencies and the columns are headed ‘buy’ and ‘sell’. Let’s say you’re going to Spain so you want Euros; you buy 300 Euros, which costs you £250. What you’ve just done is a foreign exchange transaction – you’ve bought one currency and sold another. Banks, brokers and other financial institutions do exactly the same thing, except on a much bigger scale. Where you bought 300 Euros, they will buy 300 million Euros.

Why buy so many Euros if not to fund a massive bender in Spain? Well, an FX transaction could enable a company in Japan, say, to import goods from the United States and pay US dollars rather than yen if the currency valuation is favourable. It also allows a profit to be made on inter-currency transactions, especially at the top level of the FX market, which is made up of the largest investment banks. Because they’re in a position to trade huge volumes, the banks get a better price (measured in ‘pips’, or the difference between the buy and the sell price) than someone buying their holiday money.

Each country has its own currency denoted by a three-letter code – EUR (Euros), USD (US dollars), GBP (British pounds), JPY (Japanese yen) and CHF (Swiss francs) are the major currencies. These are valued at significantly more than, say, UGX (Ugandan shilling) or CLP (Chilean peso). The most often-traded pairs are EUR/USD and GBP/USD. Some FX trivia: GBP/USD is known as ‘cable’ in the industry, which originates from the 19th century when the exchange rate was transmitted via transatlantic cable.

The value of money

Like anything else that can be bought or sold, demand for a currency influences the price. So, one day you might pay £250 for your Euros but if you buy them a week later, they could be worth £255 — in other words, the ‘buy’ price is higher. Currency valuation depends on a variety of factors such as speculation (where someone thinks the price may increase and buys more of the currency, which has the ultimate effect of increasing demand and driving up the price), or a country’s business activities and economy. For example, if a country has high unemployment, people spend less on goods and services lowering gross domestic product (GDP) and, as a result, the value of that country’s currency.

Central banks (which we mentioned in the first beginner’s guide; they’re the daddy of banks) can also affect the value of a country’s currency by increasing the supply of money to suit the economy’s needs. The term ‘quantitative easing’ has popped up in the news quite a bit over the past couple of years. For most people, it’s another bit of impenetrable jargon and almost certainly somehow the fault of bankers. What the term actually means is that the Bank of England (our central bank) has decided to try and boost the economy by effectively conjuring up more money to buy assets.

So why is the ‘sell’ price lower? Again, it’s basic supply and demand. Assuming you haven’t spent all your holiday Euros boosting the economy of Spain by buying beer and donkeys with straw hats, you might decide to exchange your leftover Euros, in effect selling them to the Bureau de Change who buy them back and sell you pounds. A straightforward buy/sell transaction like this is called a ‘spot’.

The FX markets also do ‘forward’ transactions, which means that Bank A will agree to buy 20m Euros costing £1.20 each from Bank B, but the actual transaction will happen at a future date, usually Tomorrow Next (2 days), Spot Week (one week), two weeks, one month, three months, six months, nine months or 12 months. Why do they do this? Bank A, the buyer, gets to buy Euros at an agreed rate so even if the currency valuation increases before the transaction takes place, they still pay £1.20 for their 20m Euros while Bank B gets to charge a premium price for undertaking the risk that the currency value will increase. Obviously, if the currency value drops, then Bank B will make a profit.

London’s place in the market

London is currently the most important financial centre in the FX markets and accounts for over 40% of global foreign exchange transactions with New York (19%) and Tokyo (7%) behind, so you can see why the government (and by extension the mayor of London) are quite keen to hang on to the financial industry. FX is a tremendously fast-moving market and operates 24 hours a day, five days a week. In April 2011 alone, FX turnover in the UK was $2,191bn. So based on this, we could be forgiven for thinking that a tax on financial transactions (or Tobin Tax as it’s often known) is a fantastic idea. It could raise a huge amount of revenue for the Treasury and only affects the banks, right?

Not quite. If the tax was imposed globally then it wouldn’t be a problem because all countries would be equally liable for it. But the governments in Asia and the US have opposed a financial transactions tax, so the upshot of imposing it in London alone is that the banks, brokers and hedge funds who contribute to that 40% would up sticks and move to Asia or the US where they aren’t taxed. And you may remember from the previous guide how important the financial industry is to London and the UK in terms of tax take, local economy and GDP. So when you think of it like that, prime minister David Cameron’s stance that he would only consider a financial transaction tax if it was applied globally looks less like a rampant capitalist Tory protecting banks than an attempt to look out for the interests of the country, doesn’t it?

FX is just one market within the financial industry, albeit the one with the largest volume and amount of money involved. Over the next few weeks we’ll take a look at some of the other market areas, including the one where it all went so wrong – debt.

Photo by Stuart-Lee in the Londonist Flickr pool

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Article by Beth Parnell-Hopkinson | 664 Articles | View Profile

  • Joel Phillips

    Assuming that you wanted a realistic example, it ought to have been 358 euros costing 300 pounds.

    • BethPH

      Oops, slight error with the currency converter there. Thanks for pointing that out!

  • Nick

    Wow it is that bad

  • Anonymous

    A ‘Tobin Tax’, or ‘Robin Hood Tax’, or ‘Financial Transactions Tax’ (FTT) in the UK would ensure the banks pay their fair share in the crisis, and encourage longer term stability in the financial sector while raising tens of billions of pounds to help those living in poverty in the UK and abroad. An FTT can be designed in such a way that it gives little incentive for banks to relocate overseas. The UK’s own 0.5% tax on share transactions (the Stamp Duty) is one of the best examples of a successful FTT raising the Exchequer more than £3billion each year without a significant loss of business from London.  If you want to own the shares of a UK-traded company, regardless of where in the world you are when you buy them, you have to pay the UK stamp duty.  If you don’t, then your ownership of the shares is not legally enforceable. And there are other factors that also make relocation from London difficult and unlikely. These include the City’s stable and well developed financial and IT infrastructure, lack of corruption, ancillary services such as lawyers, accountants and IT specialists, and location.  Many cannot afford to ignore London’s pool of highly skilled workers, who in turn are attracted by the culture, language, world class education and variety of things to spend their money on.But beyond all this, there is a multi-billion pound reason why banks would be mad to move away: an implicit subsidy from taxpayers to governments that dwarfs anything the banks pay in tax.  Credit rating agencies such as Standard & Poor know the UK government will not let the big banks fail because that would bring the rest of the economy down with them.  As a result they provide two credit ratings for the major banks, a practical one used by the markets, which takes this guarantee into account, and a theoretical one which illustrates the ‘stand-alone’ strength of the banks.  The difference between the two shows how much more cheaply banks can borrow because of taxpayers’ guarantee.  According to Andrew Haldane, Executive Director of financial stability at the Bank of England, this was worth £100bn at the height of the crisis, and over £50bn on average between 2007 and 2009.Nobody turns down a £48bn freebie, and that’s what the banks would be doing if they moved operations overseas.  Most countries are simply not capable of offering this kind of support. Those who are capable may not be willing to risk having to fund a bail-out. Supporting only a ‘global’ Financial Transaction Tax is a convenient excuse for UK politicians to hide behind, knowing that they will never be called upon to live up to their promise. Instead, the UK government should become world leaders in taxing the banks and take advantage of the very real current political opportunities to introduce a Robin Hood Tax on financial transactions in the UK and elsewhere.