What is foreign exchange?

Foreign exchange is the exchange of one country’s currency with another country. Each country has a different currency for its countries. The currency of one country is pegged with another country. It is required by every business or organization for trading or exchanging its goods and services overseas. Foreign exchange is also used for hedging themselves against the exchange rate fluctuations. There are many foreign exchanges currencies such as the U.S. has US Dollars (US$), China has Yuan (¥) as its currency, Switzerland has Swiss Franc (CHF), India has Indian Rupee (INR-₹), and many others. There are certain trading platforms provided to the investors and the organizations to exchange these currencies and trade-in.

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Understanding of foreign exchange market

The foreign exchange market is one of the most volatile financial markets in the world. The foreign exchange market is used to trade the foreign currency of different countries. Previously, the foreign exchange market was only accessible to large corporations but now it is accessible to various locals and has been more decentralized. There are many constituents of this market that include:

  • Banks
  • Central Banks
  • Commercial Businesses
  • Retail Forex Brokers

Different operations and functions are being performed by these institutions. Retail forex brokers provide the speculation function and trading to the investors is provided for 24 hours. There are many forex activities performed under these market that involves the exchange of various currencies such as US Dollars, Pound Sterling, and many others. These forex brokers earn trading commissions on the transactions conducted in the forex market. The commission is sometimes earned by these dealers per trade, i.e., a fixed charge is paid based upon the transaction and not as per the size of that particular transaction. Retail foreign exchange dealers (RFEDs) acts as a counterparty to set off the exchange of buying and selling. The Central Bank of any country is responsible to control the money supply with the purchase and sale of foreign exchange. Commercial businesses require foreign exchange to trade across the international borders for which the banks facilitate financing in these different currencies.

Foreign exchange market regulation

Foreign exchange is a global and more decentralized market. The forex market has no centralized clearinghouse or central exchange. Therefore, regulations of this market are essential to control its effectiveness and make it more fraud-proof. It becomes risky because it has no direct control which makes it mandatory to be regulated. The forex regulations have become essential. The forex regulation could be done through some government institutions or any governing body. Two bodies that usually govern the operations in this market are National Futures Association (NFA) and Commodity Futures Trading Commission (CFTC). In European countries, MiFID (Markets in Financial Instruments Derivatives) regulates the foreign and the derivative market by increasing transparency. Switzerland has FINMA (Swiss Financial Market Supervisory Authority) as its regulatory body of the forex market. The self-regulatory body of the foreign market in Canada is IIROC (Investment Industry Regulatory Organization of Canada).

National Futures Association (NFA) and CFTC

NFA is the National Futures Association meant for regulating the derivatives market. The forex market is also regulated by NFA since the foreign exchange is also an underlying asset for these derivatives. NFA is an independent body that regulates the foreign exchange by providing the stockbrokers with the licensing after taking into care due diligence. The minimum amount to be maintained is enforced by NFA. All the disclosures and record-keeping are also ensured by NFA.

NFA is being designated as one of the regulators of the foreign market by CFTC. CFTC was created in the year 1974 to regulate the derivatives market and its instruments. It demotivates the bad practices, manipulations, and frauds in the foreign market. The major activities and functions of CFTC include preparing orders and guidelines, assessing the risk and regulations, monitoring the compliance of the rules, reviewing the plans and their implementation for consistency, and various others. There are 13 operating divisions and offices other than the offices of chairman and commissioner under CFTC.

To make the forex market a more secure place, FDMS (Federal Docket Management Systems) requires the security deposit from the retail customers and protects everyone against defaults. The security deposit to be maintained while dealing in the currencies is five percent of the notional value of other currency transactions.

Objectives of foreign exchange regulation

The foreign exchange market is regulated for some purpose. There are common objectives for which the regulations of the foreign exchange market and forex activities are required. To conduct a fair business transaction and ensure ethical practices in the foreign exchange market, the regulation of this market is required. The regulations require obtaining a license for operating in this market. The investors must be kept protected and secured against any frauds that could be conducted by the investment broker-dealers. The brokers must be liable to get reviewed, audited for more safety concerns. For the brokers to not get bankrupt, a minimum amount may be prescribed to be maintained. The disclosure may be also required to keep up with the regulations of the foreign exchange market to maintain transparency such as what MiFID does. An anti-money laundering system is also used to prevent crimes, fraud against finances. This acts as an anti-fraud system for the organizations and parties to the foreign market. The non-regulation of the forex market could lead to huge financial losses to the country and its economy.

Context and Applications

This topic is significant in undergraduate, postgraduate, and professional exams, especially for:

  • Masters of Business Administration (MBA)
  • Bachelors in Business Administration (BBA)
  • Masters of Science in Finance (MSF)

Practice Problem

Question 1: CFTC is one of the governing bodies of the foreign exchange market. How many divisions and offices are there in CFTC?

    1. There are 10 offices.
    2. There are 13 offices.
    3. There are 20 divisions.
    4. There are no offices or divisions in CFTC.

Answer: (b)

Explanation: There are 13 offices in the CFTC other than the office of the commissioner and the chairman.

Question 2: What is the purpose of the National Futures Association?

    1. To regulate the foreign market
    2. To regulate the derivatives
    3. Provide guidelines of trading in the market
    4. All of the above

Answer: (d)

Explanation: National Futures Association is the independent governing body regulating the foreign and the derivatives market and providing the guidelines, rules, and regulations of trading to the organizations.

Question 3: CFTC is one of the regulators of the foreign exchange market that also designated NFA as well for its regulation in the foreign exchange market. What does CFTC stand for?

    1. Commodity Futures Trading Commission
    2. Common Futures Trading Commission
    3. Coordinating Foreign Trading Commission
    4. Commodity Foreign Trading Controller

Answer: (a)

Explanation: CFTC stands for Commodity Futures Trading Commission that regulates the derivatives market and its instruments.

Question 4: There are certain statements related to foreign exchange regulations listed below. Which of the following is incorrect?

    1. Foreign exchange regulation is important for ethical practices.
    2. It is independent and freely exists.
    3. It is governed by regulatory bodies.
    4. None of the statements is incorrect

Answer: (b)

Explanation: The foreign exchange market needs to be regulated and thus, this function is performed by NFA and CFTC. Therefore, the above-said statement is incorrect.

Question 5: The Foreign Exchange market is accessible to many parties. Which of the following party is accessible?

    1. Retail Forex Brokers
    2. Commercial Organization.
    3. Central Banks.
    4. All of the above

Answer: (d)

Explanation: The parties involved in the foreign exchange market include the banks, commercial companies, central banks, and the forex broker-dealers. Hence, all the statements given in the question related to the parties accessible are correct.

Common Mistakes

It is often observed that the students ignore the topic. It is one of the important topics that is considered by the organization for trading globally. The forex market is required to be regulated and not be determined and flow as per the market forces. The understanding of regulatory bodies governing the foreign exchange must be there.

While studying this topic, it is recommended to read the following topics to get a better knowledge:

  • Investments and consulting
  • Finance
  • Online trading
  • Foreign Exchange

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