Forex Market Beginner's Guide: Master the World's Largest Trading Market in 5 Minutes

How Does the Forex Market Work?

The forex market is the largest and most liquid financial market in the world, with daily trading volumes exceeding several trillion dollars. Unlike centralized exchanges, the forex market operates on a decentralized structure, meaning there is no single pricing center. Instead, numerous participants quote prices based on supply and demand.

Because of this characteristic, the same currency pair may have different quotes from different brokers. However, this seemingly chaotic market actually follows a strict hierarchical system, forming a highly organized trading ecosystem.

Hierarchical Structure of the Forex Market

The forex market is divided into three tiers, each with different levels of liquidity and quoting advantages.

Top Tier: Interbank Market

This is the core level of the forex market, composed of the world’s largest financial institutions, including Citibank, JPMorgan Chase, UBS, Barclays, Deutsche Bank, Goldman Sachs, HSBC, and Bank of America, among others. These banks trade directly via phone or electronic broker platforms, with EBS Market and Thomson Reuters Matching being the two main platforms.

The interbank market features the most favorable quotes and highest liquidity. For example, major currency pairs like EUR/USD and USD/JPY have more liquidity on the EBS platform, while currency pairs like GBP/USD and AUD/USD are more actively traded on Thomson Reuters.

However, even though everyone can see each other’s quotes, not everyone can execute transactions at these prices. Participation in the interbank market benefits from established credit relationships—institutions with good credit and strong capital reserves naturally obtain more favorable trading conditions.

Middle Tier: Institutional Investors and Professional Traders

Hedge funds, large trading companies, retail market makers, and ECN platforms operate at this level. Since these institutions do not have the same credit standing as top-tier banks, they must transact through commercial banks acting as intermediaries. As a result, their quotes are usually slightly higher than interbank prices.

Bottom Tier: Retail Traders

The advent of the internet and retail forex brokers has enabled ordinary investors to participate in the forex market. Although retail quotes tend to deviate more from market prices, trading thresholds are significantly lowered, with account opening funds as low as a few tens of dollars.

Who Participates in the Forex Market?

Participants in the forex market come from various sectors, each with different trading goals and strategies.

Large Financial Institutions

These giants in the interbank market execute hundreds of billions of dollars daily, trading for their own portfolios and acting as counterparties for clients. Based on supply and demand, they continuously provide buy and sell quotes to the market.

Multinational Corporations and Commercial Banks

Companies like Apple purchasing parts from Japan need to pay in yen, and European firms engaging in international trade need to convert currencies—such demand drives part of the market volume. They typically work with commercial banks to complete currency exchanges.

Central Banks and Government Agencies

Central banks influence exchange rates by adjusting interest rates and also directly buy and sell currencies to achieve policy goals. The Federal Reserve, European Central Bank, Bank of Japan, and others are active participants. When a country’s central bank believes its currency is overvalued or undervalued, it may conduct large-scale transactions to adjust the exchange rate.

Speculators and Retail Traders

Speculators buy undervalued currencies expecting appreciation for profit. Due to continuous fluctuations and uncertainty in exchange rates, this creates profit opportunities for traders.

How Has the Forex Market Evolved?

Bretton Woods Era (1944-1971)

After World War II, major Western countries established the Bretton Woods system, pegging all currencies to the US dollar, which was convertible to gold. The goal was to maintain relative stability in global exchange rates. However, as economic growth rates diverged, this fixed system gradually collapsed.

Start of the Floating Exchange Rate Era (1971-Present)

In 1971, the Bretton Woods agreement was officially abolished, and the world entered the floating exchange rate era. Since then, exchange rates are determined by market supply and demand, no longer fixed artificially. Initially, the market struggled to quickly discover fair prices, but advances in computer and communication technology greatly improved trading efficiency.

Retailization Era (Post-1990s)

Banks began developing their electronic trading platforms, and entrepreneurs created retail forex brokers targeting individual investors, allowing ordinary traders to access the forex market. The internet reduced trading costs, increased liquidity, and significantly expanded the base of market participants.

Two Main Models of Forex Brokers

Market Maker Model

Market makers set their own bid and ask prices, with retail traders trading directly against them. For example, a market maker might quote EUR/USD at a bid of 1.2000 and an ask of 1.2002; the spread (0.0002) is the profit margin for the market maker.

Although the spread on a single trade may seem small, when millions of such trades occur daily worldwide, the accumulated profit is substantial. The advantage of the market maker model is fast execution and controllable costs.

ECN Broker Model

ECN (Electronic Communication Network) brokers connect directly to liquidity providers in the interbank market, automatically matching the best bid and ask prices for clients. Traders can choose their own order prices, and ECN brokers charge commissions instead of spreads.

This model offers smaller spreads, higher transparency, and lower commissions, making it more attractive to cost-sensitive traders.

The reason why the forex market is the most active financial market globally lies in its multi-tiered structure, diverse participant composition, and relatively free trading mechanisms. Whether you are a hedge fund or an individual investor, understanding how this market operates is the first step toward successful trading.