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What is Forex and How does it work?

27 Jan 2023 - Forex Litigation - Min Read 8 min
What is Forex and How does it work?

The Foreign Exchange Market is is a decentralised global market for the exchange of currencies, giving the term Forex, and its further abbreviation, FX.

The principal actors are brokers, those who liaise with financial markets, and traders, meaning private investors, banks, institutional investors, or hedge funds.

The hall of negotiations is the Forex market, where international currencies are bought and sold.

It can be considered the largest market in the world, because any transaction of different currencies passes through it.

Since it is the largest, it is also considered amongst the most complicated markets, because currencies are subject to rapid and unpredictable variations.

Without adequate preparation it is impossible to manage transactions technically, let alone emotionally.

The currencies are exchanged in an “over-the-counter” market, meaning without a specific residence.

Obviously other actors involved have their own specific geographical location.

The peculiarity of the FOREX lies in its extreme liquidity: the Forex is undoubtedly the most liquid market in the world, generating daily trades averaging between 3 and 4 billion dollars.

This is the prime element that makes it the market of choice for various traders and investors: the high liquidity allows prices to suffer less from strong speculative movements, and to always find a counterparty, for any exchange.

How does trading in the Forex market work?

Forex trading means trading up and down on currency pairs.

A currency pair consists of two currencies, the price relationship of which is called a currency exchange rate.

Whenever you hear, for example, “euro-dollar exchange rate,” you are talking about Forex.

The relationship given by the value of the euro and the dollar, the value of which is determined by purchases and sales, is called the exchange rate.

Through CFD, Contract for Difference, you can trade on the Forex exchange rate. One can decide, for example, to bet on a rise in the exchange rate, to get results proportional to increases in the rate, or one can imagine that there will be a decline, at which point the results would be related to declines in the exchange rate.

When trading forex, one speculates that the price of the base currency will rise or fall relative to the counter currency. Thus, in GBP/USD, i.e., Pounds Sterling versus U.S. Dollars, it should be assumed that the pound will increase in value against the dollar, or if the opposite will happen.

To summarize: one buys one currency and simultaneously sells another, and the exchange takes place through a broker, or dealer.

How is the Forex market regulated?

The Forex market is less regulated than expected, given its vastness, as there is no dedicated body to govern it.

The member states of the European Union abide by Directive 2004/39CE, known as MiFID II, while in general, at the national level, Forex is monitored by designated Entities.

Each individual Entity, authorized by its country, sets the standards and rules to be observed and is responsible for overseeing the FX market.

The Entities cooperate with each other and with local law enforcement authorities, exchanging information.

Brokers who want to operate, adhering to the rules, must apply for a license from the regulatory bodies.

Brokers who are licensed, go through continuous analysis, which is why they offer more assurance to investors when unclear situations arise.

If brokers do not comply with the rules, fines, revocation of licenses or closure of companies are triggered.

Once the company’s assets are seized, herby closed, defrauded customers can be reimbursed through compensation systems. But this is only applicable to the people who has already reported it.

The infraction may also lead to criminal penalties.

The Forex Market Operators

In the large and democratic Forex market, we can distinguish several figures that can be summarized as follows:

  • Forex trader
  • Forex brokers
  • Forex regulation authorities

Forex traders

Traders are people who make financial decisions in the markets.

They can be distinguished into two main categories: day traders and position traders.

Day traders trade daily, while position traders may hold their positions for weeks, months or even years.

In the case of Forex, they use a trading platform to better manage their investments.

Traders can be considered the individual private investor, who decides to “bet” his or her money in Forex, but also a multinational corporation, which buys foreign currencies as a form of hedging investments made in foreign currencies, a bank, which wants to increase (or reduce) its foreign exchange reserves, or again, an investment fund that wants to maximize profits from client savings.

Forex brokers

Financial brokers are intermediaries that are responsible for connecting all Forex traders to each other to facilitate trading.

This is done through a platform or software made available to clients.

Commissions will go to the Broker, the amount of which will depend on the exchange rate at the time of the trade.

Forex Regulation Authorities

The Regulation Authorities monitor the normal course of Forex trading, verify that brokers have the qualifications to trade, and shut down sites considered unreliable.

In Italy, the Consob, the National Commission for businesses and the stock market, which deals with the safeguarding of investors, took some measures against abusive operators.

The agencies operate through warnings (cautionary notices) regarding “entities that have been operating through the Internet channel, enacting violations of intermediary regulations” and sanctioning those who operate without authorizations. Consob can rely on an international network of supervisory bodies:

  • ESMA (European Securities and Markets Authority) – Europe;
  • AMF (Financial Market Authority) – France;
  • FCA (Financial Conduct Authority) – England;
  • CySEC (Cyprus Securities and Exchange Commission) – Cyprus;
  • NFA (National Futures Association) e CFTC (Commodity Futures Trading Commission) – USA;
  • FINMA (Federal Authority for Financial Market Supervision ) e ARIF (Romande Association of Financial Intermediaries ) – Switzerland;
  • BaFin (Bundesanstalt Für Finanzdienstleistungsaufsicht) – Germany;
  • ASIC (Australian Securities and Investment Commission) – Australia;
  • British Columbia Securities Commission e l’Ontario Securities Commission – Canada;
  • Danish FCA – Denmark;
  • Securities and Futures Commission of Honf Kong – Hong Kong;
  • Comisión Nacional del Mercado de Valores –Spain;
  • Finansinspektionen – Switzerland.

Brokers should provide some information about the firms to which they report and specify whether they have been approved by any regulatory authority (and if so, by which one).

In this way, investors could distinguish companies that do advice in a regulated manner from those that do not and make appropriate considerations.

Leverage in Forex and its risks

Forex is a market open to everyone, regardless of age or financial ability. The investment of modest sums is allowed by the possibility of taking advantage of “Leverage”.

Obviously, if the investment does not bear fruit, the money invested is abruptly lost, and if you are unable to cover with other funds, you may not have a chance to recover.

In Forex one can find oneself in the condition of being able to invest small amounts but find oneself virtually in possession of enormously larger sums.

This is because the value is made to increase exponentially through levers.

Thus, by depositing even a minimum amount of 100 euros, with a leverage of 1:100, each euro will produce its own profit of 100 €.

What was initially 100 euros will have the value of 10,000 euros.

This means that a movement of 1% can produce a profit of 100%, but also a loss equal to the amount initially invested.

In online trading, 1% can move in no time at all and, if you are below capital on it, you can see investments disappear immediately.

When you use leverage, the amount that the trader deposits is considered a “Margin”, that is to say a guarantee that serves to cover the display relative to the position that it wants to open up.

The “Margin Call” serves as a warning when the account is about to go negative by preventing this from happening.

The margin always represents the initial balance, and not the one to be used.

The risk with leverage is that you will find yourself cut off from the market because you do not have the resources to supplement what you have lost: if you don’t deposit money, at the right time, you are left with the losses only; if you deposit you might recover but if it goes wrong, you also lose the rest of the money.

A few terms to know

Margin: deposit carried out in the account.

Used Margin: the margin held back by the broker to keep the positions open. They cannot be touched because they remain fixed, guaranteeing active positions.

Usable margin: money still available for the opening of new positions. It is equal to the equity minus the used margin.

Equity: the usable margin added to the used margin. If the usable margin falls it can only cause equity to fall as well.

Margin call: request to supplement the margin.

PIP (Price Interest Point): in a price quotation it corresponds to the fourth decimal figure for the major currency pairs, if in the couples there is the Yen involved, it is in fact the second. Every PIP is 1/100 of one cent. One talks in terms of PIPs when small capital is moved.

CFD (Contract for Difference): a type of derivatives contract under which the difference in value of a certain security or underlying asset, accrued between the time of opening and closing a contract, is exchanged.

Spread: This indicates the difference between the price of acquisition and price of sale of a currency pair.

Lot: The unit used to measure the dimensions of forex transactions. The dimension of a standard contract is 100,000 units of the initial value. It would not be negotiable without leverage.

Leverage: This is a sort of loan. It allows trading operations to be executed with money on their own part and part made available to brokers.

Why investing in Forex is risky?

Investing in Forex is risky because we cannot deny the accuracy of making money as well as the possibility of having access to a large amount of capital by the people who do not actually possess it. Herby, all this liquidity attracts too many scammers!

Never underestimate the risk, no matter how much you invest, scammers are looters who take advantage of our weaknesses and try to grab even the most insignificant investments. When you invest, learn to recognize the warning signs: what seems too good to be true is never true.

To avoid falling victim to Forex scams, it is important to do thorough research before investing. Make sure that the broker or fund manager is licensed and regulated and has a good reputation.

Although it is not possible to eliminate the risk of being scammed in Forex trading, knowing about Forex scams and how to recognize them can help traders prevent any problems. By taking proper precautions and doing thorough research on brokers and fund managers, it is possible to avoid being a victim of Forex scams.

Before investing “in earnest,” consider practicing on demo accounts, made available by all major trading platforms, always be careful, however, that once you move on to real-money investments, different emotional factors come into play.

If you have invested and lost money in Forex, try to reflect and figure out whether it was your own failing, or perhaps bad luck, or whether you ran into a dishonest broker.

In the latter case, report the broker to the appropriate authorities, only then can you take the first useful step in recovering your money.

In case you think you need legal assistance contact our lawyers in the Forex Litigation Department, who are always available for clarification and advice.

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Calogero Boccadutri

Calogero Boccadutri is the Managing Partner of Boccadutri International Law Firm. He has trial experience in Forex, Personal Injury and Administrative litigation.

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