Forex, From Zero to IDK

Foreign  -> For
Exchange -> Ex
Market

Forex, aka realtime currency exchange, what is it and how does it work?

Is it physically a market?

Market

As in any financial market, each currency pair has sellers and buyers (e.g. if the pair is EUR/USD, there is someone who wants to sell EUR in exchange for USD and someone who wants to buy EUR using USD).

Taking the EUR/USD exchange rate as an example, we therefore have two prices at any given time, the Bid Price (the maximum USD amount that any entity is willing to pay for EUR in the given moment) and the Ask Price (the minimum USD amount that any entity is willing to receive to sell EUR in the given moment). When the prices of the buyer and of the seller coincide, the actual financial transaction on the broker takes place.

Midmarket

At any given time, the two price values may have some difference, called spread, and to try to return the most representative value, most of the currency conversion services decided to show the midmarket rate to the user, which is nothing but the average between the Bid price and the Ask price.

Examples of the use of midmarket rates

Decentralization

The forex market is decentralized and therefore is open 24 hours a day, because there is no single source that returns all current prices on worlwide currency exchange, but instead there are many brokers each independent of the other. It is so by definition: each bank, institution or currency exchange is in fact independent of the others and has its own currencies.

The broker can certainly help match supply and demand, but it isn’t strictly essential. Potentially if one person has tons of euro banknotes and another has a suitcase full of dollars, they can arrange with each other for a physical exchange by hand and no one will know anything.

This concept can be summarized in the term Over The Counter (OTC), an unregulated market where anyone can participate in it, unlike for examples shares of companies (e.g. Apple, Microsoft) that must necessarily be listed on a stock exchange such as the NYSE (aka Wall Street), NASDAQ, etc.

If you are one of the previous websites that needs to accurately return the current currency exchange value, for example, it isn’t enough to take the midmarket rate exclusively from one source and trust it blindly; to get a value as accurate as possible, it’s necessary to aggregate several midmarket rate values into one, making a weighted average of them.

Outliers filtering

Not all currency conversion values taken from different providers are equally reliable. If a broker has a low volume of transactions at a certain time, for example, it is very likely that its value will deviate from what the actual forex market prices are.

If we want to get an accurate result, we cannot afford to include these prices that don’t meet current market values (outliers) and we must therefore do what we can to identify and eliminate them from the calculations as soon as possible, using all the data available (not only the raw midmarket rates, but also something like the latest rate update time, source reliability, etc.).