Foreign exchange: global trends

By its very nature, the foreign exchange (FX) market is in a constant state of flux. The value of currencies is based around macro-economic trends, which means that world events can have positive, or potentially disastrous, implications for a particular currency.

However, one constant theme over the last few years has been the US dollar's decline from a global powerhouse to a weak kitten on the world stage. This is largely because of continuing concerns over the US economy, its housing sector, banks and fiscal position. It's also having a knock on effect to currencies pegged to the dollar, within Asia and the Middle East.

Similar concerns over growth and inflation in the UK have led to sterling taking a tumble in recent months, while the euro seemingly goes from strength to strength.

While these factors are obviously important for traders, FX is all about predicting how economic factors will influence the likelihood of one currency rising (appreciating) or falling (depreciating) against another.

FX desks have been an importantly lucrative area for banks this year, and trading volumes have been heading upwards for a number of years now. Last year, for instance, global turnover rose by 41% to reach $175 trillion from $125 trillion in 2006, according to data compiled by Euromoney magazine.

Julian Wantling, MD and London head of FX distribution at UBS, says: "When volatility increases in other markets, FX tends to be traded more with active currency hedging of underlying equity and bond exposures. This is a time also where FX as an asset class becomes more attractive, as risk is reduced in other asset classes."

Other contributing factors to the FX market's growth are increasing trading by hedge funds, portfolio diversification, algorithmic strategies, retail trading and globalisation, according to a study by Greenwich Associates.

Banks have started to embrace the use of technology in the foreign exchange space, after a period of apparent reluctance. IT consultant Celent predicts that by 2009-10 electronic foreign exchange trading (or eFX) could account for 75% of the inter-dealer spot trading market (where market makers trade with each other) and 50% of the dealer-to-client market.

Deutsche Bank, the world's biggest FX player, says it has invested heavily in technology for its foreign exchange business and now 50% of its total trading volume is done electronically.

Click here for an explanation of the foreign exchange sector.