3-Minute Guide to the Forex Market: Understanding How the Foreign Exchange Market Works from Scratch

What exactly is the Forex Market? Why is it called “decentralized”?

Many people feel a bit confused when they first hear about the Forex Market concept. In simple terms, the Forex Market is the foreign exchange market, the largest financial market in the world. But its biggest difference from the stock market is—there is no single unified exchange.

What does this mean? Stock trading has a central exchange like the New York Stock Exchange, where everyone sees roughly the same Apple stock price. But in the Forex Market, the EUR/USD exchange rate may vary slightly among different traders because the quotes are decentralized. Although it sounds chaotic, market participants form a clear hierarchical structure.

The three-tiered pyramid of the Forex Market: Who is deciding your trading costs?

First layer: Interbank Market — The Brain of the Market

Imagine the world’s top banks (Citibank, JPMorgan Chase, UBS, Barclays, Deutsche Bank, etc.) quoting prices to each other every day. They trade directly via phone or electronic broker platforms (like EBS Market and Reuters Matching). These big banks set the fundamental global exchange rates.

But there’s a threshold—not everyone can trade at these best rates. Exchange rates largely depend on the credit relationships between banks, similar to loans; banks with better credit get more favorable rates.

Second layer: Institutional Traders — The Middlemen

Hedge funds, trading companies, large corporations, and retail market makers operate at this level. They can’t access the interbank market directly (due to insufficient credit relationships) and must go through commercial banks as intermediaries, so their rates are slightly worse than those in the first layer. For example, Apple sourcing parts from Japan needs to exchange yen? They trade at this level.

Third layer: Retail Investors — The Excluded

In the past, retail traders couldn’t access the forex market at all. But the internet changed everything—retail brokers and electronic trading platforms now allow ordinary people to trade currencies. Although retail rates are worse than the upper two layers, they finally get a ticket to participate in the world’s largest financial market.

Who is driving the Forex Market? Five key participants

Major Investment Banks: Decide the base exchange rate, with astonishing daily trading volumes

Multinational Corporations: Need to exchange currencies for international trade, making them stable participants

Central Banks and Governments: Influence exchange rates through interest rate adjustments, buying and selling operations, or direct intervention. For example, the Bank of Japan often does this

Speculators: Buy currencies they expect to appreciate, hoping to sell at higher prices. Because exchange rates fluctuate constantly, they have profit opportunities

Retail Traders: Increasingly more ordinary people are participating. Although their costs are the highest, the market is now open to them

The evolution of the Forex Market: From fixed exchange rates to free floating

After World War II, Western countries adopted the Bretton Woods system, tying the US dollar to gold, with other currencies pegged to the dollar. The goal was to stabilize the global economy, but as different countries’ economies developed at different speeds, this system became increasingly unsuitable.

In 1971, the system was abolished, replaced by a floating exchange rate regime. Exchange rates began to be determined by market supply and demand, with much greater volatility. Initially, technical limitations made pricing difficult, but with the rise of computers and the internet, these issues were resolved.

After 1990, retail forex brokers emerged like mushrooms after rain, finally giving ordinary investors the chance to participate in forex trading.

Two models of Forex brokers: Your trading costs can vary greatly

Market Maker

Brokers set their own bid and ask prices. It’s like going to a bank to exchange dollars—you must accept their quoted rates, no bargaining.

For example: EUR/USD bid price 1.2000, ask price 1.2002, the spread is 0.0002. It seems small, but with hundreds of millions of trades daily, this spread becomes a huge profit for the broker. Retail traders usually face the highest trading costs.

ECN (Electronic Communication Network)

ECN brokers do not set their own prices but instead source the best bid and ask prices from the interbank market and automatically match clients. Since traders can set their own prices, ECNs typically charge lower commissions.

Comparison result: ECN spreads and commissions are much lower than those of market makers, making trading costs for retail traders significantly lower on ECN platforms.

Why is understanding the structure of the Forex Market important?

Understanding the hierarchical structure and participants of the Forex Market essentially means understanding: your position as a retail trader in the market, and where your trading costs come from. Choosing the right type of broker (ECN vs. Market Maker) can directly impact your profits and losses. The Forex Market isn’t complicated; what’s complicated is how to find your opportunities within this largest global financial market.