How Foreign Exchange Works

Russell Gous
Last Edited Nov 28, 2023

On the face of it, foreign exchange can seem like a complex minefield that’s only for the financially-savvy.

Indeed, there’s an argument that some in the industry prefer to keep it this way in order to exploit customers and make as much money as possible.

To be honest, having worked at banks and currency brokerages in the past, I’m inclined to agree.

In this guide, I’ll provide an overview of exactly what the foreign exchange market is, how FX works and how banks and foreign exchange providers make money.

We’ll round it off by seeing what the future may hold for the industry too.

What is the foreign exchange market?

The foreign exchange market in its totality can be thought of as the global marketplace where various financial instruments that relate to currencies are traded. 

That could be buying, selling or speculating on currencies.

Let’s explore some of the key features of the foreign exchange market.

It operates across the globe

Technically, there is no ‘one’ foreign exchange market. 

There are various foreign exchange markets, with the most popular being the UK, USA, Singapore, Hong Kong and Japan.

London sees by far the biggest share of trading activity, meaning it’s a time where currencies are said to be more ‘liquid’ and tighter spreads are possible. 

FX Market by Country
FX Market by Country

Increased trading activity can also lead to increased volatility, meaning profits and losses can be larger too.

Other sizable FX markets include Switzerland, France and Germany.

It runs 24 hours a day

The three major FX trading sessions are known to be:

  • Tokyo (Asian session)
  • London (European session)
  • New York (North American session)

With the Sydney forex market completing the 24-hour loop, meaning currencies can be traded 24 hours a day during the working week (5pm Sunday – 4pm Friday).

The 24-hour nature of the FX markets was evidenced when the pound fell by more than 10% overnight following the Brexit referendum.

It’s the largest financial services market in the world

A mammoth $7.5 trillion is traded every day across a number of different foreign exchange products.

Most Popularly Traded FX Products

FX Products by Volume

Spot FX refers to FX transfers done “on the spot”, i.e. at the time the transfer is initiated. 

They’re the most likely product that you or I would turn to when sending or receiving money from abroad.

But, as you can see, they actually only account for around a quarter of all foreign exchange activity. 

This is largely because FX trading actually dwarfs the amount of foreign exchange that is conducted for transactional purposes (more on this later).

See our relevant guides to learn more about other types of FX transfer, like FX swaps and FX forwards.

All in all, there are 180 currencies recognised by the United Nations and some FX providers let you trade 150+.

Most Popularly Traded Currencies


USD is by far the most popularly traded currency, followed by EUR, JPY and then GBP.

How are currencies valued?

There are two types of currency exchange rates – fixed and floating.

Fixed currencies

Some countries choose to peg their currency to another currency (often USD) so that both currencies move identically.

Countries that opt for a fixed exchange rate are usually developing countries seeking currency stability.

Pegging to a secure currency like USD helps to reduce a currency’s volatility, which can increase confidence in international trade and promote economic stability.

The trade-off is that it relinquishes a country’s policy autonomy and can have an impact on free trade and liquidity.

To operate a fixed currency, a country’s central bank typically commits to buy and sell its currency in the open market in order to maintain its pegged ratio.

This requires the central bank to have sufficient foreign exchange reserves in order to maintain the peg. A significant devaluation of the currency can occur if the central bank runs out of reserves.

Some currencies like the Hong Kong Dollar link to the US Dollar within a specified trading band. While it’s not a strictly fixed rate, it still provides the desired stability. 

Floating currencies

The vast majority of currencies operate on a floating basis. 

Like any financial instrument, a currency’s value when it is free floating is ultimately determined by the underlying supply and demand for it. 

When trading between two currencies, you’re balancing the supply and demand of one currency versus the supply and demand of another.

What impacts currency rates

Factors that influence the value of a currency include: interest rates, inflation, economic performance (demand), and quantitative easing (supply). 

Interest rates

Currencies of countries offering higher interest rates typically strengthen, assuming all other factors remain constant. 

This occurs because investors are drawn to higher interest rates, leading to increased demand for the currency and an appreciation in its value.


High inflation erodes the purchasing power of any individual or business holding that currency. 

This may lead to a decline in currency demand, resulting in a depreciation of its value.

Economic performance

Positive economic performance, like a growth in exports or GDP, should have a positive effect on a country’s currency.

Likewise, negative economic performance can have the opposite effect.

Quantitative easing

A higher money supply generally leads to a lower currency value, and conversely, a lower money supply often strengthens the currency.

Learn more about the economy around exchange rates:

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Today’s Currency Exchange Rates

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How currency rates impact people’s lives

Individuals, businesses and investors all need to consider how fluctuations in the foreign exchange market will impact their activities.

As an individual, you’ll find that when your domestic currency is stronger, going abroad becomes cheaper. 

Pound Sterling to TRY exchange rate graph (1 year)

For example, Brits will find their pound goes 62.5% further in November 2023 vs November 2022.

Each pound sterling is now buying 36.5 Turkish lira vs 22.5 Turkish lira in November 2022. Imagine the difference that can make to a restaurant bill.

As a domestic currency strengthens, imports become cheaper too. Buying that luxury handbag abroad becomes cheaper (relatively) than buying it domestically. 

But, it’s not all good news.

A strong currency isn’t necessarily good for domestic businesses. Raw material costs might be lower on import but, conversely, their goods become more expensive on the export market.

Reducing expert competitiveness can lead to a trade deficit for a nation and you’ll find that this actually operates as a self-adjusting mechanism to the value of the currency.

How do FX transfers work?

An FX transfer sees an exchange of one currency to another, at an agreed rate. 

A foreign exchange transfer often involves, but doesn’t have to involve, sending money to a bank account in another country.

At this stage, it’s important to differentiate deliverable FX transfers from speculative FX trading.

Deliverable FX

A deliverable FX transfer sees once currency exchanged to another for the purpose of it being used in the real world.

illustration of online money transfers

When a cross-currency transfer is required to buy goods and services, or to hold money in a bank account, this can be regarded as deliverable FX.

For example, deliverable FX occurs each time a business pays a supplier abroad or an individual buys a property overseas.

Forex Trading

Forex trading involves the speculative buying and selling of currencies in quest of profit.

It’s done with one broker or trading platform and the currencies stay within this platform. 

Profits from the platform can be withdrawn by the account holder to their account, but if they then wanted to send these profits to an account abroad, a deliverable fx transfer would be required.

How banks make money on FX

Banks profit through the foreign exchange market in two ways.

First, they generate fees through being market makers. They act as intermediaries between buyers and sellers and earn a profit from the spread they apply to the buy and sell price of a currency pair.

This could be when customers buy and sell currency for deliverable purposes or, in the case of investment banks, when they allow clients to trade forex for speculative purposes.

In addition to this, some banks make money by speculating on currencies themselves.

Let’s look at each of these in more detail.

Market maker

As a market maker, banks make a profit through the buy and sell price of a currency, adding a margin on top of the interbank rate.

This applies regardless of whether an FX transfer is booked for deliverable purposes or speculative purposes.

Deliverable FX

For deliverable FX, banks add a markup on the currency exchange on top of the interbank rate, alongside fixed payment fees.

This could be a very small margin when trading currency on behalf of other financial service providers and multinational corporations.

Or, it could be a very high margin in the case of trading currency on behalf of individuals and SMEs.

For individuals and SMEs, it’s common to pay a 3-6% currency exchange markup with a bank.

Speculative FX

In addition to deliverable FX, some banks trade currencies on behalf of forex traders who wish to speculate on the currency markets.

This could be individual investors, corporations, institutional investors like hedge funds or even governments and central banks.

When this happens, they’ll make profit through the buy and sell price of a currency, as well as any supplementary fees to book FX trades through them.

The amount banks trade on behalf of institutional investors exceeds the amount they process on a deliverable basis for individuals and businesses.

HSBC 2022 Annual Report

HSBC reports 2022

Global foreign exchange was the top performing area of HSBC’s Global Banking and Markets division in 2020, 2021 and 2022. 

In 2022, the firm made over four times as much revenue through FX trading than it did equity trading.

The revenue it made from FX trading also exceeded the sizable revenues from Global Payment Solutions, i.e. deliverable FX.

Currency trading

It doesn’t stop there for banks when it comes to profiting off FX.

In fact, for many of the world’s largest banks with their own FX trading desks, the revenue generated from providing services to clients is eclipsed by the profits they accrue from their own speculative currency trading activities.

The overwhelming majority of the $7.5 trillion which is traded every day is by institutional investors like hedge funds and investment banks. 

That’s more than investment banks trade in other financial markets like commodities and fixed income products.

Some individual traders are known to make their banks hundreds of millions of dollars, with one trader reported to make JPMorgan $300m in profits in 2021.

It’s the bankers on these trading desks who stand to make huge bonuses if they make big profits for their bank, or, stand to lose their bank a lot of money, if they speculate wrongly.

Unfortunately, the quest for profits and quite frankly, greed, has led some traders to collude and seek to influence FX markets.

The fact that only a handful of traders can influence the direction in which currencies move demonstrates the sort of volumes involved.

FX Banking scandals

Banks have faced mammoth fines from industry regulators for seeking to unfairly profit from the FX market in the past. 

In 2014, the FCA found six banks to have colluded in order to influence FX rates and put their clients at a disadvantage.

Traders were found to have shared information about clients’ activities which they had been trusted to keep confidential.

They attempted to manipulate spot FX currency rates, including in collusion with traders at other banks, in a way that could disadvantage other market participants.

The European Commission also completed a review in 2019, finding that five banks undermined the integrity of the financial sector at the expense of the economy and consumers.

Money transfer companies as bank alternative for FX transfers

When it comes to deliverable FX, there are now a plethora of alternatives to choose from which offer individuals and SMEs a better deal and better level of service. 

These came about in order to fill a gap in the market; banks were, and still are, overcharging for cross border FX payments. Here is some more information on the associated costs:

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Overall, these bank-alternatives are known as money transfer companies or foreign exchange companies.

Money transfer companies should hold a licence with the FCA as either an authorised payment institution or an electronic money institution.

I’ll explain the two major types of money transfer companies briefly now.

Currency brokers

Currency brokers are best suited when you have a requirement to transfer large volumes overseas (>£25,000).

With a currency broker, clients get direct access to their trading desk to discuss currency hedging strategies and are also able to book a variety of currency hedging products at bank-beating exchange rates.

This includes spot FX, FX forwards and FX swaps, providing it’s for a real purpose, like buying a property abroad.

You can’t speculate on the markets with a currency broker. 

To do this, you’d need to find yourself a forex broker that holds a different type of licensing with the FCA. 

Excellent examples of a currency broker include Currencies Direct and moneycorp.

Money transfer apps

The last ten years has seen a massive growth in fintech companies who help customers to send money overseas easily through a mobile app.

They’re best suited for smaller volumes (<£25,000) as you don’t get direct access to a real person who can assist you should anything go wrong.

Still, they offer low fees (much better than a bank) and have a slick interface that should make the whole process a pretty simplay affair.

Wise is the most popular money transfer app and indeed one of the largest non-bank money transfer companies in the world.

How do money transfer companies make money?

Money transfer companies make money through deliverable FX transfers.

There are town main types of fees. Let’s look at each of these now.

Payment fees

First, there are the direct payment fees associated with a transfer.

These fees can vary depending on the receiving currency and country.

They tend to be cheap when sending money to Europe and more expensive when sending money to the rest of the world.

Some currency brokers offer fee-free transfers to anywhere in the world.

Payment fees are easily evident. You should see it advertised prior to initiating a transfer.

Markup on the currency exchange

Secondly, there’s the markup applied to FX transfer.

This ‘fee’ is much less evident.

It’s the difference between the rate the provider can book a currency exchange themselves and the rate they offer you as the customer.

It’s calculated as a percentage of the overall transfer, so costs can quickly escalate.

Breaking it down

A foreign exchange company is able to book currency trades close to the ‘interbank’ or ‘official’ exchange rate. 

That’s because they buy large quantities of currencies from the bank and get a preferential deal.

Just like the way a large wholesaler of coca cola would be able to achieve a better cost then what customers pay at retail.

When you book an FX transfer with a foreign exchange company, they add their margin. 

As a rough guide, this could be anywhere from 0.1% to 2.5%, depending on the amount sent and the currencies involved.

It’s in this markup that a foreign exchange company really makes their profit.

It far exceeds the money they make from direct transfer fees.

The main issue for customers is that the currency exchange markup is not easy to spot.

It’s built into the exchange so often goes unnoticed.

This example should make it easier to understand:

  1. Interbank exchange rate for GBPEUR: 1.15
  2. Wholesale rate the provider gets: 1.1495
  3. Customer rate: 1.4725
  4. Spread applied by the provider: 1.5%

When booking a trade, you’ll only see one part of this equation – the customer FX rate and it’s up to you to calculate how far this is from the official interbank rate.

Some companies like Wise charge a ‘variable fee’ instead of an FX markup. 

This works in the same way but makes Wise more transparent as you can easily see exactly how much you’re paying.

Understanding the interbank rate

The interbank exchange rate is the rate that banks use when they’re trading foreign currencies with one another.

It’s the true midpoint between the buy and sell rate 

It’s simply not possible to access the interbank rate – after all, FX providers incur a whole bunch of costs to provider their service – but there’s definitely a huge opportunity cost in picking the wrong provider and paying over the odds.

As they specialise only in foreign exchange there should be significantly less unnecessary costs that aren’t related to providing an FX service. 

With this in mind they can provide better exchange rates to their customers than banks and more often than not, a significantly better service too.

The future of FX transfers

One of the hottest financial trends right now is the growth of digital currencies.

The term ‘digital currencies’ refers to all types of currencies that exist in the electronic, but not physical, realm.

This includes cryptocurrencies like bitcoin, which are decentralised, and the newly-mooted central bank digital currencies (CBDCs).

The use of CBDCs should, in theory, make fx transfers both faster and cheaper. 

Transfers on a centralised payment system may remove the need for intermediaries (like commercial banks) and could avoid their costly processing fees.

However, it’s still likely that some form of private company would be involved in order to provide the digital wallet and user experience. 

Using CBDCs for FX transfers would require both the sending and receiving country to have adopted a CBDC and whether a markup would be applied to the currency exchange remains to be seen.

What’s more, CBDCs are likely to be tested on a domestic basis first and CBDC FX transfers are probably still someway off. 

It could be that they’re not deemed appropriate at all.

Concerns remain on the use of CBDCs. They could be open to government interference, censorship, and manipulation.

Summary: the mechanics behind the foreign exchange market & FX transfers

Though FX might initially appear as a complex financial realm, beneath its surface lie some basic principles.

We’ve explored how the foreign exchange market operates, including its global nature, the factors influencing a currencies value, and how foreign exchange providers make money.

Past banking scandals have led to regulatory fines, highlighting the need for improved policies and culture within these institutions.

However, not all providers are aiming to maximise profits and exploit those needing to make an FX transfer.

Specialist foreign exchange companies allow you to send money with low, or no, payment fees and bank-beating exchange rates. 

Unlike banks, they do not speculate on the currency markets in the quest for profit. It goes against what their licensing allows them to do with customer funds.

They’re safe, credible and have vast experience in handling FX transfers.

The future of foreign exchange transfers may be shaped by digital currencies, but this still has a long way to play out.

Right here, right now, be sure to do your research if you have an upcoming requirement to make an FX transfer.