Foreign Exchange 101
Foreign Exchange is the trade of currencies. It underpins all inter-currency exchanges on the planet. It's abbreviated as Forex, ForEx, and FX.
Forex trades usually happen relatively immediately as "spot" trades or sometime in the near future "forward" trades. Spot trades usually occur within two business days of the initial trade date, while forward trades can be anywhere from a few days to about a month out from the initial trade date.
Forex products are quoted with the terms "bid" and "offer", which function as "buy" and "sell". A trade/order might look like "Bid 1.3456 / Offer 1.3459".
The FX Market
The FX market is the largest "over the counter" market in the world - OTC means that there is no organized or prescribed exchange on which trading must occur. Market makers always act as principals, and have no obligation to pass any price on to their clients. Because of this, FX market makers are usually unable to charge commission fees to their clients who want to trade currencies, to the point that many countries have simply made commission charging on OTC FX transactions illegal.
FX brings in money for an institution by participation as a Principal Market Maker and through Fusion/Agency. What both of these roles do is provide revenue or profit by charging fees for taking risks on assets and performing services for clients.
A market maker is a firm that actively participates in making and providing bids and offers in what's called a two-sided market (which is a market where buyers and sellers of a product can engage). FX market makers can make or lose money on any transaction, and the market is highly competitive, which does not allow for much opportunity to charge large/exorbitant spreads (the difference between a buy rate and a sell rate between two currencies).
An example of a principal market maker is Morgan Stanley: they'll also engage in bids and offers on Morgan Stanley assets. As a market maker, an institution like Morgan Stanley makes money via compensation for holding risk. They might buy an asset from a seller, but they'll tack on a fee and negotiate a favorable buying price in order to offset the risk of the asset declining in value before they get an opportunity to sell it to someone else for a profit.
Market makers like Morgan Stanley will figure stuff out about a given bid/offer like the mid price and then run the numbers to find out what they should charge as a fee and what they should buy/sell at to offset risk and/or make a profit.
Continuing with Morgan Stanley as our example financial institution, Fusion/Agency is the idea that an institution like Morgan Stanley also becomes a market of its own where customers can go to them and find bids/offers for other customers, and Morgan Stanley is then able charge a commission/fee for their services on top of any existing fees they charge for taking risk on assets. The twist for Fusion/Agency is that Morgan Stanley isn't the only agency offering these services, so customers have a variety of firms to choose between, but Morgan Stanley will adjust/not charge fees in some cases to stay competitive.
Who participates?
Commercial and investment banks are usually the market makers in foreign exchange, think J.P. Morgan, Morgan Stanley, etc. Traditionally, commercial banks are in the forex market because they serve corporations who needed access to currency markets; can't conduct international business without being able to exchange currency.
However, currency transactions that are "traditional" to everyday people like imports, exports, transfers, and tourist activities are known as "current account transactions" and are subject to a different set of rules than capital market transactions in regards to forex.
While commercial and investment banks are starting to blend together in regards to the sectors they cover, investment banks/houses are usually in the forex market to facilitate international investment flows, cross-border mergers and acquisitions (M&A), and cross-border financing.
Central banks and national governments are another group of players in the forex market, and as the guardians of national currencies, they set monetary and rate policy. Some countries, like Japan, take a very hands-on approach to managing the exchange rate of their currency. As a counter-example, the United States is more hands-off in management. Central banks are the executioners of these policies. Governments usually only step into managing the market because of economic needs.
Corporations use the forex market to facilitate international business and use currency markets as a hedge for other investment attempts. Sometimes, corporations will actively trade currencies for profit.
Money managers use the forex market to diversity portfolios and acquire foreign currency needed to pay for investments abroad. Hedge funds will also use the forex market to diversify their portfolios.
Who doesn't participate?
Everyday people do not participate in the forex market. They might participate in tangential ways like buying and selling goods and services from/with companies, but foreign exchange requires a significant amount of capital for participation. Individuals who do attempt to participate in the forex market will require extremely high amounts of leverage, which is a large risk.
The only individuals who might hope to participate in the forex market are those with high net worth ($10-20 million as of '04).