Abstract
This chapter describes the structure and microeconomics of the foreign exchange market. It begins by outlining the major participants and the instruments they trade and highlights the vast institutional changes that accompanied emerging electronic trading since the 1990s. The chapter then discusses how and why order flow drives exchange rates, the economics of liquidity provision, the price discovery process, and volatility. It concludes that order flow is a crucial driver of exchange rate returns. The influence of order flow reflects private information and the finite elasticity of currency demand, especially corporate demand. The chapter also concludes that the microstructure of currency markets differs in striking ways from the microstructure of some other well‐studied markets, so exchange rate models must be carefully designed. Strategic dealing and market power considerations rather than adverse selection dominate bid‐ask spreads for foreign exchange customers. Exchange rates are driven by the interaction between corporate flows, which are mostly nonspeculative, and financial flows, which are mostly speculative. Any microstructurally rigorous model must include both.