What Exactly is Forex? (Part Two)

What Exactly is Forex (part two)

What Exactly is Forex? (Part Two)

A brief review of the birth of money and today’s digital exchanges

In part one we tracked the creation of currencies from ancient time, leading up to the mid-20th century. By then organised multinational trade that required a connected monetary system with an easier exchange of national currencies was established, but the war changed everything.

After the end of WWII, the devastation caused by the conflict was widespread and there was hardship all over Europe and most of Asia. Before the Marshall plan came into full swing, the Bretton Woods Accord was signed. Under it currencies were only allowed to move in a 1% range, and a “gold standard” was introduced – countries fixed their currencies to the ascending U.S. dollar and by proxy to gold – one ounce of gold was priced at $35. All this was done in order to restore stability and predictability to a shaken world and marked the leading role of the USA in the post-war era.

This brings us to 1971-73, a period which saw a loosening of the range to 2%, a tripling of the volume of currency trading and, perhaps symbolically, the introduction of monitors in place of phones and telex on trading floors. This new era was proving that centralised trade, within ranges and performed only by countries and their central banks was no longer effective and couldn’t maintain the rate of development of countries and their currency needs.

One by one all countries allowed the private exchange of currencies without physical ownership and this has led to today’s state of affairs.

Foreign exchange still has different levels of activity. The highest level is called the interbank market, where central and private banks and liquidity providers act. The spread and volume here are not public and remain something shared only between the parties that take part in the transactions, although it is known that this segment accounts for 39% of all trading.

The second-highest level is where relatively smaller banks and multinational companies operate, as well as the largest insurance companies, hedge, pension and mutual funds. The insurers and different funds have grown into this role only recently (i.e. the last 15 or so years). This is the reason why forex traders pay attention to what their CEO’s and fund managers have to say.

Central banks also have to be mentioned here, although they are only occasional participants in the actual buying and selling of a currency (and are more frequently reported on when they buy gold). With their role in setting interest rates, combating inflation and unemployment they exert the largest direct influence on the condition and perception of a country’s financial stability. It’s worth mentioning though, that the central banks aren’t the main engines behind an economy – these have always been innovation, efficiency, work rate and on occasion – military power.

So what stands behind the USD sign and the EUR. For one thing – it’s definitely not physical money – most of the world’s currencies (as much as 90% according to some estimates) are in the form of something like a complex IOU.

Without going into too much detail about debt, inflation and more complex finance, we can still say that currency is what the people dealing with it perceive as its value. Imagine all the daily transactions in shops, restaurants and hotels where cash or credit is used. All these, combined with the transactions between local and international companies make up its value. Being a fiat currency (not backed by something physical), the collective opinion these transactions create is what forms the foundation of its value. When there is a large scale shift in perception, or if the largest players change their expectations after an actual improvement or worsening of GDP or another economic indicator, then larger and sharper movements can occur – making it important to follow the announcements for inflation, employment and interest rates, so that you can feel the pulse of an economy and its currency.

In all of this, retail forex has a relatively small volume, estimated at around 3.5% of the $5.3 trillion overall market. Trading for individuals has seen tremendous growth with the spread of high-speed internet and more user-friendly, web-based platforms, as well as trading on margin.

The future of currencies and their exchange promises a lot of opportunities for all. More and more complex algorithms are being used for actual trading, including high frequency trading. New currencies will become more readily available for trading, including the Chinese renminbi, as well as virtual currencies born out of the Web like Bitcoin and Litecoin. Interesting times ahead.

Our next article will be out tomorrow at 4:00pm GMT – “Before the event: Google, Amazon and Alibaba with earnings in one day”.

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