An Introduction to the Journey
Now of course it would be absolutely unrealistic for me to give you a complete look into the world of FX (which is an abbreviation of Foreign Exchange), so this will only be a quick bird’s-eye view. In the most basic of explanations, foreign exchange is the mechanism of exchanging one currency for another.
It is quite hard to believe that the largest and most liquid market in the world is a relatively new market, compared to the stock market which dates back many centuries. Ten years ago the Wall Street Journal estimated the daily trading volume in the FX market to be in excess of $1 trillion. By 2013 that figure had grown to exceed $5 trillion a day! However, keep in mind that the main reason why there was no real Forex market back in the day is because the vast majority of world currencies were derivatives of a standard to gold.
The very basis of how we trade goods from one country to another is made possible through the FX market. Businesses use FX when they buy goods from other businesses in the other countries. For example, if you are living in the UK and want to buy the finest of wines from France, either you or the company that you buy the wine from has to pay the French for the wine in Euros. This conversion of currency goes through the FX market at the current exchange rate. This rate fluctuates every second based on supply and demand for each currency.
Now taking the idea of fluctuating exchange rates brings forth the concept of speculation. Speculators will attempt to buy currencies which they think will increase in value and sell currencies which they think will decrease in value. Sounds awfully simple, doesn’t it?
However, unlike a stock, currency valuation is relative to the value of other currencies and that is why the price is given in relation to a second currency. It gets a bit more complicated when you have to consider factors that may affect both currencies. Many different factors that affect supply and demand can drive the price and volatility of a currency, including economic factors, political conditions, market psychology and technical trading. Things don’t sound so simple anymore, right?
Considering the earlier example of purchasing the finest French wine, and scaling this idea onto an international level with consumers and suppliers in all 196 countries in the world, allows us to consider the importance of International Businesses in the FX market. The transfer of goods from one country to another is paid in the local country’s currency. This type of trading happens everywhere and every day.
Tourists, to a lesser extent, have an impact on the FX market too. Individuals purchase foreign currencies with their local currency in order to travel and spend money on fancy souvenirs. The level of tourism from one country to another can also affect the fluctuation of an individual exchange rate.
The Past into the Present
The Forex market is a cash inter-bank or inter-dealer market, which was established in 1971 when floating exchange rates began to appear.
Prior to 1971 towards the end of WWII, the Bretton Woods Agreement was created as an attempt to fix currencies permanently. A set value was decided for each currency relative to the US dollar, whilst the US dollar was separately given a peg of $35 per ounce of gold. This prohibited countries from devaluing their currency to improve their trade position by more than 10%. Before all of this the gold exchange standard had been used since 1876, preventing kings and rulers from arbitrarily debasing money and triggering inflation.
The natural supply and demand influenced the fluctuations of gold reserves a country had, leading to cycles of boom and bust until the outbreak of WWI, which interrupted the free flow of trade. This was what mainly led to the creation of the Bretton Woods Agreement and shortly after, the abandonment in 1971.
From this point onwards things started to get a bit more interesting. By 1973 currencies became more freely floating, controlled by supply and demand. The increase in volume led to new financial instruments, market deregulation and open trade which led to the rise in power of speculators. In the 1980’s the advancement in technology allowed market interaction through Asian, European and American time zones.
Now in 2016, technology has led to the development of new banks, electronic brokers with dealing rooms that trade the FX market daily with million dollar trades being executed every second. The FX market has grown exponentially through time with more and more people having greater influence on price action.
We now have significant market players who can bring down major Institutions like the Bank of England, make $1 billion on a single trade, and cause an entire nation’s currency to fall as traders pile into short positions.