What is forex, a History of the Money Market ; Intro

Once upon a time a very long time ago, people had no need of money -Mainly because it hadn’t been invented yet! In those days each man used to exchange –or barter - what he had, for what he needed .This way each man in-fact created, stored and exchanged his own money.This was total monetary freedom at it’s best.

Over the ages as you shall in this and the following posts see ,we lost this freedom till at last in our present times the wheel has come full circle. Now in the age of the internet man's computer provides each man the ability to create, store and exchange his own money legally and as he wills. Want to learn more ? Read the next post.

Money in the Stone Age (Cattle, Crops and Fancy Items)

The earliest barter is thought to have involved cattle. Later with the development of agriculture ; crops and agricultural produce came to be used as a means of exchange. Even now in some agricultural economies of the third world the village cobblers, weavers, mechanics and even doctors, continue to accept agricultural produce as payment. But storing or carrying around huge quantities of goods for exchange can be a bother ! Another problem : you can’t barter if the other party does not need what you have; and even if they do , both have to decide on the relative value of the items being bartered before they can get on with it.

So you can see how even though it was not an issue for the “oldest profession of the world”, for all others it was important that a generally accepted and more common base for valuation of goods to be exchanged be established. In China around 1200BC. cowry shells became the first generally accepted medium of exchange. Thereafter the cowry has served as money throughout history –in some places even till the middle of the 20th century. Other economies began to use some other specific item, such as teeth, feathers, polished stones, etc.

Money In The Iron Age

At the end of the Stone Age, the Chinese once again took the lead. Around 1,000 B.C., they produced mock cowry shells made of base metal. In addition they used tools made of metal (knives and spades), as money. This was the world’s first metal currency! It gradually evolved into round pieces of the metal to be used as a means of exchange. The Chinese even solved the problem of carrying large number of such ‘coins’. They put holes in them to facilitate carrying them as a necklace!(This too was an idea which persisted till modern times, for as a kid I remember seeing a Pakistani one paisa coin with a large hole in it’s centre.) This was an age in which the common folk bartered, the moneyed gentry used base metal for exchange; while the ruling class accumulated precious metals and stones.

The reasons for this are obvious. Base metal was still a precious commodity, as whatever was available was barely sufficient for producing weapons and the tools required for the other important trades. Kings in particular needed huge quantities of base metal for equipping their armies. Apart from use of force, only precious metals could induce actual producers/suppliers of the needed metals and equipment to come up with the quantities required –but the use of force could be counter productive - and so treasuries to accumulate such ‘capital’ became a compulsion. Most famous of these are the fabled and now lost” King Solomon’s Mines’. Such treasuries were to become the fore-runners of our present day ‘State Treasuries and Banks’!

But with some kings this compulsion became an obsession, best exemplified in the story of Halaku Khan’s destruction of Baghdad. After ordering the massacre of every living being in the city, he invited the defeated King to a banquet. Here, instead of food ,the dining dishes were heaped full of gold, silver ,diamonds, rubies and other precious stones. On the poor man’s protesting how he could possibly eat them,Halaku counter questioned “then why did you gather them”, thereafter he ordered his beheading! This Incident was not the first evidence of anti-capitalistic thinking in history. Much before him the story of “Stephens” the first Christian martyr shows the communistic basis of early Christianity. But of course we digress, so back to a history of money.

Eventually even base metal became common and lost its value. And while we can assume that bartering including use of base metal continued to survive amongst the peasentry, its days amongst the increasingly prosperous merchant class and nobility were over. Amongst them, precious metals- in particular gold and silver, established themselves as an accepted means of payment as well as a reliable storage of value. Till around 500 B.C., pieces of silver were used as a means of payment. The control of money had even till then not been instutionalised!

Eventually however this form of money was replaced by coins of precious metals.These were also embossed with images of various gods and kings to mark their value. Such coins were first minted by the king of Lydia (Turkey), but after his defeat by the Persians metal coinage was adopted as the means of exchange throughout The Persian Empire.The Greek, Macedonian, and Roman empires built upon this ,till eventually officially minted bronze, gold, and silver coins became the predominant means of exchange of value throughout the world. The fact that these coins were composed of scarce metals such as bronze, gold, and silver, which had far greater intrinsic value,facilitated the process.Henseforth only Kings and Emporers could produce and control the use of money.Monetary control had finally been instutionalised and monopolised by the rulers.

Currency in The Middle Ages

In Europe , initially, coins minted from precious metals continued to be the preferred means of exchange.Never-the-less another form of currency besides coins emerged i.e. the introduction of a paper form of governmental I.O.U. Initially this type of I.O.U. was introduced more successfully through force rather than through persuasion.Subsequently it was universally realized that these paper bills represented transferable third-party payments of funds. They thus became the preferred means for making currency payments ,causing both regional economies and foreign exchange trading to flourish. Such an I.O.U. is now the basis of all of today’s modern currencies.

Currency In The Colonial Ages

In 1816, England pegged the value of it’s currency to a certain number of ounces of gold. This would help to prevent inflation of currency. By 1876 the gold remittance standard was in wide use and continued until the First World War. In 1900 even the U.S. went on the gold standard. Thus before the first World war, most Central banks supported their currencies with convertibility to gold i.e.paper money could always be exchanged for gold.

But, the gold remittance standard system had it’s defects. As a country industralises and it’s economy grows, it feels the need to import massive products which exhausts it’s gold reserve. The supply of the currency reduces, the interest rate rise, and so the economic activity starts to decline leading to recession. Finally the commodity prices fall to the lowest levels attracting other countries who rush in to purchase.Exports start rising , gold coming into the country increases currency supplies, leading to lower interest rates, and creation of wealth. A perpetual cycle of " prosperity vs decline” .Which by itself could easily lead to excess of printed currency,unless properly handled.

Moreover as, it was unlikely that all holders of paper money would request gold at the same time, banks only needed to keep a determined amount on hand to handle normal foreign and internal trade exchange requests (gold reserves). This could tempt a state into excessive printing of money relative to the amount of actual gold in hand. Infact such an increased supply of paper money (IOUs), relative to gold reserves led to numerous cases of devastating political instability , inflation , and disruption of foreign exchange supplies on a worldwide basis. During such times of economic crisis a further bolt from the blue would be a “run on the bank,” i.e. a large amount of currency holders requesting conversion into gold at the same time ,with the banks unable to meet the demand.

Because of the above defects and the recession of 1930, the U.S began pressing for an abolition of the gold standard.

Early Non-Metal Money

Again the Chinese took the lead .They were the first to introduce non-metal forms of value exchange.In 118 B.C. One-foot square pieces of white deerskin edged in vivid colors were commonly exchanged for goods. This was the forerunner of the first actual paper currency used in China from the ninth century to the fifteenth century A.D . Unfortunately, in 1455 the use of paper currency vanished from China, much before Europe had even got round to the idea of printing currency.An important point to note is that most forms of Chinese paper money were non-institutionalized i.e. in private hands.

WW II -The Bretton Woods Agreement

To protect their local national interests, the colonial powers had already increasingly introduced foreign exchange controls world wide. These were designed to prevent market forces from leading to monetary irresponsibility. In particular during the latter stages of WW II, the Western Powers met on July 1944, at Bretton Woods (New Hams hire) to finalize ‘The Bretton Woods Agreement’. Rejecting John Maynard Keynes suggestion for a new world reserve currency in favor of a system built on the US dollar; they agreed to introduce a system of fixed exchange rates, permanently fixing the US dollar at USD35/oz of gold ,while also fixing the rates of the other main currencies to the dollar.

The stated intent being to structure a world economic system that would stabilize the volatility in the foreign exchange markets that had occurred previously. The countries which signed the treaty agreed to maintain the domestic currency to US dollar exchange rate, along with the necessity to maintain the corresponding ratio of the gold. They were also prohibited from depreciating the currency value to gain trade benefit, and only allowed no more then 1% fluctuation from pegged rates.

Other international institutions such as the IMF, the World Bank and GATT were created in the same period as the emerging victors of WWII searched for a way to impose monetary discipline on the world’s financial institutions. All currency speculation was effectively finished. The foreign exchange Market became the sole domain of governmental institutions operating under the agency of central banks.

The Road to Monetary Freedom- A Choice of Peg, Semi-Peg or Free Float

During the 1960s the volatility between different country economies became more extreme, making it difficult for some to maintain the pegging system. The Bretton Woods system came under increasing pressure as national economies moved in different directions. It collapsed in August, 1971, when President Nixon suspended the gold convertibility standard. The dollar was no longer suitable as the sole international currency at a time when it was under severe pressure from increasing US budget and trade deficits.

After the Bretton Woods Accord came the Smithsonian Agreement in December of 1971. This agreement was similar to the Bretton Woods Accord, but allowed for a greater fluctuation band for the currencies. In 1972, the European community tried to move away from its dependency on the dollar. The European Joint Float was established by West Germany, France, Italy, the Netherlands, Belgium and Luxemburg. The agreement was similar to the Bretton Woods Accord, but allowed a greater range of fluctuation in the currency values.

Both agreements made mistakes similar to the Bretton Woods Accord and in 1973 collapsed. The collapse of the Smithsonian agreement and the European Joint Float in 1973 signified the official switch to the free-floating system. This occurred by default as there were no new agreements to take their place. Governments were now free to peg their currencies, semi-peg or allow them to freely float. In 1978, the free-floating system was officially mandated.

The Birth Of The Euro

In Europe, the idea of fixed exchange rates had by no means died. The European Economic Community introduced a new system of fixed exchange rates in July 1978, the European Monetary System. Like all of the previous agreements, it failed in 1993. With the 1991 signing of The Maastricht treaty the quest continued in Europe for a stable currency independent of the US $. It was agreed to not only fix exchange rates but also actually replace many of them with the Euro in 2002.Today, Europe has embraced the Euro in 12 participating countries. The physical introduction of the Euro on January 1, 2002 saw the old countries currencies made obsolete on July 1, 2002.In Asia too, the lack of sustainability of fixed foreign exchange rates has gained new relevance with the events in South East Asia in the latter part of 1997, where currency after currency was devalued against the US dollar, leaving other fixed exchange rates in particular in South America also looking very vulnerable.

Currencies Today- The Structure of The FX Markets

The major currencies today move independently from other currencies, with their prices driven purely by market forces. Whereas formerly only banks and huge corporations with millions of dollars at their disposal could do so, now any one with as little as $200.00 and in some cases even less can trade them. Today it is a market providing ease of liquidity and round the clock access to everybody-even the smaller speculator.The major players in the market now are:

Central Banks.The national central banks play an important role in the (FOREX) markets. Ultimately, central banks seek to control the money supply and often have official or unofficial target rates for their currencies. As many central banks have very substantial foreign exchange reserves, their intervention power is significant. Among the most important responsibilities of a central bank is the restoration of an orderly market in times of excessive exchange rate volatility and the control of the inflationary impact of a weakening currency.

Frequently, the mere expectation of central bank intervention is sufficient to stabilize a currency, but in case of aggressive intervention the actual impact on the short-term supply/demand balance can lead to the desired moves in exchange rates.
If a central bank does not achieve its objectives, the market participants can take on a central bank. The combined resources of the market participants could easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992-93 with the European Exchange Rate Mechanism (ERM) collapse and 1997 throughout South East Asia.

Banks.The interbank market caters to both the majority of commercial turnover as well as enormous amounts of speculative trading. It is not uncommon for a large bank to trade billions of dollars daily. Some of this trading activity is undertaken on behalf of corporate customers, but a banks treasury room also conducts a large amount of trading, where bank dealers are taking their own positions to make the bank profits.

The interbank market has become increasingly competitive in the last couple of years and the god-like status of top foreign exchange traders has suffered as equity traders are again back in charge. A large part of the banks' trading with each other is taking place on electronic booking systems that have negatively affected traditional foreign exchange brokers.

Interbank Brokers.Until recently, foreign exchange brokers were doing large amounts of business, facilitating interbank trading and matching anonymous counterparts for comparatively small fees. With the increased use of the internet, a lot of this business is moving onto more efficient electronic systems that are functioning as a closed circuit for banks only.
The traditional broker box, which lets bank traders and brokers hear market prices is still seen in most trading rooms, but turnover is noticeably smaller than just a few years ago due to increased use of electronic booking systems.

Commercial Companies.The commercial companies' international trade exposure is the backbone of the foreign exchange markets. A multinational company has exposure in accounts receivables and payables denominated in foreign currencies. They can be protected against unfavorable moves with foreign exchange. That is why these markets are in existence. Commercial companies often trade in sizes that are insignificant to short term market moves, as the main currency markets can quite easily absorb hundreds of millions of dollars without any big impact. It is also clear that one of the decisive factors determining the long-term direction of a currency's exchange rate is the overall trade flow.Some multinational companies, whose exposures are not commonly known to the majority of market, can have an unpredictable impact when very large positions are covered.

Retail Brokers.The arrival of the internet has brought us a host of retail brokers. There is a numbered amount of these non-bank brokers offering foreign exchange dealing platforms, analysis, and strategic advice to retail customers. The fact is many banks do not undertake foreign exchange trading for retail customers at all, and do not have the necessary resources or inclination to support retail clients adequately. The services of such retail foreign exchange brokers are more similar in nature to stock and mutual fund brokers and typically provide a service-orientated approach to their clients.

Hedge Funds.Hedge funds have gained a reputation for aggressive currency speculation in recent years. There is no doubt that with the increasing amount of money some of these investment vehicles have under management, the size and liquidity of foreign exchange markets is very appealing. The leverage available in these markets also allows such a fund to speculate with tens of billions at a time. The herd instinct that is very apparent in hedge fund circles was seen in the early 1990's with George Soros and others squeezing the GBP out of the European Monetary System.

It is unlikely, however, that such investments would be successful if the underlying investment strategy was not sound. It is also argued that hedge funds actually perform a beneficial service to foreign exchange markets. They are able to exploit economical weakness and to expose a countries unsustainable financial plight, thus forcing realignment to more realistic levels.

Investors and Speculators

In all efficient markets, the speculator has an important role taking over the risks that a commercial participant hedges. The boundaries of speculation in the foreign exchange market are unclear, because many of the above mentioned players also have speculative interests, even central banks. The foreign exchange market is popular with investors due to the large amount of leverage that can be obtained and the liquidity with which positions can be entered and exited. Taking advantage of two currencies interest rate differentials is another popular strategy that can be efficiently undertaken in a market with high leverage.

Chief Attractions of The Modern Currencies Markets

The currencies market is absolutely unique in many ways.It is the only market which is open 24 hours a day for a continuous 5.5 days a week trading period. Moreover because of the huge world demand for foreign exchange it is the worlds biggest trading market with a daily turnover in excess of US $ 1.5 trillion a day. Meanwhile the availability of the computer and the inter-net has enabled round the clock acces to the market at all times. All this has created certain very vital opportunities for a common trader like you or me.
· Avoidance of Market Manupulation.The scale of daily transactions makes it impossible for even the biggest trader to manipulate the market at the cost of the smaller investor.
· Easy Liquidity. Similarly the size of daily transactions is a guarantee that no matter how small or large the quantity you invested, you would not be stuck with it when you want to dispose it.
· Commission less Trading. Again because of the volume of trading and the use of automated transactions over the inter-net it is possible for a forex broker to charge you no commission at all. It is the only form of trading where you get to keep all your profits.
· Ease of Trading. All good brokers provide very modern computerized user friendly trading platforms which you can download. Also you can practice on this using dummy account, before you use real money. These apart from providing you with instant quotes on all major currency pairs, also give you the latest financial news, forecast, and analytical tools to help you make a correct decision. Once you decide to make a trade, it implementation and execution is only a mouse click away!
· Round the Clock Trading. It is the only market which never sleeps for 5.5 days of the week. This is because the sun is always shining on some part of the world; and so while some markets close others open up, providing you with round the clock access.
· Easier Profitability. Profitability lies is one’s ability to predict the future direction or trend of a commodities price and capitalizing on the ability. Currencies are amongst the most profitably tradable commodities. The main reasons being their volatility and their consistent trending While this provides no guarantee against loss, it does however mean that provided you analyze all data properly their future trends are the easiest to predict. Also it has been estimated that the prices of the major currency pairs fluctuate about 18,000 times a minute and it possible for a trader to make a small profit every times he enters a market, since he can trade either way i.e. even make a profit when the currency rate is declining by going short or selling rather than buying.
· Greater Profitability.Forex trading gives you the possibility of greater percentage returns on your investment than any other forms of trading.This is because the broker requires only the amount necessary to cover the maximum loss on your trade ,and not the total amount of the trade.e.g. if you placed an order to buy $200,000.00 and in any one day the $ is expected to loose maximum .5 percent of it’s value he would only need $ 1000.00 of actual money for you to be able to buy $200,000.00 for you.This translates into a margin of 1:100.Most brokers offer margin of from 1:20 to 1:400. Looking at it another way suppose you had $2000.00 to invest. The choice for you was to invest in either stocks or currencies. Also suppose in both markets the currency or share you wanted to buy was certain to go up 3% only. Remember your forex broker gives upto 1:400 margin: here is a calculation to show your percentage return even if you decide to use even a lower margin - one say only1:40,here are you % returns on each investment:
a. Stocks. Invested $2000.00. 3% Profit on 2000 = $ 60.00
b. Forex. Invested $2000.00.As broker Margin 1:40 so $’s Purchased= 80,000.00
3% Profit on $ 80.000= $2400.00