The-Forex-Marketplace

The Forex Marketplace


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The Forex Marketplace



Knowledge of the past is always beneficial for advancement in to the future, and so it’s appropriate
to explain the origins of the modern currency market before we commence with the finer details of

speculative forex trading as we know it today. This chapter is by no means a boring history lesson
containing nothing more than novelty curiosity value. On the contrary, it is the starting point from
which to fully grasp the reasons for the existence of the retail market, and for understanding the
fundamental basics of its purpose. It’s always interesting and perhaps a little worrying to speak with

new traders and realize just how few of them know anything beyond the “get rich” opportunity
being presented to them in internet adverts. What you will learn here is the background information

essential for “knowing” your preferred market of choice; the currency market.

We’ll start with the gold standard as there is around 400 years of credible history of currencies being

measured against the value of gold, although interestingly, prior to the 19th century silver was the
predominant measure for which many countries backed their money.


Germany was the leading economic influence in the latter third of the 19th century after it adopted
the deutsche mark and fixed it to a strict gold standard. They opted to do this largely thanks to a

substantial indemnity paid in gold to Germany by France after the Franco-Prussian war. The huge
influx of gold prompted Germany to off load its less valuable reserves of silver on to its European
trading partners. With Germany committed to gold as its currency measure, most other countries

soon followed suit, and the gold standard became firmly established amongst the leading developed
countries of the time.


What the gold standard meant was that 1 ounce of gold was fixed at a specific price, and that
monetary amount could be exchanged at any time for the equivalent weight in gold. For example, if

the rate was set at $20 per ounce, you could exchange $20 for 1 ounce of tangible gold at any time
you liked.


This system had obvious drawbacks, not least because a country always had to hold enough gold
reserves to pay out on demand, and there were many times the standard looked to be in jeopardy.

For instance, if Great Britain had accumulated a large reserve of Deutsche Marks and decided they
wanted to exchange them for gold, the German government was obliged to pay out, and this could
leave then dangerously low of supplies in case another foreign entity chose to do the same thing.
The aftermath of World War I accelerated the problems when the free flow of gold supplies was




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severely disrupted, depleting many countries reserves of the metal and making it difficult for them
to honor the exchange when it was required. The standard finally met its demise in the 1930’s when

massive withdrawals of gold from British banks forced the British government to abandon the gold
standard altogether in 1931. Three years later the United States was in a similar position and

introduced the Gold Reserve Act under guidance from President Roosevelt which reset the value of
gold at $35 per ounce, and ended the legal ownership of gold coins and bullion by citizens for the
next 20+ years.


Although the gold standard had come to an end, it was by no means the end of valuing cash
currency against the metal, and in July 1944 the Bretton Woods system was introduced which was

the first system of fixed exchange rates between participating nations. It required all nations which
signed up to the agreement to maintain the value of their currency within a very narrow 1% range
against the US dollar and its corresponding gold rate of $35 per ounce. It was the Bretton Woods

agreement which established the US dollar as the world’s reserve currency which it still holds today
(although this status is now dwindling). Essentially it meant that a country’s currency was fixed
against the US dollar, and the US government agreed to pay out 1 ounce of gold for every $35

delivered to the US treasury by another nation. This is the reason why dollars became accepted and
even favored in basically every country around the world, because the holder of those dollars could

always exchange them for physical gold which holds genuine value.

The new agreement between nations introduced 3 primary points:

1. The introduction of key bodies to promote fair international trade and economic harmony.

2. The fixing of exchange rates between national currencies.

3. The ability to convert US dollars in to gold and vice versa.


It was point number 1 which saw the establishment of the IMF (international monetary fund) and
the World Bank, which remain in existence to this day. Actually, point number 1 is the only part of

the agreement which has survived.


Unsurprisingly, the Bretton Woods system was not without its short falls, and during the 1950’s the
US dollar began to lose value as a result of huge US capital outflows aiding the post war recovery in
Europe, coupled with an increasing surplus global supply of US dollars. These factors made it ever

more difficult for the US government to convert cash into gold on demand at the fixed exchange
rate. The situation intensified in to the late 1960’s which led to a dangerous depletion of the US gold
reserves and more devaluation of the dollar in comparison to the metal.


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To compound the problem, the US government was printing ever larger amounts of money which
could not be backed by tangible gold quantities (effectively worthless bits of paper were being

printed – quantitative easing as it is now known). Eventually in 1971, the US government could no
longer sustain the conversion of dollars in to gold when foreign nations demanded it, and President

Nixon revoked on the arrangement, closed the system, and refused to pay out any more of the US
gold reserves.


Over the next 2 years other systems were introduced, namely the Smithsonian agreement which
attempted to fix exchange rates inside a 2.25% bracket as opposed to the 1% under Bretton Woods,
but this time currencies were not to be backed with gold. Ultimately this proved to be untenable

also, since there was no fixing of the exchange rate to gold, the cost of the metal shot up, and
eventually in 1973 it was decided that the value of the US dollar was to be determined entirely by
the free market. No longer would a currency be fixed against gold, nor would the exchange rate

fluctuations be bounded by restrictive parameters. Each currency would now be valued relative to
the value of other country’s currencies, and thus the free market capitalism of supply and demand
would be the new measure of exchange rates.


Therefore, the end of the Bretton Woods system in 1971 paved the way for the birth of the foreign

exchange market as we know it today which effectively began in 1973. It also introduced the exciting
possibility of new speculative opportunities for those willing to bet on exchange rate fluctuations.
Our market was born!


You should note that the primary purpose for the foreign exchange currency market is nothing to do

with speculating for profit. It exists to facilitate cross border trade and commerce between
international businesses and governments. Speculating is a side effect (for want of a better phrase) of
the existence of the market. While you and I can take advantage of the market for our own profitable

endeavors, it is not there to accommodate us.

Now whilst businesses can use the market in different ways depending on their objectives (we will

discuss this later in chapter 5), the basic method is simply enabling buying and selling between
entities in different countries. For example, when Boeing wants to buy engine components from a
German manufacturer for their assembly factory in the UK, they will have to convert British pounds

in to Euro’s first in order to make their purchase. They exchange GBP into EUR, or more accurately,
they sell GBP and buy EUR and then use their new Euro’s to purchase the engine components for
their factory. Likewise, when Toyota wish to pay their factory workers in Japan using the proceeds




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of car sales made in the United States, they first exchange their USD into JPY (sell USD and buy JPY),
and then use their new Yen’s to pay their employees’ salaries.


It is important to remember this elementary point that enabling international trade is the primary
reason for the existence of the forex market. The market does not exist for the purpose of speculating

for profit. It’s all too easy for traders to become blinkered and caught up in the belief that speculative
trading for profits is what the market is all about. Always remember the market is there to facilitate

business, not to facilitate us.

With that said, what the market is intended for and what we use it for are two entirely different

things, and for us, buying and selling currencies at different price points for profit making is our
main concern. Trading of foreign currencies was first introduced to the public in 1972 by the
Chicago Mercantile Exchange when they created a product which allowed speculators to trade a

futures contract based on the exchange rate of the US dollar against other major currencies.


Prior to this time, the market was strictly the reserve of governments and international banks, but
the new futures contract proved to be very popular. It wasn’t long before brokers and dealers
devised ways to make currency trading available outside of the central location of the CME. Even so,

for the next 20+ year’s currency trading was limited in access to large institutions and funds, due in
part to the minimum contract size being $100,000 (this is the standard “lot” size) and leverage only
offered in small amounts. What finally opened up forex to the rest of the retail public was the advent

of the internet.

The internet is actually responsible for two major developments with regards the foreign exchange

market. Firstly, it opened up the market to a much larger audience, and savvy entrepreneurial
brokers & dealers quickly introduced new lot sizes in the form of a mini lot ($10,000) and the micro

lot ($1,000), as well as offering their customers higher leverage. This of course meant forex trading
was rapidly much more accessible to lower net worth individuals who in many cases could open
new trading accounts with as little as $250.


Unsurprisingly with such advancements, forex has become the favorite market for the mass retail
public willing to try their hand at financial speculation (it is increasingly marketed as a get rich

quick opportunity). The huge influx of new public traders has helped (note the word “helped” and
not “caused”) the currency market to grow substantially in size over recent years.







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Another thing the internet has done for the forex market is dramatically increase the quantity of
exchange transactions as a result of e-commerce. The number of purchases being made daily online

is truly staggering, and this has significantly contributed to the volume of currencies being
exchanged back and forth between one another. If you think of the number of sales and purchases

made on eBay alone each day, and it isn’t hard to imagine just how many transactions are made
across the tens of millions of sites across the entire web. Daily transactions on the popular PayPal
network alone are estimated to be $315 Million, ($3.650 per second) which is an additional amount
which never existed before the invention of the internet. There is no accurate way to estimate the

total web based volume, but we can guess it is substantially more than what PayPal alone transact.
Any proportion of that amount being exchanged across borders is going to impact the forex volume.


We have of course also seen an enormous increase in international trade relations in recent years. As
trade barriers are made less restrictive and emerging economies have burst in to the world market,

there has been a surge in the sale of goods being imported and exported between nations. Referring
back to the internet, it is clear it has had a significant input to eliminating borders in terms of
commerce between nations.


People often debate why the size of the forex market has grown so much over the past 20 years, yet

it’s no coincidence that the rapid growth of the currency market has coincided with the equally
impressive expansion of the internet and the breakdown of international trade barriers in general.
Every time you purchase or sell something online in a currency other than your own, or buy an item

made outside of your home country, you are adding to the daily volume of the forex market.


This brings us neatly to the subject of the size of the currency market. The typical figure bandied
about in the media is that forex trades at approximately $5.3 trillion in transactions each day,
making it the largest market in the world by some considerable margin. While this is true, it is also

somewhat misrepresentative in terms of the market we trade in and how we perceive our
participation in it. Currency trading as you, I, and most other public retail traders engage in is
carried out in the spot market only. The spot market is a direct exchange between two currencies

and is conducted in cash. Online purchases and converting one currency for another at your local
bank prior to vacationing abroad are both examples of a spot cash transaction. This is the market we
trade in, and it actually only amounts to $2 trillion in daily volume. I say “only”, but of course this

figure is still spectacularly big and dwarfs all other markets, but as you can see the real picture is
slightly different to what is commonly stated.





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The remaining majority of the volume in the foreign exchange market is conducted in forward or
futures contracts (the agreement on an exchange rate for a date in the future, and the transaction

occurs on that date, regardless of what the market rates are then), swaps (where two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later date),

and options (a derivative where the owner has the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed exchange rate on a specified
date).


Looking at the numbers above, you can see that 38% of foreign exchange is occupied by the spot
cash market where one currency is actually exchanged for another. The remaining 62% is conducted

in other areas of the market which have different purposes, namely speculation to some degree or
another, and most notably hedging (we will discuss this in more detail in the next chapter). To that
end you can clearly see that the majority of transactions completed in forex are purposes other than

straight forward conversions of cash.


What you should note is that although forex is separated into different parts with different
purposes, it is all still one market, and all the participants are interacting to some extent and are
affected by the same economic factors. Of course, what you are most interested in as a retail

currency trader is the spot cash market. This is arguably the most important part of the market as a
whole for many reasons, not least because this is where the exchange rates are actually established
and set. Everything else takes its lead from the spot market, so we are trading the primary element

of forex.


The surprising thing that many people don’t realize is that speculative trading in terms of betting on
the direction of future price direction is actually only a minority percentage of the forex market
volume, as a whole and in the spot segment by itself. Wikipedia and other amateur sources edited

by non-specialist laypersons will often cite forex as being 70-90% speculative in nature, but this
simply isn’t true in relation to the $5.3 trillion daily volume. Speculation accounts for approximately
15% of foreign exchange activity across the entire market and approximately 18% in the spot market

in isolation. The remaining 85% of transactions (82% of spot) have nothing whatsoever to do with
betting on the direction of the exchange rate fluctuation. Retail traders like you are reasonably
insignificant minority participants, accounting for only 3.5% of total market volume (3.8% in spot).

Even the major hedge funds account for only 14% of volume in the spot market.







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Does that mean the rest of the $2 trillion exchanged every day in the spot market comes from
utilitarian participants such as businesses, the internet, and holiday makers converting their money

from one currency to another? Actually no, and this is something else that comes as a surprise to
many people.


The main activity inside both the wider market and the spot market comes from inter-dealer trading
between the major world banks and other dealers. We will explain this in much more detail in the

next chapter, but to touch on it briefly here, the fact is that because the foreign exchange is an
opaque and decentralized marketplace, it is often very difficult for dealers to quote accurate prices
from their own isolated assessments or to balance their inventory “in-house” on their own books.


If each dealer simply quoted prices based on their own opinions and traded with their own clients
exclusively, each one would be offering quotes at wildly different levels, and arbitrageurs would

quickly take advantage and profit from the divergences, but also the dealer would find it hard to
balance their own inventory. To make sure they all quote at a similar price and off-set their own

risks, dealers trade amongst themselves, offering and accepting “bids” and “asks” in quick
succession and passing off trades (risk) to other dealers. This is known as “hot potato” trading. So,
the majority of the activity in the spot market is one dealer (this could be a major bank or a smaller

financial institution) selling to another, who sells to another, who sells to another, until a dealer
receives a position that restores their target inventory, and the process is repeated. It may seem a
somewhat novel or even implausible situation to someone who has never studied the detailed

structure of the currency market, but it is nevertheless reality backed up by factual statistical data,
and we will cover it in greater depth in the next chapter.


The point of importance is that the spot market is huge with significant relevance to a much wider
contingent of market participants around the world. The main activity within the spot market is the

banks and other dealers trading amongst themselves as market makers. This effectively forms the
liquidity pool of the market. After the inter-dealer “hot potato” trading activity which accounts for
the vast majority of the recorded volume, comes the utilitarian traders who trade for business

motivated reasons, and then finally there are also the speculators. Both businesses and speculators
fall in to a general bracket of “retail”.


The retail sector comprises of all those participants who need or want to physically exchange one
cash currency for another, and comprises primarily of businesses and individuals buying and selling
goods across borders. Forex traders as you might typically understand (people like you who day




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trade currencies for speculation) are categorized in this retail non-financial sector. You are not
bracketed in with the big speculators like hedge funds and investment firms. Individual traders like

yourself account for only 3.8% of the spot market, so in reality are a very small contingent element.

As you can see there are 3 very broad groups of participants in the spot market: the dealers trading

amongst themselves are the largest group, followed by utilitarian traders, and finally the
speculators.


This is a very crude break down of the participants, and we will break this apart more thoroughly in
a later chapter, but for now it serves the purpose of demonstrating how the spot market is

comprised and where we fit in to it as “traders”.

While this chapter is not intended to give you a master’s degree in the history of the currency
market, it has provided you with an elementary understanding of the origins of our chosen market,
and a basic appreciation of where we slot in to the grand scheme of this enormous financial arena.
These are just the first necessary steps prior to moving on to the further complexities of currency
trading basics. The following chapters will dissect the market into much more specific individual
components and lay the foundations which will help propel you to the professional level of trading.













































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