Forex History and Market Participants
Given the global nature of the forex exchange market, it is
important to first examine and learn some of the important historical events
relating to currencies and currency exchange before entering any trades. In
this section we'll review the international monetary system and how it has
evolved to its current state. We will then take a look at the major players
that occupy the forex market - something that is important for all potential
forex traders to understand.
The History of the Forex Gold Standard System The
creation of the gold standard monetary system in 1875 marks one of the most
important events in the history of the forex market. Before the gold standard
was implemented, countries would commonly use gold and silver as means of international
payment. The main issue with using gold and silver for payment is that their
value is affected by external supply and demand. For example, the discovery of
a new gold mine would drive gold prices down.
The underlying idea behind the gold standard was that
governments guaranteed the conversion of currency into a specific amount of
gold, and vice versa. In other words, a currency would be backed by gold.
Obviously, governments needed a fairly substantial gold reserve in order to
meet the demand for currency exchanges. During the late nineteenth century, all
of the major economic countries had defined an amount of currency to an ounce
of gold. Over time, the difference in price of an ounce of gold between two
currencies became the exchange rate for those two currencies. This represented
the first standardized means of currency exchange in history.
The gold standard eventually broke down during the beginning
of World War I. Due to the political tension with Germany, the major European
powers felt a need to complete large military projects. The financial burden of
these projects was so substantial that there was not enough gold at the time to
exchange for all the excess currency that the governments were printing off.
Although the gold standard would make a small comeback
during the inter-war years, most countries had dropped it again by the onset of
World War II. However, gold never ceased being the ultimate form of monetary
value. (For more on this, read The Gold Standard Revisited, What Is
Wrong With Gold? and Using Technical Analysis In The Gold Markets.)
Bretton Woods System Before the end of World
War II, the Allied nations believed that there would be a need to set up a
monetary system in order to fill the void that was left behind when the gold
standard system was abandoned. In July 1944, more than 700 representatives from
the Allies convened at Bretton Woods, New Hampshire, to deliberate over what
would be called the Bretton Woods system of international monetary management.
To simplify, Bretton Woods led to the formation of the
following:
- A method of fixed exchange rates;
- The U.S. dollar replacing the gold standard to become a primary reserve currency; and
- The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT).
One of the main features of Bretton Woods is that the U.S.
dollar replaced gold as the main standard of convertibility for the world's
currencies; and furthermore, the U.S. dollar became the only currency that
would be backed by gold. (This turned out to be the primary reason that Bretton
Woods eventually failed.)
Over the next 25 or so years, the U.S. had to run a series
of balance of payment deficits in order to be the world's reserved currency. By
the early 1970s, U.S. gold reserves were so depleted that the U.S. treasury did
not have enough gold to cover all the U.S. dollars that foreign central banks
had in reserve.
Finally, on August 15, 1971, U.S. President Richard Nixon
closed the gold window, and the U.S. announced to the world that it would no
longer exchange gold for the U.S. dollars that were held in foreign reserves.
This event marked the end of Bretton Woods.
Even though Bretton Woods didn't last, it left an important
legacy that still has a significant effect on today's international economic
climate. This legacy exists in the form of the three international agencies
created in the 1940s: the IMF, the International Bank for Reconstruction and
Development (now part of the World Bank) and GATT, the precursor to the World
Trade Organization. (To learn more about Bretton Wood, read What Is The
International Monetary Fund? and Floating And Fixed Exchange Rates.)
Current Exchange RatesAfter the Bretton Woods system
broke down, the world finally accepted the use of floating foreign exchange
rates during the Jamaica agreement of 1976. This meant that the use of the gold
standard would be permanently abolished. However, this is not to say that
governments adopted a pure free-floating exchange rate system. Most governments
employ one of the following three exchange rate systems that are still used
today:
- Dollarization;
- Pegged rate; and
- Managed floating rate.
Dollarization This event occurs when a country
decides not to issue its own currency and adopts a foreign currency as its
national currency. Although dollarization usually enables a country to be seen
as a more stable place for investment, the drawback is that the country's
central bank can no longer print money or make any sort of monetary policy. An
example of dollarization is El Salvador's use of the U.S. dollar.
Pegged Rates Pegging occurs when one country
directly fixes its exchange rate to a foreign currency so that the country will
have somewhat more stability than a normal float. More specifically, pegging
allows a country's currency to be exchanged at a fixed rate with a single or a
specific basket of foreign currencies. The currency will only fluctuate when
the pegged currencies change.
For example, China pegged its yuan to the U.S. dollar at a
rate of 8.28 yuan to US$1, between 1997 and July 21, 2005. The downside to
pegging would be that a currency's value is at the mercy of the pegged
currency's economic situation. For example, if the U.S. dollar appreciates
substantially against all other currencies, the yuan would also appreciate,
which may not be what the Chinese central bank wants.
Managed Floating Rates This type of system is
created when a currency's exchange rate is allowed to freely change in value
subject to the market forces of supply and demand. However, the government or
central bank may intervene to stabilize extreme fluctuations in exchange rates.
For example, if a country's currency is depreciating far beyond an acceptable
level, the government can raise short-term interest rates. Raising rates should
cause the currency to appreciate slightly; but understand that this is a very
simplified example. Central banks typically employ a number of tools to manage
currency.
Market Participants Unlike the equity market - where
investors often only trade with institutional investors (such as mutual funds)
or other individual investors - there are additional participants that trade on
the forex market for entirely different reasons than those on the equity
market. Therefore, it is important to identify and understand the functions and
motivations of the main players of the forex market.
Governments and Central Banks Arguably, some
of the most influential participants involved with currency exchange are the
central banks and federal governments. In most countries, the central bank is
an extension of the government and conducts its policy in tandem with the
government. However, some governments feel that a more independent central bank
would be more effective in balancing the goals of curbing inflation and keeping
interest rates low, which tends to increase economic growth. Regardless of the
degree of independence that a central bank possesses, government
representatives typically have regular consultations with central bank
representatives to discuss monetary policy. Thus, central banks and governments
are usually on the same page when it comes to monetary policy.
Central banks are often involved in manipulating reserve
volumes in order to meet certain economic goals. For example, ever since
pegging its currency (the yuan) to the U.S. dollar, China has been buying up
millions of dollars worth of U.S. treasury bills in order to keep the yuan at
its target exchange rate. Central banks use the foreign exchange market to
adjust their reserve volumes. With extremely deep pockets, they yield
significant influence on the currency markets.
Banks and Other Financial Institutions In
addition to central banks and governments, some of the largest participants
involved with forex transactions are banks. Most individuals who need foreign
currency for small-scale transactions deal with neighborhood banks. However,
individual transactions pale in comparison to the volumes that are traded in
the interbank market.
The interbank market is the market through which large banks
transact with each other and determine the currency price that individual
traders see on their trading platforms. These banks transact with each other on
electronic brokering systems that are based upon credit. Only banks that have
credit relationships with each other can engage in transactions. The larger the
bank, the more credit relationships it has and the better the pricing it can
access for its customers. The smaller the bank, the less credit relationships
it has and the lower the priority it has on the pricing scale.
Banks, in general, act as dealers in the sense that they are
willing to buy/sell a currency at the bid/ask price. One way that banks make
money on the forex market is by exchanging currency at a premium to the price
they paid to obtain it. Since the forex market is a decentralized market, it is
common to see different banks with slightly different exchange rates for the
same currency.
Hedgers Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.
If there is one thing that management (and shareholders)
detest, it is uncertainty. Having to deal with foreign-exchange risk is a big
problem for many multinationals. For example, suppose that a German company
orders some equipment from a Japanese manufacturer to be paid in yen one year
from now. Since the exchange rate can fluctuate wildly over an entire year, the
German company has no way of knowing whether it will end up paying more euros
at the time of delivery.
One choice that a business can make to reduce the
uncertainty of foreign-exchange risk is to go into the spot market and make an
immediate transaction for the foreign currency that they need.
Unfortunately, businesses may not have enough cash on hand
to make spot transactions or may not want to hold massive amounts of foreign
currency for long periods of time. Therefore, businesses quite frequently
employ hedging strategies in order to lock in a specific exchange rate for the
future or to remove all sources of exchange-rate risk for that transaction.
For example, if a European company wants to import steel
from the U.S., it would have to pay in U.S. dollars. If the price of the euro
falls against the dollar before payment is made, the European company will
realize a financial loss. As such, it could enter into a contract that locked
in the current exchange rate to eliminate the risk of dealing in U.S. dollars.
These contracts could be either forwards or futures contracts.
Speculators Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.
The most famous of all currency speculators is probably
George Soros. The billionaire hedge fund manager is most famous for speculating
on the decline of the British pound, a move that earned $1.1 billion in less
than a month. On the other hand, Nick Leeson, a derivatives trader with
England's Barings Bank, took speculative positions on futures contracts in yen
that resulted in losses amounting to more than $1.4 billion, which led to the
collapse of the company.
Some of the largest and most controversial speculators on
the forex market are hedge funds, which are essentially unregulated funds that
employ unconventional investment strategies in order to reap large returns.
Think of them as mutual funds on steroids. Hedge funds are the favorite
whipping boys of many a central banker. Given that they can place such massive
bets, they can have a major effect on a country's currency and economy. Some
critics blamed hedge funds for the Asian currency crisis of the late 1990s, but
others have pointed out that the real problem was the ineptness of Asian
central bankers. (For more on hedge funds, see Introduction To Hedge Funds -
Part One and Part Two.)Either way, speculators can have a big sway
on the currency markets, particularly big ones.
Now that you have a basic understanding of the forex market,
its participants and its history, we can move on to some of the more advanced
concepts that will bring you closer to being able to trade within this massive
market. The next section will look at the main economic theories that underlie
the forex market.
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