At the
end of the World War II, the whole world was experiencing so much chaos that
the major Western governments felt the need to create a system to stabilize the
global economy.
Known as
the "Bretton Woods System," the agreement set the exchange rate of
all currencies against gold. This stabilized exchange rates for a while, but as
the major economies of the world started to change and grow at different
speeds, the rules of the system soon became obsolete and limiting.
Soon enough, come 1971, the Bretton Woods Agreement was
abolished and replaced by a different currency valuation system. With the
United States in the pilot's seat, the currency market evolved to a
free-floating one, where exchange rates were determined by supply and demand.
At first,
It was difficult to determine fair exchange rates, but advances in technology
and communication eventually made things easier.
Once the 1990s came along, thanks to computer nerds and the
booming growth of the internet (cheers to you Mr. Al Gore), banks
began creating their own trading platforms. These platforms were designed to
stream live quotes to their clients so that they could instantly execute trades
themselves.
Meanwhile,
some smart business-minded marketing machines introduced internet-based trading
platforms for individual traders.
Known as
"retail forex brokers", these entities made it easy for individuals
to trade by allowing smaller trade sizes. Unlike in the interbank market where
the standard trade size is one million units, retail brokers allowed
individuals to trade as little as 1000 units!
Retail Forex Brokers
In the
past, only the big speculators and highly capitalized investment funds could
trade currencies, but thanks to retail forex brokers and the Internet, this
isn't the case anymore.
With
hardly any barriers to entry, anybody could just contact a broker, open up an
account, deposit some money, and trade forex from the comfort of their own
home. Brokers basically come in two forms:
1. Market
makers, as their name suggests, "make" or set their own bid and ask
prices themselves and
2. Electronic Communications Networks (ECN), who use the best bid and ask prices available to them from
different institutions on the interbank market.
Market Makers
Let's say
you wanted to go to France to eat some snails. In order for you to transact in
the country, you need to get your hands on some euros first by going to a bank
or the local foreign currency exchange office. For them to take the opposite
side of your transaction, you have to agree to exchange your home currency for
euros at the price they set.
Like in
all business transactions, there is a catch. In this case, it comes in the form
of the bid/ask spread.
For instance, if the bank's buying price (bid) for EUR/USD is 1.2000, and their selling price (ask) is 1.2002, then the
bid/ask spread is 0.0002. Although seemingly small, when you're talking about
millions of these forex transactions every day, it does add up to create a
hefty profit for the market makers!
You could
say that market makers are the fundamental building blocks of the foreign
exchange market. Retail market makers basically provide liquidity by
"repackaging" large contract sizes from wholesalers into bite size
pieces. Without them, it will be very hard for the average Joe to trade forex.
Electronic Communications Network
Electronic
Communication Network is the name given for trading platforms that
automatically match customer's buy and sell orders at stated prices. These
stated prices are gathered from different market makers, banks, and even other
traders who use the ECN. Whenever a certain sell or buy order is made, it is
matched up to the best bid/ask price out there.
Due to
ability of traders to set their own prices, ECN brokers typically charge a VERY
small commission for the trades you take. The combination of tight spreads and
small commission usually make transaction costs cheaper on ECN brokers.
Of course, it's not enough to know the big guys in the biz. As Big Pippin once said, "Trading requires timing". Do you know WHEN
you should trade?
