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 the 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?
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