Nixon Shock and the birth of FOREX !

Much of the mankind’s history for the last 200 years have had the biggest events resulting from the decisions of American Presidents. Be it Thomas Jefferson’s guile to leap at Napoleon’s Louisiana property sale which led to doubling the size of US at a bargain price of 5cent per acre, Trump’s withdrawal from Paris agreement, Bush’s War on Terror, Harry Truman ending WW2 with Atom Bombs, James K Polk going to war with Mexico and the list goes on. Several of these decisions re-stitched the fabric of our society.

One such decision was Richard Nixon’s pulling out of Bretton Woods System (Nixon Shock). Little did anyone know, that this would go on to give birth to the world’s biggest(by trading volume) and most liquid market. Forex Market.

BACKGROUND:

While still abiding the Bretton Woods system(BWS) of fixed exchange rates, in the cold war era United States, intervention was used to help maintain the exchange rate within prescribed margins and was considered to be essential to a central bank’s toolkit. The dissolution of the Bretton Woods system was largely due to President Richard Nixon’s unilateral cancellation of the direct international convertibility of the United States dollar to gold in 1971, after the dollar struggled throughout the late 1960s in light of large increases in the price of gold.

For the first 5 years after WW2, BWS worked well and by the end of WW2 , Europe and Japan were rebuilding themselves. Most countries outside US were slowly recovering from WW2, they needed dollars to buy American goods-car, machinery etc. US had the largest(more than half the world’s) reserves of gold and dollar was pegged to gold, therefore BWS appeared secured.

However, from 1950 to 1969, as Germany and Japan recovered, the US share of the world’s economic output dropped significantly. Further, growing public debt incurred by the Vietnam War, and monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued in the 1960s.

Result:

• In 1965 President Charles de Gaulle announced his intention to exchange its U.S. dollar reserves for gold at the official exchange rate.
• In 1971, the money supply had increased by 10%.In May 1971, West Germany left the Bretton Woods system, unwilling to revalue the Deutsche Mark. In the following three months, this move strengthened its economy.
• CHAIN EFFECT — Other nations began to demand redemption of their dollars for gold. Switzerland redeemed $50 million in July. France acquired $191 million in gold. On August 5, 1971, the United States Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against “foreign price-gougers”. On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland left the Bretton Woods system. The pressure began to intensify on the United States to leave Bretton Woods, which it finally did in 1971, following up with precautions for protecting potential inflationary effects, unemployment, run-down on dollars etc.

By 1973, the Bretton Woods system was replaced de facto by a regime based on freely floating fiat currencies that remain in place to the present day. Since the end of the traditional Bretton Woods system, IMF members have been free to choose any form of exchange arrangement they wish (except pegging their currency to gold), such as: allowing the currency to float freely, pegging it to another currency or a basket of currencies, adopting the currency of another country, participating in a currency bloc, or forming part of a monetary union.

On May 16, 1972, under Leo Melamed’s leadership and Milton Friedman’s commissioned paper validation, the Chicago Mercantile Exchange established the International Monetary Market, a futures market in seven foreign currencies.

Subsequently, numerous other exchanges sprang up across the globe and offer foreign exchange futures services around the globe. Many large corporations conduct business globally, and FX futures market allowed them to efficiently and effectively hedge the financial risk they incur as currency prices fluctuate in response to financial, political and economic events.

WHY FOREX ?

• It has low start-up(not to confuse with its capital intensive nature) requirements and relatively inexpensive account costs. Trading starts with as little as a few hundred dollars, sometimes less.
• Forex brokers charge no fees, commissions, or hidden charges. They earn their money on the difference, called the spread, between the buy and sell price, typically a few ten-thousandths, called pips, of the price
• Forex markets often reflect changes in sentiment before other markets, and so offer profitable clues of where other markets are going.
• Flexible hours. Forex markets trade in a seamless 24-hour session, 5.5 days a week, from Sunday 5:15 P.M. EST until Friday 5:00 P.M. EST.
• Most Liquid Market.
• Because there is no centralised exchange with specialists holding monopoly power to regulate prices. No single specialist regulates prices of individual currency pairs. Rather, multiple exchanges and brokers are competing for your business.
• Las two points result in less slippage. ( Reason: Usually Highly Liquid — typically running at full speed in at least one if not two continents 24 hours a day, over five days a week and trading at such larger volumes than equities.Also, they have no specialists influencing prices.)
• The low margins of relative profit compared with other markets of fixed income.
• Lastly, my personal favourite -the use of Leverage to enhance profit and loss margins and with respect to account size.

The most important indicators/factors that I personally feel one should have a hold on and be constantly aware of:

• Interest Rates
• Public Debt
• Political Stability and Economic Performance
• Terms of Trade
• Geo-Political Events/Acts of God
• Current Account Deficit
• Inflation
• The combination of — timing of your Trades and currency pairs involved.

The forex market is ultimately driven by economic factors that, in turn, are indicators of a country’s economic strength. The economic outlook for a country is the most important determinant of its currency’s value, so knowing the factors and indicators to watch will help you keep pace in the competitive and fast-moving world of forex.

Market Participants:

• At the top of the level, Interbank Foreign Exchange Market(made up of largest commercial banks and securities dealers).
• Smaller Banks and Large MNC’s.
• National Central Banks (in some cases) trying to control tcurrenciesncies volatility, inflation, money supply etc.
• Large Hedge Funds (have shown prominent growth in recent years)
• Pension Funds, Insurance Companies, Mutual Funds etc.
• Non Bank Foreign Exchange Companies(The volume of transactions done through Foreign Exchange Companies in India amounts to about USD 2 billion per day This does not compete favorably with any well developed foreign exchange market of international repute, but with the entry of online Foreign Exchange Companies the market is steadily growing. Around 25% of currency transfers/payments in India are made via non-bank Foreign Exchange Companies. Most of these companies use the USP of better exchange rates than the banks.)
• Even Retail Market Makers in some cases.
• Money transferr/remittance companies(example- Western Union, UAE exchange etc).
• Bureau De Exchange (generally located at airports)
• The mere expectation or rumour of a central bank foreign exchange intervention might be enough to stabilize a currency. However, aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.

But, what are you buying and speculating about in the forex market ?

You are buying and selling money. In the forex market, think of money as a commodity, you are buying a currency hoping that its value will increase, and if you are selling you are betting that it will decrease.

You can also think of buying currencies as buying shares in a country, you are betting on the success or failure of a particular country’s economy.

While I won’t make an attempt to teach you how to become a trader, I would any day love to help and have a chat about anything more you may want to know about Forex trading.

I really hope that you learnt something or generated some interest in Forex after reading this.

I will be happy to discuss anything and everything about Forex , that you might want to know about , so lets catch-up !