1. An understanding of probability and risk

An economics expert who doesn’t understand what risk is and how he must manage it can never be a trader. Excellent understanding of the banking system, a thorough grasp of the international flow of currencies will not be helpful if one is not capable of making use of the knowledge in the context of a carefully thought-out, conservative risk strategy. As such, understanding risk is the first and foremost requirement from a trader.

2. A realistic and rational approach to trading

A trader must be level-headed. Trading does not forgive stupidity, or emotional immaturity. Traders are naturally ambitious, but they should direct their ambition towards the goal of mastering the technique of trading, and curb it when it cautions about unparalleled opportunities, or never returning chances.

3. Patience, Diligence, and Independence of Mind

The trader must be patient to let his plans come to fruition over time. He must be diligent in applying the various lessons that he learns throughout his career. He must have an independent mind so that he can expose himself to the opinions of others yet still make his own judgment.

4. Disciplined Application of Money Management Principles

The most important technical aspect of trading is money management. One must make sure that the account is being managed in such a way that profits are maximized, losses cut short, and trade decisions are taken according to a logical, meaningful plan. The plan may not be perfect, and it may not work all the time, which is beside the point anyway. But the trader must be able to manage the loss in such a way that even the best case scenario does not lead to irreversible consequences.

5. Humility and Readiness to Correct Errors

Upon gaining the necessary confidence after applying these principles, one must keep focusing on his failings and recall that forex education never ends. Profits can be increased, losses can be reduced, as there is always room for improvement.

Many traders are worried about forex scams and fraud in the industry, and rightly so, but it is the case that the overwhelming majority of traders lose their accounts because of faulty trading decisions, unrealistic expectations, and a lack of education. The above recipe for success will in fact be enough to guarantee you profitability, but it is action, not pledges or words that counts, and applying these principle in live trading appears to be a formidable task for many traders. Yet the goal is out there, you know what you need to do, and instead of trying unworkable and unreliable methods, you can just focus on these skills to test what you can and cannot achieve in forex.

When the euro, the new currency of the European Union, was introduced Jan. 1, the European Central Bank pegged the rate of exchange with the dollar at $1.18, not the expected $1.20. By February the exchange rate had slipped to $1.11 and, as Insight went to press, it was $1.07, a rate that head central banker Wim Duisenberg did not anticipate.

European officials talk as if this is not a worry. “The Governing Council does not regard current monetary trends as constituting a signal of future inflationary pressures” said Duisenberg April 8. Privately, however, officials tell Insight that each day’s trading makes them ask, “Why is it sliding?”

When the euro was being phased in by 11 of the 16 countries of the European Union, or EU, the new money was conceived as the tool of a political strategy to make trade in the European countries like that of a single nation. The conventional wisdom was that the euro could become either a great partner, taking some of the pressure off the dollar as the world’s overriding reserve currency, or a competitor that would strip the United States of some huge advantages that the dollar’s primacy has brought. But there is a third scenario, unspoken for the most part: The euro might collapse, leaving the basket of separate national currencies.

The stable dollar-euro relationship envisioned in the first scenario could turn out to be an international stabilizer, helping steady the portfolio of stocks and bonds held by Americans, for example. And if the euro were to outperform the dollar, it might actually help U.S. exports while raising the price of many consumer goods, as well as the cost of interest on every loan. But neither outcome would be as dramatic as a failure of the new currency.

More than likely, currency traders say, the decline of the euro reflects nothing more than a composite of declines by the German deutsche mark, the Italian lira, the French franc and other EU currencies against a surging dollar. But the question that must be answered during the coming year is whether the survival of the euro depends on its value or on how well each country in the bloc gets along in conforming to the economic straitjacket it assumed when joining the euro group. The concept of the euro is founded on a contradiction — that each country will keep its sovereignty while actually giving up its No. 1 instrument of economic sovereignty, control of its own interest rates.

As global-market analyst Alexei Bayer says, “The United States runs a single budget deficit or surplus, while our states are required to balance their budgets. In Europe, the Maastricht Treaty obliges member states to limit their deficits to just 3 percent of GDP [gross domestic product] in order to become members of the currency group; but once in, there are few safeguards against profligate national spending. This could allow one nation to live well beyond its means at the expense of its neighbors, who will have to curb spending or raise taxes to support the common currency.”

Bayer also points out that European workers have far less mobility than U.S. workers. Rather than seeking work by moving to a new region which might be in a different country with a different language, out-of-work European workers are much more likely to seek higher welfare spending from their own government. European unemployment ranges from 9 percent to as high as 18 percent in Spain. If Germany should have a boom, while others, say Italy and Portugal, fall into a slump, political tensions could bust the euro apart.

Martin Feldstein, who was chairman of the Council of Economic Advisers in the Reagan administration, sees the political bomb as the chief threat to the euro. “Without tough standard-setting by the German central bank, the process is likely to drift to higher inflation rates” he cautions, citing “the mistaken hope that an easier monetary policy would have favorable long-term effects on employment and growth…. How Germany responds to the conflict caused by rising inflation will be a critical issue in Europe’s political future.”

A team of economists at Prudential Securities, after a technical study, sees the issue in similar terms. They tell Insight: “Our view is that the euro will … eventually be tested. At some point, one or a few member countries probably will fall out of line with the restrictions of monetary union. If the euro can survive that test, its prospects will be good [in the] longer term.”

Will the euro survive as a permanent alternative to the dollar in world trading and finance and a threat to the dollar’s dominance? The British pound, for example, has been quoted at about $1.60 for years without it being considered a threat to the dollar. But other countries no longer think of the pound as a reserve currency. A stabilized euro could be different because it represents a large bloc with a larger population than the United States and a GDP nearly 80 percent as large. The Bank of China, which holds $146 billion in hard-currency reserves, announced in advance that it would move some of its holdings into euros. At the present time, however, 57 percent of the reserves held by the world’s central banks are in dollars. That preference for the dollar is the chief reason why the United States has been able to sustain a trade deficit of imports over exports of more than $200 billion per year. The possibility of a dollar glut, which would send the value of the dollar reeling, is averted because the foreign national banks find the purchase of U.S. Treasury securities attractive and stabilizing. The United States, in effect, is living on money borrowed from foreigners and is paying them well in interest for the privilege.

C. Fred Bergsten, director of Washington’s Institute for International Economics, is one who fears a sharp fall of the dollar if a number of
foreign governments were to convert dollar holdings into euros. Another well-known authority, James Grant, editor of Grant’s Interest Rate Observer, agrees, saying, “What America is about to lose — or, more exactly, begin to lose — few Americans ever realized they had…. Thanks to the euro, the dollar will be less appealing for foreigners to hold. This will cause dollar interest rates to be higher than they would otherwise have been.”

Yet there are other factors that could diminish concern about the dollar/euro exchange rate. The decisions which a central bank makes on which kind of money to hold always will be made on the basis of the rate of return and the risk. There are two good reasons for preferring to hold dollars rather than euros in national reserves.

• First is military security. Experts point out that whenever there is the least uneasiness in eastern Europe, Russia or the Middle East, there is a noticeable rush to buy dollars, simply because the nations of the euro group are closer to the scene of danger.
• Second is the amazing strength of the U.S. economy as compared to Europe’s. As a result of U.S. industrial restructuring and the development of information technologies, U.S. unemployment is below 5 percent, while Europe’s is between 9 percent and 18 percent. Moreover, the burden of Europe’s vaunted “social welfare net” and intense bureaucratic regulation has kept new job creation flat, even in Germany. If Europeans established artificially low interest rates to stimulate their economies, the result would be steady inflation of the euro.

In any case, the quantity of money held in government reserves is so huge that any transfer of preference would take place at glacial speed, making it less of a factor in determining exchange rates than the free-floating commercial value generated in the dally marketplace — a marketplace governed by the needs and decisions of millions of individuals. Their actions decide whether the dollar gets an upward push or a downward shove, as they engage in the exchange of merchandise, stock and bond trading, corporate investment flows and tourism.

Although such individuals involved in trading don’t usually think consciously of the economic formulae that drive their decisions, they are responding to “purchasing-power parity” — that is, comparing how much merchandise or services a certain currency will buy in various foreign countries and how that compares with what other currencies will buy. The dollar, by all standard technical tests, has more buying power than its stated value shows. Another way to put it is that the dollar, in most places, buys more than its exchange-rate value indicates. It’s even stronger than it looks. Why does the euro’s survival count for much more than the exchange-rate comparison? The overriding U.S. and global economic problem is that the entire world is counting far too much on selling to the United States. The rate of U.S. consumer spending has continued unabated with the result that U.S. personal-savings rates have dropped, literally, to zero. Yet the United States cannot stop the increase in the trade deficit for fear of the economic havoc that would create among all the countries that live off sales to the U.S. markets.

Only if the best hopes for the euro are realized and European growth figures improve can hopes to improve the U.S. balance of trade be realized. If the euro system starts to unravel, the cause undoubtedly will be the result of a downward trend in European business. The euro’s success — far from being a threat — is of the greatest importance to us and to the whole global-trading system. If the euro fails, the United States would be left as the only substantial buying area and would be the target of economy-killing dumping from every nation in the world capable of getting their products here. That’s great for U.S. consumers for a time, until it wrecks our productive base.

The Business of Exchanges

From the money changers of biblical times to the modern age of intercontinental jet setters, the act of exchanging one form of currency for another has been taking place for thousands of years. Our modern, global economy has spawned a constant need for consumers and businesses to swap currencies, and most international travel wouldn’t be possible without the ability to make money exchanges. Banks, exchange houses, money brokers, hotels and airport exchange counters are all major participants in this dynamic industry. Credit and debit card issuers such as VISA, MasterCard and American Express process millions of currency exchange transactions each day on behalf of their customers, streamlining international trade through advanced technology.

The art of money changing is hardly a philanthropic endeavor. The various individuals and businesses involved in this trade – whether legally sanctioned or not – all have one common motivation: profit. By taking in more money than they return in trade, money changers capitalize on every individual transaction, and by handling a sufficient volume of transactions, a steady and sizeable revenue stream is realized.

In some countries, a “black market” exists for money changing, where participants conduct their business in a highly informal, unregulated manner. While some black market exchangers are actually legitimate entrepreneurs who seek to capitalize on the tourist trade, consumers must always be wary of engaging in these types of exchanges, as they may be prohibited under local law. The potential for violent crime is high, and incidents of robbery and physical battery can and do occur on a regular basis. Additionally, many tourists engaging in black market money exchanges unknowingly accept and distribute counterfeit currency, which exposes them to the possibility of further criminal prosecution.

The Element of Profit

In practice, there are several methods by which a money changer can earn a profit on an exchange. Money changers must not only cover their actual costs of making an exchange, but they must also include a extra margin in order to keep their business viable. Money changers use a combination of exchange rates and service fees in order to ensure a profit on each transaction. Understanding how these figures are calculated can help you get the most out of all your currency exchanges.

Most frequently, the money changer’s compensation will be included in the exchange rate itself. For example, a money changer’s advertised exchange rate for a US Dollars-to-British Pound Sterling transaction might be USD $1.00/£0.5417, and suppose a consumer might need to convert USD $100. What the consumer may not realize is that the money changer’s actual yield in converting USD $100 to the British Pound Sterling might be £56.42. By assessing a 4% fee on the converted amount, equating to £2.25, the consumer would receive the advertised rate in the exchange, equating to £54.17.

In some cases, a tiered fee system is utilized, resulting in a different charge contingent upon the transaction size. In a rare instances, a money changer will charge a flat fee for exchanges of all sizes. Consumers should be cautious of any money changer advertising a “0% commission” for a transaction, as there are probably some other fees involved that may exceed any reasonable percentage-based calculation.

Airports: A Captive Audience

Frequent international travelers are familiar with the need to change at least some of their home currency over to foreign currency before arriving at their destination in order to pay for incidental expenses like taxi fares, tips and other small purchases. In general, while an airport exchange counter is often the most convenient location for consumers to make currency exchanges, these counters also tend to offer the worst value.

Passengers awaiting flights in an international airport terminal constitute something of a captive audience, and money changers are keenly aware of this. As a result, they essentially have the liberty to charge consumers whatever rates and fees they want. Some governments regulate airport exchange rates, but for the most part, it’s a free market. Additionally, airport money changers often have high overhead costs, due primarily to the fact that their airport real estate costs are artificially inflated. Unless their rent is being subsidized by the local governmental airport authority for the convenience of all airline passengers, these overhead costs are passed along directly to consumers in the form of higher fees and poorer exchange rates. At some international airports, the combined fees for currency exchanges can be as high as 10-20% of the transaction amount.

If you absolutely need to exchange currency at a departure airport, try to make it a small transaction that will tide you over until you have some other options available at your destination. If you want to exchange currency prior to returning home, allow yourself enough time at the end of your trip to investigate other options before getting to your departure airport.

Heartbreak Hotels

Hotels represent another convenient means of exchanging money, though they are not known for providing the best value in currency exchanges. The hotel business is geared around the notion of comfort and convenience. From an accountant’s standpoint, room rates merely represent a base charge upon which hotel staff can then add various service charges for convenience items, so the “privilege” of being able to exchange your money at the same location where you rest your head each evening comes at a steep cost. Smaller hotels may not offer the service at all.

One slight advantage of using a hotel’s services to obtain foreign currency is that the charges can usually be added to your bill for convenience, but this convenience can be costly. Since most travelers end up paying their bill by credit or debit card, the cost of obtaining foreign currency from a local ATM machine that honors cards from the VISA, Plus, MasterCard, Maestro, or Cirrus financial networks may actually be cheaper than getting currency from the hotel.

Banks: The Best Bang For The Buck

Banks, in general, offer the best rates of exchange to consumers. This is primarily due to the fact that banks tend to base their exchange rates on “wholesale” prices offered to their larger commercial customers. All banks compete with one another, and it’s rare to find any two banks offering the same rate of exchange and fees on a particular currency transaction. Provided that you have the time and motivation, it often pays to shop around for the best deal before committing to a transaction.

Large commercial banks with an international presence will tend to offer better exchange rates and fees than smaller banks. This is due to the fact that many smaller institutions lack the infrastructure to process currency exchange transactions in-house, and will instead partner with a larger institution through a “correspondent” relationship to provide these services. The partnership comes at a cost to the smaller bank, which in turn, passes the expense along to consumers in the form of higher rate and fees.

Even in some of the largest foreign cities, the task of finding a conveniently located bank is not always easy. Additionally, banking hours can vary widely from country to country, creating another obstacle to exchanging currency. Many a traveler has frantically rushed to a foreign bank branch recommended by their hotel’s concierge, only to find the bank’s doors locked for the day. So while banks offer the “best bang for your buck,” it’s important to remember that even your friendly, local neighborhood bank branch includes a significant profit component in all of their consumer currency exchanges.

Money Brokers: The Exchange Specialists

Money brokers specialize in providing currency conversion services. Sometimes known as a “bureau de change” or a “casa de cambio,” the typical money broker deals in a wide range of currencies to accommodate the various needs of tourists and businesspeople. As in any free enterprise system, money brokers compete with each other, so comparing the exchange rates and fees offered by rival firms can often yield pleasant surprises.

Some money brokers and other financial firms offer express currency exchange services, by which a customer can receive foreign currency without ever leaving home. Upon receiving an order, the broker issues a pre-authorized Electronic Funds Transfer (EFT) request which deducts the exchange amount and all associated fees from the customer’s bank account. In the alternative, costs can also be charged to a credit card account in many countries. The foreign currency is then shipped to the customer by means of a secure, overnight delivery service. While the fees for such services are comparatively higher than most other forms of money changing, many consumers prefer the convenience of being able to have foreign currency delivered to their home or office before leaving on a trip.

Words To The Wise

All reputable money changers post their prevailing exchange rates where consumers can clearly inspect them. Use this fact to your advantage, and always shop competitors to make sure you get the best deal possible.

Take the time to gain a basic familiarity with a foreign currency before you actually end up handling it. There are numerous Internet resources available that include depictions of foreign currencies, as well as the denominations issued. The ability to count your change can be a very valuable skill when you need to make an exchange, and even with limited experience, you may be able to spot counterfeit bills.

Additionally, consumers should always ask for a printed receipt containing the details of their transaction. Not only does the receipt serve as a record for comparing rates of exchange and fees for future transactions, but the receipt may actually be required should you need to convert foreign currency back into your native currency. Many countries have limits on the amount of currency that can be converted upon departure, and without a valid receipt, you will have no means of being granted an exception to the rule, or of proving how you acquired a large amount of currency as a foreigner.

Is currency trading right for me?

The dynamic nature of the foreign exchange marketplace is an appealing draw to many investors. But as is the case with any type of investment vehicle, there are risks and rewards to be dealt with in currency trading. The opportunity for round-the-clock, computer-based virtual trading on the international currency markets is highly appealing to those investors who don’t wish to bound by the outmoded conventions of traditional equities and commodities markets. As an added attraction, the potential for a skilled investor to realize significant profits in foreign exchange is large. But market participants must also familiarize themselves with the potential downsides of international investing to determine whether or not foreign exchange should play a prominent role in their portfolios.

Managing risk

By definition, every astute investor is also a risk manager. He or she must constantly evaluate the potential upside of a transaction versus its potential downside, taking necessary precautions to preserve principal while taking maximum advantage of opportunities for growth. As is the case with other common forms of investing such as stocks, bonds, real estate, bank deposits, antiques and precious metals, currency trading also has some inherent risks and rewards. The decision whether or not to partake is a highly personal one, and should be made very carefully.

A completely different animal

At first glance, the appeal of the foreign exchange marketplace is easy to understand.

For starters, the foreign exchange markets are truly global in nature and operate around the clock. Unlike traditional equity markets such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealer Automated Quotations (NASDAQ), there are no set trading hours for the foreign exchange market. With no opening and closing bells to constrain or influence trading activity, and no demanding shareholders to satiate on a quarterly basis, the foreign exchange marketplace is considered by some investment professionals and economists to be a better real-time barometer of global economic activity than many other computed indices.

Portfolio diversification

Anyone familiar with modern asset allocation models understands the benefits of maintaining a well-balanced array of investment vehicles that meet predefined criteria. The introduction of a foreign exchange component can offer a unique form of diversification to an investment portfolio. Due to the unique nature of the currency markets, foreign exchange rates are not tied to major equities indices such as the Dow Jones Industrial Average® or the Standard & Poor’s 500®, and are not directly influenced by bond rates.

Appealing potential

For the savvy investor, the notion of realizing large profits in foreign exchange transactions is enticingly high. Given the fact that the average daily volume of the foreign exchange market is 30 times larger than that of the U.S. equity markets, huge volumes of money are changing hands on a regular basis, giving investors more opportunities to realize profits. In fact, many hedge funds now make extensive use of foreign exchange instruments such as derivatives, futures and options as a means of supplementing lackluster returns in their equity portfolios.

Improved market access

For many years, the minimum investment threshold in foreign exchange was firmly fixed at $1 million or greater, effectively barring many individual investors from participating in these markets. But in recent years, this price-of-entry figure has dropped in many cases to just $10,000, providing access for many more non-institutional speculators.

With all of the good things going for it, currency trading might seem like it’s the right choice for almost every investor. Lest we paint too rosy a picture here, there are also some distinct disadvantages to dealing in the foreign exchange markets that one must factor into the decision making process.

Inherent risk

Each foreign exchange transaction is unique and comes with its own associated risks, including volatility, exchange rate risk, credit risk, monetary risk, interest rate risk, and the possibility of government intervention in the financial markets. A wise investor always takes the time to study these individual variables before deciding to plunge into a new currency transaction.

Rock around the clock

The global nature of currency trading means that the markets are always open, hence time zone differences must be reckoned with. London is the undisputed capital of foreign exchange, due in part to the large number of global investment banks located there, and to London’s geographic distance from the International Date Line. To catch what’s happening on the foreign exchange markets as London’s business day starts at 8 a.m. local time, a New Yorker must rise at 3 a.m., and a Los Angeles trader must be awake at midnight. Therefore, it comes as no surprise that U.S. participants in the currency markets sometimes have strange sleep cycles.

No safety net

Because the foreign exchange market is largely unregulated on an international scale, trading activity is generally subject to the laws and customs of each individual participant’s home nation. U.S. investors in traditional instruments such as certificates of deposit, stocks and bonds are afforded some form of protection by various governmental, quasi-governmental and private regulatory bodies such as the Federal Deposit Insurance Corporation (FDIC), the National Association of Securities Dealers (NASD), the Security Investors Protection Corporation (SIPC), the National Futures Association (NFA) and the Municipal Bond Insurance Agency (MBIA). However, in comparison, participants in the foreign exchange markets are afforded relatively few protections. Therefore, investors walking the high wire of the currency markets must be extra cautious when conducting their business.

The curse of devaluation

One of the most perilous events for foreign exchange traders occurs during episodes of currency devaluation. When a government devalues its currency in relation to other nations’ currencies, a substantial reduction in the prevailing exchange rate takes place. Sometimes, devaluation is a process that takes place over a matter of years. At other times, it happens in the blink of an eye. Either way, paper notes, bank deposits and other currency-derived instruments can quickly lose tremendous value, all due to a variety of social, economic and political factors which are completely beyond the average investor’s control.

A dramatic example of currency devaluation induced by inflationary pressures occurred when the German deutschmark suffered a precipitous drop between the World Wars. Saddled with war reparations imposed by the Treaty of Versailles, Germany was thrown into chaos when the prevailing exchange rate went from 4 marks to the dollar in 1916 to about 4 trillion marks to the dollar in 1923.

In 1960, the French government chose to devalue the franc in a move to rectify economic imbalances that had developed over the previous decade. Currency holders received one new franc for every 100 old francs in their possession. Needless to say, foreign currency traders who had acquired sizeable holdings in francs prior to the devaluation lost significantly sums of money as a result.

Another example of huge financial losses which were partially tied to currency devaluation occurred in 1998. Long-Term Capital Management (LTCM), a hedge fund based in Greenwich,Connecticut, used a series of complex investment strategies to build up a large, highly leveraged portfolio consisting primarily of domestic and foreign bond futures. When Russia suddenly devalued the ruble in August of 1998, the resulting shock wave spread around the world and severely impacted investments tied to the value of the ruble, including those amongst LTCM’s massive holdings. The event prompted the U.S. Federal Reserve Bank to assemble an unprecedented $3.65 billion bail-out fund from 14 different commercial banks in order to shore up LTCM’s losses and prevent further economic damage. LTCM eventually liquidated its remaining assets and closed its doors in 2000.

A weak dollar

While the markets rarely see devaluation examples quite as extraordinary as these, smaller scale devaluations happen on a fairly frequent basis. Even though the value of the venerable U.S. dollar is generally viewed as being fairly stable, between February 1985 and February 1987, the dollar still managed to fall almost 30 percent against major foreign currencies. There are no guarantees that this won’t happen again someday.

Your own worst enemy

Markets can rise and fall quite quickly, and an inexperienced currency trader can instantly be blindsided by his or her own poor decision-making. Many foreign exchange investments are executed on a highly leveraged basis, so dramatic swings in the market can lead to an investor being exposed to substantial risk, possibly culminating in catastrophic portfolio losses. Assessing personal risk tolerance is an important step for any individual to take before plunging into a new investment. It is a particularly appropriate measure with regard to entering the foreign exchange marketplace. Arming yourself with the appropriate knowledge and the best analytical tools can go a long way in making you a more effective currency trader.

Buyer and seller beware

With no global regulatory body in place to oversee international trading activity on the foreign exchange markets, the potential exists for participants to engage in illegal activity and questionable business practices. Traders are bound largely by the laws and conventions in their own country of residence. Some types of transactions involving foreign currency can be quite complex, and as such, individual investors must have the utmost confidence in the individuals and firms with whom they choose to do business. By the time the various parties with interests in a suspicious transaction have put the puzzle pieces back together, considerable financial damage can be wrought, and the available avenues for legal recourse are often limited – or worse – nonexistent.

The underlying mechanics of foreign exchange are necessarily complicated. For the markets to function in an orderly manner, a great deal of cooperation and communication must occur between all interested parties. While actual transactions are usually executed by means of a quick telephone conversation or a simple click of a computer mouse, individual investors need to fully comprehend the risks borne by dealing with a faceless business partner or by engaging the services of intermediaries to execute their trades.

Who’s Minding The Store?

Under the terms of domestic legal conventions such as the Uniform Commercial Code, it is presumed that all parties to a business transaction are acting in good faith. In principle, the foreign exchange marketplace is no different, even though no set of legal codes exists to enforce compliance with commonly accepted international business practices. Unfortunately, traders in foreign exchange cannot rely on a Geneva Convention-type treaty that demands fair treatment for all market participants, or a Warsaw Convention-type policy that limits participants’ liability should things suddenly go awry.

Harkening back to the very definition of the medium, currency is exchanged between two parties because they mutually believe that currency has a common value. But recent history clearly shows that in spite of the trust and faith placed in individuals and institutions, sometimes, all is not as it seems to be. And occasionally, whether due to malfeasance or outright criminal activity, the impacts of fraud can cascade across the world like a tsunami.

The “other” irrational exuberance

Anyone who has ever been captivated by the Las Vegas-style slot machine known as a “one-arm bandit” can tell you that the heart and the mind don’t always cooperate with each other. Drawn like a moth to the flame, an adrenaline-fueled speculator will often continue to feed a highly irrational investment scheme to the point where he or she is utterly oblivious to the eventual outcome. Trading in the foreign exchange markets requires a mindset that will allow continual comparisons between the rational and the irrational. The business of foreign exchange also requires a system of internal checks and balances to ensure that solvency is maintained at all times.

Unstable pyramids

While confidence games come in all shapes and sizes, one of the most common types of fraud in the financial services industry is a criminal enterprise known as the “Ponzi scheme.” Originally named after Charles Ponzi, a dubious New Englander who bilked investors out of millions of dollars in the 1920s through a sham involving international mail coupons, Ponzi schemes – or “pyramid” schemes – continue to operate illegally in every country today. In a typical Ponzi scheme, an individual or company attempts to hide its mounting investment losses by luring in new customer money and paying old investors with new deposits. When losses hit catastrophic levels and customers are unable to withdraw their money as promised, the entire “house of cards” topples over.

In a classic example of a Ponzi scheme, a Princeton, New Jersey trader by the name of Charles Kohli induced his clientele to fund bad currency trading investments through a series of small companies, culminating with the loss of more than $40 million of private investors’ money in 1995. Kohli was subsequently convicted and sent to prison.

The wrath of the rogues

Even within large, seemingly stable financial institutions, certain personality types can lead to undesirable behavior patterns which skirt established policies and procedures put in place to minimize an institution’s risk of exposure to bad deals. Often classified as “rogue” traders, these individuals can shake entire organizations to their very foundations.

The Barings Bank of England collapse in February of 1995 has become a classic case study on risk management and “rogue” trading. Barings, a well-known and respected British investment house, was decimated to the tune of almost £850 million by the activities of a single person. Nick Leeson, a trader based in the firm’s Singapore office, engaged in a series of risky transactions, all while carefully concealing his mounting losses through faulty internal accounting procedures and funding new investments via new lines of credit without management’s authorization. While the scandal didn’t arise directly from interbank foreign exchange trading, it did involve certain futures contracts and over-the-counter (OTC) deals that were not listed on any official exchanges. The incident led to the enactment of new regulations regarding the reserves that are required to be held by international banks engaged in making commercial loans. Today, Barings is no more, and Leeson sits in a prison cell serving a lengthy sentence after being extradited back to his native >Britain .

Five years after the Barings collapse, another “rogue” trader at a U.S. division of Ireland’s Allied Irish Bank accrued $690 million in losses involving Japanese yen/U.S. dollar transactions made over the span of several months in the year 2000. Again, poor internal controls and a lack of management oversight were primarily to blame.

Where are the currency police?

It strikes some investors as odd that there is no single entity that regulates the foreign exchange marketplace. At various points throughout history, individual nations – including the U.S. – have attempted to exert control over the markets, but have failed to succeed. Most traders agree that this is a good thing – ensuring that no one nation can unduly influence the financial affairs of another, or unfairly restrict international trade. In the case of foreign exchange futures, U.S.-based investors have some limited protections afforded to them under the watchdog activities of the Commodity Futures Trading Commission (CFTC). However, the CFTC doesn’t regulate the foreign exchange industry per se – it only monitors compliance with domestic statutes involving the trading of currency-based futures.

Watchful eyes of government

Over the years, numerous U.S. law enforcement and governmental agencies have investigated domestic and international criminal activity involving the foreign exchange markets. Because financial crimes often involve interstate activity, the bulk of enforcement efforts often fall under the jurisdiction of the federal government. The Securities and Exchange Commission (SEC), the Department of the Treasury, the Federal Bureau of Investigation (FBI), and the United States Postal Service’s Postmaster General (USPS) have all played key roles in uncovering fraudulent practices. Additionally, attorneys general offices in many U.S. states have developed highly-trained task forces which are devoted exclusively to the pursuit and prosecution of financial crimes.

Self defense tactics

Individual investors should always be wary of institutional foreign currency traders who promise huge profits with little or no risk. Additionally, any foreign exchange trader who urgently pressures a client to authorize a trade must be viewed with some degree of suspicion. Unlike securities brokers who must be licensed by the National Association of Securities Dealers (NASD) in order to legally conduct business, there is no universal accreditation in the world of foreign exchange. Thus, the onus falls on the individual investor to vet the authenticity of any trader with whom he or she chooses to do business. While foreign currency traders may or may not also be licensed to sell securities, investors can easily check with the NASD to see if there is any history of violations or enforcement actions against registered individuals.

When investors deal with large institutions, there is often a presumption that the risk for being victimized through fraudulent activity is generally low. In reality, this is not always the case. Investors in the foreign exchange markets must learn how to read and interpret the statements that they receive from any trading firm. Oftentimes, questionable entries on a paper statement are the first tip-off that a customer’s account has been used for unauthorized activity. Investors also have the right within reason to ask for an explanation of a firm’s internal accounting controls, and should feel free to inquire about the educational and business backgrounds of any individuals who might be assigned to servicing their accounts. Investors can also access the SEC’s various databases and query various states’ attorney general offices to check for violations and enforcement actions against U.S.-based financial firms.

The foundations of modern foreign exchange

The beginnings of modern currency trading can be traced back to the origins of money itself. A key tenet of foreign exchange theory involves a shared belief that various forms of money have value, and can be readily exchanged for products, services and other commodities. Currency has a long history of being backed by the value of various precious metals, including silver and gold. During the nineteenth century, most of the currencies in worldwide circulation were backed by stores of gold bullion, a concept first initiated by the government of England. But global turmoil in the twentieth century gradually led to a rescinding of the gold standard. Recognition of the United States of America as a global economic superpower meant that the U.S. dollar was almost universally accepted around the world as a medium for barter and trade. Today, the U.S. dollar continues its dominance by playing a role in an astounding 70% of all foreign exchange transactions.

Money makes the world go round

The origins of coin-based currency date back as far as 2000 BC. The age of modern metal-based coins is believed to have begun in Asia Minor sometime during the seventh century B.C. The first coins were struck from naturally occurring metals such as electrum and silver. Later, other minerals and alloys such as bronze, copper, lead and gold were utilized. Due to the fact that these metals were prized for their rarity, the coins minted from them had intrinsic value. Bearers of these coins could literally carry their wealth with them at all times. In fact, many coins from the Roman era had center-punch holes so that they could be strung on a cord for easier transport.

Paper currency is generally believed to have been introduced in China around 806 AD. Unlike coins of the era, paper currency was created as a system of stored value, backed by a known commodity and the credibility of the issuer. In addition to creating an orderly means of trading, the use of paper currency eliminated the need for individuals to haul large quantities of coin – or worse, heavy ingots or bullion – in order to engage in trade. As might be expected, the introduction of paper currency also gave rise to the first incidences of counterfeiting, and the struggle to create highly-unique, non-reproducible bank notes – a challenge that continues to this very day – was first born.

As good as gold

In order to instill real value into money and make it worth more than the paper on which it was printed, governments gradually began to tie their currencies to carefully guarded stores of precious metals. The “gold standard,” or the practice of issuing bank notes directly tied to the value of gold, was first established by England in 1816. The concept proved to be fiscally sound, and by 1900, most global currencies – including that of the United States – were backed by gold reserves. But the stock market crash of 1929, currency devaluations, and the economic depression that followed had impacts of global proportions. These events triggered a gradual evolution away from the gold standard.

In 1933, U.S. President Franklin Roosevelt officially repealed the right of U.S. citizens and business entities to exchange their dollars for gold. However, foreign entities holding U.S. dollars still retained the right to make such an exchange. Realizing that the dollar was growing in worldwide influence, the United States passed the Gold Reserve Act in 1934, allowing the U.S. Treasury to intervene in the foreign exchange market as needed by means of an Exchange Stabilization Fund in order to stabilize the U.S. dollar.

The dawn of global economic cooperation

Already long recognized as one of the strongest nations in the world – both economically and militarily – the United States of America assumed an important role in the global economy. Having emerged from World War I with its industrial might intact, the inherent strength of the U.S. dollar allowed this currency to become a very popular form of legal tender in transactions outside of the United States.

The outbreak of the Second World War in 1939 introduced new economic pressures in many nations. In a few short years, Europe and had been decimated, both literally and figuratively. If there was to be any global economic stability after the defeat of the Axis Powers, the U.S. and its almighty dollar would surely need to play a role in building that stability. To lay the groundwork, a conference of Allied nations was held in rural New Hampshire in 1944. Known as the Bretton Woods Conference, the meeting was intended to foster international cooperation and economic stability in the years following the war. Participating nations agreed to create a gold-based exchange rate for their own individual currencies. At this time, the value of the U.S. dollar was set at $35 per ounce of gold, and the currency exchange rates of participating nations were expressed in terms of dollars. The Bretton Woods Conference also led to the creation of the World Bank and the International Monetary Fund – two important entities that would help to ensure the flow of capital and currency between nations during the rebuilding phase.

For obvious reasons, foreign exchange between Allied and Axis powers was suspended during wartime. Exchanges with the German mark resumed in 1950, and exchanges with the Japanese yen resumed in 1956.

Birth of the floating rate

As the United States continued to contribute huge sums of money to global economic stabilization in the post-war years, the popularity of the U.S. dollar continued to grow. While gold reserves continued to back the value of the U.S. dollar on an international basis, the U.S. simultaneously exported significant amounts of gold to back the currencies of other friendly nations. By 1970, foreign nations held almost $47 billion in U.S. currency, and the U.S. had to face the fact that it no longer had the necessary gold reserves to back this massive exposure. In 1971, the U.S formally decided that its dollars would no longer be tied to the gold standard, and the modern foreign exchange market was born. This became known as a “floating rate” system, under which prevailing currency exchange rates would fluctuate according to supply and demand.

From brittle wires to silicon chips

Technology has been responsible for introducing major changes to the foreign exchange marketplace over the years. For much of the early 20th century, international currency transactions were handled primarily by telegram, telephone and telex machine. The advent of the computer age during the 1960s and 1970s introduced new methods of data transfer to the financial services industry. Thanks to high-speed digital data lines and satellite-based communications systems, foreign exchange transactions could be conducted rapidly and in “real time.” This technological transformation of the marketplace continues today, as new computer hardware and software advances are introduced to aid in maximizing trading efficiency.

New maps and new unions

Geopolitical change continues to affect the currency markets. From the dissolution of the former Soviet Union, to the formal expiration of Britain’s lease on the colony of Hong Kong and its subsequent repatriation to China, to the birth of new democracies in the Middle East – the transforming face of the world also helps to transform the currency trading marketplace.

One of the most dramatic changes in foreign exchange occurred on January 1, 1999, when the euro was adopted as the new currency of the European Union member states. While actual euro notes and coin were not introduced into circulation until January 1, 2002, the new currency had a profound effect on the global economy. The euro was primarily intended to create a unified trade market amongst members and improve liquidity of the financial markets, but it also created new opportunities for foreign exchange, and hence, new opportunities for profits.

The future of foreign exchange

For better or for worse, the U.S. dollar continues to represent the “king” of all global currencies, and plays a role in an estimated 70% of all foreign exchange transactions today, attesting to its strength. In years to come, developing industrial economies such as those of China, India and Brazil will undoubtedly have an impact the foreign exchange markets, but the greenback shows no imminent signs of relinquishing its domination.

Real-time information resources. Real-time profit opportunities.

Welcome to the largest investment marketplace in the world. Each business day, almost $2 trillion worth of currency trades take place on the global foreign exchange markets, providing unparalleled profit opportunities for institutional and individual investors alike. Operating around the clock and at lightning speed from world financial centers such as London, New York, Tokyo, Sydney and Bahrain, this dynamic industry relies upon vast quantities of real-time information to facilitate prudent decision-making. Whether your trading desk is perched high above the city streets in a gleaming skyscraper or merely tucked into a comfortable corner of your home office, modern digital technology has evened the playing field for all market participants by providing access to a wide range of high quality analytics. With the simple click of a mouse, investors can now perform currency conversions using both current and historical data, check interactive cross-rate tables, and review interactive foreign exchange rate tables. Once available to only the most sophisticated international bankers, these affordable, easy-to-use resources can become powerful tools in the hands of every savvy foreign exchange investor.

The world on your desktop

Originally developed as a means to facilitate commerce between neighboring nations, currency trading has evolved into a complex, highly profitable, global industry that significantly impacts governments, financial markets, businesses, and – ultimately – almost every human being on the planet. The constantly changing supply and demand for individual currencies at any point in time determines a value for which the currencies can be exchanged, and investors attempt to anticipate these values and profit from them. While some 170 different currencies are available to be traded today, most actual trades are confined to a specific group of 36 currencies. Cumulatively, these foreign exchange transactions amount to a daily volume of nearly $2 trillion taking place between various parties on six continents, representing the single largest investment marketplace in the world – all accessible from a personal computer with an Internet connection.

The foundations of exchange

From the bills of various denominations that fill our wallets and purses, to the coins that weigh down our pockets, we are all familiar to some extent with currency. In addition to being a form of money that allows us to purchase goods and services as well as settle debts, currency is a stored value system that allows two parties to confidently engage in barter. Currency is also a convenient means of payment because both parties to a transaction have faith that the money is actually worth something, and is backed by a known value.

Just as each individual country has its own form of currency for conducting trade within its borders, there must exist a means of exchange – or a way of converting one form of currency into another – in order for countries to trade with each other. In fact, the primary function of currency trading – also known as foreign exchange, forex, or simply “FX” – is to facilitate international trade. Without this vital economic lubricant to keep the engines of global commerce in peak operating condition, our world would be a very different place today.

From small-time to big-time

On the most basic level, a traveler to a foreign country will convert some of his or her home currency for a foreign currency – either before heading abroad or soon after arriving there – in order to be able make purchases in the local currency. Most travelers aren’t terribly picky about exchange rates when they make this conversion, and simply accept the prevailing rate posted by the exchanger out of convenience. Travelers using credit or debit cards in a foreign country will find that their financial institution automatically calculates the conversion using an exchange rate of their choosing. But in the grand scheme of things, these transactions are generally considered to be insignificant, and rarely do individual consumers contest the rate of exchange that has been applied to these types of conversions.

On a grander scale, individuals, businesses and organizations frequently need to change several thousands or millions of currency units at one time. Importers often need to pay for large shipments of foreign-made goods in the local currency of the manufacturer. International banks often agree to loan a large sum of money to foreign corporations and governments. In these situations, it is essential for at least one party – if not both – to obtain the most favorable rate of exchange possible, either at the time of the transaction, or at some known point in the near future. This is the essence of foreign exchange.

A highly profitable business

Participants in the foreign exchange marketplace attempt to profit from successfully anticipating fluctuations in the exchange rates of different forms of currency. In the world of equities trading, investors are familiar with age-old adage, “Buy Low, Sell High.” The same general principle applies in currency trading, but foreign exchange speculators are focused on more than just a single price. The act of buying a certain amount of currency always involves selling a certain amount of another currency. In most cases, the currency being sold is actually being borrowed by the investor, and is akin to a margin-type situation encountered when trading equities. Therefore, investors trading on the foreign exchange market must be concerned with multiple variables: individual currencies; exchange rates; time factors; and interest rates. When managed properly, these four elements can yield significant profits.

A global marketplace

Typical foreign exchange traders include banks, corporations, brokers, governments and even individual investors from every corner of the world. The overwhelming majority of foreign exchange transactions don’t involve the physical transfer of any currency at all. If they did, all of the ships and airplanes in the world could not carry the paper bills and coins that are represented in these daily exchanges, nor could they do it at the speed necessary to effectively consummate the transactions. Rather, currency trades on the foreign exchange market are accomplished by means of computer-generated accounting entries that reflect deposits of currency held at financial institutions around the world.

The overwhelming majority of foreign exchange transactions each day – estimated at a volume of nearly $2 trillion – are executed for the sole purpose of profiting on the transaction, as opposed to being tied to the sale of goods and services between nations. This makes the foreign exchange market about 50 times larger in volume than the global equity markets. It’s no wonder than participants in foreign exchange trading are motivated by the huge profit potential that can be realized by accurately anticipating fluctuations in currency values.

The virtual exchange

The global nature of the foreign exchange marketplace means that it has no centralized trading floor, no set hours of operation, and no individual governing authority. Trades are conducted at all hours of the day and night around the world, and the parties to the exchanges are bound only by certain conventions, principles and faith that the transactions are legitimate. While individual governments may enforce statutes regarding foreign exchange dealings that take place within their own borders, there is no international regulatory body that polices the industry per se. In spite of this apparent lawlessness, the world of foreign exchange is actually an orderly, self-regulating marketplace that normally conducts its business smoothly, efficiently, and with blinding speed.

Today, the foreign exchange markets represent a unique, hybrid blend of public and private interests that is unduplicated in any other global business sector. In spite of dramatic changes in world political structure and numerous technological innovations that have been introduced over time, the basic underlying principles of foreign exchange have remained constant for centuries.