At the end of 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 the US dollar against gold. Which allowed all other currencies to be pegged against the US dollar.
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.
Bretton Woods
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 into 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:
- Market makers, as their name suggests, “make” or set their own bid and ask prices themselves and
- 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 customers’ 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 commissions usually makes transaction costs cheaper for ECN brokers.