by David C. Ballantine

    ICT Revolution: Access For All in the FX and Commodities Markets

    According to Investopedia, a market is defined “As a medium that allows buyers and sellers of a specific good or service to interact in order to facilitate an exchange. The price that individuals pay during the transaction may be determined by a number of factors, but price is often determined by the forces of supply and demand.”

    Money-changers have facilitated inter-country trading since ancient times. They are mentioned in the Bible, where it states they carried out transactions outside the temples even before the Christian era.

    In today’s world, markets have become extremely sophisticated with technological advances. One particular sector has profited from these enhancements: the FX markets. The requirement to exchange goods and services helped facilitate the FX markets in its most basic physical state after the barter system was no longer used. The exchange of money or items that were used as the equivalent of money gave way to a new exchange for goods or services on a worldwide platform. Fees or commissions are charged by the money-changers of the modern era in this facilitation of foreign exchange.

    The foreign exchange market in its current form was initiated during the 1970s after the Bretton Wood system gave way. This previous system had fixed rates of exchange and had set the rules and regulations between industrialised countries regarding foreign exchange. After the Second World War, it was replaced by a floating exchange rate system.

    The most significant leap in information technology was the change from the open cry system, carried out on exchanges such as the London International Financial Futures Exchange (Europe’s largest derivatives exchange), to the electronic trading platform. LIFFE was established in 1982, after the removal of currency controls in the U.K. in 1979. The exchange was developed along the same criteria as the Chicago Board of Trade and the Chicago Mercantile Exchange in the U.S.

    On 24th November 2000, the last three of what were once 26 open cry pits on LIFFE closed because LIFFE had progressed with LIFFE Connect, their electronic trading system for all aspects of the derivatives markets, including foreign exchange and commodities in various types of contracts.

    This allowed clients the opportunity to have a variety of trading software platforms to encourage traders to trade on LIFFE Connect. In time, this led to traders from varied and diverse time zones to trade in global fx and commodities markets throughout the world. Eventually, LIFFE Connect sold their trading platform to the Tokyo Financial Exchange, the Chicago Board of Trade, and the Tokyo Stock Exchange. LIFFE was ultimately bought by Euronext and became Euronext LIFFE in 2002, possibly due to its late entry into electronic trading through LIFFE.

    There were significant improvements in the electronic-screen-based trading as both computer hardware and software improved, allowing today’s investors, other participants, and even the man on the street access to the fx and commodities markets to trade with nothing more than a laptop, a dongle, and some downloaded software. However, it is more advisable to leave the trading to professional traders than take the huge risks involved. But the siren song beckons to many investors since the returns from the fx are potentially among the highest of any investment asset class.

    The ultimate evolution has been the implementation of automated algorithmic trading, which takes emotions out of the investment decision process. This approach uses computer software to make programmed decisions regarding whether to buy or sell positions in the markets.

    These innovations have decisively led to the fx and commodities markets being seen as the purest examples of Adam Smith’s free market definition. Defined in Wikipedia as “A market structure in which the distribution and costs of goods and services, wage ratesinterest rates—along with the structure and hierarchy between capital and consumer goods—are coordinated by supply and demand unhindered by external regulation or control by government or monopolies” (http://en.wikipedia.org/wiki/Invisible_hand).

    These markets trade a staggering $4 trillion per day. The fact that the market is globally decentralised and has high volumes, which are transacted through the markets daily, means that access to the capital invested is very quick. This transparency allows exchange rates to be set by the law of supply and demand, averting the risk of control measures being put into place and showing that discipline leads to profitability even in this particular trade.

    Trading takes place 24 hours a day in all time zones from Monday morning to Saturday morning. It is anchored around financial centers throughout the world, which determine the relative values of currencies and commodities in various countries. The opportunity to leverage on these markets means that the initial investment is a fraction of the money at work in the markets. For example, in a trade with margin where the amount of money invested can be a multiple of the initial sum up to 400 percent, a $400,000 trade in a currency would only require an investment of $1,000.

    Carbon is the latest commodity to be developed in relation to new emissions standards set by the Kyoto Protocol framed by the United Nations. This agreement binds industrialised countries and urges governments worldwide to prevent carbon emissions.

    However, the over-the-counter nature of the carbon market in the Middle East has led to a plethora of companies being set up. It is the selling brokers of the carbon products setting the price which is not listed on a proper exchange market. Instead of buyers and sellers setting the price through interaction of demand and supply, there is no clear price determinant in this market, leading to utter unpredictability and broker-led pricing. With a number of companies charging as much as 40 percent of the initial investment in fees from the clients, they are still able to return a profit to these investors, which is a business model not often seen.

    The carbon market will continue providing finance for innovative energy sources, although not potentially in its current form. It may come into the existing commodities markets under a new title such as green energy, just as oil and gas is at present within the Natural Resources section. This may allow green energy to be traded, although this might be done through the electricity market, where Scotland has 25 percent of Europe’s renewable energy resources.

    With the advancement of market trading onto handheld devices, the man on the street has accessibility to these markets like never before. Investments in these markets should represent 10 percent to 20 percent of everyone’s portfolio. However, with increased accessibility to the markets through improved information technology, one should be extremely careful since this type of direct investment can prove very difficult for the novice self-investor.

    David Ballatine is the Chief Investment Officer at Alfa Financials (Dubai).

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