Money, money, money

Will Hodges on currency: what it is, why we use it – and how it's now a commodity in its own right
Commercial awareness
Politics and economics

People kill for it; Abba sung about it; footballers pine for it; cash; dosh; reddies; wonga; beans; dough - call it what you will, but money in all its forms is fundamental to the workings of economics and of modern society. The credit and debit cards, cash points and internet banking we use today bear little resemblance to the shells and crude coins exchanged between farmers and tradesmen in Sumeria, Mesopotamia, Babylon and other ancient civilisations. Currency and currency exchange has even developed into a multi-billion pound industry in its own right. Yet our use of money and the value we place on it in many ways has remained unchanged.

From shells to small change

History does not record when money was first invented, but its birth can be traced to somewhere between 5,000 and 100,000 years ago. It is thought to have originated when traders, rather than directly bartering their products, began to use intermediary items instead, to exchange goods - typically something of value such as metal wares or crops. This stroke of genius allowed traders to purchase much-needed items outside the season when they would usually produce their own goods, as long as the intermediary item was deemed to hold sufficient value by both parties. The units of exchange gradually became more complex. There is evidence of shells being used as tokens of exchange in parts of China for thousands of years; in Mesopotamia they used standard measures of grain; while in Japan, rice was the preferred medium. Around 1,000 BC, the Chinese began to experiment with using lumps of metals moulded into shapes as a proxy for shells. These early ancestors of modern coins quickly evolved and by 700 BC, standardised units of gold, silver and bronze were being circulated in Greece. These carried official symbols or imprints on them - and so the idea of currency as we know it today had been born.

The idea of a country having a single, universal form of currency is a relatively new idea. For example, before the creation in 1913 of the US Federal Reserve Bank (America's equivalent of the Bank of England), American banks were able to issue their own currencies, leading to the circulation of more than 5,000 varieties of bank notes in the US.

The use of commodity money (money which carries with it some intrinsic value) was eventually overtaken by symbolic currencies (money which carries value, but is fashioned out of practically worthless materials), which were in turn replaced by bills of trade and bank notes. Still, the concept of representative money, that is, currency which could theoretically be exchanged for an equivalent amount of gold or silver, survived into the early 20th century.

Good as gold

The growth of international commerce coupled with the formation of new nation states such as Italy and Germany in the 19th century led to a need for a regulated international monetary system. Without such a system, there was nothing to stop governments from simply printing as much money as they liked in order to trade with their neighbours. Hence the decision that the money supplied by a state should bear a relation to the amount of physical wealth, usually gold, that the country had in reserve. Those issuing too much cash risked diluting their currency, causing what we now refer to as inflation and making it more expensive for them to buy goods from abroad. This system came to be known as the "gold standard" which was to be the world's first recognised exchange rate mechanism.

This system remained in place from 1870 until 1914, when the outbreak of the First World War meant countries were forced to leave the gold standard in order to print more money to finance the heavy cost of war. Unsurprisingly, this decision left the economies of many countries in a bit of a mess. For example, Germany handed over a large proportion of its gold reserves in reparations to the Allies but continued to print money as before, rendering its currency (the Reichsmark) next to worthless, in what became a textbook case of hyperinflation.

In the decades that followed, the international community toyed with a series of substitute ways of governing currency exchange. The most famous of these were the Bretton Woods agreements which aimed to restore credibility to the global monetary system after decades of war and economic malaise. In 1944, in a small town in New Hampshire, 44 states agreed to adhere to a new set of regulations: all members present would have a common "peg" or standard to which they would link the value of their currency. Unlike before, rather than the gold standard, the peg would be the US dollar. Being the only currency still theoretically tied to an equivalent value in gold (US$35 per ounce, if you're interested) the dollar became - and remains - the world's de facto reserve currency. A unit of any given currency had an equivalent value in dollars to which governments were required to adhere closely. The system was not fated to be long-lasting, however - a lack of faith in the dollar as a gold substitute led to the abandonment of the Bretton Woods system in 1971, heralding the current era of monetary independence which allows countries to float their currencies freely against each other in the international marketplace.

Moving the markets

With over $1 trillion moving through it each day, the currency markets have become a key part of the global financial infrastructure. It's not just about buying a few euros for a holiday or traders winning and losing fortunes, it's also fundamental to the global economy. In the age of multi-billion dollar international deals, the currency market is the only place where money can be transferred between parties where they operate in countries that use different currencies. Similarly, institutional investors (pension funds, insurance companies, asset managers, and so on) need foreign cash when buying equities in overseas companies to add to their portfolio. And finally, governments use the currency market to amass reserves - not only of their own currency but also of currencies of other nations.

Meanwhile, the relaxation of fixed currency pegs in most states has opened up the markets to ever greater levels of financial speculation. Foreign exchange (or Forex or FX within the financial industry) is used by traders to take advantage of fluctuations caused by the recession, economic booms, government crises and any development which may alter the value of a given currency. Meanwhile, individuals with some cash to spare are also using internet trading platforms to trade significant volumes of currency from their own homes - it has been claimed that Japanese housewives with large savings have a significant effect on global FX markets. Any country trading its currency on the open market is a legitimate target for speculators, which can have potentially disastrous ramifications for the country involved. The UK Treasury, assisted by a young David Cameron, lost £3.4 billion in a single day in September 1992 (now known as Black Wednesday) when traders successfully bet on the value of the pound depreciating, forcing the UK to temporarily withdraw sterling from the European Exchange Rate Mechanism.

It's not just traders who have learnt to play the sovereign market, however. Countries themselves have learnt to manipulate the value of their own currencies with some accuracy by buying or selling dollar reserves on international markets. Currency trading boils down to a relatively simple case of demand and supply. By buying their own currency in exchange for dollars, governments can boost its value by reducing the supply of it on international markets. Or they can sell their own currency in exchange for dollars, increasing the supply in circulation and thereby reducing its value. While deliberately devaluing one's own currency may seem an odd move to some, it is a common tactic used by governments wishing to lower the cost of their exports and so render them more competitive.

This kind of manoeuvring is not without controversy, however. For example, having been one of the first peoples to experiment with using currency thousands of years ago, the Chinese continue to exert a significant influence on world money markets. In recent years, the Chinese government has been scrutinised by the international community for allegedly deliberately devaluing the yuan in order to keep the country's immense export-led economy ticking over. China's alleged actions have affected its relationship with the US in particular, which remains the largest single recipient of Chinese goods. As the US is keen to boost its own export prowess, Uncle Sam has being putting increasing pressure on the People's Republic to revalue the yuan. So far, however, there has been little sign of China yielding to such demands, and a trade war between the two powers looks increasingly likely.

I'll let you be the one to remind Mr Obama that money was their idea in the first place.

Flex your FX muscles: a career in foreign exchange trading

What's foreign exchange trading all about?

There are many different kinds of traders. Some trade spot FX, that is, trade currencies at today's market prices, while forward FX traders trade currency at a pre-agreed future prices. Finally, some trade more complex currency derivatives.

What skills do you need to be a good FX trader?

Being a good trader is about making decisions in the face of uncertainty, be it financial, economic or political. That means being able to analyse a lot of numerical data, much of it quite complex, so there is a particular demand for people with a quantitative background, say in mathematics or engineering. Good analytical skills are important, as well as an understanding of the international developments which drive the currency markets.

What does FX sales involve?

FX sales and FX trading are fundamentally different jobs. Those on the sales side will not trade themselves, instead concentrating on building relationships with clients by offering advisory services, market information and analysis to clients with the aim of generating interest and so being rewarded with more business.

Who could I work for?

Most of the larger investment banks have dedicated in-house FX services. In addition, there are a plethora of stand-alone broker-dealers who specialise in foreign exchange. The City is recognised as being the home of the FX market, so if you're happy to be based in London, you have plenty of options. You could also work for one of the companies who provide FX trading platforms to clients as well as research and market information.

Is now a good time to go into FX?

FX was very resilient throughout the global financial crisis and a number of institutions are now growing their operations and staff head counts in this area. At the end of the day, companies, governments and individuals will always need to trade currencies so it'll always be a good area to go into!

Continue learning below