Sunday, January 20, 2013

Currencies Games In Danger Zone

The games central bankers are playing in supporting their and other currencies has reached a dangerous level, we may be in the "red zone". Currencies are important chips in the commerce of government and the business of running a country. History has shown that in the past both leaders and governments have fallen with the demise of their coin. The volume of trades, the sheer magnitude of monies flowing back and forth across borders has become staggering. This area of finance has become the worlds largest casino, where players have the potential to quickly suffer staggering losses.

The British pound, U.S. dollar, and European euro are just a few of the many currencies that are traded. The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutions, speculators, corporations, governments , businesses, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 survey, coordinated by the Bank for International Settlements, average daily turnover was $3.98 trillion in April 2010, of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps and other derivatives.

Recently trading in the UK accounted for 36.7% of the total, making it by far the most important center for foreign exchange trading. National central banks play an important role in the foreign exchange markets as they control the money supply, inflation, and/or interest rates. They can use their often substantial foreign exchange reserves and currency swaps to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful and questionable in the long term. While central banks do not go bankrupt if they make large losses, there is no convincing evidence that they do make a profit trading.

Figures show that about 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency but they were solely speculating on the movement of that particular currency. Hedge funds have become a huge player and have gained a reputation for aggressive currency speculation often using borrowed money. They may even overwhelm intervention by central banks to support a currency if the economic fundamentals and prospects are extremely weak. Individual Retail speculative traders constitute a growing segment of this market.

Back to the idea that we may now have entered "the danger zone". In a silly movie promoted as a political and financial thriller  named "Rollover"  the stars played by Kris Kristofferson and Jane Fonda watch the world collapse and crash. Things have progressed since the film was made back in 1981. In the past currencies were part of a self regulating self adjusting system that was suppose to punish those guilty of economic mis-steps. Today it is questionable how well that mechanism functions, an argument could be made that it is becoming less effective due to manipulation from both central bankers and politicians alike. A word of caution, actions have consequences, and countries can still be punished through their currency.    

More and more often we see Central Bankers pulling rabbits out of their hats. Last summer Mario Draghi, president of the European Central Bank gave a speech, now many people say that "he saved Europe."  Intervention and manipulation seems to be the flavor of the day,  making real value an outdated concept. A falling currency is a double edged sword, while it increases exports by making them less expensive it makes everything imported into a country more expensive. Like in the silly film first viewed decades ago, if people lose faith in the system it could just come crashing down around our ears. At a time when billions of dollars can be traded in just the blink of an eye imagine how fast things could go to hell.

Footnote, this is all a continuation down a murky path, please see the following post. One deals with how this has detached from reality and other looks at how if a meltdown occurs many people will use it as a reason to adopt a new "world currency"

Footnote#2, A few more recent post concerning currencies can be found below

1 comment:

  1. I'll ask the dumb question - where is all this 'money' coming from? What are hedge funds using to buy foreign currency? I suspect it's debt - which itself is frequently borrowed (after all, deposits in banks are just a loan). So this entire merry-go-round consists of fred loaning to joe who loans to bob, who takes a bet on bert, and bert is loaning fred... and all the time, the banks take a cut of the action and claim huge profits from virtual cuts of virtual transactions.