We all know that central bank decisions are some of the most influential occurrences on the forex markets, but how do the actual mechanics work? When the Bank of Japan lowers interest rates, the SNB stops buying Euros, or the ECB starts buying bonds, what’s going on?
Here we’re going to have a look at the basic mechanics that cause central bank decisions to hit the forex markets. The important thing to remember is that old solid Supply and Demand. Currencies trade based on this in the same way as any other commodity. Central Banks have to affect on, the other or both in order to change exchange rates.

Interest rate changes
Back before 2008 central bank’s simply wouldn’t attempt to intervene overbearingly in markets and interest rate changes were the only likely outcome of a meeting of the Federal Reserve. When the Federal Reserve changes its interest rate, it changes the relative benefit of keeping money in one currency instead of another.

If the central bank increases the interest rate, bank rates and bond rates in the United States tend to go up. If everything else remains equal the US dollar is more attractive to hold that the euro or yen and money begins to flow into the country’s investments.

Basically the price of the currencies with higher interest rates will go up until no more money can be made through simple transfers. On the financial markets, as you can see after major interest rate decisions are made, this happens almost instantly.

Direct market intervention
This is the actual buying and selling of currencies by central banks designed to influence exchange rates. At its simplest level it involves affecting the demand for one currency in another by central bank intervention. It can take several different forms in specific cases, however.

The best example in recent years has been the intervention of the Swiss National Bank which set the maximum exchange rate at 1.2 Franc to the Euro in 2011. The central bank kept its currency low against the euro by printing francs and using them to buy euros, meaning there would always be infinite supply of Francs at that level and none above it. Nobody is going to sell 1.3 francs for a euro when the central bank is selling them at 1.2.

This, of course, was risky for the Swiss National Bank and was a last gasp policy designed to reduce the impact of serious deflation brought on by a flight to safety during the financial crisis.

The other, more common side of direct intervention is propping up a currency: a practice Russia attempted sporadically through 2014. This involves buying your own currency with the central bank’s foreign currency reserves. This is an unstable practice that can result in the bank running out of reserves, and the weakening of the currency accelerating as a result.

Quantitative easing and other innovations
Less understood than direct intervention because of its novelty, QE involves printing currency in order to buy securities, i.e. bonds and equities. The US began doing this several years ago and was followed by the ECB, the BoE and the BoJ. The way it affects currencies is still debatable, but the central theory references two factors: increase in currency supply and lower interest rates.

Buying US treasuries at such a level means that yields fall substantially, lowering demand for the dollar to buy them in and having a knock-on effect on interest rates across the economy, and having the same effect, at one level, as a change in interest rates.

Increasing the money supply by such a margin, 60 billion euro in the case of the ECB program, every month creates a downward pressure on the price of the currency compared to others.

This has been the basic effect of easing programs in the US, Japan and the UK, but the ultimate result of the European program remains to be seen. Further study as central bank innovations keep popping up will result in greater understanding of these mechanics.

Predicting movement

The above gives an outline of the mechanics that central bank decisions drive on the market, but there’s so many factors affecting the supply and demand for currencies that none is a guaranteed bet. Take any currency chart and look at it through the last seven or eight years to get an idea of the unpredictable volatility that drives forex at certain points in time.

Knowing is half the battle, however, so getting used to the way that central bank decisions are made, and learning about these mechanics and the decision making apparatuses behind them will put you ahead of the average market participant and give you insight into the more complicated derivative results of central bank intervention.

Market Place

MKTPlace is a leading digital and social media platform for traders and investors. MKTPlace offers premiere resources for trading and investing education, digital resources for personal finance, news about IoT, AI, Blockchain, Business, market analysis and education resources and guides.

The Financial Conduct Authority of the UK has released a clarification on the nature of copy-trading services like eToro and the kind of permissions that platforms will need in order to carry out the practice in the country.

Copy trading is a relatively new type of investment that allows investors to release their trades publicly and have other traders follow them in their decisions. Online social trading platforms are driving the possibilities, and they’re becoming a big enough problem that financial regulators are .

The basic definition at the heart of the statement from the FCA is the following: If the brokerage asks permission before every copied trade it’s not managing the portfolio. If it executes the trades automatically it is involved in portfolio management and will need a license that allows it to do so legally.

In its own words it is portfolio management in a case where“managing portfolios in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments.”

Regulators move in
The increased popularity of copy-trading is making it impossible for investors to avoid regulating the area, though there seems to be little protest from inside the industry to the current level of regulation. It’s clear that the area is becoming important enough to pay attention to, though it’s not being regarded as a major concern.

A relatively light touch procedure is certainly being followed, but increased regulation may still bring massively increased costs. This week’s announcement could cause an increase in wages and legal fees for some copy trading platforms, and the effects of regulatory action in the UK will inform the debate on similar moves on the line in the United States.

As with so many Internet-borne financial innovations, most traders are waiting to see what the establishment thinks before getting in on the action. With stories of fraud and bad returns strangling much of the media coverage of breakout Fintech, it’s not surprising.
Big returns are there for some people, and there will always be stories of the major victors in the papers. Copy trading should only be added to a portfolio if the risks are understood, and you have a good idea of the process from start to front.

Copy trading gains prominence

With an increase in lower cost trading platforms, copy trading is becoming a real force in retail investment. Though people have always tried to follow the likes of Warren Buffett into big moves, today’s atmosphere is decidedly different from that old-school style.

Nowadays using platforms like eToro you can follow somebody without a news presence and attempt to get exposure to their good decision making. The point of the regulator’s clarification is that this sometimes constitutes portfolio management by the investment services offering it.

Regulators have essentially decided that if the client needs to approve each trade there is no need for the platform to follow portfolio management regulations. If, however, the trades are executed automatically in line with the investor’s follows, that is seen as portfolio management and extra rules have to be followed in order to make it legal.

Shock risks loom big

Famed experts on copy trading sites, like Chris Fahrner a 25-year-old German currency trader, aren’t immune to the problems of the wider market, meaning that shocks, like that in Switzerland last week can cause huge slumps.

Fahrner is one of the stars of eToro who, at his peak, had more than 5,000 people copying his every trade. His total gain across the last year is close to 300%, but in the last three months he’s lost 10% of his portfolio value and copiers keep deserting him. In the last month he’s dropped 15% of his value.

Copy-trading is investing in a single person and, though you may be able to pick the wheat from the chaff, one irrational decision can ruin an investor and wipe out your portfolio at the same time. Shock macro situations, like the Swiss Central Bank’s decision last week can be similarly destructive.

Some are still betting that copy trading will remain a niche method of investing, but the sites involved continue to grow. eToro says that growth in 2014 was four times levels in the previous year, a striking statistic.

Regulators also seem interested in letting the industry breath for the time being, so copy trading, and other forms of network driven social investment, will likely form the backbone of a major trend in changing investment in 2015.

Market Place

MKTPlace is a leading digital and social media platform for traders and investors. MKTPlace offers premiere resources for trading and investing education, digital resources for personal finance, news about IoT, AI, Blockchain, Business, market analysis and education resources and guides.