In 1982, I started my career as a trader in the currency futures pits of the Chicago Mercantile Exchange (CME). But my first currency transactions took place three years before and 6,000 miles from Chicago while spending a year in Israel as a student at the Hebrew University of Jerusalem.

At that time, inflation in Israel was running more than 1,000 percent annually. The Israeli government, unwilling to admit how weak the Israeli pound (now the “shekel”) truly was, fixed its value at an unrealistically high rate relative to the dollar. The government tried to forestall devaluation by the implementation of currency controls, prohibiting Israeli citizens from selling their increasingly worthless native currency to buy dollars. I had a total of five hundred bucks spending money, an amount I initially feared would barely last through the first semester. However, I found myself becoming wealthier with each passing day as my dollar nest egg appreciated in value.

Timing the Trade
As an example of the incredible purchasing power of the greenback, the annual cost for room and board at the university was 4,200 pounds, an amount that, when I arrived in Israel at the start of the school year, equated to about $100 a month. I did not, however, pay the bill until year-end, at which point I was able to purchase 4,200 devalued pounds for about $100 and settle my account for one-twelfth of what it would have cost me had I paid upfront.

Israeli banks were prohibited from exchanging pounds at other than the official rate. So in order to take advantage of the arbitrage opportunity – although I didn’t actually know that what I was doing had a name – it became necessary for me to transact business in the thriving black market for dollars. This was a market the Israeli government allowed to operate practically unfettered, and it was as close as your next-door neighbor and open for business virtually anywhere and at any time.

At various points during the year, I exchanged dollars with a stranger at a bus stop, the proprietor of the neighborhood grocery store and, incredibly, while waiting in line at the bank to pay an electric bill.

The underground economy was as much a state of mind as an actual marketplace.

A Precursor to the Trading Floor
In most cases, however, when I wanted to change money I would make my way to the Old City of Jerusalem. There, in the teeming Arab souk just inside the Damascus Gate, mustachioed moneychangers smoking hand-rolled cigarettes paid the highest rates for dollars. They ushered prospective customers into their cramped booths like honored guests, sealing transactions with hot mint tea served in unwashed glasses. For me, these trips were not merely about making a profit, but experiencing the sights, sounds and smells of the bustling marketplace. The butcher shop with whole lamb carcasses hanging from hooks in the open air, the sharp crack of backgammon dice against olivewood, the plaintive cry of the muezzin calling the faithful to midday prayer, the aroma of grilled meats, exotic spices and a thousand other smells—some familiar, others unidentifiable—that mixed together in what can best be described as the pungent smell of commerce. Being there was exhilarating, as well as a bit frightening and not so terribly different, I would think a few years later, than standing in the pit on the floor of the CME.

My First Brokerage Job
I became accustomed to doing business in the souk, rushing up and down the alleyway from moneychanger to moneychanger, first to Hamid, then to Abdullah, finally to Naghib, and then back to Hamid to get his final, best rate. Again, not so much different than I would do a few years later in the pit!

I also expanded my operation, changing money for my fellow students at Hebrew U., most of whom did not want to bother with dealing with moneychangers. I charged a ten-percent commission for this service. Although I found that waiving the fee for my prettiest customers – my first introduction to the concept of soft-dollars – dramatically improved my social life. As I spread the word, my client list grew, but after a few months I began to notice a drop-off in business and profitability. It seems a competitor had emerged. He was a fellow overseas student – from New York, of course – who was changing money for a five-percent commission. This meant that I was going to have to work twice as hard to make the same amount of money. I did not appreciate, until many years later, how accurately this foreshadowed later events in my currency-trading career.

While this trip down memory lane has been fun for me, you may be wondering how it is relevant to achieving an understanding of currency trading in the year 2005. Anyone who has traveled outside the U.S. in the last 12 months, anyone who imports or exports goods, or anyone who invests in companies with a global reach will get the point. Unpredictable currency values create risk, but it should not be forgotten that they also create opportunity.

For everyone who has been hurt in the last year by the falling dollar, there is a doppelganger somewhere in the world that has gained. It is a zero-sum game in which we are all players. For every American tourist who cursed last year when paying $600 a night for a tiny room in Paris in which the only view of the Eiffel Tower was on postcards for sale in the hotel lobby, there is a French exchange student at an American university who is ecstatic about how cheap room and board is.

It Ain’t Over ‘Til the Fat Lady Trades:
CME Currencies Are Back
When currencies began trading at the CME in 1972, they were the first financial futures products. The product line experienced tremendous growth for about 20 years, fueled by an inflow of retail orders, bank participation and so-called “locals” – like yours truly – who stood in the trading pits and provided liquidity. By the mid-1990s, however, CME currency trading began to decline, as a number of New York banks expanded their currency trading operations and captured a significant portion of the market share the CME had developed. There were a number of reasons why the banks were able to outmaneuver the exchange.

But the most important thing that happened was that Reuters developed an electronic trade-matching platform called Dealing 2000 that allowed market participants to communicate over a computer network. (The current generation’s product is called Dealing 3000.)

This doesn’t sound very interesting today, but in 1992 it constituted a revolution. In response to the success of Dealing 2000, a group of the world’s largest banks—who had never been happy about having to share the forex pie with the CME or anyone else—saw an opportunity in electronic trading to recapture what they felt was their rightful superiority in the FX market hierarchy. Therefore, in 1993 they formed a consortium called Electronic Broking Services, or EBS, and established an online network of FX market makers that has become the primary market for the world’s cash currencies. (The entire market for cash currencies is referred to as the interbank market.) Today, while Reuters maintains a strong presence in FX, particularly in the British pound, Canadian dollar and Australian dollar, EBS is the clear leader in Japanese yen, euros and all the key currency pairs. It is estimated that more than 85 percent of all interbank spot business (transactions in which delivery must be made within one to two days) is done on EBS or Reuters.

Give and Take
As the amount of business transacted on EBS and Dealing 2000 grew by exponential measure, CME currencies seemed to shrink in response. Its traditional customers left the exchange en masse, and local traders moved on to other pits and, eventually, electronic markets. Industry experts smugly predicted the imminent and certain demise of the exchange’s venerable product line. As one who sat on the CME board of directors at that time, I can tell you that many exchange members were convinced the pundits were right. But EBS and Reuters are largely closed systems, restricted to banks and currency dealers. The CME board recognized that the exchange’s FX product line could fill an important niche and recapture market share if the business model was adjusted to address the needs of those who did not qualify to trade on the cash market systems.

Therefore, beginning in the late 1990s, the exchange implemented a series of initiatives to bolster its presence in the currency markets that today are producing sustained and significant growth. The two most important steps it took relate to transitioning business from the trading pit to Globex, the CME’s electronic trading platform.

First, the exchange allowed customers to choose whether to conduct their transactions in the pits or on Globex. At this writing, the side-by-side arrangement has resulted in approximately 80 percent of all CME currency trading being transacted on Globex. There is widespread acceptance among members of the exchange that the pits eventually will be shut down, or simply die from inactivity.

The second initiative was an even bolder step – among the most original ideas any exchange has ever tried – the establishment of the Globex Foreign Exchange Facility, or GFX.

Looking for the Best FX Price?
The GFX is a unique undertaking in the world of foreign exchange trading. It was established as a subsidiary business of the CME and funded with capital from the exchange. It consists of a currency dealing room with a staff of more than 20 traders and risk managers. They make markets in each CME currency 24 hours per day, simultaneously hedging any trades that are made with cash market transactions. If the GFX were just another FX market maker conducting futures versus cash arbitrage, there would be nothing particularly noteworthy about it. The GFX, however, is unlike any other dealing room in the world in that it does not attempt to make a profit on its market-making activities. That’s right; when you trade against the GFX, your counterparty actually hopes that you make money and it does not. As unbelievable as this may sound, it is absolutely true. The goal of the GFX is simply to create liquidity, so that CME members and customers can transact their business on Globex at the best possible price.

Here is how the GFX operates: It searches for the best FX price available in the cash market and translates it into a futures price. It then enters a bid and offer based on that futures price onto Globex for a defined number of contracts and waits for a counterparty that wants to trade at either price. In the event that there are resting Globex orders that can be filled based on the translated price, the GFX will act aggressively to execute the orders. When the GFX makes a futures trade in either of the two scenarios explained above, it immediately covers the exposure with a corresponding trade in the cash market. At that point, appropriately hedged, the GFX books the trade and at a later time closes out both the cash and futures portions to flatten the position. Success is not measured by its daily profit/loss (P/L) statement, but the quality of bids and offers GFX traders enter into the system; how often they post a two-sided market and how tight a spread they provide.

Compare to the Interbank Market
In order to appreciate how extraordinary this concept is, consider what happens in the interbank market, where every participant tries to make money on every trade. Here is what you will find:

• Bank X contacts a dealer and asks for a price on $10 million worth of Canadian dollars. The dealer checks the prevailing bid on Reuters and, not knowing for certain whether Bank X is buying or selling the currency, quotes a price of 1.2015/1.2020. The dealer is confident that there is enough of a spread between the bid and ask so that whether the bank buys or sells, it will be possible for the dealer to make a profit. The bank, liking the dealer’s price, sends an electronic message agreeing to sell the $10 million at the bid price of 1.2015. In all likelihood, the dealer has already lined up a counterparty on the system that will pay more than 120.15, allowing the dealer to close out the position with a profit.

• A large hedge fund manager enters an order with a dealer to buy $100 million worth of Japanese yen. The dealer will search for an offer on EBS. If he can buy $100 million yen cheaply and quickly enough, he may choose to take the trade into his own portfolio and sell the entire lot at a higher price to his customer. If he cannot find a sufficient amount of yen at the price his customer wants to pay, the dealer is not necessarily required to take the trade into his own portfolio but can search the system to try to satisfy the order. There is, however, intense competition for customer business, and large customers often will pressure dealers to accommodate them by threatening to send future orders to competitors. Often, dealers and customers carry on a love-hate relationship, characterized by a desire to see the other trade profitably, but at the expense of someone else in the market.

• The bank that employs the dealer initiates a transaction to satisfy its own internal operations, asking the dealer, for instance, to sell 20 million pound sterling at 1.8850. In many cases, because the dealer’s P/L is separate from the bank’s, the dealer will try to make a profit in the execution of the order at the expense of the corporate parent.

• The European Central Bank unexpectedly raises interest rates, making the euro more valuable relative to the dollar. The dealer, thinking the market will move sharply higher, buys $25 million worth of euros for the proprietary account of the bank. If the dealer has a resting customer order to sell euros at lower levels that would guarantee the dealer a windfall profit, he is likely to execute the customer’s order by buying it for the dealer’s own portfolio. The dealer can choose to give the customer the windfall, and it is fair to say that in some cases a dealer will avoid the temptation to act as principal to the trade rather than as the customer’s agent. Very often, large customers get such accommodations, but not always. By contrast, in the futures markets, which are regulated by the Commodity Futures Trading Commission (CFTC), trading against a customer order is expressly prohibited. The CFTC argues that a broker who acts as both agent and principal has an inherent conflict of interest. In the interbank market, which is unregulated, there are no such prohibitions.

A Telling Story
Because the interbank market is so gigantic and dominated by well-trained professionals, many retail customers are intimidated by it. If you fall into that category, you are missing out on some of the most lucrative market opportunities available.

Let me tell you a short story that I hope will reduce your apprehension and bring you into the FX trading fold. I recently visited the trading room of a major New York currency dealer. The room is about the size of the Rose Bowl and filled with more computer equipment than a Best Buy just before the doors open for business the day after Thanksgiving. I visited with an old friend who continued trading as we talked, and over the course of an hour he made and lost a bit, finally blowing about $1,000 on a yen trade that didn’t go his way.

That night we had dinner, and for three hours I had to listen to him analyze the stupid yen trade and how annoyed he was over it. This is an individual who owns shoes worth more than $1,000, a guy who has moved hundreds of millions of dollars worth of currency at a time through the market without breathing hard. Why was he so aggravated? It certainly wasn’t the money. Traders make plenty of wrong decisions. But lurking in the back of every bank trader’s brain is the idea that at any time, a competitor can emerge; someone who is more efficient, faster, smarter, technologically more advanced – someone who, like my nemesis in Jerusalem long ago, will make it necessary to work twice as hard to earn the same amount of money.

I own a trading arcade in Chicago, and upon commencing operations five years ago, my customers traded E-minis exclusively. Today, however, more than 80 percent of the business they transact is in CME currency futures on Globex. The recent volatility of the dollar surely played a part in pointing us in this direction, but of equal importance was the knowledge that the GFX ensures a fair price and the Globex trading platform is stable and easy to use.

In fact, given my own history, it seems that the return to currency trading was logical and probably inevitable; with currency trading, as with most things in life, the more things change, the more they stay the same. In the span of 26 years, I went from trading dollars for Israeli pounds with the moneychangers of the Jerusalem souk, to trading dollars for Deutschemarks in the pits of Chicago, to trading dollars for a dozen different currencies in the vast infinity of cyberspace. The venue and modalities may be different than they were when I began, but the goal is obvious and timeless; buy low and sell high. This is the simple, immutable principle by which all successful currency traders abide.