How Are Foreign Exchange Rates Determined?
By: Onomy Protocol
Tags: Trading, Foreign Exchange, Exchange Rate, Forex, Defi

The Forex market is huge. Every day, trillions of dollars are traded to meet the ever-changing demand for different currencies on a moment by moment basis. This trade reflects not only the shifting sands of geopolitical architecture that denotes a currency’s value, but also the actions of traders, consumers, businesses and middlemen who are engaged in currency swaps for pleasure, pragmatism, or profit.

Fixed and Floating Rates

The foreign exchange rates you see when you go to buy your travel money are directly influenced by the Forex market chugging away in the background. These numbers are not arbitrary, but how are they arrived at?

Currencies fall into two main categories when it comes to their exchange rate. Some currencies have a floating rate, while others have a fixed rate.

What Are Floating Exchange Rates?

A floating currency exchange rate is where the value of the currency can rise and fall in line with market demands, supply, and geopolitical pressures. Major examples include the US dollar and the British pound. Floating currency rates have been the norm for most of the world since the collapse of the Bretton Woods system and the unlatching from the gold standard.

What Are Fixed Exchange Rates?

A fixed currency exchange rate is where the value of the currency is pegged to another currency and tracks the value of another currency. Major examples include the Chinese Yuan and Saudi Arabian Riyal, which are pegged to the value of the U.S Dollar.

For example, to ensure that the Chinese RMB maintains its rough peg to the US dollar, the central bank buys dollars with the home currency when the currency rises in value, and sells dollars when the currency falls in value, artificially increasing or decreasing the supply of dollars so the government can keep the peg where it wants it to be. This infuriates the American government, as it unbalances the trade deficit between the countries unnaturally. However, the Chinese government is, now, very slowly transitioning from this long-held policy in order to let the Yuan start to float.

Are Floating Currencies Truly Floating?

Most currencies in the world are notionally floating. Why notionally? Because although national governments allow the currency’s value to morph appropriately in response to market forces, central banks have frequently, throughout history, taken measures to prop up the price of the currency in the face of damaging headwinds or prevent its appreciation in light of surging market desire.

For example, the Swiss Franc — in light of the 2008 financial crisis when capital flight took refuge in their banking sector — had further appreciation stunted by the government’s purchase of US dollars and Euros. On the other side of the equation, the Japanese Yen underwent government-led devaluation through the purchase of US treasury bonds by their central bank.

However, with floating exchange currencies, governments generally seek only to influence, not affect, the price of the currency through various policies. With fixed exchange rate currencies like the Yuan, this kind of activity can happen regularly.

The Key Factors that Influence Exchange Rates

With floating exchange rate currencies, there are several key factors that influence the value of currency.

Interest Rates

One of these is the interest rate paid by the central bank to holders of the currency in the form of government bonds. Central banks which borrow money issue bonds with a specific interest rate, and that rate is one of the core determinants of a currency’s value. The higher the interest rate, the more investors are keen to buy, swap for, and hold the country’s currency and store it to receive the rate, which makes the currency more valuable.

Money Supply

Another factor is the money supply. When facing economic difficulties, countries often print money (called Quantitative Easing) in order to prop up shortfalls in economic activity. This sudden explosion of money supply can have deleterious effects on the value of the currency on the foreign exchange market. It makes sense, the higher the supply, the less the value of each individual unit.

Rampant inflation, whether by natural economic activity or ill-judged economic policy, results in currency devaluation. Bitcoin has risen so startlingly in value not only because of its inherent properties (like a limited supply), but also being used as a ‘flight to safety’ due to the unprecedented rate of money printing by the Federal Reserve as it flushes more dollars into the economy — either to prop it up from economic shock or to facilitate government spending on a grand scale. Recent Central Banking actions are partly responsible for an increase in public distrust and the proliferation of cryptocurrencies, including decentralised stablecoins, which are on-chain assets pegged to the value of fiat currencies like the US Dollar..

PPP and the Law of One Price

Another factor in a currency’s exchange rate is the purchasing power parity (PPP) and the ‘law of one price’. In theory, a good (such as a Big Mac) in one country should cost the same as it does in another, as it consists of the same elements. However, due to factors like transportation costs, transaction costs, legal issues, the buyers and sellers in a market, alongside myriad other factors, this does not often hold in practice — and the value of a currency shifts as a result.

Investor Faith

Finally, and far more nebulously, currency value is determined by the overall economic health and stability of the issuing country. Economic growth, productivity improvements and overall faith in a countries legal, financial and political systems all contribute to a higher valued currency as investors are confident that the country will both meet its domestic and international obligations, but also that the political armature of the state won’t collapse, seize investment, or otherwise damage the growth of the country.

A current example of this is the Turkish Lira. As disquiet grows over the Erdogan government’s handling of the country’s finances, the Turkish Lira has seen a precipitous fall in value as investors lose faith in the future direction of the country and fear economic reprisals.

Market Forces and Their Effect on Exchange Rates

There are, of course, more short-term factors that can spike or depress a currency’s value. Rumours of upcoming interest rate changes, natural or man-made disasters that inflict economic damage on a country, or simple consumer supply and demand can all affect the value of a currency.

As well as this, of course, are the actions of Forex traders who are speculating on the price of the currency, and by doing so, can instigate market movements. If every Forex trader began collectively shorting the Euro, that impact would be felt on the Euro’s market value — just as with any other market instrument.

This, of course, opens the door to currency manipulation by huge players who by their speculation can hurt the nation’s economy. A famous example is George Soros, who took short positions on the British pound to the tune of £10 billion. He also egged other investment banks like JP Morgan to get in on the act. The result was catastrophic. The Bank of England desperately tried to buy sterling to negate the effects of the attack, but it wasn’t enough, and the pound devalued 15%, while George Soros reportedly pocketed $1.1 billion as a result of the speculative assault. Thus, it can be seen that liquidity on exchanges can dramatically impact the market value of a currency for a period of time, until buy or sell pressure subsides.

Onomy Protocol’s Vision for On-Chain Forex

Foreign exchange rates vary constantly. It represents the constant push and pull of geopolitical market factors allied with the actions of traders who seek to arbitrage and profit from the shifting value in currencies, and the faith, market climate, or expectations in their issuing country. The Forex market is a key machine that helps define the state of international cooperation and competition, and is the largest single market by value throughput, with $6.6 trillion changing hands daily. Similar principles to determining the exchange rates are applicable in the case of stablecoins.

In the case of Onomy Protocol, a financial ecosystem designed to converge centralised finance with its decentralised counterpart by facilitating on-chain Forex trading through the minting of fiat-pegged stablecoins, exchange rates are determined by relying on the NOM token as collateral for all stablecoins minted through the protocol. In other words, just like any other digital asset, NOM has a corresponding fiat value determined in USD, EUR, JPY, CHF, CAD, and others. By over-collateralizing each stablecoin minted and with the help of peg mechanisms operating in the background, the value of each stablecoin will remain stable relative to its real world counterpart, marking a return to the gold-standard model of collateral.

Price divergence that Forex traders bank on follows the standard exchange rates present in the traditional market, whereas slight discrepancies caused by the purchase and sale of currencies in pairs lead to profit or loss for traders, or arbitrage opportunities for advanced traders. This is made possible through our AMM liquidity pools coupled with the order book UI, allowing for simple pricing of Forex trading pairs without relying on oracles.

Powered by a layer-1 Cosmos chain that brings unprecedented efficiency, and later on, via our custom consensus engine, traders worldwide will engage in high frequency Forex trading directly on-chain.