The History of Forex

Introduction

Long ago, the world’s economy was based on the bartering method. The value of a particular item, was measured by it’s worth in exchange for other items. But, this system had it’s obvious limitations. If you had nothing of value to exchange, you had no way of obtaining items you needed. This created the need to establish a more acceptable way of buying and selling early in history.

In various cultures and economies, anything could be considered valuable as long as there was a need for it. In some cases items such as animal pelts, corn, wheat and even hand made items were exchanged to obtain other much needed items. Eventually, the monetary standard became precious metals such as gold and silver. These metals not only served as a widely accepted method of payment, they’ve also became one of the most popular methods of investment.

Coins were originally simply minted from the metal that was preferred at the time. But, during the Middle Ages, the introduction of paper forms of money gained wide acceptance. Although, paper forms of currency were more successfully introduced by force that by choice, they still served as the basis of modern day currencies.

Before the beginning of World War I, many of the major banks allowed their currencies to be converted to gold. But, while paper currency could be converted to gold at any time, very few people took advantage of this practice. For this reason, many often felt it was unnecessary for the government to stock a full reserve of gold in their central banks.

However, with an ever increasing supply of paper currency entering circulation and not enough gold to cover it, inflation occurred which resulted in an instable government. More and more foreign exchange controls were instated to protect the national interests and prevent the market from plunging. In July of 1944 during the latter stages of World War II, the Bretton Woods agreement was signed that established a fixed rate for the exchange of currency that was linked to the U.S. dollar.

The Bretton Woods Accord

The Bretton Woods Accord was a major transformation in the way money was exchanged around the world. It began near the end of World War II and was the result of an agreement between France, Great Britain and the United States. The meeting was held at the United Nations’ Monetary and Financial Conference with the goal of designing a new economic order.

This location was designated as the meeting place because at the time, the U.S. was the only country in which a war wasn’t being fought. And, many European countries had been nearly destroyed by war. Before World War II, the major currency by which most of the world’s currencies were compared was Great Britain’s British Pound.

When the Nazi’s started their campaign against Britain, this practice changed due to their major effort in counterfeiting the currency. The stock market crash in 1929 had resulted in the U.S. dollar having very little value. However, World War II stabilized its value and helped it become the monetary standard. The main purpose of the Bretton Woods Accord was to establish a stable economic environment around the globe so countries could re-establish themselves.

The world’s major currencies became pegged by the U.S. dollar and could only fluctuate as much as one percent in value either lower or higher. Anytime that the exchange rate of a particular currency would approach the allowed fluctuation, intervention from the countries central bank would bring the rate back into the standard range. By associating the U.S. dollar with gold, which at the time was $35 per ounce, the Forex situation was also stabilized.

At the Bretton Woods conference, John Maynard Keynes had suggested a new world reserve currency would be much better than a system that was built upon the U.S. dollar. But, this suggestion was quickly rejected. The exchange rates finally settled upon helped to reinstate the standard of gold by setting the dollar at the current per ounce price and then setting the other major currencies to the dollar. This system was meant to be a permanent standard for exchanging currencies.

National economies began to move in different directions during the 1960′s, placing and increasing amount of pressure on the Bretton Woods system. Through a series of adjustments to the system, it remained in effect for some time. However, in August 1971 U.S. President Nixon suspended the conversion of gold and the system collapsed. At a time when pressure was also increasing on trade deficits and the U.S. budget, the dollar became unsuitable as the only international currency.

Pegged and semipegged currencies

The first real test of the Bretton Woods Accord was due to the dramatic fluctuation rates of currency. A chain reaction resulted that ended with President Richard Nixon abandoning the gold standard in 1973. And, heavy pressure from the world markets caused the collapse of the fixed rate system allowed currencies to float freely.

Since the ancient days of Pharaoh, there has been some form of money. The first known use of paper currency and receipts is accredited to the Babylonians. The first exchanges of coins between various cultures were first practiced by Middle Eastern money changers. The need for other forms of currency other than coins occurred during the middle ages. But, the Foreign Exchange market, known as Forex as we know it today wasn’t established until 1973.

Regional economies began to flourish when paper currency made it much easier for traders and merchants to make and receive payments in funds. From the middle ages when the Forex system first began emerged up until World War I, the market had remained fairly stable and didn’t see much speculative activity.

However, after World War I, speculative activity increased as much as tenfold and the Forex markets became very unstable. The general public as well as most institutions began to look upon the Forex system unfavorably. The removal of the gold standard during the Great Depression in 1931, created a serious decline in Forex activity.

The market went through a series of changes that made a major impact on global economies between 1931 and 1973. During these years, there was very little speculation in the Forex markets. Today, the Forex market if one of the fastest growing markets world wide. In 1998, it became available to average investors and sees volumes that exceed the entire stock market almost 100 times over on a daily basis.

After the demise of the European Joint Float and the Smithsonian Agreement, foreign exchange markets made the official switch over to a free floating market system. Although, the free floating system was mainly chosen because of a lack of other options, it was not forced in any way. This gave each individual country the freedom to choose to peg, semi-peg or free float their respective currencies.

Pegged currency simply refers to currencies that have an exchange rate based on the currency of another country. Many smaller economies have pegged their currency with that of countries with larger economies that they consider to be economic liaisons. Many of the Caribbean nations, like Jamaica, have chosen to peg their currencies to the U.S. dollar.

Since 1993, the practice of using semi-pegged currencies has no longer been in use. The European Monetary System, EMS is a good example of how currencies were semi-pegged. Those European currencies were only allowed to fluctuate at a rate of 2.25 percent and with intervention bands of 6 percent. When the foreign exchange crisis hit in 1993, the EMS expanded their intervention rates to 15 percent. When currencies neared the maximum values allowed, semi-pegging would minimize them. The EMS switched their semi-pegged currencies over to pegged values forming the Euro in 1999.

Free-floating currencies and fixed exchange rates

When major global currencies such as the U.S. dollar are referred to as free floating, it means that their values are independent of the values of other currencies. Value is determined by the supply and demand of the currency and there are no set standards regarding intervention that need to be observed. Free-floating currencies can be traded by any one and are the most popular choice of trading.

Along with computers and technology, capital movements across borders accelerated in the 1980′s. This advent extended the market though the United States, Asian and European time zones. New technology made it possible for private investors to enter into a market that had once been dominated by larger institutions and banks. During the 1980′s, foreign exchange transactions were around $70 million per day, within just two decades; they had soared to over $1.5 trillion each day and had a speculative volume of almost 95 percent.

Throughout the preceding decades, foreign exchange trading continued to develop into the largest global market in the world. Most countries have removed all restriction on capital flows and have left the market forces free to adjust the foreign exchange rates based up their individual perceived values. But, the practice of using a system of fixed rate exchanges has by no means been completely done away with.

A brand new system of fixed exchange rates was introduced by the EEC in 1979, the European Monetary System. But, this attempt to fix the monetary exchange rates was almost done away with through 1992 and 1993, when economic pressures resulted in devaluations of several weak European currencies. Europe continued to work toward a stable currency by not only fixing them, but by replacing many of their currencies with the Euro beginning in 2001.

The project had become fairly advanced by 1998 and fixed levels of exchange and the final structure were decided. However, a three year period followed in which devaluation candidates could literally be attacked with little risk before the final introduction of the Euro came in this millennium.

The events that occurred in South East Asia toward the end of 1997 increased the relevance of the lack of sustainability that comes with fixed foreign exchange rates. One currency after another became devalued again the U.S. dollar, which left other fixed exchange rates appearing to be very vulnerable, particularly in South America.

In recent years, as commercial companies have been faced with a currency environment that has been more volatile, financial institutions and investors have found a new area to focus on. The foreign exchange markets have become much larger than any other market for investment that exists. Every day, it is estimated that over 1,200 billion USD is traded. A total that exceeds the world wide total of the bond market and the stock market combined.

Timeline of Foreign Exchange:

1944 – Bretton Woods Accord is established after World War II to help stabilize the global economy.

1971 – Smithsonian Agreement is established which provided greater fluctuation bands for currencies.

1972 – In an effort to move away from the dependency the European community had acquired on the U.S. dollar, the European Joint Float was established.

1973 – The official switch to a free floating currency system was made after both the European Joint Float and the Smithsonian Agreement failed.

1978 – In a joint effort to help other countries gain independence from the U.S. dollar, the European Monetary System was introduced to other countries.

1978 – The IMF officially mandated the free-floating currency system.

1993 – A worldwide free-floating currency system is established when the European Monetary System failed.