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History of Forex
The Foreign Exchange market, (“FX” or “Forex”), as we know it today, originated in 1973. However, money has been around in one form or another since the time of the Egyptian Pharaohs. While the Babylonians are credited with the first use of paper bills and receipts, Middle Eastern moneychangers were the first currency traders exchanging coins of one culture for another. During the middle ages, paper bills emerged as an alternative form of currency besides coins. These paper bills, or promissory notes, represented transferable third party payments of funds, which made foreign exchange much easier and less cumbersome for merchants and traders. National governments, provinces and municipalities began storing gold, silver and other items of value and issued promissory notes against a set value. The problem was that on any given day that value could change based solely on the decisions of the kings and governors.
From the infantile stages of the Forex during the Middle Ages to World War I (WWI), the Forex market was relatively stable without much speculative activity. After WWI, it became very volatile and speculative activity increased ten fold. Speculation in the Forex market was not looked on as favorable by most institutions and the public in general. The Great Depression and the removal of the gold standard in 1931 created a serious lull in Forex activity. From 1931 until 1973, the Forex market went through a series of changes. These changes greatly impacted the global economies at the time. There was little if any speculation in the Forex market during these times.
Gold Standard
The “Gold Exchange Standard”, which prevailed between 1876 and WWI dominated the international economic system. Under the gold exchange standard, currencies gained a new phase of stability as they were supported by the price of gold. It abolished the age-old practice in which kings and rulers arbitrarily debased money and triggered inflation.
However, the gold exchange standard had its weakness. As an economy strengthened, it would import heavily from abroad until it ran down its gold reserves required to back its money. As a result, money supply would shrink, interest rates would rise, and economic activity would slow down to the extent of recession. Ultimately, prices of goods would bottom out, appearing attractive to other nations. Consequently, this would cause a rush in buying sprees that would inject the economy with enough gold to increase its money supply, drive down interest rates, and recreate wealth into the economy. Such patterns prevailed throughout the gold standard until the outbreak of WWI, which interrupted trade flows and the free movement of gold.
Several other major transformations occurred after the Gold Exchange Standard, leading to the birth of the current Forex market: the Bretton Woods Accord, Smithsonian Agreement, and the Free-Floating System.
Bretton Woods Accord
The Bretton Woods Accord was the first major transformation occurring towards the end of World War II. A total of 44 countries, including the United States, Great Britain, and France met in New Hampshire in July 1944, to designate a new economic order.
The design of the Bretton Woods framework was to have the United States become an anchor for all free world currencies. The accord aimed at installing international monetary stability by preventing money from fleeing across nations and restricting speculation in the world currencies. Major currencies were pegged to the dollar, which was in turn tied to gold at a value of $35 per ounce. The dollar was the primary reserve currency and member countries were able to sell to the Federal Reserve in exchange for gold at the present rate. In addition to these interventions, the International Monetary Fund (IMF) and the International Bank for Reconstruction were established to ensure that the Bretton Woods system would operate effectively.
Once the Bretton Woods Agreement was founded, the participating countries agreed to try and maintain the value of the currency with a narrow margin against the dollar and a corresponding rate of gold as needed. Countries were prohibited from devaluing their currencies to their trade advantage and were only allowed to do so for devaluations of less than 10%.
Trading under the Bretton Woods system had unique characteristics. Since exchange rates were fixed, intense trading took place around devaluation or revaluation, known as creeping pegs. Speculation against the British pound in 1967 demonstrated creeping pegs patterns. Despite all the efforts by the Bank of England and other central banks to support the pound, the pound was devalued. This failure was monumental because it was the first time that the central bank intervention failed under the Bretton Woods system. The failure of the central bank intervention continued with the dollar in the following years. As the Bretton Woods system was highly dependent on a strong US dollar, the dollar began to experience pressure in 1968, causing extreme speculation on the future of the system. The Agreement was finally abandoned in 1971, and the US dollar would no longer be convertible into gold.
Smithsonian Agreement
After the Bretton Woods Accord came to an end, the Smithsonian Agreement, which was similar to the Bretton Woods Accord, but it allowed for a greater fluctuation band for foreign currencies. A negative balance of payments, growing public debt incurred by the Vietnam War and Great Society programs, and monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued in the 1960s. The drain on US gold reserves culminated with the London Gold Pool collapse in March 1968.
On August 15, 1971, President Richard Nixon unilaterally suspended the convertibility of dollars into gold, thus strategically defaulting on the United States debt. His administration subsequently entered negotiations with industrialized allies to reassess exchange rates following this development.
Meeting in December 1971 at the Smithsonian Institution in Washington D.C., the Group of Ten (G-10) signed the Smithsonian Agreement. The Smithsonian Agreement strived to maintain fixed exchange rates, but to do so without the backing of gold. Its key difference from the Bretton Woods system was the value of the dollar could float in a range of 2.25%, as opposed to just 1% under Bretton Woods.
Ultimately, the Smithsonian Agreement proved to be unfeasible as well. Although hailed by President Nixon as a fundamental reorganization of international monetary affairs, it failed to encourage discipline by the Federal Reserve or the United States government. Without exchange rates fixed to gold, the free market gold price shot up to $215 per ounce. Moreover, the U.S. trade deficit continued to grow, and from a fundamental standpoint, the US dollar needed to be devalued beyond the 2.25% parameters established by the Smithsonian Agreement. In light of these problems, the foreign exchange market was forced to close in February of 1972.
European Joint Float
Parallel to U.S. efforts, the European Economic Community, established in 1957, tried to move away from the US dollar toward the Deutsche mark, by designing its own monetary system. In April 1972, West Germany, France, Italy, the Netherlands, Belgium and Luxembourg developed the European joint Float. Under this system the member countries were allowed to move between 2.25 percent band, known as the snake, against each other, and collectively within 4.5 percent band, known as the tunnel, against the US dollar.
Unfortunately, the European Joint Float did not address the independent domestic problems of the member countries from the bottom up, attempting instead to focus solely on the large international picture and maintain it by artificially enforcing the intervention points. By 1973, this system also collapsed under heavy market pressures.
Free Floating System
The collapse of the Smithsonian Agreement and the European Joint Float in 1973 signified the official switch to the free-floating system. This occurred by default, as there were no new agreements to take their place. Governments were now free to peg their currencies, semi-peg, or allow them to freely float. In 1978, the free-floating system was officially mandated.
The value of the US dollar was to be determined entirely by the market, as its value was not fixed to any commodity, nor was the fluctuation of its exchange rate confined to certain parameters. While this did provide the US dollar, and other currencies by default, the agility required to adapt to a new and rapidly evolving international trading environment, it also set the stage for unprecedented inflation.
Europe tried to gain independence from the US dollar by creating the European Monetary System (EMS) in July of 1978. Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank soon emerged as the centre of the EMS. Because of its relative strength, and the low-inflation policies of the bank, all other currencies were forced to follow its lead if they wanted to stay inside the system. Eventually, this situation led to dissatisfaction in most countries. This, like all of the earlier agreements, failed in 1993.
The major currencies today move independently of other currencies. The currencies are traded by anyone who wishes to trade. This has caused a recent influx of speculation by banks, hedge funds, brokerage houses, and individuals. Central banks intervene on occasion to move or attempt to move currencies to their desired levels. The underlying factor that drives today’s Forex market, however, is supply and demand. The free-floating system is ideal for today’s markets.