The History of the Foreign Exchange Market By David Thorpe

Introduction

The foreign exchange, FX or forex market, as we know it has been evolving for hundreds of years. It is believed that the concept of banking first arose in ancient Mesopotamian times. Royal palaces and temples were used to store harvested commodities which in turn created the need for receipts. These receipts were used for transfers to those who made the deposits and to third parties. The very same banking and receipt business was also used in ancient Egypt. Receipts were often used to settle debts with priests, tax collectors and exchanged with traders. It wasn’t until the early forms of coinage came about that we saw the first real currency traders. As empires were divided, expanded, conquered and founded the currencies of different cultures had to be exchanged for one another.

During the Middle Ages paper bills replaced coins as the currency of choice. This made foreign exchange much easier. At this point things remained relatively stable in the World of foreign exchange until the First World War.

At the end of WWI there was a brief period of massive currency speculation. The official view on currency speculation at this point was decidedly negative but no regulations were ever drawn up. This speculation came to a crashing halt with the arrival of the ‘Great Depression’. This World recession effectively killed any growth in FX speculation as disposable income was at a premium. Sentiment returned to favouring stable exchange rates until the Second World War brought about some factors that would force governments to regulate their currency rates.

The Bretton Woods Accord

Until the start of WWII, the British Pound Sterling (GBP as we know it today) was the World’s most prominent currency. It was against the GBP, and not the dollar, that most other currencies were compared. However, the arrival of war saw a massive Nazi counterfeiting campaign aimed at devaluating the Sterling. The campaign worked and the World’s confidence in the GBP was shaken. At this time neither the United States nor its Dollar Currency had endured this devaluing campaign or the strain of War on domestic infrastructure. The US Dollar had been out of favour due to the massive stock market crash in 1929 but the economy had recovered and it was seeing a boom cycle once again.

At the end of WWII the World’s economy, with the exception of the US, was in disarray. Representatives from the US, Britain and France met at Bretton Woods, New Hampshire with the objective of creating an infrastructure that would allow the rebuilding of the World’s economy. The result was the Bretton Woods Accord.

The Accord decided that the US Dollar would become the World’s benchmark and all other countries would measure the value of their currencies against it. Part of this agreement was the Gold Standard which fixed the price of Gold at $35 an ounce. All other currencies were pegged to the dollar at a certain rate. This rate was not allowed to fluctuate more than 1% in either direction (higher or lower). If a fluctuation greater than 1% did occur then the relevant central bank had to enter the market and restore the exchange rate to within the accepted band. There are mixed opinions as to whether the Bretton Woods Accord was successful in restoring economic stability to Europe and Japan. Despite this, the agreement eventually failed in 1971. It was superseded by the Smithsonian Agreement.

The Smithsonian Agreement

The Smithsonian Agreement tried to succeed where Bretton Woods had failed. Rather than give a 1% margin, greater room for manoeuvre was introduced. Not long into this agreement, Europe made its first attempt at breaking free from the Dollar dominated system. In 1972 Europe formed the European Joint Float. Member nations included West Germany, France, Italy, the Netherlands, Belgium and Luxembourg. This agreement was very similar to Bretton Woods but with a larger band for rate fluctuation.

Just as their predecessors had failed, these agreements were flawed and subsequently fell apart. However, this time there was no new agreement to take its place. For the first time since WWII there was a ‘free float’ system in place. This was not the result of some Genius planning; it simply existed because there was nothing else to replace it. The value of each currency is now governed completely by the laws of supply and demand. Large banks, private companies and individual speculators are all active participants in the Forex market. The Internet boom and the increasing ease of access to foreign exchange has further increased participation, especially that of individual speculators.

However this lack of official restraint hasn’t stopped central banks from trying to manipulate the value of their currencies in the free float system.

The European Monetary System

The European Economic Community (EEC), as it was known in its early days, established the European Monetary System in 1978. Its purpose was to regulate the value of EEC members’ currencies against each other. A rate fluctuation band of 2% was introduced. As previously seen in the Bretton Woods and Smithsonian agreements, central banks were required to maintain this band. The problem with this system was that it failed to recognise the number of private speculators that were now active participants and their cumulative financial might. This mistake was very costly for the Bank of England (BOE). In 1993 speculators made an attack on the GBP forcing the bank to intervene. The financial attack was so strong that the BOE deemed currency regulation too expensive and withdrew from the European Monetary system. This led to the collapse of the system leaving the free float that has remained unchallenged to the present day.

The Eurozone Single Currency

The official currency of the European Union (EU), the Euro, was launched in 1999 with coins and banknotes issued in 2002. Current member nations are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. It is possible for any member of the EU to join as long as they adhere to the strict monetary requirements. The Euro is managed by the European Central Bank (ECB) which has the authority to set monetary policy over all of its member states. The formation of the Euro is seen as the beginning of evolution towards a single European state as the Eurozone attempts to compete directly with the US. The Euro is now one of the most heavily traded currencies in the World.

David Thorpe is a senior contributor for http://www.passion-trading.com a free educational resource centre for traders and investors. The goal of the site is to stimulate the minds of its users, enabling them to achieve a greater understanding the art of trading, thus helping them to become more profitable.

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