History of the foreign exchange market
Money began to be used during the time of the pharaohs, although the Babylonians were the first to use notes and receipts. Since in the Middle East each town had its own currency, foreign currency transactions arose to facilitate commercial exchange between different individuals, regions, and towns.
During the Middle Ages, merchants found it necessary to use a more convenient means of payment, which led to the adoption of notes that represented money. This process then later became banknotes. In this sense, the economy of the nations that opted for the use of notes began to flourish.
The foreign exchange market took its current form in the mid-1930s. London had become the capital of international trade and the pound sterling was the base currency. However, the Second World War changed the rules of the game, leading to the collapse of the British economy. Meanwhile, the United States, having not been devastated by war, emerged as the new leader in the foreign exchange market.
The gold standard and the Bretton Woods Agreement
To begin with the explanation of the relationship between the gold standard and the Bretton Woods agreement we can mention an anecdote that occurred in the year 1967 when a bank in the city of Chicago did not provide a loan to a university professor named Milton Friedman.
The loan was in sterling and Friedman wanted to use it to exploit the fall in the price of the British currency which he thought was to take place shortly. Friedman then realized that the pound was too expensive compared to the U.S. dollar so his intention was to sell the currency and once the price of the same fell, buy it back to return the money the bank lent.
In this way, Milton thought that he would get a profit quickly and easily. However, due to the Bretton Woods agreement established 20 years ago, the bank denied the loan. The Bretton Woods agreement fixed the price of currencies against the U.S. dollar and stated that this currency would be worth $35 per ounce of gold.
This agreement was established in the year 1944 and its objective was to establish greater international monetary stability in order to prevent the flight of capital between nations while restricting speculation in currencies worldwide. Before the Bretton Woods, the gold exchange standard governed the global economic system and prevailed from 1876 until the First World War. Under this system, currencies enjoyed remarkable stability since they had the backing of the gold price which eliminated the old practice of many rulers who arbitrarily lowered the value of money which inevitably caused inflation.
Despite its advantages, the gold standard system had serious flaws. For example, whenever the economy of a country was strengthened, it began to buy much from outside the country (which increased imports) which substantially reduced its gold reserves required to support the value of its currency. Thus, interest rates rose, the amount of money or money supply fell and the overall economic activity declined until the recession occurred. At the same time, the prices of goods fell to reach their lowest point which made them more attractive to other countries, which bought these products excessively. This situation injected gold into the country which increased its money supply, lowered the interest rates, and made the economy grow again.
While the gold standard was established, these patterns of booms and busts in economies were common and prevailed until the movement of gold and trade flows was interrupted due to the beginning of the I World War. After both World Wars passed the main economies of the world celebrated the Bretton Woods agreement whereby participants pledged to try to keep the value of their currency within a narrow range compared to the U.S. dollar according to a corresponding rate of gold, depending on the need.
Also, the agreement forbade the countries to devalue their currencies in order to benefit their trade with other countries. The agreement only allowed devaluations lower than 10%. Because the volume of international trade was constantly growing, during the decade of 50 there were significant movements of capital generated by all construction during the postwar period. This immediately resulted in the destabilization of exchange rates that had been established in the Bretton Woods agreement.
Therefore, the agreement was finally abandoned in 1971 and from that moment the U.S. dollar could no longer be turned into gold. As early as 1973, the currencies of major economies began to be traded more freely and were controlled mainly by the forces of supply and demand of the speculative market. In this way, the prices were fixed according to a constant free rate, which together with an increase in volatility, the speed and volume of trade in these currencies, resulted in the birth of new financial instruments, trade liberalization, and market deregulation during the decade of the 70. Thus was born the Forex market.
With the advent of technology especially in the computer area, the movement of money across borders was accelerated which extended the activity of this market directly to America, Europe, and Asia. Thus, currency trading has increased incredibly from about $70 billion dollars a day in the mid-’80s to more than 3.5 thousand billion dollars a day at the beginning of the XXI century which makes the Forex market the greater financial market worldwide.
The International Monetary Fund
Another important fact that emerged from the Bretton Woods agreements was the establishment of the International Monetary Fund or IMF, whose function was to provide economic assistance to developing countries. The IMF provides assistance to struggling economies, stabilizing them and promoting their growth.
The development of the Euromarket
A fact that strongly influenced the increase in trading volume in the foreign exchange market was the rapid development of the Euro-dollar market through which U.S. dollars are deposited in banks located outside the United States. Thus we can say that Euromarkets can be defined as those markets where assets are deposited in a currency other than the original currency.
With respect to the Eurodollar market, this originated in the decade of the ’50s when the income from the Soviet Union for sales of oil (these revenues were in dollars) was deposited outside the U.S. due to fear of Russians that the funds were frozen by U.S. authorities. Because of this, there was a lot of capital in U.S. dollars outside the United States that was beyond the control of the U.S. government. For its part, the government of that country created strong laws seeking to restrict dollar lending to foreigners with the objective to limit the outflow of dollars from the United States that might be outside its control.
At that time the Euromarkets were quite attractive to investors because they did not have so many regulations and the yields offered were higher. Since the late 80s, U.S. companies began to borrow outside the country because they found that Euromarkets were an environment where they could maintain excess liquidity, finance imports, and exports, and obtain short-term loans.
Since then, London is the principal offshore trading market and since the decade of 80, it has been the nerve center in the Eurodollar market from the time when major British banks began lending in U.S. dollars as an alternative to pounds. Thus, these banks sought to maintain their position of strength and leadership in the field of global finance. The current dominance of Euromarket is reinforced by the geographical location of London which allows it to operate at the same time that the U.S. market and Asian market.
The joint European float
In 1972, Germany, France, Italy, Holland, Belgium, and Luxembourg decided to float their respective currencies together, up to a fluctuation level of 2.25%, in order to prevent these currencies from depending on the dollar.
At the initiative of Germany and France, the European Monetary System had been created in order to stabilize exchange rates, reduce inflation and prepare the ground for monetary integration. The exchange rate mechanism allowed each participating currency to be linked to a basket of currencies represented by the European Monetary Unit and thus have a specific exchange rate.
The participants had to keep their currency within the band of 2.25% with respect to the agreed exchange rate. This system was a progressive devaluation and in the period 1979-1987 nine adjustments were made to the reference exchange rate for each currency.
The era of free float
The era of free-floating in the foreign exchange market began in 1971, and the exchange rates of the different currencies became floating, that is, varying as a result of the supply and demand of currencies.
Since then, the main variables that affect the forex market are based on economic issues. Of special importance are the macroeconomic indicators of the United States, as well as the monetary policies set by the Central Banks. However, there are other factors that determine the value of exchange rates, among which we can mention social and political events and, above all, technical factors.
The foreign exchange market today
Currently, the free float policy, which is based on the principle of supply and demand, is the dominant policy of global markets. In other words, when the demand for a particular currency is high, the currency in question appreciates or increases in value; on the other hand, when the demand falls, the value of the currency decreases or depreciates, since all the investors try to get rid of it by selling it.
Central banks hardly try to influence exchange rates and do so only very occasionally. That is why the free float system is ideal for carrying out transactions in the electronic currency market, and speculative movements of capital play a transcendental role in the forex market.