History of the Forex Market

 

Overview

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• Until the 1970s or so, currency trading was limited mostly to the needs of large companies conducting business in multiple countries.

• Trading for investment and speculative purposes was not widely practised at this time, and most trading was centered on commodities and individual stocks.

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            Speculation – An attempt to profit on the fluctuation in prices for currencies and other investment securities.

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The Bretton Woods Accord – Courting Controversy

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• After World War II, economies in Europe were left in tatters.

• To help these economies recover – and to avoid mistakes made in the wake of the First World War – the Bretton Woods Accord was convened in July 1944.

• Several resolutions arose from Bretton Woods, but it was the "pegging" of foreign currencies to the U.S. dollar that arguably had the greatest immediate impact on the global economy.

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            Gold Standard Currency – A commitment to fix the value of a currency to a specific quantity of gold.

            Under this  system, the holder of the country's currency can convert funds to an equal amount of gold.

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            Fiat or Floating Currency – Fiat currency is the opposite of a gold standard arrangement. In a fiat currency      

            system, the currency's value rises and falls on the market in response to demand and supply pressures. It is

            this fluctuation that makes it possible to speculate on future currency values.

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Pegging U.S. Currencies to the U.S. Dollar

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• By pegging (or linking) these currencies directly to the dollar, the value of the pegged currencies remained dependent on the value of the dollar.

• At the same time, the value of the dollar was tied to the price of gold which, at the time of the Bretton Woods Accord, was valued at $35 an ounce.

• The U.S government was obligated to maintain gold reserves equal to the amount of currency in circulation, making the United States a true gold standard economy.

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Why We Have Richard Nixon to Thank

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• It did not take long for cracks to appear in the Bretton Woods Accord.

• For the pegged currencies, it was impossible for individual countries to manage the value of their own currency.

• Likewise, the value of the dollar itself was subject to fluctuations in the price of gold.

• As resistance grew to the restrictions imposed by the original agreement, two events in particular would spell the end of the Bretton Woods Agreement.

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           The Bretton Woods Accord was not popular with every country included in the agreement. By linking many                         European economies to the U.S. dollar, the dollar became the de facto world currency. This made it impossible for             sovereign nations to manage the value of their own currency.  

                   

           Some U.S. officials were likewise unhappy with tying the U.S. dollar to the price of gold. With this arrangement,

           a run-up in gold prices also forced the value of the dollar upwards, and this contributed to the inflation crisis of

           the early 1970s.

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1. The Eurodollar Market

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• The first attack on Bretton Woods came in the form of what would be known as the Eurodollar market.

• The term "eurodollar", defines any instance of U.S. dollars deposited in a bank outside the United States – initially, the source of much of the foreign-held dollars was oil.

• The Soviet Union became an important oil producer shortly after World War II, and because oil contracts sold on the international markets were settled in U.S. dollars, the Soviet Union started receiving huge amounts of U.S. currency.

• Coincidently, this period also marked the beginning of the "Cold War" between the east and the west.

• Worried that their bank accounts could be seized by the U.S., the Soviet Union opted to deposit its U.S. dollars in European banks, out of the reach of American authorities.

• As the number of U.S. dollars held in this new eurodollar market grew, it soon became an important source of lending capital for governments and large companies around the world.

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          Market-Maker – A dealer or broker that provides a two-way quote (i.e. a bid and ask price) for which the dealer

          agrees to buy or sell. Offering both sides of a trade literally "makes" a market for those wishing to engage in

          currency trading. XM is an example of a forex market-maker.

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2. U.S. Inflation and the Energy Crisis

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• In 1971, inflation in the U.S. continued to erode the purchasing power of the dollar. At the same time, an energy crisis was simultaneously pushing up the price of oil and other commodities.

• As a result, investors – as is often the case when confusion reigns in the markets – turned to gold as a hedge to protect savings.

• The increased demand caused gold prices to soar and because the dollar was tied to gold, the U.S. dollar followed suit, further exacerbating the inflationary pressures.

• Finally, in an attempt to deal with surging inflation in the U.S. economy, President Nixon dropped the gold standard requirement and devalued the U.S. dollar to 1/35th of an ounce of gold.

• This effectively ended not only the gold standard, but also the Bretton Woods-imposed pegging of currencies, leading ultimately to free-floating individual currencies based on market conditions and other economic factors.

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           A hedge is the practice of buying a physical commodity to protect against a possible currency devaluation.

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The Interbank Market and OTC Trading

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• Sometimes referred to as institutional forex trading, the Interbank market consists of a small group of large banks. Non-bank outsiders are forced to pay high service fees to trade in this market.

• Forex trading is an "over-the-counter" (OTC) market, and is not conducted in a physical location such as a stock exchange.

• A forex deal exists as a contract between two parties.

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Exchange-Based Trading

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• The Chicago Mercantile Exchange (CME) became the first exchange to offer currency trading.

• In 1971, the CME launched the International Monetary Market (IMM).

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The Rise of Web-Based Trading and Forex Market-Makers

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• In recent years, new developments in web-related technologies have made it possible for a number of independent brokers to develop internet-based trading platforms.

• These brokers serve as market-makers and provide a two-way quote for each currency pair they support.

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