Initially, the value of goods was expressed in terms of other goods, i.e. an economy based on barter between individual market participants. The obvious limitations of such a system encouraged establishing more generally accepted means of exchange at a fairly early stage in history, to set a common benchmark of value. In different economies, everything from teeth to feathers to pretty stones has served this purpose, but soon metals, in particular gold and silver, established themselves as an accepted means of payment as well as a reliable storage of value.
Originally, coins were simply minted from the preferred metal, but in stable political regimes the introduction of a paper form of governmental IOUs gained acceptance during the Middle Ages. Such IOUs, often introduced more successfully through force than persuasion were the basis of modern currencies. Before the First World War, most central banks supported their currencies with convertibility to gold. Although paper money could always be exchanged for gold, in reality this did not occur often, fostering the sometimes disastrous notion that there was not necessarily a need for full cover in the central reserves of the government.
At times, the ballooning supply of paper money without gold cover led to devastating inflation and resulting political instability. To protect local national interests, foreign exchange controls were increasingly introduced to prevent market forces from punishing monetary irresponsibility.
In the latter stages of the Second World War, the Bretton Woods agreement was reached on the initiative of the USA in July 1944.
The Bretton Woods Accord
The first major transformation, the Bretton Woods Accord, occurred toward the end of World War II. The United States, Great Britain and France met at the United Nations' Monetary and Financial Conference in Bretton Woods, New Hampshire to design a new economic order. This location in the U.S. was chosen because, at the time, was the only country unscathed by war. Most of the European countries were in shambles. Up until WWII, Great Britain and the British Pound had been the major currencies by which most currencies were compared.
This changed when the Nazi campaign against Britain included a major counterfeiting effort against its currency. In fact, WWII vaulted the US dollar from a has been currency after the stock market crash of 1929 to the benchmark by which most currencies were compared. The Bretton Woods Accord was established to create a stable environment by which global economies could re-establish themselves. The Bretton Woods Accord established the pegging of currencies and the International Monetary Fund (IMF) in hopes of stabilizing the global economic situation.
Major Currencies were pegged to the US dollar. These currencies were allowed to fluctuate by one percent on either side of the set standard. When a currency's exchange rate would approach the limit on either side of this standard, the respective central bank would intervene, thus bringing the exchange rate back into the accepted range. In addition to this, the US dollar was pegged to gold at a price of $35 per ounce. Pegging the dollar to gold and the pegging of the other currencies to the dollar brought stability to the world Forex situation.
The Bretton Woods Conference rejected John Maynard Keynes suggestion for a new world reserve currency in favour of a system built on the US dollar. Other international institutions such as the IMF, the World Bank and GATT were created in the same period as the emerging victors of WW2 searched for a way to avoid the destabilising monetary crises which led to the war. The Bretton Woods agreement resulted in a system of fixed exchange rates that partly reinstated the gold standard, fixing the US dollar at USD35/oz and fixing the other main currencies to the dollar - and was intended to be permanent.
The Bretton Woods system came under increasing pressure as national economies moved in different directions during the sixties. A number of realignments kept the system alive for a long time, but eventually Bretton Woods collapsed in the early seventies following president Nixon's suspension of the gold convertibility in August 1971. The dollar was no longer suitable as the sole international currency at a time when it was under severe pressure from increasing US budget and trade deficits.
Pegged and semipegged currencies
In 1971, the Bretton Woods Accord was first tested because of dramatically uncontrollable currency rate fluctuations. This started a chain reaction, and by 1973, the gold standard was abandoned by President Richard Nixon. The fixed-rate system collapsed under heavy market pressures, and currencies finally were allowed to float freely.
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 Pharaoh. 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, the need for another form of currency besides coins emerged as the method of choice.
These paper bills represented transferable third party payments of funds; this made foreign exchange much easier for merchants and traders and caused the regional economies to flourish. From the infantile stages of Forex during the Middle Ages to WWI, the Forex markets were relatively stable and without much speculative activity. After WWI the Forex Markets 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. Speculation in the Forex markets during these times was little if any.
The foreign exchange markets officially switched to a free-floating market after the double demise of the Smithsonian Agreement and the European Joint Float. This switch occurred more due to lack of any other available options, but it is important to understand that the free floating of currency was not, by any mean, imposed. This means that countries were free to peg, semipeg, or free-float their currencies.
Pegged: Some smaller economies have attached their currencies to larger economies with which they hold close economic liaisons. For instance, many Caribbean nations, such as Jamaica, have pegged their currencies to the U.S. Dollar.
Semipegged: Semipegged currencies have disappeared since 1993. A perfect example of semipegging would be the currencies of the European Monetary System (EMS). Those currencies only would be allowed to fluctuate within 2.25 percent or, exceptionally, within 6 percent intervention bands. Following the foreign exchange crisis of 1993, the new EMS intervention rates were expanded to 15 percent. Semipegging would have a slowing-down effect on currencies when they were reaching the extreme values allowed within the range. Since 1999, the semipegged currencies of the EMS were switched to fully pegged values that form the Euro.
Free-floating currencies and fixed exchange rates
Free-Floating: When the major currencies are free-floating, such as the U.S. Dollar, they move independently of other currencies. The value of the currency is determined by supply and demand, which has no specific intervention point that has to be observed, and can be traded by anybody so inclined. Free-floating currencies are in the heaviest trading demand.
The FOREX market was made available to the average investor in 1998 and is one of the fastest growing markets in the world, with daily volume of nearly 100 times that of the entire stock market.
In the 1980s, cross-border capital movements accelerated with the advent of computers and technology, extending market continuum through Asian, European and American time zones. These same technologies made it feasible for private investors to enter a market that had traditionally been the sole domain of banks and large institutions. Transactions in foreign exchange rocketed from about $70 billion a day in the 1980s, to more than $1.5 trillion a day two decades later, with close to 95% of the volume being speculative.
The following decades have seen foreign exchange trading develop into the largest global market by far. Restrictions on capital flows have been removed in most countries, leaving the market forces free to adjust foreign exchange rates according to their perceived values.
But the idea of fixed exchange rates has by no means died. The EEC introduced a new system of fixed exchange rates in 1979, the European Monetary System. This attempt to fix exchange rates met with near extinction in 1992-93, when pent-up economic pressures forced devaluations of a number of weak European currencies. Nevertheless, the quest for currency stability has continued in Europe with the renewed attempt to not only fix currencies but actually replace many of them with the Euro back in 2001.
This project is fairly advanced now and the final structure and fixed levels were decided in May 1998. After this a dangerous three-year period loomed, where devaluation candidates could be attacked nearly without risk until the final introduction of the Euro in this Millennium.
The lack of sustainability in fixed foreign exchange rates gained new relevance with the events in South East Asia in the latter part of 1997, where currency after currency was devalued against the US dollar, leaving other fixed exchange rates, in particular in South America, looking very vulnerable.
But while commercial companies have had to face a much more volatile currency environment in recent years, investors and financial institutions have found a new playground. The size of foreign exchange markets now dwarfs any other investment market by a large factor. It is estimated that more than USD1,200 billion is traded every day, far more than the world's stock and bond markets combined.
Timeline of foreign exchange
- 1944 â€“ Bretton Woods Accord is established to help stabilize the global economy after World War II.
- 1971 â€“ Smithsonian Agreement established to allow for greater fluctuation band for currencies.
- 1972 â€“ European Joint Float established as the European community tried to move away from its dependency on the U.S. dollar.
- 1973 â€“ Smithsonian Agreement and European Joint Float failed and signified the official switch to a free-floating system.
- 1978 â€“ The European Monetary System was introduced so other countries could try to gain independence from the U.S. dollar.
- 1978 â€“ Free-floating system officially mandated by the IMF.
- 1993 â€“ European Monetary System fails making way for a world-wide free-floating system.