The Forex market as we know it today originated in 1971. However, the idea of foreign currency exchange dates back to the Middle Ages when paper money was introduced and represented transferable third-party payments for merchants and traders.
During the almost fifty year period from the 1870s to the end of WWI in 1918, the gold exchange standard reigned over the international economic system. Because they were supported by the value and price of gold, currencies experienced a new era of stability under the gold exchange. However, the gold exchange standard had many weaknesses. The key weakness was the boom-bust economical pattern. The economic peaks and valleys (economic booms and recessions) created by this pattern were in large part due to a country’s economic instability caused by a lack of gold reserves and a devaluation of commodities and currency.
Up until the end of WWI, the Forex markets were relatively inactive and remained stable. However, after WWI the volatility of the Forex market greatly increased and speculative (definition found in Key Terms section) activity saw tremendous growth. Then, from 1931 until 1973, the Forex market went through a series of changes. These changes led to the structure of the Forex market today.
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The Bretton Woods Agreement
Established in 1944 at a conference with representatives from 44 nations in New Hampshire, the Bretton Woods Agreement fixed national currencies against the U.S. dollar, and positioned the dollar at a rate of $35 per ounce of gold. The purpose of this agreement was to curb the economic instability of nations due to the gold exchange standard caused boom-bust patterns. On the global trading front, this agreement aimed at establishing international economic stability by preventing money (currencies) from jumping national borders, and to control speculation (see definition in key terms section) in the international currency market.
The countries participating in this agreement agreed to attempt to maintain the value of their currency within a thin margin against the dollar and an equivalent rate of gold as needed. As a result of this, the U.S. dollar became the standard for currency value and was a top reference currency as it was now exchangeable into gold. A calculated move, this agreement signaled the shift in global economic power from Europe to the U.S. Also as a result of the agreement, and as an attempt to restore stability in the global marketplace, participating countries were prohibited from devaluing their currency to benefit their foreign trade. The policies set forth by the Bretton Woods Agreement were short lived, however, as the trading volume of the international Forex market led to massive movements of capital. This was caused by post WWII prosperity, which in turn destabilized the foreign exchange rates established in Bretton Woods.
A new system was needed to answer this growth and provide an arena for better trade in the burgeoning Forex market.
The Free-Floating System
In 1971, in large part due to the U.S.’s abandonment of the gold standard, the international economic community abandoned the policies set forth in the Bretton Woods Agreement. By 1973, the currencies of the leading industrialized nations now floated more freely across nations. Essentially, trading borders were torn down as Forex trade increased and became a large institution in the global financial market. This resulted in an increase in trade volumes, speed of transactions, and price volatility, which all continued throughout the 1970s. Also, new financial instruments, market deregulation and loose trade restrictions emerged.
After the failure of other attempts to monitor the Forex market – The European Joint Float, established to lessen Europe’s dependence on the U.S. dollar as a reference currency, and The Smithsonian Agreement, a last ditch effort to sustain the U.S. dollars role in international trade – in 1978, the free-floating system was officially mandated.