The History of the Forex market

Invezz
  • September 15th 2019, 17:36

History of the Forex Market

When you open your laptop, analyse some price charts, and place a forex trade which is executed in a few microseconds, it’s hard to imagine how foreign exchange transactions took place long before there was electricity, computers, internet, telephones, or even banknotes.

Let’s take a brief look at how currencies have been traded and exchanged over the course of many centuries until this present time.

Foreign Exchange in Ancient Times

Thousands of years ago, ancient societies bartered livestock, grains, fish, animal skins, vegetables, fruit, spices, wine, olive oil, honey, clothing, metals, wood, property, weapons, etc. For obvious reasons, bartering was often burdensome and impractical. Imagine having sold a piece of land for 5 tons of grain. Delivering the 5 tons of grain to the seller would have been hard work, even if the buyer and seller were neighbours. If you compare this to transacting with a few kilograms of gold, there’s a big difference in convenience.

Metal Coins

To overcome the obstacles and inefficiencies of bartering, the ancient people eventually minted metal coins to trade with. Coins were much easier to move around than livestock, grains, etc. It was also a much better standardised medium of exchange than the different types of bartered goods. Coins were also more practical than metal bars, simply because the smaller unit sizes enabled more precise pricing in smaller increments. Some of the metals used for coins include gold, silver, copper, bronze, electrum, and tin. Although the metal coin was not the first or only form of currency, it was definitely the most important for many centuries.

Ancient Chinese Coins

Different countries and regions had different types, weights, and sizes of coins. Merchants, smiths, and money changers exchanged different types of coins for one another. This is one of the earliest forms of currency exchange.

Foreign Exchange Between 500 and 1944 A.D.

Paper Currency (700 A.D. and Onward)

An important reason why metal coins improved trade and commerce, was because it was easy to carry around. And when paper money was invented, trade became even more convenient.

The first paper money was used in China during the Tang Dynasty (618 to 907 A.D.). A few hundred years later in 1661, Europe also started using paper money with Sweden printing the first banknotes.

Currency Exchange Boosted by Increasing International Trade

In the 1500s, the booming textile trade played an important role in developing the foreign exchange market. The Medici family (Italy) who owned the Medici bank opened banks in different offshore locations to exchange currencies on behalf of textile merchants.

As the banking industry and international trade further developed, foreign exchange became increasingly important. Around the 17th century, there was an organised foreign exchange market in Amsterdam. At this time, Britain was also actively involved in currency exchange. Of course, financial systems across the rest of Europe, the Middle East, and Asia were also evolving rapidly.

The British pound has been around for more than 1,000 years (since 775 A.D.)

The U.S. Dollar and Early Foreign Exchange in the USA

In the late 1700s, the U.S. dollar came into circulation in the United States. During the late 1700s and the early 1800s, the first U.S. banks came into existence. Some of the most notable U.S. foreign exchange firms in the 1800s include Alex. Brown & Sons and Banco Espirito Santo.

 

Different U.S. dollar notes.

In 1866, the first successful transatlantic submarine communications cable was completed. This copper telegraph cable transmitted currency quotes between New York and London and was an important infrastructure improvement for currency trading between the U.S. and Britain. This is where the GBP/USD currency pair’s nickname Cable originated from. 

Foreign Exchange During The Gold Standard

In 1890, the classical gold standard was adopted in England, after which it spread to Germany, France, Switzerland, Belgium, and the United States. This implied that each country had to peg its currency to a certain weight of gold, for example, $20.67 per ounce (in 1879 in the United States). These values were called parity rates. Countries who observed the gold standard had fixed currency exchange rates between each other because their currencies were all pegged to gold. This was obviously not a good time to participate in currency speculation.

Obviously, the gold standard had its limitations and drawbacks. In times of slow economic growth, governments couldn’t just print cash and inject it into their economies. They had to keep enough gold to back the amount of currency in circulation. Establishing the correct parity value was also a challenge.

The gold standard became a heavy stumbling block to global economic growth.

With the advent of the First World War, European countries abandoned the gold standard in order to finance military expenses. After the war, Europe returned to a modified gold standard. After the First World War, currency speculation increased dramatically as the foreign exchange market became very volatile. When the Great Depression came along, however, the forex market gave back much of this excessive volatility.

When the Great Depression struck the world between 1929 and 1939, it forced countries around the world to abandon the gold standard. Deflation and contracting economic activity could only be countered by disconnecting currencies from gold. An example is when President Franklin D. Roosevelt disconnected the U.S. dollar from gold, pumped money into the economy, and lowered interest rates to lift the U.S. economy out of the depression.

Foreign Exchange From 1944 to 1973

The Bretton Woods Accord

Towards the end of the Second World War, the Bretton Woods Accord was signed in July 1944 at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire. This agreement between the 44 Allied nations was the start of a new economic order wherein global economies could restore themselves in a stable economic environment.

Instead of adopting the classical gold standard again, the Bretton Woods Accord pegged global currencies to the U.S. dollar at specific rates, with a permitted fluctuation of plus or minus one percent. The U.S. government backed the U.S. dollar with gold at a fixed price of $35 per ounce and would exchange gold with participating central banks at that price. Because the United States had the largest gold reserves in the world, it was appropriate for its government and currency to be the backbone of the Bretton Woods system.

The Bretton Woods system created a stable platform for the restoration of the global economy and at the same time stabilised major exchange rates. Forex volatility was confined to the narrow bands as defined by the Bretton Woods agreement and the guidance of the IMF (International Monetary Fund).

The End of the Bretton Woods and Smithsonian Systems

For obvious reasons, the Bretton Woods Accord could not last forever. In the 1960s gold supply grew much slower than global trade, which meant that payment imbalances could not be matched with a large enough supply of gold. This meant that governments would have had to restrict payments and trade, which in turn would have dampened worldwide economic growth.

Another major problem was that there were not enough gold reserves in the United States to back all the dollars held by central banks around the world. Trust in the U.S. government waned and as the dollar became more and more overvalued, governments from around the world began to exercise their right to exchange their dollars for gold at $35 per ounce. Gold flowed out of the United States at an alarming pace and eventually, U.S. President Richard Nixon put an end to gold redemptions by foreign central banks on August 15, 1971. This removed the basis on which the Bretton Woods Accord was built and resulted in its abandonment.

The United States Bullion Depository (Fort Knox), Kentucky.

The sudden fall of the Bretton Woods system urged governments to negotiate new exchange rate arrangements. A meeting was held at the Smithsonian Institute in Washington in December 1971. The resulting Smithsonian Agreement specified new par values for different currencies and allowed currencies to fluctuate within a ±2% band. The Smithsonian Agreement devalued the U.S. dollar to $38 per ounce of gold but foreign governments were still not able to exchange dollars for U.S. gold.

The Smithsonian Agreement eventually failed as well and a transition was made to a free-floating foreign exchange market in 1973.

Foreign Exchange in Modern Times

From 1973 and onwards, the governments of developed countries progressively exercised less control over foreign exchange trading. In 1978, the free-floating currency exchange system was officially mandated by the IMF. Free-floating exchange rates presented good opportunities for speculative participation in the forex market and in the 1980s, retail bank clients traded currency pairs for the first time.

Before the advent of online retail forex trading platforms in the 1990s, retail forex trading was mostly done by wealthy individuals who executed their trades through their investment banks. The minimum trade size was immense and was usually placed over the telephone.

Online Retail Forex Trading Platforms

When online retail forex trading became available, however, the minimum trade size was much smaller than before. Forex brokers also offered margin accounts to their clients, which meant that traders had access to leverage and could control large forex positions with relatively small amounts of capital. Trade execution was also much more convenient because traders could place trades via broker platforms without having to phone a banker.

Online trading platforms also made technical analysis really convenient with live price charts and technical indicators. The availability of different types of orders also helped a lot. Examples are stop loss orders, take profit orders, and different types of pending orders.

Institutional Forex Trading

The forex market is known for immense trading volume and high liquidity. This makes the forex market attractive to institutional market players like banks and hedge funds. In some cases, central banks are also actively involved in the forex market. Banks, hedge funds, investment companies, central banks, and even large international corporations are the major role players in the forex market.

Algorithmic Forex Trading

Institutional and retail traders both have access to algorithmic trading. This type of trading works with computer programs called trading robots or trading algorithms. A trading robot can execute and manage forex trades automatically, with minimal human intervention. Other advantages of algo trading include super-fast decision making and order execution.

One of the earliest retail trading platforms to support algo trading is MT4 (MetaTrader4). Trading robots coded in the MQL4 language are called expert advisors. Another example of a coding language used for algo trading is Python.

Forex Copy Trading

In 2006, the world’s largest copy trading platform, eToro, was founded by Ronen Assia, Yoni Assia, and David Ring. By 2018, eToro already had more than 9,000,000 users in its community.

eToro’s copy trading platform allows users to automatically copy the trades of experienced traders called popular investors. With this platform, investors can analyse the historical performance of thousands of different popular investors, see which instruments they trade, and construct a diversified portfolio that copies the trades of up to 100 popular investors simultaneously.

eToro makes copy trading really convenient!

eToro not only has forex instruments, but also stocks, cryptocurrencies, indices, ETFs, and other financial instruments.

Foreign Exchange for Travel and International Trade

Let’s not forget that forex transactions take place whenever travellers change money and when international trade takes place. Technology has greatly increased the speed at which these actions take place. Travel and international trade are important sources of forex market liquidity.

Conclusion

During the last few decades, the foreign exchange market has undergone some really significant changes. Billions and even trillions of dollars of currency is traded on a normal business day, making this global decentralised market the most liquid and traded of all markets.

Retail forex brokers and their online trading platforms make it possible for any person to conveniently participate in the forex market, which operates basically 24 hours a day, 5 days a week. What a great contrast there is between ancient foreign exchange and that which we have today!

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