History of the Forex Market
Prior to 1971, speculation was not permitted in the currency markets due to an agreement called the Bretton Woods Agreement. This agreement was set up in 1945 with with the purpose of stabilizing international currencies and preventing money fleeing across nations. This agreement fixed all national currencies against the dollar and set the dollar at a rate of $35 per ounce of gold. Before this agreement was established the gold exchange standard had been used since 1876. The gold standard used gold to back each currency preventing kings and other rulers from arbitrarily debasing money and triggering inflation. Only the Federal Reserve System and other similar institutions in the United States have this kind of power.
Even so, the gold exchange standard had problems of its own. As an economy grows it would import goods from overseas until it ran its gold reserves down. Thus resulting in a decrease of money supply which then resulted in rising interest rates and a slowing of economic activity to the point that a recession would occur.
Eventually the recession would cause prices of goods to decrease so low that they would appear attractive to other countries. This in turn led to an inflow of gold back into the economy and increase in money supply which led to the decrease of interest rates and the strengthening of economy. During the gold exchange standard years these boom-bust patterns prevailed until the start of World War I which interrupted the free flow of trade and thus the movement of gold.
After the war concluded the Bretton Woods Agreement was established. Participating countries agreed to attempt to maintain the value of their currency with a narrow margin against the dollar. Rates were used to value the dollar in relation to gold. Countries were banned from devaluing their currency to improve their trade position by more than 10%. After World War II international trade expanded rapidly due to post-war construction and this resulted in substantial movements of capital. This destabilized the foreign exchange rates that had been set-up by the Bretton Woods Agreement.
In 1971, the Bretton Woods agreement was finally abandoned and the US dollar was no longer convertible to gold. By 1973, currencies of the major industrialized nations were floating more freely, helped by the forces of supply and demand. Prices were set, with volumes, speed and price volatility, all increasing during the 1970’s. This guided the way to new financial instruments, market deregulation and open trade. It also led to a rise in the power of speculators.
Accelerated with the arrival of computers during the 1980’s, the movement of money across borders became a continuum, trading through the Asian, European and American time zones. The big banks created dealing rooms where hundreds of millions of Dollars, Euros, Pounds and Yen were exchanged within minutes. Today electronic brokers trade daily in the Forex market. For Example, in London single trades for tens of millions of dollars are priced in a matter of seconds. The market has changed considerably with the majority of international financial transactions being carried out not just to buy and sell goods but to speculate on the market with the intention of most dealers to make money out of money.
London has developed to become the world’s leading international financial center and is the world’s largest Forex market. This occured due to its location, operating during the American and Asian markets, as well as its creation of the Eurodollar market. The Eurodollar market was created during the 1950’s when Russia's oil revenue, which was all in US dollars, was deposited outside the US with the concern of being frozen by US authorities. This produced a substantially large pool of US dollars that were outside the control of the US. These considerable cash reserves were very attractive to foreign investors because they offered higher yields and had far less regulations.
London continues to grow to this very day as more and more American and European banks come to the city to establish their regional headquarters. The sizes dealt with in these markets are enormous and the smaller banks, private investors and commercial hedgers almost never have direct access to this liquid and competitive market. This is because they do not meet required credit criteria or because their transaction sizes are just too small. Although, today market makers are allowed to break down larger inter-bank units and can give small traders the opportunity to buy or sell any number of these smaller units (lots).