The FOREX market (FOReign EXchange) is the inter-bank market for trading currencies. It came into existence in the 1970's when the move towards a free-floating or flexible currency system was completed. In a free-floating system the exchange rate between two currencies, e.g. the Euro and the US-Dollar, is determined by the market forces, i.e. by supply and demand.
The volume traded on the FOREX market vastly exceeds the volumes traded on all other financial markets. The daily volume traded on the FOREX market is estimated at 3 to 4 trillion US Dollar. The daily volume traded on the stock markets are, for comparison, around 500 billion US Dollar. 90 - 95 per cent of the traded volume on the FOREX market is carried out by the largest international banks, either as own trading or as trading carried out for customers. The continued advance in Information Technology makes this sphere also available for individual investors. An increasing number of brokers and banks provide individual investors direct access to the FOREX market via the Internet. Generation of financial results (profits as well as losses) on the foreign exchange market rests on the simple fact, that every national currency is a product like wheat, sugar, gold or silver. The fact that the world changes at an accelarating pace and that the economy (national product, inflation, unemployment, etc.) of each individual country is increasingly entwined with the development and economy of other countries and that this affects the value of one currency relative to another is the main reason for ever-fluctuating exchange rates.
From 1870 to 1914 the world's exchange system was operated under the Gold Standard System. According to this system, all the world's currencies were pegged to gold. This system worked well until the First World War when many countries overprinted money in relation to their gold reserves in order to meet the extraordinary economic demands at that time.
Consequently, it led to unprecedented inflation. Therefore, many European countries were forced to abandon the Gold Standard System. In July of 1944, sixteen major western nations established the International Monetary Fund ("IMF") to supervise exchange rates and to establish a standardized system for international payments. By agreement the price of gold was fixed (at that time to US $35.00 per troy ounce) and a pool of reserves was created by the member nations. Although market forces were free to determine day-to-day exchange rates, the fluctuations were restricted to plus/minus 1% of the agreed value. Member nations had the power to intervene in order to ensure that those restrictions were adhered to.
The system worked reasonably well until the 1960's when the divergent inflation rates seriously altered the relative competitiveness of the major trading countries. The year of 1971 resulted in the series of US dollar crises, which caused the collapse of the system. Thus, IMF came up with the Smithsonian Agreement, under which the US dollar was devalued by 10% and a wider fluctuation band (between 1% and 2.25% above or below the official spot rate) was adopted. By March of 1973 the Smithsonian Agreement also collapsed.
The outcome of these failures was to let member currencies free-float in relation to each other. In 1979 the members of the European Economic Community established a system under which every member was required to maintain its exchange rate within a fluctuation band of plus/minus 2.25% in relation to other currencies, and within plus/minus 1% of the European Currency Unit ("ECU"). The system was managed with the help of generated reserves to aid members who needed to support their currencies.
THE EVOLUTION OF FX MARKETS
The Gold Exchange and the Bretton Woods Agreement
In 1967, a Chicago bank refused a college professor by the name of Milton Friedman a loan in pound sterling because he had intended to use the funds to short the British currency. Friedman, who had perceived sterling to be priced too high against the dollar, wanted to sell the currency, then later buy it back to repay the bank after the currency declined, thus pocketing a quick profit. The bank's refusal to grant the loan was due to the Bretton Woods Agreement, established twenty years earlier, which fixed national currencies against the dollar, and set the dollar at a rate of $35 per ounce of gold.
The Bretton Woods Agreement, set up in 1944, aimed at installing international monetary stability by preventing money from fleeing across nation, and restricting speculation in the world currencies. Prior to the Agreement, the gold exchange standard-prevailing between 1876 and World War I-dominated the international economic system. Under the gold exchange, currencies gained a new phase of stability as they were backed by the price of gold. It abolished the age-old practice used by kings and rulers of arbitrarily debasing money and triggering inflation.
But the gold exchange standard didn't lack faults. As an economy strengthened, it would import heavily from abroad until it ran down its gold reverses required to back its money; consequently, the money supply would shrink, interest rates rose and economic activity slowed to the extent of recession. Ultimately, prices of gold had hit bottom, appearing attractive to other nations, who would rush into buying sprees that injected the economy with gold until it increase its money supply, and drive down interest rates and recreate wealth into the economy. Such boom-bust patterns prevailed throughout the gold standard until the outbreak of World War I interrupted trade flows and the free movement of gold.
After the Wars, the Bretton Woods Agreement was founded, where participating countries agreed to try and maintain the value of their currency with a narrow margin against the dollar and a corresponding rate of gold as needed. Countries were prohibited from devaluing their currencies to their trade advantage and were only allowed to do so for devaluations of less than 10%. Into the 1950s, the ever-expanding volume of international trade led to massive movements of capital generated by post-war construction. That destabilized foreign exchange rates as set up in Bretton Woods.
The Agreement was finally abandoned in 1971, and the US dollar would no longer be convertible into gold. By 1973, currencies of major industrialized nations floated more freely, as they were controlled mainly by the forces of supply and demand. Prices were floated daily, with volumes, speed and price volatility all increasing throughout the 1970s, giving rise to new financial instruments, market deregulation and trade liberalization.
In the 1980s, cross-border capital movements accelerated with the advent of computer and technology, extending market continuing through Asian, European, and American time zones. Transactions in foreign exchange rocketed from about $70 billion daily in the 1980s, to more than $1.5 trillion a day two decades later.