Chapter 1: History of foreign exchange
The roots of modern-day currency trading can be traced back to the Middle Ages when countries with different currencies began to trade with each other. Payments for these transactions were generally made in gold or silver bullion or coins by weight. Transactions were made through money-changers operating in the major trading centres and market places. Their main roles were to weigh the bullion or coins with a degree of precision and to determine the authenticity of the coins being exchanged.
Over time, a system of transferable bills of exchange evolved for use by traders and merchants, reducing the need for them to carry around large amounts of gold or silver bullion or coins.
Introduction of the gold standard
As economies began to expand and international trade grew, so too did the need to make transactions simpler and add stability to the exchange of currencies around the globe. Payments made using gold and silver were not only cumbersome, but were also affected by price changes caused by shifts in supply and demand.
The Bank of England took the first steps to stabilise its country’s currency. The Bank Charter Act of 1844 established Bank of England Notes, which were fully backed by gold, as the legal standard for currency.
In 1857, US banks suspended payments in silver, which it had used since the introduction of a silver standard in 1785, as silver had lost much of its appeal as a store of value. This had a disastrous effect on the financial system and is seen by many as a contributing factor to the American Civil War. In 1861 the US government suspended payments in both gold and silver, and began, through the government central bank, a government monopoly on the issue of new banknotes. This gradually began to restore stability to the country’s financial system, as the banknotes began to be accepted as a single store of value — unlike the supply of gold and silver, the supply of these notes could be regulated.
Following the American Civil War, as the US economy expanded and international trade increased, there was a dramatic increase in the demand for credit to facilitate trade and finance rapidly expanding world economies.
The main aim of the implementation of the gold standard, whereby currencies are linked to the price of gold, was to guarantee the value of any currency against that of another. Because countries participating in the gold standard maintained a fixed price for gold, currency exchange rates were thus fixed to the gold price. Each country also had to maintain adequate gold reserves to back its currency’s value, which provided a high level of stability.
The British pound, for example, was fixed at £4.2472 per ounce of gold (1 ounce is equal to about 28 grams), while the US dollar was fixed at $20.67 per ounce of gold. So the exchange rate was essentially fixed at US$4.8667 per £1 (US$20.67/£4.2472 = US$4.8667).
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The use of a gold standard to control monetary policy (the use of interest rates to slow or grow an economy) and its impact on inflation, unemployment and economic growth has many economic implications that are beyond the scope of this book.
If the supply of gold remains relatively stable, then so does the supply of money. The use of a gold standard essentially prevents a country from printing too much money, thereby limiting inflation, but at the cost of higher unemployment.
From the perspective of the forex market, the use of a gold standard implies a system of fixed exchange rates between countries. If all countries are on the gold standard, then there is really only one ‘real’ currency — the price of gold — from which the value of all currencies is determined. The gold standard leads to stability in foreign exchange rates, which is often cited as one of the biggest benefits of using the standard.
The stability that results from use of the gold standard is also one of its biggest drawbacks, because it prevents exchange rates from responding freely to changing circumstances in different countries.
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A gold standard limits the monetary policies a country’s central bank can use to stabilise prices and other economic variables, resulting in severe economic shocks.
After a long period of relative stability, the gold standard broke down at the beginning of World War I as the larger European powers were forced to focus their spending on military projects, which led to the printing of excess money. The outbreak of war also interrupted trade flow and the free movement of gold, undermining the ability of the gold standard to function as it should — allowing gold to flow back and forth between countries to ensure a stable currency base.
The gold standard was briefly reinstated between 1925 and 1931 as the Gold Standard Exchange. Facing massive gold and capital outflows as a result of the Great Depression, Britain departed from the gold standard in 1931, and this latest version of the gold standard broke down.
By the mid 1930s London had become the global centre for foreign exchange and the British pound served as the currency both to trade and to keep as a reserve currency. Foreign exchange was originally traded on telex machines, or by cable, earning the pound the nickname cable.
Major influences on foreign exchange since World War II
The real growth of the forex market has taken place as a result of events after World War II. The abandonment of the gold standard and the war effort had devastated the British and other European economies. The British pound had also been destabilised by the counterfeiting activities of the Nazis.
In stark contrast to the affects of World War II on the British pound, the US dollar was transformed from a dismal failure after the 1929 stock market collapse, to the leading benchmark currency to which most international currencies were compared. The US economy was on fire. The US emerged as a global economic powerhouse and the US dollar became the pre-eminent global currency.
The Bretton Woods Accord
While the war raged in Europe, representatives of the British and US treasury departments were already planning for postwar economic reconstruction. Central to this was the ability to allow free trade to be conducted without wild currency fluctuations or sudden depreciation, coupled with an effective system of international payments.
During July of 1944 the 44 allied nations met for the United Nations Monetary and Financial Conference at Bretton Woods in the US. The countries agreed to a number of measures designed to stabilise the global economy and currency markets in the aftermath of the war. Chief among these measures was an obligation for each country to adopt a monetary policy that pegged its currency to the US dollar. Each currency was permitted to fluctuate plus or minus 1 per cent from this initial value. When a currency exceeded this range, and at specified predetermined intervention points, the central bank of the country had to either buy or sell the local currency in order to bring it back into the range. This became known as the Bretton Woods system.
As the US dollar was pegged to the value of gold at US$35 per ounce, all currencies were effectively still pegged to the gold price. The US dollar was now assuming the role played by gold under the gold standard. The US dollar became the world’s reserve currency.
In order to regulate the member countries’ currencies, and to ensure procedures and rules put in place at Bretton Woods were adhered to, the International Monetary Fund (IMF) and International Bank for Reconstruction and Development (IBRD), now the World Bank, were established. The major purpose of the IMF was to maintain a stable system for buying and selling currencies between countries, and to ensure payments for international trade and exchange were conducted in a timely and smooth manner.
The main tasks of the IMF (as noted on its website) were and still are to:
⇒ provide a forum for cooperation on international monetary problems
⇒ facilitate the growth of international trade, thus promoting job creation, economic growth and poverty reduction
⇒ promote exchange rate stability and an open system of international payments
⇒ lend countries foreign exchange when needed, on a temporary basis and under adequate safeguards, to help them address balance of payments problems.
The Nixon Shock
The decision now referred to as the Nixon Shock was a series of measures taken by US president Richard Nixon that destroyed the Bretton Woods system and led to the free-floating currency system that exists today.
By 1970 the cost of the Vietnam War and increased domestic spending were causing a rapid rise in inflation in the United States. The US was also running both a balance of payments deficit and a trade deficit, causing other Bretton Woods member countries to become concerned about America’s ability to pay its debts. To cover this spending the US was printing excess money, resulting in a dollar glut. In effect the US dollar was over-valued compared with the other currencies that were part of the Bretton Woods Accord.
At the same time, gold was trading at a higher price on the free market than the rate at which it was pegged against the US dollar. This allowed traders to make an arbitrage play by buying pegged gold with US dollars and selling it at the higher prices prevailing in the free market. This combination of events saw government gold coverage of the US dollar decline from around 56 per cent to less than 25 per cent. When the US lifted its quota on the import of oil, this also triggered further massive dollar outflows from the US economy.
In May 1971 West Germany, fearful of building inflationary pressures in both the German and global economies as a result of the US trade and balance of payments deficit, became the first member country to opt out of the Bretton Woods system, and the value of the US dollar declined by 7.5 per cent against the German (Deutsche) mark. During this period France accumulated almost US$200 million worth of gold, and Switzerland US$50 million of gold, further depleting US gold reserves. In early August 1971, as the US Congress recommended devaluation of the US dollar to protect it from what they referred to as foreign price gougers, Switzerland also withdrew from the Bretton Woods system.
On 15 August 1971 President Richard Nixon announced measures to combat the rampant inflation in the US and stabilise the economy. These included a 90-day price and wages freeze, a 10 per cent import surcharge, and the cancellation of the convertibility of US dollars to gold. These decisions were made without consultation with the other members of the Bretton Woods system, and became known as the Nixon Shock.
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From a foreign exchange trading perspe...