This article traces the evolution of the forex market from its early beginnings to its present day. It answers the question: how did the business of trading money come about? Read and understand how forex trading came about.
Forex trading simply means buying and selling currencies. It is a bit like being a grocery store owner, where the grocer buys goods and resells them at a higher price to make a profit. In forex trading, the trading entity aims to make money from the minute-by-minute differences in the exchange rates of two currencies that are paired with each other. Forex trading came about as many governments decided to “float” the rates at which their currencies can be exchanged. The process of floating allows a currency’s value to be determined by the forces of supply and demand. But was this always the situation? Let’s delve a bit deeper into the history of the forex market to see how we got here.
Money has evolved over several centuries, from the time when cowrie shells, manillas, silver and gold were used as a means of exchange, all the way to the use of paper money. Even though gold is no longer used in everyday transactions as legal tender, it still plays a pivotal role in how the forex market evolved into a 24-hour business of trading money. Indeed, gold was still used as a means of exchange up until the late 19th century, when paper notes began to be introduced.
The 2nd World War and its aftermath was to define the future of money and change it forever. At that time, paper notes and coins were the universal means of exchange and countries which were under colonization used the currencies of their colonial masters. WWII pitched the Nazi-led coalition against the British-led Allied Forces. By the time the war entered its 5th year in 1944, the economies of the countries that were in active combat were virtually in ruins, as all economic and human resources had been mobilized for the war effort. The United States only joined the war in 1941 after Pearl Harbor was bombed by Japanese warplanes, and therefore did not suffer much of the economic downturn that Britain and Europe had suffered.
This was the backdrop on which the economic conference of Bretton-Woods, New Hampshire was held in 1944. The essence of this conference was to chart the course of the post-war world economy. One of the decisions reached in that conference was the introduction of the gold-standard; a means of stabilizing exchange rates by pegging an ounce of gold to the US Dollar. The US Dollar was chosen as the reserve currency for international transactions and the gold peg because it had not suffered the economic devastation that had befallen Britain and other nations fighting under the banner of the Allied Forces.
The US gold standard was to last for a total of 27 years. By 1971, the US government of Richard Nixon which had been financially stretched by the protracted conflict in Vietnam, abandoned the peg which at this time had doubled to $70 per ounce of gold. The government scrapped the use of gold as the backing standard for the US-dollar, and introduced a floating exchange regime where the rate of exchange of the US Dollar would be determined strictly by market forces.
This move therefore formed the basis on which currencies are bought and sold today as the forex market. If the exchange rate were to continue being fixed by government fiat, then there would be no exchange rate differential to profit from. But by introducing a flexible regime where the market determines the rates, it is possible to profit from buying/selling two currencies against each other.
Following the abolishment of the USD-gold peg, other pegs that had been maintained by other countries to the US Dollar all gave way to floating exchange rate regimes. But throughout the 1970s to the mid-1990s, trading of currencies was only limited to banks, hedge funds and major financial institutions. This was because currencies had to be traded in very large volumes, which meant that retail investors had absolutely no chance of participating in this market.
The coming of the internet and advances in information and communications technology was to revolutionize the market forever. With the internet and ground-breaking trading platforms, traders could connect with brokers, market makers and liquidity providers all with the click of a mouse button.
Here is a summary of the history of the forex market to date, detailing important milestones.
– Paper currency in use around the world, but strictly used as legal tender and a means of exchange for goods and services.
– Bretton-Woods Conference is held in the town of Bretton-Woods, New Hampshire, USA to discuss structure of post-war global economy. Outcome of meeting led to formation of the International Bank for Reconstruction and Development (World Bank) as well as changes to international trade and currency systems.
– US Dollar is pegged to an ounce of gold at a price of $35 an ounce, and the US Dollar becomes the international reserve currency, leading to pricing of commodities and international transactions in US Dollars.
– Cost of maintaining the peg has increased, and it is now at a value of $70 an ounce.
– Richard Nixon-led US government decides to abolish the peg, and the US Dollar is now backed by the US Federal Reserve.
– The value of US Dollar now to be determined by market forces.
– Forex trading is deregulated, allowing participation of individual traders. The number of retail forex brokers starts to increase.
– The Euro is introduced, and is expected to replace all national currencies of participating Eurozone countries by 2002. The EUR/USD is introduced as a currency pair and eventually becomes the most traded currency pair in the FX market.
– The US Patriot Act is passed in 2001, redefining how financial institutions can relate with citizens of certain countries.
– A blacklist from the Office of Foreign Assets and Control (OFAC) means that citizens of certain countries can no longer do business with US companies as a direct response to the September 11, 2001 terrorist attacks. This leads to existing brokers stopping services to non-US citizens and permanent residents.
– The first smartphones are launched, and with the advent of the smartphones come new mobile-compliant trading platforms. For the first time, traders can trade forex on mobile devices.
– The global financial crisis rocks the forex market and causes central banks to cut interest rates in a coordinated fashion. Several central banks launch coordinated quantitative easing programs to boost confidence in their various economies as well as the financial markets.
– The volatility of the forex market increases as a result of the quantitative easing policy of various countries.
– The Dodd-Frank Act is passed, and the Commodities and Futures Trading Commission (CFTC) sets new leverage requirements for retail forex trading in a bid to lock out “unsophisticated investors”. This is meant to stop retail traders without much investing knowledge from participating in risky markets.
– The Swiss National Bank (SNB) introduces a peg which sees the Swiss Franc (CHF) trade against the Euro at 1.2000. • The first effects of the Eurozone sovereign debt crisis are being felt in Ireland, Greece, Spain and Italy.
– Sovereign debt crisis in Europe worsens, with Greece and Ireland getting substantial bailouts from the European Central bank, European Commission and the International Monetary Fund (IMF). • The Euro drops to levels last seen in its early introduction years against major currencies.
– The Swiss National Bank abandons its EUR/CHF peg, causing an upheaval in the forex market. Several brokers who provided large leverage to their traders either go insolvent or lose colossal amounts of money.
– New leverage rules on forex trading come into effect in Europe, mandating forex brokers to significantly raise margin requirements on trading accounts.