An understanding of what foreign exchange trading is begins with knowledge of what money really is. Before money, people bartered and traded goods for goods; this was very inefficient. Perhaps, someone wanted a horse, but only had grain to trade and the owner of the horse had no need of the grain. There was no way to make the deal. The creation of money as a medium of exchange and a store of value overcame this problem.
Gold and Silver Coins, The Gold Standard for Paper Money
As traders of goods and services became willing to accept money as payment, trade could take place between parties that did not have products desired by each other. Early on, gold coins were popular as money as there was an inherent value to the gold. Paper money eventually replaced gold as between traders with a legal guarantee that the paper could be exchange for gold from the government that issued the paper. This was known as the gold standard. Governments defined by law what was known as "legal tender" for the settlement of debts.
As countries began to trade with each other, it became important to international sellers of goods and services to be able to value the money issued by different governments. As long as each country primarily issued coins of precious metals or guaranteed payment of a fixed amount of gold for paper currency, this was not a difficult problem. Absent a uniform precious metal standard, another method was necessary.
The Bretton Woods Accord: Fixed Exchange Rates Between Countries
Near the end of World War II, the setting of international currency standards was undertaken by the Allied Nations at Bretton Woods, New Hampshire. The Bretton Woods conference, by treaty, established a system for each country to adopt a policy maintaining the exchange rate of its currency a fixed value in terms of gold. On August 15, 1971, the United States unilaterally ended the dollar’s convertibility to gold. In 1973, the gold standard and fixed rates of exchange between money of different countries were formally abolished. This set the stage for the modern Forex, or foreign exchange, market.
After Bretton Woods: Floating Exchange Rates Give Rise to Forex
Through history rates of exchange had been tied to a commodity, such as gold, with its own value. An exchange rate is defined as the value of one country’s money expressed in terms of a quantity of another country’s money. Over time, such rates have been fixed such as during the period Bretton Woods was in effect or floating. Floating rates are constantly changing, driven by supply and demand.
When the Bretton Woods standards were abandoned, large multinational corporations that did significant business in differing countries needed a method to be certain of the value of a contract in the currency of their home country for a transaction that would take place in the future. These companies wanted to guarantee the value of the future payments, and in response to this need, a market arose for companies to exchange money at a fixed rate. This was to guarantee the company profits from an exchange of goods or services, not to make money on the trade of the currencies themselves.
These markets were dominated by large banks and institutions that traded the currencies between themselves. The Chicago Mercantile Exchange began to offer contracts to buy a currency at a fixed price for delivery at a later date. These “futures contracts” were used to hedge an international trader’s risk that currency values would be different when a contract was performed from the time the contract was entered.
The Rise of Forex Brokers and Retail Forex Traders
With the growth of technology and trade, the ability to exchange money very quickly evolved. Brokers arose to meet the needs of smaller banks that did not trade in money directly as did the large banks, corporations and institutions. In the 1990’s, money exchanges began to take place over the Internet and through Internet broker systems.
As these systems developed, it became easier for individuals to “invest” in currencies, trying to profit on the fluctuation in value between for example, the US Dollar against the Great Britain Pound. Individual traders make up what is known as the retail market. These individuals do not buy and sell money to protect the value of trades in goods and services, but, rather simply, to make money in their home currency.
The Forex market has become the world’s largest financial market. Estimates of trading in the market are near $4 trillion dollars each and every day. It is largely decentralized, with trading centers around the world allowing for the trade of foreign currencies to take place 5.5 days per week, 24 hours per day.
David J. Shestokas - Mr. Shestokas is a former prosecutor & writes on the Constitution & legal issues for the Save America Foundation & Suite 101.
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