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History of the Foreign Exchange
The Evolution of the Foreign Exchange Market
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The Gold Exchange and the
Bretton Woods Agreement |
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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 nations, 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 reserves 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 goods had hit bottom, appearing
attractive to other nations, who would rush into buying sprees
that injected the economy with gold until it increased 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 setup 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 computers and technology, extending market
continuum through Asian, European and American time zones.
Transactions in foreign exchange rocketed from about $70
billion a day in the 1980s, to more than $1.5 trillion a day
two decades later.
The Explosion of the Euromarket
A major catalyst to the acceleration of Forex trading was the
rapid development of the eurodollar market; where US dollars
are deposited in banks outside the US. Similarly, Euromarkets
are those where assets are deposited outside the currency of
origin. The Eurodollar market first came into being in the
1950s when Russia’s oil revenue-- all in dollars -- was
deposited outside the US in fear of being frozen by US
regulators. That gave rise to a vast offshore pool of dollars
outside the control of US authorities. The US government
imposed laws to restrict dollar lending to foreigners.
Euromarkets were particularly attractive because they had far
less regulations and offered higher yields. From the late
1980s onwards, US companies began to borrow offshore, finding
Euromarkets a beneficial center for holding excess liquidity,
providing short-term loans and financing imports and exports.
London was, and remains the principal offshore market. In the
1980s, it became the key center in the Eurodollar market when
British banks began lending dollars as an alternative to
pounds in order to maintain their leading position in global
finance. London’s convenient geographical location (operating
during Asian and American markets) is also instrumental in
preserving its dominance in the Euromarket.
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