The practice of Forex trading (exchanging of currencies) has been in existence for a very long time, as far back as the Babylonian era. Currently, the forex market is one of the most liquid and largest markets in the world.
Forex traders must have an understanding of the history of foreign exchange marketing and the significant events that have shaped it over the years. As posited by Edmund Burke, “those who don’t know history are doomed to repeat it”. This is hinged on the fact that similar events could occur again even in these contemporary times in different hues and shades, affecting the trading landscape.
The Barter system
The concept of forex trading began around 6000 BC among Mesopotamian tribes, which is located in modern-day Iraq. The system of exchange they developed is what is popularly known as the barter system. The barter system of trading involves the exchange of goods or services without using a medium of exchange such as money. They used the barter system to exchange products via ship. Later on, as the system became widely accepted, salt and spices became the major forms of exchange that existed in those days.
The bartering system further spread across to other areas, especially to the Babylonians, which is also located in modern-day Iraq. The Phoenicians in the eastern Mediterranean were also involved before the system later was known to, and accepted across other ethnic groups and cities.
The advent of the metallic coin system of trading
The Barter trading system continued until the sixth century BC when the use of gold coins emerged. The use of metallic (gold) coins marked the most major change in the trading system after thousands of years of use. The use of Gold and other metals became a widely accepted means of exchange due to their resilience, consistency (a gram of gold is equivalent to another gram of gold), and divisibility. These traits made them highly attractive to a diverse group of people.
The cons of this system became an issue, especially in international trade, since there was no particular standard procedure for determining the value of these coins. The only solution at the time was to make use of coins made by a single issuer who was trusted and widely accepted.
The “Fiorino d’Oro” coin
Somewhere in the 13th century, the Republic of Florence, located in present-day Italy, became a force and superpower in the European and Mediterranean regions. Between 1252 AD and 1533 AD, the “Fiorino d’Oro” or “Florin,” gold coin was developed having a pre-determined gold content. The Florence gold coin became internationally accepted for foreign exchange at that time because other European countries couldn’t produce gold coins with the same quantity of gold as the florin coin. Given this, the majority of historians think that the florin coin system was a miniature or a type of the gold standard that was introduced in the 1800s.
The Medici bank – the “Nostro” account book
In the 15th century, the Medici Bank established by the Medici family of the Republic of Florence became Europe’s greatest bank during that period. They had to establish their bank in other foreign countries to facilitate their commercial activities and support other merchants in terms of currency exchange. This caused the Medici family to become the wealthiest political dynasty, out of which came four popes in Europe. The introduction of the “nostro” account book, which featured two columns displaying quantities in foreign and local currencies by the Medici Bank, further promoted and encouraged forex trading.
The Gold Standard
The Gold Standard was hence introduced to control and manage currency value and payment volatility. It regulated currency conversion into a specific amount of Gold. Since major currencies were backed by Gold, it became the responsibility of Governments to keep enough gold reserves to back their currencies. The gold standard was birthed in the nineteenth century, but by the later part of the twentieth century, it became weak. It was phased out and replaced by the fiat system, which had gained popularity and allowed the printing of currencies with ease.
Europe moved to paper money, increasing the volume of international trade that could occur. This led to the first currency market, due to Banks and the ruling classes trading in currencies from other nations to aid their travels and businesses.
The forex trading companies began to increase in London from three (3) to seventy-one (71) in the year 1913. The Pound Sterling accounted for half of all those transactions. Today, the Pound Sterling is the fourth most traded currency after the US dollar, Euro, and Japanese yen.
The Bretton Woods System
The Bretton Woods system was established in 1944 by 44 countries that had their 700 representatives gathered at Mount Washington Hotel in the US. It was created to replace the Gold Standard during World War II since it became weak due to the economic downturn that occurred after the stock market crash in 1920.
The Bretton Woods system validated the US Dollar as the world’s reserve currency. Its value was linked to the price of Gold. Notwithstanding, this system also failed due to low gold reserves. On 15th August 1971, the US President, Richard M. Nixon, had to withdraw the Dollar/Gold convertibility that existed under this system. This led to a new framework with fixed exchange rates and three international agencies to oversee economic activity.
The Free-Floating System
After the Bretton Woods Agreement came the Smithsonian Agreement, which was established in 1971. Though it was similar to the Bretton Woods system, it had a wider fluctuation band. The US pegged the dollar to gold at $38/ounce, thereby depreciating it. Other major currencies were allowed to fluctuate by 2.25% against the US Dollar, also pegged to gold.
West Germany, France, Italy, the Netherlands, Belgium, and Luxembourg came together to form the European Joint Float in 1972. Its purpose is to reduce reliance on the US Dollar. Both agreements failed due to mistakes, leading to the official switch to the free-floating system in 1973.
The Plaza Accord
In the early 1980s, the US dollar rose significantly against other major currencies, making it harder for exporters and leading to a 3.5% GDP deficit. To combat stagflation, Paul Volcker raised interest rates, causing a strong dollar and reducing US industry competitiveness.
The Plaza Accord was formed in 1985 by the G-5, which included the US, Great Britain, France, West Germany, and Japan, to encourage the appreciation of non-dollar currencies, causing a significant drop in the dollar value. This led to currency trading and potential profit despite government intervention, which became clear a decade after Bretton Woods’ collapse.
The three (3) exchange rate systems used today
Floating rates
The floating exchange rate system is the exchange rate system in which a currency fluctuates based on market demand and supply. Central banks can intervene to control the extreme volatility by altering short-term interest rates, increasing bank reserve requirements, and purchasing/selling their currency to control pricing.
Pegged rates
The linking of a country’s currency exchange rate to another currency is referred to as a currency peg. China’s Yuan and Hong Kong Dollar are pegged to the US Dollar, and Bulgaria’s Lev and Denmark’s Krone are pegged to the Euro.
Dollarisation
Some countries may choose to use a foreign currency as their national currency. This is typically done when the country’s currency is unstable or inflationary. Usually, most countries rely on the US dollars for this kind of transaction. Two countries that use the American Dollar as their official currency are Panama and El Salvador. By utilizing the U.S. Dollar, these countries can benefit from the stability and global recognition of the world’s most widely used currency.
The Internet and Online Forex Trading
Currency trading took a different turn in the 1990s, during which advancements in Information Communication and Technology (ICT) brought about new possibilities for forex trading. The fall of the Berlin Wall and the Soviet Union further made online trading a success.
Competitive forces have also been created in the marketplace with unparalleled liquidity, giving room for individuals to trade large amounts. These individuals have access to the same electronic communications networks used by international banks and merchants.
The central banks, commercial banks, large financial institutions, and wealthy investment fund controllers used to be solely in charge of the forex market. Nevertheless, due to the advent of the internet and technological advancements; internet-based trading platforms for individual traders also emerged. These trading platforms are mostly provided by numerous entities that can either be market makers or Electronic Communications Networks (ECN).
