Evolution of forex market
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Forex Trading
This chapter talks in detail about how the Forex market has evolved over the course of last several centuries. We start with the earliest known system of exchange - the Barter system - and proceed all the way to today's digital era.
The objective of this chapter is to introduce the reader with important milestones that have eventually shaped up the Forex market of today. The objective of this chapter is to talk about the evolution of the Forex market, from the earliest known method of exchange - the barter system - to the currently used method of exchange - the free float system. In this chapter, we will talk about each of the major landmark systems of exchange that have eventually shaped the Forex market of today.
So, let us begin. The barter system is the earliest known method of exchange. It is believed to have originated among the Mesopotamian tribes sometime around B. Back then, bartering was confined to local areas, where people used to exchange goods for items such as food, beverages, and spices.
As time progressed, the barter system spread beyond local areas. During the middle ages, the bartering system spread across countries and continents, where people from one country and continent started to exchange goods and services with people from other countries and continents. Not only were the necessity items such as food and beverages exchanged during this time, but also non-essential items such as crafts, artistic works, perfumes etc.
Put it in simple words, bartering system is a method wherein goods and services are exchanged for other goods and services without any involvement of money.
As an example, a person who has surplus rice but needs salt might exchange it with someone who has surplus salt but needs rice. This is an example of bartering because the exchange is taking place without any involvement of money.
During the ancient times, before the advent of money, all the transactions used to take place in the form of bartering. However, there were complications in the bartering method of exchange.
As we can see from the above examples, bartering can take place when the requirements of both the sides are met. Without this, it is difficult to exchange goods and services for other goods and services. For instance, a person who has surplus rice but needs salt is likely to be unsuccessful in selling it to someone who has surplus salt but has no requirement of rice.
As such, at times, it became very difficult to find a suitable buyer for the surplus goods and services that one possessed and needed those to exchange for something else. The other difficulty that arose with this system was the way to measure the value of goods and services. For instance, if one person had surplus rice and needed to exchange it for salt, how much quantity of rice equated a certain quantity of salt?
This question was highly subjective and was usually determined by the need and the bargaining ability of the two parties. Because of the complications of the barter system, the need to develop a better and a convenient medium of exchange arose. A medium that could be measured in value terms, a medium that was more convenient to carry, a medium that was durable and non-perishable, and a medium that would be readily acceptable by any buyer and seller.
The barter system eventually lost its appeal to the gold system in some case even silver was accepted, though it had a lower appeal than gold , wherein gold gradually started to become the standard medium for exchanging goods and services.
The major complications of the bartering system eventually paved way for gold to be considered as a medium of exchange. Ever since the ancient ages, people have been fascinated by the aura of gold. The metal has been considered as a symbol of status since the ancient times because of its unique features such as visual appearance, scarcity, durability, and divisibility into smaller denominations.
These features of gold along with its ready acceptance and measurability in terms of value, made the yellow metal a preferred medium for exchanging goods and services across the world. Around the year BC, the first officially known gold coins were minted in the region of Lydia, which in now a part of Turkey. Eventually, the usage of gold coins as a medium of exchange spread to other parts of the world. Civilizations in Europe from Rome to Greece also started issuing gold coins as a medium of exchange.
However, as time evolved and the global trade started expanding, there came a need to move to a new system of exchange. One of the reasons for this was the inconvenience of carrying huge quantities of gold for making large transactions. Another problem that arose was related to storage. It started to become increasingly difficult and risky to store large quantities of the precious metal at home or at any other place.
Yet another problem was related to the tampering of gold coins - what if a person melts the gold coin and reduces the gold content in it by a small portion before forging the coin again? All these issues eventually led to the adoption of the Gold Standard in the 19 th century. By the early 17 th century, gold was the most dominant method of exchange around the world. The yellow metal was readily accepted by every buyer and seller as a medium of exchange. What however became problematic was the inconvenience to carry gold whenever there was a need to transact.
The larger the transaction, the larger the quantity of gold that was needed to be carried along. Eventually, to address this issue, people started depositing gold with goldsmiths on whom they could trust. These goldsmiths, in return, would issue depository receipts to the tune of gold that was deposited with them. These receipts, instead of the physical gold, would then be used as a medium of exchange between a buyer and a seller.
The person holding these receipts could go to the goldsmith with whom the gold was deposited and exchange it for gold, as and when needed. These receipts were a type of paper money, because they were valuable and represented a promise to pay gold as and when the holder of these notes demanded them. As the trade started getting bigger and bigger, a lot of these depository receipts were issued. Eventually, due to the ever-expanding volumes and number of transactions, a lot of these goldsmiths grew into private banks.
They now started not only issuing promissory notes whenever someone deposited gold with them, but also lending excess gold from their vault at a certain rate of interest. This is how the process of depositing and lending began back when currency notes were not in existence.
Eventually, as the global trade expanded at a rapid pace and as the government needed someone from whom it could borrow money by issuing debt, there came a need for the development of an entity that could act not only as a regulator for the growing numbers and volumes of the deposits and lending but also as a lender to the government.
This led to the growth of central banks. The Riksbank of Sweden was the first recognized central bank, established in the year It was a few years later followed by the establishment of the Bank of England in Other central banks in different parts of Europe were also established over the course of the next few decades. Eventually, as the global trade flourished, as the acceptance of gold-backed promissory notes became more pronounced, as the number of private banks started expanding, and as the role and importance of central banks grew, there was a need for the development of a more robust monetary system.
Gradually, most of the countries followed suit and started adopting the Gold Standard system. Under this system, the central banks started issuing paper money, by backing them to the amount of gold they had in their vaults. The greater the amount of gold they had in their vaults, the greater the number of paper money they could print, and vice versa. The price of gold was decided by the central bank, which in turn would determine the value of the currency.
As we can see, if the central bank fixes gold at a higher price, the value of the currency would drop, and vice versa. This way, central banks could adjust the value of its currency depending on various factors such as demand and supply conditions. When needed, people could go to the banks and exchange paper money for a certain quantity of gold. As such, central banks could print only as much money as the quantity of gold they possessed. This in turn helped to rein in inflationary pressures greater the money in circulation in the economy, higher the inflation, and vice versa.
Gold Standard system benefited nations which enjoyed a Balance of Payment surplus, as they received gold tothe tune of their surplus, which they could then use toincrease the money supply of their own currency. However, this came at the cost of the nations that had a Balance of Payment deficit, who had to settle this deficit by giving gold, which would reduce the quantity of gold in their reserves and in turn reduce their ability to increase the money supply.
The Gold Standard system worked very well during the 19 th century, but things started to change in the early parts of the 20 th century. While the supply of gold was growing because of continued mining of the metal, it nonetheless was growing at a slower pace as compared to the growth of the world economy.
More importantly, as World War I inched closer, the governments of various nations needed considerable sums of money to fund for war-related expenses.
However, as we know by now, the existing Gold Standard system put a cap on the amount of money that could be printed. As a result, confidence in the Gold Standard system started eroding. Post World War 1, nations also needed a lot of money for rebuilding their economies following the devastation caused by the war as well as the economic devastation caused by the Great Depression a few years later in As a result, countries started abandoning the Gold Standard system.
England abandoned the Gold Standard system in , while the US followed suit two years later. By the end of World War 1, the US had become a major economic power.
Because of all these factors, the Dollar became a dominant global currency. A lot of nations who had abandoned the Gold Standard system started pegging the value of their currency to that of the Dollar rather than to gold. After seeing the instability and the inflexibility caused by the Gold Standard system during the war years, the major Allied forces as well as other countries believed there was a need to develop a more robust system which would be more stable and flexible.
As a result, it was decided during this meet in Bretton Woods that the value of other currencies be pegged to the value of the Dollar, which in turn would be pegged to the value of gold. The reason why the Dollar waschosen was because of the growing strength of the US economy, as highlighted earlier, and because of the apparent safety of the US — it was one of the very few major powers in the world on whose land war did not officially enter.
Meanwhile, the reason why the Dollar was pegged to gold was because the US could do it — it had the largest gold reserves in the world, which continued expanding rapidly because of the US's status as a creditor nation and because of strong gold mining in the US.
Hence, in , a new international system was introduced and was called the Bretton Woods system named after the place of the meet.
As we already know, before the Bretton Woods agreement, the balance of payment differences was settled using gold. After the agreement however, the balance of payment differences was settled using the Dollar.
As a result, countries around the world started accumulating dollarsin their reserves rather than accumulating gold. As the Dollar was fully convertible to gold, when necessary, countries could freely convert their dollar holdings into gold, on demand.
The system worked excellently for a few years as it helped to promote stability and order. A lot of nations that were devastated by the effects of World War 2 were able to recoverand make economic progress during the time of the Bretton Woods system. However, just like its predecessors, the Bretton Woods system started showing cracks in the s. Because of the expansionary monetary policy in the US and improving economic conditions across several European countries, the US started experiencing a balance of payment deficit.
As such, the gold reserves of the US started depleting. Also, increased spending by the US government to fund for the Vietnam war and other activities led to an increase in the amount of dollars in circulation.
By the end of the s, the gold that the US had in its vault started falling short of the dollars in circulation. Fearing a run on its gold reserves by the member nations as well as reluctance of the member nations to revalue their own currencies against the Dollar, the US finally ended the Dollar-to-gold convertibility in , bringing an end to the Bretton Wood system.
The end of the Bretton Woods system in eventually gave birth to the free-floating system within the next couple of years.
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London: Macmillan, Paul Einzig was both a financial journalist and an author of scholarly works. A brief, excellent biography of Einzig is Tether, Einzig was a prolific writer in both the popular press and academic realms. For two decades, he contributed a regular,? Lombard Street,? Because of his popular writings, academic economists have a tendency to discount Einzig?
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Until the early seventies, given the fixed rate regime, the foreign exchange market was perceived as a mechanism merely to put through merchant transactions. With the collapse of the Breton Woods agreement and the floatation of major currencies, the conduct of exchange rate policy posed a great challenge to central banks as currency fluctuations opened up tremendous opportunities for market players to trade in currency volatilities in a borderless market. The market in Indian, however, remained insulated as exchange rate controls inhibited capital movements and the banks were required to undertake cover operations and maintain a square position at all times.
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