Foreign exchange market history

The market for currencies, conducted mainly through bank dealers around the world. Although the market has existed since ancient times, developments since World War II have changed the modern market that is conducted in the United States by money center banks in the major financial centers.

The market is divided into two compartments— the spot market and the forward market. The spot market trades currencies for immediate delivery, while the forward market trades for delayed delivery for periods up to one year. Spot prices for the dollar against most other currencies can be obtained daily, although the forward market is limited to prices between the major trading currencies only. Banks in the United States quote the dollar against other currencies, and the dollar also is quoted against the same currencies by banks in other countries. In such a manner, the market has developed into a 24-hour exchange that is constantly quoting prices in the major trading currencies around the world. When a dollar is traded in another country against a currency that is not native to the country in which it is being quoted, the rate is called a cross-rate.

Until the early 1930s, the market was based upon the dollar and the gold bullion standard. Most major trading currencies were stated in gold terms. When Britain and the United States abandoned the GOLD STANDARD in the early 1930s, the system did not return to normal until after World War II. After the BRETTON WOODS SYSTEM was implemented, the dollar was the major currency in the system, quoted at $35 per ounce of gold. Many currencies were protected in some form or other by exchange controls. Their respective central banks controlled their international flows to ensure stability of the exchange rate and their own reserves.

The Bretton Woods system effectively was abandoned in August 1971, when President Nixon pulled the United States off the convertibility standard. The old system was temporarily replaced by the Smithsonian Agreement, but it lasted only a short time. The foreign exchange markets were in turmoil until a new regime emerged. Within a year the major trading, or hard, currencies were floating against each other. Rather than be stated in gold terms and have a fixed parity in the market, the currencies floated freely against each other and continue to do so today. Smaller currencies continue to be linked to larger currencies, normally to that of their major trading partner.

The international monetary system has undergone other changes in addition to the adoption of floating currencies. The European Union adopted the EURO, a composite currency representing a weighted value of its members, in January 1999 to ensure stability of the European Union’s imports and exports in light of competition from the dollar and the yen. Within that system, currencies do not float against each other but have stable values that may require adjustment from time to time.

In the 1980s, the foreign exchange market began developing new financial products for use by its large institutional customers. New currencyrelated products such as options, caps, and collars were developed so that customers could limit foreign exchange exposure rather than use traditional forward contracts.

In the 1990s, many countries with historically weak currencies tried linking them to the U.S. dollar. There were several ways of doing this, with some countries adopting the direct peg and a currency board. These techniques were usually attempts by a country to link its currency directly to the fortunes of the dollar, although the results were mixed at best.

See also FOREIGN INVESTMENT.

Further reading

• Einzig, Paul. The History of Foreign Exchange. London: Macmillan, 1970. 
• McKinnon, Ronald I. The Rules of the Game: International Money and Exchange Rates. Cambridge, Mass.: MIT Press, 1996. 
• Solomon, Robert. The International Monetary System. New York: Harper & Row, 1977.