The creation of the gold standard monetary system in 1875 is one of the most important events in the history of the ForEx market. Before the gold standard was created, countries would commonly use gold and silver as method of international payment. The main issue with using gold and silver for payment is that the value of these metals is greatly affected by global supply and demand. For example, the discovery of a new gold mine would drive gold prices down given the sharp increase in gold supply.
The basic idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency was backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for currency exchanges. During the late nineteenth century, all of the major economic countries had pegged an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first official means of currency exchange in history.
The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects, so they began printing more money to help pay for these projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the extra currency that the governments were printing.
Bretton Woods System
Before the end of World War II, the Allied nations felt the need to set up a monetary system in order to fill the void that was left when the gold standard system was abandoned. In July 1944, more than 700 representatives from the Allies met in Bretton Woods, New Hampshire, to deliberate over what would be called the Bretton Woods system of international monetary management.
To simplify, Bretton Woods led to the formation of the following:
-A method of fixed exchange rates;
-The U.S. dollar replacing the gold standard to become a primary reserve currency;
-The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT).
The main feature of Bretton Woods was that the U.S. dollar replaced gold as the main standard of convertibility for the world’s currencies. Furthermore, the U.S. dollar became the only currency in the world that would be backed by gold. (This turned out to be the primary reason why Bretton Woods eventually failed.)
Over the next 25 or so years, the system ran into a number of problems. By the early 1970s, U.S. gold reserves were so low that the US Trasury did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve.
Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, essentially refusing to exchange U.S. dollars for gold. This event marked the end of Bretton Woods.
Even though Bretton Woods didn’t last, it left an important legacy that still has a significant effect today. This legacy exists in the form of the three international agencies created in the 1940s: the International Monetary Fund, the International Bank for Reconstruction and Development (now part of the World Bank) and the General Agreement on Tariffs and Trade (GATT), which led to the World Trade Organization.
Market size and liquidity in recent history
The foreign exchange market is the most liquid financial market in the world. Traders include governments and central banks, commercial banks, other institutional investors and financial institutions, currency speculators, other commercial corporations, and individuals. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was $3.98 trillion in April 2010 (compared to $1.7 trillion in 1998).Of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps, and other derivates.
In April 2010, trading in theUK accounted for 36.7% of the total, making it by far the most important centre for foreign exchange trading in the world. Trading in the United States accounted for 17.9% and Japan accounted for 6.2%.
For the first time ever, Singapore surpassed Japan in average daily foreign-exchange trading volume in April 2013 with $383 billion per day. So the order became: United Kingdom (41%), United States (19%), Singapore (6%), Japan (6%) and Hong Kong(4%).
Turnover of exchange-traded foreign exchange futures and options has grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). As of April 2016, exchange-traded currency derivatives represent 2% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are traded more than to most other futures contracts.
Most developed countries permit the trading of derivative products (such as futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging markets do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies. Countries such as South Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.