The roots of our modern forex market are an interesting topic that has
been covered ad nauseum by other trading books; however, I do believe
it is important to have some knowledge of the market’s history, so this
section covers the key points. If you have never studied global monetary
systems, consider this section an abridged history of the forex market.
The modern forex market’s roots began with over-the-counter currency
trading desks established by banks throughout the 1970s and 1980s,
following the collapse of a postwar-era monetary system known as the
Bretton Woods system. Bretton Woods was established in June 1944, as
World War II came to a close. The Allied nations sought to establish a new
monetary system to promote global investment and capitalism and to eliminate
the challenges of a gold standard system.
Under the Bretton Woods monetary system, member nations agreed
to value their currency at parity to gold ±1 percent and then set their exchange
rate against the U.S. dollar. In exchange, the United States agreed
to peg the dollar against a gold standard of $35 per ounce and guarantee its
exchange for gold. This promise by the U.S. government effectively made
the dollar a global payment standard instead of using a gold standard. The
phrase “good as gold” was frequently used to describe the U.S. dollar under
the Bretton Woods monetary system. Although the system worked to foster
investment and capitalism, it also encouraged a tremendous outflow of
dollars into overseas currency reserves. The world needed dollars to support
a global payment system based on the dollar, and the United Stateswas content printing more money. The United States assumed it could
balance the deficit with trade. Unfortunately, the outflow of capital finally
caught up to the Unites States in 1950 and the country began posting a negative
balance of payments, despite the government’s best efforts to increase
trade.
As inflationary concerns loomed on the horizon, the United States
found itself in a difficult position. Failing to supply the global demand for
dollars would bring the monetary system to its knees, whereas continuing
to print money would eventually threaten to devalue the dollar. Confidence
in the U.S. government’s ability to maintain a gold match standard for the
dollar began to wane, and speculation grew that a serious devaluation in
the world’s primary reserve currency was inevitable.
In August 1971, President Richard Nixon finally intervened by suspending
the peg dollar had against gold. The Bretton Woods era of a fixed
exchange rate system was over. Policy steps were taken to implement a
floating exchange rate system, which is the cornerstone of today’s modern
forex market. In the 1970s trading desks were established among major
banking institutions to facilitate currency transactions for major clients.
This private trading arrangement was known as the interbank, a term still
used today to describe the electronic trading arrangements among major
banks, institutions, and currency dealers. Today prices are determined
by the forces of supply and demand within the forex market, allowing
traders to capitalize on small swings between the exchange rates of two