The History of Foreign Exchange: How and why we have a foreign exchange system

Bobby Ward, Director of Vorto Trading, investigates how and why the foreign exchange market has developed over time

As with all great ideas, foreign currency exchange had to start somewhere. The UK’s economic development during the industrial revolution meant Britain was the world’s leading commercial nation. While the modern capitalist economy was already flourishing, the revolution catapulted international commerce to a new level meaning a better and more stable solution for international trade was necessary. Up until this point, countries would use either gold or silver as a method of international payment. This method had its issues as it was heavily influenced by worldwide supply and demand. For instance, should a new gold mine be discovered, gold prices would be driven down by oversupply.

The Gold Standard System, established in 1875, negated these issues. The basic idea was that countries would fix their currency value against an amount of gold, usually an ounce. By doing this, an exchange rate between two countries could be created and fixed too.

The Gold Standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers completed large military projects and consequently began printing more money to help pay for these projects. The financial burden of this was so substantial that there was not enough gold at the time to exchange for all the extra currency that the governments were printing. Such huge worldwide political and financial unrest was the undoing of the Gold Standard system and while it had a small comeback between the world wars, at the advent of World War II its usefulness had expired completely. Gold however still was and will remain a safe haven for those seeking stability in terms of investment.

After the Gold Standard was abandoned and with the end of World War II in sight, the Allied countries met at Bretton Woods, New Hampshire in order to set up a new monetary system to replace the old Gold Standard. The new system was aptly named the Bretton Woods system of international monetary management. In a massive change, it was decided the US dollar would now become the benchmark for all exchange rates rather than gold. Every currency would have a fixed price against the dollar rather than an ounce of gold. Off the back of Bretton Woods, 3 economic agencies were formed: 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 Organisation.

Bretton Woods had its issues and President Nixon had to close the gold window in 1971, which meant US dollars could no longer be exchanged for gold. US gold reserves had got so low that there was not enough to cover all the dollars in reserve in foreign central banks.

While Bretton Woods didn’t last, its legacy did in the form of the 3 international monetary bodies above that are still in action today.

Since the collapse of the Bretton Woods system, IMF members have been free to choose any form of exchange arrangement they wish (except pegging their currency to gold): allowing the currency to float freely, pegging it to another currency or a basket of currencies, adopting the currency of another country, participating in a currency bloc, or forming part of a monetary union.

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