Forex is the largest and most liquid market in the world. In 2010, it accounted for more than $3 trillion of daily trading. Yet, oddly enough, this market didn't exist a century ago. Unlike stock markets, which can trace their roots back centuries, the forex market as we understand it today is a truly new market. We'll take a brief look at the origins of forex and its function today.
The Oldest Market in the World?
Some will say that the forex market actually dates back to the dawn of time when rocks, feathers, shells or notched bones were traded for goods. While it is true that these did herald the birth of currency, we don't really have evidence of early man shorting rocks against feathers.
In its most basic sense - that of people converting one currency to another for financial advantage - forex has been around since nations began minting currencies. If a Greek coin held more gold than an Egyptian coin due to size or content, then a merchant could trade in a way that left him with more Greek coins. This was the extent of the forex market up until the modern era; parties with the ability to transact in one of two currencies would use the lower valued currency for paying out and demand the higher valued currency for payments received, profiting from the arbitrage - the difference in value between the two.
It All Comes Down to Gold
The primary reason there was no real forex market in the past is because the vast majority of world currencies were derivatives of a standard like silver and gold. If there were any debasement of the currency, people would naturally adjust by exchanging their holdings into a more responsible foreign currency or trading it in for the precious metals themselves. After all, early paper currencies were considered bills of exchange convertible for the precious metals held in reserve. At least this was the theory. (For more on this type of standard system, see The Gold Standard Revisited.)
Many nations, the U.S. included, experimented with printing extra money in spite of the stated gold standard. The hope was that people and other nations wouldn't be quick enough to notice that this debauched currency was being used to pay off bonds and other public debts. Occasionally it worked, depleting the savings of the nation's citizens through rapid inflation and allowing the ruling parties to effectively duck out on their obligations. (To learn more about this scenario, check out Monetarism: Printing Money To Curb Inflation.)
Too frequently, it was possible for a country to simply refuse to covert currency for gold or silver, meaning that shipments of devalued currency were the only payment for debts. This behavior was endemic during the Great Depression. Many nations began to demand an end to this damaging practice. Thus, work began on the Bretton Woods system. (Learn about the history behind this agreement in Global Trade And The Currency Market.)
Towards the end of WWII, a meeting was held by the allied nations to formalize the currency exchange rates between nations. Simply put, it was an attempt to fix currencies permanently. A set value was decided for each currency relative to the U.S. dollar, and the U.S. dollar was separately given a peg of $35 per ounce of gold. Every government was expected to keep a monetary policy that justified the peg, and the U.S., having the dollar as a reserve currency, was expected to keep within its stated value in gold.
If any country had a surplus of a nation's currency, they could trade it in for the set amount of gold via a "gold window" according to values set in the agreement. Or they could convert it to U.S. dollars - considered as good as gold because of the convertibility. This protected nations in trade and made it harder for them to inflate the domestic currency without prompting some foreign power exchanging currency for gold.
The Times, They Are A-Changing
The pegs set at Bretton Woods made sense when they were set, but the world moved on and things changed. As world trade grew and certain nations surged ahead while others flagged, the pegs became distorted. Added to this fact was the problem of an honor system for monetary policy. Bretton Woods often took a back seat to inflationary policy when a government saw inflation as the quickest way out of debt. And when the U.S. inflated, its status as a reserve currency distorted things even further. Bretton Woods had little in the way of flexibility to respond to these changes.
Friedman, the Pound and the Birth of Forex
In 1967, Milton Friedman was positive that the British pound was overvalued compared to the U.S. dollar due to the favorable Bretton Woods peg it received and the economic problems it had suffered since. He attempted to sell it short. All the Chicago banks he called to set up the transaction refused him. They would not allow the transaction unless there was a commercial interest. Point in fact, multinational banks and nations themselves had been carrying out similar transactions for years. France, in particular, had been systematically shorting the U.S. dollar by constantly receiving gold in exchange for overvalued dollars.
Friedman vented his indignation in a Newsweek column, catching the attention of Leo Melamed of the Chicago Mercantile Exchange (CME). Melamed commissioned Friedman for an 11-page paper laying out the necessity of floating currencies and a currency trading market using futures for trading. As luck would have it, the stagflation of the 1970s forced President Nixon to close the gold window or see France and other nations empty out Fort Knox. This combination of foresight and luck led to a true forex market using futures being launched out of Chicago in 1972. (For more on the U.S. stagflation problem, see Stagflation, 1970s Style.)
Forex and Fiscal Discipline
Forex futures turned out to have much more utility than anyone foresaw. Now, instead of holding reserves in several different currencies and repatriating them when rates were favorable - complicating balance sheet reporting in the process - companies could smooth out currency risk and speed up transactions with a single contract. Speculators began using the same contracts to profit when a nation's monetary policy became too loose relative to other nations - a development that often worked more effectively to encourage monetary constraint than Bretton Woods ever did. Although their intention is profit, forex traders are an effective way to enforce fiscal discipline on inflating nations.
Because it was naturally decentralized, forex took off when the internet turned it from 24/7 out of the necessity of world time zones to 24/7 real-time. It is the fastest market in the world, responding instantly to supply and demand signals sent by outstanding contracts. It has also removed much of the currency risk faced by companies with operations spanning the globe.
With trillions of dollars changing hands, forex markets gain and lose huge amounts of money every minute. A Hungarian immigrant (George Soros) can take down the Bank of England, make $1 billion on a single trade, and cause an entire nation's currency to plummet as traders pile into short positions. (Find out more in The Greatest Currency Trades Ever Made.)
Currency Robin Hoods
It is the unintentional function of forex markets and traders to enforce fiscal discipline between nations that makes them a necessity. It is unlikely that governments will willingly accept a standard again, even one as loose as tying money supply to the easily manipulated GDP of a nation, so fiat money is here to stay. In a world where printed money can only be exchanged for more paper money, forex is needed to keep nations from inflating away their citizens' savings - if they make money carrying out these good deeds, all the more power to them.
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