The historical evolution of foreign exchange markets can be compartmentalized into 3 distinct phases namely the gold exchange period, followed by the Bretton Woods Agreement, to its current setting.
The gold exchange standard ruled over international economic system between 1876 and World War I. This was a fairly stable system wherein currencies were supported by the price of gold.
But the gold exchange standard had a weakness of evolving on an all or nothing pattern. For example, when a country’s economy strengthened, that country may import a great deal until its gold reserves may not be sufficient to support its currency
Consequently this could lead to lesser money supply, escalation of interest rates and perhaps recession. In such a scenario, the rock bottom commodity prices would be a stimulus for other countries to engage in frenzied buying activity until normalization of the economy with decline in interest rates occurred. This worked fine until World War I caused blockage of trade inflows and movement of gold and along with that ended the all or nothing pattern typical of the gold standard.
The Bretton Woods Agreement was cobbled in 1944 to regulate international forex markets as it existed then. The essence of this agreement was to ensure international monetary steadiness and curb speculation in international currencies. As per this agreement, the value of national currencies was fixed against the dollar with the dollar rate set at 35USD per ounce of gold.
Participating countries were required to maintain the value of their currency within a narrow band against the dollar and an equivalent rate of gold.
Consequently the dollar became a sort of reference currency, inasmuch as it signaled a shift in global economic dominance from Europe to the U.S.
With effect from 1971 the US dollar was no longer exchangeable into gold signaling the demise of the Bretton Woods Agreement. Furthermore by 1973, the major industrialized nations' currencies were floated more freely across nations, coinciding with currency prices being quoted daily, together with increase in volume, speed and price volatility of forex deals.
Post Bretton Woods Agreement also saw the emergence of several new financial instruments and trade liberalization. Furthermore with the advent of computers and technology in the 1980s the market reaches for cross-border forex trading gained momentum extending through Asian, European and American time zones.
Gradually foreign exchange transactions increased intensively to all the facets we see today in forex markets worldwide.
Another major factor that speeded up Forex trading was the emergence of the Eurodollar (US Dollars deposited in banks outside U.S) market.
Since 1980s London is reckoned as the key center in the Eurodollar market where U.K based banks lend dollars as an alternative to pounds, and its geographical proximity to both Asian and American markets has allowed the Eurodollar market to flourish as well.
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