F/X Markets Today\'s Foreign Exchange

F/X Markets

Today's foreign exchange market is among the most dynamic markets in the world. Whereas equities and fixed income securities trade on perhaps one or two exchanges, foreign exchange trading takes place on exchanges around the world. There are four main f/x exchanges -- New York, London, Tokyo, and Singapore. The securities exchanged -- the world's major currencies -- are the same in each of these markets. This means that currency trading is conducted twenty-four hours a day during the work week. Combine the multitude of market players with the small handful of free-floating currencies and the f/x market is the most liquid in the world.

The rise of the modern currency market essentially began with Bretton Woods, which began the end of the gold standard. The gold standard was officially eliminated which Bretton Woods ended. For the entire industrial age, the gold standard was the main determinant of currency value. The gold standard was adopted de facto in England in 1717, and most nations followed suit to some degree. The gold standard functioned by fixing the value of the nation's currency to the value of gold. As the value of gold fluctuated, so too did the value of the nation's currency. The gold standard was officially adopted in England in 1819. The United States began life under de facto gold standard, though it was officially bimetallic (the other being silver). Gold standard was officially adopted in the U.S. In 1900 as a result of the Gold Standard Act. (Bordo, no date).

From 1880 to 1914, the gold standard was in use in most of the world's major economies. The gold standard broke down as a result of World War I, as we can see from Germany's post-war hyperinflation. However, from 1925 to 1931 the gold standard was restored. However, the United Kingdom left the standard, a move soon followed by the United States.

Until that point, the underlying principle was that gold was a powerful store of wealth. Nations held their reserves in gold, and these reserves backed the currency. Each U.S. dollar during the gold standard years in essence entitled the holder to a certain amount of gold. By the time the UK dropped out of the gold standard, only the U.S. And the UK held stores of gold to back their currencies. Most countries held stores of dollars or pounds (Ibid).

The Bretton Woods system brought a version of the gold standard into play, with nations fixing the value of their currency to the value of gold, with room for movements of 1% plus or minus. The value was the "peg" and the flexibility was the "band." An interesting point relating directly to today's pro-gold standard argument is that one of the drivers behind Bretton Woods was the near-universal agreement that the free-float of currencies in the interwar period had discouraged trade, and encouraged destabilizing speculation and competitive depreciations (Cohen, no date).

The Bretton Woods system collapsed in 1971 when the United States unilaterally withdrew. Prior to that, almost 2/3 of America's gold reserves had been transferred to Europe, a reflection of the growing negative balance of payments. The U.S. had become unable to control the value of its own currencies, while other nations could by trading dollars. The collapse of the gold standard can be attributed to the fact that the system relied on the United States as a force of global economic stabilization. Yet with no external controls on U.S. policy, the economy of the U.S. began to destabilize as a consequence of Vietnam War expenses, taking the entire global monetary system with it (Ibid).

The gold standard had certain advantages and disadvantages. It provided a stable rate of exchange. The architects of Bretton Woods realized that a characteristic of free floats was instability, and that has been played out numerous times in the post-Bretton era in the form of currency crises. The stability is evident in the statistics as well. Between 1880 and 1914, the golden age of the gold standard, inflation averaged 0.1%. Between 1946-2003, even with Bretton Woods, inflation average 4.1% (Bardo, n.d.). Short-term price changes, however, could be highly unstable. This is a consequence of the fact that the gold standard ignores fundamental economic principles. Any system where the value of a good is established by artificial means is subject to such shocks. Another drawback to the gold standard is that it gives governments very little discretion over monetary policy. Another drawback is the cost of producing gold. The gold standard relies on having physical gold reserves. Thus, gold must be produced, and for that there is a cost (Ibid).

With the decline of Bretton Woods, the gold standard died. It was replaced by the modern foreign exchange system. At the core of this system are fiat currencies. Whereas currencies were once backed by the value of that nation's gold, dollar or pound reserves, now they were backed only by the implied power of the nation's economy. While this makes intuitive sense, it also means that no unit of currency has any underlying value. This is why today we have individual nations selecting a range of monetary policy regimes. The world's strongest economies have free-floating currencies. Others, such as China maintain a hybrid pegged float system, only slightly more flexible than that offered under Bretton Woods. Other countries maintain a hard peg, which in many cases leads to black market trading of their currencies.

The world's foreign exchange markets allow for trading, mainly in the free-floating currencies. Currencies are exchanged for a variety of reasons. International trade is one reason. In particular, banks need to access foreign exchange markets to meet the currency needs of their customers. Banks and other financial institutions also trade on their own accounts, and as a consequence are the world's most active participants in the foreign exchange markets.

Foreign exchange markets today are close to perfect competition, as reflected by the uniformity of the product offerings, the knowledge of the participants and the liquidity of the market. Today's foreign exchange markets are also characterized by a high use of derivatives, particularly futures contracts, which are traded in Chicago. Indeed, the Chicago Mercantile Exchange is the only central exchange for f/x trading, albeit only in derivatives. In the other major currency trading centers, there is no central trading system. Market participants must deal with one another directly, which is one of the major reasons why global banks are the most active forex participants.