Market Evolution FOREX
Every day, billions of dollars' worth of currencies are traded on the world's financial markets, enabling global trade and investment. This tutorial provides the background to the modern era of foreign exchange markets, detailing the international agreements and the impact of technology on this 24-hour-a-day business. Between World Wars I and II, currencies operated under a fixed exchange rate system based on gold and silver standards. Known as the era of convertibility, governments honored currencies they had issued against a specific amount of gold and silver. The dominant world currency was sterling, with the US dollar next in importance. Convertibility ceased around 1929, at the beginning of the Depression. During the World War II, the foreign exchange market virtually ceased to exist.
The Bretton Woods Agreement 1944
Par value' system based on a gold-exchange standard was introduced.
International Monetary Fund (IMF) and International Bank for Reconstruction and Development (World Bank) were founded.
USD replaced sterling as dominant currency on the market.
Clearing Arrangements
Agreement on Multilateral Compensation 1947.
European Payments Union (EPU) 1950-1958.
European Monetary Agreement (EMA) 1958-1973.
Disintegration of the Bretton Woods Agreement
Formation of the Gold Pool in 1961 (abandoned in 1968)
Introduction of the Special Drawing Right (SDR) in 1969.
Strong currencies have to revalue or float upwards.
Smithsonian Agreement 1971
Devaluation of the dollar and upward realignment of other currencies.
European Snake 1972
Prompted by German skepticism over the Smithsonian Agreement, European currencies maintained narrow bands with each other and floated together against the dollar, i.e., a mini-system was formedà.
OPEC Oil Crisis 1973-74
In response to the inflationary impacts of the oil crisis, countries began adopting money supply targets with resultant increases in interest rates. These interest rate changes led to vast amounts of internationally mobile short-term capital moving between countries in search of higher interest rates, thus reinforcing a floating rate regime.
European Monetary System (EMS) 1979 objectives:
to facilitate convergence towards greater economic integration and stability among EU members;
to establish a managed exchange rate system, with intervention points of +/- 2.25% from agreed central rates for most currencies, i.e., the ERM;
to establish the ECU as the key monetary unit of the EU.
The parity grid was the cornerstone of the ERM. Bilateral central rates for each currency formed the basis of the grid.
European Economic and Monetary Union (EMU) 1990-2002
the circulation of a single currency (the euro) within the participating Member States of the European Union (EU);
the operation of a single European Central Bank (ECB);
a common monetary policy between the participating Member States of the EU;
Exchange rates between the participating countries were fixed on January 1, 1999, with Euro coins and notes brought into circulation in Jan 2002.
Technological Revolution
The technological revolution resulted in greater speed and efficiency of communication. Dealers were able to expand their activities due to developments in computerized money payment systems and information systems. Technological advances led to higher levels of speculation and volatility.
Other Developments
The authorities involved in the G7 process attempt to peg exchange rates within selected target bands or reference ranges.
The Plaza Accord (1985)
The Louvre Agreement (1987)
The international payments system is effectively based on a de facto dollar standard
The Bretton Woods Agreement 1944
The Bretton Woods Conference, held in New Hampshire in 1944, was an attempt by western allied powers to restore some order to the relationship between international currencies and the international payments system. Under the agreement, arrived at in Bretton Woods, a modified return to the gold standard and convertibility was seen as the best method for encouraging the recovery of world economies and the expansion of international trade.
The agreement at Bretton Woods re-established fixed (but adjustable) exchange rates between currencies in the form of so-called 'par values' defined in terms of gold. Countries were obliged to intervene in the foreign exchange market to maintain the exchange rate within 1% above or below its par value.
The system was based on a gold-exchange standard, whereby US dollars held by foreign regulatory authorities were made directly convertible into gold at a fixed price of approximately USD 35 per ounce by the US government. National currencies were then fixed in relation to the dollar, into which they were supposed to be fully convertible. In effect, the dollar replaced gold as the reserve asset of the international payments system. If inflation in a country was rising at too fast a rate, the Bretton Woods Agreement implied that that country had to cut demand in order to maintain the external value of its currency and limit the drain on its reserves. Hence, monetary policy was guided by the exchange rate.
The Bretton Woods Agreement also led to the foundation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development or the World Bank as it is usually called. The agreement saw the replacement of sterling by the US dollar as the dominant currency on the market by pegging par values of convertible currencies against the US dollar.
Most countries had a shortage of US dollars and arranged a clearing system (in 1947), the Agreement on Multilateral Compensation, to offset surpluses and deficits between member countries.
This was followed by the Intra-European Payments Agreements of 1948-49 and the European Payments Union (EPU) of 1950-58.
The EPU was established by six European states to provide a framework for the multilateral netting of trade positions.
The EPU developed the Unit of Account which was adopted as the European Community's common measure of value.
With the planned restoration in 1959 of the convertibility of currencies, the EPU ceased to exist (as of December 27, 1958) and was succeeded by the European Monetary Agreement (EMA).
The EMA established a multilateral system for settlements and a European fund.
The multilateral system for settlements assured member countries' central banks of obtaining settlement, in dollars, of any balance in another member's currency. The exchange rate would be known in advance.
The fund lent credits in gold to member countries for a period of three to five years. In 1973, it was replaced with new arrangements involving some of the OECD members
In March 1961, both the US dollar and sterling were overvalued; this caused the Deutschmark to be revalued by 5%.
Disintegration of the Bretton Woods Agreement
To combat pressure on the US dollar and sterling, the central banks of Belgium, France, Germany, Italy, Netherlands, Switzerland, the UK and the US formed the Gold Pool in 1961.
Pressure on the International Monetary Fund's (IMF) resources led to the major industrialized nations undertaking to lend to the IMF under the General Arrangements to Borrow (these concluded in January 1962).
Also at this time, the US Federal Reserve negotiated swap facilities with most major central banks and with the Bank for International Settlements (BIS). Similar facilities were arranged by the Bank of England and were used extensively between 1964 and 1968 (sterling devalued in November 1967).
In March 1968, the flight to gold occasioned by the Arab-Israeli Six Day War of 1967 led to the suspension of the Gold Pool and maintenance of the official gold price of USD 35 per ounce only for transactions between central banks.
The French franc, devalued in August 1969, and the Deutschmark, floated upwards in September, revaluing in October.
A new form of international reserve asset, the Special Drawing Right (SDR), was created by the IMF in July 1969 as an alternative to devaluing the US dollar.
The downward pressure on the US dollar had become huge, spurred by a huge balance of payments deficit. Strong currency countries (Germany, Holland, Switzerland, Japan) either formally revalued their currencies or let them float upwards.
The US government, under President Nixon, put an end to the convertibility of the dollar in December 1971 at the Smithsonian Conference, thus ending the Bretton Woods Agreement.
The Smithsonian Agreement 1971
The Smithsonian Agreement incorporated a 10% devaluation of the dollar and a consequent upward realignment of other currencies, via an increase in the official price of gold to USD 28 an ounce.
Greater flexibility was allowed for by widening to 2.25% the permitted margins of fluctuations for currencies around their new central rates against the dollar.
The European Snake 1972
By 1972, the foreign exchange markets were experiencing levels of fluctuations totally new to the participants. Currency tensions during 1972-73 led to a devaluation of the dollar to USD 42.22 per once of gold. In the prevailing climate, the Smithsonian Agreement was short-lived.
Although the Smithsonian Agreement had allowed other currencies to fluctuate within a band against the dollar, many countries were dissatisfied with being locked into this band. Considerable discontent existed, especially when the dollar continued to weaken.
In early 1972, the German government, viewing the Smithsonian Agreement with skepticism, encouraged partners in Europe to form a mini-system
The heart of this system was that European currencies would maintain narrow bands with each other and would float together against the US dollar.
This system became known as the Snake.
The UK decision to join the Snake in May 1972 encouraged other countries to float their currencies against the dollar rather than maintaining the bands imposed by the Smithsonian Agreement.
Thus, the Smithsonian Agreement was effectively replaced. In fact, the UK was forced to withdraw from the Snake after only 7 weeks as a result of a speculative run on sterling.
OPEC Oil Crisis
An embargo by Arab and Arab-supporting oil producing countries on nations who supported Israel in the 1973 Yom Kippur War, led to oil shortages and price rises. Through a series of rapidly developing events, oil prices more than trebled in 1973-74 with dramatic results:
economic activity slumped, especially in the US;
inflation rates in industrial countries rose from already high levels to double digits;
balance of payments deficits increased enormously;
the OPEC oil surplus increased almost tenfold by 1974, leading to major recycling problems and the dramatic growth of the Eurodollar market.
To cope with the inflationary impacts of the oil crisis, major countries began adopting money supply targets, which inevitably led to higher interest rates. This fed through into the foreign exchange market with huge short-term capital flows chasing the higher interest rates and thus increasing exchange rate volatility and reinforcing a floating rate regime.
In 1976, a meeting of the IMF Interior Committee, known as the Jamaica Agreement, amended the IMF articles regarding fixed exchange rates. Thus, floating exchange rates were legalized. The official gold price was also abolished.
The European Monetary System (EMS) 1979
The EMS was a modified, more elaborate version of the Snake. Its overall objective was not only to stabilize the currencies of the EU countries, but also to unify them at some future date.
Specifically, its objectives were to:
facilitate convergence towards greater economic integration and stability amongst EU members.
establish a managed exchange rate system, the Exchange Rate Mechanism (ERM), with intervention points of +/- 2.25% from agreed central rates for most currencies.
establish the ECU as the key monetary unit of the EU.
All currencies participating in the Exchange Rate Mechanism (ERM) had an ECU related central rate. These central rates were expressed as a certain quantity of currency per ECU.
By crossing the ECU central rates it was possible to establish a series of bilateral central rates for each currency. These bilateral central rates formed the basis of the Parity Grid.
The Parity Grid was the cornerstone of the system. The Grid set constraints on exchange rate movements and imposed specific obligations on the individual central authorities. Each central authority was required to keep the market rate for its currency within a certain band against all other member currencies.
Up until August 2, 1993, currencies were allowed to fluctuate within a band of
- 2.25% and + 2.25% around their bilateral central rates (+ 6% and - 6% for pound sterling, Spanish peseta and Portuguese escudo).
When a currency had fluctuated by + 75% or - 75% of its allowable band, it was presumed that the central authority responsible for the diverging currency would intervene.
Sterling was withdrawn from the ERM by the UK government on September 16, 1992. The Italian lira was withdrawn on September 17, 1992, but rejoined in November 1996.
On August 2, 1993, the finance ministers and central bank governors for the 12 EU member states agreed to widen the fluctuation banks for the currencies within the ERM.
A central authority could take the following action if its currency diverged:
direct intervention (buy or sell the currency).
changes in interest rates.
other fiscal or monetary measures.
European Economic and Monetary Union (EMU) 1990
European Economic and Monetary Union (EMU) was a three-stage process, which began in 1990 and was completed in 2002. It was designed to bring about:
the circulation of a single currency within the participating Member States of the European Union (EU).
the operation of a single European Central Bank (ECB).
a common monetary policy between the participating Member States of the EU.
The objectives of the EMU are:
a more efficient single market.
a more stable economic environment.
increased international monetary stability.
further political integration within the EC
Effect of the Technological Revolution on the FX Market
The impact of technology has radically changed the modern business environment. The introduction of a succession of computerized products for international traders transformed all the financial markets.
Prior to computerization, to find the price of an asset, it was necessary to contact the broker or trader directly. In 1964, that changed when the Reuters Stockmaster service became the first service to transmit financial data internationally.
In 1973, the launch of the Reuters Monitor created the first electronic marketplace for foreign exchange making prices visible, around the world, in real-time. This transparency caused the market to explode in size and volumes as new participants joined. Up until the 1980s, the majority of trades were carried out over the telephone or via telex. In 1981, Reuters launched its Monitor dealing system, which allowed electronic trader-to-trader contact. The system further increased access to the markets.
Computerized money payment systems also led to the expansion of dealer activities. Greater integration of the major trading centers and the development of a high profile for foreign exchange in the US led to trading on a global 24-hour basis. These technological developments have led to higher levels of speculation and volatility on the foreign exchange markets.
In the period since the Smithsonian Agreement, the foreign exchange markets have undergone fundamental structural changes. A transition to a floating rate regime has occurred. However, this is not a freely floating system whereby currencies find their own value. Instead, a so-called dirty or managed floating regime is employed by most countries, for example, members of the G7.
Under this approach, central authorities try to peg exchange rates within selected target bands or reference ranges. Central authorities will intervene in the foreign exchange market to try to counteract appreciations or deprecations which take currencies outside of their desired trading range.
Plaza Accord
In September 1985, G5 (US, UK, Germany, France and Japan) finance ministers and central bank governors met at the Plaza Hotel in New York and agreed to co-operate to encourage an orderly appreciation of the main non-dollar currencies against the US dollar.
Louvre Agreement
In February 1987, the G6 countries (G5 and Italy) declared their currencies to be at the right levels and promised to co-operate to foster the stability of exchange rates around current levels. There was an unpublished broad intention to keep rates within a 5% band.
Payment Systems
The international payments system is effectively based on a de facto dollar standard which exists in reality though not officially recognized.
Foreign central authorities hold their reserves primarily in the form of dollars and use them to settle international indebtedness. However, the dollar is not convertible anymore into gold or anything else. Thus, the purchasing value of world dollar reserves is dependent on the performance of the US economy. This situation looks like continuing until alternative reserve assets become widely accepted.
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