Brief History of Currency Trading

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This material may not seem very relevant to trading currencies today, but even a modest, perspective adds substance and depth to a trader. "He who knows only his own generation remains always a child," George Norlin once said.

Ancient Times

Foreign exchange dealing may be traced back to the early stages of history, possibly beginning with the introduction of coinage by the ancient Egyptians, and the use of paper notes by the Babylonians. Certainly by biblical times, the Middle East saw a rudimentary international monetary system when the Roman gold coin aureus gained worldwide acceptance followed by the silver denarius, both a common stock among money changers of the period. In the Bible, Jesus becomes angry at the money changers. I hope His wrath was directed at the poor exchange rates and not the profession itself!

By the Middle Ages, foreign exchange became a function of international banking with the growth in the use of bills of exchange by the merchant princes and international debt papers by the budding European powers in the course of their underwriting the period's wars.

The Gold Standard, 1816-1933

The gold standard was a fixed commodity standard: participating countries fixed a physical weight of gold for the currency in circulation, making it directly redeemable in the form of the precious metal. In 1816 for instance, the pound sterling was defined as 123.27 grains of gold, which was on its way to becoming the foremost reserve currency and was at the time the principal component of the international capital market. This led to the expression "as good as gold" when applied to Sterling—the Bank of England at the time gained stability and prestige as the premier monetary authority.

Of the major currencies, the U.S. dollar adopted the gold standard late in 1879 and became the standard-bearer, replacing the British pound when Britain and other European countries came off the system with the outbreak of World War I in 1914. Eventually, though, the worsening international depression led even the dollar off the gold standard by 1933; this marked the period of collapse in international trade and financial flows prior to World War II.

The Fed

As an investor, it is essential to acquire a basic knowledge of the Federal Reserve System (the Fed). The Federal Reserve was created by the U.S. Congress in 1913. Before that, the U.S. government lacked any formal organization for studying and implementing monetary policy. Consequently, markets were often unstable and the public had very little faith in the banking system. The Fed is an independent entity, but is subject to oversight from Congress. This means that decisions do not have to be ratified by the president or anyone else in the government, but Congress periodically reviews the Fed's activities.

The Fed is headed by a government agency in Washington known as the Board of Governors of the Federal Reserve. The Board of Governors consists of seven presidential appointees, who each serve 14-year terms. All members must be confirmed by the Senate, and they can be reappointed. The board is led by a chairman and a vice chairman, each appointed by the president and approved by the Senate for four year terms. The current chair is Alan Greenspan, who has been chairman since 1987. His latest term expires in 2006.

There are 12 regional Federal Reserve Banks located in major cities around the country that operate under the supervision of the Board of Governors. Reserve Banks act as the operating arm of the central bank and do most of the work of the Fed. The banks generate their own income from four main sources:

1. Services provided to banks

2. Interest earned on government securities

3. Income from foreign currency held

4. Interest on loans to depository institutions

The income generated from these activities is used to finance day-to-day operations, including information gathering and economic research. Any excess income is funneled back into the U.S. Treasury.

The system also includes the Federal Open Market Committee, better known as the FOMC. This is the policy-creating branch of the Federal Reserve. Traditionally the chair of the board is also selected as the chair of the FOMC. The voting members of the FOMC are the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Reserve Banks who serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions whether or not they are voting members. The FOMC makes the important decisions on interest rates and other monetary policies. This is the reason they get most of the attention in the media.

The primary responsibility of the Fed is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar, and moderate long-term interest rates."

In other words, the Fed's job is to foster a sound banking system and a healthy economy. To accomplish its mission the Fed serves as the banker's bank, the government's bank, the regulator of financial institutions, and as the nation's money manager.

The Fed also issues all coin and paper currency. The U.S. Treasury actually produces the cash, but the Fed Bank then distributes it to financial institutions. It is also the Fed's responsibility to check bills for wear and tear, taking damaged currency out of circulation.

The Federal Reserve Board (FRB) has regulation and supervision responsibilities over banks. This includes monitoring banks that are members of the system, international banking facilities in the United States, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The Fed also helps to ensure that banks act in the public's interest by helping in the development of federal laws governing consumer credit. Examples are the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, and the Truth in Savings Act. In short, the Fed is the policeman for banking activities within the United States and abroad.

The FRB also sets margin requirements for investors. This limits the amount of money you can borrow to purchase securities. Currently, the requirement is set at 50 percent, meaning that with $500 you have the opportunity to purchase up to $1,000 worth of securities.

Securities and Exchange Commission, 1933-1934

When the stock market crashed in October 1929, countless investors lost their fortunes. Banks also lost great sums of money in the Crash because they had invested heavily in the markets. When people feared their banks might not be able to pay back the money that depositors had in their accounts, a "run" on the banking system caused many bank failures.

With the Crash and ensuing depression, public confidence in the markets plummeted. There was a consensus that for the economy to recover, the public's faith in the capital markets needed to be restored. Congress held hearings to identify the problems and search for solutions.

Based on the findings in these hearings, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws were designed to restore investor confidence in capital markets by providing more structure and government oversight. The main purposes of these laws can be reduced to two commonsense notions:

1. Companies that publicly offer securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing.

2. People who sell and trade securities—brokers, dealers, and exchanges— must treat investors fairly and honestly, putting investors' interests first.

The Bretton Woods System, 1944-1973

The post-World War II period saw Great Britain's economy in ruins, its infrastructure having been bombed. The country's confidence with its currency was at a low. By contrast, the United States, thanks to its physical isolation, was left relatively unscathed by the war. Its industrial might was ready to be turned to civilian purposes. This then has led to the dollar's rise to prominence, becoming the reserve currency of choice and staple to the international financial markets.

Bretton Woods came about in July 1944 when 45 countries attended, at the behest of the United States, a conference to formulate a new international financial framework. This framework was designed to ensure prosperity in the postwar period and prevent the recurrence of the 1930s global depression. Named after a resort hotel in New Hampshire, the Bretton Woods system formalized the role of the U.S. dollar as the new global reserve currency, with its value fixed into gold. The United States assumed the responsibility of ensuring convertibility while other currencies were pegged to the dollar. Among the key features of the new framework were:

• Fixed but adjustable exchange rates

• The International Monetary Fund

The End of Bretton Woods and Floating Exchange Rates

After close to three decades of running the international financial system, Bretton Woods finally went the way of history due to growing structural imbalances among the economies, leading to mounting volatility and speculation in a one-year period from June 1972 to June 1973. At the time the United Kingdom, facing deficit problems, initially floated the sterling. Then it was devaluated further in February of 1973 losing 11 percent of its value along with the Swiss franc and the Japanese yen. This eventually led to the European Economic Community floating their currencies as well.

At the core of Bretton Woods' problems were deteriorating confidence in the dollars' ability to maintain full convertibility and the unwillingness of surplus countries to revalue for its adverse impact in external trade. Despite a last-ditch effort by the Group of Ten finance ministers through the Smithsonian Agreement in December 1971, the international financial system from 1973 onward saw market-driven floating exchange rates taking hold. Several times efforts for reestablishing controlled systems were undertaken with varying levels of success. The most well known of these was Europe's Exchange Rate Mechanism of the 1990s which eventually led to the European Monetary Union.

International Monetary Market

In December 1972, the International Monetary Market (IMM) was incorporated as a division of the Chicago Mercantile Exchange (CME) that specialized in currency futures, interest-rate futures, and stock index futures, as well as futures options.

Until the arrival of the Euro in 2002 (see next subsection), the international scene has remained essentially unchanged for over 30 years, although the volume of transactions in foreign exchange has increased enormously. Electronic trading has made it possible to initiate instantaneous trades in the billions of dollars. That has introduced the fragile nature of technology with its lack of redundancy, but no fallout from that has yet to be seen. China's emergence as a world power has focused attention on its economy and its currency, the yuan, which at the present time is controlled and does not float. The author believes it will be impossible to continue the tight control over the yuan, and floating rates will be inevitable.

Arrival of the Euro

On January 1, 2002, the Euro became the official currency of 12 European nations that agreed to remove their previous currencies from circulation prior to February 28, 2002. See Table 2.1.

Current Perspective

TABLE 2.1 European Monetary Union

Austria Belgium Finland France







Greece Ireland Italy




Luxembourg Netherlands



Portugal Spain



The Euro was considered an immediate success and is now the second most frequently traded currency in FOREX markets. More details on the Euro can be found in the Appendix of this book.

Table 2.2 depicts the major events in FOREX history and regulation.

TABLE 2.2 Timeline of Foreign Exchange

1913—U.S. Congress creates the Federal Reserve System.

1933—Congress passes the Securities Act of 1933 to counter the effects of the Great Crash of 1929.

1934—The Securities Exchange Act of 1934 creates the beginnings of the Securities and Exchange Commission.

1936—The Commodity Exchange Act is enacted in direct response to manipulating grain and futures markets.

1944—The Bretton Woods Accord is established to help stabilize the global economy after World War II.

1971—The Smithsonian Agreement is established to allow for a greater fluctuation band for currencies.

1972—The European Joint Float is established as the European community tries to move away from their dependency on the U.S. Dollar.

1972—The International Monetary Market is created as a division of the Chicago Mercantile Exchange.

1973—The Smithsonian Agreement and European Joint Float fail, signifying the official switch to a free-floating system.

1974—Congress creates the Commodity Futures Trading Commission to regulate the futures and options markets.

1978—The European Monetary System is introduced to again try to gain independence from the U.S. Dollar.

1978—The free-floating system is officially mandated by the International Monetary Fund.

1993—The European Monetary System fails to make way for a worldwide, free-floating system.

1994—Online currency trading makes its debut.

2000—Commodity Modernization Act establishes new regulations for securities derivatives, including currencies in futures or forwards form.

2002—The Euro becomes the official currency of twelve European nations on January 1.


• Until the late 1960s the currency markets were extremely stable and very much a closed club. Things were about to change rapidly!

• Currency trading is probably the world's second-oldest profession!

• The Euro, introduced in 2002, is the official currency of twelve European countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.

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