Simple Answers to Complex Questions about the Modern Foreign Exchange Market
At any given moment of the day, huge volumes of international trades are exchanged between countries around the world. This feature of the global economy requires exchanging currency so that companies, individuals and institutions in one country can properly compensate their trading partners for the value of the goods and/or services they purchase.
Today’s international currency exchange system evolved to its current state through centuries of international trade, as people around the world struggled to find the most equitable and efficient way of engaging in trade across international borders.
Essentially, the world’s current system of foreign currency exchange seeks to provide an answer to the question: “How can people in different countries, with different currencies, engage in fair trade?”
Facilitating International Trade
The answer to the deceptively simple question above, for most people, has been for one party (usually the buyer) to exchange their home currency for the currency used in the seller’s country in order to carry out the transaction.
If the world had only two countries, the economics of international business would be fairly straightforward. But the international system of foreign currency exchange is extremely complicated, due to the large number of countries and currencies in the world, growing ever more complex with each passing day as the type and number of international trading relationships increase.
Enter: Exchange Rates
In the modern foreign exchange system, currencies have relative value. The price people pay for currencies when executing a transaction is the result of the market forces of supply and demand.
Many different market conditions can affect the price of the Canadian dollar relative to the Australian dollar, for example, depending on the volume of each currency that is bought or sold through foreign exchanges.
From Bartering Natural Resources to Floating Exchange Rates: Foreign Exchange Market History in a Nutshell
In what now seems like the ancient past to most people, international trade was carried out with help from the gold standard. This was a monetary system in which nations would buy or sell commodities and assets by first exchanging them for gold, which was set at a fixed price.
In this way, international trade was facilitated through the medium of gold, providing an adjustment mechanism that allowed greater levels of trade and more widespread economic participation.
The gold standard solved certain problems, but it created others as the international economy evolved. Recessions and instability became a feature of the system, because gold was the ultimate reserve currency. As such, the movement of gold could have serious economic impacts on national economies and place banks under tremendous pressure.
The International Monetary Fund & Exchange Rates
Following the global upheaval experienced during the Second World War, the International Monetary Fund (IMF) helped create a modified system for foreign currency exchange that was based on the legacy of the gold standard.
Participating countries established gold valuations for their domestic currencies, which were registered with the IMF to serve as the basis of exchange between various currencies. This system still fixed currency prices in relation to gold, but currency prices were now also pegged to each other, allowing them to fluctuate with a certain range.
The Evolving Foreign Exchange System
The system of fixed-yet-floating currency exchange rates remained in place until systemic issues that began in the 1960s boiled over in the 1970s.
Throughout the 1960s, the adjustment mechanisms of the IMF system proved to be inadequate to handle disturbances affecting international payments. Many countries had large imbalances in their international payments, which undermined confidence and brought their liquid reserves into question.
At this time, the traditional methods of shoring up reserves - mining gold and acquiring other currencies - no longer served. The growth and scale of gold mining could not come close to keeping pace with the increases in international trade. Also, the validity of primary reserve currency at the time, the U.S. dollar, was brought into question by other countries, as the large balance-of-payments deficits held by the United States became cause for concern.
Floating Exchange Rates
In the early 1970s, certain governments began allowing their currencies to float on international exchanges. In 1971, President Nixon formally ended the U.S. commitment to the gold standard, and many other countries began to let foreign exchange markets determine the value of their own currency.
This new phase of foreign exchange had two major benefits. First, market forces worked to naturally correct, or at least mitigate, trade imbalances. Second, monetary policy became a much more powerful tool for governments to manage their own economies. Central banks could now use their money supply to either stimulate the economy or pump the brakes on economic growth.
The Contemporary Foreign Exchange Market
Today, the foreign exchange market sees trillions of dollars traded daily across markets around the world. Economic activities, such as tourism, imports/exports and foreign direct investment, account for billions on a daily basis, however, foreign exchange activity is driven largely by investors and foreign exchange dealers. Most transactions involve investing in relatively short-term positions, where investors hope to capitalize on market trends by moving capital between currencies.
If you want to develop a foreign exchange strategy that can help your business, or your investments, contact Olympia Trust for tailor-made global payment and foreign exchange solutions.