The roots of trading of currencies can be traced back to the Middle Ages. It was developed by the development of bills of exchange by international merchant bankers. These bills of exchange represented transferable third-party payments, which facilitated both flexibility and growth in the trades that included foreign exchange.
The forex as we know it today with its volatility and relative stability began to be shaped in the 20th century.
At that time London was a leading foreign exchange center. As a result the British pound turned into the major currency for executing trades. Additionally, it was the main currency in which bank reserves were held.
The use of telex machines or cable for the execution of currency trades during those times gave the pound the nickname cable. However, the World War II left Britain economically devastated.
This led to the emergence of the USA as a financial center, since its economy was not greatly influenced by the negative impacts of the war.
Combined with the Breton Woods Agreement of 1944 between the USA, Great Britain and France, the US dollar was turned into the reserve currency for the capitalist countries. As a result all other currencies were linked to the American dollar.
The currency rates were allowed to be adjusted by the central banks of the corresponding country by using such means as interventions or the purchase of currencies. On the other hand the gold was used as a base measure for the value of the US dollar, meaning that it was linked to it. As a result, the US dollar was turned into the reserve currency of the world economy.
The International Monetary Fund (IMF) was established under the same agreement. Its major activities surrounded the financial support of the former socialist countries and the developing countries that were undergoing a transformation of their economic activities after the war. In order to achieve its goals the IMF applied the following activities:
- monitoring of economic and financial developments, as well as providing policy advice with the purpose of crisis-prevention;
- IMF lending to countries having difficulties in balance of payments;
- technical assistance and training in order to help member countries to effectively manage their financial and economic activity.
The main factor that contributed to the development of the foreign exchange market as we know it today is the free-floating of currencies that was established at the end of the seventies.
The free-floating of currencies represents the ability of everyone to be involved in the trading of currencies, while their prices are determined by the levels of supply and demand.
Additionally, this principle includes the aspect of no particular intervention point occurrence. As a result of the free-floating of currencies, the volume growth has significantly increased.
The major factors that contributed to the increase in the volume of currencies trade include:
- Volatility of currencies rates.
- The experienced technology revolution in currency trading, facilitated by the introduction of automated dealing systems and the development of the Internet.This factor contributed to a particularly great extent to the development of the forex market. The connection of traders located all around the world was made possible by dealing machines. Traders have become more sophisticated due to the advances in technology, computer software and telecommunications. As a result their ability to make profits and deal appropriately with the risks of foreign currency trading has increased.
- Mergers of corporations of different origin.
- Increasing two-way influence of different economies over bank-rates set by central banks.
- Goods markets experienced higher competition.
Reserve Currencies
After the Breton Woods Agreement was signed in 1944 the US dollar was established as the major currency to which other currencies were pegged. This turned the US dollar in the global reserve currency. However, there are other international reserve countries besides the USA.
The European Monetary System was created in 1978 by a plan between nine of the member states of the European Community. This system was governed by the European Fund of the Monetary Cooperation.
In 1999 the transition to the euro, which represented the common European currency of these countries (also known as the Euro zone), was made. The euro bills can be found in 5, 10, 20, 50, 100, 200 and 500 euro denominations.
Additionally, euro coins can be found in 1 and 2 euros as well as 1, 2, 5, 10, 20 and 50 cent denominations.
As a result the euro zone countries held their reserves in the euro currency. On the other hand, the countries of the Southeast Asia hold their reserves in the Japanese yen.
However, depending on the prevailing international conditions, the portfolio of reserve currencies that a specific central bank holds can be changed to include the Swiss franc as well.
Global currency reserves
Here are the official foreign exchange reserves as a percentage of total identified holdings.
| ’00 | ’01 | ’02 | ’03 | ’04 | ’05 | ’06 | ’07 | |
|---|---|---|---|---|---|---|---|---|
| US dollar | 70.5% | 70.7% | 66.5% | 65.8% | 65.9% | 66.4% | 65.7% | 63.3% |
| Euro | 18.8% | 19.8% | 24.2% | 25.3% | 24.9% | 24.3% | 25.2% | 26.5% |
| Pound sterling | 2.8% | 2.7% | 2.9% | 2.6% | 3.3% | 3.6% | 4.2% | 4.7% |
| Japanese yen | 6.3% | 5.2% | 4.5% | 4.1% | 3.9% | 3.7% | 3.2% | 2.9% |
| Swiss franc | 0.3% | 0.3% | 0.4% | 0.2% | 0.2% | 0.1% | 0.2% | 0.2% |
| Other | 1.4% | 1.2% | 1.4% | 1.9% | 1.8% | 1.9% | 1.5% | 1.8% |