Post world war all major currencies of the world were fixed against the value of gold and under international deal at a conference held at Bretton Woods. This system stabilized the exchange rates at the beginning but later became unsustainable when economies developed and gold prices soared. This gold standard system was discontinued in 1971 which enabled the exchange rates to float freely. In the late 90’s when there was a breakthrough in the internet adoption, banks created online networks to create quotes which are automated in nature to provide instant trading experience. Advanced technology paved the pathway for individuals to trade in foreign exchange for the first time.
Trading has been around for a while. Way before there was a modern economy and civilization existed, thus therefore the concept of money evolved. The evolution of concept of money finally settled in a commodity called gold. Almost all the trades in the early centuries happened only through exchange of gold and therefore the gold became the global currency, it is recognized and used worldwide and also can be compared with US dollar which is also recognized everywhere around the world. In the later centuries when the volume and frequency of the trades expanded it became difficult to carry around so much gold. Thus paper currencies came into existence. The paper money is not recognized as money back then; it was just a representation of money as receipt for the gold. This monetary system wherein the prices of everything in the economy were fixed by gold is known as the gold standard, it is probably the best way to manage an economy. Gold functioned as an efficient medium of exchange on the individual level as it did on the national level as well. The prices of all the currencies were fixed in terms of their weight in gold.
The gold standard was very efficient in multiple ways. One of the ways it promoted efficiency is, it did not allow for imbalances to grow in the market. For instance, if there was foreign trade between two currencies and one was importing a lot from the other, then the importing country would have to pay out a lot of gold to the other. The falling amount of gold in the importing country would create a situation of deflation and the prices would automatically fall making its internal prices lower and therefore making the imports look expensive. Similarly, the exporting country will witness a huge inflow of gold. Increased gold in the money supply will lead to inflation and therefore the prices of goods will increase making the exports expensive. The gold standard would therefore automatically prohibit an unhealthy trade imbalance between two countries..
The gold standard was prevalent in the world in one form or the other till 1970. It had been replaced and renewed many times. However, it was still present till the 1970’s. In 1971, President Richard Nixon of the United States closed what is called the gold window. Thus, he effectively took the world off the gold standard. This meant that currency notes which were earlier redeemable for a fixed weight of gold now could not be redeemed. This event is known as the Nixon shock since such a bold move had not been anticipated by the entire world and sent shockwaves in the global economic system.
When President Nixon took the world of the gold standard, all the currencies of the world suddenly had no backing in gold. This meant that the exchange rate between them could not simply be calculated using arithmetic, rather the value of a currency now depended on a variety of factors. A lot of these factors were under the control of governments. Hence, there was the need of a market where the exchange rates will be determined on a real time basis based on the information flowing through the markets. Since the Forex market was where currencies have always been exchanged, it was well positioned to take up this role. The Forex market therefore came into prominence when the world went off the gold standard. This is because during the gold standard, there were no exchange rates to determine. It is only after gold was removed as the common denominator between currencies that all of them became freely floating and there was a need to value them against one another.
The European countries were fighting World War II. As such the economies of the world had been destroyed. Many countries had resorted to printing money to be able to finance the humungous war expenses. Therefore, there was an alarming threat that as soon as the war got over, many economies in Europe would simply implode because of the natural instability in their currency markets. As such to prevent such an outcome from happening, all the countries in the world, with all the prominent political leaders and economists held a conference at Bretton Woods in the United States. This came to be known as the Bretton Woods conference and had huge implications on the future monetary system and evolution of the Forex market.
The objective of the conference was to create a new monetary system that could withstand the possible shocks that it would receive once the war ended.
This meant that the conference was meant to create a system that would enable the nations to avoid rapid depreciation and complete fallout of their currency systems.
The arrangement decided at the Bretton Woods system was slightly complex as compared to the gold standard that was already in place.
The United States had the largest reserve of gold in the world after World War II. According to many estimates, it had more gold than all the European economies put together. This is the reason that the United States dollar overtook the British pound sterling as the most important currency during this period. Since United States had most of the gold in the world, the value of the United States dollar was pegged to gold. There was a Federal gold window where anybody holding a dollar bill could go to exchange it for gold.
All the other currencies in the world were pegged to the dollar. This meant that if the value of the dollar changes by 5% then the value of the other currencies would also change by 5% only. There was a 1% fluctuation that was allowed between the value of the dollar and other currencies. If the difference in the value of the dollar and the value of other currencies was greater than 1% then the Central Banks were instructed to engage in open market buying and selling operations and bring the currency within the relevant range.
The Bretton Woods system ended up making the dollar the reserve currency of the world. Since all the countries were now transacting in US dollars instead of gold, the essential commodities such as gold and oil also came to be priced in terms of US dollars instead of gold. As such, dollar became a reserve currency. This means that every country that wanted to conduct foreigntrade had to hold some amount of US dollars regardless of whether or not they wanted to trade with the United States.