The Origins of Foreign Exchange

You will soon be vastly more knowledgeable regarding the origins of foreign exchange.

The roots of the foreign exchange market, the world’s largest financial market, has been considerably impacted, influenced and transformed by history. Much of the fx trading terrain that millions of investors rely on daily has been molded by historical events and technological advancements long since forgotten. This publication aims to serve as your guide to the past, or as some may call, a stroll down memory lane regarding the history of forex, forex trading and the foreign exchange markets.

Twelve minutes from now, you will be vastly more knowledgeable regarding the forex industry’s origins. Why is this important? It is essential to understand the history of forex to understand better why certain factors possess stronger influences than others. To help pave the way, the core historical events surrounding the FX market include:

1. The Birth of Gold Coins
2. The Gold Standard
3. The Bretton Woods System
4. The Smithsonian Agreement & Free Floating System
5. The After Effects of the Plaza Accord
6. Formation of the EU & the Euro
7. The Dawn of Internet Trading

Now let’s get you on the fast track regarding the history of forex tradingForex TradingForex trading is the buying and selling of foreign curr…Read this Term.

History teaches us that the Mesopotamia tribes introduced what is known as the barter system back in 6000 BC. The barter system concept implies an exchange of one item of goods for another, which later cultivated into the exchange of uniform goods (such as salt, spices, wool and leather).

As trade flourished through the barter system, the first form of foreign exchange became active due to trade ships’ exports. Trade ships were rich in cargo and new goods, bringing new supply and demand markets.

It is believed that the Lydian King Croesus invented the world’s first gold coin by separating the gold from silver by using the naturally forming electrum compound. The Persians, who later captured Croesus, adopted gold as the primary metal for their coins, which ultimately helped grow gold’s global acceptance. Over the years, gold was issued by the Romans (the aureus), Venice (the gold ducat), and England (the florin, crown, angel, and guinea), which further influenced gold’s acceptance as a universal currency.

Over time, gold became a form of currency whose significance cannot be overemphasized.

Containing similar characteristics to that of tender:

• It has easy portability.
• It has compositional uniformity.
• It has limited supply and high demand.
• It has global acceptance.

For over 12 centuries, gold coins dominated the foreign exchange scene predominately through the barter system.

The Ushering in of the Gold Standard

The gold standard’s creation holds immense importance to forex history because it allowed participating countries to set fixed prices for their domestic currency for gold. As a result, national currency forms (bank deposits, notes, and silver) could be freely exchanged at a fixed price for gold.

By definition, the forex market is a globally decentralized (OTC) market where participants can exchange, buy, sell and theorize currencies.

In other words, the gold standard paved the way for the global exchange of goods and fiat currencies. Nowadays, the foreign exchange market is centralized around the exchange of one currency for another.

Now back to history.

First, put into effect by the United Kingdom in 1821, the gold standard replaced silver as the world’s primary monetary metal. It was not until about 50 years later, in the 1870s, when the United States, France and Germany accepted a monometallic gold standard after the discovery of gold in western North America (the California Gold Rush of 1914). While the gold standard’s brilliance is undeniable, it was short-lived due to the start of World War I.

Spanning between 1944 to 1971, the foreign exchange market would experience its most significant change yet with the Bretton Woods System’s implementation. In an attempt to restore global economies safely and with stability following the end of WWII, the United States, France and Great Britain met in Bretton Woods, NH, at the United Nations Monetary and Financial Conference.

The success of the Bretton Wood System created an adjustable pegged foreign exchange market where the price of a foreign currency was fixed to the U.S. dollar. Gold was being pegged strictly to the US dollar because back then, the United States had the world’s largest gold reserves (freshly stocked from the California gold rush).

For nearly thirty years, the Bretton Wood System worked until the global gold stock became insufficient to fuel international reserves’ demands. Simultaneously, the United States had circulated too many US dollars due to increased government lending and expenditures.

When President Nixon prohibited foreign central banks from exchanging U.S. dollars for gold, a crisis erupted, which led to the creation of the Smithsonian Agreement in December 1971. (Nixon stopped trading the US dollar for gold because of sharp inflation rates, the Bretton Wood System’s instability and the overall adverse effects to the US dollar).

To make a long story short, the Smithsonian Agreement devalued the U.S. dollar by 8.5% regarding gold while also fixing the gold price at $38 instead of $35. On the whole, the Smithsonian Agreement lasted 15 months and led to more countries (Belgium, Netherlands, Italy, Germany, France and Luxembourg) gravitating towards float exchange rates rather than pegged exchange rates, and it is also characterized as the end of the gold standard era.

Shaping the Present Forex Landscape

The foreign exchange market blossomed as more nations moved towards a floating exchange rate. However, no country’s currency dominated as strongly as the US dollar, whose value had significantly appreciated against other leading currencies.

Due to the US dollar’s strength, exporters faced challenging times despite the US running a GDP deficient of 3.5%. Third-world nations all but crumbled under the staggering debt while American factories started closing due to an inability to compete with foreign competitors.

This is where the Plaza Accord, also known as the Plaza Agreement, came into play.

In an attempt to rectify trade imbalances between the U.S. and Japan, and the U.S. and Germany, the G-5 nations (Germany, France, Japan, the U.K. and the U.S.) held a meeting in 1985 at the Plaza Hotel. The result?

The Yen and the Deutsche significantly increased in value to the US dollar (the US dollar depreciated as much as 50% to the Deutsche and Yen.) Unintentionally, the Plaza Accord improved Japan’s ability to trade and venture with East Asia, which led to Japan becoming less reliant on the United States.

Naturally, the Plaza Accord resulted in a continual decline in the US dollar. Later, the Louvre Accord (1987) aided the wounded US dollar by keeping the U.S. and Japan bound by monetary pledges. Germany, France and the United Kingdom agreed to intervene should their currencies deviate outside a set range, therefore, helping solidify market continuity.

The vital lesson to remember about the Plaza Accord is that it contributed significantly to Japan becoming a significant force in the international market due to being less reliant on the U.S.

Perhaps the most recent historical event to impact the foreign exchange markets would be the signing of the Maastricht Treaty in 1992, which recognized and brought together the European Union (EU) and ultimately fueled the creation of the Euro.

The European Union, composed of 28 European countries, brought together collective political agendas, free trade and European citizenship, while the Euro became the official currency for nineteen of those countries.

So why was the Maastricht Treaty brought forth?

There were three core purposes behind the Maastricht Treaty.

1. To grant European citizenship to every citizen of a member state while enabling people to run for office and vote.
2. To introduce a central banking system along with the Euro as the standard currency.
3. To enact better cooperation on social, political and environmental policies collectively.

While the Maastricht Treaty has been amended on multiple occurrences, it has still centered and operates as one body regarding foreign policy, security and economics.

The core advantage resulting from the Euro’s creation would be that it enabled European businesses and banks the option of revoking exchange risk (during what was then a sophisticated globalizing economy).

Revolution of FX Trading

Innovations in technological advancements combined with Internet trading’s birth revolutionized how financial markets, including the foreign exchange market, operated. Never before were traders able to gather accurate prices, relevant market data and access to trader-friendly investment platforms until the internet trading became mainstream.

During a time of growing globalization and capitalism, the foreign exchange market flourished in emerging markets (like Southeast Asia) and where once totalitarian-controlled markets were prohibited. The added diversity to the foreign exchange market cultivated competition, sparked currency speculation and attracted capital.

For the past 80 years, the foreign exchange market has operated as a seamless free market with exceptionally high liquidity, lessening trade spreads and improved competition. Shaped by the macroeconomics events of major economies, the current forex trading atmosphere is directly influenced by the historical events that have molded its existence.

From the first gold coin, to the creation and demise of the gold standard, and the rapidly occurring technological advancements, what we know as forex trading and the foreign exchange market has become accessible from the comfort of our homes and the touch of a fingertip.

Risk-to-Reward Ratio

By using the risk-to-reward ratio, traders can manage capital and better proportionally understand the risk of loss. In trading, the recommended risk-to-reward ratio is 1:3, which means that an expected return of three units of reward is anticipated for every unit of risk.

Depending upon the trading methodology, risk-to-reward ratios can fluctuate in accordance with a trader’s strategy; it does not necessarily have to remain your only risk-to-reward ratio. For instance, sometimes day traders employ a risk-to-reward of 1:5 or 1:7 but modify their stop losses to obtain those targeted ratios.

To practically identify times of emotional or greed trading, ask yourself the following:

• Does this trade position follow the rules of my trading plan?
• What is the risk-to-reward ratio for my past twenty trades?
• (If it is less than 1:3, reconsider).
• Am I following my risk management strategy and using stop losses?

While a trader’s minds may not be as ready to admit it, traders can identify times when they have been greedy in the past. By keeping accurate trade journals documenting risk-to-reward, sharing target price levels, and giving insight into that day’s emotional state, traders can see times when their risk exposure was higher than it should have been.

Tapping Into a Successful Trading Mindset

In forex trading, there is no barrier of entry or secret formula to success. What separates successful traders from those who have failed? It is the mind. The mind’s ability to remain disciplined in the pursuit of goals, to strictly follow a strategic trading plan, and to remain consciously aware of times when they are slipping into a negative headspace.

To enter a successful trading mindset, try these actions:

1. Bury the Ego – An inflated ego may alter how a trader would typically identify and execute specific trade setups, cause them to negate risk management tactics and be a leading cause of failure. Traders also need to remain open to the idea that winning every trade is impossible and that challenging losing streaks will test them to their core. While no trader wishes to experience losses, traders can build account equity with proper risk management and trade discipline even if they obtain a higher number of losing trades than winning.
2. The Power of Positive Attitude – Some traders have a less difficult time than others tapping into the constructive powers of positive thinking. Whether a trader is naturally optimistic, pessimistic, or in between, the ability to consciously keep the mind empty of negative thoughts or replace them with positive affirmations is a trading superpower that every trader should strive to possess.
3. Trade with Intent – Do not just trade the foreign exchange markets because you can – it is a recipe for disaster. Trade with intent, which is brought forth by following consistent strategies and risk management parameters. Lastly, do not force trade entries because you generally place an ‘x’ amount of trades per day. Ask any successful trader; they have undoubtedly had days to weeks of no trading but stayed the course, weathered the storm, and came out on the other side.
4. Revisiting the Big Picture – Many traders labor under the delusion that trading and generating consistent profits in forex is much easier said than done. They enter the industry with a condensed timeline of trading goals brought upon by the marketing trading videos they see, their ignorance in not knowing what they simply do not know, and the lack of experience they possess. Let us make it clear, though. Successful forex trading is not a sprint but rather a marathon, followed by disciplined trade after trade.

The Bottom Line

When you are facing times of uncertainty, try to step back and detach yourself from the situation. Can you identify the negative thoughts circulating through your mind and replace them with positive thoughts of can-do? If that is not the issue, then maybe reanalyze the markets to see if you are trading with intent or if the markets are not favorable. Lastly, make sure to bury your ego to an unrecoverable depth and invest with the big picture in mind.