Each day around the world, massive sums of currency are exchanged, seemingly with nothing more than a click of a computer mouse or a brief satellite-connected telephone conversation between traders on different continents. Technology has helped to evolve the foreign exchange industry a long way from its rather humble beginnings. Developing an appreciation for how this system developed over time – as well as an understanding of the modern analytical tools at a trader’s disposal – can greatly aid in investment decision-making.

The foundations of modern foreign exchange

The beginnings of modern currency trading can be traced back to the origins of money itself. A key tenet of foreign exchange theory involves a shared belief that various forms of money have value, and can be readily exchanged for products, services and other commodities. Currency has a long history of being backed by the value of various precious metals, including silver and gold. During the nineteenth century, most of the currencies in worldwide circulation were backed by stores of gold bullion, a concept first initiated by the government of England. But global turmoil in the twentieth century gradually led to a rescinding of the gold standard. Recognition of the United States of America as a global economic superpower meant that the U.S. dollar was almost universally accepted around the world as a medium for barter and trade. Today, the U.S. dollar continues its dominance by playing a role in an astounding 70% of all foreign exchange transactions.

Money makes the world go round

The origins of coin-based currency date back as far as 2000 BC. The age of modern metal-based coins is believed to have begun in Asia Minor sometime during the seventh century B.C. The first coins were struck from naturally occurring metals such as electrum and silver. Later, other minerals and alloys such as bronze, copper, lead and gold were utilized. Due to the fact that these metals were prized for their rarity, the coins minted from them had intrinsic value. Bearers of these coins could literally carry their wealth with them at all times. In fact, many coins from the Roman era had center-punch holes so that they could be strung on a cord for easier transport.

Paper currency is generally believed to have been introduced in China around 806 AD. Unlike coins of the era, paper currency was created as a system of stored value, backed by a known commodity and the credibility of the issuer. In addition to creating an orderly means of trading, the use of paper currency eliminated the need for individuals to haul large quantities of coin – or worse, heavy ingots or bullion – in order to engage in trade. As might be expected, the introduction of paper currency also gave rise to the first incidences of counterfeiting, and the struggle to create highly-unique, non-reproducible bank notes – a challenge that continues to this very day – was first born.

As good as gold

In order to instill real value into money and make it worth more than the paper on which it was printed, governments gradually began to tie their currencies to carefully guarded stores of precious metals. The “gold standard,” or the practice of issuing bank notes directly tied to the value of gold, was first established by England in 1816. The concept proved to be fiscally sound, and by 1900, most global currencies – including that of the United States – were backed by gold reserves. But the stock market crash of 1929, currency devaluations, and the economic depression that followed had impacts of global proportions. These events triggered a gradual evolution away from the gold standard.

In 1933, U.S. President Franklin Roosevelt officially repealed the right of U.S. citizens and business entities to exchange their dollars for gold. However, foreign entities holding U.S. dollars still retained the right to make such an exchange. Realizing that the dollar was growing in worldwide influence, the United States passed the Gold Reserve Act in 1934, allowing the U.S. Treasury to intervene in the foreign exchange market as needed by means of an Exchange Stabilization Fund in order to stabilize the U.S. dollar.

The dawn of global economic cooperation

Already long recognized as one of the strongest nations in the world – both economically and militarily – the United States of America assumed an important role in the global economy. Having emerged from World War I with its industrial might intact, the inherent strength of the U.S. dollar allowed this currency to become a very popular form of legal tender in transactions outside of the United States.

The outbreak of the Second World War in 1939 introduced new economic pressures in many nations. In a few short years, Europe and had been decimated, both literally and figuratively. If there was to be any global economic stability after the defeat of the Axis Powers, the U.S. and its almighty dollar would surely need to play a role in building that stability. To lay the groundwork, a conference of Allied nations was held in rural New Hampshire in 1944. Known as the Bretton Woods Conference, the meeting was intended to foster international cooperation and economic stability in the years following the war. Participating nations agreed to create a gold-based exchange rate for their own individual currencies. At this time, the value of the U.S. dollar was set at $35 per ounce of gold, and the currency exchange rates of participating nations were expressed in terms of dollars. The Bretton Woods Conference also led to the creation of the World Bank and the International Monetary Fund – two important entities that would help to ensure the flow of capital and currency between nations during the rebuilding phase.

For obvious reasons, foreign exchange between Allied and Axis powers was suspended during wartime. Exchanges with the German mark resumed in 1950, and exchanges with the Japanese yen resumed in 1956.

Birth of the floating rate

As the United States continued to contribute huge sums of money to global economic stabilization in the post-war years, the popularity of the U.S. dollar continued to grow. While gold reserves continued to back the value of the U.S. dollar on an international basis, the U.S. simultaneously exported significant amounts of gold to back the currencies of other friendly nations. By 1970, foreign nations held almost $47 billion in U.S. currency, and the U.S. had to face the fact that it no longer had the necessary gold reserves to back this massive exposure. In 1971, the U.S formally decided that its dollars would no longer be tied to the gold standard, and the modern foreign exchange market was born. This became known as a “floating rate” system, under which prevailing currency exchange rates would fluctuate according to supply and demand.

From brittle wires to silicon chips

Technology has been responsible for introducing major changes to the foreign exchange marketplace over the years. For much of the early 20th century, international currency transactions were handled primarily by telegram, telephone and telex machine. The advent of the computer age during the 1960s and 1970s introduced new methods of data transfer to the financial services industry. Thanks to high-speed digital data lines and satellite-based communications systems, foreign exchange transactions could be conducted rapidly and in “real time.” This technological transformation of the marketplace continues today, as new computer hardware and software advances are introduced to aid in maximizing trading efficiency.

New maps and new unions

Geopolitical change continues to affect the currency markets. From the dissolution of the former Soviet Union, to the formal expiration of Britain’s lease on the colony of Hong Kong and its subsequent repatriation to China, to the birth of new democracies in the Middle East – the transforming face of the world also helps to transform the currency trading marketplace.

One of the most dramatic changes in foreign exchange occurred on January 1, 1999, when the euro was adopted as the new currency of the European Union member states. While actual euro notes and coin were not introduced into circulation until January 1, 2002, the new currency had a profound effect on the global economy. The euro was primarily intended to create a unified trade market amongst members and improve liquidity of the financial markets, but it also created new opportunities for foreign exchange, and hence, new opportunities for profits.

The future of foreign exchange

For better or for worse, the U.S. dollar continues to represent the “king” of all global currencies, and plays a role in an estimated 70% of all foreign exchange transactions today, attesting to its strength. In years to come, developing industrial economies such as those of China, India and Brazil will undoubtedly have an impact the foreign exchange markets, but the greenback shows no imminent signs of relinquishing its domination.