The foreign exchange market (also Forex from the English. Foreign Exchange – “foreign exchange”, sometimes FX) is a system of stable economic and organizational relations arising from transactions for the purchase or sale of foreign currency, payment documents in foreign currencies, as well as transactions on the movement capital of foreign investors.
In the foreign exchange market, the interests of investors, sellers, and buyers of foreign exchange values are coordinated. Western economists characterize the foreign exchange market from an organizational and technical point of view as an aggregate network of modern communications that connect national and foreign banks and brokerage firms.
Operations in the forex market for purposes can be trading, speculative, hedging, and regulatory (foreign exchange interventions of central banks).
Prerequisites for the formation of the foreign exchange market
Currency exchange operations existed in the ancient world and in the Middle Ages. However, modern foreign exchange markets emerged in the 19th century. The main prerequisites that contributed to the formation of the foreign exchange market in the modern sense were the following:
extensive development of various international economic relations;
creation of a world monetary system based on the organization and regulation of currency relations enshrined in interstate agreements;
- widespread use of credit funds for international settlements and payments;
- consolidation and centralization of banking capital, widespread development of correspondent relations between banks of different countries, including the maintenance of correspondent accounts in foreign currency;
- development of information technologies and means of communication: telegraph, telephone, telex, which simplified contacts between foreign exchange markets and reduced the time for obtaining information about completed transactions.
The developing national currency markets and their interaction have formed a single world currency market, where the leading currencies in the world’s financial centers began to circulate freely.
Development of operations in the foreign exchange market
Historically, two main methods of payment were distinguished in international circulation: tracing and remittance, which was used in international circulation before the First World War, and partially (to a lesser extent) in the period between the First and Second World Wars.
The term “tracing” is associated with the use of a bill of exchange – a draft. When paying using this method, the creditor writes a bill on the debtor in his currency (for example, a creditor in London presents a demand to the debtor in Chicago to pay the debt in dollars) and sells it on his foreign exchange market at the buyer’s bank rate. Thus, when tracing, the creditor acts as an active party; he sells the bill of exchange in the debtor’s currency in his foreign exchange market.
When remitting, the debtor acts as an active person: he buys the creditor’s currency on his foreign exchange market at the seller’s rate.
In the early years after World War II until the late 1950s, when foreign exchange restrictions were in place, industrialized countries were dominated by spot (with immediate delivery of currency) and forward transactions.
From the 1970s, futures, and options foreign exchange transactions began to develop. This type of transaction provided new opportunities for all participants in the foreign exchange market for both foreign exchange speculators and hedgers, that is, to protect against foreign exchange risks and generate speculative profits. Banks began to make foreign exchange transactions in combination with swap transactions with interest rates.
The modern forex market
On August 15, 1971, US President Richard Nixon announced a decision to abolish the free convertibility of the dollar into gold (he abandoned the gold standard), thereby unilaterally refusing to comply with the Bretton Woods Agreements (according to which the dollar was backed by gold and all other currencies with the dollar).
In December 1971, the Smithsonian Agreement was reached in Washington, according to which, instead of 1% fluctuations in the exchange rate against the US dollar, fluctuations of 4.5% were allowed (9% for non-dollar currency pairs). This destroyed the system of stable exchange rates and was the culminating event in the crisis of the post-war Bretton Woods monetary system. It was replaced by the Jamaican monetary system, the principles of which were laid down in March 1971 on the island of Jamaica with the participation of the 20 most developed states of the non-communist bloc. The essence of the changes that took place boiled down to a more liberal policy in relation to gold prices. If earlier exchange rates were stable due to the action of the gold standard, then after such decisions the floating gold rate led to inevitable fluctuations in exchange rates between currencies.
Quite quickly, a number of problems emerged, for the discussion of which in 1975 French President Valerie Giscard d’Estaing and German Chancellor Helmut Schmidt (both former finance ministers) invited the heads of other leading Western states to gather in a narrow unofficial circle to communicate face to face. The first G7 summit (then still only of six participants) was held in Rambouillet with the participation of the USA, Germany, Great Britain, France, Italy, and Japan (Canada joined the club in 1976, Russia was a member of the club from 1998 to 2014) … One of the main topics of discussion was the structural transformation of the international monetary system.
On January 8, 1976, at a meeting of the ministers of the IMF member countries in Kingston (Jamaica), a new agreement was adopted on the structure of the international monetary system, which had the form of amendments to the IMF charter. The system replaced the Bretton Woods monetary system. Many countries have actually abandoned pegging their national currencies to the dollar or gold. However, it was only in 1978 that the IMF officially allowed such a refusal . From that moment on, freely floating rates became the main method of currency exchange.
In the new monetary system, the principle of determining the purchasing power of money based on the value of its gold equivalent (Gold Standard) has finally been abandoned. The money of the countries participating in the agreement ceased to have an official gold content, the exchange began to take place on the free foreign exchange market (forex) at free prices.
The emergence of a floating exchange rate system has led to three significant results:
- Importers, exporters, and banking structures serving them were forced to become regular participants in the foreign exchange market since changes in exchange rates can affect the financial results of their work, both positively and negatively.
- Central banks were able to influence the exchange rates of the national currency and influence the economic situation in the country by market methods, not just administrative ones.
- The rates of the most liquid national currencies are formed on the basis of the market’s search for an equilibrium point between current demand and available supply, and changes in supply and demand in the market cause a shift in the exchange rate in one direction or another.
Characteristics of modern world foreign exchange markets
Modern world foreign exchange markets are characterized by the following main features.
- The international nature of foreign exchange markets is based on the globalization of world economic relations, the widespread use of electronic communications for the implementation of transactions and settlements.
- Continuous, non-stop nature of transactions during the day, alternately in all parts of the world.
- Unified nature of foreign exchange transactions.
- Using operations in the foreign exchange market for the purpose of protecting against foreign exchange and credit risks through hedging.
- A huge share of speculative and arbitrage operations, which many times exceed foreign exchange operations associated with commercial transactions. The number of currency speculators has increased dramatically and includes not only banks and financial and industrial groups, TNCs but also many other participants, including individuals and legal entities.
- The volatility of exchange rates, which does not always depend on fundamental economic factors.
The modern foreign exchange market performs the following functions:
- Ensuring the timeliness of international settlements.
- Creation of opportunities for protection against currency and credit risks.
- Ensuring the interconnection of world currency, credit, and financial markets.
- Creation of opportunities for diversification of foreign exchange reserves of the state, banks, enterprises.
- Market regulation of exchange rates based on the interaction of supply and demand of currencies.
- The possibility of implementing monetary policy as part of the state economic policy. The possibility of implementing coordinated actions of different states in order to implement the goals of macroeconomic policy within the framework of interstate agreements.
- Providing opportunities for participants in the foreign exchange market to obtain speculative profits through arbitrage operations.
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