Currency trading has been around for almost as long as paper money has. It is believed that currency trading dates back to the Babylonians, who were also the first to use paper money and receipts. Before this, almost all trade took the form of barter, which is the direct exchange of goods or services. The inherent limitations of this system, in that you could only obtain things if you had something the other party wanted, encouraged the development of more generally accepted tokens of exchange. Some societies used items such as teeth, stones, or feathers for this purpose, but the inherent worthlessness of these items meant that this system was too easily abused. Soon, metals such as gold and silver, which were much harder to obtain, and could be easily moulded into standardised coins, took over as the main type of currency. During the middle ages, paper IOU notes began to gain acceptance in some of the more politically stable societies, and the modern concept of currency was born. For example, at one stage, an English pound note could be exchanged for 240 pieces of silver, which weighed a pound in total. The need to be able to exchange between different types of IOU note led to the first currency exchange systems.
Up until the First World War, the majority of central banks used gold as the basis for their currency, a system known as the Gold Standard. During the 19th century, some countries suspended their currencies from being convertible into gold at various points in order to suit their circumstances. For example, Britain went off the Gold Standard during the Napoleonic Wars, so that they could afford to increase expenditure at a time when tax revenues were virtually non-existent. The USA did the same during the Civil War, as did many major economies during the First World War. The abandoning of the Gold Standard tended to lead to massive inflation, causing huge political instability in many countries. While most countries reverted back to it in the aftermath of the First World War, the Great Depression of the 1930s was to prove the last straw for the Gold Standard, and many countries such as the UK and US abandoned it altogether in 1931. A new system, in which the dollar was set at a fixed value against gold, and all other currency values were set at a fixed rate against the dollar, was established in a conference in Bretton Woods, New Hampshire in 1944. This system was known as the Bretton Woods system, or sometimes the Gold Exchange Standard. At the same time, international institutions such as the International Monetary Fund (IMF), The World Bank, and the General Agreement on Tariffs and Trade (GATT) were established in an effort to prevent the economic instability that had led to the Second World War.
During the 1960s, the Bretton Woods system began to run into some serious difficulties as national economies moved in different directions. While a number of realignments to the system were made during this decade in an effort to keep the system in place, it finally collapsed in 1971, when the Nixon administration suspended the dollar’s convertibility into gold. The reason for this move is that economic troubles in the US meant that the dollar was no longer fit for purpose as the sole international currency. From this point on, the value of the US dollar relative to other currencies would be determined solely by the laws of supply and demand, paving the way for the forex market as we now know it.
In 1979, in an effort to bring monetary stability to Western European nations and pave the way for a single currency, the European Economic Community brought in a new system of exchange rates between European currencies known as the Exchange Rate Mechanism. This allowed for a certain amount of variance between currency values, as long as it stayed within an agreed threshold. This system left European currencies vulnerable to abuse by currency speculators, and in 1993 the UK was forced to withdraw from the ERM for this reason. Similar events transpired in South-East Asia in 1997, and by the early 2000s the entire currency exchange market had shifted towards the free market model embraced by the US in 1971.
Between 1931 and 1971, there had been very little in the way of currency speculation, but the collapse of the Bretton Woods system made it possible once again to profit from speculating on currency values. In the decades that followed, the forex market has evolved into the world’s largest global financial market, with trillions of dollars worth of currency being traded on a daily basis. Unlike stock markets such as the FTSE and the NASDAQ, the global forex market is not based in one building or even one country. Rather, it is a giant decentralised market based on domestic and intercontinental telecommunications exchanges.
Up until relatively recently, if you wanted to speculate on the forex market directly, you had to have a huge amount of starting capital, which effectively restricted it to investment bankers and high net worth individuals. The reason for this is that the smallest units that can be traded on the forex market typically cost around £50,000 or more, which is too much for the average investor to afford. Also, the transaction costs were very high, which could wipe out any profits that you made from trading.
However, in recent years, web-based retail forex brokers such as Saxo Bank have made it possible for smaller investors to get in on the action. Most retail forex firms offer margin trading, where you only have to stake a small percentage of the units that you are trading, and you can still claim the profits that you would get if you staked the full amount yourself. The flipside of this is that if a trade goes against you, you would be liable for the same level of losses as if you had staked the full amount, so you could end up losing more than your initial stake. However, you can place ‘stop losses’ on your trades, which will automatically close the trade whenever the currency moves by a pre-set amount.
Also, the fact that you can now do it all online, without the need for a middleman, means that your overheads can be low enough to make the whole thing profitable. Today, retail forex trading is one of the fastest growing sectors in the financial market, accounting for an increasingly large proportion of all forex trades, and this trend is expected to continue for the foreseeable future.