Money and Banking: Structure of Forex Market

Dr. Moyi Harry Ruben

The structure of the foreign exchange market is an outgrowth of one of the primary functions of commercial banks, constituted to assist clients in the conduct of international commerce. For example, a corporate client desiring to import merchandise from abroad would need a source of foreign exchange if the import was invoiced in the exporter’s home currency. Alternatively, the exporter might need a way to dispose of foreign exchange if payment for the export was invoiced and received in the importer’s home currency. Assisting in foreign exchange transactions of this type is one of the services that commercial banks provide for clients, and of the services that bank customers expect from their banks.

Foreign exchange is the largest, most dynamic market in the world. About $ 5 Trillion worth of currency is traded daily in a market that literally does not sleep. Centers like Tokyo, London and New York, traders deal smoothly across borders and time zones, often in multiples of billions in transactions that take less than a second. The market development into its current forms has left it virtually unrecognizable from 30 years ago. The, banks dealt with currencies of behalf of their clients via traders holding multiple telephone conversations or perhaps using the relatively new electronic systems offered by the providers. Today, clients can deal alongside banks on a number of platforms and the quiet hum of computers has done much to reduce the noise level of trading floors. Monetary environment has originated far back and to understand this, it may need a bit of historical background to be told. The international monetary system went through many stages of evolution among these includes; Bimetallism, Classical gold standard, Interwar period, Bretton Woods system and flexible exchange rate regime. While the first was bimetallism, Classical gold standard spanned from 1875- 1914. Under the gold standard, the exchange rate between two currencies was determined by the gold contents of the currencies. Balance of payments disequilibrium was automatically corrected through the price specie-flow mechanism. The gold standard still has ardent supporters who believe that it provides an effective hedge against price inflation.  Under the gold standard, however, the world economy can be subject to deflationary pressure due to the limited supply of monetary gold. To prevent the recurrence of economic nationalism with no clear rules of the game, witnessed during the Interwar period, representatives of 44 nations met at Bretton Woods New Hampshire, in 1944 and adopted a new international monetary system. Under the Bretton Woods system, each country established a par value in relation to the US dollar, which was fully convertible to gold. Countries used foreign exchanges, especially the US dollar, as well as gold as international means of payments. The Bretton Woods system was designed to maintain stable exchange rates and economization on gold. The Bretton Woods system eventually collapsed in 1973 mainly because of US domestic inflation and the persistent balance of payments deficits.

The flexible exchange rate regime that replaces the Bretton Woods system was ratified by the Jamaica agreement. Following a spectacular rise and fall of the US dollar in the 1980s, major industrial countries agreed to cooperate to achieve greater exchange rate stability. The Louvre Accord of 1987 marked the inception of the managed floating system under which the G7 countries would jointly intervene in the foreign exchange market to correct over or undervaluation of currencies.

Therefore, “Where Money Talks very loudly,” a good or ideal monetary system should provide liquidity, adjustment, and confidence to the people. In other words, a good IMS should be able to provide the world economy with sufficient monetary reserves to support the growth of the international trade and investment. It should also provide an effective mechanism that restores the balance of payments equilibrium whenever it is disturbed like ours. Lastly, it should offer a safeguard to prevent crisis of confidence in the system that result in panicked flights from one reserve asset to other. Politicians and economists should keep these three criteria in mind when they design and evaluate the international monetary system and relates it to national monetary policy.

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