Article provided by The Federal Reserve Bank of New York

Trading foreign exchange: a changing market in a changing world

In a universe with a single currency, there would be no foreign exchange market, no foreign exchange rates, no foreign exchange. But in our world of mainly national currencies, the foreign exchange market plays the indispensable role of providing the essential machinery for making payments across borders, transferring funds and purchasing power from one currency to another, and determining that singularly important price, the exchange rate. Over the past twenty-five years, the way the market
has performed those tasks has changed enormously.

Since the early 1970s, with increasing internationalization of financial transactions, the foreign exchange market has been profoundly transformed, not only in size, but in coverage, architecture, and mode of operation. That transformation is the result of structural shifts in the world economy and in the international financial system. Among the major developments that have occurred in the global financial environment are the following:

- A basic change in the international monetary system, from the fixed exchange rate “par value” requirements of Bretton Woods that existed until the early 1970s to the flexible legal structure of today, in which nations can choose to float their exchange rates or to
follow other exchange rate regimes and practices of their choice.

- A tidal wave of financial deregulation throughout the world, with massive elimination of government controls and restrictionsin nearly all countries, resulting in greater freedom for national and international financial transactions, and in greatly increased competition among financial institutions, both within and across national borders.

- A fundamental move toward institutionalization and internationalization of savings and investment, with funds managers and institutions around the globe having vastly larger sums available, which they are investing and diversifying across borders
and currencies in novel ways and in ever larger amounts as they seek to maximize returns.

- A broadening and deepening trend toward international trade liberalization, within a framework of multilateral trade agreements, such as the Tokyo and the Uruguay Rounds of the General Agreement on Tariffs and Trade, the North American Free Trade Agreement, and U.S. bilateral trade initiatives with China, Japan, and the European Union.

- Major advances in technology, making possible instantaneous real-time transmission of vast amounts of market information worldwide, immediate and sophisticated manipulation of that information to identify and exploit market opportunities,and rapid and reliable execution of financial transactions—all occurring with a level of efficiency and reduced costs not dreamed possible a generation earlier.

- Breakthroughs in the theory and practice of finance, resulting not only in the development of innovative new financial instruments and derivative products, but also in advances in thinking that have changed our understanding of the financial system and our techniques for operating within it. The common theme underlying all of these developments is the role of markets—the growth and development of markets, enhanced freedom and competition in markets, improvements in the efficiency of markets,increased reliance on market forces and mechanisms, and the creation of better market techniques and instruments. The interplay of these forces, feeding off each other in a dynamic and synergistic way, created a global environment of creativity and ferment. In the 1970s, exchange rates became more volatile and imbalances in international payments grew much larger for well-known reasons: the advent of a floating exchange rate system, deregulation, and major macroeconomic shifts in the world economy. That caused financing needs to expand, which—at a time of rapid technological advance—provided fertile ground for the development of new financial products and
mechanisms. These innovations helped market participants circumvent existing controls and encouraged further moves toward deregulation, which led to additional new products, facilitated the financing of still larger imbalances, and encouraged a trend toward institutionalization of savings and diversification of investment. Financial markets grew progressively larger and more sophisticated, integrated, and efficient.

In that environment, foreign exchange trading increased rapidly and changed intrinsically. The market has expanded from one of banks to one in which many other kinds of financial and non-financial institutions also participate— including nonfinancial corporations, investment firms, pension funds, and hedge funds. Its focus has broadened from servicing importers and exporters to handling the vast amounts of overseas investment and other capital flows that currently take place. It has evolved from a series of loosely connected national financial centers to a single integrated international market that plays a far more extensive and direct role in our economies, affecting all aspects of our lives and our prosperity.

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