The Foreign Exchange Market is the largest and amongst the most liquid in the world. FOREX was originally set up as a type of inter bank exchange that allowed currency conversion between banks only. According to the Bank for International Settlements, between $600 and $800 billion of foreign currency transactions were traded per day in 1990. The FOREX market has grown dramatically since then and currently trades approximately $6.6 trillion each day. By comparison, a very busy day on the New York Stock Exchange would equate to only $200 Billion USD in trading volume, or less.
From 1870 to 1914 the world's exchange system was operated under the Gold Standard System. According to this system, all the world's currencies were pegged to gold. This system worked well until the First World War when many countries overprinted money in relation to their gold reserves in order to meet the extraordinary economic demands at that time.
This consequently led to unprecedented inflation. As a result, many European countries were forced to abandon the Gold Standard System. In July of 1944, sixteen major western nations established the International Monetary Fund ("IMF") to supervise exchange rates and to establish a standardized system for international payments. By agreement, the price of gold was fixed (at US $35.00 per troy ounce) and a pool of reserves was created by the member nations. Although market forces were free to determine day-to-day exchange rates, the fluctuations were restricted to plus/minus 1% of the agreed value. Member nations had the power to intervene in order to ensure that those restrictions were adhered to.
This system worked reasonably well until the 1960's when divergent inflation rates seriously altered the relative competitiveness of the major trading countries. In 1971 the US experienced a series of dollar crises, which caused the collapse of the Gold Standard system. As a result, IMF came up with the Smithsonian Agreement, under which the US dollar was devalued by 10% and a wider fluctuation band (between 1% and 2.25% above or below the official spot rate) was adopted. By March of 1973 the Smithsonian Agreement also collapsed.
The outcome of these failures was to let member currencies free-float in relation to each other, and thus the FX market as we currently know it was born.