Dollar Dominance in FX Trading
72 Pages Posted: 2 Aug 2021 Last revised: 1 Nov 2022
Date Written: August 1, 2022
Over 85% of all foreign exchange transactions involve the dollar, whereas the United States accounts for a much smaller fraction of global economic activity. My paper attributes this dominance of the US dollar to the strategic avoidance of price impact. I derive three conditions for dollar dominance: Dollar pairs exhibit i) larger and ii) more volatile fundamental trading demands but iii) less volatile exchange rates than non-dollar pairs. I empirically test these conditions and provide evidence consistent with my theory. I show that 36-40% of the volume in dollar pairs arises from using the dollar as a vehicle currency to indirectly exchange two non-dollar currencies.
Keywords: Dollar dominance, foreign exchange volume, price impact, strategic complementarity
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation