Dollar Dominance in FX Trading

Abstract

Over 85% of all foreign exchange (FX) transactions involve the US dollar, whereas the United States accounts for a much smaller fraction of global economic activity. My paper attributes the dominance of the US dollar in FX trading to strategic avoidance of price impact. Utilising a model of FX trading, I derive three conditions for dollar dominance. I then empirically test these conditions using a globally representative FX trade data set and provide evidence that is consistent with my model. I find that US dollar currency pairs enjoy a low-price-impact advantage, which favours their use as a vehicle currency to indirectly exchange two non-dollar currencies. Using a novel identification strategy, I show that up to 36-40% of the daily volume in dollar currency pairs are due to vehicle currency trading.