Since 1944, the US dollar has been the world’s global reserve currency. Before we look at how the US dollar reached this position, it’s important to understand what a reserve currency is and why it’s important for global trade.
What is a global reserve currency?
A global reserve currency, such as the franc and the Australian dollar, is a currency that’s held by central banks around the world, as well as other financial organisations, to both stabilise economies and underpin international trades.
Global reserve currencies are particularly important for trading. By using a common currency to buy and sell goods, companies and countries can avoid currency exchange fees.
Although the US dollar is the dominant global reserve currency, other currencies are also used in a similar way – most notably the euro. However, few come close to the US dollar’s dominance, with 58 per cent of global foreign exchange reserves held in dollars.
Meanwhile, 54 per cent of international trades are conducted in the US currency, while 88 per cent of foreign exchange transactions involve the US dollar. The euro is the next-biggest currency, but it only accounts for 20 per cent of global foreign exchange reserves.
Has the US dollar always been the dominant global reserve currency?
No, it wasn’t until 1944 that the US dollar became such a powerful force in global currency markets. Prior to the second world war, the British pound was the main currency of choice for international trades.
However, as a result of the two world wars, the UK’s economy took a significant hit. Meanwhile, many European countries transferred their gold assets to the US during this turbulent period to keep them safe.
In 1944, under what’s known as the Bretton Woods Agreement, the US dollar, which at that point was pegged to gold, was named as the world’s primary reserve currency. The aim of this agreement was to create a unified international money market.
Under Bretton Woods, the value of all currencies would be linked to the US dollar, rather than to the price of gold. However, because at this point the US dollar was pegged to the gold price, little practically changed in terms of currency valuations.
It wasn’t until the 1970s, when Richard Nixon decoupled the US dollar from gold, that the floating currency exchange rates we have today emerged. The reason behind this decision was that the US no longer had enough gold reserves to cover all the US dollars in circulation around the world.
What does a currency need to be a global reserve currency?
The key requirement for a global reserve currency is stability. Now that all currencies have been decoupled from the value of gold, each currency is underpinned by the governments of individual countries – or in the case of the euro by a block of countries.
Although China has been pushing to make the renminbi an alternative to the dollar, the fact is that too few global trades are conducted in its currency and too few governments hold it in their reserves for it to seriously challenge the US dollar at this stage.
One of the main reasons why the US dollar has dominated global currency markets for so long is that the majority of oil transactions around the world are conducted in dollars. It is also used for many other commodity trades globally.
The sheer volume of trades conducted with US dollars makes it highly liquid – another important trait for a global reserve currency.
Why is it important to understand global reserve currencies if you’re trading forex?
Liquidity is important – and it’s one of the main reasons why the forex market is so highly traded around the world.
In the context of forex, and other areas of global trade, a currency that is highly liquid can easily and quickly be bought and sold. This indicates that many other people trust the currency that you’re trading – after all, if no one wants the currency you’re trying to trade, that indicates that it is not worth as much.
Therefore, currencies like the US dollar that are highly liquid are considered stable and therefore desirable for traders and governments alike.
Forex trades take place quickly, which is why it’s important to ensure you are comfortable with the market before you start trading in real-time. Funding prop firms give you a chance to run trades in a simulated account.
In doing so, you can practice your forex trading and demonstrate that you’ve got what it takes to make it on the markets, giving the firm confidence in funding you to trade for real.