Dollar Dominance in FX Trading

Over 85% of all foreign exchange (FX) transactions involve the US dollar. I argue that the US dollar dominates FX trading volume because of strategic avoidance of price impact. To show this, I leverage the fact that non-dollar currency pairs can be traded indirectly by using the US dollar as an intermediate vehicle currency. I present a model of FX trading that embraces this idea and derive a set of sufficient 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. To establish causality, I employ a systematic approach to identify quasi-exogenous spikes in the sufficient conditions. Lastly, I use non-overlapping holidays as a novel identification tool to show that up to 36-40% of the daily volume in dollar currency pairs are due to vehicle currency trading.