THE MARKET’S MOSTWIDELY TRADED CURRENCY IS THE DOLLAR

The dollar is by far the most widely traded currency. According to the 1998 survey, the dollar was one of the two currencies involved in an estimated 87 percent of global foreign exchange transactions, equal to about $1.3 trillion a day. In part, the widespread use of the dollar reflects its substantial international role as:

• Investment” currency in many capital markets
• Reserve” currency held by many central banks
• Transaction” currency in many international commodity markets
  
• “Invoice” currency in many contracts
• Intervention” currency employed by monetary authorities in market operations to influence their own exchange rates.
  

In addition, the widespread trading of the dollar reflects its use as a “vehicle” currency in foreign exchange transactions, a use that reinforces, and is reinforced by, its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the dollar, although by the mid-1990s the Deutsche mark also had become an important vehicle, with its use, especially in Europe, having increased sharply during the 1980s and ‘90s.

Thus, a trader wanting to shift funds from one currency to another, say, from Swedish krona to Philippine pesos, will probably sell krona for U.S. dollars and then sell the U.S. dollars for pesos.Although this approach results in two transactions rather than one, it may be
the preferred way, since the dollar/Swedish krona market, and the dollar/Philippine peso market are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other.

By using the dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle.