The Dollar’s Role in the Next Decade

The 2010s were a decade shaped by macroeconomic disruption, which drove both positive and negative policy developments. The financial crisis of 2008 caused a number of significant repercussions ranging from Europe’s Sovereign Debt Crisis to China’s increasingly feeble economy; however, the US Dollar continued to command a dominant share of derivatives turnover in spite of the influence of the Financial Crisis, unorthodox monetary stimulus, the rising global clout of emerging markets, and Washington’s aggressive sanctions policy.

At the same time, the global balance of power shifted with more aggressive and dynamic policymaking shaped by China’s attempt to assert itself as a financial power emulated in the ambitious Belt and Road Initiative.

Though these developments often challenged economic orthodoxy, such as the advent of negative interest rate policy, much of the underlying currency foundations of the international financial system remained rock-solid, as evidenced by the latest BIS Triennial Survey. 

The Triennial Survey, collected every three years, reflects market engagement in foreign exchange and OTC derivatives products. The latest one showed FX derivative turnover return to its past upward trajectory after a brief decline in 2016 due to idiosyncratic events and regulatory shifts. Among specific FX transactions, swaps and forwards expanded their share from 51% in 2010 to 64% bolstered by financial motivations global economy.

Among advanced economies, the dollar’s share of FX swap transactions was even higher than the overall derivatives market making up 90% of turnover. The transactions were supported by the three-most traded tenors, USD/EUR, USD/JPY, and USD/GBP. Smaller and more regional banks, which have little access to direct dollar funding, played a key role in bolstering FX swaps and providing an off balance sheet alternative for funding in foreign currencies. Meanwhile, on the opposite end, institutional investors reduced their role in EUR/USD and JPY/USD FX swap trades, as the flattening yield curve in the US reduced the attractiveness of Treasury positions hedged using such swaps.

Further volatility in the trajectory of US interest rates bolstered the dollar’s market share of interest rate derivatives as well. The shift from a tightening to accommodative bias between 2015 and 2019 was matched by a 141% growth in turnover, supporting the dollar’s 50% market share in interest rate derivatives. The euro also experienced a 148% growth in turnover, making up a 24% market share. Geographically, the dollar remained the preferred currency of choice for dealers in emerging markets, while growth in euro exposures was driven by greater interest from dealers in emerging Europe.

Emerging market currencies themselves boosted their turnover from 13% in 2013 to 23% in 2019. In FX markets, restricted currencies such as the Indian rupee, Indonesian rupiah, and the Philippine peso experienced dramatic growth as offshore markets for non-deliverable forwards deepened with greater market development. The Malaysian ringgit was an outlier, seeing a decline in turnover after authorities passed stringent regulations on domestic entities’ participation in offshore markets.

Similarly, the RMB saw a virtually stagnant turnover between the 2016 and 2019 surveys, seeing a fall in offshore turnover share from 73% to 64%. Such a decline was spurred by a variety of factors, including reduced liquidity as a result of both squeezes in 2016 and 2017 as well as a tightening of official controls on offshore RMB bond issuance. However, Chinese authorities expanded onshore channels such as Stock Connect, Bond Connect, and CFETS connect thus linking approved foreign investors to RMB-denominated financial products.

With respect to both advanced economies and emerging markets, derivatives activity has become more concentrated in traditional financial centers; New York, London, Hong Kong, and Singapore leading the global pack. These four cities’ collective share of global trading has growth from 65% in 2010 to 71% in 2016 and 75% today— a reflection of network effects. In particular, London’s share of euro-denominated turnover grew from 73% to 86%, while RMB turnover rose to 22% relative to Hong Kong’s 41%, thus overtaking Singapore as the largest RMB hub outside of Greater China.

In spite of the drastic macro changes that shaped market participants’ and governments’ actions, this decade may well be regarded as a conventional one with respect to its currency foundations. The dollar has maintained a dominant role in derivatives markets, as well as in other key reserve currency functions such as international debt issuance, central bank reserves, and trade invoicing. Meanwhile, its main rivals, the euro and the renminbi, both faced challenges of their own that limited their international appeal.

For much of the decade, the euro’s international prowess lagged the shadow of the Sovereign Debt Crisis and the potential for a breakup of the eurozone. Despite stabilization of activity and greater harmonization of core and periphery bond markets, the euro’s international clout will rest on the completion of politically sensitive financial reforms. With Christine Lagarde at the helm of the European Central Bank, these may very well be realizable as evidenced by German Finance Minister Olaf Scholz’s concession in November on a potential deposit insurance. Such reforms will need to be buttressed by the provision of a euro-denominated safe asset in adequate supply for official and private investors, likely through greater fiscal stimulus.

In the 2020s, the euro will likely face the stark binary of resolving these core issues or potentially facing another existential crisis. On the other hand, the renminbi’s nascent internationalization push was stifled by the harsh reassertion of official controls after the 2015 Financial Crisis. After verbal commitments to harsh deleveraging, authorities appear to be shifting their tone on the financial sector, promising greater openness to foreign players. Whether these reforms will be carried out in earnest may well be another matter, given the continued Chinese financial instability, which is best encapsulated in the government’s rescue of Baoshang Bank earlier this year. Beijing faces a monumental obstacles in its ongoing growth slowdown, as it challenges its political economy and raises serious questions about the future of the country’s capital markets. The next decade may well hold a subdued role for the renminbi, depending on how these problems are addressed.

Relative to currencies, the greatest shifts in the next decade may well take place in the financial centers in which they are processed. Of the four traditional financial centers, Hong Kong and London both face serious existential questions about their future role in international finance. Though London maintains a commanding share of euro-denominated derivatives, such flows are likely to be dependent on the extension of equivalence, which, as in Switzerland earlier this year, are likely to be politically contentious. A greater push for European oversight of UK participants may very well attract American regulators as well, thus setting the stage for a transatlantic showdown on the future of the global derivatives markets. Meanwhile, Hong Kong’s continued protests raise questions for intermediaries about the credibility of One Country, Two Systems and may spur its eventual demise, as Chinese onshore markets potentially gain greater foreign participation.

The past decade raised serious questions about the structure and functionality of global financial markets but left many uncertainties. Beyond these open questions, the 2020s are likely to see trends that will shape the structure of international financial markets. Similar to how financial technologies have driven an increase in network effects in derivative markets, the rapid advance of new payments platforms may very well do the opposite, thus relaxing some of the network effects associated with the dollar. 

Contingent on the proper reforms, the renminbi could be bolstered by China’s advanced mobile payments system providing faster real-time payments for its clients traditional banks have the capability to perform. Further, the trajectory of the trade war, coupled with the idiosyncratic challenges facing Hong Kong, could buttress existing regional financial hubs, such as Tokyo or Singapore, at Hong Kong’s expense. The trade war could also contribute to the creation of more economic epicenters as trade flows diffuse in new locations. For better or for worse, the 2020s will hold the answers to many, but not all, of the open questions of the 2010s.

Statements and views expressed in this commentary are solely those of the author and do not imply endorsement by Harvard University, Harvard Kennedy School, or the Belfer Center for Science and International Affairs.

Michael B. Greenwald is a fellow at Harvard Kennedy School's Belfer Center for Science and International Affairs. He is also a senior adviser to Atlantic Council President and Chief Executive Officer Frederick Kempe and North America Deputy Director of the Trilateral Commission. From 2015-2017, Greenwald served as the US Treasury attaché to Qatar and Kuwait.