Dollar's vehicle role amplifies volatility, study finds
A Swiss National Bank working paper finds that the US dollar's role as a vehicle currency amplifies its own volatility. Cross-trades, where non-USD currencies are traded via the dollar, transmit shocks across the currency network.
Liquidity vs. volatility: A dollar dilemma
The US dollar is involved in 88 percent of global foreign exchange transactions, largely due to its role as a vehicle currency.
While this dominance enhances market liquidity and lowers transaction costs, the study reveals a systemic risk.
Information shocks between non-USD currencies can transmit to USD pairs when trades are executed via the dollar, ultimately increasing the USD's own volatility.
Researchers developed a novel methodology using high-frequency data from primary interdealer platforms to identify these USD cross-trades.
They show that such trades generate substantial price fluctuations in USD exchange rates, considerably greater than equivalent direct trades.
Increased cross-trading activity amplifies aggregate USD volatility by as much as 12 percent for a one standard deviation increase in cross-trading.
Unpacking cross-trade dynamics
The novel methodology identifies USD cross-trades using high-frequency data from primary FX spot interdealer platforms.
Cross-trades are defined as pairs of trades occurring within one second in two USD pairs, matching in size and direction, and being more cost-efficient than direct trades.
This allows for precise quantification of trading via the USD.
An information-based model, building on Lyons and Moore (2009), illustrates how cross-trades affect exchange rate volatility.
In this model, market makers observe only one leg of a cross-trade, leading to information asymmetry.
This mechanism allows increased volatility in a non-USD currency pair to spill over and generate higher price volatility in USD pairs.
A double-edged sword
This research provides crucial empirical evidence for a previously unidentified channel of volatility transmission.
While dollar dominance offers clear benefits in terms of liquidity, its role as a vehicle currency also exposes it to external shocks.
Policymakers must now consider this trade-off when assessing the broader implications of the dollar's central role in global financial markets.