Reserve Currency and Foreign Exchange Trading

In view of the recent stock market crashes across the globe, a number of financial analysts and foreign exchange traders are touting the more consistent earnings prospects in currency trading. According to them, in view of collapsing stock markets, shaky bond markets and falling commodity prices only the foreign exchange market remains unaffected in terms of prospective gains.  Whereas the investment moves to be made in stock, bond and commodities markets are restricted by today’s volatile and bearish economic outlook, forex analysts claim that foreign exchange trading offers investors the same legroom to maneuver their trades.  Whether the dollar rallies or dips, whether the Yuan crashes or soars, the earnings potential in foreign exchange trading remains.  The catch, however, is you need to be on the right side of the trade.  That means you need to know what you are doing.

If foreign exchange trading does offer great prospects for gains, what should an investor understand in order to trade well?

One fundamental concept to understand before jumping into forex trading is the nature of the United States Dollar, which is considered as the world’s most dominant reserve currency. It’s a common saying that when the United States sneezes, the whole world catches a cold.  By understanding the US Dollar along with other major currencies, the foreign exchange trader can have a better grasp of the direction of the foreign exchange market as a whole.

A reserve currency is a currency held by central banks to form a significant portion of their foreign currency reserves.  Governments and institutions have their FOREX reserves primarily in US Dollars today.  Next to the US dollar, the Euro, Pound Sterling, Japanese Yen, Swiss Franc, Canadian Dollar and Chinese Yuan are also held by central banks as part of their reserves.

In the face of severe market and economic uncertainties, investors tend to flock to the United States Dollar as a safe haven.  For example, the current race of national governments to depreciate their currencies against each other has taken the form of a currency war.  Because of this volatile state, some experts believe that the United States Dollar is bound to rally as investors run to it for safe haven.

However, it is also important to consider that severe market jolts, like a world war, for example, can utterly shake up the normal state of things. What was formerly a dominant currency can,in the face of such an event, be replaced by another.

For instance, prior to World War II, the Pound Sterling was considered the world’s reserve currency.  More than 60% of global trade was denominated in Pound Sterling.  The British funded investments around the world and London was the center of banking.  Great Britain was an empire that dominated trade, exporting its goods and services around the world.  The sun did not set on the vast expanse of British territories.

However, after World War II, a different economic landscape began to take shape.  The United States, having ended the war once and for all with the bomb, became the new reserve currency when all the nations, coming out of the war, agreed in Bretton Woods, to anchor the global financial system on the currency of the United States.  Apart from decisively ending the war, the United States’ economy had also grown and outpaced that of Great Britain.


Fast forward to the present state of the global economy, the US Dollar is facing a number of contenders vying for its reserve currency status – the most aggressive challenger being the Chinese Yuan.

Just last November 30, the IMF welcomed the Chinese Yuan to become a part of its Special Drawing Rights (SDRs) basket of currencies. The value of SDRs is calculated on a daily basis, from the basket of values of the US Dollar, Euro, British Pound, Japanese Yen and now, Chinese Yuan.  China is a major proponent of using SDRs for international payments.

China also recently launched the Asian Infrastructure Investment Bank.  Some experts view the AIIB as the beginning of the end of the current global financial system based on the Bretton Woods Agreement. The AIIB, stands to compete against the International Monetary Fund and the World Bank in terms of effectiveness and relevance to the international economy.

The United States aggressively campaigned against the AIIB in 2015.  Surprisingly, US allies such as Germany and Australia, and even China’s supposed enemies such as the Philippines, lined up to join the AIIB, despite the discouragement from the United States.

Forex traders need to consider these subtle shift in sentiments because a change in the global reserve currency is bound to shake the foreign exchange markets.  Knowing the general trend like what we do at LOM will contribute in making sure an investor is on the right side of the trade.




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