What is a reserve currency?
Reserve currencies refer to any government-issued currency (fiat currency) that multiple central banks store in large quantities. Countries primarily use reserve currencies for investment and trade. Since reserve currencies are easily accessible, they are the most liquid means of exchange for international transactions.
While reserve currencies are closely associated with central banks, they are crucial in the private sector. Multinational businesses, financial firms, and private investors hold reserve currencies on their balance sheets. Companies and individuals often use reserve currencies to preserve purchasing power or avoid foreign exchange (forex) fees.
Interestingly, no laws give foreign currencies a "reserve status." Throughout history, nations with the highest GDP and robust trade networks were those defining the world's reserve currency. For instance, the Dutch guilder gained prominence as the Netherlands expanded its trade routes in the 17th century. Before that, Spain and Portugal had the most widely used currencies.
In addition to coming from a geopolitically strong country, a reserve currency must be highly liquid—it can be quickly bought or sold at value. The most dominant reserve currencies are easily convertible into other assets, making them convenient trade and investment vehicles.
Although reserve currencies are the most actively traded currencies, it doesn't mean they're the "strongest" currencies. The market price of a fiat currency depends on multiple factors, including a nation's inflation percentage, interest rates, and political stability. Even though the U.S. dollar is widely held in reserves, competing currencies have higher purchasing power, such as the British pound and the Chinese yuan.
How big are reserve currencies in the global economy?
According to the International Monetary Fund (IMF), there is currently $12 trillion in global reserves. Of this $12 trillion, 59% is USD. The euro is the second largest reserve currency at 19.6%, followed by the Japanese yen at just over 5%.
The People's Bank of China holds the largest fiat reserve at over $3 trillion. Japan and Switzerland are the only other nations with over $1 trillion each in reserve currencies.
When did the USD become the world reserve currency?
Formally, the USD became the world's reserve currency after the Bretton Woods Agreement of 1944. The 44 representatives at this New Hampshire conference established many organizations and policies that continue to influence international trade. Most significantly, Bretton Woods attendees agreed to use the USD as the global standard for foreign exchange rates. To this day, every fiat currency and commodity is priced against the USD.
Although Bretton Woods cemented the USD's status as a global reserve currency, the greenback had already grown in importance over the previous decades. Arguably, the two world wars were the primary reason behind the USD's status in the 20th century. During these global conflicts, dozens of nations took their national currencies off the gold standard to pay for war expenses. More countries than ever before sent gold to the U.S. in exchange for equipment, food supplies, and bonds.
It's important to note that the U.S. remained on the gold standard throughout WWI and WWII. The Gold Reserve Act of 1934 established the USD's worth at $35 per troy ounce of gold. This "gold-backed" status was another reason countries felt comfortable holding the U.S. dollar as a reserve currency.
The USD held its gold-backed status until President Nixon introduced his New Economic Policy. Due to increased money printing during the Vietnam War, the USD began to lose its value relative to gold. More foreign nations began redeeming their USD reserves for equivalent gold bars to reduce their risk of geopolitical conflicts. The U.S. government abolished the gold standard to stop foreign nations from swapping USD for gold.
Although the end of the gold standard triggered a drop in the USD's value, the dollar remains the primary global reserve currency. Since all commodities and foreign currencies are pegged to the USD, it’s easiest for nations to use this currency in business. In fact, estimates from the Bank for International Settlements (BIS) suggest 88% of all forex transfers are between the USD and another currency.
What was the world reserve currency before the U.S. dollar?
The U.K.'s pound sterling was the world's reserve currency before the USD. The combination of the Industrial Revolution and Britain's colonial empire increased the sterling's prominence on the world stage. However, the U.K. ended its gold standard in 1931 to address the Great Depression. As America's GDP grew and the U.K. borrowed to fund World War II, the sterling lost its preeminent role as a world reserve currency. However, the Great British pound still accounts for 5% of total reserves.
What are the USD's biggest rivals?
In terms of the percentage held in reserves, the euro is the USD's biggest rival. First introduced in 1999, the euro is now the official currency of 20 member countries in the Eurozone. The European Central Bank (ECB) manages the monetary policy for the euro, similar to the Fed for the USD.
IMF estimates suggest there is $2.4 trillion worth of euros held in reserve. By comparison, central banks have roughly $7 trillion in USD.
Some financial analysts also believe China's renminbi could eventually challenge the USD. Although the renminbi is less widely held as a reserve currency, the Chinese economy is one of the fastest growing in the world. Not only does China have the second-largest GDP, but it also has the world's largest population. Plus, the Chinese government holds the largest amount of reserves. If the Chinese economy continues to expand, the renminbi could become increasingly competitive in international trade.
Can Crypto become a global reserve currency?
Many crypto enthusiasts believe Bitcoin or another crypto will unseat the USD to become the new global reserve currency. Some nations, such as El Salvador, have already adopted Bitcoin as legal tender and hold BTC in their reserves. Harvard economists also suggest Bitcoin's finite supply could make it an attractive alternative asset for central banks.
Bitcoin's creator, Satoshi Nakamoto, initially intended BTC to be a peer-to-peer payment network. Although BTC has gained a reputation as "digital gold," it's unclear how many central banks will accept the "Bitcoin standard." And while more governments may adopt BTC in their reserves, crypto remains a highly speculative asset class. Many nations are still concerned with Bitcoin's price volatility and legal status.
Presently, most countries are more interested in transforming their fiat currencies into cryptocurrencies rather than adopting Bitcoin. Central Bank Digital Currencies (CBDCs) use the same blockchain technology as other cryptos, but central banks have privileged access over their supply and issuance.
The U.S. is already working on a CBDC known as the Federal Reserve Digital Dollar. China and the ECB are working on CBDCs for the renminbi and euro. If more nations adopt CBDCs, they may compete with decentralized cryptos like Bitcoin for global reserve status, as they are far easier to transact and access than traditional currencies
There's no denying the USD's influence on the global economy. Even without the backing of physical gold, the USD accounts for over half of the reserves held in central banks. U.S. dollars are also the dominant currency for international finance, trade, and forex. Although there are viable rivals, most economists agree the USD will remain a competitive currency in the 21st century.
Interestingly, the USD has also become an integral part of the crypto ecosystem. All of the most influential crypto stablecoins are pegged 1:1 with the USD. While centralized firms issue the world's largest stablecoins (like USDT and USDC), there are a few experimental projects like DAI. Built on the Ethereum blockchain, DAI is a decentralized stablecoin that uses crypto collateral to maintain its peg.
Worldcoin believes tokens like DAI will play a defining role in the emerging decentralized finance (DeFi) ecosystem. To learn more about claiming free DAI stablecoins, download Worldcoin's World App and subscribe to our YouTube channel.