A reserve currency is a currency that central banks hold as part of their foreign exchange reserves.
Reserve currencies, also known as “foreign exchange reserves,” are used for international transactions, investments, and to maintain stability in the global financial system.
They are typically characterized by their stability, liquidity, and wide acceptance in international trade and finance.
The U.S. dollar emerged as the global reserve currency after the Second World War.
What are reserve currencies?
The primary purpose of holding reserve currencies is to support a country’s own currency by maintaining its value and ensuring it can be exchanged for goods and services in international trade.
Additionally, central banks use reserve currencies to intervene in foreign exchange markets to stabilize exchange rates, manage inflation, and mitigate financial crises.
Reserve currencies are always strong currencies with a major role in international trade.
The U.S. dollar is currently the most widely used reserve currency, followed by the euro, the Japanese yen, and the British pound
They’re often also defined as a “hard currency” or “safe-haven currency“, as these have a more stable value than less commonly used currencies, which allows them to be used as a store of value.
What are examples of reserve currencies?
The history of reserve currencies can be traced back to ancient times when various civilizations used commodities such as gold and silver as a store of value and medium of exchange for trade.
Throughout history, several currencies have held the status of the world’s dominant reserve currency, reflecting the economic and political power of their respective issuing countries.
- Byzantine solidus (4th-11th centuries): The solidus, a gold coin introduced by the Byzantine Empire, was widely recognized and accepted throughout Europe, North Africa, and the Middle East.
- Florentine florin (13th-15th centuries): The florin, a gold coin minted in Florence, Italy, gained prominence in international trade during the late Middle Ages, thanks to the powerful Florentine banking system.
- Venetian ducat (13th-16th centuries): The ducat, another gold coin, was minted in Venice and became the dominant reserve currency in the Mediterranean region due to Venice’s prominent role in international trade.
- Dutch guilder (17th-18th centuries): The Dutch guilder emerged as the reserve currency during the Dutch Golden Age when the Netherlands was a leading global economic and financial power.
- Spanish real (16th-18th centuries): Spain’s silver real became a prominent reserve currency during the Age of Exploration, as Spain’s empire expanded and its silver mines in the Americas flooded global markets with silver.
- British pound sterling (19th-20th centuries): The pound sterling rose to prominence during the British Empire’s height, underpinned by the United Kingdom’s economic, political, and military power. The gold standard further reinforced the pound’s status as a reserve currency.
- U.S. dollar (20th century-present): After the Bretton Woods Agreement in 1944, the US dollar was pegged to gold, and other currencies were pegged to the dollar, leading to its dominance as the world’s primary reserve currency. The US dollar’s status was further solidified after the Bretton Woods system collapsed in 1971, and currencies began to float freely against one another.
Currently, around 56% of global foreign exchange currency reserves were held in U.S. dollars, followed by the euro at 20%, the British pound at 5%, and the Japanese yen at 5.5%.
The dominance of the U.S. dollar as a reserve currency is due to factors such as the size and stability of the U.S. economy, the liquidity of its financial markets, and the widespread use of the dollar in international trade and finance.