Trade Networks and the Rise of a Dominant Currency

TL;DR

This paper presents a model explaining how trade networks and liquidity provision influence the rise and fall of dominant currencies, emphasizing feedback mechanisms and network effects.

Contribution

It introduces a novel model linking currency issuer liquidity, user preferences, and network effects to explain currency dominance dynamics.

Findings

Incumbent issuers maintain dominance through liquidity provision.

Network effects reinforce currency adoption and issuer commitment.

Conditions for the rise and fall of dominant currencies are identified.

Abstract

We develop a model where currency issuers provide liquidity, while users in a trade network choose currency usage for trade settlement. We identify a feedback mechanism where a user's currency preference spillovers to others and increases the issuer's commitment to liquidity provision, which in turn increases the adoption of the currency. Our findings highlight not only the advantage of the incumbent issuer in maintaining dominance, but also the conditions that lead to the rise and fall of dominant currencies. Our framework offers testable implications for the share of global settlement currencies, the network structure, and the strategy of issuers.