The author is a professor of economics and political science at the University of California, Berkeley

The decision by the United States and its allies to freeze Russia’s foreign exchange reserves has sparked a heated debate about the future of the international monetary system.

This debate is raging because the stakes are high, and at least 75 years, and World War II, because a similar decision was made – and then the system shifted. However, this debate is confusing because it ignores what is actually happening in the global monetary system.

Despite repeated references to “dollar dominance,” the U.S. dollar’s ??share of the world’s identified foreign exchange reserves has been on a 20-year downward trend, from just over 70% at the turn of the century to just 59% in the third quarter of the century . 2021.

This trend is not the result of changes in currency or interest rates affecting the value of different reserve assets. It also did not reflect the dollar aversion to the accumulation of large reserve balances by a few banks. Rather, it is the result of numerous central banks’ efforts to diversify away from the dollar.

Now comes the surprise. The diversification does not target the euro, sterling and yen, which are other long-term components of the IMF’s SDR basket, a multi-currency reserve asset. The collective reserve share of these currencies has remained largely unchanged for two decades.

Also, only a quarter of the renminbi transferred to China, which joined the SDR in 2016.A full three-quarters are transferred to the currencies of smaller economies such as Canada, Australia, Sweden, South Korea and Singapore, as work documents For the IMF show I co-authored.

What explains the rise in these currencies? First, their markets have become more liquid. Historically, only a few countries have had deep and liquid markets open to the rest of the world. Forex traders can only find counterparties in a few currencies. In reality, it’s mostly U.S. dollars, but also EUR, GBP, and JPY. These are units that are used as instruments for international transactions, so central banks hold them as reserves.

But with the advent of electronic trading platforms and new technologies for automated market making and liquidity management, the cost of trading in affiliated currencies has fallen. We see this in the bid-ask spreads in the subordinate currencies, which are now as low as EUR, JPY and GBP – and sometimes even lower.

Second, central banks have become more aggressive in chasing returns. Reserve portfolios are larger, increasing the stakes.

Third, and relatedly, low yields on bonds of major reserve issuers have fueled the search for alternatives. Non-traditional reserve currencies often offer attractive volatility-adjusted returns relative to traditional reserve currencies.

As a result, we have seen a move towards a more multi-polar international monetary system – rather than the three-polar system dominated by the dollar, euro and renminbi that many observers expected.

Recent events may accelerate diversification. As far as Russia is concerned, it is true that all indirect reserve issuers, with the exception of China, are actively involved in reserve freezing. Therefore, Russia’s long-term shift to non-SDR reserve currencies has not provided it with a safe haven.

However, now that the sword of freezing reserves has been drawn, we can also imagine a scenario in which the United States freezes one country’s reserves, while other governments do not. In this case, diversification of additional reserves in the target country may provide insurance benefits.

How about faster diversification of the renminbi? Anyone planning to move reserves in this direction must consider the possibility that China could be subject to secondary sanctions. In addition, Putin’s behavior is a reminder that authoritarian strongmen can be headstrong when there is a lack of checks and balances at home. President Xi Jinping has shown little willingness to intervene in PBOC operations, and there is no guarantee he will maintain that stance in the future. It is no coincidence that every major reserve currency issuer in history has had a republic or democratic form of government, constrained by executive power.

Russia’s reserve managers have no choice but to turn to the People’s Bank of China, as long as it continues to grant them access. But for other central banks, an ironic consequence of the U.S. decision to weaponize the dollar may actually be slowing international absorption of the yuan.