At the turn of the century, foreign exchange traders, hedge funds and heavyweight economists were fascinated by central bank reserves.

The euro is still a baby, and proponents face the difficult task of elevating it to a currency with global reach and integration into international trade and investment. Any data that suggests the greenback is eroding its dominance in global central bank coffers is seen as a sign of progress towards that goal and leads to a sudden shift in the euro’s exchange rate.

It’s an obsession, not without foundation, that proves to be enduring. One of the reasons behind the high-profile (and erroneous) predictions that the euro would fall below parity against the dollar during the Greek debt crisis that peaked in 2012 was that central bank reserve managers may have lost confidence in the legal and political framework behind the euro and put it on the table. Pop out of a rainy reserve.

Central bank reserve diversification becomes the preferred explanation for any incomprehensible intraday currency movement. Euro recovering? Ask a trader and he (always “he”) will often tell you that “Boris” (i.e. Russia) or another central bank is buying. Or maybe China is reducing dollars from its reserves.

The Russian invasion of Ukraine has resurfaced this market concern that has been largely dormant for several years. As former French president and finance minister Valéry Giscard d’Estaing argued controversially in the 1960s, the United States has made good use of its “excessive” efforts to punish Russia for the Ukrainian conflict. privilege”.

As dollar decoyers often observed two decades ago, the dollar’s global role, its huge share of world trade, and its dominance in financial markets give the United States enormous power to use sanctions to bring geopolitics to its knees at your own will.

Now, you can argue whether this is appropriate. What if a less predictable White House uses that privilege in more contentious cases in the future? Should any country have this power to use money as a weapon?

Decent question. But in the eyes of the market, it is important that sanctions against the Russian central bank by the United States and its allies will prompt other countries that are not geopolitically aligned with the United States to reconsider holding so much money on their books.

Currency analysts at Goldman Sachs said “the result could be a weaker dollar”, adding that they had seen “a lot of client interest in this theme.” This is one that hedge funds can really invest in.

Then again, the U.S. investment bank warned against getting too excited. “We should stress that the structure of currency markets does not change overnight, and there are many reasons why the dollar retains its global dominance,” it said.

Another reason not to bet the farm on the dollar’s impending collapse: The U.S. isn’t freezing Russia’s foreign-exchange reserves alone. Officials involved in developing sanctions against Russia know they are best off working with the European Union, Britain and other G7 nations.

So, of course, Moscow or another tricky regime could shun the dollar in the future, but where? Given that payment sanctions also apply to these, Russia cannot turn to euros, pounds or yen. It can avoid all of that, but the money it spends on buying necessities or defending the ruble will all be in the form of a currency with limited international use. Furthermore, choosing the yuan to avoid a politically motivated freeze seems rather naive.

Still, the possibility that this will weaken the dollar’s reserve status is real. The implications could be far-reaching and could take years to become fully clear. IMF Deputy Managing Director Gita Gopinath has spoken of the possibility that the global financial system could be “broken.”

Previous market attention to the issue suggests that traders will remain keenly aware of short-term opportunities despite the accelerating pace of structural change.

one International Monetary Fund Research Last month, addressing the “stealth erosion of the dollar’s dominance” provided clues as to where these opportunities lie. The IMF said the dollar’s role in international reserves has declined markedly since the turn of the century, from 71% in 1999 to 59% in 2021, reflecting “aggressive portfolio diversification” by central banks.

Interestingly, the reserve shares of the other “big four” currencies – GBP, JPY and EUR – do not make up for this shortfall. “Instead, the dollar has moved in two directions: one-quarter to the renminbi, and three-quarters to the currencies of smaller countries that have a more limited role as reserve currencies,” the IMF said.

More easily tradable assets and more flexible trading technology have made it easier to snap up Australian and Canadian dollars, Chinese yuan and a range of Nordic currencies.

“The reserve currency competition is often seen as a battle of giants,” the IMF said. In fact, the question is not whether the dollar will be replaced, but whether the smaller currencies will get a larger share.

The next time the small currency jumps for no apparent reason, expect that to be the explanation.