Around the turn of the century, currency traders, hedge funds and heavy-hitting economists obsessed over central banks’ foreign exchange reserves.

The euro was a baby, and backers faced a daunting task raising it as a currency with global impact, enmeshed in international trade and investment. Any data suggesting it was eating into the dollar’s dominance in global central banks’ coffers was taken as a sign of progress towards that aim, and produced abrupt shifts in the euro’s exchange rate.

It was an obsession, not without foundation, that proved lasting. In the Greek debt crisis that peaked in 2012, one of the reasons behind shouty (and faulty) predictions that the euro would drop below parity against the dollar was that central bank reserve managers could lose faith in the legal and political framework behind the European currency, and eject it from their rainy-day reserves.

Central bank reserve diversification became a go-to explanation for any hard-to-fathom intraday currency move. Euro picking up? Ask a trader and he (it was invariably “he”) would often tell you “Boris” (ie Russia) or another central bank was buying. Or maybe China was nixing dollars from its reserves.

Russia’s invasion of Ukraine brings this market preoccupation, which had laid largely dormant for several years, back to the fore. The US, in its effort to punish Russia for the Ukraine conflict, has made spectacular use of its “exorbitant privilege”, as Valéry Giscard d’Estaing, the former French president and finance minister, controversially put it in the 1960s.

As the dollar-baiters of two decades ago frequently observed, the global role of the dollar, its outsized share in world trade and its dominance of financial markets, confers enormous power on the US to use sanctions to bend geopolitics to its will.

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

Decent questions. But in the market’s view, what matters is that sanctions by the US and its allies on Russia’s central bank will prompt other countries that are not geopolitically aligned with the US to rethink holding so many bucks on their books.

Goldman Sachs’ currency analysts said “the result could be dollar depreciation”, adding that they had seen “lots of client interest” in this theme. It is one into which hedge funds could really sink their teeth.

Then again, the US investment bank warns against getting overly excited. “We should stress that the structure of currency markets will not change overnight, and there are many interrelated reasons why the dollar maintains its dominant global role,” it said.

There’s another reason not to bet the farm on an imminent dollar collapse: the US did not freeze Russia’s reserves on its own. Officials involved in crafting the sanctions against Russia knew they would work best in conjunction with the EU, UK and other G7 nations.

So, sure, Moscow, or another prickly regime, can in future shy away from dollars, but go where instead? Russia cannot shift to euros, sterling or yen given that payment sanctions extend to those as well. It could eschew them all, but then its funds for buying essentials or defending the rouble would all be in currencies with limited international use. In addition, opting for the renminbi to avoid politically motivated freezes seems rather naive.

Still, the potential for this to diminish the dollar’s reserve status is real. The implications are potentially profound and could take years to become fully clear. Gita Gopinath, deputy managing director at the IMF, has spoken of the potential that the global financial system could “fragment”.

Previous market fixations on this issue suggest that, despite the tectonic pace of change, traders will keenly spot short-term opportunities.

An IMF study last month, addressing the “stealth erosion of dollar dominance”, offers clues to where those opportunities lie. The dollar’s place in international reserves has clearly shrunk since the turn of the century, from 71 per cent in 1999 to 59 per cent in 2021, the IMF said, reflecting “active portfolio diversification” by central banks.

Intriguingly, the share of reserves in the other “Big Four” currencies — sterling, the yen and the euro — has not picked up the slack. “Rather, the shift out of dollars has been in two directions: a quarter into the Chinese renminbi, and three-quarters into the currencies of smaller countries that have played a more limited role as reserve currencies,” the IMF said.

More availability of easy-to-trade assets and slicker trading technology have made it easier to snap up Australian and Canadian dollars, the Chinese renminbi and a clutch of Nordic currencies.

“Reserve currency competition is usually framed as a battle of giants,” the IMF said. In fact, the issue is not whether the dollar will be replaced, but whether smaller currencies take a bigger slice of the pie.

The next time a small currency jumps for no obvious reason, expect this to be offered as the explanation.

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