More than 85% of all foreign exchange (FX) transactions have the US dollar on one side. I show that the US dollar dominates FX trading volume because of strategic avoidance of price impact. To demonstrate this, I exploit that non-dollar currency pairs can be traded indirectly by using the US dollar as an intermediate ‘vehicle’ currency. I present a model of FX trading that embraces this idea and derive a set of sufficient conditions for dollar dominance. I then empirically test these conditions using a granular FX trade data set and provide evidence that is consistent with my model. To establish causality, I show that dollar dominance increases by 7% after quasi-exogenous spikes in the liquidity of dollar currency pairs occurring on days with scheduled US monetary policy announcements.​

J.E.L. classification: F31, G12, G15

Keywords: Dollar dominance, Foreign exchange, Price impact, Strategic complementarity, Trading volume​