Vehicle currency

Suppose an Indian company needs Philippine pesos. There is hardly any direct rupee-peso market. So the company sells rupees for US dollars, then sells the dollars for pesos. The dollar is the vehicle that carries the money from one currency to the other.

The workbook explains that for most pairs of currencies, market practice is to trade each of them against a common third currency rather than against each other. The vehicle currency used most often is the US dollar, though EUR has recently become important too.

It is two transactions instead of one, and still usually cheaper. The USDINR and USD-peso markets are far more active and liquid, with better information, than any bilateral rupee-peso market could be.

Why markets use one. Banks can hold most of their working balances in the vehicle currency rather than managing many currencies, and can concentrate research on it. The workbook sums up the advantages: fewer, larger and more liquid markets, fewer currency balances, reduced information needs and simpler operations.

The arithmetic of fewer markets. With n currencies and no vehicle, every currency must trade against every other:

The link to the dollar's dominance. Chapter 1 lists the dollar's roles as investment, reserve, transaction, invoice and intervention currency — and vehicle currency, a use that "reinforces its international role in trade and finance". The BIS April 2022 survey the workbook reproduces puts USD on one side of 88.4% of global FX turnover (out of 200%, since each trade has two currencies).

The link to cross rates. Because non-dollar pairs route through the dollar, their prices are usually derived as cross rates from two dollar pairs.

Pairs without a vehicle currency = n(n − 1) / 2
Pairs with one vehicle currency  = n − 1

Illustrative. The company, the amount and the peso rate are hypothetical; the USDINR offer of 75.65 is the workbook's quote.

Mehta Textiles must pay a supplier in Manila PHP 5,00,000. No bank offers a liquid INR-PHP quote, so it routes through USD.

Suppose USD-PHP is 56.00 (pesos per dollar, the bank's rate for selling pesos to the company).

Dollars needed = 5,00,000 / 56.00        = USD 8,928.57
Rupees needed  = 8,928.57 × 75.65        = Rs 6,75,446

Two trades — INR→USD, then USD→PHP — but each in a deep, competitively priced market.

The count of markets. If the world had only 10 currencies, removing the vehicle would multiply the pairs banks must quote from 9 to 45. At 100 currencies it would be 99 versus 4,950.

Chapter 1, section 1.2.1 (Major Currencies), explains the vehicle currency within the description of the US dollar, including the INR-to-peso example and the 10-currency and 100-currency counts. It is a natural source for a formula question (n(n−1)/2) and for "why is USD so widely traded" questions.

• 45, not 90. A pair counts once; n(n−1)/2 for 10 currencies is 45.
• With a vehicle, pairs = n − 1, because the vehicle does not trade against itself.
• The most-used vehicle is USD; the workbook notes EUR has also become important recently.
• Using a vehicle means two transactions, but in more liquid markets — the workbook presents this as the preferred route, not a disadvantage.
• Currency shares in the BIS table add to 200%, because every trade involves two currencies.