Implications of de-dollarization on US financial markets

Purpose The share of U.S. dollar reserves has declined in recent times. However, the concept of international currency markets remains poorly understood due to its several roles. This study examines the effect of reserve currency shares on U.S. financial markets through the lens of safe asset scarcity theory. One reason for examining this declining trend is that the implications of the U.S. economy and its currency for global financial risk cannot be overemphasized. Most recently (2007–2010), a downturn in the U.S. housing market catalyzed a global financial crisis. Design/methodology/approach To understand the implications of U.S. dollar reserves on U.S. financial markets, we developed a Dirichlet process mixture EGARCH (DPM-EGARCH) model to improve volatility estimation in the presence of leptokurtosis and asymmetric innovation. This model is advantageous because it captures the effects of both positive and negative returns. In addition, we test these implications using the safe asset scarcity theory, extending Caballero et al. (2016) to incorporate a boycott mechanism whereby coordinated strategic withdrawal from dollar-denominated assets creates heterogeneous convenience yields across investor types. Findings Using the Akaike information criteria and Bayesian information criteria, the DPM-EGARCH model performed better than the EGARCH (1,1) and NM-EGARCH (1,1), making it a useful choice for data that are leptokurtic with asymmetric innovations. We find that de-dollarization has a heterogeneous effect across U.S. financial markets. Results show that energy price volatility (NYHG and WTI) and market-implied uncertainty (VIX) are reduced by de-dollarization, while volatility increased for the DOW and DGS10 as a result. These findings suggest that a declining reserve share reallocates rather than uniformly amplifies financial risk, consistent with the view that reserve currency status confers differential stability across market segments. Originality/value This is the first study to examine the effect of reserve currency shares on U.S. financial markets using a Dirichlet mixture model judiciously coupled with the EGARCH model to effectively capture stylized features of financial data, such as asymmetric innovations, skewness, and kurtosis. We document a novel domestic transmission channel of reserve currency dynamics, showing that changes in the U.S. dollar's reserve share systematically affect volatility within U.S. financial markets. Additionally, we model financial market volatility as an equilibrium outcome of global safe asset scarcity, demonstrating that de-dollarization-induced scarcity operates through market fragmentation, elevated convenience yields, and forced portfolio reallocation rather than traditional demand-supply imbalances.