The US Dollar's Structural Dominance in FX Markets Amid Tariff-Driven Volatility

The U.S. dollar's entrenched role in global foreign exchange (FX) markets remains unshaken, even as trade policy uncertainties and geopolitical tensions have intensified volatility in 2025. Despite a 10% decline in the dollar's value year-to-date, it continues to feature in 89% of all FX transactions, a marginal increase from 88.4% in prior surveys. This structural dominance is reinforced by the dollar's unparalleled liquidity and the institutional depth of U.S. financial markets, which remain the bedrock of global trading and hedging activity according to recent analysis. However, the interplay between tariff-driven volatility and the dollar's centrality has spurred a surge in hedging activity, while liquidity hubs like New York and London have adapted to shifting dynamics. For investors, understanding these trends is critical to navigating a landscape where policy risks and market fragmentation loom large.

Tariff Volatility and the Surge in Dollar-Based Hedging Instruments

The U.S. government's aggressive tariff announcements in early 2025 triggered a wave of hedging activity, as corporations and financial institutions sought to mitigate currency risk. According to the Bank for International Settlements (BIS), forex swaps-the most traded hedging instrument-saw an average daily turnover of $4 trillion in April 2025, though their share of global turnover declined to 42% from 51% in 2022. Outright forwards, used to lock in future exchange rates, experienced a 60% increase in turnover, accounting for 19% of total FX transactions. Meanwhile, the use of forex options for hedging nearly doubled, contributing 7% of global turnover.

This surge in hedging demand was driven by the dollar's depreciation against a basket of currencies, prompting institutional investors to deploy forwards to curb further losses. The Federal Reserve's divided outlook on interest rates further amplified uncertainty, spurring a spike in swaption activity. Implied volatility on three-month swaptions tied to 10-year swap rates peaked at 22.23 basis points in November 2025, as traders sought protection against potential rate cuts. Open interest in SOFR options also rose, reflecting heightened demand for tools to hedge against short- and long-term policy shifts.

Liquidity Hubs: Adaptations and Structural Vulnerabilities

New York and London, the twin pillars of global FX liquidity, have recalibrated their operations in response to 2025's volatility. In New York, the Treasury market faced temporary liquidity deterioration following April's tariff announcements, with bid-ask spreads widening and order book depth declining. However, liquidity metrics normalized after the postponement of new tariffs, aligning with historical patterns of volatility. The Federal Reserve's Financial Stability Report highlighted cross-margining practices and the concentration of client clearing services through central counterparties as potential risks.

London's liquidity infrastructure, meanwhile, grappled with structural shifts in the silver market. A 53.88 million troy ounce import of silver into London vaults in October 2025-driven by ETF liquidations-exposed vulnerabilities in traditional clearing pools. The Bank of England (BoE) has flagged rising risks from global trade fragmentation and sovereign debt pressures, which could further strain liquidity dynamics. In response, London's FX market has seen a shift toward direct, relationship-driven trading platforms, with banks and clients prioritizing minimum variance portfolios (MVPs) over fragmented market access.

Strategic Positioning for Investors

For investors, the dollar's structural dominance and the surge in hedging activity present both opportunities and challenges. The BIS's triennial survey underscores that the dollar's role in global trading is unlikely to wane, given its liquidity and institutional infrastructure. However, the IMF's Global Financial Stability Report warns that concentrated dealer activity and currency mismatches could amplify volatility during periods of stress.

Strategic positioning should prioritize flexibility in hedging strategies. North American fund managers have already extended hedging horizons and increased automation in FX processes to manage risk more effectively. Similarly, investors should monitor liquidity hubs for signs of fragmentation, particularly in London's silver and FX markets. Diversification across hedging instruments-such as a mix of forwards, swaps, and options-can provide a buffer against policy-driven shocks according to the BIS survey.

Conclusion

The U.S. dollar's structural dominance in FX markets remains intact, but its role as a hedging anchor is being tested by tariff-driven volatility and evolving liquidity dynamics. While New York and London have adapted to these challenges, structural vulnerabilities persist. For investors, the path forward lies in leveraging dollar-based hedging instruments with precision and maintaining a keen eye on liquidity hubs. As the IMF and BoE caution, the interplay between policy uncertainty and market fragmentation will shape the next phase of global financial stability.