Convertible Currency

What Is a Convertible Currency?

A convertible currency is any nation's legal tender that can be easily bought or sold on the foreign exchange market with little to no restrictions. A convertible currency is a highly liquid instrument as compared with currencies that are tightly controlled by a government's central bank or other regulating authority.

A convertible currency is often referred to as a hard currency.

How a Convertible Currency Works

There are hundreds of fiat currencies around the world, however, some are more stable and liquid than others. Fully convertible currencies are those typically backed by nations that are economically and politically stable. For example, the most tradable currencies in the world are, in order, the U.S. dollar, the Euro, the Japanese Yen, and the British pound. Convertible currencies are useful to forex investors because they can be confident these currencies' prices are relatively stable in the short term.

The level of convertibility of a nation's currency is also an important concept in the field of international trade. For example, a company would much rather do business in a nation whose currency has a high level of convertibility so it can protect itself from paying unexpected fees or jumping through regulatory hoops. Dealing with a fully convertible currency allows companies to do business across borders with confidence and gives them access to transparent pricing. Also, a convertible currency is more liquid, which reduces volatility. 

On the other hand, developing countries or those with more authoritative governments are more likely to place restrictions on the exchange of their currency with another. Currencies from these countries are typically less stable and may come from economies with high inflation rates. Non-convertible currencies are also more illiquid.

Types of Convertible Currencies

Fully Convertible

Perhaps because major fiat currencies are no longer tied to the gold standard, the popularity of foreign exchange trading has increased in recent years. However, for the most part, currencies such as the U.S., Canadian, and Australian dollar, along with the Japanese Yen, Euro, and British pound still account for the vast majority of trading.

One major advantage of the U.S. dollar is that central banks hold it as their main reserve. Furthermore, a number of asset classes are denominated in U.S. dollars, meaning payments and settlements are made in U.S. dollars.

Partially Convertible

Currencies such as the South Korean won and Chinese Yuan are known as partially convertible currencies. A partially convertible currency is the legal tender of a country that is traded in low volumes in the global foreign exchange market. The governments of these countries place capital controls that limit the amount of currency that can exit or enter the country.

Non-convertible

Nearly all countries have currencies that are at some level at least partially convertible. However, currencies such as the Brazilian real, Argentinian peso, and Chilean peso are considered non-convertible because it is virtually impossible to convert them into another legal tender, except in limited amounts on the black market.

Convertible Virtual Currency

The rise in popularity of cryptocurrencies in recent years has brought about yet another term: convertible virtual currency. This refers to digital currencies such as bitcoin, Ether, and Ripple, which are unregulated but can be used as a substitute for real and legally recognized currency even though they do not have the status of legal tender.