Special Drawing Rights in a New Decentralized Century

TL;DR

This paper explores how Decentralized Ledger Technology (DLT) can enable the IMF to expand Special Drawing Rights into a decentralized global reserve currency, enhancing stability amid geopolitical and economic uncertainties.

Contribution

It proposes a novel two-step approach for integrating SDRs with DLT, positioning them as a decentralized numeraire for international transactions.

Findings

DLT can mitigate risks in the current IMS.

SDRs can be expanded into decentralized currencies.

A two-step approach facilitates SDR integration with DLT.

Abstract

Unfulfilled expectations from macro-economic initiatives during the Great Recession and the massive shift into globalization echo today with political upheaval, anti-establishment propaganda, and looming trade/currency wars that threaten domestic and international value chains. Once stable entities like the EU now look fragile and political instability in the US presents unprecedented challenges to an International Monetary System (IMS) that predominantly relies on the USD and EUR as reserve currencies. In this environment, it is critical for an international organization mandated to ensure stability to plan and act ahead. This paper argues that Decentralized Ledger-based technology (DLT) is key for the International Monetary Fund (IMF) to mitigate some of those risks, promote stability and safeguard world prosperity. Over the last two years, DLT has made headline news globally and created a worldwide excitement not seen since the internet entered the mainstream. The rapid adoption and open-to-all philosophy of DLT has already redefined global socioeconomics, promises to shake up the world of commerce/finance and challenges the workings of central governments/regulators. This paper examines DLT core premises and proposes a two-step approach for the IMF to expand Special Drawing Rights (SDR) into that sphere so as to become the originally envisioned numeraire and reserve currency for cross-border transactions in this new decentralized century.

Full text

Special Drawing Rights in a New Decentralized Century111Paper proposal for the Georgetown University-International Monetary Fund Research and Policy Conference on Cryptoassets, 2018

Andreas Veneris222University of Toronto, Department of Electrical and Computer Engineering, and Department of Computer Science, 10 King’s College Rd, Toronto, Ontario M5S 3G4, Canada, tel: (416) 946-3062, veneris@eecg.toronto.edu and Andreas Park333University of Toronto, Department of Management and Rotman School of Management, University of Toronto, 105 St. George Street, Toronto, M5S 3E6, tel: (416) 946-3015, andreas.park@rotman.utoronto.ca

1. Introduction

Unfulfilled expectations from macro-economic initiatives during the Great Recession and the massive shift into globalization echo today with political upheaval, anti-establishment propaganda, and looming trade/currency wars that threaten domestic and international value chains. Once stable entities like the EU now look fragile and political instability in the US presents unprecedented challenges to an International Monetary System (IMS) that predominantly relies on the USD and EUR as reserve currencies [1, 2, 3, 4]. In this environment, it is critical for an international organization mandated to ensure stability to plan and act ahead. This paper argues that Decentralized Ledger-based Technology (DLT) is key for the International Monetary Fund (IMF) to mitigate some of those risks, promote stability and safeguard world prosperity. Over the last two years, DLT has made headline news globally and created a worldwide excitement not seen since the internet entered mainstream. The rapid adoption and “open-to-all” philosophy of DLT has already redefined global socioeconomics, promises to shake up the world of commerce/finance, and challenges the workings of central governments/regulators. This paper examines DLT’s core premises and proposes a two-step approach for the IMF to expand Special Drawing Rights (SDR) into that sphere so as to become the originally envisioned numeraire and reserve currency for cross-border transactions in this new decentralized century.

2. The Global Socioeconomic Impact of Crypto-Economics

The idea of “digital money” is not new but early attempts failed because they could not solve the double spending problem[5] — until Bitcoin. Building cryptographic-economic principles on a peer-to-peer (P2P) network, Bitcoin: (i) allows everyone to participate pseudo-anonymously, (ii) has a market-driven value, (iii) has low transaction fees that are determined by competition, (iv) allows fast settlement with no intermediaries, and (v) requires no central authority with jurisdiction over its operation. As users only need a smartphone to transact in Bitcoin, it is not surprising that it has been rapidly embraced in developing economies that lack legacy telecommunication or proper financial infrastructure.

Ethereum generalized DLTs to materialize the vision of “Decentralized Autonomous Organizations” [6]. It is the world’s first decentralized Turing Machine, a “social operating system” that guarantees trust in software execution in terms of smart contracts through P2P consensus. Such contracts enable commerce, trading of financial securities, automated supply-chain management, enforcement/transfer of digital rights, and transparent trade-offs between privacy and security [7]. Application sandboxes are already found in Ukraine, which examines to use Ethereum to conduct an election [8], Estonia, which develops a DLT-based e-residency to register out-of-country investments [9] and Dubai’s SmartCity, which awarded a blockchain contract to connect government and citizens [10]. The latest cryptographic “alt-coin” DLTs such as Zcash, Monero, or ZK-Snarks (Ethereum) ensure anonymity of network transactions, and protocols like Cardano and Algorand replace power wastage with crypto-economic consensus equilibria. Private permissioned blockchains such as Hyperledger and Corda use messaging to form endogenous DLT communities.

Its cross-border nature complicates and confounds the regulation of DLTs [11], resulting in capital and technology flows to jurisdictions with favorable regulatory regimes. What remains remarkable is that most DLT innovation was not driven by firms that chase profits or governments that seek a national advantage (i.e., for their military) but by freelance enthusiasts often coined as “cypherpunks.” Despite the ecosystem’s significant volunteer nature, its “distributed governance” so far has proven resilient and effective.

3. SDR as Unit of Account and Secondary Markets

In 1969, the USD was pegged to gold and in light of ongoing looming changes in US money supply the international community felt it necessary to phase in an alternative international reserve asset. The IMF thus established the Special Drawing Rights (SDRs) and later, as part of the Second Amendment to its Articles, the Fund members agreed that SDRs will become the principal reserve asset in the IMS.

Much has changed in international finance since the 1970s as currencies are no longer pegged to gold nor to one another. With exchange rates floating freely, the world economy has seen an unprecedented rise in trade and economic prosperity. At the same time, international trade/finance remains anchored to the USD and, to a lesser extent, the Euro, as primary reserve currencies. With this also came the Triffin dilemma, the international dependence on domestic US and EMU monetary policies. The recent decision of the US to start an international trade war to (presumably) address its domestic problems highlights once again the risk exposure of world trade and international finance to internal political shifts in reserve currency countries.

SDRs were originally intended (following the Second Amendment) as the unit of account for international settlements. An immediate advantage of the SDR’s denomination as a basket of five currencies is that its intrinsic value depends less on a single country’s political decisions allowing it to retain relative stability to any one of the currencies included in same basket. Common usage of SDRs would therefore reduce exposure to fluctuations in exchange rates and promote financial stability. For instance, since the basket expansion and US election in 2016, the brief historical data already show a convergence of SDR-to-gold pricing in the 875-925 SDR/oz range, a much tighter zone compared to that of each currency in the SDR basket against the metal. Despite this attractive characteristic and the large expansion of allocations in 2009, today SDRs are still practically irrelevant in international trade chiefly due to geopolitical and institutional reasons. Migrating SDR accounting to a permissioned DLT would promote wide adoption and help SDRs to finally fulfill their original mandate of serving as the unit of account in international settlements.

Specifically, current and future accounting of SDRs should migrate to a permissioned DLT with smart contracts [12] that: (i) allow automated and fully transparent, passive allocation-and-redemption of SDRs based on balance of payment demands, (ii) promote the emergence of secondary private markets around SDRs (such as SDR-denominated bonds and derivatives), and (iii) advocate SDR’s role as the unit of account for international settlements. Recent projects by the Bank of Canada (Jasper) and the Monetary Authority of Singapore (Ubin) have set successful technical sandboxes around which such a DLT-based accounting system can be built. At the same time, it is crucial that the new system is designed as forward-looking so as to ensure interoperability with existing permissionless DLTs (such as Ethereum) that can facilitate the creation of secondary private “alt-SDR” markets.

The benefits of a DLT-based SDR are multi-fold. Smart contracts are efficient mechanisms to execute international transactions with an automated 2-step conversion through an in-and-out process (e.g., Mexican Pesos to SDR to Danish Krone). By linking to an SDR platform, private businesses and the public can develop an automated, secure, and immutable ecosystem to handle and improve existing multi-layer complex exchanges that are cumbersome, slow, and excessively complex for them today with multiple single-country reserve currencies. The key feature here is the availability of the multi-denominational SDR and its stable intrinsic value, to promote usage in the public and private sector with the goal of reducing uncertainty/costs/complexities in large- and small-scale cross-border transactions.

As the acceptance of SDRs as a unit of exchange increases, there will be a natural increase of demand for SDR-related financial instruments. As recently witnessed within the Bitcoin and Ethereum ecosystems, a plethora of innovative financial products are expected to emerge in private secondary markets such as “alt-SDR” denominated bonds, futures, or forwards. This “phased-in” gradual development of a private “alt-SDR” security market will further help to establish SDRs as a formal numeraire in daily markets, without exerting abrupt pressure on the underlying basket of currencies, the existing currency reserves, or the stability of the IMS.

Historically, “hard” currencies are often used to store value in countries that face political instability and large exchange rate/price fluctuations. In today’s globalized economy, it is imaginable that people who don’t have access to a stable currency or worry about currency controls resort to using a “world currency” in denominating their daily commercial interactions. Ultimately, it is imaginable –and probably desirable– that “alt-SDRs” become an easily accessible “hard” currency for eligible small businesses and individuals.

4. SDR as a Currency Reserve

History indicates that a move to pragmatically establish SDRs as a reserve currency may require exorbitant political will by the IMF’s voting members. This paper argues that, in absence of acute economic turbulence, a thriving private secondary market in SDR related instruments will be the catalyst to reach agreement. The existence of such a market may ultimately require amending the Articles of the IMF so as to allow: (i) the issuance of SDRs under currency board rules, (ii) the establishment of substitution SDR accounts of reserve assets to provide liquidity, (iii) the development of further DLT-based financial instruments to ensure operation and transparency, and (iv) a gradual transition from the current basket of currencies to a basket of common goods and commodities. The first two points have been debated extensively in the prior literature, and we touched upon the third in the context of the preceding section. Although all four assertions are admittedly intertwined, in what follows we elaborate on the last one.

The purpose of SDRs is to facilitate trade-related international transactions and so instead of tying SDR to currencies that are subject to domestic monetary policies it is imaginable to tie its intrinsic value to a basket of commonly traded goods, commodities, and services that capture real basic human needs. Such a basket should include metals, oil, and natural gas, all of which have shown to already correlate well with present-day SDRs’ value. It should also contain standardized agricultural products such as wheat, corn, and soybeans. Finally, similar priority should be given in pricing metrics such as a water cost index [13], carbon emissions and generation/use of renewable energy. Because human needs change only slowly over longer time horizons when compared to currency exchange rates, such anchoring is expected to create more stability yet respect global growth and promote prosperity. Blockchain technology can ensure that money supply is transparent; moreover, all basket ingredients themselves would likely be tradable on financial markets as tokens, ensuring arbitrage-free pricing, and existing central bank currencies would float freely against the SDR. The pegged basket of goods will become the new “gold” standard, but without its shortcomings as it represents tangible modern human needs, and adheres to global agreed-upon constraints and requirements.

5. Conclusion

The evolution of premissionless DLT platforms such blockchain technology offers domestic and international monetary policy two choices: (1) disregard, regulate, and contain it so to maintain status quo, or (2) understand its intricacies and adapt existing practices [14]. The thesis of this paper is that macro-economic and political attitudes today place IMF at a central position to enhance SDR in a two-step process within a permissioned and permissionless DLT framework, shifting it closer to reserve currency status. Looking back at market charts of the music industry in the past 20 years indeed confirms that mishandling P2P innovation may backfire; only those who adapt lead the opportunity [15].