Forget about the IMFcoin. Have you heard of SDRs?
The Wall Street Journal posted an article entitled “Forget Bitcoin. Have You Heard of IMFcoin?” While the piece makes for an interesting read, it is misguided in its belief that the International Monetary Fund (IMF) wants to create an alternative to Bitcoin or other decentralized cryptocurrencies. We’d like to set the record straight on what the SDR is and does and offer our vision for a digital SDR in a series of posts.
For starters, the IMF is not a central bank charged with issuing a global fiat currency. The IMF is a Bretton Woods institution created to ensure the stability of the international monetary system — the system of exchange rates and international payments that enable cross-border transactions.
Contrary to the WSJ article’s claim, the SDR is neither an international currency nor a claim on the IMF, which would be the case for central banks issuing fiat currencies. Instead, the SDR is a potential claim on the five currencies that make up the so-called “currency basket” — the USD, Euro, Japanese yen, Pound sterling, and the Chinese RMB. The only attempt to create a supranational global currency, the bancor, was rejected during the Bretton Woods Conference in 1944 in favor of a pegged exchange rate system.
The role of the SDR
Under the pegged exchange rate system, gold and the U.S. dollar grew increasingly insufficient to meet the financing needs of an expanding global trade system. Creating the SDR as an international reserve asset to supplement the IMF members’ official reserves was supposed to offer a viable way to manage liquidity in the global monetary system.
The Bretton Woods system of pegged exchange rates eventually evolved into the more market-driven floating exchange rate system we see today. These developments meant the end of convertibility of dollars into gold at a fixed price and enabled creditworthy governments to borrow more from international capital markets. As a result, countries accumulated significant amounts of international reserves and did not need to rely on the SDR for liquidity purposes.
In addition to its role as a global reserve asset, the SDR serves as the unit of account for the IMF and other international organizations. The SDR can be used to denominate financial instruments across borders and organizations in the same unit of account, making transactions easier and lowering the exposure to foreign exchange (FX) risk.
The value of the SDR
In the early years, SDR value was defined by the fixed exchange rate regime under the Bretton Woods system. After the liberalization of the exchange rate system in 1974, SDR value is determined by the currency basket, which includes the U.S. dollar, Euro, Chinese renminbi, Japanese yen, and Pound sterling.
The IMF calculates the daily value of SDRs according to the weighted exchange rates of the five currencies against the U.S. dollar. The IMF’s Executive Board reviews the SDR valuation every 5 years to determine the currencies and their respective weights in the SDR valuation basket. The weights of the individual currencies in the basket is determined based on the value of their exports over a five year period and are limited to currencies deemed to be freely usable by the IMF.
After the initial weights are determined, the relative weight of the individual currencies adjusts with their exchange rate movement. A currency appreciating against the dollar would gain weight in the basket, while a depreciating currency against the dollar would lose weight. Check out the box below to see how the weights of currencies in the basket change over time.
The value of the SDR is determined by the exchange rates of the individual currencies, not by market forces, such as supply and demand. Rather, it’s the IMF that manages the flow of SDRs to ensure liquidity in the system. Although the SDR resembles a currency mutual fund as pointed out in the WSJ article, the weights of the individual currencies are fixed, and the supply of SDRs is finite. Unlike a currency mutual fund, the SDR is not an investment vehicle but is an alternative reserve asset and unit of account for the IMF and member institutions.
The use of the SDR
The SDR cannot compete with other cryptocurrencies like the WSJ article suggests, because it is not a medium of exchange for private individuals like the USD, Euro, or Bitcoin. SDRs are only held and used by IMF member countries and prescribed institutional holders like the European Central Bank or the Bank of International Settlements. Their use is generally limited to transactions with the IMF, but are also used to transact foreign exchange between member countries and institutions.
Since the late 80s, the SDR market has functioned primarily through voluntary trading agreements (VTAs), where member countries volunteer to buy or sell SDRs under the coordination of the IMF. The role of the IMF in this managed market is to act as an intermediary, matching participants and facilitating the exchange of SDRs.
We believe that the SDR cannot compete with Bitcoin or other cryptocurrencies in its current form and role. However, we do believe that the SDR lends itself well to digitization and that a digital SDR would be a more effective instrument to ensure stability in the international monetary system. In our next piece, we will go into more detail on the use of the SDR within the IMF and how its digitization could galvanize the global use of SDRs.