Where is bitcoin on its way to becoming the world’s reserve currency?
The changing geopolitical order and its impact on central bank reserves.
I wrote this essay shortly after the Russian invasion of Ukraine on February 24th. I took me some time to publish, as I was busy finishing other pieces.
Bitcoin is the perfect reserve asset and as such offers anyone, including nation states, the opportunity to adopt bitcoin, for example to stabilise their national currency or to build a sovereign state reserve. The Bitcoin community has been aware of this since Saifadean’s book “The Bitcoin Standard” at the latest. Whether or not one believes that nation-state adoption of bitcoin is important to Bitcoin’s success doesn’t matter. Nation states are adopting bitcoin because of its superior monetary properties.
Before going into detail about bitcoin, I would like to revisit the history of the US dollar, the global reserve currency. I will focus on how the US dollar became the global reserve currency, what this means for our monetary system and ultimately for bitcoin and its journey to becoming the digital world reserve currency.
How the US dollar became the world’s leading currency
From June 1–22, 1944, just before the end of World War II, 44 allied nations, led by the United States, met in Bretton Woods, New Hampshire. The intent of the US and its allies was to establish rules for an international monetary system, leading to the Bretton Woods Agreement. By the end of World War II, the United States held about three-fourths of the world’s gold supply, and as a result, a pure gold standard had become obsolete. Instead, the US proposed that all allied countries’ currencies should be pegged to the US dollar. The dollar, in turn, was linked to the price of gold. The value of the dollar was fixed at 1/35th of an ounce of gold. The conference established the US dollar as the world reserve currency, replacing a pure gold standard.
This became known as the Bretton Woods Agreement. The idea was to give nations more flexibility than strictly adhering to the gold standard, while offering less volatility than a standardless monetary system and establishing the United States as the central monetary authority (federalreservehistory.org).
As the dollar became a substitute for gold, the value of the dollar began to appreciate relative to other currencies. This created problems for the US government, which was interested in exporting goods and services to its allies and other nations around the world, which became expensive and therefore unattractive. The US had also spent too much money on foreign military programs, particularly in Vietnam. A gold standard meant the Federal Reserve was limited in its ability to create dollars. By 1970, the US ran out of gold to back its foreign dollar holdings and faced a serious liquidity crisis.
The “Nixon shock”
On August 15, 1971, President Nixon announced that the United States would end the convertibility of the US dollar into gold, effectively ending the Bretton Woods Agreement and making the dollar a fiat currency.
The “Nixon shock” ushered in a new era in which central banks began operating a fiat-money-based system with floating exchange rates and no currency standard.
The Petrodollar System
When Nixon announced that the dollar could no longer be exchanged for gold, the US had to find another way to create demand for the dollar, because the US wanted to ensure that the dollar remains the global reserve currency in order to be able to continue to exercise control over the global monetary system. This led to the creation of the petrodollar system in 1973, in which the US and Saudi Arabia, the world’s largest oil exporter, agreed to fix oil prices in US dollars. That meant any country buying oil from the Saudi government had to convert its currency to US dollars before the sale was complete. In return, the US gave security guarantees to Saudi Arabia.
This prompted the remaining OPEC (Organization of Petroleum Exporting Countries) countries to price their oil in US currency and follow suit. The 13 member countries account for an estimated 44 percent of global oil production and 81.5 percent of the world’s known oil reserves (Colgan, J. D. 2021). The word “petro” stands for petroleum (oil). The petrodollar system allowed the US dollar to remain the world’s reserve currency despite the end of the Bretton Woods Agreement. Petrodollars are the main source of income for many OPEC members and other oil exporters. They typically use the excess dollars they have from oil sales to buy US Treasury bonds, which are considered the best risk-adjusted way to store money due to a low probability of default by the US government as the obligor. Demand for US Treasury bonds is one of the US government’s most important sources of liquidity, and its worldwide use as a store of value is one of the reasons why the US dollar has remained the global reserve currency to this day.
Changes in Geopolitics: China
Recently, the balance of global economic power has shifted from the United States and Europe to China and several other rapidly developing countries. China has positioned itself as a major bilateral development lender for infrastructure projects in developing countries, especially in Africa, and could build international economic institutions and financing arrangements aimed at replacing existing US-led institutions in the long term (Congressional Research Service, 2022). Rumors surfaced in October this year that the BRIC countries (Brazil, Russia, India, China, and South Africa) were working on a common currency to compete with the US dollar as the dominant world reserve currency.
A new geopolitical epoch
After invading Ukraine on February 24, 2022, Russia fell out of favour with the international community and was hit with massive sanctions. On February 26, 2022, US President Joe Biden announced the seizure of foreign exchange reserves of the Central Bank of Russia totalling 630 billion US dollars (European Commission, 2022). This decision heralds a new geopolitical epoch. It was the most aggressive move to weaponise the US dollar system in history and will undermine the US dollar’s nature as a global reserve currency, as it could prompt other foreign powers to sell their US Treasuries over fears that the US government could freeze their reserves for political reasons in the future. China alone holds over $1 trillion in US dollar reserves. It is the country with the largest foreign exchange reserves held in dollars (Lyn Alden, 2022).
Central banks will likely reconsider their reserve practices and switch back to more gold as a reserve asset while also possibly focusing on maintaining larger inventories of industrial and agricultural commodities. Scarce commodities that are physically within the jurisdiction of the country cannot be sanctioned or frozen.
Bitcoin
The change has not gone unnoticed by the US government. On March 2, 2022, Fed Chair Jerome Powell publicly stated that there was room for multiple reserve currencies, including cryptocurrency (Brooke, O. 2022).
The properties associated with bitcoin make it an ideal reserve asset. The supply is finite. There will never be more than 21,000,000. It is easily portable, divisible, durable, fungible, censorship-resistant, and non-custodial. A central bank can set up its own cold wallet (a device that stores cryptocurrency offline) and protect its bitcoins from the threat of sanctions. It is a purpose built money for the digital age — permissionless, open-source, sound and global. Bitcoin is easy to buy, store and sell. High in liquidity and tradable 24/7. It is digital gold. These characteristics make it an ideal asset for a central bank, as reserves are designed to give a central bank the ability to defend the currency at all costs (McLellan, 2022).
Adoption
We are already seeing the adoption of bitcoin as a reserve asset by small nation states. In September 2021, El Salvador became the first country to make bitcoin legal tender (bbc.com). Shortly after, President Nayib Bukele stated that his country bought 500 bitcoins at an average price of $30,744 to hold as a reserve asset. Since then, the country has made numerous bitcoin purchases. The Central African Republic was the second nation state to make bitcoin legal tender in April 2022 (Hoije, Goko, 2022). For developing countries like El Salvador, which do not have an official currency, it is easier than large nation states to adopt bitcoin, as few changes need to be made to the existing monetary system. However, once larger nation-states understand the utility of bitcoin, it will be a matter of time before they too adopt bitcoin, albeit the process will be more complex.
Future adoption
The US, for example, needs to find something to back the dollar with. It is unlikely that they will back the dollar with gold. This would be playing into the hands of Russia and China who have far larger gold reserves. As explained by Luke Mikic, this leaves the US with their „backs against a wall“. „Faith is being lost in the dollar and they would surely want to retain their global reserve currency status. The last time the U.S. was in a similarly vulnerable position was in the 1970s with high inflation. It looked like the dollar would fail until the US government pegged the dollar to oil through the petrodollar agreement with the Saudis in the 1973. The country is faced with a similar conundrum today but with a different set of variables. They no longer have the option of backing the dollar with gold.”
Conclusion
In summary, it can be assumed that the US dollar will lose its sole position as the world’s leading reserve currency. There will be other competing reserve currencies like the Chinese yuan, used by countries with strong economic ties to China. This will be accompanied by a shift to holding gold and other commodities as central bank reserves, particularly in the East but as bitcoin is increasingly accepted as a digital store of value, central banks will most likely add it to their reserves. Bank deposits are managed almost exclusively digitally. Electronic money is the most used form of money today. It is only logical that central banks will also hold a digital reserve asset. Chances are high that this will be bitcoin. Nothing is certain, of course, but combined, bitcoin’s qualities as a scarce digital store of value make it seemingly invincible.
Gold cannot compete with bitcoin. Bitcoin is the better store of value.
An absolutely scarce digital native bearer asset with no counter-party risk that cannot be inflated and is easily transportable, ultimately defeating gold in the digital age. Holding physical gold in your own vault makes it a difficult asset for a foreign power to freeze, but also very difficult to move. Bitcoin can be sent anywhere in the world at almost no cost at the speed of light. There is a real chance that bitcoin becomes the reserve currency of the world. The tipping point for that event might be when bitcoin is adopted as a global unit of account for the trade of energy products. When oil, natural gas and electricity are priced in bitcoin, bitcoin will definitely supplant the US dollar as the world reserve currency (Greg Foss, 2021; p. 27). I think this is likely as bitcoin mining will become an integral part of our energy markets in the near future through financial incentives. For the first time in history, we have a global buyer of electricity: Bitcoin miners. Global energy asset owners now have the optionality of selling to two energy buyers: the grid, or the Bitcoin energy market, and because of this energy will likely be priced in bitcoin at some point.
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