Facebook finally came out with its long-awaited cryptocurrency framework, and there were many surprises. Instead of building a centralized system, they are building a distributed one. Instead of keeping control in perpetuity, they propose to gradually relinquish control. Instead of putting themselves in charge, they established a controlling consortium of entities with very diverse interests.
And, of interest to me, instead of making up a coin from thin air, they base activities on something that’s backed by “a basket of government securities from six major currencies.”
Now, where have we heard that before? Yes, the IMF. In the context of the Bretton Woods agreement, the IMF created the so-called “Special Drawing Right” (SDR) in 1969. An SDR is essentially a unit of account measured against a basket of, currently, five currencies (the US dollar, Euro, Yen, Pound Sterling, and the Yuan).
The SDRs’ purpose is to supplement countries’ reserves and was used most intensively in the wake of the 2008 financial crisis. An SDR is not a currency or a claim, and no normal person can use it. Why not actually? Why don’t we have such an international currency? Wouldn’t that be something really helpful for people in the developing world who currently only have access to money that’s not worth the paper that it’s printed on?
That’s essentially the question that Andreas Veneris from Electrical and Computer Engineering at the University of Toronto and I asked ourselves in 2018. When the IMF Institute for International Economic Law put out a request for proposals for the “Georgetown-IMF Research and Policy Conference on Cryptoassets”, we took a chance and submitted the idea. To us, it seemed important enough to start a conversation.
What we proposed was essentially to establish a widely useable world currency based on SDRs on a permissioned but distributed platform to enable international commerce. That’s Libra in a nutshell.
But — I guess it was too outlandish and our project proposal was rejected/ignored. (Or maybe we’re just not part of the right club?) I guess we should have written it after all. Anyway, for the interested reader, here is the June 2018 proposal (the original, submitted version contains citations which I am omitting here):
Special Drawing Rights in a New Decentralized Century
Dormant 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 Euros as reserve currencies. In this environment, it is critical for an international organization with a mandate to ensure stability to plan and act ahead. This paper argues that Decentralized Ledger-based Technology (DLT) is a key tool to mitigate some of those risks so as to promote stability and safeguard world prosperity. Over the last two years, DLT has made headline news globally and creates a worldwide excitement not seen since the internet entered the mainstream. The rapid adoption and “open-to-all” philosophy of DLT have already redefined global socioeconomics, it promises to shake up the worlds of commerce/finance, and it challenges the workings of central governments/regulators. This paper examines DLT's core premises and proposes a two-step approach for the International Monetary Fund (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 Digicash — until Bitcoin.
Building on cryptographic-economic principles in a peer-to-peer (P2P) network, Bitcoin premised that (i) everyone can participate pseudo-anonymously, (ii) its value is market-driven, (iii) transaction fees are determined by competition, (iv) transactions are (almost) instantaneous with no intermediaries, and (v) no central authority has jurisdiction over its operation. As users only need a smartphone to transact in Bitcoin, it is not surprising that it was embraced in developing/bartering countries that lack legacy telecommunication or financial infrastructure.
Ethereum generalized DLTs to materialize the vision of “Decentralized Autonomous Organizations”. 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/security. Applications examples are found in Ukraine, which prepares to use Ethereum to conduct an election, Estonia, which develops a DLT-based e-residency to register out-of-country investments and Dubai's SmartCity, which awarded a blockchain contract to connect government and citizens. Newer cryptographic “alt-coin” DLTs such as Zcash, Monero, and ZK-Snarks (Ethereum) ensure the anonymity of all network transactions. Protocols like Cardano and Algorand reduce 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, resulting in capital and technology flows to jurisdictions with favorable regulatory regimes. What remains remarkable is that most DLT innovation has not been driven by firms that chase profits or governments that seeks national advantage (i.e., for their military) but by freelance enthusiasts often coined as “cypherpunks.” Despite the ecosystem's volunteer nature the “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 have 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 International Monetary System (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 comes 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 political shifts in reserve currency countries.
SDRs were originally intended (in 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, improve reduce exposure to fluctuations in exchange rates and promote financial stability. 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 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) promote SDR's role as unit of account in international settlements. Recent projects by the Bank of Canada (Jasper) and the Monetary Authority of Singapore (Ubin) provide successful technical sandboxes around which such a DLT-based accounting system can be built. At the same time, it is crucial that same system is designed as forward-looking so 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 is 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 business can develop an automated, secure, and immutable worldwide ecosystem to handle and improve existing multi-layer complex exchanges that are cumbersome, slow, and excessively complex with today's multiple single-country reserve currencies. The key feature here is the availability of the multi-denominational, stable SDR promotes its usage in the public and private sector and reduces uncertainty/costs/complexities in large- and small-scale cross-border transactions.
As the acceptance for SDRs as a unit of exchange increases, there will be demand for related financial instruments. As recently witnessed with Bitcoin and Ethereum, a plethora of innovative financial products soon emerged in the private sector secondary markets such as “alt-SDR” denominated bonds, futures, or forwards. This “phased-in” gradual development of private sector securities will further perpetuate the establishment of SDRs as a formal numeraire in daily life, without exerting pressure on the basket of currencies, the currency reserves, or the stability of the IMS.
Historically, “hard” currencies often play the role of the store of 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” as a replacement in daily interactions. Ultimately, it is imaginable -and probably desirable- as a first step for “alt-SDRs” to become an easily accessible “hard” currency to eligible small businesses and individuals.
4. SDR as a Currency Reserve
History shows that a move to pragmatically establish SDRs as a reserve currency would require strong political will by the IMF's voting members. This paper argues that the development of a thriving private sector market in SDR related instruments will be the catalyst to reach an 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 (see below) to provide liquidity, (iii) the development of further DLT-based financial instruments to ensure operation and transparency, and (iv) the transition from the current basket of currencies to a basket of common goods and commodities. The first two points have been discussed in the literature, and we covered the third one in the preceding section. In what follows, we elaborate on the last assertion.
The purpose of SDRs is to facilitate trade-related international transactions and so instead of tying SDRs to currencies that are subject to domestic monetary policies, it is imaginable to tied the value of SDRs to a basket of commonly traded goods, commodities, and services to capture basic human needs. Such a basket may include metals, oil, and natural gas, all of which already correlate with the current SDR. It may also contain standardized agricultural products such as wheat, corn, and soybeans. Finally, a similar priority should be given to pricing metrics such as a water cost index, and maybe carbon emissions or renewable energy. As human needs change only slowly over longer horizons compared to exchange rates, such anchoring may create more stability. Blockchain technology can ensure that the 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 respects true human needs and adheres to global agreed-upon constraints.
The evolution of permissionless 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. 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 back re; only those who adapt lead the opportunity.
Warren Coats. What’s wrong with the international monetary system, April 20, 2017.
International Monetary Fund. IMF policy paper: Considerations on the role of the SDR, April 2018.
Judy Shelton. The case for a new international monetary system, Spring/Summer 2018.
Zhou Xiaochuan. Reform the international monetary system, March 23, 2009.
Nick Szabo. Formalizing and securing relationships on public networks,http://www.fon.hum.uva.nl/rob/courses/informationinspeech/cdrom/literature/ lotwinter-school2006/szabo.best.vwh.net/formalize.html, 1999.
Phillip Rogaway. The moral character of cryptographic work, asiacrypt 2015, March 2016. http://www.nasdaq.com/article/ukraine-government-plans-to-trial-ethereum-blockchain-based-election-platform-cm585001, November 5, 2017.
C. Sullivan and E. Burger. E-residency and blockchain, ScienceDirect, Elsevier, Vo. 33, №4, 8/17, pp. 470–481.
Smart Dubai. https://smartdubai.ae/en/Media/Lists/Stories/DispForm.aspx?ID=85, November 5, 2017.
Stephane Blemus. Law and blockchain: A legal perspective on current regulatory trends worldwide, December 11, 2017.
Ian Grigg. The Ricardian contract, IEEE international workshop on electronic contracting, pages 25–31, 2004.
IBM. Water cost index, https://researcher.watson.ibm.com/researcher/view group subpage.php?id=5091.
Christine Lagarde. Central banking and FinTech: A brave new world?, September 29, 2017.
International Federation of the Phonographic Industry. Global Music Report, http://www.ifpi.org/downloads/GMR2017.pdf, 2017.
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Now that’s that. Libra will likely implement many of the outlandish things that we proposed to at least discuss at an IMF forum … oh well.
For background, this proposal was developed as part of work at the UT LedgerHub, the University of Toronto’s global knowledge hub for crypto-economic blockchain technology. Andreas Veneris, Fan Long from the Department of Computer Science, and are running this initiative. The development of distributed ledger technologies such as Bitcoin and Ethereum has almost entirely occurred outside of the mainstream tech sector, with universities and their researchers largely at the sidelines. To address this knowledge gap, the UTLedgerHub bundles research across technology, finance, law and governance to establish U of T as an international leader in research and teaching of decentralized ledger technology and help cement Toronto as a leader in the field at a global scale.