Crypto Drawing Rights — A Thought Experiment
By: Fintech For Development
Tags: Bitcoin, Cryptocurrency, Sdr, Imf, Distributed Ledgers

In our previous posts, we discussed what the IMF’s Special Drawing Rights (SDRs) are and how they are used. In this post, we’d like to discuss what a hypothetical crypto-SDR, or Crypto Drawing Rights (CDR), would look like and how it could benefit the IMF and its member organizations.

To recap, SDRs are a type of reserve asset where its value is determined by the weighted exchange rates of the world’s five strongest currencies against the U.S. dollar (USD). In essence, SDRs are a financial derivative that provides relative predictability in its exchange rate and on-demand convertibility into one of the five sovereign fiat currencies which make up the IMF’s currency basket. Given the SDR’s unique characteristics, it should be an ideal reserve asset for central banks, but it has not come close to rivaling the USD as the predominant reserve choice for most countries.

Why not SDRs?

There are many reasons why SDRs are not a popular choice among central banks, but one obvious culprit is the long and complicated process required to trade them. Currently, it can take up to 14 days to complete a trade of SDRs, and in the case of delays or cancellations, hedging risks and opportunity costs can grow to relatively large levels. The costs and time associated with SDR trades make them attractive only to organizations with an explicit need for them and consequently restrains SDR trading activity as a result. The limited use of the SDR leads most IMF members to prefer only holding what is necessary and creates an excess of SDRs in the IMF General Resources department. If SDRs could be traded nearer to real-time, they would be more attractive and more widely used by IMF members.

The current wait period results from the numerous steps involved to complete a trade. The IMF provides a breakdown of the process in the table below.

Table 1: Timeline to trade SDRs under Voluntary Trading Arrangements

Source: IMF Financial Operations 2016

The process includes three phases: execution, clearing, and settlement. The execution phase includes the initiation and agreement to trade, usually facilitated by the IMF; the clearing phase involves confirmation and reconciliation; and the settlement phase includes final receipt of assets for the parties involved. The clearing and settlement phases are uniquely appropriate use cases for blockchain or distributed ledger technology (DLT). By moving the clearing and settlement phases onto a DLT platform, the IMF could automate many of the steps in the above table and significantly reduce the time and cost associated with SDR trades. A DLT platform would also allow IMF to move away from its current operational intermediary role in the trades to one more focused on governance and supervision.

DLT Platforms

Without going into too much detail, there are two overarching types of blockchain- or DLT-based platforms — public and permissioned ledgers. (for more in-depth explanation see here.) The most well-known and widely used examples of DLT platforms are Bitcoin and Ethereum, which run on public blockchains. Public ledgers, or blockchains, allow anyone with internet access to view or make transactions, and the record of transactions are viewable to anyone. Although the transaction data can be encrypted, parties involved in a transaction are only “pseudo-anonymous,” and their identities are easily traced back by anyone with the time and ingenuity to do so. Permissioned ledgers, on the other hand, are only accessible to participants with the correct credentials.

In permissioned DLTs, designated administrators can determine the level of access and rules of engagement for the network, removing much of the concern that outsiders can easily view or interact with the system. In comparison to public DLTs, permissioned DLTs are much easier to scale and adapt to an organization’s unique requirements. Permissioned DLTs also don’t require the elaborate and inefficient proof-of-work consensus mechanisms needed to validate transactions that are in use on most public blockchains. Given the sensitivity and concern for privacy involved in SDR trades, a permissioned DLT platform would be the most viable option for the IMF.

Permissioned DLT-based SDR

Permissioned DLT systems are criticized by some in the blockchain space, but many of the issues relate to organizations using DLT for operations that don’t need them, regardless whether its permissioned or not. However, when there is a clear use-case for DLT and the public platforms are not an option, permissioned networks provide a valuable solution. Permissioned DLT networks are suitable only when:

there is a tradable asset; there is a designated issuer of an asset; there is a closed system of permitted participants; assets only move amongst permitted participants in the market.

The IMF and its SDR operations meet all of the above criteria. SDRs are:

a tradable asset; only issued by the IMF; only available to IMF members; only traded between IMF members or prescribed holders

A permissioned DLT platform is not hard to imagine for the SDR. In permissioned networks, participants (nodes) are often divided into different roles that propose, validate, or audit transactions. Generally, transactions are proposed by one entity, either individually or batched into “blocks,” and distributed to each node on the network for validation. Once a transaction is validated by a predetermined number of nodes, it is finally published to the ledger. Responsibility for proposing transactions would be entrusted to the IMF’s SDR department, which could use smart contracts to run daily SDR valuations and assign appropriate participants in an SDR trade. The SDR department could then yield validation of the clearing and settlement process to the participatory nodes. Once transactions are confirmed and published to the ledger the SDR department could then act as a final auditor of transactions and alter the ledger if necessary.

Benefits of Crypto Drawing Rights

We are the first to admit that the technicality of this would need to be poured over and developed by people much more experienced in creating DLT platforms, but the idea is feasible and not far-fetched. Central banks and financial institutions are increasingly experimenting with DLT, and the IMF should assume a leading role in this rapidly developing technology. A DLT-based trading system would allow the IMF to reduce operational costs, mitigate risks of manual errors and make record-keeping and auditing of SDR trades more transparent. If the SDR platform is made interoperable with future DLT-based payment systems used by central banks, it could eliminate the need for messaging and reconciliation, as transaction and settlement would be one in the same. This would be an opportunity to migrate away from the SWIFT-messaging service currently in use by the IMF, further mitigating unneeded exposure to external points of failure.

The operational benefits of using a DLT trading platform are significant, but the implications of a tokenized SDR may be even more exciting. The current trading system is slow and complicated, but if trading were faster and less costly, the SDRs might finally become a more popular choice for central bank reserve management. Unlike other reserve currencies, the value of SDRs is more stable and less susceptible to fluctuations in individual exchange rates or unilateral interventions by central banks. A crypto-SDR (or CDR) would finally provide an alternative to the world’s existing reserve currencies that is both predictable and shielded from foreign exchange rate risk. Liquidity in the monetary system would become more transparent and subject to international agreement rather than in the hands of a single country’s central bank.