The Role Of CBDCs In Diversifying Global Reserves Beyond SDRs And Traditional Currencies

World finance is being reconfigured at breakneck pace and wide amplitude. The historical supremacy of mature reserve currencies like the US dollar, euro, and yen are being challenged by fresh monetary innovations. Central Bank Digital Currencies (CBDCs) are being proposed as a possible new pillar of cross-border reserve systems, with special advantages that could complement or even remake the current framework of Special Drawing Rights (SDRs) and traditional fiat monies.

Appreciating the potential for the use of CBDCs to diversify global reserves requires an examination of the current reserve system, the possibilities and limitations of digital currencies, and the ways in which the instruments could be incorporated into global monetary policy.

Understanding the Current Global Reserve System

Central banks globally have been holding foreign exchange reserves for decades in order to foster economic stability, defend currency exchange rates, and enhance liquidity during times of need. The reserves usually are safe and well-liquid instruments denominated in stable and highly accepted currencies.

The most significant among them is the US dollar, as it acts as the world's reserve currency owing to its extensive liquidity, robust legal framework, and the large size of the US economy. The euro, the Japanese yen, the British pound, and the Chinese renminbi all have major but secondary roles to play.

Besides national currencies, the IMF also established the vehicle of Special Drawing Rights (SDRs) as a reserve asset to complement traditional reserves. SDRs are not currency but a basket of major currencies that has been established to serve to provide additional liquidity and to minimize dependence on one national currency.

But the current system has a vulnerability. Overreliance on a few currencies exposes countries to geopolitical incidents, rate-of-interest changes, and issuing countries' economic situation. This is where CBDCs could offer a further diversification tier.

What Are CBDCs and How Do They Differ from Current Currencies?

A Central Bank Digital Currency is a digital version of a country's national currency, issued and controlled by the central bank. A CBDC differs from cryptocurrencies like Bitcoin or Ethereum in that it is centralized, backed by the full faith of the government, and is legal tender.

CBDCs are distinct from the existing digital money in bank accounts because they are a direct central bank liability, and not that of a commercial bank. This is to say that they offer the security of central bank money, allied with the speed and ease of use of advanced digital payment systems.

The scope for the use of CBDCs in cross-border transactions—wholesale between banks and institutions—makes them directly pertinent to reserve diversification discussions.

The Case for Diversification Beyond SDRs and Key Currencies

Dependence on a group of dominant reserve currencies can be systemically risky to the global economy. For instance, abrupt policy actions on the part of the US Federal Reserve can spread in world markets, hurting dollar-dependent countries. Regional shocks, in a similar vein, can undermine the resilience of a reserve currency, leaving its owners vulnerable to unexpected losses.

SDRs were meant to hedge against such risks through a basket of diversified currency but have not yet broadly circulated as they are based on underlying fiat currencies and cannot be broadly accepted for typical transactions.

CBDCs can fill this chasm. With digital, programmable, and maybe more transparent form, CBDCs can diversify reserves not just in asset composition but also in usage.

CBDCs as a New Reserve Asset

CBDCs would possess a set of properties that might render them attractive for foreign reserve usage. First, they would be able to facilitate real-time settlement and increased security in cross-border payments, lowering settlement and operational risk.

Second, CBDCs would be able to be fully integrated with digital trade platforms, smart contracts, and automated payments systems, attributing them value over and above the fixed reserve asset.

Thirdly, the transparency of blockchain or distributed ledger-based CBDCs can promote trust and mitigate the potential for fraud in cross-border settlements.

Finally, CBDCs will be better positioned to facilitate new economic activities, including digital trade networks, decentralized finance (DeFi) platforms, and programmable supply chain finance that may increasingly apply to cross-border trade.

Potential Models of CBDCs in Reserves

A few ways that CBDCs may enter into international reserves are as follows:

One approach would be for countries to simply hold foreign CBDCs in reserve balance, the same way as they now hold foreign fiat money. E.g., a nation can hold digital dollars, digital euros, or digital yuan from their respective central banks.

A second model might be a multilateral CBDC from the IMF or other global institutions that is supported by a basket of national CBDCs. It would be the digital equivalent of SDRs, taking the diversification advantage of a currency basket and the convenience and speed of digital settlement schemes.

Apart from that, regional blocks may also introduce their own co-mingled CBDCs for intra-regional trade and reserve holding. An instance of this would be an ASEAN CBDC, which would allow more financial integration among Southeast Asian economies while offering a dollar or euro-free reserve instrument.

Benefits of CBDCs for Reserve Diversification

CBDC inclusion in reserve holdings could have a number of advantages. They would be able to diminish reliance on a limited group of major fiat currencies and distribute geopolitical and economic risk more evenly. They can also lower the cost of cross-border settlement, particularly if CBDCs provide instant or near-instant settlement between central banks.

In addition to that, CBDCs may encourage financial inclusion at the macroeconomic level. Through enabling greater direct access to central bank money, CBDCs might render financial systems in emerging economies more secure and less exposed to extrinsic shocks. Lastly, programmability in CBDCs may enable central banks to add certain monetary or regulatory attributes, such as negative interest rates or rule checks, so that they may be more responsive to evolving economic conditions.

Challenges and Risks

While CBDCs hold promise, there are risks associated with their use as reserve assets. Interoperability of different national CBDCs is likely the most significant technical and policy issue. In the absence of standards, cross-border CBDC transactions would be fragmented, making them less efficient as a reserve instrument.

Another risk is cybersecurity. A digital-only reserve asset could be vulnerable to hacking, cyberwarfare, or system failure.

Geopolitical issues also exist. The use of CBDCs could increase currency competition and even lead to a "digital currency race" among big economies. This could destabilize the international monetary system if not managed collaboratively.

Moreover, issues of privacy and surveillance can deter some countries from holding foreign CBDCs, particularly if there is worry that transaction data could be released to the issuer country's government.

CBDCs and the Future of SDRs

CBDCs could complement and support the role of SDRs rather than replace them. For example, allocations of SDRs could be disbursed directly in the form of digital currency within a multilateral CBDC platform to make them more convenient to use and settle. This could render SDRs more practically useful and enhance their uses in trade settlement and reserve management.

In this vision, SDRs would deliver the diversification advantage of a currency basket, and CBDCs would offer the operational efficiency, transparency, and programmability required for contemporary global finance.

Why SDRs haven't replaced traditional reserve currencies

The SDR theory is sound—bridging a basket of stable currencies to reduce risk. They do fall short, however. SDRs cannot be used in ordinary trade or investment transactions; they can be used only among IMF members and certain institutions that have been approved. This limits their utility for immediate liquidity needs.

In addition, SDR allocation is at the mercy of IMF policy, which is dictated by geostrategic interests. Recipient nations in periods of distress are not necessarily given sufficient allocations, thus rendering SDRs useless during periods of crises.

CBDCs, however, would be transferable instantly between central banks and possibly between approved institutions worldwide, thus rendering them more responsive within the global financial system.

Case Studies: Tests in New CBDCs with International Implications

The following nations are already testing out CBDCs with features that could potentially make them attractive as reserve assets.

1. China's Digital Yuan (e-CNY)

China's CBDC began development in 2014 and is now in the advanced pilot stages. While primarily domestic payments, China has already conducted cross-border settlement with Hong Kong, Thailand, and the UAE. If implemented in international trade on a large scale, the e-CNY might become a reserve asset to countries deeply engaged with China's Belt and Road Initiative.

2. The Bahamas' Sand Dollar

Despite being a small economy, The Bahamas was the first to launch a fully operational CBDC. Far from being a significant reserve asset, it is a showcase for how CBDCs will enhance payment efficiency and financial resilience even in smaller economies.

3. mBridge Project

This is a collaborative effort between the central banks of Thailand, Hong Kong, China, and the UAE, with the support of the Bank for International Settlements. The project aims to create a multi-CBDC system for faster, cheaper cross-border payments. If rolled out globally, it can be a model for CBDCs in reserve portfolios.

CBDCs and Blockchain's Role

Not all CBDCs will use blockchain technology, but the majority are contemplating it due to its transparency, security, and programmability capabilities. As a reserve tool, a distributed ledger could provide central banks with an auditable record of holdings and transactions, reducing them to near zero disputes.

But blockchain also presents with it challenges, such as the need for consensus systems to balance speed, security, and efficiency. For international reserves, such systems need to sustain high traffic without compromising stability.

Possible Future Scenarios for CBDCs in Global Reserves

We can imagine a couple of possible possibilities:

Scenario 1: CBDCs as a Supplement

CBDCs coexist with existing currencies and SDRs, diversifying without replacing existing structures. This is the most likely short-term reality.

Scenario 2: Regional CBDC Blocks

Regional blocs of countries issue joint CBDCs in a bid to increase regional trade as well as reduce dependence on foreign exchange. Over time, regional CBDCs can become leading reserve assets.

Scenario 3: A Global CBDC Reserve Asset

A global institution like the IMF issues a CBDC backed by a basket of national CBDCs, effectively creating an electronic, liquid alternative to the SDR. This would be the most radical result but requires high levels of trust and coordination.

CBDCs and Financial Stability

One of the key questions is whether CBDCs would enhance or reduce risks within the world's financial system. On the positive side, faster and more transparent transactions may reduce the risk of systemic crisis. On the negative side, enhanced capital mobility could accelerate capital flight in the event of crises.

To avoid this, reserve CBDCs may need embedded controls, such as a cap on transfers by day or programmable limits triggered in times of crisis.

The advent of Central Bank Digital Currencies is a watershed moment in the history of international finance. While SDRs and fiat currencies have been the backbones of world reserves for decades, CBDCs offer one more layer of diversification—one that combines the permanence of central bank money with the creativity and velocity of digital technology.

If they are properly implemented, CBDCs can reduce systemic risks, reduce the cost of transactions, and enhance the world financial system's resilience. The challenges exist, from interoperability to cybersecurity, but these are not insurmountable.

The future of reserves can as easily be hybrid—backed by a foundation of solid traditional assets, supplemented by SDRs, and propelled by the force of CBDCs. Here, digital and traditional currency can coexist, complementing each other to offer a more robust and inclusive global economy.