Wednesday, August 31, 2016

BIS and IOSC Issue New Report on Derivative Clearing House Problems

The potential for a derivatives related failure to trigger another major global financial crisis has been discussed here for some time. Both the IMF and the BIS have issued warnings in the past related to the situation which are included on our page documenting various such warnings

The Bank for International Settlements (BIS) and the International Organization of Securities Commission (IOSC) have now issued a new report that says that many years after the 2008 crisis, there are still gaps and concerns related to derivatives transactions. This article in the Financial Times details the new report. Below are a couple of selected quotes from the FT article and then some added comments.

"Some of the world’s largest clearing houses are failing to meet global standards to withstand derivatives trading shocks, the world’s most powerful markets watchdog has found.

Four years after guidelines were introduced, a survey of 10 derivatives clearing houses found that some did not have sufficient policies or procedures to ensure they had enough money to keep going, or to replenish diminished reserves. Others needed to improve their stress tests, the report said."

. . . . 

Clearing houses act as market utilities, ensuring a deal is completed if one party defaults — they have become a vital part of policymakers’ efforts to reform global trading. Authorities have mandated that more risk management of the over-the-counter derivatives market be transferred from banks to clearing houses. These risk managers have now been labelled the global markets’ new “too big to fail”.

My added comments: Here we are many years after the last big crisis in 2008 and it is clear that there are still serious risks to the stability of the present financial system out there. Please note that this was a limited study of only 10 clearing houses that are expected to be able to withstand a default related to derivatives transactions they handle. This study found ongoing gaps and problems in several of these 10 and said they needed to be fixed by year end 2016. 

Of course we know there are many more out there including those involved in unregulated "Shadow Banking" which the IMF has warned about in the past

Bottom line: While it is true that some steps have been taken to try and improve the situation related to derivatives risk to the entire system, by no means are the risks now gone. This is just one type of event (among others) that could trigger a systemic crisis. A reader here sent me this article which talks about another. This is why we have to remain alert and stay informed. It's not fun or easy, but must be done given the legitimate risks that do exist. On 9-1-16 we will run our monthly Crisis Watch Update. There is not much new to report, but there are a few new items readers may find of interest.

Monday, August 29, 2016

G20 Summit - What to Watch For

Soon the G20 Meeting will be underway in China. While the G20 covers a broad array of topics, our focus here is on any news that relate to the potential for monetary system change. Since anything that would tend to dislodge the US dollar as the global reserve currency falls into this category, we will keep an eye out for whatever the G20 (and especially China) says regarding an increased role for the SDR. The SDR is one candidate to some day replace the US dollar so we keep up with news on it.


We already know that G20 will release some kind of statement in support of the SDR. In the July communique they tell us that. Below are a couple of excerpts and then some added comments.



Communiqué G20 Finance Ministers and Central Bank Governors Meeting

 Item # 8. We endorse the recommendations towards further strengthening the international financial architecture (IFA) developed by the IFA Working Group. Building on the ongoing work by relevant IOs, wewill continue to improve the analysis and monitoring of capital flows and management of risks stemming from excessive capital flow volatility. We look forward to the IMF’s review of country experiences and emerging issues in handlingcapital flows by year-end. We note the ongoing work on the review of the OECD Code of Liberalization of Capital Movements. We support work to further strengthen the Global Financial Safety Net (GFSN), with a strong, quota-based and adequately resourced IMF at its center, equipped with a moreeffectivetoolkit, and with more effective cooperation between the IMF and Regional Financing Arrangements (RFAs), respecting their mandates. In this respect, we welcome the upcoming CMIM-IMF joint test run and call for further work regarding the IMF’s lending toolkit. We look forward to the completion of the 15th General Review of Quotas, including a new quota formula, by the 2017 Annual Meetings. We reaffirm that any realignment under the 15th review in quota shares is expected to result in increased shares for dynamic economies in line with their relative positions in the world economy, and hence likely in the share of emerging market and developing countries as a whole. We support the WBG to implement its shareholding review according to the agreed roadmap and timeframe, with the objective of achieving equitable voting power over time. We underline the importance of promoting sound and sustainable financing practices and will continue to improve debt restructuring processes. We support the continued effort to incorporate the enhanced contractual clauses into sovereign bonds. We support the Paris Club’s discussion of a range of sovereign debt issues, the ongoing work of the Paris Club, as the principal international forum for restructuring official bilateral debt, towards the broader inclusion of emerging creditors, and welcome the admission of the Republic of Korea to the Paris Club. We welcome China’s regular participation in Paris Club meetings and intention to play a more constructive role, including further discussions on potential membership. We support examination of the broader use of the SDR, such as broader publication of accounts and statistics in the SDR and the potential issuance of SDR-denominated bonds,as a way to enhance resilience. We call for further work by the IOs to support the development of local currency bond markets, including intensifying efforts to support low-income countries. We will extend the IFA Working Group’s mandate into 2017.

 Reports received

#16.The IMF’s Note on Role of the SDR—Initial Consideration

Issues for further action

#12.We look forward to the IMF’s paper on examining ways in which the SDR can contribute to strengthening the international monetary system by January 2017.


My added comments: This is what G20 has already released so this will not be news when announced in September. We note that the IMF report on the SDR is not due until January 2017. Ahead of the upcoming meeting, the World Bank has announced it will issue 2 Billion in SDR denominated bonds payable in Chinese renminbi. So here we have more official support for the SDR at least from a symbolic standpoint. Observers will watch to see the market response for bonds like this. One early report stated the market for these bonds is not very strong

What we watch for here are a couple of things. One would be bigger news related to the SDR that signals that a more serious move towards the SDR might be coming. Willem Middelkoop has written recently about the concept of an SDR substitution fund at IMF that would allow for a very large swap of SDRs for US dollars in a short time frame. While it is not expected that something like that would be announced at G20, it would be very big news if and when it was announced and the kind of signal we watch for. Keep in mind that an agreement to do something like this would require member approval of 85% and the US holds a 16% vote which essentially works sort of like a veto.

That leads to the second thing to watch for at the G20, which is the reaction to any SDR news announced by both China and the US. We expect that China will be very enthusiastic about an expanded role for the SDR. Some experts wonder if the US shares that enthusiasm. So we will watch to see if the US sounds supportive or lukewarm about the SDR, or if it says anything at all about it. It will also be interesting to see how the western financial press covers SDR news versus how the eastern press presents it.

We will just keep an eye on it here and report what we find after the meeting in September.

Update 8-31-16: World Bank has now issued the first batch of SDR Bonds ($700 million) per this Reuters update: --- Interest rate is .49% on the 3 year bonds.

Saturday, August 27, 2016

Will We Get a Cental Bank (or IMF) Digital Currency that Everyone Can Own?

This is a question we have raised here and followed for some time. When this concept first caught my interest, there was not too much in the public domain on it. Lately, we see more public information coming out from official sources that suggest the idea is being studied. 

Below are links to blog articles covering recently released reports from the IMF and the BOE that indicate that their is interest in potentially developing a central bank digital currency that anyone could own rather than just major financial institutions and also for an expanded role for the SDR in the future. Also below are some excerpts on these two proposals and then some added comments.


IMF to Study SDR Denominated Assets that "Could be Held by Any Parties"

We asked the former head of SDR Operations at IMF what they mean by SDR assets that "could be held by any parties". Here was his direct reply to us: 

"The Managing Director’s reference to “SDR-denominated assets, which could be both issued and held by any parties” clearly refer to private SDRs, that is SDR denominated assets and liabilities created in the private sector.  These would be attractive to cross border transactors wanting to invest in or borrow instruments with more stable exchange value and to those trading commodities such as oil internationally, especially if those commodities are priced in SDRs. The IMF would not be directly involved and would have no control over private SDRs, but their development and proliferation would promote and facilitate the demand for and use of the IMF’s own SDR reserve asset. Thus the IMF is hopefully interested in encouraging the development of private SDRs." ---  Warren Coats

The IMF released more information that used the term M-SDRs to describe this private version of the SDR. Here is how they explain it:

"This note sets out some initial considerations on this matter. The note sketches some key issues bearing on the role of the SDR in each of three concepts: (i) the official SDR, or “O-SDR”, the composite reserve asset issued and administered by the IMF; (ii) SDR-denominated financial market instruments, or “M-SDRs,” which could be both issued and held by any parties; and (iii) the SDR as a unit of account."

Both China and the IMF appear to be interested in an expansion of the role for the SDR, but it is not clear that the US is very enthusiastic about that at this time and the IMF report clearly says that further study is needed which takes time of course. A version of the SDR that all of us could own does not appear to be on the near term horizon.

Bank of England Studying Central Bank Digital Currency Anyone Can Own?

Here is a quote from our BOE article where they make it clear the study underway could include a new digital version of a central bank currency that all of us could own:

"However, things do not end there.  The point about the new technology is not just that it might make exchanging assets more efficient, to a greater or lesser extent.  In principle, it also makes it easier to widen the access to those assets, perhaps dramatically so.  If you create a platform on which the existing participants can more easily exchange central bank money, why not extend the right to others
As I said in the introduction, this certainly isn’t impossible under the current settlement system, known as RTGS (for Real Time Gross Settlement). There are already some non-bank institutions that have access to the Bank of England’s regular facilities8. As my fellow Deputy Governor Minouche Shafik recently explained, the Bank is currently undertaking a review of RTGS and the question of access will be one of the issues involved (Shafik (2016)). 
But it seems likely that a distributed ledger would make that process easier, opening up the balance sheet to a wider variety of financial firms.One might go further, giving access to non-financial firms, or perhaps even individual households. In the limit, a distributed ledger might mean that we could all of us hold such balances.
If so, our accounts would no longer be a claim on commercial banks but, like banknotes (Federal Reserve notes in the US), the liability of the central bank."
My added comments: At first glance these seem like two different proposals with no apparent connection. However, if the BOE proposal for a new Central Bank Digital Currency (CBDC) moves forward and some day becomes a reality, this could be the starting point for a global version of a digital currency based on the SDR used at the IMF. 

This is pure speculation on my part, but not unreasonable speculation given that the technology exists today to make these kinds of things actually feasible. It's important to note that both the BOE study and the IMF study imply that we are in the early stages of research on this whole idea. These new studies just issued raise potential problems and questions that need further research and do not say that any kind of real world system is ready to be implemented. The experts I talk to on this kind of idea also suggest to me that there is nothing on the near term horizon right now. Most seem to agree that it would probably take another major financial crisis to speed up any kind of major change like this.

All the evidence I have suggests that a variety of ideas and proposals are being discussed and studied (we gave some examples here). While we can assume that the SDR is a candidate for some kind of potential role as a global reserve currency in the future, we are likely some distance from a digital version of the SDR that anyone could own. 

There are a number ways we could end up with a digital global reserve currency at some point in the future. It could happen starting with a new Central Bank Digital Currency (in the UK?) and expand from there. It could happen first on a regional basis (in Asia and/or the AU?) and then later on a global basis. It could involve gold or not involve gold (at least initially) depending on the state of public confidence in the monetary system. It's possible that China and Russia might be more proactive in pushing for change than the US and the West. The process tends to move at a pretty slow pace under normal conditions. And as we can see in this article, some are quite skeptical that the public will ever demand that the SDR become the new global reserve currency. Dr. Warren Coats has told me that it is hard to get the political will and consensus needed for major changes like this. 

So, will we get a new Central Bank (or IMF) Digital Currency that everyone can own?

I don't think any final decisions are made at this point in time. Many sources believe we will get some significant news related to the SDR at the G20 conference in China this September (see point #8). Whether there will be more news than has already been announced is an unknown.

BOE Governor Mark Carney said in this speech posted on the BOE web site that he does not think we will see a new Central Bank Digital Currency any time soon as it will take time to fully study the idea. Here is his quote from the speech on that (see pages 8-9)

"In the extreme, a DL for everyone could open the possibility of creating a central bank digital currency. On some levels this is appealing. For example it would mean people have direct access to the ultimate risk-free asset. In its extreme form, it could fundamentally and perhaps abruptly re-shape banking

However, were it to co-exist with the current banking model, it could exacerbate liquidity risk by lowering the frictions involved in running to central bank money. These questions and others are why these topics are being examined as part of the Bank’s research agenda, with the prospect of a central bank digital currency for the UK, in my view, still some way off. We will work to make payments easier, and though cash may no longer be king it once was, its reign will endure for some time."

For those expecting that we are about to see a  "cashless society" soon, I would call your attention to the last sentence of the above quote from Governor Carney.

As we have noted here for some time, without another major financial crisis to motivate central banks and policy makers, all the available evidence right now suggests that any significant changes to the monetary system such as a new global reserve currency or a new central bank digital currency (or both) will most likely be a slow moving process. 

We will continue to follow events here to see what actually does happen over time.

Wednesday, August 24, 2016

SDR Denominated Bonds Coming- What response will we see?

With the upcoming G20 meeting expected to call for looking at ways to encourage broader use of the SDR, we are seeing news headlines about the issuance of new SDR denominated bonds. Earlier we ran this blog article to provide a simple example for how an SDR denominated bond might work in the real world.  

These headlines spur all kinds of speculation in regards to possible dramatic announcements about major monetary system change. Since we watch for that here, it's of interest for sure. But we need to understand the reality of what is actually happening and also the challenges the SDR still faces to broader adoption in the future. 

This news about new SDR bonds is important because it is somewhat of a first step towards a more broadly accepted SDR. But as we can see from this article in the Nikkei Asian Review, there is still a long road ahead for the SDR. The first thing to watch for is what kind of market reaction there is to these new SDR bonds. 

Below are a few excerpts that talk about this and some added comments. I submitted this article to IMF and SDR expert Dr. Warren Coats to see what he thought. He reviewed everything below and then offered his thoughts in red type. I am including his comments in red below as I think this will give you a very unique opportunity to see what a true expert thinks. Note how he points out a couple of errors he sees in the Nikkei Asian Review article. Dr. Coats also provided me this direct quote to include with this article:

"I fully agree that short of a real crisis, developing and expanding the role and use of the SDR will be a gradual step by step process. The development of private SDRs, for example, requires no decisions by the IMF at all if the existing currency basket is used. This was the topic of my "Asian Infrastructure Investment Bank and the SDR” article."  ----  Warren Coats


With the yuan set to enter the Special Drawing Rights currency basket in October, China looks to create a market for SDR-denominated bonds as a step toward internationalizing the country's currency. [building SDR instruments is more about replacing the USD than internationalizing the RMB] -WC

The government-linked China Development Bank as early as this month (August) will issue $300 million to $800 million in notes denominated in the International Monetary Fund's reserve currency, with maturities of around six months. This will mark the first float of SDR-denominated bonds by an individual financial institution." [I am pretty sure there were some in the early 1980s as well as SDR denominated bank deposits]-WC
. . . . . 
"President Xi Jinping hopes to cite a successful SDR bond float as progress toward the yuan's internationalization when G-20 leaders meet next month in Hangzhou, China. But whether a substantial market exists remains an open question. The SDR's value is based on multiple currencies, making hedging against currency risk complex and costly. [there is nothing complex about it but as it involves 5 currencies rather than one, it will be somewhat more costly]-WC The government's decision to opt for short-term bonds was likely based on the assumption that buyers would hold the notes until maturity."
Investors are also unimpressed with the coupon. The bonds likely will pay an annual rate of just 1% or so, a major bank said, though this will depend on demand. Given the costs involved, many banks likely would end up losing money. Cultivating a market for the instruments will require heeding investors' opinions.
Beijing's strong push for SDR-denominated bonds could lead to some purchases by Chinese banks and foreign banks operating in the country. But the lack of past floats by U.S. or European financial institutions suggests that potential demand is thin." [which is why I have recommended starting with invoicing oil and other internationally trading commodities, as well as the activities of the IFIs in order to build real demand for SDR asset]-WC


My added comments: There are several points of interest in this article for me. Here is a quick bullet point list: 

- SDR Bond issuance is a significant event that may signal larger future developments
- China seems more interested in this than the EU and the US (agrees with input I have gotten from a source I view as credible) [because they have long wanted to replace the USD in international reserves with a truly international asset]-WC 
-these first bonds will have a pretty short maturity because of the complex currency nature of an SDR denominated bond (based on 5 currencies)- not exactly market friendly

- interest rate of only 1% and banks that fool with this may lose money on it - not exactly a motivator for banks to get involved [but we don’t know the rate China will set or that will result from the markets biding]-WC

I think the challenges mentioned in this article for these new SDR bonds illustrates something I see in my own research. Many times we see headlines on all this that sound as if some major dramatic change to the monetary system is about to suddenly change the world. But once we get past the attention grabbing headline, the real world comes into play. It's still a big question what kind of market response these bonds will get. It appears that the US in particular is not enthusiastic at all about any changes that might lead away from the current US dollar centered system towards the SDR as a replacement. It will be interesting to see how the US and China behave at the upcoming G20 meeting in regards to whatever SDR news is announced. 

This reminds me of another similar situation. If you follow these issues, you often see headlines about how the SDR will replace the US dollar as global reserve currency and become the new "world money." I think most people envision this being like money they have now such as dollars or Euros. While that is indeed possible some day, here is a question worth asking when you see a headline like this: Exactly how in the real world would such an event take place? You cannot just wave a magic wand under current IMF rules and declare the SDR to be a new world money the next day like it sometimes sounds in these headlines. 

Under existing rules and the existing dollar heavy system, there are a number of issues that would have to be resolved to do anything like this. In the first place, you would need 85% approval for any IMF rule changes needed (with the US having veto power at 16%). Assuming you did get that, there are still many real world issues and challenges to deal with. I realized this when I read Dr. Warren Coats Real SDR Currency Board proposal. You don't have to read very long to realize that Dr. Coats lists a number of challenges to actually implementing an SDR based system (the nuts and bolts of actually making it work) and then proceeds to explain how he would deal with those issues to make it work. Here are just a few issues he raises himself in his own proposal for example:

- to do anything you must have broad political will and support 
-  the IMF Board would have to approve issuance of SDRs under a Currency Board (under   Dr. Coats proposal)
- IMF member approval to change the SDR valuation basket from a group of currencies to a basket of goods (under Dr. Coats proposal)
- Who would be allowed to hold SDR acccounts at the IMF? Dr. Coats explains his idea
- What assets would be accepted to issue or redeem SDRs? Dr. Coats covers this

- How would countries substitute their existing reserves for SDRs? He also covers this

The list goes on and on. In his proposal, Dr. Coats says these issues can be resolved with the approval of IMF members, but how long would that take and what if the US balks at it with 16% veto power at the IMF. The US held up the 2010 reforms for years before finally approving them in late 2015.

This is what you do NOT see in the attention grabbing headlines. Somehow, to get a true "world money" SDR that people could use like an actual currency, you have to have a real proposal that could actually be voted on approved by IMF members. A little detail that I feel gets overlooked many times in some articles I see on this topic. 

Another point of interest for me is that this proposal by Dr. Coats is the only actual proposal on the table anywhere that I know of for the IMF to consider to make the SDR like a real currency. To consider a different proposal they would have to deal with all the issues and challenges Dr. Coats points out in his own proposal. The IMF tends to move very slowly and all of this would take a lot of time. 

So, What could change this situation and speed up the process? I can only think of one thing. Another major crisis worse than 2008 where the major world powers decided that an emergency global meeting had to be held to deal with all this (a kind of new Bretton Woods). Under those circumstances there would be more urgency. Perhaps any approvals for rules changes needed would be easier to get. Or, if things were really bad and really urgent, perhaps they just suspend the existing rules and start out with completely new "rules of the game?"

This is why I think that unless we get this kind of new major crisis, we should not expect to see sudden and dramatic monetary system changes take place. Instead, the "piecemeal engineering" process (slow incremental steps) Jim Rickards talks about is more likely in a non crisis environment. As we see from Dr. Coats quote above, he tends to agree and mentions the expansion of "private SDRs" as an example of a small incremental step.

All this has led me to conclude that there are really just two main events to watch for here:

1- Another major global financial crisis worse than 2008 that could create urgency 

2- The various possible proposed "solutions" to any such crisis that exist now and that have a realistic chance to actually be considered for implementation.

We feature Dr. Coats Real SDR Currency Board proposal here because it is an actual serious proposal the IMF is aware of now. He has already done some work to raise the various issues and challenges to actual implementation that would have to be dealt with in any new proposal to use the SDR like a global currency (or "world money"). That would save some valuable time from the IMF's perspective under crisis conditions it seems to me.

If you were the IMF and were forced to deal with a huge major global crisis, what would you do? Start all over from scratch or look at an actual serious proposal already on the table from a recognized expert? Remember, time is of the essence and you don't have the luxury to study a brand new proposal for months or years. This is why I think anyone interested in all this should read and understand Dr. Coats proposal. In a time of crisis, it might get serious review and consideration.

Please keep this in mind when you see attention grabbing headlines on the SDR as "world money." The headlines are not necessarily wrong, but there are always "details to follow" and they do matter. 

Added notes: After reading the direct quote from Dr. Coats he gave for this article (after I wrote the part above), I should point out that his Real SDR proposal that I talk about would require some IMF rule change approvals which would slow things down. Dr. Coats points out in his quote above that these private SDR denominated bonds (now called M-SDRs by the IMF) would not require all this IMF approval process so long as they use the existing currency basket to value it. This is an important distinction and I am glad he mentioned it.

While these private SDRs could be used more easily and quickly, they still are not a "world money" type of legal tender currency private citizens could spend directly. This is why we feature Dr. Coats proposal here (which really could be implemented like that, but requires the rules changes). These different "kinds" of SDRs (official vs. private) do add some confusion to understanding all this.

These private SDRs as they are right now are really just a way to own the variety of currencies in the SDR basket (now five) by owning one bond. We could do somewhat the same thing by just obtaining the actual five currencies in the basket in the same ratio as they are in the SDR basket. Not really a monumental change as I would view it.

You and I could not spend a private SDR (or M-SDR) anywhere as legal tender as far as I know. First you must convert it back into a legal tender currency or currencies to be able to spend it. So I don't view this initial expansion of private SDRs as the kind of monumental monetary system change we watch for here. Instead, I think of them as more like a first step towards (see more here) the concept of an SDR as money like most people would think of it (like a US dollar or a Euro or a Japanese Yen).

For this to morph into a true legal tender version of a "world money" that anyone could own and use without having to convert it back into existing currencies (what we watch for here), you would still need the kinds of IMF rule changes Dr. Coats talks about in his "Real SDR" proposal. That is why I feature it here. He has the ONLY serious proposal I know of that provides a path to this kind of "Real SDR" anyone could own that could be considered by the IMF at this time. If someone does know of another real actual proposal like that, I would be interested to know about it and would cover it here. This is the last of our three part series of articles on the SDR leading up to the G20 meeting.

Update 8-25-16: South China Morning Post runs this article on the upcoming SDR Bond issue providing more details.

Sunday, August 21, 2016

How Would "SDR Denominated Bonds" Work? + A Comment from Jim Rickards

With all the news lately about the push to issue "SDR Denominated Bonds" I thought it might useful to ask the question: How Would SDR Denominated Bonds actually work? This whole idea is a foreign concept to most of us as we use the currency that is legal tender where we live for our regular financial transactions. In the US we spend US dollars. If we buy US government bonds with savings those bonds are "denominated" in US dollars. When we sell the bond (or it matures) we exchange it for US dollars, etc.

I thought that a simplified example using an SDR Denominated Bond might make it easier to see how such a thing would work. Since the IMF recently talked about SDR assets that "any parties could hold" we will make the assumption in this example that I am a US citizen who would like to own an SDR (denominated) bond. Let's see how we might buy and sell such a bond if we could own one.

For the purpose of the example, let's say I live in the US and want to own a 10,000 SDR bond.

In order to buy a 10,000 SDR denominated bond based on the current exchange rate (as of 8-5-16) of about $1.40 for 1 SDR I would have to pay $14,000 US dollars for a 10,000 SDR bond.

Now, let's say a month later I needed the money to spend and I wanted to sell my 10,000 SDR bond. During that month the US dollar dropped in value vs. the SDR such that the exchange rate is now $1.42 for 1 SDR. I would sell the bond for $14,200 US dollars based on the new exchange rate. I have to sell it and convert it back in to dollars to be able to spend the money since I cannot use SDRs for legal tender. Notice that I made a $200 gain in US dollars because the US dollar dropped in value vs. the SDR during the month I owned the SDR bond. (see Jim Rickards comment below).

To simplify things, I would assume that interest rates did not change during the month and had no impact on the value of the bond. 

I ran this simple example by both Dr. Warren Coats and Jim Rickards to be sure it is accurate. They both told me it is. Jim Rickards went on to add an interesting point I had not even thought of about the US Treasury exchanging US dollars for SDRs. Here is what he explained to me about that:

"Your example is correct. Notice how you profited (in dollars) when the dollar went down. That's because the other SDR components went up against the dollar. When you convert dollars to SDRs, you are short the dollar to some extent. That's important because when the U.S. contributes to the IMF resources, we send the IMF dollars and they give us a note denominated in SDRs. So, in effect, the U.S. Treasury is shorting their own currency when they finance the IMF. Very insidious for Treasury to short the dollar." -- Jim Rickards

A key point to understand is that right now in order for a private entity to use an SDR denominated bond in the real world, they must convert it back into a legal tender currency like US dollars, Euros, Yen, etc. The IMF actually distinguishes a private SDR asset (like an SDR denominated bond) as an "M-SDR" to make it clear that this version of the SDR is not the official reserve SDR (O-SDR) issued by the IMF itself. It is this so called private SDR that Dr. Warren Coats talked about in our earlier article here.

M-SDRs are not legal tender in the US. If I did sell an M-SDR denominated bond I would have to convert it back instantly into US dollars to be able to use the money in the US. If I lived in Europe I would convert it back into Euros and so on. If I were a business that transacted in both US dollars and Japanese Yen I could convert the M-SDR bond into both of those currencies in any ratio I wanted to as well. But I would have to convert it back into something other than M-SDRs to be able to use the money.

If the M-SDR were to someday become a legal tender currency that anyone could own and be used globally, then I could spend M-SDRs anywhere they were accepted as legal tender. This is not possible today. In fact, neither the O-SDR or the M-SDR are actually currencies right now in the way that the average person would think of a currency. I think that trying to convert them into something like that would require a lot of public education as most people have little or no awareness that SDRs even exist.

Hopefully, this simple example will help in understanding how an "SDR Denominated Bond" would work under current legal tender laws. As you can see, the issuance of SDR Denominated Bonds is kind of a first step towards broader acceptance of the concept of the SDR as a currency, but is still quite a long way from the SDR becoming an actual global reserve currency usable in daily transactions by private citizens.

The IMF moves very slowly on things like this so unless another major crisis were to create a sense of urgency, we can expect that an SDR global currency usable in daily transactions by everyone is not on the near term horizon.

Added note: This is the second of three articles on SDR basics leading up to the G20 meeting in September when we expect some news on the SDR. Here was the first. For more info on the SDR, see our list of articles here.

Friday, August 19, 2016

Jim Rickards: Janet Yellen 21st Century Houdini

Jim Rickards has a new article out on the "handcuffs" he says Janet Yellen and the Fed are working to get free from right now. This article lays out the problems the Fed faces in trying to get more inflation into the economy. Below are some excerpts and then some added comments.


"Harry Houdini was the greatest escape artist of the 20th century. He escaped from specially made handcuffs, underwater trunks and once escaped from being buried alive. Now Janet Yellen will try to become the greatest escape artist of the 21st century.
Yellen is handcuffed by weak growth, persistent deflationary trends, political gridlock and eight years of market manipulation from which there appears to be no escape. Yet there is one way for Yellen and the Fed to break free of their economic handcuffs, at least in the short run. Yellen’s only escape is to trash the dollar. Investors who see this coming stand to make spectacular gains.
Yellen and the Fed face as many constraints as Harry Houdini in trying to escape a potential collapse of confidence in the U.S. dollar and a possible sovereign debt crisis for the United States. Let’s look at some of the constraints on Yellen — and the possible “tricks” she might use to escape."
. . . . . 
"The Fed’s final destination is inflation — the Fed needs inflation to escape its handcuffs. What are the indications and warnings of inflation from a policy perspective?
There are four ways to get inflation when rate cuts are off the table. These four ways are helicopter money, world money, higher gold prices and currency wars."
. . . . 
"The second way to get inflation is for the IMF to issue world money in the form of special drawing rights, SDRs. This may happen in the next global financial crisis, but it won’t happen in the short run. The IMF moves even more slowly than the Fed. SDRs may be issued in sufficient size to cause inflation in 2018. But it’s unlikely to happen before then."
. . . . 
"If we can potentially expect helicopter money in 2017, SDRs in 2018 and a high official gold price in 2019, what can we expect here and now? How can the Fed cause inflation in 2016?"
. . . .
My added comments: What most caught my attention in this article is the timetable Jim lays out for the events he talks about to unfold. I have not seen anything like this before and it is helpful in giving us a reasonable time frame to expect things to happen. Of course, I am sure this not intended to be an exact timetable, but still gives us a useful guide. 
I can add that this timetable he describes fits very well with input I have gotten from a number of the expert sources I talk to. None of those sources tells me they expect consensus to replace the US dollar as global reserve currency in the near term. They also indicate that they think it would take another major crisis to create a sense of urgency in policy makers to move faster towards major monetary system reforms. 
I view this new article by Jim Rickards as additional confirmation that major monetary system changes like we watch for here are currently not expected to unfold in the near term and are more likely to gradually happen over an extended time frame like he talks about in this article. As always, a sudden and unexpected new major crisis could change things and create urgency to move quicker. I always point that out even if the timing for such a crisis is unknown and may not happen soon. It is impossible to know the timing of an event like that.

Added note: Because we have had the SDR in the news quite a bit lately I am running a series of articles that try to cover some basic information about it before the G20 meeting. The first was this article which tries to explain how their are actually two versions of the SDR (O-SDRS & M-SDRs) even while neither version is actually a currency at this time like people normally think of a currency. Soon I will have an article that provides a simple example of a theoretical SDR denominated bond to help explain how that might work for a person in the US if they were ever to own one. Later, ahead of the G20 meeting, I will have an article that was fully reviewed by Dr. Warren Coats. He also offered some of his own commentary as well to include in this article.

To be able to get information directly from someone like Dr. Coats who is a former Head of the SDR Department at the IMF is incredible and I hope readers realize how fortunate  we are in that regard. He knows SDRs and the rules that govern them at the IMF as well as anyone in the world. He has contributed information and quotes to many articles here on this blog.

There are not a lot of sources that cover the SDR. Jim Rickards and Willem Middelkoop are two who do. They actually prompted my initial interest in learning more about them a few years ago. My reasoning was that if they really do someday replace the US dollar, I need to learn all I can on the subject. Both of them do a great job of taking a complex topic and making it easier for someone with no background to get the basic ideas. I consider them both role models to try and emulate in that regard. 

Honestly, it is hard to tell right now if the SDR will play a more prominent role in the global monetary system any time soon. It seems like China and the other emerging nations are more devoted to this than the western nations and the US in particular as best I can tell. Willem Middelkoop's new article on the concept of an SDR substitution account has created great interest and something to watch for in the future.

Perhaps we will get a better idea after the upcoming G20 meeting. If the SDR does someday replace the US dollar as global reserve currency, many more people will want to learn about the SDR because so few know about it now. The goal here is to create an archive of information/articles that people can access free in the future to learn more if the SDR does become more prominent. It is very much an unknown at this time if this will actually happen. Major changes at the IMF require member approval of 85% and the US has a 16% vote which is essentially a veto power of sorts.

People can make up their own minds about the idea of the SDR as a global reserve currency, but before doing so it's always good to know the facts of the situation which is what we try to present here as accurately as possible with the help of experts like Dr. Coats.

Monday, August 15, 2016

Confused about SDRs? - It's Not Hard to See Why + More from Willem Middelkoop

With more news coming lately about SDRs, I am realizing that for most people this can quickly become a very confusing topic. It's understandable. First, most people probably have never even heard of an SDR. No regular citizen anywhere can use SDRs to buy anything like they would their own currency (US dollars, Euros, Yen, etc). Secondly, many people tend to say: Why Should I Care about an SDR?

I don't know if people need to care about them any time soon or not. However, lately there is a lot of SDR news that people who do follow these things feel is significant. We have the World Bank press release about its coming issuance of "SDR Denominated Bonds". We have the IMF releasing news in July that they are planning to do a study on the potential for broader use of the SDR in the global monetary system (July 2016). We have the G20 saying they support broader use of the SDR (see item #8) and look forward to the IMF report due out by January 2017. So, something is clearly up related to the SDR.

I thought perhaps it might be helpful to people totally unfamiliar with SDRs to try and provide at least some very basic information on them. I believe this to be a very large group of people. Below is a series of Q&A's to try and do that. Hopefully, they will be helpful to anyone wanting to learn more and not add to the confusion :-)

Q: What are SDRs?

A: Do you mean official reserve SDR's used within the IMF system of member nations only or the private version of SDRs the IMF is now calling M-SDRs?

Q: Excuse me. You mean there are TWO kinds of SDRs? One is hard enough to follow.

A: Yes, the IMF describes the official reserve SDRs here on their web site as follows:

 "The Special Drawing Right (SDR) is an interest-bearing international reserve asset created by the IMF in 1969 to supplement other reserve assets of member countries.
• The SDR is based on a basket of international currencies comprising the U.S. dollar, Japanese yen, euro and pound sterling(and the yuan starting in October 2016). It is not a currency, nor a claim on the IMF, but is potentially a claim on freely usable currencies of IMF members. The value of the SDR is not directly determined by supply and demand in the market, but is set daily by the IMF on the basis of market exchange rates between the currencies included in the SDR basket.
It can be held and used by member countries, the IMF, and certain designated official entities called "prescribed holders"—but it can not be held, for example, by private entities or individuals. Its status as a reserve asset derives from the commitments of members to hold, accept, and honor obligations denominated in SDR. The SDR also serves as the unit of account of the IMF and some other international organizations."

This July however, the IMF explained to us that there is another version of the SDR other than these official reserve SDRs. In their recent statement, they explain the difference here:

"This note sets out some initial considerations on this matter. The note sketches some key issues bearing on the role of the SDR . . .  (i) the official SDR, or “O-SDR”, the composite reserve asset issued and administered by the IMF; (ii) SDR-denominated financial market instruments, or “M-SDRs,” which could be both issued and held by any parties."

Q: I am a little confused. Why are there two kinds of SDRs and what is the biggest difference?

A: It does get a little confusing. One key difference is who can "issue and hold" each version. Only the IMF can issue the official reserve SDRs and relatively few entities (mostly IMF member nations) can hold them. M-SDRs are different because they "could be both issued and held by any parties." Short version for those of us who are not IMF members: We cannot own or try to use (spend) any of the official SDRs, but it is possible that we could own assets denominated in M-SDRs (like bonds for example). 

Q: What do you mean "assets denominated in M-SDRs?

A: This is an asset that derives its value based on the basket of currencies used to value the official reserve SDR (the US dollar, the Euro, the Yen, the Pound, and soon the Chinese Renminbi). Using an SDR denominated bond as an example, the value of the bond from a currency standpoint would actually fluctuate daily based on the floating exchange rates of the five currencies used to make up the SDR currency basket.

Q: So, Can I cash in such a bond and go spend my "M-SDRs" anywhere?

A:  As far as I know, there is no place on earth you or I could spend an M-SDR like we would US dollars or Euros, etc. There are no M-SDR bills (like say a $10 bill in your billfold or purse) that exist.

Q: This is getting a bit confusing again. If I can own these 'M-SDRs" but cannot spend them anywhere on earth, why would I want any of them?

A:  That's a good question right now. The only way you could convert them into something you could actually spend would be to exchange them (at the current currency exchange rates) into a currency of your choice that is a legal tender currency.

Q: OK, so again, Why would I want any of these?

A:  Right now for most people there is probably not a compelling reason to own them. If you were wanting to hedge your own national currency for some reason (you felt it might go down in purchasing power for some reason) you might use this M-SDR asset to do that since it is valued based on a composite of the five currencies in the SDR currency basket. But honestly, you could also do that by just obtaining the five currencies in the same ratio they are used in the SDR basket to do the same thing. Right now, that may be easier than trying to use an SDR denominated bond to do that and almost certainly less confusing to most people who have never heard of any kind of SDR.

Q: OK, if all this is correct, explain to me again:  Why I should care about all this or even want to fool with SDRs?

A:  I'll try. Many people believe that the current monetary system we use now has problems. It relies heavily on the US dollar. This can get complicated quickly, but this over reliance on the US dollar along with other problems like too much overall debt etc. are creating stress on the system we use now. Many people believe at some point in the future the stress might become so great it causes the system we use now to stop functioning properly (or even at all). If this were to happen, all kinds of consequences might follow that impact things like what the US dollar is worth (and also all other currencies). Some think a "reset" of the system might be needed under those circumstances. Some also think the SDR might then take a more prominent role in the monetary system and somewhat replace the US dollar. If that happens, then we all care quite a bit about SDRs and if we should be trying to own them or something else like gold for example (what will we trust?). No one can know the future, but there are many who follow all this closely and think it is possible the current system will have to be replaced. Some sooner than others. This blog watches for all that. (added note 8-19-16: here is a very creative video that kind of summarizes the above in less than 8 minutes based on the view of Jim Rickards)

Q: So, when I see headlines in the news saying "SDR to replace the US dollar", which version of the SDR are they talking about?

A: Now you've got me. I honestly don't many times myself. Sometimes I am not sure if the author of the article even realizes two versions exist. We now enter the realm of the unknown and all we can do is ask more questions that do not currently have answers as far as I know like:

- Would everyone be allowed to own SDRs in the future?
- If so, which version? or would they change things so only one universal version was used?
- How would any future SDR I could own connect with my national currency?
- How would any future SDR like this be anchored (or backed)?
- Would a conversion to some kind of SDR happen quickly or slowly?
- Would the public even accept any kind of new SDR (or any other proposed global currency)? Also, if not would everyone start trying to buy gold?

We could keep this up, but I suspect these are enough unknowns.

Q: Thank you for trying to help, but I am still a bit confused on how all this might work. Any more you can add?

A: Not right now. I feel your pain. I can only refer you to the title of this article and say I understand why you may not feel all is perfectly clear. It's because it is not. I have been following this for over two years and it is all I can do to try and keep it straight.

This article is the first of three to be published with some basic information on the SDR. For more in depth information, go to our page of archived articles here.

Added note: I have this bit of followup news from Willem Middelkoop. He sent me an email with permission to publish this quote:

"So Dr. Coats, Jim Rickards and myself all agree on the time line of the SDR process.
But the real shocker will be once investors start to realise dollar assets can be exchanged for SDRs in a not too distant future."

Just to make sure, I asked him if he was talking about the private SDR (M-SDR) or the official SDR in this quote. He replied with this answer:

"exchange fund is for official SDR's initially"

Later, I got this added bit of information from Willem to say that he is not trying to make a prediction on the timing for a large swap of official SDRs for US dollars:

"Again, I cant prove this will be possible soon, but such an (account/fund) exchange mechanism is the only possible solution to restructure $-debts (other debts possible could be restructured through this as well)"

A thank you to Willem for the added clarification and for the information he shares with us.

I believe he is talking about the substitution fund he wrote about in his recent article that we covered here. This would be significant news related to the SDR whenever it did take place. I am advised by Dr. Warren Coats that:

"The only limit on the number of SDRs that could be created via a substitution account is the amount of reserves central banks have to exchange for them."

I should add that it is my understanding from Dr. Coats that in order for the IMF to create this kind of substitution fund, they would need 85% approval from members which means the US would have be in agreement since it holds a 16% vote. All this just provides even more incentive to watch for any news related to this type of exchange fund at IMF. It would signal a breakthrough in the potential expansion of SDRs and that the members can reach consensus on such an important issue. In that regard, please note Dr. Coats comment below on how they have been unable to do this in the past on this issue.

Also, here is a new article in The Epoch Times by Valentin Schmid that fits well with this blog post as it talks about some of the issues we covered in the Q&A above and the new SDR Bond issue. It also quotes Jim Rickards and Willem Middelkoop. It does a good job of making the distinction between the official SDR and the M-SDR (private SDR). And I do understand if you are still a little confused.

Additional added note: After reading the information from Willem about the concept of a substitution fund, Dr. Warren Coats sent me this as a bit of interesting history related to this idea from the past. This is interesting information we just cannot get anywhere else and I appreciate so much he shares it with us:

"To add to my note a few minute ago, the IMF failed to adopt the substitution account in the 1970s because the membership could not agree on how the liability from exchange losses that might be incurred from issuing SDR liabilities against dollar asset should be allocated. The US wanted any losses to be born in proportion to quotas and the rest of the membership want any dollar losses to fall on the US."  --- Warren Coats