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.
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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.