Digital currency could one day deserve 'reserve' status

In 2015, China’s yuan joined the US dollar, euro, UK pound and yen as an elite currency in the IMF’s ‘special drawing rights’ that members can access in emergencies.

The yuan’s ascent to IMF-sanctioned status recognised that the banknotes featuring Mao Zedong’s portrait had become the world’s newest ‘reserve currency’. This tag means a currency is widely held by governments and institutions among their foreign-exchange reserves because it is seen as a store of value.

While the yuan forms a small percentage of world forex reserves, the currency’s elevation to, first, reserve, then, IMF status was controversial. The yuan is not “freely usable” and, unlike the other four currencies, is not market set. Other differences are that Beijing restricts capital flows and China’s financial markets are not deep or wide.

The next currency to deserve reserve status could break even more rules. It could well be a privately issued digital currency that’s yet to exist. Watch out when a virtual currency such as Facebook’s proposed Libra is born. Privately managed money issued by profit-seeking global platforms has the potential to become a mainstream means of exchange worldwide, an achievement that could upend global finance.

A cyberspace currency based on blockchain technology issued by a consumer platform such as Amazon, Apple or Facebook (or China’s Alibaba or Tencent, for that matter) could revolutionise finance for four reasons. The first is that these platforms have billions of users around the world who are likely to use the digital money. The second is that virtual currencies could introduce financial services to the 1.7 billion people in emerging markets who Facebook estimates lack access to financial services. The third is that money transfers within a secure private network could be close to costless, instantaneous and hassle free. Digital currencies would thus take business away from the expensive, inconvenient and sluggish payments, settlement and money-transfer systems that are run by commercial and central banks under country-based regulatory systems.

The last reason is that digital currencies can be designed to conquer the handicap that keeps cryptocurrencies to the fringe; that coded software has no ‘intrinsic value’. 

The telling advantage of Facebook’s Libra over Bitcoin is that Libra will be fully backed by safe assets denominated in reputable currencies.

No surprise; the prospect of a privately issued digital currency has spurred resistance, even calls that such money should never be permitted. Policymakers worry about letting powerful platforms gain even more influence over society. They fret about privacy and criminal use. They worry e-money will erode control over money supplies and impede monetary policy. Above all, they are wary of possible threats to banking systems.

No matter; a shock to global finance is being prepared. The technology exists. The latent public demand is there. The business opportunity is immense. The most successful currency issued by a digital platform could easily merit reserve status. But regulatory concerns will need to be allayed first and there is no guarantee they will be any time soon.

It could be argued that a digital currency backed by safe state-issued currencies is a security rather than money. But economists define money as anything that does what money should do and a successful privately created digital currency would meet that definition. So why not reserve status if virtual money reaches critical mass? Mainstream acceptance is not assured, of course. Much of the infrastructure surrounding Libra is incomplete. Governments will limit the penetration of digital currencies by insisting that many transactions be in local currency. Regulators might endlessly delay digital currencies. People might shun this form of money. After all, is it even needed in a world already going cashless where further innovations could vastly enhance traditional payment systems? Funnily enough, people in the US are ripe for digital money because the country’s payments system is creaky (though the Federal Reserve is intent on modernising over the next five years). Keen too are people in areas of the emerging world where payments are primitive. Those billions of platform users generally take to new things.

When public demand is high and the technology exists, then something usually happens. In time, if regulators are willing, digital currencies could be widely used means of exchange that enhance the global financial system but make it riskier in new ways too.

By Michael Collins, Investment Specialist

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