IGTA Journal - Winter 2020/2021

bonds. What global investors care about is the ability to pay for things. ey needed cash (or, in the modern sense, bank deposits). For global investors, that meant selling Treasuries and bidding for dollars in money markets. A spike in the FX swap basis tells the story. To nance the purchase of dollar investments, global investors often “swap” their domestic currency (e.g., Japanese yen) for dollars. In turn, banks provide those dollars as a service. In that sense, the dollar plays a vital role in the global system. A negative “basis” means that borrowing dollars through FX swaps is more expensive than just borrowing in the dollar money market. In March 2020, many investors with dollars preferred to keep them rather than lend them out, and a dollar crunch ensued. e cost of borrowing in dollars spiked. For example, the three-month basis (the di erence between borrowing through FX swaps and borrowing in money markets) widened to -144 basis points for the Japanese yen, -85 basis points for the euro, -107 basis points for the Swiss franc, and -62 basis points for the pound sterling. 3 Fortunately for the Federal Reserve, there was an easy solution. With banks incapable of sourcing dollars or unwilling to provide them, the Fed provided dollars to foreign central banks (e.g., the Bank of Japan), which in turn provided those dollars to local banks. At the height of the crisis in March, the Fed “swapped” $400 billion with 19 central banks. In fact, almost everything the Fed did in March and April was to supply more dollars to alleviate the shortage and calm the panic, from buying Treasuries from cash-strapped dealers to swapping dollars with the Bank of Japan. In this way, the Fed played the role of not just the “U.S. central bank” but also the global central bank. As long as the Fed is willing to act as the backstop to the dollar, it will be hard for other currencies to unseat it. HISTORY AS A GUIDE? THE DEATH OF A RESERVE CURRENCY Despite our con dence in the greenback and the lessons of March 2020, we’d be foolish to say the dollar’s reign is eternal. History tells the story. If you were alive in the 18th century, then Amsterdam, not America, would have been home to your “safe assets.” Riding a wave of prosperity as a global trading powerhouse, the “reserve currency” at the time was the florin issued by the Bank of Amsterdam, founded in 1609. e orinwas neither a coinnor a note. Customers of the Bank of Amsterdam (“the Bank”) deposited metal coins, which led to their accounts’ orin credits at the Bank. e service was tremendously useful. Instead of transacting in gold coins, which were of varying quality, customers could settle retail and wholesale payments using their account at the Bank of Amsterdam as the central ledger. While not coin-backed (depositors had to pay a fee to withdraw metal), the Bank threw its vaults open to prove its credit-worthiness. 4 Moreover, the Bank supported money markets. Savers could deposit coins for a xed period and earned interest—the modern “repo” market. A healthy money market meant that investors could nd willing buyers of trade acceptances used to nance commerce all over the world—the same role played by the U.S. dollar today. According to accounts of the era, “it was fairly commonplace for, say, a merchant in, say, London, to pay for goods imported from, say, Gdansk with a bill drawn on Amsterdam.” is way, bills from Amsterdam became a form of short-term credit and the orin turned into the unit of account in the transaction. 5 e Bank acted the way a modern central bank does, providing direct credit to the Dutch East India Company. Unfortunately, loans to the Company went unpaid as global shipping su ered through a series of military con icts in the late 1700s; hence, incomes dropped, con dence in the Bank eroded, and deposits ed. After the French invaded the Netherlands in 1795, the Bank’s accounts were made public, and the shockingly low metal stock con rmed what investors had long feared: e Bank was insolvent. Hobbled and without scal backing from the state or local government, the Bank limped on until 1820, but only as a shadow of its former self. By then, London, not Amsterdam, had become the world’s nancial capital. IMAGINING A 21ST CENTURY RESERVE CURRENCY: A DIGITAL COIN? Rather than fanciful headlines touting the end of the dollar’s dominance due to the current account de cit, it may be more productive for investors to consider what, if anything, would upend the dollar’s dominance. Who—or what —is next? For now, with the U.S. a premier destination for global capital and the Federal Reserve willing and able to maintain the dollar system, the U.S. dollar’s role appears secure. One intriguing possibility is not a at-backed challenger like the renminbi or euro but a digital currency that would allow global investors to place on deposit their local currency and transact and settle payments in a new, global coin—a 21st-century version of the Bank of Amsterdam’s orin. Just as the Bank of Amsterdam threw open its vaults to prove its reserves, in the 21st century, an open-source software program could provide evidence of reserves to ensure investor con dence or perhaps receive central bank backing (a so- called central bank digital currency or CBDC). We doubt the U.S. dollar will always reign supreme. After all, the pound sterling displaced the florin , and the “greenback” superseded the pound only 100 years ago. But until a more formidable competitor comes along, the U.S. dollar remains the global standard. inking about the past rise and fall of reserve currencies may help investors imagine what will come next. In the meantime, ignore the dollar doomsayers. ENDNOTES 1. See for example: Stephen Roach. “ e end of the dollar’s exorbitant privilege.” Financial Times . 4 October 2020. https:// www.ft.com/content/46b1a230-8c6c-4feb- b617-21a520cc201b 2. e phrase “exorbitant privilege” is famously attributed to French president Valery Giscard D'Estaing in the 1970s--an early dollar bear. 3. “Dollar funding costs during the Covid-19 crisis through the lens of the FX swap market.” Bank for International Settlements (BIS) Bulletin No 1 . 1 April 2020. 4. Jon Frost, Hyun Song Shin, and Peter Wierts. “An Early Stablecoin? e Bank of Amsterdam and e Governance of Money.” BIS Working Papers No. 902 . November 2020. 5. StephenQuinn andWilliamRoberds. “ e Death of a Reserve Currency.” International Journal of Central Banking , Vol. 12 No.4, December 2016. U.S. dollars Euro Yen Pound Sterling Other currencies Renminbi Canadian dollars Australian dollars Swiss francs Unallocated reserves 0% 10% 20% 30% 40% 50% 60% Share of Total fig 2. CASH HOARD: FX RESERVE HOLDINGS STILL FAVOR USD Source: IMF 10 IGTA eJournal | Winter 2020/21 | 55