As more countries issue or develop central bank digital currencies (CBDC), the prospect of a digital currency as part of mainstream finance is increasingly becoming a reality. How will the digital currencies affect the international reserve ecosystem?

A recent paper by the International Monetary Fund (IMF) seeks to provide the answer to that question. This year's pandemic has already hastened the move toward a reconfiguration of the international reserve system. "COVID-19 could alter the global economic landscape … trigger strategic shifts in reserve holdings … in particular, the emergence of digital currencies and advances in payment systems could speed up the transition to alternative and, perhaps, less stable configurations of reserve currencies." the paper's authors write.

Key Takeaways

  • A new IMF paper states that the international reserve ecosystem will become less stable after the introduction of digital currencies.
  • The paper's authors state that the U.S. dollar will retain its dominant status in the international reserve ecosystem even after the introduction of digital currencies.

Will the Dominance of US Dollar Be Threatened? 

With a 61% share of global reserves, the U.S. dollar currently dominates international reserves. Rising interest in digital currencies has led some experts to posit that the greenback's position might be usurped by the digital equivalent of a fiat currency.

But that is not a foregone conclusion. A CBDC issued by countries already dominant in the reserve category could make their currencies even more powerful and increase demand for them, according to the IMF paper. In other words, a digital dollar may become as powerful as its fiat equivalent, if not more powerful. While the Federal Reserve has not yet committed to a timeline to introduce the digital dollar, the agency is reported to be actively pursuing research in the area.

The IMF paper arrived at its conclusion after a study of the factors that drive demand for a reserve currency. There are four: the economic size and credibility of issuers, transactional demand between parties, and inertia. The U.S. dollar trumps other currencies in all four respects.

However, a succession of financial crises and unchecked Fed money printing may have weakened the dollar's position. Coupled with these developments is the emergence of a new world order with multiple economic centers of gravity. Despite these seismic shifts, composition of the international reserve ecosystem will not change much. "… the high degree of inertia in the currency composition of global reserves suggests that the dollar will remain the dominant reserve currency for the foreseeable future," conclude the IMF paper's authors.

An alternative to this state of affairs is the development of a synthetic CBDC backed by a basket of global CBDCs. The idea has already been proposed earlier by former Bank of England governor Mark Carney. The IMF paper's authors write that such a digital reserve currency could provide efficient cross-border payment services, meaning faster processing, due to the credibility of multiple central banks backing it. The benefits of faster processing through digital currencies would be offset by a less stable reserve system configuration due to a multiplication of cyber risks, the paper's authors write.

A World Dominated by Private Digital Currencies

The paper also makes a mention of private digital currencies (PDCs), such as Facebook, Inc.'s (FB) proposed digital currency, Diem. According to its authors, PDCs have the potential to become global stablecoins, or monetary instruments that work across borders, and could attain reserve currency status. Fiat currencies could also become more powerful in the process because PDCs backed by fiat currencies could lead to an increase in demand for the latter.

One of the major concerns, when Facebook's Libra was announced, was that the social network's proposed digital currency could overwhelm the fiat currency of countries with weak economies. In response to such concerns, Facebook has modified its original design to introduce multiple stablecoins backed by fiat currencies of the respective countries.

But that’s not the end of it. The paper's authors have sketched an alternate scenario in which digital currencies issued by technology conglomerates could make fiat currencies and central banks irrelevant. "AI is used to establish exchange parities between digital currencies by facilitating price finding. To maintain credibility of the system, a technology consortium is set up to supervise the digital networks and provide emergency liquidity financing by pooling digital currencies across currency areas. Traditional reserve assets thus cease to exist and are replaced by holdings of private digital currencies," the authors write.