Will there ever be a digital reserve currency?

17 January, 2020

It is no secret that China hopes its recently released digital currency will eventually become a reserve currency. Chinese aspirations are so high that they sincerely believe their central bank distributed currency (CBDC) is actually capable of displacing the U.S. dollar as the world's favored reserve. But realistically, does their plan really have a chance?

It would be foolish to completely discount digital currencies and their potential to eventually displace fiat. Anything can happen. But many people, including International Monetary Fund (IMF) chief economist Gita Gopinath, don't see a major shakeup in reserve currencies during the short term. They see the U.S. dollar maintaining its dominant position as the favored reserve.

This post could end right now and not require any more information to make the point. Still, it's worth exploring digital currencies as reserve currencies, especially in light of what they are now lacking to take such a position. If cryptocurrency's shortcomings could be overcome, it would technically be possible to replace fiat reserves with better and more secure digital alternatives.

Definition of a reserve currency

At this point, a definition of 'reserve currency' would be helpful. The Investopedia website defines a reserve currency as "a large quantity of currency maintained by central banks and other major financial institutions to prepare for investments, transactions and international debt obligations, or to influence their domestic exchange rate."

Simply put, a reserve currency is one that central banks, governments, and investment banks hold in large volumes for the purposes of transacting business across borders. Reserve currencies are used to purchase most commodities - like gold and oil. As such, international players stockpile large volumes of reserve currencies in order to do business on commodities markets.

Believe it or not, China owns a lot of U.S. dollars. They buy them so that they can turn around and buy goods on international markets. So do other countries. They also buy U.S. dollars in order to facilitate easier bank transactions.

It is all about having a common instrument of payment. If all of the international partners involved in a given market are trading with U.S. dollars, their transactions are a lot easier than if they all brought different currencies to the table. That's really what all of this is about.

A digital reserve currency

It is theoretically possible to use a digital currency as a reserve currency. After all, actual cash does not change hands when international interests buy and sell reserve currency to access commodities markets. The dollars they own are represented digitally on computer systems. It is not like they are loading trucks filled with bills and sending them back and forth.

On the other hand, the bills and coins that represent U.S. dollars still exist as tangible assets. They are stored somewhere. As such, any international player who wanted to actually take possession of the dollars and owns could do so. That is not possible with digital currencies for the simple fact that such currencies are not tangible.

For the sake of the discussion, let us assume Bitcoin managed to supplant the U.S. dollar as the world's favored reserve. What would that look like? For starters, central banks would hit the exchanges and start purchasing BTC with their own fiat. You can bet the price of BTC would skyrocket as a result.

With their BTC secured, central banks would then use the digital coins to do what they do. Coins would be transferred to commercial banks for the purposes of buying oil, gold, and other commodities. Governments would use the coins to settle their debts and pay their bills. Meanwhile, central banks would continue buying BTC in order to keep their coffers flush.

All of the buying, selling, and trading would be recorded on Bitcoin's blockchain ledger alongside your Bitcoin deposits at your favorite online casino. Moreover, the ledger would grow exponentially by the day simply due to the volume of Bitcoin transactions created by central bank involvement.

If this seems unworkable to you, you have just discovered why it is highly unlikely Bitcoin will ever become the world's preferred reserve currency. Bitcoin's infrastructure simply cannot support such a high volume of international transactions.

Stability and resilience

Something else to consider is stability. Any currency that would act as a reserve must be extremely stable if central banks are going to rely on it. There's a reason Venezuela's bolivar is not a reserve currency. It is too unstable, to unreliable, and not very resilient.

The U.S. dollar is all three of those things. That is why it has been the world's favored reserve currency for decades. Central banks and world governments can rely on the value of the dollar even under the worst economic conditions. They can rely on its stability. Most importantly, they can rely on the dollar's resilience.

The real value of the dollar lies in the U.S. economy. And though we do not like to talk about it a lot, no one can deny the resilience of that economy year after year. During the Great Recession that began in 2008, the damage to America's economy was minor compared to what was observed in other countries. For all intents and purposes, the Great Recession was a hiccup in the U.S.

Even if you go back to the Great Depression of the late 1920s and early 30s, you see a U.S. economy that, while hit hard, began working on its own recovery almost immediately. The American economic system is built on the premise that growth and expansion are always possible. It is designed to not settle for stagnation. So even when times are tough, America's economic engine keeps churning until things are turned around.

It is this resilience that gives the U.S. dollar its clout. The dollar certainly isn't hurt by America's economic output either. All this leads to the inevitable conclusion that something drastic would have to happen to the dollar for a digital currency to supplant it as the world's reserve.

Digital replacements for cash

There is one scenario in which it is possible to envision a digital reserve currency. It is a scenario in which cash is replaced by digital alternatives. Enter China's CBDC. Right now, it is not a drop-in replacement for yuan. However, that is the eventual goal. China plans to eventually eliminate cash altogether. Once that happens, their CBDC will be their only currency.

Do not be surprised to someday learn that China is not the only country pursuing such a strategy. As cryptocurrency matures, central banks are coming to the conclusion that the days of cash payments are quickly drawing to a close. Once people are no longer paying for things with cash, there will be no need to have it. That is when digital currencies will truly take their place in the world.

So, could this be an opportunity for a digital currency to replace the dollar as the world reserve? Yes and no. Yes in the sense that a digital currency will have to be the world's reserve when we eventually reach the point at which cash no longer exists. But no in the sense that the dollar is not going to be replaced by China's CBDC, or any other for that matter.

In all likelihood, the only thing that will replace the dollar as the world's reserve is the U.S. replacement for the dollar itself. Once the U.S. Federal Reserve has a digital currency ready to replace printed bills and minted coins, there will no longer be a need for cash. All of those bills and coins will be redeemed for digital tokens representing the exact same value.

What happens next? America's CBDC becomes the new currency of the nation. It also becomes the new reserve currency for the exact same reasons that the dollar is the dominant reserve right now.

Private and Central Bank digital currencies

One final thought here - about the realities for both private and central bank digital currencies in relation to the reserve principle. All of the reserve currencies now used on international markets are printed and controlled by central banks. That much is never going change. Central banks and their government partners are not going to give up economic control by abandoning what they do in favor of private cryptocurrencies.

As such, do not hold your breath waiting for something like Bitcoin or Litecoin to overtake fiat. Private digital currencies are very good as monetary systems, payment systems, and investments. No one disputes that. But expecting central banks to take a backseat to private cryptocurrencies is a fantasy. It is not going to happen.

China may be very confident in the ability of their CBDC to overtake the dollar as a world reserve. Let them have at it. They are going to discover, eventually, that a reserve currency has to be one with more than just a large quantity of coins. It has to be a currency that the world trusts for its stability, value, and resilience.

Will there ever be a digital reserve currency? The chances are pretty good. It is just unlikely to be a private cryptocurrency or anything other than a drop-in digital replacement for current reserves.