The Fed & SDR Denominated Derivatives



Many for so long have proclaimed the end of the dollar and a collapse of the USD system. Though the dollar will be adjusted downward at some point in the initial implementation of a multilateral system, its sustainability in a broader monetary framework will be a fundamental corner stone to correcting the imbalances which originated from the USD system itself.

The USD monetary system is based on using the domestic currency of the United States as the global reserve unit of account.  This arrangement has created systemic imbalances in the international financial framework which has lead to inherent risks in all segments of the system, such as trade, credit, exchange rates, inflation/deflation, commodities, capital flows, and geopolitical power shifts.

Some of these imbalances have been extremely prominent in the last days as oil continues its dramatic depreciation, the Swiss removed the francs peg to the euro, (as the euro was depreciating against the appreciating dollar), Russia converting a portion of its foreign reserves into rubles, and geopolitically Russia has diverted natural gas flows into Europe from the transit points in Ukraine to transit points in Turkey.

On a more macro level, the Bank of China (Hong Kong) has stated that the inclusion of the RMB into the SDR basket of currencies will accelerate international monetary reform which will help build stability in the system.  This stability will be constructed around using the SDR as the global unit of account in place of the USD.

We have covered the importance of the RMB to the SDR supra-sovereign reserve system, along with the BRICS Development Bank, in the post The SDR Purpose of BRICS.

One of the least understood segments of the USD imbalances are the derivative trades.  These trades are a method of hedging against the risk which is inherent in the USD system.  As in all trades or exchanges, there are two ends, a gain end and a lose end.  The derivatives are meant to take the risk out of trade for trans-border businesses and other financial institutions, along with large private investors.

Each trade needs to be cleared though a clearing house and the risk of systemic failure because of the potential loses are building.  The current policies and institutions handling the clearing process are incapable of dealing with this systemic risk.

Supra-sovereign and trans-border institutions and entities such as banks and hedge funds, which are structured around national and domestic frameworks, cannot provide the international policy changes required to address the risk associated with derivatives.

As such, a single and unified international policy is required.

The development and implementation of the multilateral monetary framework is capable of addressing this risk more effectively than the USD system.  By denominating derivatives in SDR, both virtual aspects of the unit of account and derivatives will align, allowing for a more unified policy response to the risk.

SDR denominated derivatives will fundamentally reduce the exposure by functioning above the constraints of national fiat currencies, which are heavily influenced by the multi-trillion dollar non-sovereign dominated Forex markets.  The SDR, held by sovereign central banks, will help stabilize the international supra-sovereign response required to reduce the derivatives risks and enact the unified policies.

The clearing of derivatives will also have to be handled in a broader multilateral framework as well.  The establishment of clearing entities, or banks, perhaps with only one or two acting as the mandated clearing houses, can facilitate the reduction of systemic risk to the international monetary framework.

Derivative contracts that are considered high risk can be fragmented into clearable (low risk) and unclearable (high risk) segments.  This disaggregation of illiquid derivative contracts will ensure the overall credit risk, or exposure, is reduced or eliminated on the cleared portion of the contract, while the risk associated with the uncleared portion is reduced in the markets.

The clearing house, in this case the Federal Reserve, will be accountable to provide liquidity for the uncleared “high risk” segments at valuations which are compatible with the margins of the defaulting members and contracts.  This process would reduce the chances of default with the least amount of systemic risk to the broader international monetary structure.

There are many moving pieces to the transition from the USD structured system to the multilateral SDR framework.  The risk associated with derivative clearing is one of the more important factors which will require a unified policy framework which operates above the limited policies which exist at the national and domestic level.

The USD will not collapse and the SDR will be implemented as the international unit of account.  No one currency or country has the ability or policy framework to deal with the challenges presented in correcting the imbalances which have developed from the USD system.  China, Russia, or any other grouping of countries, are not interesting in replacing the USD as the international unit of account.  The response to the systemic imbalances which exist will require the unified approach to policies and procedures which only the multilateral framework can provide.

Anyone pumping and promoting the collapse of the dollar does not fully understand the multilateral framework or the trans-border nature of the associated risks inherent in the USD system. – JC

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