Appendix III: Role of the SDR in the International Financial Markets82
- International Monetary Fund
- Published Date:
- August 1981
Although the potential usefulness of the SDR in providing an international store of value and unit of account that is more stable than any currency in the SDR basket has long been recognized, the SDR has only recently begun to play a more important role in the international financial markets. Part of the increasing interest in SDR-denominated financial instruments is attributable to the severity of exchange rate fluctuations in recent months, but a more important factor has been the simplification of the SDR basket. The resulting development of the market for SDR instruments is a self-reinforcing process, as greater depth in the market enhances its attractiveness to potential participants. This Appendix reviews recent developments in the role of SDR-denominated instruments in the international financial markets and summarizes the views on that role expressed by many bankers in the discussions forming the background to this paper.
Simplification of the SDR Basket
The simplification of the SDR basket to five currencies, which took effect January 1, 1981, has, in the view of the market, greatly enhanced the attractiveness to both borrowers and lenders of the SDR as a unit of account for deposits and other financial obligations. The previous SDR basket of 16 currencies had included currencies for which money markets were little developed and which were not actively traded in foreign exchange markets. The inclusion of such currencies had made it virtually impossible for banks to cover SDR deposits in all the component currencies, and handling a basket consisting of 16 currencies was administratively costly. This had led to reluctance on the part of some banks to accept deposits denominated in SDRs, and interest rate quotations were significantly lower than the weighted average of rates on the component currencies.
With the basket simplified, the principal attraction of the SDR—its stability in terms of major currencies—has received more attention, particularly in view of the large exchange rate fluctuations of recent months. In contrast to earlier periods when market interest in SDR-denominated assets was strongest when the U.S. dollar was weak in foreign exchange markets, the recent attention developed at a time when the U.S. dollar was appreciating.
Deposits Denominated in SDRs
The SDR’s major advance appears to have been in the market for bank deposits, including certificates of deposit.83 According to market reports, some 40 to 50 banks, as well as official institutions, such as the Bank for International Settlements (BIS) and the Nordic Investment Bank, are now offering time deposit facilities denominated in terms of SDRs. A more recent innovation is the availability at some large banks of demand deposit accounts denominated in SDRs. These facilities permit the use of the SDR for direct payments between account holders without going through another currency and facilitate trading in SDR-denominated securities.
The SDR deposit market is a wholesale market, mainly for deposits for periods up to 12 months. The principal depositors have been multinational corporations, central banks, and governmental and intergovernmental institutions. Interest rates on SDR deposits are calculated on the basis of the weighted average of the Eurocurrency deposit rates of the constituent currencies or by using a specific Eurocurrency rate, usually the Eurodollar rate, and adjusting it for the cost of covering the other four currencies in the SDR basket in the forward markets. According to market reports, SDR deposit rates generally are marginally below the weighted average of interest rates on the five component currencies. This difference has declined with the simplification of the SDR basket, and some commercial banks currently offer rates matching those on the component currencies. The spread between bid and offered rates for SDR deposits has also narrowed, strengthening the interbank market in SDR deposits. Some banks are offering forward quotations for SDRs against major currencies, in particular the U.S. dollar.
According to many bankers, the major problem associated with taking up SDR deposits, particularly for interbank transactions, has been the relatively limited supply of SDR-denominated assets, which implies that banks accepting SDR deposits and wishing to be fully covered have to split deposits into the component currencies for investment, by converting the appropriate proportion of the vehicle currency into the other four currencies in the SDR basket. Since June 1980, this shortage of SDR-denominated assets has been alleviated by issues of SDR-denominated certificates of deposit (CDs). Development of an SDR-CD market has been facilitated by the standardization of a negotiable instrument proposed by a Steering Committee comprising the most important banks participating in the SDR market. This standardization is likely to assist in the formation of a secondary market in which CDs denominated in SDRs can be traded, thereby rendering the certificates more liquid. There have also been issues of floating rate notes (with maturities of up to three years) denominated in SDRs. The interest rates on the most recent issues have been based on the average rates quoted on SDR deposits rather than on London interbank offered rates (LIBOR) for the constituent currencies.
The simplification of the SDR and the development of a market dealing in standardized instruments would tend to reduce the relative attractiveness of custom-tailored baskets at the specification of clients. As long as SDR deposits needed to be split up into the component currencies for investment, it was not more costly to banks to produce individualized baskets which, though similar to the SDR, were yet sufficiently different to take into account special needs. The present less complex SDR basket accommodates more of the currency diversification needs actually existing in the market.
Loans Denominated in SDRs
In recent months the first syndicated medium-term (5-year to 8-year) loans containing an SDR-denominated portion have been made. Sweden’s recent jumbo loan included an SDR tranche of SDR 500 million in addition to a dollar tranche of $800 million. If the borrower and the bankers agree that the SDR market has developed to such an extent that SDRs can be treated as a currency, repayment of the SDR-denominated portion will take place in SDRs. The interest rate en the SDR part of the loan is based on six-month LIBOR for the U.S. dollar plus the premium (or discount) on the forward rate of the SDR in terms of U.S. dollars; this premium (or discount) is calculated as the weighted average of forward rates on the currencies in the SDR basket. A recent medium-term loan to Ivory Ccast also includes an SDR tranche, but with the proviso that the loan will be repaid if the U.S. dollar rises by more than 10 per cent against the SDR. The reference interest rate over which the spread on this tranche is set is the average of six-month SDR offered rates quoted by five reference banks.
Bonds Denominated in SDRs
The first SDR-denominated bonds were issued on the Eurobond market in 1975. Eleven issues were brought to the market between 1975 and early 1981, amounting to close to SDR 450 million. Three of these have taken place since the change in the SDR basket. They include one bond issue by the Nordic Investment Bank and two floating rate note issues, by a public Italian electricity company and by a large French company.
Many bankers reported that pricing difficulties arising from the thinness of the secondary market were an obstacle to issues of fixed-rate SDR-denominated paper. A broader market for longer-term SDR deposits would be instrumental in easing these pricing difficulties. The trading of SDR-denominated securities should be greatly facilitated by the recently announced introduction of demand deposit accounts denominated in SDRs, which can be used for the clearing of transactions in SDR-denominated bonds. Bankers report that the generally depressed state of the bond markets has dampened investor interest in SDR-denominated bonds as well.
Involvement of the Fund
While the Fund has so far not played a role in the private market for SDR deposits, it temporarily held substantial amounts of SDR deposits with the BIS on behalf of the Trust Fund. While these deposits have now been disbursed, new SDR-denominated accounts with the BIS have been opened for the temporary investment of funds borrowed by the Fund, pending disbursement under the enlarged access policy, and for the temporary investment of the resources of the supplementary financing facility’s Subsidy Account. There is also the possibility that short-term or medium-term bearer notes issued by the Fund as evidence of drawings under borrowing arrangements with official institutions will be offered in the private market for SDR instruments. As the option of requesting such notes and of offering them for sale lies with the lender, it cannot be foreseen whether and to what extent they will in effect be offered for sale in the secondary market for SDR paper.
Other Uses of the SDR as a Unit of Account
The smaller SDR basket should facilitate the use of the SDR as a unit of account in treaties, commercial transactions, and agreements between international organizations. Currently, Suez Canal charges are denominated in terms of SDRs and the Universal Postal Union has, in effect, adopted the SDR as unit of account. The SDR is also used as a unit of account in a number of private contracts and international treaties, and by international and regional organizations, in addition to the Fund itself.
The period following the introduction of the new valuation has been marked by a growing use of the SDR as a unit of account in financial markets. While the markets for SDR-denominated instruments remain small in relation to the global money and capital markets, it is to be expected that more widespread use will increasingly be made of SDR-denominated instruments. The reduction in the number of currencies in the SDR basket has largely eliminated the administrative difficulties and reduced the cost previously impeding such use. The new basket is also more attractive to investors, who prefer simpler “currency cocktails.” New SDR-denominated assets (such as certificates of deposit) have emerged, and more such developments are anticipated by bankers. As a first result, the interbank market in SDR-denominated instruments should widen and thereby facilitate and support trading in SDR instruments. Eventually, more widespread circulation of SDR-denominated assets outside banks could also result. Although the overall role of the SDR remains small, compared with the U.S. dollar and other currencies, market sentiment is that SDR-denominated instruments are likely to assume an increasing role in international financial markets in the future.