Abstract

A major difficulty in introducing a discussion about the SDR or the European currency unit (ECU) is the fact that each can potentially refer to a number of different things. The SDR and the ECU are, first of all—and, in an important sense, primarily—units of account. As such, the manner in which the value of each unit is determined or established and its behavior over time are of primary importance. Both the SDR and the ECU have their values defined in reference to baskets of currencies. These baskets are generally reviewed and adjusted every five years.

I. Introduction

A major difficulty in introducing a discussion about the SDR or the European currency unit (ECU) is the fact that each can potentially refer to a number of different things. The SDR and the ECU are, first of all—and, in an important sense, primarily—units of account. As such, the manner in which the value of each unit is determined or established and its behavior over time are of primary importance. Both the SDR and the ECU have their values defined in reference to baskets of currencies. These baskets are generally reviewed and adjusted every five years.

Each unit may be used in a wide variety of ways, and these give rise to most of the other things that might be meant when referring to the SDR or the ECU. Each has been used to denominate privately created financial instruments, so-called private SDRs and private ECUs. These have taken or potentially take all the forms possible for financial instruments denominated in national currencies. While private SDRs now exist only in the form of bank deposits, private ECUs range from bank deposits and credits to ECU bonds, puts, calls, options, credit cards, traveler’s checks, and enjoy fairly active spot and forward foreign exchange markets.

The SDR and the ECU have also been used to denominate a variety of contracts or treaties establishing liabilities of various sorts. They have been used to denominate the accounts and financial dealings of a number of institutions, such as the International Monetary Fund for the SDR, or the European Commission for the ECU. In addition, the SDR and the ECU provide the basis for pegging a number of exchange rates, though this is most elaborately developed for the ECU in the context of the European Monetary System.

The SDR and the ECU are also, and are often primarily understood to refer to, official reserve assets created by the International Monetary Fund and the European Monetary System, respectively. The mechanisms by which these two official reserve assets are created and allocated are integrally related but importantly distinct. Hence, the SDR is sometimes taken to refer to a method of reserve supplementation, while the ECU may be understood as a mechanism for mobilizing gold (and U.S. dollar) reserves held by European Economic Community (EEC) members.

In this paper, I discuss the official SDR, the reserve asset created and allocated by the International Monetary Fund. In a companion paper, Professor Mario Giovanoli discusses some interesting developments in the clearing and settlement of private ECU payments.

II. The Official SDR

The official SDR can be held only by Fund members (participants) and official international entities prescribed to do so by the Fund (prescribed holders), of which there are presently 16. About 21.4 billion SDRs have been allocated to date. These SDRs may be used in a wide variety of financial dealings between participants and the Fund, as well as among participants and prescribed holders. Among participants and prescribed holders, SDRs may be bought or sold against foreign exchange through two mechanisms. Participants with a balance of payments need to use reserves may invoke the designation mechanism, which obligates participants in a strong reserve position to accept SDRs and provide a freely usable currency at the Fund’s official exchange rate.

Any holder, whether it has a balance of payments need or not, is free to buy or sell SDRs against currencies if it can find a willing counterparty to the transaction. These are called transactions by agreement when they are settled in three business days or less and forward operations when the agreed settlement takes place more than three business days after the transaction is initiated. These two voluntary exchanges of SDRs, transactions by agreement and forward operations, are the primary subjects of this paper. It describes the efforts the Fund has made, and the techniques it has employed, to assist in the development of these two types of transactions and some of the legal considerations that were involved.

Since the SDR interest rate was raised to 100 percent of the combined market interest rate,1 the amount of SDRs used in transactions by agreement has increased significantly and at a much greater rate than have the amounts of SDRs put to other uses. Over the same period, the amount of SDRs used in transactions with designation has fallen significantly. The growth in voluntary transactions and the reduction in transactions with designation are the consequences of a number of factors, but it seems reasonable to conclude that steps taken since the adoption, in 1978, of the Second Amendment of the Fund’s Articles of Agreement to make the SDR more competitive with other reserve assets have contributed to these trends.2 In addition, the Fund has played an important role in facilitating these transactions by finding the counterparties for transactions by agreement that holders have wanted to engage in.

III. Transactions by Agreement

Introduction

Markets for individual financial instruments invariably rely on market makers to ensure their smooth functioning. Even instruments that trade in large volumes require middlemen between buyers and sellers. The use of mid-rates—that is, the absence of margins or spreads—when transacting with SDRs removes an important profit incentive for making a market for SDRs; however, the Fund and a few of its members have taken steps intended to overcome this difficulty. The Fund has taken on the task of helping those wishing to buy or sell SDRs to find counterparties for the transactions.

In performing these brokerage sendees, the Fund has taken advantage of differences in the preferences of holders. Some holders wish to buy or sell specific amounts of SDRs on specific dates against specific currencies, while others only wish to raise or lower their holdings over some general period of time and, hence, are fairly flexible with regard to the precise dates of transactions. The Fund has exploited the flexibility of the latter group in order to accommodate the preferences of the less flexible group. Because of time-zone differences among the potential transactors and the time it takes to arrange transactions, it has been convenient to establish standing arrangements with some members of the more flexible group.

Recent Developments

For several years now, for example, anywhere from two to eight members wishing to reduce their SDR holdings (or to keep them from rising in the face of inflows of SDRs from one source or another) but having little interest in the precise timing of sales have authorized the Fund to arrange sales on their behalfs, subject to general guidelines with regard to max imum amounts, currency counterparts, etc. For these holders, sales could be delayed somewhat in order to accommodate a holder that wished to buy SDRs on particular dates. As a result, for several years now; the Fund has been able to arrange every purchase holders have requested it to arrange. Because fewer holders were prepared to be as flexible with regard to the timing of their purchases of SDRs, it has been more difficult, until very recently, to arrange for voluntary sales on specific dates with the same degree of certainty.

To facilitate the use of voluntary transactions, members wishing to sell SDRs that would otherwise do so in transactions with designation have generally allowed the Fund staff to arrange the sales by agreement if voluntary buyers could be found for the indicated value dates.3 In practice, however, it was generally difficult to find holders that wished to buy SDRs on the same days that others wished to sell them, even when the amounts holders wished to sell roughly matched the amounts others wished to buy, on average, over longer periods.

In order to help overcome this mismatch of timing, a number of Fund members have recently entered into arrangements that allow the Fund to arrange purchases or sales of SDRs from their holdings, as needed, to accommodate the desires of other holders to buy or sell SDRs on particular dates. To date, eight members have entered into such two-way arrangements for the SDR. Holders entering into these arrangements specify the terms and conditions under which the Fund may initiate transactions by agreement on their behalfs. These include the range of SDR holdings within which transactions may be initiated, the currencies to be exchanged, and whether transactions are to be settled in two or three business days. The two-way arrangements in effect at present provide for potential purchases or sales of slightly more than SDR 1 billion, in the aggregate, against U.S. dollars. Within this aggregate amount, smaller amounts may be arranged against deutsche mark, French francs, pounds sterling, or yen. The actual amounts of purchases or sales that can be arranged at any particular time depend on the levels of SDR holdings at that time of those with two-way arrangements.

These two-way arrangements have had an impressive impact on the distribution of SDR transactions between designated and voluntary mechanisms. In 1987, the amount of SDRs exchanged for currency in transactions among members and prescribed holders was about 40 percent greater than in 1982, the first year after the SDR interest rate was raised to market levels. (See Table 1.) Of such transactions, transactions by agreement rose by a multiple of five while designated transactions fell by about two thirds. This large-scale substitution of sales by agreement for sales with designation has been made possible primarily by the “market-making” activity of the eight members that have established two-way arrangements. These arrangements have allowed the Fund to satisfy with voluntary transactions every request to arrange a purchase or sale of SDRs that it has received since August 1987. As a result, there have been no designated transactions since that time.

Table 1.

Summary of Selected SDR Transfers

(Billions of SDRs)

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As a result of these two-way arrangements, those participants either not having a balance of payments need to use reserves or prefering not to make a formal representation of such a need and all prescribed holders, which are not allowed to use SDRs with designation, have been able to trade SDRs whenever they wanted. In addition, these arrangements also assisted the Fund in executing its currency budget.

Valuation Issues and Compensation for Late Payments

These recent developments, along with earlier ones that have given the SDR characteristics similar to those of market assets, have made the SDR more competitive with other reserve assets. However, because the Fund’s rules for valuing payments do not explicitly provide for the compensation of losses incurred when payments are made late, the SDR is potentially placed at a competitive disadvantage vis-à-vis other reserve assets.

The currency counterpart of the SDRs sold in a transaction by agreement is established, in accordance with the Fund’s Rules (Rule P-6), on the basis of the Fund’s exchange rates on the same day or one, two, or three business days before the value date, depending on whether the transactors have agreed to settle the transaction on the same day or in one, two, or three business days. When a transaction by agreement is settled late, Rule P-6 requires that the SDR value of the currency paid be reestablished on the basis of the official SDR exchange rate the appropriate number of days before the actual value date unless the exchange rate has moved to the advantage of the party responsible for the late settlement, in which case the originally advised amounts and exchange rate are used. As a result, the amount of SDRs transferred against the currency received might be smaller than had been originally agreed, but could never be larger.

This differs from the market standard for dealing with the late settlement of foreign exchange transactions, which is to adhere to the originally advised currency amounts, without regard for when they are actually paid, and to require compensation for any interest income lost as a result of the late settlement. Any loss to the seller of SDRs as a result of the late receipt of the currency counterpart, however, can be prevented (or made up) by the payment of compensation.

When entering into transactions by agreement, holders are free to agree on the rules governing compensation when payment instructions are not properly executed. It is assumed, however, that when transactions are arranged through the Fund, no separate explicit understanding exists between the parties to the transactions with regard to late payment compensation. Therefore, for transactions by agreement arranged by the Fund that are settled late, the Fund advises the party that paid currency late of the amount it is expected, but not obligated, to pay as compensation. This amount reflects any excess of the interest paid (at the overnight interbank rate) for the currency (implicitly borrowed) over the interest earned on the SDRs being transferred.4 In the event that the party paying currency late also experiences an exchange loss, that loss will be deducted when any interest compensation is determined.

IV. Forward Operations

Introduction

The Fund has also prescribed the purchase or sale of SDRs forward. These so-called forward operations are basically the same as transactions by agreement, but have value dates four or more business days in the future; an important difference, however, is that parties to a forward operation are free to establish the exchange rate used. There have been only four forward operations to date. In order to assist holders wishing to arrange forward operations, the Fund offers brokerage services similar to those it provides in arranging spot transactions by agreement.

Reasons for Forward Operations

The principal motive for forward foreign exchange operations is the desire to reduce or eliminate uncertainty about future exchange rates. Forward exchange rates are, generally speaking, rather poor indicators of future spot rates.5 Although forward exchange rates reflect all available information considered relevant to the level of future spot rates,6 actual future spot rates remain uncertain. Therefore, future spot exchange rates between the SDR and a national currency may turn out to be quite different than had been expected—that is, than had been suggested by current forward rates. Forward operations in SDRs can be used to achieve certainty about the currency equivalents of future transfers of SDRs well in advance of the value date.

If a member knows that at some future point in time, it will have to discharge obligations in SDRs, a forward purchase of SDRs will allow the member to eliminate the uncertainty about the SDR’s currency price without having to acquire them now. Similarly, a member expecting to receive SDRs in the future could sell them forward for currency to secure the SDRs’ currency equivalent—that is, to eliminate the risk of unfavorable exchange rate changes reducing the currency value of the SDRs to be received in the future.

In addition to enabling members to cover exchange rate exposures, the development of a forward market in SDRs would create a means of obtaining a fixed SDR interest rate for periods longer than the present maximum of one week over which the SDR’s interest rate is fixed. A holder of SDRs who desires to earn the interest rate on SDRs implicit in the calculation of the forward exchange rate for a certain maturity7 would be able to do so by selling the SDRs that it already owned spot for currency, investing the currency for the relevant maturity, and buying SDRs forward with the expected proceeds. Without the use of this technique (investment of currency and forward purchase of SDRs with the expected proceeds), the ability to earn SDR interest rates that are fixed for longer maturities is presently limited to investments in SDR-denominated instruments available in private financial markets or in the component currencies. Markets for SDR-denominated instruments are very thin, resulting in wider margins on these than for most other investments, and thus making this option relatively unattractive.

Forward operations in SDRs potentially provide the ability to obtain certainty with regard to future exchange rates and fixed SDR interest rate investments for longer periods and at lower costs than can be obtained using the alternative techniques presently available. The development of a market for forward operations in SDRs is an important step toward integrating the SDR more fully into the international money and capital markets, and making the SDR more useful and attractive.

Role of the Fund

Parties to forward operations are free to determine the exchange rates to be used. No holders currently quote forward exchange rates for SDRs. Holders wishing to transact forward in SDRs could negotiate and agree on the exchange rate on the day the operation is initiated. However, it would facilitate the finding of counterparties for those wishing to buy or sell SDRs forward if the Fund were to play the same brokerage role for these operations that it performs for transactions by agreement. Given the time it normally takes to arrange transactions on a worldwide basis, it would facilitate the Fund’s brokerage activity if the potential parties to these operations were prepared to accept forward exchange rates calculated by the Fund in the same way they presently do for transactions by agreement. Transactions by agreement are generally arranged without the parties knowing the exchange rate that will apply. They do know the manner by which the rate will be determined, however, and this is generally sufficient.8 A similar approach might be helpful for forward operations.9

Because the result of a forward transaction can be achieved in alternative ways, arbitrage generally ensures that forward exchange rates are set so as to remove at the margin any advantage from taking one approach over the other. The forward exchange rates for the SDR in terms of the U.S. dollar that are used by the Fund for forward operations it arranges are calculated as the appropriately weighted average of the forward exchange rates of the SDR’s component currencies in terms of the U.S. dollar. These will leave prime rate transactors indifferent between a forward transaction at that rate and borrowing U.S. dollars, buying the SDR’s components spot, and investing the latter.

Any member of the Fund, as well as all prescribed holders, can engage in forward operations in SDRs. However, holders most likely to be interested in forward operations are those with obligations to the Fund that are denominated in SDRs and that either must or may be settled with SDRs (e.g., charges and repurchases), and those with future receipts that are denominated in SDRs and that might be received in SDRs (e.g., purchases from the Fund or loans made by the Arab Monetary Fund or regional development banks that operate on an SDR basis, such as the African Development Bank or the East African Development Bank).

Some holders with standing arrangements to buy and/or sell SDRs spot have expressed interest in facilitating the development of forward operations by being the counterparties to forward operations, as needed, at the forward rates calculated by the Fund. It is possible that other holders with standing arrangements would be prepared to add forward operations to their existing arrangements. As with transactions by agreement, standing arrangements for forward operations could overcome the timing and maturity mismatches of buyers and sellers.

To summarize, the Fund stands ready to arrange forward operations in the same way it arranges most spot transactions. Where a “natural” counterparty (i.e., a holder actively seeking the converse of the requested operation) could not be found (which would be the case most of the time), the Fund would turn to forward standing arrangements. The Fund arranges these operations at exchange rates determined by essentially the same formula used for establishing the Fund’s official SDR exchange rates used for spot transactions. (See the Appendix for details.)

Failed or Late Settlement of Forward Operations

As with transactions by agreement, failed or late settlement of forward operations can be dealt with in any way agreed between the parties to the transfer. However, in the absence of any undertaking to the contrary among the parties concerned, it would be desirable to have a procedure that transactors were expected to observe. Because of the longer period between the initiation of a forward operation (when the exchange rate is determined) and its settlement, compared with a spot transaction, the potential loss from the failure to settle a forward transaction on time is much greater.

Therefore, before arranging a forward operation, the Fund obtains the agreement of both parties to adhere to the following policies for compensating any valuation or interest rate loss resulting from failure to carry out payment instructions correctly. The rules cover cancellation, late payment of currency, and late delivery of SDRs, and they are intended to leave the party not responsible for the cancellation or late payment no worse off than if all instructions had been carried out correctly.10 Compensation amounts are to be determined by the Fund as follows and are to be paid by transferring the indicated amounts of SDRs between the parties to the operation. The Fund itself is to have no obligation to compensate either party for any loss resulting from operations it arranges on its behalf.

Compensation in Case of Late Settlement

If a payment of currency has been made late, the party receiving currency may be entitled to compensation for interest costs. The seller of SDRs is assumed to borrow the funds it did not receive on time and is paid the difference between refinancing costs (at the overnight interbank ask rates) and the interest income on the SDR at the SDR interest rate,11 if this difference is positive.12 No exchange rate compensation is required, because the exchange rate originally agreed to is never changed. If the seller of SDRs is responsible for the late settlement of a forward operation (e.g., if it failed to complete the acquisition of SDRs needed to settle the forward sale), compensation for interest forgone is due if the SDR interest income is greater than the interest income (at the overnight interbank bid rate) for the currency counterpart.

Protection of Principal

To protect the principal of the parties to a forward operation in SDRs, the Fund will transfer SDRs only after receipt of currency has been confirmed by the other party and will alert the party buying SDRs before it has paid currency when the seller does not have sufficient SDRs to complete the operation. Transferring SDRs only when currency has been received by the seller mirrors the practice followed for transactions by agreement and is straightforward, because the Fund fully controls all transfers of SDRs.

It is somewhat more complex to assure the currency-paying member that sufficient SDRs are on hand to ensure that the transfer of SDRs can be made on the value date. If the projected holdings of SDRs for the value date of the forward operation are sufficient to honor the forward operation, and the Fund is confident that the projected holdings will be realized, it will issue instructions two business days before the value date to pay the agreed-upon amount of currency. If the relevant member’s actual holdings of SDRs are expected to be too low to enable it to honor the forward contract, the Fund would notify the party paying currency, the day before the intended settlement, that it should suspend payment.

In assessing the likelihood that projected holdings will be adequate when SDRs are in the process of being acquired, the Fund will take account of the mode of acquisition. The Fund can be quite certain that an acquisition of SDRs will be completed on time if it is part of a purchase from the Fund that has been approved by the Executive Board of the Fund, or something similar. The important common characteristic of these modes of acquisition of SDRs is that the member receiving SDRs does not need to make a payment of freely usable currency. If SDRs are being acquired against the payment of currency, the acquisition should be completed one business day prior to the settlement day of the forward operation in order to avoid having the Fund advise the purchaser to suspend the currency payment.

Compensation in Case of Cancellation

Outright cancellation of a contract would allow the party whose position had developed a loss owing to exchange rate changes to rid itself of such loss. This would impose that loss on the other party to the operation and is not allowed. Therefore, if a party to a forward operation wishes to neutralize its obligations, it will generally be expected to enter into a new transaction with the same value date that reverses the first forward operation. This would be carried out as two separate transactions, so that all obligations to each of the two counterparties are fulfilled.

Situations may arise in which the party that wishes to neutralize its obligations from a forward operation cannot do so by engaging in a new forward operation that reverses the first one. In such circumstances, the original forward operation will be discontinued by informing the other party and the Fund by cable. In case payment of currency is not made, or if a sufficient amount of SDRs is not at the disposal of the seller within ten business days following the settlement date, the Fund will cancel the operation.

When a forward operation is canceled before the scheduled value date, compensation is paid by the party responsible for the cancellation if the forward exchange rate agreed to (the ask rate in the case of the purchaser of SDRs canceling the operation) is higher than the rate at which the operation could be reversed on the cancellation date (i.e., for the same case, the forward bid rate on the cancellation date for the original value date). When an operation is canceled after the scheduled value date, compensation is determined in the same way, using the spot bid rate on the cancellation day. In this case, however, compensation for interest forgone may be relevant, depending on whether the interest income on the asset being held by the party not responsible for the cancellation is less than the interest income on the asset that was to be received by that party. In the case where this party was selling SDRs, it would need to borrow at the overnight interbank ask rate to provide the funds it originally expected to receive on the value date until such time as a new sale of SDRs could be arranged after it was notified of the cancellation. This party would be entitled to compensation for interest paid in excess of the interest earned on SDRs for the period between the value date and the cancellation date, plus another two days to allow for the delay in receiving currency from selling the SDRs in a new transaction by agreement.

Adherence to these policies, which essentially conform to market practice, should help ensure the competitiveness of the use of SDRs in forward operations and thereby the general attractiveness of the SDR to the Fund’s members.

APPENDIX The Forward Exchange Rate

Because the result of a forward transaction can be achieved in alternative ways, arbitrage generally ensures that forward exchange rates are set so as to remove, at the margin, any advantage resulting from taking one approach over the other. For national currencies, the result of a forward operation can alternatively be achieved by a combination of borrowings, spot exchanges, and investments. It is a well-established empirical observation that the equivalence of using the forward or the spot markets holds very tightly for freely usable currencies as a result of “covered interest parity.”13 As a result, calculating forward exchange rates for the SDR as the appropriately weighted average of the forward exchange rates of its component currencies would leave prime rate transactors indifferent between a forward transaction at that rate and borrowing the currency, buying the SDR’s component currencies spot, and then investing them. The SDR’s component currencies spot, and then investing them. The SDR’s forward exchange rates quoted by the Fund are, therefore, calculated in that way. In short, the forward exchange rates for the SDR used by the Fund are those for the private SDR (i.e., for the SDR’s component currencies) determined in the foreign exchange markets.

Parties wishing to buy SDRs forward also have the alternative of buying official SDRs spot and holding them.14 The SDR interest rate is fixed weekly, however, and therefore cannot be known for the duration of a forward contract exceeding one week. Because the SDR differs in some, if not many, respects from its private counterparts, its interest rate (within the first week, or its expected interest rate over longer periods) will generally differ from the rate implicit in the forward exchange rate, which tends to reflect Eurodeposit rates. To the extent that the interest rate on the SDR is competitive with those on other reserve assets, the difference in interest rates reflects compensation for all of the differences between holding the private SDR and the official SDR, and would not reflect a potential arbitrage gain between the two. The forward exchange rates for the private SDR, therefore, would remain appropriate for forward operations in SDRs.15

Exchange rates in the market have bid/ask spreads. Holders seeking a forward purchase of SDRs would expect to pay the ask rate, and those seeking a forward sale would expect to receive the bid rate. In the rare case where the Fund is able to match two parties who are each actively seeking one side of a forward transaction, the bid/ask spread is shared between them—that is, the mid rate would be used, since the Fund takes no fee for its brokerage services. Usually, however, the Fund has to match the active party with a market maker at either the bid rate or the ask rate, as was explained previously.16

Forward exchange rates for the SDR against the U.S. dollar are calculated from appropriately weighted bilateral forward rates. (See Table 2.) As with spot exchange rates for currencies other than the U.S. dollar, the forward exchange rates for the SDR against particular currencies other than the U.S. dollar are obtained by crossing the forward SDR/dollar rates with the forward rates of the other currency in terms of the U.S. dollar. For the purpose of forward exchange rates, however, the forward currency exchange rate in dollars will be taken from the same market and time as the valuation basket—that is, London at noon.

Table 2.

International Monetary Fund: Sample SDR Valuation for Wednesday, April 25, 1988

(based on London noon rates)

The following data, supplied by the Bank of England at our request, was used in a forward operation initiated April 25, 1988, for value May 2, 1988. It differs from the proposed calculation of a five-day forward exchange rate by using five-day rates for the components rather than interpolating the five-day rate from the spot (settlement in two business days) and seven-day forward rates.

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Exchange rates in terms of currency units per U.S. dollar, except for the pound sterling, which is expressed in terms of U.S. dollars per pound sterling.

Forward rates between the U.S. dollar and the SDR are calculated completely analogously to the spot exchange rate. The rates used for standard maturities are the bid/ask rates on the SDR component currencies supplied by the Bank of England,17 plus the forward bid/ask premiums or discounts for the components.18 Nonstandard maturities are arrived at by linear interpolation between the neighboring forward exchange rates for the SDR.

Editor’s Note: The comment by Rudolf R. Rhomberg, which appears at the end of Chapter 3, includes observations on both Chapter 2 and Chapter 3.

*

I would like to thank my colleague Reinhard Furstenberg for the work he has done in developing the proposals reflected here for developing forward SDR transactions.