The private European Currency Unit (ECU) has become the unit of account of a major international financial market, with the ECU comprising approximately five percent of European Union securities and bank balance sheets. Currently, however, no active official or private market mechanism guarantees that private ECUs can be exchanged for a like number of units of the officially defined Basket of component currencies. The holder of private ECU-denominated bank deposits cannot expect to convert them into the official Basket of currencies at par at all times; nor can the owner of a private ECU-denominated treasury bill or bond valued in ECU convert the asset into an equal value in units of the Basket. Indeed, recent market experience has shown that the value of the private ECU can deviate substantially from the value of the Basket, which has caused a reassessment of the foreign exchange risk relative to the Basket associated with holding ECU-denominated assets, including open private ECU positions on bank balance sheets.
That the exchange rate between the private ECU and the Basket can move substantially from par raises questions concerning the factors that influence its value and that determine the yield on ECU-denominated assets. This paper addresses the question of what determines the values of the private ECU and private ECU interest rates. The usual monetary mechanisms that impart determinate value to a nominal unit of account--the existence of a real demand for the unit, a limited supply of the realized unit, and the exogenous setting of some interest rate--are absent in the case of the private ECU. A determinate value could be imparted by a commitment of the banking sector or of some central bank to deliver the official Basket for private ECU, but no such commitment exists presently because of the risk that such a par exchange rate might experience a speculative attack.
Instead, the value of the private ECU is determined through a roundabout mechanism: there is generally an expectation that the private ECU and the then current official basket will be merged by a future European Central Bank. Also, the current operation of the private ECU large-value payment and clearing system exogenously determines the private ECU overnight interest rate. The combination of an expected future fixing of the exchange rate and an exogenous ECU interest rate is sufficient to determine the current exchange rate between the private ECU and the official Basket.
The paper observes that the developments in the private ECU market provide valuable experience about the determination of the exchange rate between privately created composite currencies--that is, new units of account--and the component currencies. The possible development of additional private composite currencies, such as regional composite currencies or a private SDR, also adds interest to questions about the mechanism that ties the value of such currencies to that of their underlying baskets and determines the yields on assets denominated in such currencies. Though the paper considers these questions in the context of the private ECU, the conditions and institutional underpinning that activate a unit of account, giving determinate value and eventual use as a payment medium, transplant whole from the ECU to other units such as the SDR.