## 1. Summary of Bond Market Liquidity Indicators

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### Why enhance the role of the SDR?
- Rationale and potential functions:
  - The SDR may improve the functioning of the IMS as: a sui generis composite reserve asset defined by the Fund’s Articles and centrally allocated; as a unit of account; and as a new reserve-grade security issued by the IMF or a subset of its membership (SDR-bond).
  - Expanding the SDR basket would further support the SDR’s role.
- Objectives served by enhancing the SDR:
  - Reduce reserve accumulation/imbalances and strengthen the global safety net:
    - Official SDR allocations are a lower cost alternative to accumulation of international reserves through borrowing or accumulation of current account surpluses.
    - SDRs allow holders access to foreign currency liquidity and are especially valuable at times of systemic crisis.
    - SDR allocations could conceivably (albeit not in the current legal framework) be used as a policy incentive against excess accumulation of reserves for non precautionary purposes.
  - Develop a new reserve asset:
    - Issuance by the Fund (or related investment vehicle) of SDR-denominated securities in sufficient volume could offer a safe haven and an alternative mode of Fund borrowing.
  - Reduce impact of exchange rate swings:
    - The SDR unit of account could be used to price global trade, denominate financial assets, peg currencies, and keep accounts and official statistics.
    - The SDR’s basket characteristic provides a less volatile unit of account and store of value than its components when measured in domestic currency terms.
  - Accommodate a greater role for emerging market currencies in the IMS:
    - Inclusion in the basket would allow holders of SDR-denominated assets to acquire greater exposure to those currencies (notably the RMB) and could be conducive to financial deepening and capital account liberalization.

### Realism and constraints
- Constraints on official SDRs:
  - With their use limited to the official sector, official SDR holdings cannot be used directly for market intervention or liquidity provision.
  - Tight legal and political constraints exist to expanding use of the official SDR, including the need for an amendment of the Articles to change allocation methods or the need for an 85 percent majority of voting power to agree to an allocation of any size.
  - Sharp policy tradeoffs arise in balancing conditional and unconditional liquidity, and in balancing risk of “misuse” of SDRs versus their attractiveness as a reserve asset.
- Constraints on non-official (market) SDRs:
  - There is currently no natural demand or supply for SDR-denominated securities, reflecting strong network externalities and increasing returns to scale associated with currency functions.
  - Benefits of the basket compared to component currencies depend on (i) the frequency with which agents need to rebalance their portfolios; and (ii) the ease of access to the component currencies.
  - For most actors, replicating the current basket is essentially costless given the size, liquidity, and efficiency of global currency markets in the four component currencies; however high frequency rebalancing (e.g. weekly or daily) could involve considerable costs.
  - Providing impetus for a market in SDR-denominated securities could entail significant upfront costs (e.g., liquidity premium, hedging costs) which the official sector would have to bear, possibly for a long time.

### Way forward (summary)
- Political will and consensus across the membership are necessary to address obstacles.
- Enhancing the SDR cannot on its own remedy all IMS problems but could contribute, combined with:
  - global policy coordination and stronger surveillance;
  - improved global safety nets;
  - orderly capital account liberalization and financial deepening in emerging markets.
- The paper outlines concrete steps to enhance the SDR as an alternative reserve asset and unit of account, and discusses benefits, realism, and potential downsides.

### Expanding the supply of official SDRs
- Current scale and historical context:
  - Total outstanding SDRs (204 billion) represent less than 4 percent of global reserves—well under the peak of 8.4 percent reached in the early 1970s.
- Proposal and projected impact:
  - Regular—say annual—allocations covering a significant proportion of expected precautionary reserve demand.
  - An annual allocation of the equivalent of US$200 billion dollars would raise SDRs as a proportion of reserves to a little over 13 percent in the early 2020s.
  - Sums of this magnitude could be sufficient to meet half of the average precautionary demand for reserves over 2000–09 (extrapolating from Obstfeld, Taylor, and Shambaugh, 2008).
  - WEO forecasts of reserves are used through 2015, and then assumed to grow at 7 percent per year (average of the WEO forecast period) for extrapolation.
- Governance threshold:
  - Such regular allocations could be made if (and only if) Governors representing 85 percent of the voting power of the SDR department agree they are necessary to meet a “long-term global need ... to supplement existing reserve assets (...)” while avoiding inflation or deflation.

### Precautions and operational issues
- Contingent claims and designation mechanism:
  - Expanding SDR allocations increases the contingent claim on all participants in the SDR department, who could be required under the designation mechanism to provide freely usable currencies in exchange for SDRs up to twice their own allocation of SDRs.
  - This could be burdensome, particularly for members with floating currencies that do not typically hold large official reserves and are not freely usable currencies.
- Potential remedies:
  - Expanding voluntary trading agreements to avoid recourse to the designation mechanism.
  - Expanding the current list of freely usable currencies to include a few additional currencies that meet the Article XXX (f) definition—being widely used in fact to make payments for international transactions and widely traded in principal exchange markets. (Such an expansion in the list of freely usable currency is distinct from and would not necessarily affect the composition of the SDR basket.)

### Limits and potential downsides
- Partial substitute:
  - Official SDRs may not be perceived as a perfect substitute for borrowed or own reserves because they cannot be used directly for market intervention, have low yield, and pose relative difficulty to hedge net positions.
  - Some reserve demand is not precautionary but reflects objectives like influencing exchange rate competitiveness; SDR allocations alone would not address such motives and could encourage accumulation absent policy commitment to reduce reserve accumulation.
- Misuse risks:
  - SDRs are a low cost source of unconditional financing; as outstanding volume increases, risk rises that they could be used detrimentally (e.g., procyclical fiscal financing, substitute to adjustment, contributing over time to unsustainable debt burdens).
  - Misuse could compromise macroeconomic stability and members’ ability to pay charges on allocations or reconstitute holdings.
- Inflationary impact:
  - The potential impact on money creation of the large one-off allocation in 2009 was considered likely to be small and easily absorbed.
  - Large, regular allocations are similarly unlikely to prove inflationary if central banks issuing freely usable currencies credibly stick to their inflation targets.
  - No money is created unless countries sell their SDR holdings to issuers of freely usable currencies; any money creation could be sterilized by relevant central banks.
  - The discretion exists to not make allocations—or even cancel existing allocations—at times of strong global demand and inflation concerns.

### Options for enhancing the official SDRs
- Basic improvements (marginal measures):
  - Provide greater certainty over the basket composition through more objective valuation rules to improve attractiveness.
  - Move from weekly to daily interest rate setting to allow reserve managers fair valuation of SDR assets on a continuous basis and facilitate hedging operations (subject to lack of appropriate daily instruments in underlying currencies).
  - Clarify and expand the scope of permissible operations by moving from a positive to a negative list.
  - Eliminate the mandatory use of the official exchange rate in SDR operations.
  - Simplify reporting requirements to the Fund to record transfers among members.
- Reconstitution and safeguards:
  - Reinstating a reconstitution requirement—requiring members to restore their SDR holdings to the same amount as their overall allocation over a given timeframe—would help improve liquidity in the voluntary market by raising transaction volumes and ensuring demand for two-way transactions.
  - Reconstitution would reduce scope for misuse of SDRs as open-ended cash transfers, particularly where debt sustainability is fragile.
  - Additional safeguards could include requiring discussion of planned SDR use in Article IV consultations, ex post assessment in Article IV reports, and taking use of SDR allocations into account in debt sustainability analysis.
  - Tighter restraints would conflict with the Articles of Agreement principle that such use is unconditional and would attenuate SDRs’ substitutability with own reserves.

### Advisory group: governance and role
- Establish an advisory board of eminent experts—possibly including central bankers issuing freely usable currencies—to provide an independent opinion on matters concerning the provision of global liquidity and to guide the Managing Director’s proposals and Board of Governors’ decisions on the need and frequency of SDR allocations.
- The advisory board could make recommendations on the cancellation of SDR allocations.
- The board’s views would not be binding under the current governance structure of the Fund, but could help ensure a robust decision-making process and provide comfort that decisions are not dominated by political considerations.

### SDR lending, pooling, and private use
- SDR lending and pooling:
  - Countries could on-lend their SDRs—individually or as a pool—to countries in need of external financing; borrowers would pay the SDR interest rate (possibly with a mark-up) and exchange SDRs for freely-usable currency.
  - After the 2009 allocation, G7 and euro area countries could mobilize a total of SDR 111.7 billion.
  - There is no rollover risk associated with SDR use; timelines or compensation could be agreed for extended loans.
- Private use of SDR:
  - Allowing private sector holding and trading of official SDRs would:
    - Enhance reserve asset quality by enabling central banks to use SDRs directly for intervention or market liquidity provision.
    - Potentially spur a market in SDR-denominated assets and contribute to development of other reserve currencies.
    - Enable private holdings to be used as collateral to obtain freely usable currencies during liquidity squeezes.
  - Implementation constraints:
    - Would require consent from key central banks to provide a market for private participants, or opening the Fund’s voluntary market to them, possibly capping eligible amounts.

### Contingent allocations, targeting, and conditionality (Article amendments)
- Contingent allocations (Escrow):
  - Hold all or part of SDR allocations in escrow, to be released only in case of shocks, with release decided by the Executive Board or Board of Governors.
  - Trade-offs:
    - Downside: Reduces substitutability of own reserves for SDRs and likely is less effective than regular allocations in containing precautionary reserve demand.
    - Upside: Can reduce uncertainty about ad hoc allocations during stress and may overcome resistance to large regular allocations when liquidity appears abundant.
- Targeting of allocations:
  - Proposal: Focus allocations on countries with low precautionary reserves relative to reserve adequacy benchmarks or target allocations to countries affected by systemic shocks.
- Incentives and conditionality:
  - Make SDR allocations conditional on policy benchmarks or forward-looking commitments on reserve accumulation; possible sanctions include freezing access to SDR holdings or denying participation in future allocations.
  - Downside: Could place lighter pressure on reserve-issuing countries and blur distinction between allocations and IMF lending.
- Implication:
  - Steps that give the official SDR a much greater role would require amendment of the Articles.

### Costs and liquidity premium for SDR-denominated assets
- Market inception and liquidity premium:
  - SDR-denominated assets would operate in a shallow market at first and therefore would likely carry a liquidity premium.
  - Estimated initial liquidity premium: around 80–100 basis points.
  - Bundled goods analogy: SDR instruments might be discounted relative to readily available components unless primed by several issuers.
  - ECU precedent: rapid market development when several countries and institutions primed the market together, pushing ECU interest rates close to weighted average of national rates through arbitrage.
- Mitigating initial costs and liquidity constraints:
  - Joint/group issuance to expand volume and reduce fixed costs and liquidity premium.
  - Private placement strategy with sovereigns and institutional investors who are “buy to hold”.
  - Critical requirement: ensure adequate demand for those assets.

### Potential investors and sequencing of demand
- Investor classes:
  - Large reserve holders and sovereign wealth funds: could lead demand; lesser interest in liquidity.
  - Long-term institutional investors: may follow if mandates permit diversification into highly-rated SDR-denominated assets.
  - Large global corporations and cash managers: demand contingent on availability of liquid investment and hedging instruments.
  - Fund managers and retail investors: likely last step; inclusion in major bond indices would encourage adoption.

### Market infrastructure requirements and liquidity support mechanisms
- Public sector roles:
  - Provide liquidity support, facilitate trading, frequent interest rate setting and benchmark pricing, and establish settlement and clearing systems.
- Possible liquidity-support mechanisms:
  - An “SDR window” or Repo facility to discount SDR-denominated assets and provide daily interest rate setting.
- Private sector roles:
  - Market makers, clearing house, and other market infrastructure.
- Feasibility note:
  - Settlement and clearing systems would need to be created from scratch but ECU experience suggests this can be relatively fast with limited public support beyond initial phase.

### SDR basket composition: objectives, trade-offs, and the RMB question
- Objectives and trade-offs:
  - Aim to maximize attractiveness by making SDR representative of global weights, liquid, and simple to hedge.
  - Trade-off between evolving composition (representativeness) and predictability of future value.
  - Rules-based valuation could improve predictability.
- Emerging market currencies:
  - Benefits: enhanced diversity and representativeness; facilitation of greater EMS role.
  - Drawbacks: complexity, higher hedging costs, reduced participation if complexity rises; adding many small currencies is undesirable.
- Not-fully convertible currencies:
  - Current rule requires “freely usable currencies” in SDR basket.
  - Potential upsides: increase private demand by easing exposure acquisition.
  - Potential downsides: hedging costs, risk management difficulties, reduced attractiveness.
  - Clarification: adding non-fully convertible currencies to valuation method would not automatically add them to list of freely usable currencies.
- The RMB:
  - Recent review concluded RMB should not be included because it did not meet freely usable currency criteria.
  - Possible technical developments that could address hedging difficulties: reforms allowing nonresidents to hold RMB deposits, development of RMB derivatives in Hong Kong, additional convertibility agreements, public commitment to internationalize RMB.
  - Additional concern: RMB’s value is tied to the dollar and managed by authorities; adding RMB would de facto increase U.S. dollar weight and allow one country’s policy to impact SDR value.

### Questions for Directors (policy guidance sought)
- Do directors agree that enhancing the role of the SDR might contribute to the stability of the IMS over the medium to long term?
- Among the options presented to expand supply of official SDR, develop new SDR-denominated assets, and encourage use of SDR as a unit of account, which appear promising in the near term and should be considered further?
- Which options might be considered for the longer run?
- Which should be discarded?

### Annex 1 — Summary of key options (high-level list)
- Increasing the use of the official SDR as a reserve asset:
  - Make regular (e.g., annual) SDR allocations.
  - Expand voluntary trading agreements and list of freely usable currencies.
  - Reinstitute a reconstitution requirement.
  - Include allocations in debt sustainability analysis.
  - Staff assessment of use of SDRs in Article IV reports where relevant.
  - Establish independent advisory group on allocations.
  - Lending of SDRs between members.
  - Escrowed, crisis-contingent allocations.
  - Targeting SDR allocations.
  - SDR allocations or use conditional on appropriate policies.
  - Allow private sector use of SDRs.
  - No mandatory use of official exchange rates.
  - Daily interest rate setting.
  - Expand scope of permissible operations.
  - Greater predictability on basket composition.
  - Simplify reporting requirements.
- New SDR-denominated reserve assets:
  - Fund issuance of SDR-denominated bonds within limits of need to supplement quota resources.
  - Issuance over and above current needs (investment policy and governance concerns).
  - Create a substitution account (currency risk allocation question).
  - Create trust fund to bear currency risk.
- The SDR as a unit of account:
  - Use the SDR as unit of account for trade, reporting, pegs, and bond issuance (network effects and costs noted).
  - Support liquidity with infrastructure such as an SDR repo window.
  - Support liquidity through purchase by large reserve holders and SWFs.
- SDR composition:
  - Include new currencies in SDR basket (trade-off between diversification and currency risk management).
  - Include nonconvertible currencies (costs and benefits more acute).

### Annex 2 — Market Participants Survey (key findings)
- Respondents: nine central banks, three private sector institutions, and two international financial institutions.
- Common investor priorities:
  - Adequate liquidity is the most important and critical feature for SDR to be an attractive reserve asset.
  - Desire for diverse SDR-denominated assets in terms of maturity.
  - Request for regular publication of SDR-basket interest rates.
- IFI issuer views:
  - World Bank and Asian Development Bank would be open to issuing SDR-denominated securities if there is adequate investor demand and they can swap the SDR to desired currencies and interest rates.
  - ADB’s after swap composition is USD 87%, JPY 10%, and others 4%. World Bank hedges all issuance back to USD LIBOR.
- Market development issues raised:
  - Investors prefer direct positions in constituent currencies because transaction costs are negligible; SDR lacks liquidity, yield curve, and secondary market.
  - SDR interest rate is determined weekly and based on a weighted average of representative short-term debt rates in money markets of the four constituent currencies.
  - Reserve portfolios often include longer-term bonds; holding SDR implies opportunity costs given positive slope of yield curve.
  - Active IFI participation with low credit risk is necessary early but insufficient unless liquidity is resolved.
  - No technical obstacle prevents private sector from establishing SDR settlement system, but private firms need viable market-making profits.

### Technical and infrastructure issues (Section II highlights)
- Liquidity enhancement options:
  - Market-makers obliged to provide bids for SDR-denominated assets (public sector may need to take initial role).
  - Liquidity guarantees via buy-back provisions (put options) or repo facilities.
  - Development of funding and hedging tools such as repos and derivatives.
- SDR interest rate and fixing-frequency:
  - Maturity/fixing mismatch: SDR uses 3-month interest rates and weekly fixing; mismatch makes accurate replication/hedging impossible.
  - Shorter resetting periods reduce mismatch; daily fixing of an overnight rate is preferable to enable mark-to-market and secondary market development.
  - Practical constraint: lack of appropriate daily instruments in some underlying currencies.
- Repo facility and put option design:
  - Repo facility: credible institutions could provide repo allowing pledging of SDR assets as collateral to receive convertible currencies.
  - Put option: should be exercisable at any time with strike price linked to current market prices; anti-exploitation features suggested (below-market strike, fee, or linkage to balance of payments need).
- Settlement system design:
  - Open worldwide net settlement system with several settlement cycles per day.
  - Tiered approaches: three-tiered (only central banks hold SDR settlement accounts) or two-tiered (clearing banks and central banks hold accounts).
  - Four basic functions required: settlement agent, clearing, message transportation, liquidity provider.
  - Alternatives for liquidity backstop: IMF providing limited short-term covered credits (“SDR window”) and a guarantee fund.
  - Technical issues: ownership, financing, oversight, compliance with CPSS Core Principles, hours of operations.

### Liquidity premium evidence and indicative estimates
- Drivers:
  - Lack of market makers, higher trading costs, hesitancy of initial investors, unfamiliarity.
- Empirical observations and numeric findings (preserved exactly):
  - Estimated initial liquidity premium: around 80–100 basis points.
  - Lower bound estimate for functioning SDR-securities market: 25–30 basis points.
  - At market inception, liquidity premium could easily exceed 1 percent.
  - Comparison of notes vs. bills: liquidity premium of notes over bills: 39 basis points annualized.
  - BBB-rated issuer (early 2000 to early 2003): liquidity premium between 70–100 basis points.
  - U.S. long maturity investment grade bonds: liquidity risk premium around 0.45%.
  - High Yield bonds: liquidity risk premium around 1%.
  - EBRD bond vs. U.K. Gilt: +24 basis points; +25 basis points (different maturities).
  - EBRD bond vs. German Yield: +35 basis points.
  - Triple-A Credit Card ABS initial spread: about 1.5% over LIBOR (estimated) = roughly 180 basis points over Treasuries.
  - TIPS liquidity premium: about 1%.
  - TIPS lost value versus a similar-maturity Treasury Note for the first 19 months of the program’s existence.
- Capitalized cost examples (preserved exactly):
  - 4.7 years — capitalized cost of slightly less than 4.7 percent of the original issuance amount.
  - 2-year note — 80 basis point spread → capitalized cost of almost 1.6 percent of the issuance amount.

### Conclusion and policy implications
- Role of SDR:
  - If used more as an official composite reserve asset, unit of account, and possibly a new class of reserve assets, the SDR could potentially contribute to long-term stability of the IMS alongside other reforms.
- Implementation approach:
  - Options form a menu that can be experimented with incrementally.
  - Some options require large international consensus (e.g., amending the Articles of Agreement); others could be implemented by subsets of like-minded countries in a relatively short time frame (e.g., using SDR as a unit of account for some international trade and bond issuance).
- Interactions and sequencing:
  - No obvious sequencing; options are mutually supportive (e.g., managing large SDR allocations would be easier with liquid SDR-denominated securities or broader use of SDR invoicing).
  - A critical mass of steps is necessary for the SDR to make a visible difference.
- Time horizon and key challenge:
  - The process is measured in decades rather than years; a key issue is how to establish and retain momentum over time.

*Source: IMF staff paper excerpt on enhancing the role of the SDR (excerpts provided).*

### 1. Summary of Bond Market Liquidity Indicators...................................................................32

### 1. Summary of Bond Market Liquidity Indicators

### Why enhance the role of the SDR?
- Rationale and potential functions:
  - The SDR may improve the functioning of the IMS as: a sui generis composite reserve asset defined by the Fund’s Articles and centrally allocated; as a unit of account; and as a new reserve-grade security issued by the IMF or a subset of its membership (SDR-bond).
  - Expanding the SDR basket would further support the SDR’s role.
- Objectives served by enhancing the SDR:
  - Reduce reserve accumulation/imbalances and strengthen the global safety net:
    - Official SDR allocations are a lower cost alternative to accumulation of international reserves through borrowing or accumulation of current account surpluses.
    - SDRs allow holders access to foreign currency liquidity and are especially valuable at times of systemic crisis.
    - SDR allocations could conceivably (albeit not in the current legal framework) be used as a policy incentive against excess accumulation of reserves for non precautionary purposes.
  - Develop a new reserve asset:
    - Issuance by the Fund (or related investment vehicle) of SDR-denominated securities in sufficient volume could offer a safe haven and an alternative mode of Fund borrowing.
  - Reduce impact of exchange rate swings:
    - The SDR unit of account could be used to price global trade, denominate financial assets, peg currencies, and keep accounts and official statistics.
    - The SDR’s basket characteristic provides a less volatile unit of account and store of value than its components when measured in domestic currency terms.
  - Accommodate a greater role for emerging market currencies in the IMS:
    - Inclusion in the basket would allow holders of SDR-denominated assets to acquire greater exposure to those currencies (notably the RMB) and could be conducive to financial deepening and capital account liberalization.

### Realism and constraints
- Constraints on official SDRs:
  - With their use limited to the official sector, official SDR holdings cannot be used directly for market intervention or liquidity provision.
  - Tight legal and political constraints exist to expanding use of the official SDR, including the need for an amendment of the Articles to change allocation methods or the need for an 85 percent majority of voting power to agree to an allocation of any size.
  - Sharp policy tradeoffs arise in balancing conditional and unconditional liquidity, and in balancing risk of “misuse” of SDRs versus their attractiveness as a reserve asset.
- Constraints on non-official (market) SDRs:
  - There is currently no natural demand or supply for SDR-denominated securities, reflecting strong network externalities and increasing returns to scale associated with currency functions.
  - Benefits of the basket compared to component currencies depend on (i) the frequency with which agents need to rebalance their portfolios; and (ii) the ease of access to the component currencies.
  - For most actors, replicating the current basket is essentially costless given the size, liquidity, and efficiency of global currency markets in the four component currencies; however high frequency rebalancing (e.g. weekly or daily) could involve considerable costs.
  - Providing impetus for a market in SDR-denominated securities could entail significant upfront costs (e.g., liquidity premium, hedging costs) which the official sector would have to bear, possibly for a long time.

### Way forward (summary)
- Political will and consensus across the membership are necessary to address obstacles.
- Enhancing the SDR cannot on its own remedy all IMS problems but could contribute, combined with:
  - global policy coordination and stronger surveillance;
  - improved global safety nets;
  - orderly capital account liberalization and financial deepening in emerging markets.
- The paper outlines concrete steps to enhance the SDR as an alternative reserve asset and unit of account, and discusses benefits, realism, and potential downsides.

### Expanding the supply of official SDRs
- Current scale and historical context:
  - Total outstanding SDRs (204 billion) represent less than 4 percent of global reserves—well under the peak of 8.4 percent reached in the early 1970s.
- Proposal and projected impact:
  - Regular—say annual—allocations covering a significant proportion of expected precautionary reserve demand.
  - An annual allocation of the equivalent of US$200 billion dollars would raise SDRs as a proportion of reserves to a little over 13 percent in the early 2020s.
  - Sums of this magnitude could be sufficient to meet half of the average precautionary demand for reserves over 2000–09 (extrapolating from Obstfeld, Taylor, and Shambaugh, 2008).
  - WEO forecasts of reserves are used through 2015, and then assumed to grow at 7 percent per year (average of the WEO forecast period) for extrapolation.
- Governance threshold:
  - Such regular allocations could be made if (and only if) Governors representing 85 percent of the voting power of the SDR department agree they are necessary to meet a “long-term global need ... to supplement existing reserve assets (...)” while avoiding inflation or deflation.

### Precautions and operational issues
- Contingent claims and designation mechanism:
  - Expanding SDR allocations increases the contingent claim on all participants in the SDR department, who could be required under the designation mechanism to provide freely usable currencies in exchange for SDRs up to twice their own allocation of SDRs.
  - This could be burdensome, particularly for members with floating currencies that do not typically hold large official reserves and are not freely usable currencies.
- Potential remedies:
  - Expanding voluntary trading agreements to avoid recourse to the designation mechanism.
  - Expanding the current list of freely usable currencies to include a few additional currencies that meet the Article XXX (f) definition—being widely used in fact to make payments for international transactions and widely traded in principal exchange markets. (Such an expansion in the list of freely usable currency is distinct from and would not necessarily affect the composition of the SDR basket.)

### Limits and potential downsides
- Partial substitute:
  - Official SDRs may not be perceived as a perfect substitute for borrowed or own reserves because they cannot be used directly for market intervention, have low yield, and pose relative difficulty to hedge net positions.
  - Some reserve demand is not precautionary but reflects objectives like influencing exchange rate competitiveness; SDR allocations alone would not address such motives and could encourage accumulation absent policy commitment to reduce reserve accumulation.
- Misuse risks:
  - SDRs are a low cost source of unconditional financing; as outstanding volume increases, risk rises that they could be used detrimentally (e.g., procyclical fiscal financing, substitute to adjustment, contributing over time to unsustainable debt burdens).
  - Misuse could compromise macroeconomic stability and members’ ability to pay charges on allocations or reconstitute holdings.
- Inflationary impact:
  - The potential impact on money creation of the large one-off allocation in 2009 was considered likely to be small and easily absorbed.
  - Large, regular allocations are similarly unlikely to prove inflationary if central banks issuing freely usable currencies credibly stick to their inflation targets.
  - No money is created unless countries sell their SDR holdings to issuers of freely usable currencies; any money creation could be sterilized by relevant central banks.
  - The discretion exists to not make allocations—or even cancel existing allocations—at times of strong global demand and inflation concerns.

### Options for enhancing the official SDRs
- Basic improvements (marginal measures):
  - Provide greater certainty over the basket composition through more objective valuation rules to improve attractiveness.
  - Move from weekly to daily interest rate setting to allow reserve managers fair valuation of SDR assets on a continuous basis and facilitate hedging operations (subject to lack of appropriate daily instruments in underlying currencies).
  - Clarify and expand the scope of permissible operations by moving from a positive to a negative list.
  - Eliminate the mandatory use of the official exchange rate in SDR operations.
  - Simplify reporting requirements to the Fund to record transfers among members.
- Reconstitution and safeguards:
  - Reinstating a reconstitution requirement—requiring members to restore their SDR holdings to the same amount as their overall allocation over a given timeframe—would help improve liquidity in the voluntary market by raising transaction volumes and ensuring demand for two-way transactions.
  - Reconstitution would reduce scope for misuse of SDRs as open-ended cash transfers, particularly where debt sustainability is fragile.
  - Additional safeguards could include requiring discussion of planned SDR use in Article IV consultations, ex post assessment in Article IV reports, and taking use of SDR allocations into account in debt sustainability analysis.
  - Tighter restraints would conflict with the Articles of Agreement principle that such use is unconditional and would attenuate SDRs’ substitutability with own reserves.

*Source: IMF staff paper excerpt on enhancing the role of the SDR (excerpts provided).*

### 13.      Advisory group. In order to give comfort that decisions on SDR allocations are not

### 13.      Advisory group.

### Advisory group: governance and role
- Establish an advisory board of eminent experts—possibly including central bankers issuing freely usable currencies—to provide an independent opinion on matters concerning the provision of global liquidity and to guide the Managing Director’s proposals and Board of Governors’ decisions on the need and frequency of SDR allocations.
- The advisory board could make recommendations on the cancellation of SDR allocations (see e.g., Subacchi and Driffill, 2010).
- The board’s views would not be binding under the current governance structure of the Fund, but could help ensure a robust decision-making process and provide comfort that decisions are not dominated by political considerations.

### SDR lending and pooling
- Mechanism: Countries could on-lend their SDRs—individually or as a pool—to countries in need of external financing; borrowers would pay the SDR interest rate (possibly with a mark-up to compensate pool lenders for credit risk) and exchange SDRs for freely-usable currency.
- Mobilization example: After the 2009 allocation, G7 and euro area countries could mobilize a total of SDR 111.7 billion.
- Cost dynamics: Even if the SDR rate rises, SDR-based financing is unlikely to become more expensive than alternatives because the rate is determined as a weighted average of representative short-term rates in the component currencies.
- Risk features: There is no rollover risk associated with SDR use; borrowers and lenders could agree timelines for SDR return or additional compensation for extended-period loans.

### More radical reforms and Article amendments
- Steps that could give the official SDR a much greater role would require amendment of the Articles.
- Options discussed include contingent allocations (escrow), targeting allocations, conditional incentives, and private sector use of SDRs.

### Contingent allocations (Escrow)
- Proposal: Hold all or part of SDR allocations in escrow, to be released only in case of shocks, with release decided by the Executive Board or Board of Governors (membership-wide or targeted to affected countries).
- Trade-offs:
  - Downside: Reduces substitutability of own reserves for SDRs and likely is less effective than regular allocations in containing precautionary reserve demand.
  - Upside: Can reduce uncertainty about ad hoc allocations during stress and may overcome resistance to large regular allocations when liquidity appears abundant.

### Targeting of allocations
- Issue: Allocations distributed in line with quotas channel the bulk to countries not accumulating reserves or unlikely to participate actively in SDR transactions, complicating political decisions since headline amounts exceed actually relevant amounts.
- Proposal: Focus allocations on countries with low precautionary reserves relative to reserve adequacy benchmarks or target allocations to countries affected by systemic shocks.

### Incentives and conditionality
- Possibilities:
  - Make SDR allocations conditional on policy benchmarks or forward-looking commitments on reserve accumulation.
  - Truman (2010b) model: membership-agreed policy norms; findings of non-adherence could freeze member access to SDR holdings or deny participation in future allocations.
- Downside: Could place lighter pressure on reserve-issuing countries (which have little need for SDRs) relative to others; could be combined with escrow approach.

### Implications for Fund lending
- Conditional/targeted SDR allocations would blur the distinction between SDR allocations and IMF lending.
- Reasons to pursue SDR-based measures rather than IMF lending:
  - Increase role of SDR in the system by raising volume in circulation.
  - Provide an additional safety valve to deal with systemic shocks that might otherwise overwhelm the Fund’s commitment capacity, unless Fund resources were kept permanently far above foreseeable needs.

### Private use of SDR
- Allowing private sector holding and trading of official SDRs would:
  - Enhance reserve asset quality by enabling central banks to use SDRs directly for intervention or market liquidity provision, avoiding delays inherent in the Fund’s voluntary market or designation mechanism.
  - Potentially spur a market in SDR-denominated assets and contribute to development of other reserve currencies.
  - Enable private holdings to be used as collateral to obtain freely usable currencies during liquidity squeezes, increasing incentives to hold SDRs.
- Implementation constraints:
  - Would require consent from key central banks to provide a market for private participants, or opening the Fund’s voluntary market to them, possibly capping eligible amounts.
  - Private holdings could directly alleviate stress in crises and would mimic global provision of foreign currency swap lines.

*Source: IMF content unit "13. Advisory group." (excerpt)*

### 33.      Costs. SDR-denominated assets would operate in a shallow market at first and

### 33.      Costs. SDR-denominated assets would operate in a shallow market at first and

### Costs and liquidity premium
- SDR-denominated assets would operate in a shallow market initially and therefore would likely carry a liquidity premium.
- Estimated initial liquidity premium: around 80–100 basis points.
- Consequence: the premium could render it too costly for any individual country or IFI to take the first step and provide the impetus for an SDR-bond market, particularly in a context of fiscal consolidation pressures.
- Bundled goods (and by analogy SDR-denominated instruments) are typically priced at a discount relative to readily available components; SDR instruments might be discounted unless they include less readily available components.
- Historical precedent: the ECU experience showed rapid market development when several countries and European institutions primed the market together, pushing ECU interest rates close to the weighted average of comparable national interest rates through arbitrage.
- Additional ECU lessons: easy diversification benefits, constrained access to German government securities by non-residents at the time, and a functioning interbank market and clearing mechanism increased ECU liquidity and ensured appropriate pricing relative to component currencies.

### Mitigating initial costs and liquidity constraints
- Joint/group issuance:
  - Rationale: multiple countries issuing jointly expands volume, reduces fixed cost to individual issuers, and reduces the liquidity premium.
  - Objective: establish relatively quickly liquid benchmark instruments throughout the maturity spectrum.
- Private placement strategy:
  - Issue SDR-denominated assets for private placement with interested sovereigns and institutional investors.
  - Rationale: such investors are likely to hold assets to maturity and may not require a high liquidity premium.
  - Limitation: mitigates concern over initial lack of liquidity for first movers but does not enhance overall SDR market liquidity.
- Critical requirement: ensure adequate demand for those assets.

### Potential investors and sequencing of demand
- Key investor classes and considerations:
  - Large reserve holders and sovereign wealth funds:
    - Could lead market demand with the objective of diversifying reserve holdings (focus on new SDR assets more than re-denomination).
    - Have lesser interest in liquidity than other investor classes.
  - Long-term and “buy to hold” institutional investors:
    - Could follow if investment mandates allow diversification into highly-rated SDR-denominated assets.
    - Investment mandates typically change with inertia and place a high premium on market depth.
  - Large global corporations and cash managers:
    - Availability of liquid investment and hedging instruments would encourage demand (assuming greater use of SDR in global trade).
  - Fund managers and retail investors:
    - Likely to be the last step in building demand for SDR assets.
    - Fund managers would include SDR-denominated assets if they are included in major bond indices (which are often passively tracked).
    - Retail investors could be attracted by SDR-denominated assets as a pre-packaged diversification strategy.

### Market infrastructure requirements
- Public sector roles:
  - Provide liquidity support for SDR-denominated financial instruments.
  - Facilitate trading, frequent interest rate setting and benchmark pricing.
  - Facilitate establishment of settlement and clearing systems.
- Possible liquidity-support mechanisms:
  - An “SDR window” or Repo facility to discount SDR-denominated assets and provide daily interest rate setting.
- Private sector roles:
  - Private financial institutions could act as market makers and establish a clearing house, analogous to the ECU clearing system.
- Feasibility note:
  - While settlement and clearing systems would need to be created from scratch, ECU experience suggests the process may be relatively fast and need not involve significant public support beyond the initial phase.

### SDR basket composition: objectives and trade-offs
- Objective: maximize SDR attractiveness by making it representative of global economic and financial weights, liquid, and simple to use and hedge.
- Recognized trade-offs:
  - Evolution of SDR composition (to remain representative) versus predictability of its future value.
  - Rules-based valuation process could help address predictability concerns.
- Work program note:
  - A review of the SDR valuation methodology and considerations for expanding the basket was expected during 2011.

### Emerging market currencies in the basket
- Potential benefits:
  - Including emerging market currencies as their shares in global trade and finance increase could enhance SDR diversity, representativeness, and attractiveness.
  - Could facilitate a greater role for emerging markets in the IMS and support financial deepening.
- Potential drawbacks:
  - Adding many currencies with low weight increases complexity and transaction costs for those tracking the SDR or hedging exposure.
  - Some central banks may not be willing to increase SDR exposure if complexity rises, affecting participation in voluntary trading arrangements that support SDR liquidity.
  - Risk: if a large number of smaller arrangements lapsed, the system could be undermined.
- Conclusion: adding a large number of emerging market currencies seems undesirable; there may be a case for a few with the largest weights in global trade and economic growth.

### Not-fully convertible currencies
- Current rule: under the Executive Board-approved SDR valuation method in place since 2000, all currencies in the SDR basket must be “freely usable currencies,” as determined by the Fund (currently Dollar, Euro, Pound, and Yen).
- Historical note: from the Second Amendment’s entry into effect to 1982, the SDR basket included currencies that were not freely usable and had restrictions on current and capital account transactions.
- Potential upsides of adding not-fully convertible currencies:
  - Increase private sector demand for SDR-denominated assets by easing exposure acquisition to such currencies.
- Potential downsides:
  - Hedging costs and risk management would become more complicated; holders/issuers may not be able to hedge fully against fluctuations of a nonconvertible currency.
  - Central banks may find it difficult to hold SDRs that imply exposure they cannot manage due to incomplete convertibility.
  - Premature addition of not-fully convertible currencies could reduce SDR attractiveness and potentially lead to system collapse.
- Clarification:
  - Changing SDR valuation criteria to allow addition of non-fully convertible currencies would not automatically add them to the list of “freely usable currencies”; only currencies meeting the freely usable test under the Articles can be added to that list.
  - The ability to use currencies received in exchange for SDRs for balance of payments purposes and the SDR’s reserve asset character would remain protected.

### The RMB question
- Recent SDR valuation review conclusion:
  - Despite China’s prominent share of global exports, the RMB should not be included in the SDR basket because it did not meet the criteria to be determined a freely usable currency.
- Open question:
  - Whether the freely usable currency criterion should be retained as part of the SDR valuation method.
- Possible developments that could address technical hedging difficulties:
  - Reforms allowing nonresidents, including central banks, to hold RMB-denominated deposits.
  - Gradual development of RMB derivatives in Hong Kong.
  - Additional convertibility agreements between the PBC and other SDR designated holders.
  - A credible public commitment to internationalize use of the RMB and to liberalize capital flows.
- Additional concerns:
  - The RMB’s value is tied to the dollar and managed by the authorities.
  - Adding the RMB to the SDR basket would de facto increase the weight of the U.S. dollar in the basket and allow one country’s exchange rate policy to impact the SDR’s value in a discretionary way.

### Conclusion and policy implications
- Role of SDR:
  - If used more as an official composite reserve asset, unit of account, and possibly a new class of reserve assets, the SDR could potentially contribute to long-term stability of the IMS alongside other reforms.
- Implementation approach:
  - Options form a menu that can be experimented with incrementally.
  - Some options require large international consensus (e.g., amending the Articles of Agreement); others could be implemented by subsets of like-minded countries in a relatively short time frame (e.g., using SDR as a unit of account for some international trade and bond issuance).
- Interactions and sequencing:
  - No obvious sequencing; options are mutually supportive (e.g., managing large SDR allocations would be easier with liquid SDR-denominated securities or broader use of SDR invoicing).
  - A critical mass of steps is necessary for the SDR to make a visible difference.
- Time horizon and key challenge:
  - The process is measured in decades rather than years; a key issue is how to establish and retain momentum over time.

*Source: IMF PDF chapter/section _010711 - 33.      Costs. SDR-denominated assets would operate in a shallow market at first and*

### 43.      At this point, Directors’ views are sought on the following questions:

### 43.      At this point, Directors’ views are sought on the following questions:

### Questions for Directors
- Do directors agree that enhancing the role of the SDR might contribute to the stability of the IMS over the medium to long term?
- Among the options presented in the paper to expand the supply of official SDR, develop new SDR-denominated assets, and encourage use of SDR as a unit of account, which ones appear promising in the near term and should be considered further, including through public consultations and with potential SDR users in the private sector?
- Which ones might be considered for the longer run?
- Which should be discarded?

### Annex 1 — Summary of key options to enhance the role of the SDR
- Page Proposal Limits to feasibility or effectiveness

- Increasing the use of the official SDR as a reserve asset
  - 7 Make regular (e.g., annual) SDR allocations. Potential misuse (e.g., delayed adjustment); overwhelming of voluntary trading system.
  - 10 Expand voluntary trading agreements and list of freely usable currencies
  - 10 Reinstitute a reconstitution requirement.
  - 10 Include allocations in debt sustainability analysis.
  - 10 Staff assessment of use of SDRs in Article IV reports where relevant.
  - 10 Establish independent advisory group on allocations.
  - 10 Lending of SDRs between members.
  - 11 Escrowed, crisis-contingent allocations.
  - 11 Targeting SDR allocations.
  - 11 SDR allocations or use conditional on appropriate policies.
  - 11 Allow private sector use of SDRs.
  - 9 No mandatory use of official exchange rates.
  - 9 Daily interest rate setting.
  - 9 Expand scope of permissible operations.
  - 9 Greater predictability on basket composition.
  - 9 Simplify reporting requirements.

- New SDR-denominated reserve assets
  - 12 Fund issuance of SDR-denominated bonds within limits of need to supplement quota resources. Small amounts, irregular issuance.
  - 12 Issuance over and above current needs. Investment policy required; governance concerns.
  - 13 Create a substitution account. Who bears currency risk?
  - 14 Create trust fund to bear currency risk.

- The SDR as a unit of account
  - 14 Use the SDR as a unit of account for trade. Network effects; SDR not a means of payment.
  - 15 Report data (e.g. balance of payments) in SDRs. Costly for the Fund
  - 15 Present accounts in SDRs (e.g. internationally active private firms). National laws would need to be changed; costly for private sector if dual currency reporting.
  - 15 Exchange rate pegs referenced to SDR. SDR may not always be a superior reference
  - 15 Issuance of SDR-denominated bonds by sovereigns and MDBs. Willingness to pay liquidity premium, possibly for a long period.
  - 15, 19 Support liquidity by developing infrastructure such as an SDR repo window. Willingness to bear costs, credit risks. Change of Articles if the Fund were to do this.
  - 17 Support liquidity through purchase by large reserve holders and SWFs. Holders would have to absorb the cost of the liquidity premium.

- SDR composition
  - 20 Include new currencies in SDR basket. Trade-off between diversification benefit and costs of currency risk management.
  - 20 Include nonconvertible currencies. Both benefits and costs of trade-off more acute.

- Notes
  - Italics denote steps intended to facilitate implementation of non italicized measure just above.
  - Requires amendment of Articles of Agreement.

### Annex 2: Technical Background on SDR Market Development
- The annex is organized in two main sections: section I provides a summary of the written survey results conducted in July 2010 to solicit the views of reserve managers and IFIs on the potential for expanding use of the SDR and SDR-denominated instruments as a reserve asset.

*Source: _010711 - 43.      At this point, Directors’ views are sought on the following questions:*

### Section II details a number of technical and infrastructure issues that are critical for creating

### 4.7 years, would have a capitalized cost of slightly less than 4.7 percent of the original

### _010711 - 4.7 years, would have a capitalized cost of slightly less than 4.7 percent of the original

### Summary statement on capitalized cost examples
- A 4.7 years maturity, would have a capitalized cost of slightly less than 4.7 percent of the original issuance amount.
- For the 2-year note, an 80 basis point spread would mean a capitalized cost of almost 1.6 percent of the issuance amount.

### Table 1: Summary of Bond Market Liquidity Indicators
- (Table referenced in source; detailed table contents not reproduced here.)

### Treasury Market Studies — key findings
- Two general results summarized:
  - Liquidity risk in the Treasury bond market is priced.
  - Bond market illiquidity increases during times of economic stress.
- Amihud, Y. and Mendelson, H. (1991): Liquidity, maturity, and the Yields on U.S. Treasury Securities, Journal of Finance, pp. 1411–1425.
  - Same maturity Treasury bills and notes are compared.
  - The more highly liquid bills are found to carry lower yields than less liquid notes.
  - The liquidity premium of notes over bills was found to be 39 basis points annualized, and to decrease with maturity.
- Goyenko, R., Subrahmanyam, A., and Ukhov (2010), A., The Term Structure of Bond Market Liquidity, Working Paper, Mc Gill University.
  - On-the-Run Securities are compared with Off-the-Run securities across the maturity spectrum.
  - Changes in illiquidity are found to cause economically significant return variations.
- Note: On-the-Run treasuries are the most recently issued Treasury security of a particular maturity and usually have the highest liquidity. Off-the-run securities will usually carry a higher yield than the On-the-Run associated with that security.

### Corporate Bond Market Studies — key findings and numeric estimates
- Three general results summarized:
  - Liquidity risk in the corporate bond market is priced (i.e. nondiversifiable).
  - It is of significant relevance for corporate bond pricing.
  - On a relative basis, liquidity is of greater importance for more highly rated corporate bonds, although lower rated bonds’ returns are more affected by it on an absolute basis.
- Chacko, G. (2006): Liquidity Risk in the Corporate Bond Markets, Working Paper, Harvard Business School.
  - Uses data from three sources and develops a measure called ‘Latent Liquidity’.
  - For a BBB-rated issuer in the period from early 2000 to early 2003, the liquidity premium was found to be between 70–100 basis points, at times equaling the pure credit risk.
- De Jong, F., and Driessen, J. (2005): Liquidity Risk Premia in Corporate Bond Markets, Working Paper.
  - Corporate bond liquidity is priced explicitly together with equity and treasury market liquidity.
  - For U.S. long maturity investment grade bonds, the liquidity risk premium is around 0.45%, for High Yield bonds around 1%.

### Evidence from markets with similar quality debt — specific comparisons (quotes from Bloomberg on 8/25/2010)
- Comparison of two £-denominated bonds: EBRD 6/2032 vs. U.K. Gilt
  - EBRD bond at Gilt Yield + 24 basis points
- Comparison of two £-denominated bonds: EBRD 12/2028 vs. U.K. Gilt
  - EBRD bond at Gilt Yield + 25 basis points
- EBRD of 12/1/2025 vs. Ger 1/2024
  - EBRD bond at German Yield + 35 basis points

### Market inceptions & liquidity premium examples
- Inception of the triple-A Credit Card ABS Market (1988/89)
  - Market started out at a spread of about 1.5% over LIBOR (estimated), or roughly 180 basis points over Treasuries.
  - Many triple-A rated Credit Card ABS bonds reached spreads of below LIBOR in 2004.
- Inception of the U.S. TIPS Market (1997) — D’Amico, S., Kim, D., and Wei (2010), M, Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices, Finance and Economics Discussion Series, Federal Reserve Board.
  - The liquidity premium for TIPS is estimated to be about 1%.
  - Albeit initially positively received, TIPS lost value versus a similar-maturity Treasury Note for the first 19 months of the program’s existence.

### Representative numeric findings (preserved exactly)
- 4.7 years — capitalized cost of slightly less than 4.7 percent of the original issuance amount.
- 2-year note — 80 basis point spread → capitalized cost of almost 1.6 percent of the issuance amount.
- Liquidity premium of notes over bills: 39 basis points annualized.
- BBB-rated issuer (early 2000 to early 2003): liquidity premium between 70–100 basis points.
- U.S. long maturity investment grade bonds: liquidity risk premium around 0.45%.
- High Yield bonds: liquidity risk premium around 1%.
- EBRD bond vs. U.K. Gilt: +24 basis points; +25 basis points (different maturities).
- EBRD bond vs. German Yield: +35 basis points.
- Triple-A Credit Card ABS initial spread: about 1.5% over LIBOR (estimated) = roughly 180 basis points over Treasuries.
- TIPS liquidity premium: about 1%.
- TIPS lost value versus a similar-maturity Treasury Note for the first 19 months of the program’s existence.

*Source: Excerpt from the IMF PDF chapter/section titled “_010711 - 4.7 years, would have a capitalized cost of slightly less than 4.7 percent of the original.”*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_010711.pdf_