## _072416 - EXECUTIVE SUMMARY

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---

### Executive summary — key purpose and scope
- The IMF will explore whether a broader role for the SDR could contribute to the smooth functioning of the international monetary system (IMS).
- Objective: examine the economic rationale for or against broader use of the SDR, focusing on identifying gaps and market failures the SDR could help address given the increasingly multi-polar global economy and growing financial interconnectedness.
- Distinct SDR concepts analyzed:
  - The official SDR (“O-SDR”), the composite reserve asset issued and administered by the IMF; most of the SDR 204.1 billion stock outstanding was allocated in 2009.
  - SDR-denominated financial market instruments (“M-SDRs”), which could be issued and held by any parties.
  - The SDR as a unit of account for reporting economic statistics, financial statements, and pricing transactions.
- Note sets out initial considerations on market incentives for M-SDRs, aspects of developing such markets, reporting statistics in SDR terms, and key issues for re-examining the role of the O-SDR.
- Date: July 15, 2016

### M-SDRs — diversification properties and implications
- Rationale:
  - M-SDRs inherit diversification properties from the SDR basket and should reduce foreign exchange and interest rate risk relative to single-currency instruments.
  - SDR valuation method aims to ensure a stable value of the SDR in terms of major currencies; the switch to a basket in 1974 sought to limit the influence of any single currency.
- Empirical findings (high-level):
  - Weighted returns on instruments in the SDR basket have been less volatile than returns of the individual components because component currency fluctuations display low or negative correlations.
  - The SDR interest rate has been less volatile than individual component rates because component rates are positively correlated but to a low enough degree that the basket provides diversification.
  - Risk-adjusted returns: A synthetic SDR bond typically earned higher returns per unit of risk (Sharpe ratios) than most single-currency three-month Treasury-bill equivalents, except for RMB-denominated instruments over the sample period examined. High SDR or synthetic-SDR Sharpe ratios were driven by low exchange rate volatility.
  - Returns on M-SDRs should reflect uncovered interest parity of the currencies in the SDR basket plus issuer-specific credit premiums; holding issuer credit constant, an M-SDR should have lower variance than comparable single-currency instruments.
- Caveats:
  - Underlying risk of an M-SDR will depend on term premia and issuer creditworthiness, which can blunt diversification properties; divergences should be bounded by arbitrage.
  - The SDR is only one possible set of portfolio weights; issuers or investors could replicate preferred weights using existing instruments at relatively low cost.

### Historical experience and market-development lessons
- Historical issuance:
  - SDR-denominated assets issued beginning in 1975 and peaked in the early 1980s.
  - By end-1981: up to 50 banks prepared to accept/manage SDR deposits; SDR 5–7 billion in deposits; SDR 563 million in SDR-denominated bonds issued; five syndicated bank loans worth SDR 908 million extended.
  - No SDR bonds or credits have been issued since 1981 and bank deposits declined afterwards.
- Contrast with the ECU:
  - ECU market developed strongly through the 1980s; by 1990 the ECU ranked as the sixth most-used currency for outstanding international bonds.
  - Factors supporting ECU development: European monetary integration, official-sector support, perceived commitment to the ECU in the transition to the euro, regulatory-arbitrage opportunities, and BIS-facilitated clearing infrastructure.
- Market conditions matter:
  - SDR market’s decline associated with a strengthening U.S. dollar in the early 1980s, financial liberalization easing investment restrictions in component currencies, and innovation (e.g., currency swaps) enabling hedging without basket instruments.
  - ECU benefitted from relative stability of its component currencies and growing use in commercial and financial dealings within Europe.

### M-SDRs — additional practical considerations
- Potential benefits beyond diversification:
  - M-SDRs offer a pre-packaged diversification option attractive to retail investors and official investors (e.g., central bank reserve managers, treasury operations of international organizations) with portfolios benchmarked to the SDR or with SDR-denominated liabilities.
- Potential drawbacks and challenges:
  - SDR represents only one portfolio weighting; market participants may prefer other weightings and can replicate them with existing instruments.
  - Market development challenges include settling and clearing of M-SDR transactions; dealing with potential basket redefinition and its implications; fostering secondary market trading to generate liquidity and market depth.
- Legal and framework note:
  - Current legal framework under the IMF’s Articles of Agreement does not preclude any market participant from issuing or holding M-SDRs; market forces would determine M-SDR interest rates and the market could develop independent of the O-SDR.

### SDR as a unit of account — potential benefits and considerations
- Potential benefits:
  - Publishing economic statistics and financial statements in SDR terms could help users identify valuation changes.
- Implementation considerations:
  - Statistical authorities would need to invest in communicating the rationale for any change in practice and the implications for users.
  - Weigh benefits of SDR-denominated reporting against other considerations.

### Key technical and numerical details preserved from the note
- SDR stock outstanding: SDR 204.1 billion (allocated in 2009).
- SDR currency-basket-related figures (Table 1):
  - Dollar: Basket weight 41.9; As of October 1, 2016: 41.73; Interest-rate instrument: U.S. Treasury Bill.
  - Euro: Basket weight 37.4; As of October 1, 2016: 30.93; Interest-rate instrument: Central government bonds with AA rating and above.
  - Pound: Basket weight 11.3; As of October 1, 2016: 8.09; Interest-rate instrument: U.K. Treasury Bill.
  - Yen: Basket weight 9.4; As of October 1, 2016: 8.33; Interest-rate instrument: Japanese Treasury Discount Bills.
  - Renminbi: Basket weight unlabelled in first column but shown as 10.92 in the second column (renminbi included in the SDR basket effective October 1, 2016); Interest-rate instrument: Benchmark yield for China Treasury bonds.
- SDR interest-rate rule change:
  - On October 24, 2014, the Executive Board amended the rule for setting the SDR interest rate by introducing a floor of 0.050 percent (5 basis points) and changing the rounding convention for calculating the SDR interest rate from two to three decimal places.
- Correlation evidence (Table 2, 2005–15 monthly changes; correlations are against the SDR for exchange rates):
  - Exchange-rate correlations (against SDR): Dollar 1.00; Euro -0.87; Pound -0.24; Yen 0.22; Renminbi 0.91.
  - Interest-rate correlations (between component 3-month instruments): Dollar 1.00; Euro 0.19; Pound 0.40; Yen 0.05; Renminbi 0.01.
  - Cross-correlations indicate low or negative correlations across many pairs, supporting diversification properties.
- Annex I compares risk-return properties of a synthetic SDR bond with three-month Treasury bills in component currencies including the Chinese renminbi; synthetic SDR bond returns omit the O-SDR interest-rate floor of five basis points.

---

### 6. Both issuers and investors could reap gains from M-SDRs by consolidating the number

### Advantages of M-SDRs and investor/issuer gains
- Consolidating denominations could yield savings for both issuers and investors, echoing private ECU experience.
- For investors benchmarked to the O-SDR, M-SDRs could reduce the need for portfolio rebalancing compared to investing in single-currency bonds.
- Further analysis recommended: estimate typical transaction costs for issuance of and investment in foreign currency securities (including the foreign exchange leg) to quantify potential cost reductions.
- RMB exposure:
  - RMB exposure embodied in the O-SDR is "just over 10 percent".
  - By comparison, the weight of the mark in the ECU was "over 30 percent".
  - M-SDRs could offer exposure to the RMB effective October 2016, but activity would be limited by an active offshore RMB market.

### Domestic investor implications and issuer risk
- M-SDRs issued in onshore markets could allow domestic investors under capital controls to gain exposure to reserve currencies, potentially reducing demand for foreign currency and capital outflows by diversifying FX risk.
- Issuers of onshore M-SDRs would assume foreign exchange risk by indexing liabilities to a foreign currency instead of issuing directly in RMB.
- Entities with access to international markets may prefer direct issuance in foreign currency if they have foreign exchange needs.

### Potential disadvantages and complexity
- Fixed currency amounts in M-SDRs mean investors/issuers must accept the SDR basket weights as given; basket represents only one of many potential portfolio weight sets.
- Deep and liquid markets exist for component currencies; investors/issuers must weigh pre-packaged diversification against constructing customized currency-weighted portfolios.
- Complexity hurdles:
  - Pricing requires yield curves in each component currency plus issuer credit pricing, especially in early stages absent a well-defined M-SDR yield curve.
  - Issuers/investors take on exposures in five currencies, potentially necessitating parallel transactions or hedges for regulatory or risk-management purposes.
  - These complexities mirrored challenges in private ECU development.

### Market development issues: settlement, liquidity, and yield curve
- Settlement and clearing:
  - Widespread M-SDR accounts would benefit from an M-SDR clearing facility.
  - Until such infrastructure exists, transactions must be settled in one or more component currencies.
  - Issuance terms could specify who elects the currency of settlement and when; standardization may help liquidity.
- Liquidity and premium considerations:
  - If primarily accumulated by buy-and-hold retail investors, M-SDRs may be less liquid than comparable single-currency claims, potentially leading to an interest rate premium on issuance.
  - IMF (2011a) suggested liquidity premium range: "25 to 150 basis points", with a central tendency of "80 to 100 basis points".
  - Premium expected to decline as issuance increases; first-mover problem could deter initial issuers.
- Yield curve development:
  - Initial activity may concentrate in short-maturity instruments; a fully liquid M-SDR yield curve would facilitate pricing and secondary market trading.
  - Initially, pricing could reference swap curves in component currencies; for RMB a substitute such as the Treasury yield curve may be needed where a liquid swap curve is absent.
  - Short-dated claims reduce uncertainties related to the SDR basket review cycle; maturity could lengthen as market gains experience.

### Dealing with SDR basket revisions
- Two approaches at quinquennial SDR reviews:
  - "Open basket": instrument indexed to the official basket definition at the time, exposing participants to redefinition risk.
  - "Closed basket": maintains the basket definition in effect upon contract entry, limiting redefinition risk but producing non-standardized instruments.
- Given broad stability in SDR composition, redefinition risk magnitude should not be overstated; private ECU experience favors the "open basket" to preserve a unified definition and support market conventions, dealer arrangements, regular issuance, repos and forwards.
- Practical considerations for closed-basket contracts: specify source of exchange rate quotations for each currency to value instruments if a currency drops out.

### Other market development considerations
- Official involvement:
  - Supranational issuers that denominate balance sheets in SDRs may be attracted to issue and invest in M-SDRs to minimize currency mismatches and reduce portfolio adjustments, subject to a liquid market.
  - Asian bond fund initiative cited as a possible model where official sector involvement supported local market development.
- Foreign exchange markets:
  - Liquid FX markets with forward trading typically facilitate fixed-income activity; basket FX trading is currently rare and may be a subsequent milestone.
- Investor indices:
  - Inclusion in major bond indices or creation of an M-SDR index could expand the investor base, but requires a minimum issuance scale.

---

### SDR as a unit of account: current use and potential benefits
- Current uses:
  - International reserves data published in SDR terms by China and in International Financial Statistics.
  - Some international/regional institutions use the SDR for balance sheets; some multilateral development bank lending denominated in SDR.
  - Pricing examples: Suez Canal fees and damages under the Montreal Convention.
  - Overall uptake as a unit of account remains low.
- Potential benefits:
  - Diversification properties of the SDR basket smooth valuation changes from major currency fluctuations.
  - Commodity prices show lower volatility in SDR terms than in U.S. dollar terms (Figure 2): reported peak-to-trough and trough-to-peak comparisons include:
    - U.S. dollar peak-to-trough = "-55%"
    - SDR peak-to-trough = "-52%" and elsewhere reported as "-50%"
    - U.S. dollar trough-to-peak = "345%" and elsewhere "114%"
    - SDR trough-to-peak = "244%" and elsewhere "103%"
  - For commodity exporters, pricing in SDR terms could stabilize domestic-currency receipts.
- Statistical dissemination considerations:
  - Authorities must weigh offering pre-packaged SDR data versus user conversions; may need to publish both SDR and U.S. dollar terms.
  - Technology reduces the cost of disseminating statistics in multiple currencies; clear communication of reporting changes is essential.
  - IMF is exploring feasibility of publishing balance of payments, international investment position, and COFER survey statistics in SDR terms using IMF exchange rates to avoid expanding reporting burden.

### Redefinition risk and historical experience
- Quinquennial reviews introduce potential uncertainty; observed U.S. dollar-SDR exchange rate can differ from earlier constructs of the SDR basket, but near-term fluctuations would have been broadly similar even if weights had not changed.
- Historical changes in weights have produced a lower long-term variance in the observed basket than had weights been fixed, suggesting changes improved stability.
- BIS experience with compensatory payments for basket adjustments in past redefinitions produced small amounts; market conventions could adopt similar arrangements.

---

### Role of the Official SDR (O-SDR)

### Historical context and purpose of the O-SDR
- O-SDR created in 1969 and defined under the IMF’s Articles of Agreement.
- Created as a supplement to reserve assets in the late 1960s under Bretton Woods amid concerns over continued accumulation of claims on the United States—the “Triffin dilemma” (Triffin, 1961).
- Despite aims of the Second Amendment to make the O-SDR “the principal reserve asset of the IMS” (Article VIII, Section 7 and Article XXII), consensus was not reached on far-reaching reform proposals; after floating exchange rates the O-SDR played only a minor role.
- Significant reserve accumulation in recent decades, capital flows from emerging to advanced economies, and rising public debt of reserve currency issuers have spurred renewed discussion on whether the O-SDR should play a broader role.

### Arguments that the O-SDR could play a broader role
- O-SDR could mitigate a modern form of the Triffin dilemma:
  - By raising effective liquidity buffers, the O-SDR could reduce incentives for (i) excessive reserve accumulation and uphill capital flows as non-reserve-issuing countries build precautionary buffers, and (ii) undermining policy discipline in reserve currency issuers.
  - In such an environment external balances can become unanchored from fundamentals, or disinflationary pressures can emerge as all countries cannot simultaneously improve their balance of payments.
  - The O-SDR could help reduce these incentives by providing access to international liquidity.
- Counterargument:
  - Globalization of finance has weakened the link between policies of reserve currency issuers and the currency denomination of reserve assets; creation of sufficient liquidity in reserve currencies can be independent of reserve issuers' policies. Proponents see little impact from broader use of the O-SDR.

### Technical aspects of the O-SDR (Box 2)
- Nature and allocation:
  - O-SDR is not a currency, but a potential claim on the holdings of freely usable currencies of participants in the SDR Department (currently all IMF members).
  - Allocated by the IMF to participants according to their quotas; allocations are not targeted based on need but aim to supplement existing reserve assets.
  - Not a direct liability of any single economy nor accumulated through a balance of payments surplus.
- Uses and reconstitution:
  - O-SDRs can be held or used unconditionally to obtain a freely usable currency to meet a balance of payments need.
  - Reconstitution requirement suspended since 1981.
  - Holdings and transactions limited to SDR Department participants, General Resources Account, and prescribed holders (some international financial institutions and regional central banks).
- Exchange mechanisms and designation:
  - O-SDRs primarily exchanged through voluntary exchanges between members, typically mediated by the IMF through Voluntary Trading Arrangements (VTAs).
  - Designation mechanism remains as a backstop for participants with balance of payments need; participants cannot be obligated to increase holdings to more than twice their cumulative allocation.
  - Designation mechanism not used since 1987.
- Valuation and return:
  - Since 1974 O-SDR valued on a basket of currencies: U.S. dollar, euro, Japanese yen, and pound sterling; basket expanded effective October 1, 2016 to include the Chinese renminbi.
  - O-SDR carries an interest rate determined by yields on three-month treasury bills of component currencies.
  - Return comparable to that of an asset of the highest credit quality.
- Self-financing mechanics:
  - O-SDR mechanism is self-financing and levies charges on allocations, used to pay interest on O-SDR holdings.
  - If holdings equal allocation, charges equal interest received.
  - If holdings rise above allocation, participant effectively earns interest on the excess.
  - If holdings are fewer than allocated, participant pays interest on the shortfall.

### Key open questions and areas for further work
- Impact on reserve accumulation, global imbalances, and external adjustment:
  - By raising effective liquidity buffers, how much would a higher stock or greater usability of the O-SDR reduce accumulation of reserves through balance of payments surpluses?
  - Would broader use of the O-SDR affect external adjustment in deficit countries and in reserve currency issuers?
  - Would it have an inflationary impact, or help avert potential risks of global deflation?
  - Further examination of the effects of the 2009 allocations could provide evidence on some of these questions.
- Liquidity and attractiveness:
  - Is the O-SDR serving as a truly liquid and usable reserve asset?
  - How does its status as a call on other reserves affect its attractiveness relative to other reserve assets?
- Conditional uses and links to IMF toolkit:
  - O-SDRs (existing stock or new issuance) could be used to finance crisis prevention instruments such as precautionary liquidity facilities, or augment resources available via conditional lending.
  - Key open question: would this reduce self-insurance or improve incentives for policy adjustment?
  - Would objectives be best achieved by the O-SDR as defined in the Articles of Agreement, or by an alternative asset or funding vehicle?
  - Conditional use relates to IMF lending toolkit and size of IMF resources, requiring coordination with ongoing work.
- Additional consideration:
  - Impact on those who could be called upon to provide freely usable currency under such facilities would need to be taken into account.

---

### Annex I. Diversification Properties of the SDR Basket

### Methodology and data
- Comparison of risk-return properties of a synthetic SDR bond with three-month Treasury bills in each component currency and the Chinese renminbi (RMB), with RMB included in the SDR basket effective October 1, 2016.
- Metrics: standard deviation of returns and the Sharpe ratio (average return divided by the standard deviation of returns).
- Returns decomposed into foreign exchange fluctuations and interest income; returns calculated from the perspective of investors in each component currency.
- Investment horizons: k = 1 month and k = 3 months.
- Reported annual bond yields converted to monthly and quarterly compounded rates.
- Data period: January 2005 through December 2015.

### Main findings on stability and volatility
- Synthetic SDR bond exhibited consistently more stable returns than single-foreign-currency returns over the sample period.
- Stability driven principally by lower fluctuations in the value of the SDR basket.
- Exception: U.S. dollar–RMB rate experienced low exchange rate volatility during much of the sample period because the RMB was managed against the dollar.
- Interest rate risk contribution to volatility was small since the global crisis, due to the stability of most component interest rates near zero.

### Risk-adjusted returns
- Synthetic SDR bond typically earned higher returns per unit of risk (Sharpe ratios) than most single-currency instruments, attractive to conservative investors such as reserve managers.
- Main exception: risk-adjusted returns on RMB-denominated securities were higher for all investors over this sample period, driven by RMB appreciation outweighing its volatility (for European, Japanese, and British investors). RMB-denominated returns are not included in one comparative figure for this reason.

### Systematic risk (beta) and diversification efficiency
- Total risk decomposed into common (systematic) shocks and idiosyncratic variation; diversification mitigates idiosyncratic risk.
- Beta coefficient indicates sensitivity of a currency’s total return to movements of the SDR basket.
- Beta coefficients, 2005–15 (one-month return / three-month return):
  - U.S.: SDR 1.00 / 1.00; Dollar 2.13 / 2.01; Euro 1.28 / 1.45; Pound 0.61 / 0.64; Yen 0.10 / 0.15; Renminbi 1.00 / 1.00
  - European: SDR 1.00 / 1.00; Dollar 1.65 / 1.73; Euro 0.84 / 0.58; Pound 1.79 / 1.98; Yen 1.62 / 1.72
  - British: SDR 1.00 / 1.00; Dollar 1.15 / 1.17; Euro 0.90 / 0.81; Pound 1.54 / 1.80; Yen 1.12 / 1.19
  - Japanese: SDR 1.00 / 1.00; Dollar 0.90 / 0.93; Euro 1.35 / 1.26; Pound 1.24 / 1.33; Yen 0.94 / 0.98
  - Chinese: SDR 1.00 / 1.00; Dollar 0.11 / 0.16; Euro 2.04 / 1.91; Pound 1.20 / 1.42; Yen 0.73 / 0.77
- Synthetic SDR bond offers efficient risk reduction in many instances, but not always; where it does not, investors would require higher yield compensation.

### Representative numerical results from Tables A1.2 and A1.3 (2005–15) — U.S. investor perspective
- One-month horizon:
  - Bond Value Return (μ-100)/100 (%): SDR 0.068; Dollar 0.091; Euro 0.068; Pound -0.002; Yen 0.030; Renminbi 0.659
  - Standard deviation (σ): SDR 1.410; Dollar 0.150; Euro 3.143; Pound 2.558; Yen 2.730; Renminbi 0.646
  - Adjusted Return (μ)/σ: SDR 0.048; Dollar 0.604; Euro 0.022; Pound -0.006; Yen 0.011; Renminbi 1.020
- Three-month horizon:
  - Bond Value Return (μ-100)/100 (%): SDR 0.230; Dollar 0.272; Euro 0.243; Pound 0.031; Yen 0.219; Renminbi 2.004
  - Standard deviation (σ): SDR 2.500; Dollar 0.451; Euro 5.204; Pound 5.024; Yen 5.297; Renminbi 1.403
  - Adjusted Return/σ: SDR 0.092; Dollar 0.604; Euro 0.047; Pound 0.006; Yen 0.041; Renminbi 1.429

### Robustness over time
- Foreign exchange risk of the SDR basket has been consistently lower than for individual component currencies (illustrated using 60-month rolling volatility of one-month investment returns, 2001–15).
- Interest rate risk generally lower for the SDR basket, except for Japan (rates near zero) and China (heavy reliance on reserve requirements).
- Other studies find similar stability in earlier periods (van den Boogaerde, 1984; Medeiros and Nocera, 1988; Hoguet and Tadessee, 2011).

*IMF staff note, “The Role of the SDR—Initial Considerations,” Executive Summary (July 15, 2016).*

### EXECUTIVE SUMMARY

### _072416 - EXECUTIVE SUMMARY

### Executive summary — key purpose and scope
- The IMF will explore whether a broader role for the SDR could contribute to the smooth functioning of the international monetary system (IMS).
- The objective is to examine the economic rationale for or against broader use of the SDR, focusing on identifying gaps and market failures the SDR could help address given the increasingly multi-polar global economy and growing financial interconnectedness.
- The note distinguishes three distinct concepts for the SDR:
  - The official SDR (“O-SDR”), the composite reserve asset issued and administered by the IMF; most of the SDR 204.1 billion stock outstanding was allocated in 2009.
  - SDR-denominated financial market instruments (“M-SDRs”), which could be issued and held by any parties.
  - The SDR as a unit of account for reporting economic statistics, financial statements, and pricing transactions.
- The note sets out initial considerations on market incentives for M-SDRs, aspects of developing such markets, reporting statistics in SDR terms, and key issues for re-examining the role of the O-SDR.

*Date: July 15, 2016*

### M-SDRs — diversification properties and implications
- Rationale:
  - M-SDRs inherit diversification properties from the SDR basket and should reduce foreign exchange and interest rate risk relative to single-currency instruments.
  - The SDR valuation method aims to ensure a stable value of the SDR in terms of major currencies; the switch to a basket in 1974 sought to limit the influence of any single currency.
- Empirical findings (high-level):
  - The weighted returns on instruments in the SDR basket have been less volatile than returns of the individual components because component currency fluctuations display low or negative correlations, buffering exchange rate movements against the SDR.
  - The SDR interest rate has been less volatile than individual component rates because component rates are positively correlated but to a low enough degree that the basket provides diversification.
  - Risk-adjusted returns: A synthetic SDR bond typically earned higher returns per unit of risk (Sharpe ratios) than most single-currency three-month Treasury-bill equivalents, except for RMB-denominated instruments over the sample period examined. High SDR or synthetic-SDR Sharpe ratios were driven by low exchange rate volatility.
  - Returns on M-SDRs should reflect uncovered interest parity of the currencies in the SDR basket plus issuer-specific credit premiums; holding issuer credit constant, an M-SDR should have lower variance than comparable single-currency instruments.
- Caveats:
  - The underlying risk of an M-SDR will depend on term premia and issuer creditworthiness, which can blunt diversification properties; divergences should be bounded by arbitrage.
  - The SDR is only one possible set of portfolio weights; issuers or investors could replicate preferred weights using existing instruments at relatively low cost.

### Historical experience and market-development lessons
- Historical issuance:
  - SDR-denominated assets were issued beginning in 1975 and peaked in the early 1980s. By end-1981: up to 50 banks prepared to accept/manage SDR deposits; SDR 5–7 billion in deposits; SDR 563 million in SDR-denominated bonds issued; five syndicated bank loans worth SDR 908 million extended.
  - No SDR bonds or credits have been issued since 1981 and bank deposits declined afterwards.
- Contrast with the ECU:
  - The ECU market developed strongly through the 1980s; by 1990 the ECU ranked as the sixth most-used currency for outstanding international bonds.
  - Factors supporting ECU development included European monetary integration, official-sector support, a perceived commitment to the ECU in the transition to the euro, regulatory-arbitrage opportunities, and the BIS-facilitated clearing infrastructure.
- Market conditions matter:
  - The SDR market’s decline was associated with a strengthening U.S. dollar in the early 1980s, financial liberalization easing investment restrictions in component currencies, and innovation (e.g., currency swaps) enabling hedging without basket instruments.
  - The ECU benefitted from relative stability of its component currencies and growing use in commercial and financial dealings within Europe.

### M-SDRs — additional practical considerations
- Potential benefits beyond diversification:
  - M-SDRs offer a pre-packaged diversification option attractive to retail investors and official investors (e.g., central bank reserve managers, treasury operations of international organizations) with portfolios benchmarked to the SDR or with SDR-denominated liabilities.
- Potential drawbacks and challenges:
  - SDR only represents one portfolio weighting; market participants may prefer other weightings and can replicate them with existing instruments.
  - Market development challenges include:
    - Settling and clearing of M-SDR transactions.
    - Dealing with potential basket redefinition and its implications.
    - Fostering secondary market trading to generate liquidity and market depth.
- Legal and framework note:
  - The current legal framework under the IMF’s Articles of Agreement does not preclude any market participant from issuing or holding M-SDRs; market forces would determine M-SDR interest rates and the market could develop independent of the O-SDR.

### SDR as a unit of account — potential benefits and considerations
- Potential benefits:
  - Publishing economic statistics and financial statements in SDR terms could help users identify valuation changes.
- Implementation considerations:
  - Statistical authorities would need to invest in communicating the rationale for any change in practice and the implications for users.
  - Weigh benefits of SDR-denominated reporting against other considerations (not detailed in this summary extract).

### Key technical and numerical details preserved from the note
- SDR stock outstanding: SDR 204.1 billion (allocated in 2009).
- SDR currency-basket-related figures (as shown in the note’s Table 1):
  - Dollar: Basket weight 41.9; As of October 1, 2016: 41.73; Interest-rate instrument: U.S. Treasury Bill.
  - Euro: Basket weight 37.4; As of October 1, 2016: 30.93; Interest-rate instrument: Central government bonds with AA rating and above.
  - Pound: Basket weight 11.3; As of October 1, 2016: 8.09; Interest-rate instrument: U.K. Treasury Bill.
  - Yen: Basket weight 9.4; As of October 1, 2016: 8.33; Interest-rate instrument: Japanese Treasury Discount Bills.
  - Renminbi: Basket weight unlabelled in first column but shown as 10.92 in the second column (noted that the renminbi will be included in the SDR basket effective October 1, 2016); Interest-rate instrument: Benchmark yield for China Treasury bonds.
- SDR interest-rate rule change (technical):
  - On October 24, 2014, the Executive Board amended the rule for setting the SDR interest rate by introducing a floor of 0.050 percent (5 basis points) and changing the rounding convention for calculating the SDR interest rate from two to three decimal places.
- Correlation evidence (Table 2, 2005–15 monthly changes; correlations are against the SDR for exchange rates):
  - Exchange-rate correlations (against SDR): Dollar 1.00; Euro -0.87; Pound -0.24; Yen 0.22; Renminbi 0.91.
  - Interest-rate correlations (between component 3-month instruments): Dollar 1.00; Euro 0.19; Pound 0.40; Yen 0.05; Renminbi 0.01.
  - Cross-correlations among component currencies and interest rates indicate low or negative correlations across many pairs, supporting diversification properties.
- Annex and further analysis:
  - Annex I compares risk-return properties of a synthetic SDR bond with three-month Treasury bills in component currencies including the Chinese renminbi (included in the SDR basket effective October 1, 2016); synthetic SDR bond returns omit the O-SDR interest-rate floor of five basis points.

*Italicized source attribution: IMF staff note, “The Role of the SDR—Initial Considerations,” Executive Summary (July 15, 2016).*

### 6.      Both issuers and investors could reap gains from M-SDRs by consolidating the number

### _072416 - 6.      Both issuers and investors could reap gains from M-SDRs by consolidating the number

### Advantages of M-SDRs and investor/issuer gains
- Consolidating the number of denominations could yield savings for both issuers and investors, echoing private ECU experience.
- For investors benchmarked to the O-SDR, M-SDRs could reduce the need for portfolio rebalancing compared to investing in single-currency bonds.
- Further analysis recommended: estimate typical transaction costs for issuance of and investment in foreign currency securities (including the foreign exchange leg) to quantify potential cost reductions.
- Gaining exposure to a currency subject to capital controls could be an advantage, though RMB pickup is limited:
  - RMB exposure embodied in the O-SDR is "just over 10 percent".
  - By comparison, the weight of the mark in the ECU was "over 30 percent".
- M-SDRs could offer exposure to the RMB effective October 2016, but activity would be limited by an active offshore RMB market.

### Domestic investor implications and issuer risk
- M-SDRs issued in onshore markets could allow domestic investors under capital controls to gain exposure to reserve currencies, potentially reducing demand for foreign currency and capital outflows by diversifying FX risk.
- Issuers of onshore M-SDRs would assume foreign exchange risk by indexing liabilities to a foreign currency instead of issuing directly in RMB.
- Entities with access to international markets may prefer direct issuance in foreign currency if they have foreign exchange needs.

### Potential disadvantages and complexity
- Fixed currency amounts in M-SDRs mean investors/issuers must accept the SDR basket weights as given; basket represents only one of many potential portfolio weight sets.
- Deep and liquid markets exist for component currencies; investors/issuers must weigh pre-packaged diversification against constructing customized currency-weighted portfolios.
- Complexity hurdles:
  - Pricing requires yield curves in each component currency plus issuer credit pricing, especially in early stages absent a well-defined M-SDR yield curve.
  - Issuers/investors take on exposures in five currencies, potentially necessitating parallel transactions or hedges for regulatory or risk-management purposes.
  - These complexities mirrored challenges in private ECU development.

### Market development issues: settlement, liquidity, and yield curve
- Settlement and clearing are critical:
  - Widespread M-SDR accounts would benefit from an M-SDR clearing facility.
  - Until such infrastructure exists, transactions must be settled in one or more component currencies.
  - Issuance terms could specify who elects the currency of settlement and when; standardization may help liquidity.
- Liquidity and premium considerations:
  - If primarily accumulated by buy-and-hold retail investors, M-SDRs may be less liquid than comparable single-currency claims, potentially leading to an interest rate premium on issuance.
  - IMF (2011a) suggested liquidity premium range: "25 to 150 basis points", with a central tendency of "80 to 100 basis points".
  - Premium expected to decline as issuance increases; first-mover problem could deter initial issuers.
- Yield curve development:
  - Initial activity may concentrate in short-maturity instruments; a fully liquid M-SDR yield curve would facilitate pricing and secondary market trading.
  - Initially, pricing could reference swap curves in component currencies; for RMB a substitute such as the Treasury yield curve may be needed where a liquid swap curve is absent.
  - Short-dated claims reduce uncertainties related to the SDR basket review cycle; maturity could lengthen as market gains experience.

### Dealing with SDR basket revisions
- Two approaches to revisions at quinquennial SDR reviews (SDR basket reviewed every five years):
  - "Open basket": instrument indexed to the official basket definition at the time, exposing participants to redefinition risk.
  - "Closed basket": maintains the basket definition in effect upon contract entry, limiting redefinition risk but producing non-standardized instruments.
- Given broad stability in SDR composition, redefinition risk magnitude should not be overstated; private ECU experience favors the "open basket" to preserve a unified definition and support market conventions, dealer arrangements, regular issuance, repos and forwards.
- Practical considerations for closed-basket contracts: specify source of exchange rate quotations for each currency to value instruments if a currency drops out.

### Other market development considerations
- Official involvement:
  - Supranational issuers that denominate balance sheets in SDRs may be attracted to issue and invest in M-SDRs to minimize currency mismatches and reduce portfolio adjustments, subject to a liquid market.
  - Asian bond fund initiative cited as a possible model where official sector involvement supported local market development.
- Foreign exchange markets:
  - Liquid FX markets with forward trading typically facilitate fixed-income activity; basket FX trading is currently rare and may be a subsequent milestone.
- Investor indices:
  - Inclusion in major bond indices or creation of an M-SDR index could expand the investor base, but requires a minimum issuance scale.

### SDR as a unit of account: current use and potential benefits
- Current uses:
  - International reserves data published in SDR terms by China and in International Financial Statistics.
  - Some international/regional institutions use the SDR for balance sheets; some multilateral development bank lending denominated in SDR.
  - Pricing examples: Suez Canal fees and damages under the Montreal Convention.
  - Overall uptake as a unit of account remains low.
- Potential benefits:
  - Diversification properties of the SDR basket smooth valuation changes from major currency fluctuations.
  - Commodity prices show lower volatility in SDR terms than in U.S. dollar terms (Figure 2): reported peak-to-trough and trough-to-peak comparisons include:
    - U.S. dollar peak-to-trough = "-55%"
    - SDR peak-to-trough = "-52%" and elsewhere reported as "-50%"
    - U.S. dollar trough-to-peak = "345%" and elsewhere "114%"
    - SDR trough-to-peak = "244%" and elsewhere "103%"
  - For commodity exporters, pricing in SDR terms could stabilize domestic-currency receipts.
- Statistical dissemination considerations:
  - Authorities must weigh offering pre-packaged SDR data versus user conversions; may need to publish both SDR and U.S. dollar terms.
  - Technology reduces the cost of disseminating statistics in multiple currencies; clear communication of reporting changes is essential.
  - IMF is exploring feasibility of publishing balance of payments, international investment position, and COFER survey statistics in SDR terms using IMF exchange rates to avoid expanding reporting burden.

### Redefinition risk and historical experience
- Quinquennial reviews introduce potential uncertainty; observed U.S. dollar-SDR exchange rate can differ from earlier constructs of the SDR basket, but near-term fluctuations would have been broadly similar even if weights had not changed.
- Historical changes in weights have produced a lower long-term variance in the observed basket than had weights been fixed, suggesting changes improved stability.
- BIS experience with compensatory payments for basket adjustments in past redefinitions produced small amounts; market conventions could adopt similar arrangements.

### Role of the Official SDR (O-SDR)
- O-SDR uniqueness:
  - Allocated according to IMF quotas rather than accumulated via balance of payments surpluses.
  - Not a direct liability of any single economy; represents a potential claim on freely usable currencies of other participants in the SDR Department.
- Implications:
  - Quota-based O-SDR allocations are not targeted to match liquidity needs of individual countries; larger allocations would raise potential claims on other members' freely usable currencies.
- Reform considerations:
  - O-SDR currently plays only a minor role in the IMS.
  - Broader re-examination suggested to assess why O-SDR has played a minor role and the economic rationale for or against a broader role before exploring reform implementation.

*Source: _072416 - 6.      Both issuers and investors could reap gains from M-SDRs by consolidating the number*

### 22.      The evolution of the IMS has given rise to changing perspectives on the role the O-

### 22.      The evolution of the IMS has given rise to changing perspectives on the role the O-

### Historical context and purpose of the O-SDR
- The O-SDR was created in 1969 and is defined under the IMF’s Articles of Agreement.
- It was created as a supplement to reserve assets in the late 1960s under the Bretton Woods system of fixed but adjustable exchange rates amid concerns over the sustainability of continued accumulation of claims on the United States—the “Triffin dilemma” (Triffin, 1961).
- Despite the aims of the Second Amendment of the Articles of Agreement to make the O-SDR “the principal reserve asset of the IMS” (Article VIII, Section 7 and Article XXII), consensus was never reached on more far-reaching reform proposals discussed at the time.
- After the move to a system of floating exchange rates the O-SDR played only a minor role in the IMS.
- Significant reserve accumulation in recent decades, capital flows from emerging to advanced economies, and rising public debt of reserve currency issuers have spurred renewed discussion on whether the O-SDR should play a broader role as a reserve asset.

### Arguments that the O-SDR could play a broader role
- Some argue the O-SDR could mitigate a modern form of the Triffin dilemma:
  - With the large magnitude and volatility of capital flows, and no mechanism for symmetric adjustment of surplus and deficit countries, incentives exist for:
    - (i) excessive reserve accumulation and uphill capital flows as non-reserve-issuing countries attempt to avoid balance of payments deficits and build precautionary liquidity buffers;
    - (ii) undermining policy discipline in reserve currency issuers, manifested in current account and/or fiscal deficits.
  - In such an environment external balances can become unanchored from fundamentals, or disinflationary pressures can emerge as all countries cannot simultaneously improve their balance of payments.
  - The O-SDR could help reduce these incentives by providing access to international liquidity.
- Others argue globalization of finance has weakened the link between the macroeconomic policies of reserve currency issuers and the currency denomination of reserve assets:
  - Creation of sufficient liquidity in reserve currencies can be independent of the policies of reserve issuers.
  - According to this view, the importance of external imbalances and the precautionary motive in the growth of reserves are both overstated.
  - Proponents see little impact from broader use of the O-SDR.

### Technical aspects of the O-SDR (Box 2)
- Nature and allocation:
  - The O-SDR is not a currency, but a potential claim on the holdings of freely usable currencies of participants in the SDR Department (currently all IMF members).
  - It is allocated by the IMF to participants according to their quotas.
  - Allocations are not targeted based on need but aim to supplement existing reserve assets.
  - It is neither a direct liability of any single economy nor accumulated through a balance of payments surplus.
- Uses and reconstitution:
  - O-SDRs can be held on participants’ balance sheets or used unconditionally to obtain a freely usable currency to meet a balance of payments need (or for other reserves management purposes).
  - Originally participants who used a large share of their holdings were required to reconstitute them over time; this requirement has been suspended since 1981.
  - Transactions and holdings are limited to participants in the SDR Department, the General Resources Account within the General Department of the IMF, and prescribed holders (some international financial institutions and regional central banks; prescribed holders can hold O-SDRs but do not receive allocations).
- Exchange mechanisms and designation:
  - O-SDRs are primarily exchanged for freely usable currencies through voluntary exchanges between members, typically mediated by the IMF through Voluntary Trading Arrangements (VTAs).
  - The designation mechanism remains as a backstop by ensuring participants with a balance of payments need can exchange on demand their O-SDRs with participants with a strong external position.
  - Such participants cannot be obligated to increase their holdings of O-SDRs to more than twice their cumulative allocation.
  - The designation mechanism has not been used since 1987.
- Valuation and return:
  - Since 1974 the O-SDR has been valued based on a basket of currencies, which currently includes the U.S. dollar, euro, Japanese yen, and pound sterling.
  - The basket will be expanded effective October 1, 2016 to include the Chinese renminbi.
  - The O-SDR carries an interest rate determined by the yields on three-month treasury bills of the component currencies.
  - The return is comparable to that of an asset of the highest credit quality.
- Self-financing mechanics:
  - The O-SDR mechanism is self-financing and levies charges on allocations, which are used to pay interest on O-SDR holdings.
  - If a participant’s holdings are equal to its allocation, the charges equal the interest received.
  - If holdings rise above allocation, it effectively earns interest on the excess.
  - If it holds fewer O-SDRs than allocated, it pays interest on the shortfall.

### Key open questions and areas for further work (paragraph 23)
- Impact on reserve accumulation, global imbalances, and external adjustment:
  - By raising effective liquidity buffers, how much would a higher stock or greater usability of the O-SDR reduce accumulation of reserves through balance of payments surpluses?
  - Would broader use of the O-SDR affect external adjustment in deficit countries and in reserve currency issuers?
  - Would it have an inflationary impact, or help avert potential risks of global deflation?
  - Further examination of the effects of the 2009 allocations could provide evidence on some of these questions.
- Liquidity and attractiveness:
  - Is the O-SDR serving as a truly liquid and usable reserve asset?
  - How does its status as a call on other reserves affect its attractiveness relative to other reserve assets?
- Conditional uses and links to IMF toolkit:
  - As a departure from unconditional use under the current framework, O-SDRs (existing stock or new issuance) could be used to finance crisis prevention instruments such as precautionary liquidity facilities, or augment resources available via conditional lending.
  - Such uses could provide access to liquidity without a permanent commitment of freely usable currency.
  - Key open question: would this reduce self-insurance or improve incentives for policy adjustment?
  - Would such objectives be best achieved by the O-SDR as defined in the Articles of Agreement, or by an alternative asset or funding vehicle?
  - Conditional use of the O-SDR would relate to issues such as the IMF’s lending toolkit and the size of IMF resources, requiring coordination with ongoing work in those areas.
- Additional consideration:
  - The impact on those who could potentially be called upon to provide freely usable currency under such facilities would also need to be taken into account.

*Source: IMF content unit _072416 - 22; canonical URL provided in metadata.*

### Annex I. Diversification Properties of the SDR Basket

### Annex I. Diversification Properties of the SDR Basket

### Methodology and data
- Analysis compares the risk-return properties of a synthetic SDR bond with three-month Treasury bills in each component currency and the Chinese renminbi (RMB), with the RMB included in the SDR basket effective October 1, 2016.
- Metrics: standard deviation of returns and the Sharpe ratio (average return divided by the standard deviation of returns).
- Returns decomposed into foreign exchange fluctuations and interest income; returns calculated from the perspective of investors in each component currency.
- Investment horizons considered: k = 1 month and k = 3 months.
- Reported annual bond yields converted to monthly and quarterly compounded rates.
- Data period: January 2005 through December 2015.

### Main findings on stability and volatility
- The synthetic SDR bond exhibited consistently more stable returns than single-foreign-currency returns over the sample period.
- Stability driven principally by lower fluctuations in the value of the SDR basket.
- Exception: the U.S. dollar–RMB rate experienced low exchange rate volatility during much of the sample period because the RMB was managed against the dollar.
- Interest rate risk contribution to volatility was small since the global crisis, due to the stability of most component interest rates near zero.

### Risk-adjusted returns
- The synthetic SDR bond typically earned higher returns per unit of risk (Sharpe ratios) than most single-currency instruments, a feature attractive to conservative investors such as reserve managers.
- Main exception: risk-adjusted returns on RMB-denominated securities were higher for all investors over this sample period, driven by RMB appreciation outweighing its volatility (for European, Japanese, and British investors). For this reason, RMB-denominated returns are not included in one of the comparative figures.

### Systematic risk (beta) and diversification efficiency
- Total risk decomposed into common (systematic) shocks and idiosyncratic variation; diversification mitigates idiosyncratic risk.
- Beta coefficient (sensitivity of a currency’s total return to movements of the SDR basket) indicates the efficiency of risk reduction through the synthetic SDR bond. A beta equal to one implies identical systematic risk to the synthetic SDR; below one implies less systematic risk; above one implies more.
- The synthetic SDR bond offers efficient risk reduction in many instances, but not always:
  - U.S.-based investors could reduce systemic risk further by investing in Asian currencies rather than in a synthetic SDR-denominated instrument.
  - Chinese-based investors could reduce systemic risk by investing in dollars instead of the synthetic SDR (a result driven by the RMB’s peg to the dollar).
- In instances where the synthetic SDR does not minimize systemic risk, investors would need to be compensated with a higher yield to hold the synthetic SDR.

- Beta coefficients, 2005–15 (one-month return / three-month return):
  - U.S.: SDR 1.00 / 1.00; Dollar 2.13 / 2.01; Euro 1.28 / 1.45; Pound 0.61 / 0.64; Yen 0.10 / 0.15; Renminbi 1.00 / 1.00
  - European: SDR 1.00 / 1.00; Dollar 1.65 / 1.73; Euro 0.84 / 0.58; Pound 1.79 / 1.98; Yen 1.62 / 1.72
  - British: SDR 1.00 / 1.00; Dollar 1.15 / 1.17; Euro 0.90 / 0.81; Pound 1.54 / 1.80; Yen 1.12 / 1.19
  - Japanese: SDR 1.00 / 1.00; Dollar 0.90 / 0.93; Euro 1.35 / 1.26; Pound 1.24 / 1.33; Yen 0.94 / 0.98
  - Chinese: SDR 1.00 / 1.00; Dollar 0.11 / 0.16; Euro 2.04 / 1.91; Pound 1.20 / 1.42; Yen 0.73 / 0.77

### Representative numerical results from Tables A1.2 and A1.3 (2005–15)
- One-month horizon — U.S. investor perspective:
  - Bond Value Return (μ-100)/100 (%): SDR 0.068; Dollar 0.091; Euro 0.068; Pound -0.002; Yen 0.030; Renminbi 0.659
  - Standard deviation (σ): SDR 1.410; Dollar 0.150; Euro 3.143; Pound 2.558; Yen 2.730; Renminbi 0.646
  - Adjusted Return (μ)/σ: SDR 0.048; Dollar 0.604; Euro 0.022; Pound -0.006; Yen 0.011; Renminbi 1.020
- Three-month horizon — U.S. investor perspective:
  - Bond Value Return (μ-100)/100 (%): SDR 0.230; Dollar 0.272; Euro 0.243; Pound 0.031; Yen 0.219; Renminbi 2.004
  - Standard deviation (σ): SDR 2.500; Dollar 0.451; Euro 5.204; Pound 5.024; Yen 5.297; Renminbi 1.403
  - Adjusted Return/σ: SDR 0.092; Dollar 0.604; Euro 0.047; Pound 0.006; Yen 0.041; Renminbi 1.429

### Robustness over time
- Foreign exchange risk of the SDR basket has been consistently lower than for individual component currencies (illustrated for a U.S.-based investor using 60-month rolling volatility of one-month investment returns, 2001–15).
- Interest rate risk has generally been lower for the SDR basket, except for Japan (rates near zero) and China (heavy reliance on reserve requirements).
- Other studies find similar stability in earlier periods (van den Boogaerde, 1984; Medeiros and Nocera, 1988; Hoguet and Tadessee, 2011).

*Source: IMF staff calculations.*

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