The True Use Case of CBDCs: Dethroning the Dollar

This future will come sooner than you think, despite all the failed predictions about the end of dollar hegemony. Brazil could benefit from this shift.

Central bank digital currencies are the catalyst. They are a model of a fiat digital currency ironically inspired by governments’ response in 2008 to the invention of the anti-fiat bitcoin protocol. Bitcoin enthusiasts tend to oppose CBDCs, claiming that they are centralized tools of government and local people will fear them. They ignore the huge cross-border changes these new macro-level tools are likely to bring.

If major export economies like Brazil adopt CBDC-based settlements with their trading partners in the coming decade, it will lead to a de-dollarization trend. The impact on US capital markets, the global economy and geopolitical power dynamics will be profound.

Brazil’s central bank is one of more than 100 institutions experimenting with CBDCs. Other countries relevant to this discussion are the United Arab Emirates (UAE), Russia, Singapore and China. China is leading the way in adopting its electronic currency – the eCNY. China, of course, has made no secret of its desire to reduce dependence on the dollar.

These five economies represent about 25% of world production. But it is their major roles in international trade, as oil exporters (Abu Dhabi in the United Arab Emirates), food producers (Brazil), natural gas suppliers to Russia and consumer goods (China), and as a financial and shipping hub (Singapore) that stand out their currency strategies.

The world will be more interesting if the central banks of these countries use digital currencies to settle directly with each other, instead of using the dollar as an intermediary currency for 90% of all trade finance. DBS Bank in Singapore recently allowed direct payments in eCNY, and multilateral institutions such as the Bank for International Settlements (BIS), the World Bank and the International Monetary Fund encouraged member countries to collaborate on cross-border design of CBDC. So buckle up.

CBDCs are often viewed from a retail perspective. They are seen as the new digital payment devices that people use to make their daily purchases. This overblown idea has fueled fears that the state could monitor people’s purchases.

While valid (see my critique of the European Commission’s CBDC plans last week), these privacy concerns are only a side effect. The real problem is the large international transactions.

I have argued that protocol-based fiat digital currency exchanges between countries would have dramatic implications for international monetary systems.

By cryptographically locking exchange rate futures contracts in a decentralized blockchain-based escrow system, an exporter or importer could be protected from currency fluctuations during the life of their trade agreement without having to trust the funds to anyone else. There is no need to have the dollar in the middle.

In this system, for example, a Brazilian farmer could agree to supply his pigs with Chinese hoggery soy meal feed at a real to renminbi exchange rate fixed at the time of signing, knowing that a smart contract would automatically transfer these funds, as the Shipment arrived in Shanghai. All of this could be done peer-to-peer with the right oracles, without one party having to trust the other to deliver the funds or goods.

They could achieve this by avoiding the inefficient system currently in place, where a US-regulated correspondent bank acts as a trusted third party, first converting the importer’s renminbi to dollars and then converting it to real for the Brazilian exporter. As I have argued in the past, a proliferation of such arrangements would reduce global demand for dollars and hence investment in dollar reserves such as US Treasuries.

After listening to the Odd Lots podcast with Bloomberg’s Joe Weisenthal and Tracy Alloway (an influential economist), I now see that central bank cooperation will be more important than direct arrangements between importers and exporters to pave the way for pave the disintermediation digital billing.

Pozsar envisions central banks taking on new roles with CBDCs, such as clearing agents to settle exports and imports for their countries. They would then use CBDCs to settle directly with their counterparts abroad. They would then oust Wall Street’s powerful dollar correspondents such as JP Morgan, Citibank and others. In the end, countries won’t need that many dollars.

Pozsar believes that the trend is being driven by mid-sized economies with a strong trade component, which play an important role in both global dollar supply and demand. Net-exporting countries with trade surpluses accumulate fewer dollars and will therefore offer fewer greenbacks in the global FX market. Importers with trade deficits have less demand for dollars to buy things.

Pozsar’s “Bretton Woods III” vision is that the dollar will lose its hegemonic position over the next decade. He sees a different outcome from the British pound, which lost its reserve status in the early 20th century when it was simply replaced by the US dollar. He predicts that a multi-currency world will be the norm, where there is no dominant currency. This is possible thanks to the CBDC’s clearing mechanisms, which eliminate the need for reserve currency brokerage. The two parties must decide what currency they want to use to settle their trade deal, but not the dollar or some other universal standard.

China will not become the reserve currency leader, as many have claimed. Global influence is likely to increase as more trade contracts are signed in Renminbi. Russia, Brazil and Argentina have all agreed to trade with China in its currency. Even US Treasury Secretary Janet Yellen said a gradual decline in dollar reserves around the world is to be expected.

The US will be affected by the speed of the trend. Dollar demand by foreign companies is a major factor behind the debt accumulated by US companies, consumers and government agencies. Dollar inflows support US bond prices, which in turn lowers yields, thereby keeping US interest rates low. The demand for dollars from abroad makes American mortgages affordable. If that demand falls, the cost of US capital is likely to rise.

What should the US do?

This is sort of a “if you can’t fight them, join them” moment. Wall Street banks will gradually lose their intermediary status. Washington will not be able to use these institutions to oversee world transactions. The US must accept this reality and look for ways to maximize the advantage it still has as an issuer of a world-coveted currency. It should focus on the “soft power,” the values of openness and rule of law that underpin the dollar, and abandon the “hard power,” the elements of gatekeeping or control.

Soft power works because it reinforces a weakened but still widespread perception of the US as an open and progressive economy. It also gives the US a chance to be at the forefront of monetary innovation that will benefit users around the world.

This is the opposite path to China’s “panopticon”, a centralized digital fiat money. The US has no compelling reason to create a retail CBDC. Official digital dollars should better be reserved for cross-border payments between central banks, while domestically used digital money should be made available to private actors via decentralized models and cryptotechnology. This is where the true innovation advantage lies.

Unfortunately, as AskFX readers know, the current US government agenda seems to be anything but crypto-friendly.