Exchange Rates Innovated: The Global Currency Union

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By Michael Olson

Global Currency Union, January 8, 2013

Global currency markets are in constant turmoil. While there have been attempts throughout history to build some degree of stability into the international monetary system, they have all ultimately foundered. The gold standard of the late nineteenth century fell victim to World War I, while the Bretton Woods System was dismantled in 1971 by the very country that stood at its center, the United States, when President Richard Nixon suspended the gold convertibility of the dollar.

There has been no innovation in the structure of exchange rates for more than forty years, even though the world has seen considerable upgrades in most other structures of modern life: how you call someone on the telephone, how you get cash and do your banking, how you book travel, and so forth. The time is right for a new approach to the framework of exchange rates.

To date, countries have had little choice: either leave citizens exposed to the vagaries of currency fluctuations, or attempt to fashion regional currency solutions that provide at least partial certainty upon which better business decisions can be based. While it is true that unpredictable market forces can be influenced to a certain extent by currency interventions, this power is restricted to economically powerful states, and these states have widely varying motivations and work from different benchmarks.

Besides, a solution should be available for smaller countries, whether developed or developing, whose citizens must endure capricious changes in how much their currencies fetch in foreign markets. Companies doing international business in these countries run the risk that a currency fluctuation will exceed their profit margin over the course of a deal. This risk is a critical limiting factor, which can now be reduced.

The Innovator at Work

Denmark is among those smaller nations without much currency clout. Among its citizens is Jesper Toft, who in late 2008 was busy trying to engineer a transaction denominated in U.S. dollars with a Middle Eastern company. To his annoyance, he found the deal losing 12 percent of its value due to an unexpected dip in the value of the Danish krone (DKK) against the dollar. He plunged into a whirlwind of research trying to find a way to prevent this from ever happening to him again. Ultimately he found nothing useful?only expensive derivative solutions offered by the financial sector.

Toft is no stranger to creating something from nothing. Back in 1997 he launched the world's first free online telephone directory, thereby breaking up what had been a monopoly on that information by the Danish state telecom company. He soon followed that up with EDBPriser.dk, the first Nordic price-comparison site for computer technology.

So it took no great leap of imagination for him to realize that he was staring at a gaping hole in the global market?and he set about filling it. He established the Global Currency Union as a Danish association in November 2008, with the intention of developing a solution that could provide reduced exchange rate risk to anybody engaging in cross-currency transactions. Since then he has gathered the conceptual and technological talent needed to build a solution.

How the GCU Functions

As any system develops, the protocols by which its activities are directed must also develop. It begins with basic functions and controls. Then, as demand appears for increased capacity and efficiency, new improvements and innovations are implemented so that the full latent potential of the system can be unleashed.

We have seen this before with the telephone system where at first an operator received a caller's instructions and directed the call manually. It then evolved through direct-dial numbers to today's fully integrated regime where international calls are routed effortlessly around the globe. Telephone numbers have gone from being very short to becoming rather long. Each step increased capacity or added a new function.

In a similar way, the GCU intends to be a step up in the evolution of exchange rates?directing and completing activities between monetary systems, taking things to the next level when it comes to exchange rate stability and fairness.

The GCU solution can be viewed as a steering mechanism that acts in the global common interest, in the form of a new exchange rate structure for directing transactions. Rather than a direct exchange of currencies, business contracts conducted under this new system would be denominated in Global Currency Units. The relationship of these new units to the original currencies is calculated using "Index-Keys" which, although unique to each currency pair, are derived from the two currencies plus an index of related currencies over which the fluctuation risk is spread. While volatility is never completely eliminated, it is dampened so that periods with only low-level fluctuations dominate. To denote the process, exchange rate codes are expanded to contain three parts, totaling nine letters. For example, GBPGCUDKK represents a transaction between Denmark and the United Kingdom through the GCU.

Computer analysis of exchange rate trends confirms that the GCU approach can deliver substantially more stability. The chart below demonstrates how the volatility experienced by the dollar-krone exchange rate over a two-year period was reduced using an Index-Key comprised of a one-quarter share of USD and DKK along with lesser shares of the Swedish krona, Norwegian krone, euro, British pound, Czech koruna, and Polish zloty.

Since tradable exchange rates vary, such a system cannot rely on only one Index-Key. By designing a technical system that enables the issuance of units for settlement based on multiple underlying assets, the GCU has solved this "index problem" by making it dynamic, as seen in the nine-letter exchange rate codes instead of the customary six. Here, the characteristics of both sender and receiver are referenced for the correct Index-Key to be chosen, through an index matrix system, to function as the basis for the transaction between the two parties. There is a unique GCU Index-Key for each base-settlement currency pair that is serviced.

This approach means that it will be technically possible to direct and complete transactions through the GCU from and to all currencies with a higher degree of exchange rate stability and fairness. The GCU offers a competitive advantage over any existing exchange rate by spreading the fluctuation risk over several related exchange rates. In some cases the risk will be split over a low number of exchange rates, due to limited currency exchange availability, while in others it can be over a high number of exchange rates?but the multiple currency approach will always offer a reduced risk of excessive fluctuations to the user.

The GCU offers an advantage over any existing exchange rate by spreading the fluctuation risk over several related exchange rates.

This structure also allows for the future implementation of new exchange rate trading opportunities as well as adjustment of calculation parameters, so that the Index-Key used in relation to any two currencies can be improved further on an ongoing basis. Having this ability to use the right Index-Key, based on the characteristics of sender and receiver, also enables this service to start operating based on market circumstances at any particular time or place.

The trading opportunities currently available are certainly enough for the GCU to get started. Both Index-Key quality on the one hand and market penetration on the other can be developed further, as per available resources and priorities, since GCU Settlements is a dynamic system with no inherent limitations.

Global Implications

The result: Currency fluctuations are now tamed so that the cross-currency price-setting and payments at the heart of international business transactions become much more predictable. True, such changes in value are not abolished entirely, but their magnitude is lessened so that greater financial certainty will soon be available. GCU Settlements will be operated so as to achieve optimal market penetration as a utility. The effect can be compared to membership in a sort of halfway monetary union, in that companies gain considerable benefit in terms of currency stability without the troublesome rules or coordination that membership in a full monetary regime would entail.

If it gains traction, the stability this new exchange rate approach and settlements system provides to world trade should be substantial. The marginal calculations behind millions of cross-currency transactions will undergo a massive shift once a considerable portion of the risk is taken out of the equation. Sales that were once out of the question can now be pursued. World trade gets a substantial boost, in the form of incomes for international businesses, as well as the general quality of life for people?a wider variety of cheaper foreign goods, a greater amount of foreign investment in their economies, and, most of all, an increase in their own incomes.

Another, more subtle side effect of introducing GCU Settlements should not be overlooked. This can be summarized as "fairness," namely the symmetrical effect of using the GCU on a given cross-currency transaction for both buyer and seller. Ordinary cross-currency transactions as currently executed are not symmetrical: denominating the transaction in one side's currency means an uneven distribution of currency risk. Using the GCU, on the other hand, brings such risk back to the center, affecting the two parties equally and giving both an equal advantage, and since the GCU further provides for a high degree of stability for any such transaction, both parties know that they are working for their mutual benefit.

The marginal calculations behind millions of cross-currency transactions will undergo a massive shift.

In addition, such exchange rate stability becomes particularly important not only for big industrial trading nations but also for developing countries, whose trade income often depends on a few resources or crops. In the past, currency fluctuations?impacting both the purchasing power of their export earnings and the prices they face for imports of critical goods?have often wreaked havoc upon national economies and government budgets. The increased stability and fairness the GCU can bring to such situations will not only be much better for economic life in such countries, but it is also likely to foster a steadier investment climate that will encourage native as well as foreign investment.

Next Steps

The benefits to the common interest resulting from the Global Currency Union could be substantial. This is true even as the GCU remains for now a private effort to create a useful tool available to international business, making use of advances in data-gathering and computing power over the past decades to tame exchange rate volatility for all. The intention is not to create any sort of new currency. Rather, what will arise is a new exchange rate mechanism, free from political influences, and enabling all currencies to relate in a more stable, predictable manner.

Indeed, the GCU does not have any sort of authority to require international business to make use of its GCU Settlements facility. The onus lies on it to come forward with a facility that entrepreneurs will find useful in reducing their exposure to currency fluctuations, thereby reflecting the genuine demand in the market for such stability and fairness.

The GCU rollout has been planned in such a way as to provide a gradual introduction of its capabilities, so that its potential can be demonstrated to all observers. GCU Settlements, the operational entity for serving the international market, will be formally incorporated on January 22, 2013. It will make its first exchange rate public shortly thereafter?namely that between the pound sterling and the Norwegian krone?to be followed eventually by a formal system to offer settlement services involving the GCU.

Although a private initiative, the GCU has already attracted interest from the central bank authorities of several nations, due to its implications for world trade and the international financial system. Not surprisingly, these banks serve primarily the governments of developing countries, which are intrigued about how it could confer more stability on their own foreign trade situations, but there have been expressions of interest from some key developed countries as well.

All the while, GCU continues to develop its procedures and principles in preparation for its launch. Input at this stage from central bank authorities and similar interested parties is particularly welcome, and could potentially establish precedents that determine the fine details of GCU Settlements operation far into the future.

Read More: Business, Communication, Development, Economy, Finance, Globalization, Innovation, Technology, Trade, Denmark, Europe, Global

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Source: http://www.policyinnovations.org/ideas/innovations/data/000233

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