Understanding the hierarchy of currencies! Understanding why the US dollar is the international settlement currency, and the reasons why Bitcoin is difficult to replace fiat currencies.

The original title is "What is the 'Money Hierarchy'? Why is the US Dollar the International Settlement Currency? Why is it Difficult for Bitcoin to Replace Fiat Currency?", written by independent contributor James Chiu. The previous article explained the influence of the US dollar as an international settlement currency through Fed's report, Fed Notes. Additionally, despite being both fiat currencies, the status of the US dollar and other fiat currencies is completely different, which is known as the "Money Hierarchy". In the financial market, all commodities are priced, including Bitcoin, securities, New Taiwan Dollar, Euro, US Dollar, etc. These prices create an illusion that all commodities are on the same level, but in reality, they are hierarchical. The first distinction is between currency and credit. Currency is different from credit. Credit is a promise to redeem currency in the future, while currency is currency. The image below shows the most basic currency hierarchy: Currency > Credit. In the currency hierarchy, each level needs to be settled through liquidity from the higher level and cannot be settled using liquidity from the same level or lower. For example, to the general public, bank deposits are considered currency used to settle debts (credit); for banks, deposits are credit, and reserves are used to settle credit. The real-world currency system is quite complex. For ease of understanding, the author uses a simplified "gold standard" as the basis and illustrates the "gold standard currency hierarchy". In the gold standard system, the currency issued by a country is essentially a promise by the country to "pay in gold", and gold ranks higher than the national currency because the national currency bears the risk of being unable to be exchanged for gold. The next level is commercial bank deposits. Depositors deposit fiat banknotes into banks and earn interest. Deposits represent the bank's "promise to pay in fiat currency", and the reason fiat currency is superior to deposits is due to the risk of deposit redemption. Below deposits are securities, meaning they represent a promise to pay bank deposits. Therefore: Gold > Currency > Deposits > Securities. If we further express the currency hierarchy in an accounting balance sheet format (as shown in the image), the currency hierarchy becomes more apparent. In the balance sheet (assets on the left, liabilities on the right), we can observe: - Gold is an asset of the central bank, used to issue fiat currency, making fiat currency the central bank's liability. - Fiat currency becomes an asset of the banking system, and deposits become bank liabilities. - Deposits are assets of the private sector, while securities are the liabilities issued by them. Throughout the process, fiat currency, deposits, and securities are both assets and liabilities, while gold is only an asset and not a liability of anyone. This represents the highest level of the currency hierarchy, also known as the dominant currency in the world. According to the book "Monetary Economics", the highest level of the currency hierarchy is also known as "Outside Money".

Expansion and Contraction of the Monetary System

Many have seen Ray Dalio, founder of Bridgewater Associates, explain how the economic machine functions.

The economic machine is composed of different markets, participants, and payment methods. The spending in this economic framework comes from two sources: Money and Credit. During the business cycle, consumer spending, money, and credit all increase rapidly. The rise in assets due to economic growth will further drive this spending, creating a positive cycle.

Assuming no intervention in monetary policy by the central bank, the economic expansion will continue to self-reinforce until the cost of debt becomes extreme, profits from production can no longer cover the debt, and the deleveraging process begins.

Increase in financing and debt → Investment to increase production → Use future production to repay debt → Refinancing

The deleveraging process is quite lengthy, and a liquidity crisis will accompany the entire process of deleveraging.

During the economic expansion phase, most payment commitments are composed of credit, and third-party guarantees are usually commercial banks. Therefore, any credit default can easily trigger other defaults, leading to a sudden "liquidity crisis." A prime example is the event that occurred in March 2020, where almost all assets experienced a sharp decline.

Through the explanation above, we can understand that the entire monetary hierarchy is not static; it breathes and expands or contracts with economic growth and decline.

During economic growth, the entire monetary system expands like the black line in the diagram below. At this time, the bottommost securities and credit will expand outward and upward. Because of good liquidity, credit appears very similar to money during this phase.

However, once the deleveraging process begins and liquidity deteriorates, credit begins to discount, and market participants realize that credit is not money; what they truly need is money.

Money is money, credit is credit.

The Dollar's Status Makes the Fed the Lender of Last Resort

It is evident that in the current world financial system, the dollar sits at the top of the monetary hierarchy, becoming the international external money. During financial crises, there is notably high demand for dollar financing, and foreign financial institutions, including central banks, face difficulties in dollar financing, which has led the Fed to become the "Dealer of Last Resort."

This can be seen through the "swap lines with foreign central banks" in the Fed's reports.

To alleviate international dollar financing pressures, the Fed introduced "temporary swap lines with foreign central banks" during the 2008 financial crisis, and some tools became permanent financing tools in 2013. During the COVID-19 pandemic in 2020, the Fed increased the frequency of using these permanent facilities.

Additionally, the Fed introduced repurchase tools with foreign institutions and central banks that have accounts at the Federal Reserve Bank of New York, allowing approved users to have access to stable dollar financing even during a crisis.

The chart below shows that swap lines were widely used during the 2008-2009 financial crisis and the 2020 COVID-19 crisis, with outstanding balances reaching $585 billion and $450 billion, respectively. While other central banks have established similar mechanisms, almost no one has utilized them, with the blue line representing the dollar and the orange line representing the euro usage.

The accumulation of dollar forex reserves and usage seems to have created a self-reinforcing mechanism, inadvertently making the Fed the lender of last resort.

Source: Fed

Comparison of dollar and euro swap lines Source: Fed

Can Bitcoin Replace the Dollar?

Can Bitcoin replace the dollar? It is highly unlikely.

Firstly, there is the issue of the monetary hierarchy.

During the gold standard era, gold was at the top of the entire monetary system, but due to various reasons, in 1971, U.S. President Nixon temporarily suspended the dollar's convertibility into gold, leading the world to move away from the gold standard, and the dollar naturally assumed gold's position.

Since the international settlement currency is the dollar, it is understandable that dollar forex trading and the percentage of dollar reserves held by countries are high.

For example, one of the data points in a Fed report in 2015 indicated that 50% of the world's total GDP was produced by countries anchoring their currencies to the dollar (excluding the U.S.). Many countries, after earning trade surpluses, use these to purchase dollar-denominated assets as forex reserves, release a large amount of currency in their own country, depress the exchange rate, and create export advantages. This is also the process of self-reinforcement of the dollar reserve.

So where does Bitcoin fit in the hierarchy? The author believes that Bitcoin remains at the bottom of the monetary hierarchy: a commodity.

The chart below illustrates the current dollar system's monetary hierarchy.

Through stablecoins, the dollar system has been seamlessly integrated with cryptocurrencies. It can even be said that cryptocurrencies have been incorporated into the dollar system, becoming an offshore dollar-denominated asset class, benefiting from the wealth effect brought about by offshore dollar liquidity last year and this year.

As the majority of cryptocurrency transactions and decentralized finance transactions are settled in stablecoins, cryptocurrencies and the monetary hierarchy of DeFi fall below stablecoins.

During times of peace, when Bitcoin has excellent liquidity, it may give the impression that Bitcoin can serve as money, just as it does now. However, in times of a liquidity crisis, Bitcoin's price will significantly drop, and the market will suddenly realize that stablecoins are the safe haven.

The chart below shows the USDT (Tether) stablecoin and USD trading pair. During the liquidity crisis in March 2020, Bitcoin plummeted by over 50% within 24 hours, while USDT had a 5% premium, indicating a significant amount of USDT being redeemed.

Of course, as more people use Bitcoin, it may gradually move closer to being used as money or deposits. However, it is interesting that the price of money/deposits remains stable because governments require central banks and commercial banks to maintain a 1:1 exchange commitment—every $100 deposit can be exchanged for $100 in currency. Bitcoin, on the other hand, lacks government backing and does not have a fixed price commitment.

Another drawback of Bitcoin is its inherent lack of monetary elasticity.

If one day governments worldwide were to sit down and discuss a Bitcoin standard, what would happen?

For some believers in monetary theory and the Austrian School of Economics, a fixed total supply is a solution to prevent inflation. However, this understanding of money from "monetary discipline" may not adapt well to the current financial system's "flexible demands." In fact, this is the primary reason why the world moved away from the gold standard after World War II.

In today's era of globalization, credit expansion in the monetary system will expand and contract, with higher expansions and contractions as economic development improves. Bitcoin's total supply limit and halving supply growth each year make it an "inflexible" currency, meaning that during a crisis, Bitcoin cannot increase rapidly to meet market demand.

Bitcoin's inherent total supply limit makes it an ideal asset class during periods of abundant offshore dollar liquidity.

In fact, many renowned investors also recommend allocating a small portion of assets to Bitcoin. The reason is not difficult to understand: if Bitcoin's network consensus continues to rise, it may become an asset with a very high return on investment during the process of price discovery for Bitcoin. However, the risk is naturally high.

As an "emerging asset class," Bitcoin has performed well in recent years and may even become a means of payment outside of fiat currencies. However, as an international reserve currency or fiat currency, Bitcoin is not suitable.

Because Bitcoin's supply is absolutely not "elastic." Therefore, in times of crisis, when there is a significant demand for Bitcoin in the real economy or financial markets, and there is no lender of last resort providing sufficient Bitcoin liquidity to meet the demand, the real economy or financial markets will have no choice but to face a hard landing.

Considering the situation where the real economy and financial markets were both frozen due to the outbreak of the COVID-19 pandemic last year, if the U.S. did not provide strong support through fiscal and monetary policies in a timely manner, the crisis would have definitely spread for a longer period, and economic recovery would not have begun this year.

The above points are not meant to deny Bitcoin. In fact, the author believes that Bitcoin's design is exceptionally brilliant.

From institutional adoption last year to the recent official launch of a Bitcoin futures ETF in the U.S., Bitcoin as an asset class is entering the mainstream investor's view. Bitcoin's inherent total supply limit makes it "possibly" a very good reserve asset. However, as Bitcoin moves into the mainstream, it is essential to understand Bitcoin's asset class before investing.

Having a correct understanding of the monetary system is key to avoiding blind spots in investing in the cryptocurrency market.