Reserve Currencies

A reserve currency is defined as a currency held by government for international payment purposes. The most important usages are:

  • Repay back international debt (generally issued in reserve currencies)
  • Defend the domestic currency against depreciation
  • Improve the government credit rating

Reserve currencies are many. The IMF chooses the most important ones to peg its Special Drawing Rights (SDR or XDR): USD, EUR, JPY, GBP, and as of October 2016 the CNY. The SDR is not a currency per se, but they represent a claim on the foreign reserves held by the IMF, i.e. member countries can convert their SDRs for these currencies.

There is no official title defining the “most dominant reserve currency”. But it is widely accepted that currently such “title” is held by the US Dollar. The reason is its widespread usage in international transactions:

  • USD makes 64% of global foreign reserves
  • 65% of all USD is used outside the US
  • 33% of world GDP comes from countries with USD peg (7 of which directly use the USD)
  • 85% of FX transactions involve the USD
  • 39% of world debt is in USD

Chinese Calls for a New Global Reserve Currency

Since 1995, China has been recording consistent trade surpluses which from 2004 to 2009 has increased 10 times. Such trade surplus has allowed the country to accumulate huge amounts of foreign reserves, currently valued at $3tn. While China is ranked #1 in terms of foreign reserves held, the second position is held by Japan with “only” $1.2tn, and third by Switzerland with $0.8tn.

Unfortunately, the exact composition of Chinese foreign reserves is a State-secret, analysts agree that most of them are held in USD, specifically in US Treasuries. In fact, during the global financial crisis of 2008, China realised that it was too dependent on a single foreign nation: with a falling USD, their trillions of reserves were taking a hit. Thus, in 2009, China together with Russia called for a new Global Reserve Currency, one that would be independent on any single nation and stable in the long-run like the Gold in the past; for instance, the SDR.

Ideally, China would love the CNY to be the new reserve currency:

  • If commodities were priced in CNY, China would have no exposure to USD at all
  • China would be able to borrow at much lower rates as everyone would be happily willing to hold CNY-debt
  • China would hold much more economic power

But this idea is just unrealistic as of now, China is still far behind the US in terms of level of trade, economic power, markets transparency, or monetary policy stability, to be able to dethrone the USD.

Still, such design could be realised in the future. The USD has not always, and probably will not, be the Global Reserve Currency for eternity. In fact, China is already taking steps towards this objective, for instance by steadily liberalising the CNY: in March 2014, the Chinese government allowed the CNY to rise or fall 2% (from 1%) from a daily midpoint rate. Then, in August 2016, the government allowed the daily midpoint rate to be set by the previous day’s close instead setting it arbitrarily.

Another endeavour is represented by their increasing of Gold reserves, probably to back the CNY with Gold. China is currently the largest Gold producer in the world, with 0.4k tonnes mined in 2016. In addition, analysts speculate the country is buying gold in the market and even though officially it holds only 1.8k tonnes in reserves (7% of the world); analysts agree that the true (secret) number is much higher.

The increasing Gold reserves are particularly interesting because if China were to hold so much Gold to be able to back its currency, then it could bolster its campaign of CNY as Global Reserve Currency.


Here, an interesting market information: recently, the XAUCNY (i.e. Gold priced in CNY) has been very stable, almost as if there were to be a hidden peg.

In the next section we will discuss a possible way to trade this peg. As for now, let us speculate a bit on the possible drivers of such event:

    1. Market forces

By no-arbitrage pricing

Therefore, for the peg to exist it must mean that XAUUSD and USDCNY hold a very negative correlation (in the last year, it is -0.96). It is possible that market is pricing such correlation, so that every time the CNY depreciates (i.e. USDCNY rises), the gold value falls (i.e. XAUUSD falls) and vice versa.

This past summer, when bad news on trade wars hit the market investors reacted by selling CNY (i.e. USDCNY rises), which generally would make investors run for safety and buy Gold. Instead, Gold was sold as well. Such link goes against the conventional knowledge that Gold is held as safe-haven in moments of market turbulence.

While it is possible that investor’s appetite changed. We try to see another possibility

    2. Government intervention

As discussed briefly before, the Chinese government is extensively accumulating Gold. It is possible that they might be acting on the market to drive the price of XAUUSD in such a manner to maintain a flexible peg of XAUCNY. Such peg would be very beneficial to China as countries could trade commodities by avoiding the USD exposure.

Some countries (e.g. APAC ones) might prefer to sell commodities directly in CNY instead of USD, because they do lots of trade with China. What holds them back is probably the fact they do not trust the CNY: it is government-controlled, belongs to a non-transparent financial market and shows high volatility. Thus, a XAUCNY peg would dismiss all these critiques: all revenues in CNY would be converted, at fixed exchange rate, to the Gold and thus producers would be able to lock-in a Commodity-to-Gold price.

Not by chance, in March China enlisted Oil Futures contract priced in CNY in contrast of the widely used Oil Futures in USD. Such initiative has been proposed and tested by many countries in the past (including China), but they have all failed. Right now, China could succeed because, among other reasons:

  • China is the 2nd biggest economy of the world, and biggest in the APAC region
  • China is fostering economic integration with the One Belt One Road initiative: partner countries are happy to use CNY instead of USD
  • Middle East countries could diversify risk by borrowing in CNY and repaying back with the proceeds from selling Oil
  • CNY is much more used internationally (belongs to IMF’s currency basket of SDR)
  • Financial system is becoming much more open

Therefore, it is not to exclude that China might be artificially pegging the XAUCNY. Our next section involves discussing how to bet on such idea.

Trading the XAUCNY Peg

Trading a breaking peg is easy task, just buy in the direction you believe it would break. Betting on a stabilising peg instead, requires a bit more thinking. We will use options to accomplish such task.

Ways to play on a XAUCNY peg using non-directional option strategies:

    1. Shorting volatility on XAUCNY – the most obvious way to express our opinion would be to sell volatility on the XAUCNY pair. However, this requires that:

  • XAUCNY options are traded and accessible
  • XAUCNY volatility has been bid up in the recent past (so we have a nice entry point)

Unfortunately, most XAUCNY options seem to be OTC and we couldn’t find publicly available data on them.

    2. Expressing a view on XAUCNY implied correlation using a portfolio of options

If we take USD as a third currency in the equation, the relationship commonly referred to as “FX Volatility Triangles” can be expressed as:

where is the implied volatility of the currency options.

We can use a portfolio of options on XAUCNY, USDCNY and XAUUSD to express an opinion on the correlation between USDCNY and XAUUSD. Since, our opinion is of a peg on XAUCNY, we would expect a close to perfectly negative correlation between USDCNY and XAUUSD – and any deviation from this would represent a trade opportunity. To understand this, just think of the correlation required for to be 0 (i.e. a peg).

To short the above correlation, we would sell volatility on XAUCNY, buy volatility on XAUUSD and USDCNY – we would have no pure volatility exposure and only a short correlation exposure.

Unfortunately, this approach suffers from the same drawbacks as the previous one – the lack of availability of options of XAUCNY.

3. The third way would be a long short volatility portfolio involving only XAUUSD and USDCNY. If there is a XAUCNY peg, the volatilities of XAUUSD and USDCNY should converge for XAUCNY to remain stable. This relationship isn’t as strong and precise as the previous two, but it makes intuitive sense. As, we can see below – this is also being priced in by the options market – the ratio of 1m implied volatilities of XAUUSD and USDCNY have been tending towards 1 ever since the peg started.

While the fact that the option market seems to agree with us reinforces our thesis, it also deprives us of an opportunity to trade our thesis – what has been priced in cannot be traded.

One could argue that we could still sell volatility on XAUUSD and buy volatility on USDCNY since the ratio is till closer to 4 than to 1. However, this wouldn’t be an awfully high conviction trade given the imprecise nature of the relationship. What would still make us enter this trade would be a good positive carry (i.e., if nothing happens – we make money).

While selling a higher volatility and buying a lower volatility would mean being net theta positive, and hence a positive carry, it is also prudent to look at how our gamma PNL could unravel. To gauge the combined effect of gamma and theta – we look at the ratio of implied volatilities (as in the chart above) and compare it to the ratio of realized volatility (trailing 2m):

The ratio of realized volatilities is marginally higher than the ratio of implied volatilities (irrespective of the trailing windows used for realized volatility) – this is not a good sign for a portfolio on which we are vol sellers (short gamma, long theta).

Given the points above, we don’t believe this is a particularly high conviction trade.



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