The unlikely reality of Bitcoin as a reserve currency

Reserve currencies are the foundation of global finance, acting as a stabilizing force and a universal medium of exchange that facilitates international trade and investment. Traditionally, they have been the domain of established fiat currencies like the US dollar, which currently dominates global reserves. According to the International Monetary Fund (IMF), USD accounts for approximately 58% of global foreign exchange reserves as of 2024.

However, the dollar’s position in the global economy has gradually weakened as more and more international trade is settled through the Chinese yuan and even cryptocurrencies. Bitcoin’s role in global finance was put under the spotlight when former US President Donald Trump suggested BTC could be used as a reserve currency.

While many dismissed the statement as political pandering, it sparked intense debate among economists, policymakers, and the broader crypto industry. The idea of a country with the size and influence of the US adopting BTC as a reserve currency raised fundamental questions about the future of global finance, the role of the US dollar, and the feasibility of integrating a decentralized digital asset into the existing financial system.

In this report, CryptoSlate will examine the feasibility, implications, and potential consequences of Bitcoin becoming a reserve currency in the US. We will examine the characteristics that make a currency suitable as a reserve asset, analyze the current global reserve currency landscape, and assess how Bitcoin could fit into or disrupt this framework.

The report will also delve into the logistical, regulatory, and market challenges that would need to be overcome for Bitcoin to be adopted as a reserve currency. Finally, we will consider broader implications for the global economy, including potential shifts in international power and the impact on Bitcoin’s core decentralization and financial freedom principles.

A reserve currency is a foreign currency held in significant quantities by governments and institutions as part of their international reserves. These reserves are used to settle international transactions, stabilize domestic currencies, and maintain financial confidence. A reserve currency acts as a global financial safety net, allowing countries to manage their economies more effectively during economic uncertainty or crisis.

The primary characteristics that make a currency suitable as a reserve currency are stability, liquidity, and global acceptance. Stability refers to the currency’s ability to maintain its value over time, which is crucial for countries that rely on it for international trade and investment. Liquidity is the ease with which the currency can be bought and sold in large quantities without significantly affecting its price. Global acceptance means the currency is widely recognized and used for international transactions.

Historically, the British pound was the dominant reserve currency throughout the 19th century and early 20th century, reflecting the United Kingdom’s status as the world’s leading economic and colonial power. The pound’s prominence was supported by the size of the British Empire, which spanned multiple continents, facilitating the widespread use of the currency.

However, the US dollar overtook the British pound as the leading reserve currency after World War II, mainly due to the Bretton Woods Agreement in 1944. This agreement established the dollar as the central currency for international trade, with other currencies pegged to it. The US dollar’s dominance was further solidified when President Nixon took the US off the gold standard in 1971, allowing the dollar to float freely and be traded without fixed value — thereby becoming the world’s primary fiat currency.

According to the International Monetary Fund (IMF), the US dollar remains the dominant reserve currency, comprising about 58% of global foreign exchange reserves as of 2024. This dominance is mainly due to the size and stability of the US economy and the widespread use of the dollar in global trade and finance. For example, approximately 40% of the world’s debt is issued in US dollars, even in countries where the dollar is not the local currency.

Other major reserve currencies include the euro, which accounts for about 20% of global reserves, the Japanese yen, the British pound, and the Chinese yuan. Each plays a significant role in international finance, though none has come close to challenging the US dollar’s supremacy.

The distribution of global reserves reflects the geopolitical and economic realities of the modern world. While the US dollar remains the cornerstone of international finance, the growing diversification of reserves signals a shift towards a more multipolar financial system. This diversification is partly driven by countries’ desire to reduce their dependence on the US dollar and mitigate risks associated with US economic and monetary policy decisions.

The discussion around Bitcoin as a potential reserve currency is particularly relevant in this context. As a decentralized digital asset with a finite supply, Bitcoin starkly contrasts traditional fiat currencies. Its growing acceptance and adoption raise questions about whether it could one day play a role in the global reserve currency system. However, Bitcoin’s volatility and relatively small market size compared to traditional reserve currencies remain significant challenges to its adoption in this capacity.

Since the Bretton Woods Agreement in 1944, the dollar has served as the central currency for international trade, investment, and foreign exchange reserves. Countries accumulate dollars through various mechanisms, including trade surpluses, foreign exchange operations, and central bank interventions. For instance, with its significant trade surplus, China holds over $3 trillion in foreign exchange reserves, with a substantial portion denominated in USD. This accumulation allows China to manage its exchange rate and provide a buffer against external economic shocks. Similarly, Japan holds around $1.3 trillion in reserves, with the dollar playing a pivotal role in stabilizing the yen and supporting Japan’s export-driven economy.

Roughly 40% of the world’s debt is issued in US dollars, even in countries where the dollar is not the local currency. This widespread use reflects the dollar’s stability, liquidity, and trustworthiness, making it the preferred currency for international transactions. For example, many emerging market economies issue bonds in dollars to attract foreign investors who might be wary of local currency volatility. This reliance on the dollar creates a feedback loop where the demand for dollars reinforces its dominance.

Moreover, the dollar is commonly used to hedge against local currency devaluation. In countries facing inflation or currency instability, holding dollar-denominated assets protects against the loss of purchasing power. This practice is particularly evident in Latin American countries like Argentina and Venezuela, where locals often convert their savings into dollars to preserve value in the face of hyperinflation.

Such a high global reliance on the dollar also means that any significant sale of dollar reserves by a major global power can profoundly affect the dollar’s stability. If a country like China were to offload a substantial portion of its USD reserves, it could lead to a depreciation of the dollar, increasing volatility in global markets. However, such a move is unlikely as it would also reduce the value of the remaining dollar reserves held by that country, creating a self-defeating cycle.

Within the United States, the federal government and the Federal Reserve hold reserves in various forms, including gold, foreign currencies, and Special Drawing Rights (SDRs) from the IMF. As of June 2024, the US government holds approximately $35.2 billion in foreign exchange reserves, with the majority in dollars and a smaller portion in other currencies and assets. These reserves are used primarily to stabilize the dollar in times of economic stress and to manage monetary policy effectively.

The US acquires these reserves through a combination of trade activities, foreign exchange operations, and by issuing government debt. For example, during periods of dollar appreciation, the Federal Reserve might intervene in the foreign exchange market by selling dollars and buying foreign currencies to maintain stability. Conversely, in times of dollar depreciation, the Fed may use its reserves to buy dollars, supporting its value. These reserves also play a crucial role in influencing US monetary policy. By adjusting the levels of reserves, the Federal Reserve can impact interest rates, control inflation, and stabilize the economy. For instance, during the 2008 financial crisis, the Fed used its reserves to inject liquidity into the banking system, helping to prevent a complete collapse of the financial system.

There are several potential methods by which a country like the US could accumulate Bitcoin, each with its own set of challenges and implications. One straightforward approach would be purchasing Bitcoin on exchanges. This method is the most direct but comes with significant market impact risks. Bitcoin’s market is still relatively small compared to traditional fiat currencies; as of Aug. 23, 2024, Bitcoin’s market capitalization hovers around $1.2 trillion. Large-scale purchases by a government could drive up the price substantially, leading to volatility and potentially making the acquisition prohibitively expensive. Additionally, the public nature of Bitcoin transactions could expose the purchasing strategy, further influencing market behavior.

Another method is mining Bitcoin. While this approach allows for acquiring Bitcoin without directly impacting the market price, it requires substantial investment in infrastructure, energy, and technology. The US would need to build or acquire significant mining operations, which could be logistically challenging and costly. Furthermore, the environmental impact of large-scale Bitcoin mining is a growing concern, particularly as governments face increasing pressure to reduce carbon emissions. Thus, the feasibility of mining as a primary method for acquiring Bitcoin is limited.

A third method involves acquiring Bitcoin through taxation or forfeiting illicitly held BTC. Governments already seize significant amounts of Bitcoin through law enforcement actions against criminal enterprises. For example, the US Department of Justice seized over $1 billion worth of Bitcoin in 2020 from the Silk Road case. While this method could supplement reserves, it is not a reliable or sustainable strategy for building a significant Bitcoin reserve, as it depends on the unpredictable nature of law enforcement actions.

Recognizing Bitcoin as a reserve currency would require comprehensive legal and regulatory changes. This process would be far more complex than the actions taken by El Salvador, which adopted Bitcoin as legal tender in 2021. While El Salvador’s decision primarily involved integrating Bitcoin into daily transactions and payments, declaring it a reserve currency would necessitate a broader restructuring of financial regulations. The US would need to amend existing financial laws, particularly those governing foreign exchange reserves, and establish new regulatory frameworks to manage Bitcoin’s unique characteristics.

Key legal challenges would include defining Bitcoin’s status within the context of existing monetary policy and financial regulations. The decentralized nature of Bitcoin, which lacks a central issuing authority, poses significant challenges for regulatory oversight. Additionally, the government would need to address concerns around Bitcoin’s volatility and the potential risks it poses to financial stability. Given Bitcoin’s history of price fluctuations, integrating it into national reserves could introduce new layers of complexity to the Federal Reserve’s monetary policy operations.

Moreover, recognizing Bitcoin as a reserve currency would likely require coordination with international financial institutions, such as the International Monetary Fund (IMF) and the World Bank. These organizations play crucial roles in global monetary policy, and introducing Bitcoin as a reserve asset would necessitate discussions on how it fits into the broader framework of global finance.

Reserve currencies are critical tools for governments, especially during economic crises. Central banks hold significant quantities of reserve currencies like the US dollar to stabilize the economy, influence monetary policy, and provide liquidity during financial turmoil.

If Bitcoin were to be used as a reserve currency, the implications would be markedly different due to its unique characteristics. One of the most significant risks is market instability. Bitcoin’s market size — approximately $1.2 trillion as of late August 2024 — makes it highly susceptible to price fluctuations. Large-scale buying or selling by governments could lead to severe volatility. For instance, if a major economy were to offload its Bitcoin reserves during a crisis, it could trigger a sharp price decline, eroding the value of remaining reserves and potentially leading to a broader market crash.

Moreover, governments’ control over Bitcoin could lead to price suppression and increased volatility. Unlike fiat currencies, which are controlled by central banks that can manage supply and demand through monetary policy, Bitcoin’s supply is fixed at 21 million coins. This inflexibility means governments’ attempts to regulate or control Bitcoin could lead to unintended consequences, such as stifling innovation or driving the market underground. The imposition of stringent regulations could limit Bitcoin’s decentralized nature, which is one of its core attributes, and negatively impact global adoption.

Bitcoin’s transition to a reserve currency could also pose significant risks to its core principles. Centralization and increased regulation are inherent risks if governments begin to hold and control large amounts of Bitcoin. This would contradict Bitcoin’s original ethos of decentralization and financial freedom, potentially leading to a loss of privacy for users and greater government oversight. For example, governments could use their influence over Bitcoin to implement censorship or control monetary policy in ways that undermine its fundamental principles.

Additionally, the potential for governments to use Bitcoin in ways that contradict its original design is a significant concern. Bitcoin was created as a decentralized, peer-to-peer system to provide an alternative to traditional financial institutions. If governments begin to use Bitcoin as a tool for monetary control, it could undermine the very reasons for its creation, leading to disillusionment among its proponents and a potential decline in its adoption.

While revolutionary in its design and growing adoption, Bitcoin presents a very different profile than fiat currencies. Its decentralized nature, finite supply, and market size make it fundamentally different from traditional reserves. While advantageous in many respects, these characteristics introduce significant challenges when considering it as a reserve currency.

The steps required to officially recognize it as a reserve currency make the whole ordeal unfeasible. Unlike the process of adopting Bitcoin as a legal tender like El Salvador, declaring it a reserve currency would necessitate comprehensive legal and regulatory changes. The government would need to amend existing financial laws, create new regulatory frameworks, and navigate complex international coordination challenges. Given the lack of bipartisan support for such legislative challenges, we expect such a move to become even less plausible in the US.

Ultimately, Bitcoin’s value may be better realized as a decentralized digital asset that operates alongside traditional financial systems rather than as a replacement for them. Its role as a hedge against inflation and a store of value will likely continue to grow, but its integration into national reserves remains a distant and challenging prospect. For now, Bitcoin’s strength lies in its ability to operate outside the constraints of traditional finance, offering an alternative rather than a direct competitor to the established order. As such, while Bitcoin’s influence on the global financial system will continue to expand, its role as a reserve currency remains speculative and fraught with significant challenges.