A ‘currency basket’ is a portfolio consisting of an array of currencies with different weightings. The value of these currencies defines the weighted average rate for a currency that is not technically part of the basket. The common use of a currency basket is to diminish the potential risk of currency fluctuations.
In addition, it is often a tool for establishing the market value of another currency, which is a practice known as a ‘currency peg’. This is a government’s exchange rate policy that attaches/links the central bank’s rate of exchange to a separate country’s script. Colloquially, it is not unusual for a currency basket to be referred to as a ‘currency cocktail’.
Generally speaking, the purpose of a currency basket can vary. It can do a variety of things. From defining a currency’s conditional price to providing protection against risks of a multi-currency clause. Alternatively, its usage can be as a par value. Equity investors who have exposure to different countries will often employ the use of a currency basket as a way to smooth risk.
Depending on its core purpose, the currency basket may consist of currencies in different relative amounts or a currency’s incorporation on a constant basis. On top of that, it can change when it comes to different factors in the Forex market.
A notable example of a currency basket is the European Currency Unit that was used by the European Community member states as the unit of account. This predates its inevitable replacement by the Euro. An additional example is the distinctive drawing rights that belong to the International Monetary Fund.
The U.S. Dollar Index
A currency basket is a prevalent tool for contracts, useful for averting – or minimizing – the risk of fluctuations in currency. The European currency unit (prior to Euro) and the Asian currency unit are both noteworthy examples of currency baskets. In spite of their notable statuses, the most prominent currency basket is the U.S. dollar index (USDX).
The USDX got its start in 1973. Nowadays, it is a basket that consists of six currencies in total. They are the following:
- Japanese Yen
- British Pound
- Canadian Dollar
- Swedish Krona
- Swiss Franc
The Euro is, without a shadow of a doubt, the largest component of the index. It makes up roughly 58% of the basket. The weights of the other currencies in the index are JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), and CHF (3.6%). During the 21st century, the index has managed to obtain a high of 121 during the tech boom. Moreover, it had a low of 71 preceding the Great Recession.
Using the baskets
As previously mentioned, equity investors with exposure to various countries will use a currency basket to mitigate risk. Their primary investment strategies reside in the equity markets. However, they don’t want to provoke any substantial losses whenever they invest in foreign equity markets. This is largely due to the ever-present concern of currency fluctuations. You can easily say the exact same thing about bondholders.
For context, currency fluctuations are an outcome of the floating exchange rate system. This is very common for a majority of large-scale economies. A variety of factors – both fundamental and technical – affect the exchange rate of one currency in comparison to another. These typically include supply and demand of the currencies, economic performance, an outlook for inflation, interest rate distinctions, capital flows, and technical support and resistance levels. These factors are in a state of perpetual flux, so that means currency values regularly waver with each passing moment.
Conversely, currency traders who retain a generally broad view of a single currency will choose to own that currency. Quite often they will do this in lieu of other, different currencies. Traders and investors are able to construct their own currency baskets with different weightings. Although, this depends entirely on what their strategy is.
Recent news relating to baskets of currencies
Not too long ago, Facebook came out with new details concerning their Libra cryptocurrency (or stable coin). The company is speaking with cryptocurrency exchanges regarding the idea of selling Facebook coins to consumers. Moreover, their stable coin may share a link to a basket of currencies instead of individual currencies.
The currency basket announcement may appeal to fans of crypto and/or the financially sophisticated. On the other end of the spectrum, there is Facebook’s broad audience base whom it may not wholly appeal to.
Should there be multiple currencies, then you will have to provide exchange rates in the middle of each of them. Facebook is capable of doing that by utilizing a smart contract in order to provide automatic input of market exchange rates. Alternatively, they are able to add a margin with this technique.
Be that as it may, that could result in making Facebook very similar to Paypal and many others. Specifically, platforms that earn margins on foreign exchanges. In regards to blockchain, it would actually be consistent to redistribute the foreign exchange aspect. This has been the standard requirement of liquidity and market makers, which basically means cryptocurrency exchanges.
The inquiries that come from this
All of this culminates into raising two questions. One is whether Facebook is talking to exchanges “about selling the Facebook coin to consumers.” The other is whether the discussions concerning exchange are about market-making and liquidity for conversion. To elaborate, the conversion between the U.S. Dollar, Euro, and Rupee Facebook coins.
This leads to another question. That being, how exactly will Facebook make money? The more likely answer is the inclusion of a small transaction fee within WhatsApp. The UN claims that during the first quarter of 2018, the global average cost of transferring $200 to another country was 7.1%. With these numbers in mind, it’s evident that there is substantial room for further development.
To put simply, there is a strong possibility that this could be an enormous opportunity for Facebook.