Currency Regimes - Currency Board System

Currency board system (CBS) is a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure fulfillment of its legal obligation.

Domestic currency will be issued only against foreign exchange and it remains fully backed by foreign assets.

E.g. HKD. US dollar reserves are held to cover, at the fixed parity, the entire monetary base.

HKD-denominated bank deposits are not fully collateralized by US dollar reserves.

The Hong Kong Monetary Authority (HKMA) does not function as a traditional central bank under this system because the obligation to maintain 100 percent foreign currency reserves against the monetary base prevents it from acting as a lender-of-last-resort for troubled financial institutions. (provide short-term liquidity)

One of the advantages of a CBS: the monetary authority can earn a profit by paying little or no interest on its liability—the monetary base—and can earn a market rate on its asset—the foreign currency reserves. This profit is called seigniorage.

Under dollarization, the seigniorage goes to the monetary authority whose currency is used.