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CBB Wor k in g P ap e r N o. WP /15/ 16 T h e a u t h o r s w o u l d w e l c o m e a n y c o mm e n t s o n t h i s p a p e r . C i t a t i o n s s h o u l d r e f e r t o a C e n t r a l B a n k o f B a r b a d o s W o r k i n g P a p e r . T h e v i e w s e x p r e sse d a r e t h o se o f t h e a u t h o r s a n d d o n o t n e c e ssaril y r e p r e se n t t h o se o f t h e C e n t r a l B a n k o f B a r b a d o s SHOU LD C R Y P TO C U R R EN C I ES B E INC LU D ED IN T HE P OR TF OLI O OF I N TER N A TI ON A L R ESER V ES H ELD BY THE C EN TR A L BA N K OF BA R B A D OS BY WI N STON M OOR E A N D JEREM Y S TEP HEN CENT RAL B AN K O F BARBA DO S 1 Should Cryptocurrencies be included in the Portfolio of International Reserves held by the Central Bank of Barbados Winston Moore1* and Jeremy Stephen* Abstract In most countries, the central bank is required to hold reserve assets as a means of providing credibility for the value of the fiat currency. These assets can be in the of gold, foreign exchange, or some other internationally recognised reserve asset and are held to permit the country to engage in international transactions. Within recent years, cryptocurrencies have been increasingly utilised for international transactions, and it is possible there use might expand in the future. This paper therefore examines the potential role of cryptocurrencies as part of the portfolio of external assets held by a central bank. Using the case of Barbados, the paper also provides a simulation of the effect holding some proportion of their asset base would have had on the stability of the foreign reserves as well as the return on the portfolio of assets. Keywords international reserves; cryptocurrencies; fixed exchange rate JEL Classifications F3; E4; E5 1 Corresponding author W. Moore, Department of Economics, University of the West Indies, Cave Hill Campus, Bridgetown, BB11000, Barbados. Tel. 246-4174279; Fax246-4389104; Email winston.moorecavehill.uwi.edu * Department of Economics, University of the West Indies, Cave Hill Campus 2 1 Introduction International reserves are external assets held by the monetary authorities for conducting international transactions, intervention in foreign currency market as well as maintaining confidence in the exchange rate IMF, 2013. These reserves should normally represent some claim on non-residents and be easily convertible to cash, but does not necessarily have to be on a tangible asset e.g. gold bullion. Besides providing the liquidity to engage in international transactions, Aizenman and Lee 2007 also notes that since the 1997/98 East Asian Financial crisis there has also been a shift in the demand for international reserves beyond what is required for transactional purposes. These countries have therefore been hoarding international reserves as a means of providing some degree of self-insurance in the likelihood that the economy is subjected to an economic shock and therefore allow for some adjustment to occur on the balance of payments side Heller, 1966. It is also possible that by holding stocks of foreign exchange reserves above what is necessary for transactional purposes, countries can then finance a sudden stop and defend against a speculative attack on the currency Aizenman where some regulators have been very wary of it while the Financial Technology Fintech community have argued about the inevitable widespread use of cryptocurrencies. The main benefits cited are the security features; ease of use on mobile devices; relatively cheap costs of production and transmission via the Blockchain transmission protocol; and low long-term inflation risks Harvey, 2015. In fact, global financial corporations such as Citibank are developing their own cryptocurrency due to these perceived benefits of utilising the aforementioned protocols Madore, 2015. Harvey 2015 also noted that the main issues with the adoption of cryptocurrencies include an early track record of illiquidity, high volatility and potentially nebulous uses. Most of the issues surrounding the successful adoption of cryptocurrencies is marred in the confusion of whether they are digital or virtual currencies, and as such, how their values are determined. There has been a proliferation of virtual currencies across the globe. These include Facebook Credits, Microsoft Points and Amazon coins. Unlike Bitcoins, as alluded to before, these currencies are issued by companies and are not linked to any claims on real assets. If a large company like Facebook does launch a currency to compete with traditional currencies, network effects could ensure that the currency is taken-up quite quickly by members of the network. Furthermore, Wagner 2014 explained that the value and distribution of virtual currencies are typically controlled by centralized authority, which is usually the issuing corporation, and are used to solely facilitate online purchases. Digital currencies are closer in to physical currencies due to their usage as a medium of exchange for physical assets. Ironically, ECB 2012 posits 7 that most of the modern world’s money supply is in digital and, as such, can be considered to be in the of digital currencies. Another area of compelling arguments has been the issue of whether digital currencies should be considered to be currencies or digital assets. Given the aforementioned definition, one could expect to view the token as a currency but Glaser et al. 2014 further convey that users of cryptocurrencies are “not interested in an alternate transaction system but seek to participate in an alternative investment vehicle. Drawbaugh and Temple-West 2014 note the U.S. Inland Revenue Service sees cryptocurrencies as a virtual currency and therefore it should be considered to be an asset. Such property, under U.S. financial law, is largely subject to capital asset taxes. Other early adopting jurisdictions, such as Norway, Sweden, and Canada also recognise cryptocurrencies as an asset. However, Germany - which is also a very early adopter - accepts that cryptocurrencies are a unit of account to be used for trading and taxation within the country but in the of “private money” Clinch, 2013. There has basically been no global consensus how best to define cryptocurrencies as an asset or currency. These matters have dealt within the parameters of every jurisdiction and their capabilities to regulate it. Given the possibility of such a quick take-off, Gans and Halaburda 2013 investigate whether there is a need for regulation and oversight of these digital currencies. The authors argue that most of these digital currencies issued by companies are largely subsidies for buyers to participate in the network or plat e.g. Amazon coins and Kindle. Such a system is also cheaper for the company, as these currencies have to be spent on items on the plat e.g. Amazon rather than some outside good or service. 8 For digital currencies not tied to a particular plat e.g. Bitcoin, Gans and Halaburda 2013 note that these currencies can impact on price stability, financial stability and payment stability and therefore there might be a case for further regulation. If there is a relatively low level of interaction between these virtual currencies and traditional currencies, however, there might not be a need for any regulatory intervention. There are four potential risks associated with virtual currencies that are of interest to central banks price stability; financial stability; payment system stability; lack of regulation; and, reputational ECB, 2012. Virtual currencies could make the goal of price stability somewhat difficult if they affect the central bank’s control of the money supply through open market operations. This reduced control over the money supply can also impact on financial stability through the central bank’s ability to intervene in the foreign exchange rate market. In addition, speculation with respect to the virtual currency could occur due to the history of cyber attacks and since there is no lender of last resort for these currencies. In relation to payment system stability and lack of regulation, since the value of virtual currency union depends on whether or not a second party is willing to accept the unit as a means of final payment, there is no guarantee of payment. Moreover, since there is no legal basis for virtual currencies, there is no clear definition of the rights and obligations of each party. ECB 2012 notes that while the virtual currencies may be subject to price, financial, payment and lack of regulation risk, given that lack of interaction between virtual currencies and those issued by central banks. The paper, however, notes that these currencies do pose some degree of reputational risk for central banks, as most economic agents look to the central bank to ensure the smooth functioning of the payment and financial system. Therefore, if a 9 major event does occur the general public might perceive that the central bank was not doing its job effectively. While ECB 2012 suggests that the implications for central bank policy at present might be limited, economic models technological innovations within the banking system suggests that digital money can impact on the demand for money. Berensten 1998, for example, notes that monetary policy depends on a stable velocity of money. However, as digital money becomes a both popular means of payment, it can impact on the income velocity of money and reduce the monetary base and more significantly reduce the precision of the central bank’s control of monetary liabilities. Given that digital currencies reduce the effectiveness of monetary policy at the country level, Plassaras 2013 argues for greater international cooperation through the International Monetary Fund IMF. The author notes that typically central banks hold reserves to counter speculative attacks against the currency. They can also raise interest rates or intervene in the currency market. If the central bank runs out of reserves, it can draw down on its quota’s at the IMF. However, if wealthy Bitcoin investors launch a speculative attack on a currency there is relatively little that can be done at present as neither the central bank nor the IMF hold Bitcoin. Plassaras 2013 therefore argues that the Fund could either attempt to excise indirect control of the currency or it could offer the digital currency quasi-membership status. Such approaches will need to be further discussed as there are governance issues that would need to be addressed, however, given the growth of Bitcoin, there is a clear need to be prepared for potential speculative attacks and incorporate this means of payment better into the financial system. 10 3 ology The study employs two approaches to assess the viability of including Bitcoin in the international reserves portfolio of the Central Bank of Barbados. The first approach is a counterfactual simulation where it is assumed that a fixed proportion of the Central Bank s portfolio of foreign currency balances was invested in Bitcoin. The actual exchange rate changes are then applied to the portfolio to compare the simulated relative to the actual outcome. This assessment provides an assessment of the potential differences in volatility and returns that could have resulted from investments in Bitcoin. Relatively small investment ratios of 0.01, 0.1, and 1 percent are considered and for comparison purposes a scenario where 5 percent of the reserves are invested in Bitcoin is also considered. In the second approach, Monte Carlo s to investigate the effects of randomly generated shocks on Barbados’ portfolio of international assets over various forecasted time horizons 2015-2025. The likelihood that the stock of international reserve assets is exhausted in a given year of the simulation period is then calculated over 5000 model iterations. International reserves at the end of each period are influenced by demand-side shocks, exchange rate shocks and the initial stock of international reserves Figure 2. In each 11 Figure 2 Representative Model of Monte Carlo Experiment year of the simulation, the projected demand for imports and international payments is set equal to last period’s reserves, plus randomly generated payments and exchange rate shocks. The mean and standard deviation of these shocks are set equal to their historical value for the period 2009 to April 2015. The steps in the simulation are set to one month and a single run is pered for 1-, 2-, 5- and 10-year horizons. The analysis is then replicated 5,000 times and summary statistics are presented. 4 Cryptocurrencies as Part of the International Reserves Counterfactual simulations done over the period 2009 to present suggests that adding Bitcoin to the reserve portfolio of the central bank would not significantly increase volatility but could provide opportunities to offset exchange rate depreciations against major currencies such as the Pound and the Euro. The figures assume that some fixed Intial stock of international reserves Demand shock New value of International reserves Exchange rate shock 12 amount of reserves are held in balances denominated in a particular currency at the beginning of the period and held for the remainder. They are therefore only affected by exchange rate changes. In general, portfolios denominated in Pounds, Canadian Dollars and Euros all pretty much follow a similar pattern. This result is not surprising given that most major currencies revert to the purchasing power parity equilibrium against the US dollar Li, 2015. The first scenario, where it is assumed that 0.01 percent of reserves were invested in Bitcoin or any of the other three major currencies held by the Central Bank of Barbados from November 2010 to April 2015 Figure 3, suggests that the volatility of reserves would have been quite similar over the period. However, the Bitcoin reserves at the end of April 2015 would have been 291,926, more than 20 percent greater than had these seem funds been held in balances of any of the other major currencies. Figure 3 Counterfactual Simulations with Various Portfolio Holdings of Bitcoin 0.01 of Reserves 0.1 of Reserves 1 of Reserves 5 of Reserves 13 Source Authors’ calculations As the ratio increases, the end of period balance diverges significant from the actual outcome, due to the appreciation of Bitcoin against the US dollar that occurred over the period. With just 0.1 percent of reserves in Bitcoin, balances at the end of April 2015 would have been more than twice the actual amount, 19 times greater with 1 percent of reserves and some 100 times greater with a relatively sizeable 5 percent of reserves in Bitcoin. In addition to the counterfactual simulations, the paper also forecasts the likely future path of reserves over the next 10 years. This assessment is meant t
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