The benefits outweigh the costs of holding bitcoins for the Central Bank of Barbados

The Central Bank of Barbados recently published a working paper titled ‘Should Cryptocurrencies be included in the portfolio of International Reserves held by the Central Bank of Barbados?‘ The authors, both from the University of the West Indies, Cave Hill Campus, are the Head of the Department of Economics, Winston Moore and banking and finance lecturer Jeremy Stephen.

A small, independent Eastern Caribbean country within the British Commonwealth, Barbados is home to approximately 287,000 residents. Its national currency, the Barbadian dollar, has been pegged to the US Dollar (USD) at a constant rate of B$2 to US$1 since 1975.

The country went into recession after 2000, due to the downturn in Europe and the US, and the resulting drop-off in tourists. The economy began to recover in 2003, growing steadily until the global financial crisis of 2008, which caused a sharp fall in tourism again. A recession followed, in 2009, when GDP fell by 4.1 percent, and the economy has struggled to grow thereafter. According to the World Bank, the country’s GDP fell 15.3% in 2013. Meanwhile, Barbados’ public debt-to-GDP ratio rose from 56% in 2008 to 90.5% in 2014.

In December 2014, Standard and Poor’s downgraded the country’s long-term sovereign debt from BB- to B, with a negative outlook.

According to the Central Bank of Barbados 2014 annual report which was submitted to the Ministry of Finance, the Bank incurred a net loss of B$7.3 million, bringing the accumulated deficit to B$22.1 million by the end of the year. This “exhausted the Bank’s capital,” prompting the Minister of Finance to transfer non-negotiable, non-interest bearing securities of B$7,892,956 from the Government to the Bank “in order to preserve the Bank’s capital from impairment.”

There is no doubt that the financial situation of both the country and the central bank should be addressed, and bitcoin might just provide a solution for the debt-ridden nation. The two economists propose that since the use of cryptocurrencies has been rising in recent years, it is possible that their use will also expand in the future, therefore warranting an assessment of how they could be used by the Central Bank.

Focusing on the potential benefits and costs of holding bitcoins in the international reserve portfolio for a fixed exchange rate economy, like Barbados, Moore and Stephen conducted simulations to study the effects on the stability of the foreign reserves, and the return on the portfolio of assets.

Two empirical tools were used to conduct the analysis; a counterfactual exercise  and a Monte Carlo forecasts.

Moore and Stephen use the historical performance of various exchange rates, including bitcoin, to conduct the counterfactual exercise. They found that, if the Central Bank of Barbados had held a small amount of bitcoin from 2009 to 2015, not only would the Bank have generated “a significant return” from the appreciation of bitcoin value, but the reserve balance volatility “would not have been significantly different from that experienced due to other major currencies”

“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.”
— – Moore and Stephen

Moore and Stephen performed a few simulations to find out the effects of having different amounts of bitcoin in the Central Bank’s reserves, compared to British Pounds, Canadian Dollars, and the Euros, the other three major currencies held by the Central Bank.

The results are congruent. If 0.01 percent of reserves were invested in Bitcoin or any of the other three major currencies from November 2010 to April 2015, while the volatility of reserves would have been quite similar, the Bitcoin reserves would have been $291,926. This theoretical figure is more than 20 percent greater than any of the other major currencies would have generated.

Similarly, if 0.1 percent of reserves is invested in Bitcoin, balances would have been more than 200% more, and 19 times greater with 1 percent of reserves and some 100 times greater with 5 percent of reserves in Bitcoin. The authors stressed that these are only theoretical numbers and not an indication of real performances.

To illustrate how much more the Central Bank would have made with bitcoin in their reserve portfolio, Moore and Stephen gave comparison charts showing results of the same simulation conducted using the British pound, instead of bitcoin. While the foreign exchange balances would rise substantially with bitcoin in the portfolio, they would only fall with the Sterling.

As far as risks go, simulation results show that “the risk of portfolio losses exceeding the initial investment is very low.” However, the paper notes that as the proportion of reserves held in Bitcoin rises, the volatility of reserves would also increase.

“Within a 1-year forecasts horizon, there were no simulated instances where portfolio losses were equal to the value of the initial investment. Over longer horizons, the number of instances of portfolio losses exceeding the initial investment obviously rises.”
— – Moore and Stephen

The second set of simulations involves Monte Carlo forecasting methods to investigate the effects of randomly generated shocks on Barbados’ portfolio of international assets between 2015-2025. “The Monte Carlo forecasting exercise yields similar results,” the working paper states.

It is important for central banks to consider holding digital currencies because, as Moore and Stephen explained, central banks are required to hold reserve assets as a means of providing credibility for the value of their own fiat currency. Traditionally, these assets can be in the form of gold, foreign exchange, or some other internationally recognised reserve asset. However, since digital currency transactions have grown significantly, Moore and Stephen believe that “digital currency could become a key currency for settling transactions.”

“Centrals banks may want to be careful of overinvesting in digital currencies at this time due to the tremendous volatility. However, relatively small portfolio amounts can result in significant returns, particularly as the adoption of these currencies becomes more prevalent and more trade is done using digital currency.”
— – Moore and Stephen

As for the Central Bank of Barbados, since digital currency transactions are unlikely to account for more than ten percent of all transactions by Barbadians in the near future, Moore and Stephen asserted that “if Bitcoin is incorporated into the portfolio of foreign balances of the Central Bank of Barbados, that its share should be relatively small.”

Furthermore, Moore and Stephen urged the Central Bank of Barbados to hold enough of various currencies as a precaution against speculative attacks. In the case of such an attack, if the Central Bank of Barbados does not have enough reserves to offset the attack against the currency, it can turn to the International Monetary Fund (IMF) for help. However, Moore and Stephen warned that “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.”

Their theory agrees with Law firm Fenwick & West associate, Nicholas Plassaras who argued that the IMF would encounter numerous challenges in trying to include bitcoin in the Fund’s reserves, also citing the danger of speculative attacks involving bitcoin.

Referencing Plassaras’ work in their working paper, Moore and Stephen cautioned the Central Bank about bitcoin speculative attacks, including how the IMF is unlikely to help them since they do not hold any bitcoin reserves. So the bank is on its own to find a way to counter the attacks, and it would be easier for central banks to acquire bitcoin than the IMF due of restrictions in the IMF’s Articles of Agreement.

The Central Bank of Barbados can obtain bitcoin on the market, or can mine its own. However, the cost of mining, which includes substantial upfront investment and has intense competition from other miners, outweighs the immediate benefits, Moore and Stephen described. Instead, they suggested “it would therefore be more prudent if the Central Bank of Barbados be an active trader of the asset/currency while focusing on utilising tools to transmit cryptocurrencies over the blockchain.”

“The primary purpose for this would be to replace or to supplement the current SWIFT and RTGS systems,” Moore and Stephen boldly suggested. “The transmitted cryptocurrency becoming nothing more than a trading mechanism to balance accounts between the seller and buyer of a particular currency,” they added.

With a small portion of bitcoin in the Central Bank’s portfolio, not only does the Bank stand to make a substantial amount of profit as the value of bitcoin appreciates, but the risk is not any greater than the current risk level with other reserve currencies. According to Moore and Stephen, there seems to be more upside to adding bitcoin to the Central Bank’s reserves than downside.

The options open to central banks in deep debt have always been few, but now they have one new option that seems to be all reward and little risk.