Potential of Cryptocurrencies Being Held in the International Reserves of Central Banks

A report was published earlier this month by Winston Moore and Jeremy Stephen, who investigated the viability of a central bank (in this case the Central bank of Barbados was used as an example) holding reserves in the form of cryptocurrencies (specifically bitcoin), as an alternative to gold, foreign exchange or other traditional assets.

After introducing the need for international reserves to provide liquidity for international transactions and to act as a buffer against economic irregularities, the report highlighted the role of central banks in providing financial stability and confidence in a countries’ financial system.

Initially, the benefits digital currencies were examined, with the security features, easy mobile access, comparatively low production and transmission costs and low long-term inflation risks being noted. Following this, the main drawbacks of high volatility, potential illicit uses and early track record of illiquidity were put forward. The legal status and variable views on digital currencies being treated as currencies or assets was also mentioned. Decentralized currencies were noted as being found to possibly impact on price, financial and payment stabilities and as such require regulation.

Focusing on central banks, the report continues to posit the main risk factors cryptocurrencies which are cited as being: price stability, financial stability, payment system stability, lack of regulation and reputational. One of the key problems of using a digital currency was noted to be the lack of control of the money supply, which would impact the price and financial stability. Payment system stability and lack of regulation were at risk due to the fact that not everyone will accept cryptocurrencies as payment and the lack of legal security made it difficult to determine exactly what responsibilities and rules were in place. The potential problems that could occur were cited as the risk to the central bank’s reputation, as there would be a negative public reaction to any difficulties experienced due to the uptake of a new possibility. Alongside these potential risks, the document also raised concerns from reports over the stale velocity of digital currencies and the impact that has on available money and the bank’s ability to control monetary liabilities.

Moving on to determine the potential value of using bitcoin as one of the Central Bank of Barbados’ reserves, the investigation assessed two possibilities; firstly where a fixed proportion of the foreign currency balance was invested in bitcoin and secondly using a Monte Carlo method to determine the effects of randomly generated shocks to Barbados’ international asset portfolio over the next ten years. Various time frames and investment amount were examined, although the process focused on small investment ratios of 0.01, 0.1 and 1%.

The report found that adding bitcoin to the reserve portfolio wouldn’t alter the volatility significantly; moreover, there was the possibility to offset depreciation of the exchange rate against key currencies. Results of simulations varied, but the least showed that the bitcoin reserves out-performed others by over 20%, with a trial of 5% reserves showing balances one hundred times greater.

Furthermore, the report found that the risk of losses exceeding the initial investment amount was very low, with 12 month forecasts having no instances where a net loss was made. Expanding to the next ten years, the probability of loss was calculated to be less than 1 in 13,000, with the portfolio value rising from $27,000 in 2015 to $224 million by 2025 with the smallest investment of 0.01%, and potential returns on bitcoin accounts reaching as much as $1 billion or more. Despite these seemingly impressive results, the report was quick to point out that the margin of error increased with the time period being assessed, and that the historical values that were used were not necessarily indicative of future performance.