TRADE, FINANCE AND INVESTMENT COMPETITIVENESS FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Can Crypto-Assets Play a Role in Foreign Reserve Portfolios? Not Today, and Likely Not in the Near Future Erik Feyen Daniela Klingebiel Marco Ruiz Prepared jointly by the Finance, Competitiveness and Innovation Global Practice and the World Bank Treasury © 2024 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. 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Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. Cover photo: iStock sittipong phokawattana Can Crypto-Assets Play a Role in Foreign Reserve Portfolios? Not Today, and Likely Not in the Near Future1 Erik Feyen Daniela Klingebiel Marco Ruiz 1. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations or those of the Executive Directors of the World Bank or the governments they represent. The authors thank Zafer Mustafaoglu, Yira Mascaro, Natan Goldberger, Ayhan Kose, Batu El, James Seward, Jon Frost, Juan Carlos Quintero, Juliusz Jabłecki, Rezart Erindi, Steen Byskov, Stijn Claessens, Iker Zubizarreta, Carlos Alvarez, Antonio Candia, and Xavier Jean Nicolas Martini for their excellent comments and suggestions. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 3 >>> Contents Introduction 5 Central Bank Reserve Management and Crypto-Assets as an Investable Asset Class 9 Suitability of Investing in Crypto-Assets Given the Objectives and Principles of Reserve 9 Management Crypto-Assets versus Gold 15 The Fundamental Changes Required for Crypto-Assets to Become Suitable for Central Bank 18 Reserve Portfolios Improved Liquidity and Larger Market Cap 19 Reduced Price Volatility 19 Improved Availability of Investable Instruments 19 Adoption in Trade and Financial Flows 20 Robust Custody and Safekeeping Solutions 21 Clear Regulatory, Supervisory, and Oversight Treatment 21 Conclusion 23 Appendix 25 The Background of Crypto-Assets 25 Types of Crypto-Assets and Their Main Characteristics 25 Options for Investors to Obtain Exposure to Crypto-Assets 29 References 31 >>> Introduction Notwithstanding the substantial volatility experienced by crypto-assets and several high-profile failures, the market capitalization and liquidity of crypto-assets has increased significantly in recent years as many new players have entered the market and new exchanges, instruments, and service providers have continued to mature. Citing crypto-assets’ growing market capitalization and footprint and evolving market structure, institutional investors, including central banks, have been exploring exposures to crypto-assets and reviewing whether including these instruments in their portfolios is reasonable. Some institutions, typically those with a long investment horizon and higher risk tolerance, have started to invest in the crypto-asset space, but investment by this group accounts for only 5 percent of the total issued Bitcoin supply (Bridgewater 2022), and individual allocations are in the low-single digits of these institutions’ total assets. We discuss the potential role of crypto-assets in central bank reserve portfolios and argue that these instruments do not at present meet the eligibility criteria for inclusion. Crypto-assets are currently incompatible with the traditional objectives of safety, liquidity, and return; their value can be highly volatile, undermining their reliability as a store of value; and despite some guidance from policy makers and standard-setting bodies, they still face an uncertain regulatory environment. Considering the rapid evolution of the technological and regulatory landscape, however, a small chance exists that in the future crypto-assets could be included as an eligible central bank investment instrument, and we discuss what would be required before that could happen. (We will not cover central bank digital currencies (CBDCs), as they are very distinct from crypto-assets. For more on CBDCs, see Box 1.) While terminology differs across regulatory authorities and standard-setting bodies, crypto- assets can be broadly defined as private digital representations of value that can be used for payment or investment purposes or to access a good or service and that rely on distributed ledger or similar technology (see Financial Stability Board 2018a; Financial Action Task Force 2021; and Basel Committee on Banking Supervision 2021).2 Crypto-assets typically operate on open, decentralized computer networks. Some decentralized networks aim to maintain an immutable distributed ledger that enables users to store funds with global reach and relatively fast settlement in a purely peer-to-peer fashion without the need for intermediaries (i.e., “permissionless” operation) or the potential for third-party interference (i.e., providing “censorship resistance”).3 2. The definition of crypto-assets typically excludes e-money, central bank digital currencies (CBDCs), and digital representations of traditional financial instruments. 3. The open-source software protocols enforced by these decentralized networks allow for consensus formation about the “state of the world” in low-trust environments without requiring a trusted third party and seek to imbue crypto-assets with certain characteristics such as scarcity, verifiability, and, more broadly, programmability (e.g., Nakamoto (2008) and Buterin (2013)). The benefits of decentralization come at a cost, typically by posing tradeoffs with throughput capacity and/or security. See Feyen, Kawashima, and Mittal (2022) for further details. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 5 As outlined by the Financial Stability Board (2022a), crypto- (Figure 1). It reached an all-time high of almost $2 trillion in assets can be broadly divided into three main categories: (i) 2021, after which market capitalization dropped precipitously unbacked crypto-assets, which do not constitute a claim on to around $1 trillion in the second quarter of 2022. The fall any party (e.g., Bitcoin); (ii) stablecoins, which aim to maintain in market capitalization coincided with a tightening of global a stable value relative to a specified asset, most often the US monetary and financial conditions, but it was also driven by dollar and usually through collateralization (e.g., USDC); and sector-specific adverse developments such as the failure (iii) decentralized finance (DeFi), an experimental ecosystem of TerraLuna, a large stablecoin project, and the demise of built on top of distributed ledger or similar technology and several crypto-asset services and investment firms, notably consisting of projects or decentralized apps (dapps) that aim FTX, that came under pressure due to, inter alia, large price to provide a range of interoperable financial services (e.g., drawdowns and financial interlinkages and, in the case of FTX, exchange, asset management, and lending). Dapps often allegations of fraud and material weaknesses in governance, issue their own crypto-asset, and in practice many suffer from risk management, and other corporate controls.4 the “illusion of decentralization,” since the need for governance makes some degree of centralization necessary (Bank for Given the open nature of distributed ledger technology, anyone International Settlements 2021). (See the Appendix for a more can create a crypto-asset. As a result, worldwide over 10,000 detailed description of the main types of crypto-assets.) crypto-assets are available for trading today, although the overwhelming majority are small, illiquid, and have doubtful Since Bitcoin’s genesis in 2009, crypto-assets have gained economic use cases and valuations. Bitcoin tops the ranking momentum and captured media attention, notably after prices by far in terms of market capitalization, followed by Ether, the rose dramatically in 2013 and 2017. The combined market native crypto-asset of “smart contract” platform Ethereum. value of crypto-assets grew significantly in the past few years >>> Figure 1. Market Capitalization of the Top Five Crypto-Assets Source: Bloomberg. Note: Latest data as of December 2022. 4. See for example the testimony of Mr. John J. Ray III, CEO of FTX Debtors (2022), https://docs.house.gov/meetings/BA/BA00/20221213/115246/HHRG-117-BA00- Wstate-RayJ-20221213.pdf. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 6 Crypto-asset activity has witnessed significant growth in percent. At the same time, adoption by long-term investors recent years, particularly among retail investors in emerging such as pension funds and endowments remains very low; market and developing economies (Figure 2). According to a and although high net-worth individuals and family offices Statista survey held in over 50 countries for the years 2019 have created exposure to this type of asset (Figure 3), their and 2021, the average share of respondents using or owning overall allocation to crypto-assets as a percent of capital tends crypto-assets rose on average by 3 percentage points to 14 to be very small. >>> Figure 2. Share of Respondents Indicating They Either Owned or Used Crypto-Assets 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% ak le U Em nd ilip nd ab re n Tu m a es T h eria So gen y N B a d tes g u M ya a ia om s rl il n Ke d Ko e Po ia Sp l C bia So Gre g Vi nes itz ca ga Ar rke a C and he z ut t in si on er re ai n ut ec n hi na ch d et ra a Ph aila at ist n i la Ko ay ni ira r In rt u P C l ig pi Sw Af St ze er et al N ol I h h P te H Ar d 2021 2019 te ni U Source: Statista. >>> Figure 3. Adoption of Crypto-Assets by Type of Investor Source: Fidelity International Digital Asset Survey (2022). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 This paper is organized into two substantive sections, necessary changes discussed are the need for significantly followed by a conclusion. The first main section assesses the enhanced liquidity and decline in the volatility in crypto-assets’ suitability of crypto-assets for central bank reserve managers’ valuation; reduced specific operational risk for the instrument; purposes. In this context, we review the objectives of reserve crypto-assets’ adoption as globally accepted medium of management and discuss the currency composition and exchange and store of value; abatement of concerns about characteristics of crypto-assets versus those of gold, a long- crypto-assets’ potential adverse impact on financial stability; term reserve asset. The second substantive section analyzes and clarification of the still uncertain regulatory treatment of the fundamental changes required if crypto-assets are to crypto-assets. The conclusion summarizes our findings from become eligible instruments for reserve portfolios. Among the this analysis. BOX 1: FUNDAMENTAL DIFFERENCES BETWEEN CRYPTO-ASSETS AND CENTRAL BANK DIGITAL CURRENCIES While Bitcoin and similar block-chain-based cryptocurrencies, to some extent, inspired the concept of central bank digital currencies (CBDCs), the two currencies fundamentally differ. CBDCs are issued by and have a direct claim on a central bank; they are denominated in the national currency; and they are fully convertible to other forms of money. Depending on the objectives, a CBDC can be made accessible to all domestic users as a substitute for cash (retail CBDC) or to select financial institutions to help improve financial market efficiency (wholesale CBDC). Launched in October 2020, the Bahamas’ sand dollar is a fully operational CBDC and is considered retail. Numerous countries and central banks have studied issuing their own CBDCs, and many have completed proofs of concept or pilots (Bank for International Settlements 2020). It is still early days for CBDCs, but it is safe to assume that reserve managers would adopt them quickly because they are backed by central banks and governments. Adoption of CBDCs for reserve management could potentially improve operational efficiency—their main potential advantage—by improving the speed of transactions and reducing settlement windows. The current Swift infrastructure is secure, but it has room to improve in efficiency. Electronic transfers are not instantaneous: participants must send Swift messages to their banks, which may take some time, even days, to process the instructions. Similarly, trading in most securities takes a few days to settle. Blockchain technology, including distributed ledgers, offers a potential mechanism for speeding up those transactions and reducing operational costs. Central banks could leverage this technology to improve efficiency in financial markets. Although reserve managers would welcome CBDCs as options, their added value would be minimal from a portfolio investment and diversification perspective. Central banks already invest in digital versions of fiat currencies by investing in commercial bank deposits. Since any CBDC would trade at parity with the existing fiat currency, investing in CBDCs would not bring any diversification benefit.5 5. Despite this, the possible impact of CBDCs on reserves management, and more generally on central banks’ need to hold reserves in anticipation of future developments, continues to be discussed (see Dong et al). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 >>> Central Bank Reserve Management and Crypto-Assets as an Investable Asset Class The International Monetary Fund (IMF) defines reserve assets as “those external assets that are readily available to and controlled by monetary authorities for meeting the balance of payments financing needs, for intervention in exchange markets to affect the currency exchange rate” (IMF 2010). The IMF defines as reserve assets monetary gold, special drawing rights holdings, reserve position in the IMF, and currency, as well as deposits, securities (including debt and equity securities), financial derivatives, and other claims (loans and other financial instruments). Crypto-assets do not currently fit into these conditions, and it is difficult to assess if and when they will, given their low relevance as an internationally accepted medium of exchange and store of value. Suitability of Investing in Crypto-Assets Given the Objectives and Principles of Reserve Management To assess the suitability of crypto-assets for reserve management purposes, we review the objectives and reserve management principles that drive reserve management activities. We also review the factors underlying the specific currency composition of reserves to analyze the circumstances under which crypto-assets could be included in reserves. RESERVE MANAGEMENT DIMENSIONS AND CRYPTO-ASSETS Reserve management objectives. Figure 4 shows that central banks invest reserves to meet macroeconomic objectives such as providing self-insurance against external shocks, conducting foreign exchange policy, and servicing external debt or obligations. Achieving or maximizing long-term returns (“to ensure savings for intergenerational equity”) is less relevant for most central banks. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 >>> Figure 4. Reserve Management Objectives Source: Third RAMP survey on the Reserve Management Practices of Central Banks (2021). Because reserve assets are held for self-insurance purposes, Bitcoin and Ethereum, currently the dominant crypto-assets, is they must be highly liquid in the face of external shocks. Crypto- a fraction of the daily trading volume of the foremost reserve assets are not liquid enough to include in reserve portfolios. currencies. Tether, the largest stablecoin, has a greater daily The daily trading volume of crypto-assets is extremely low trading volume than Bitcoin and Ethereum, but it is well below compared to any of the currencies in the special drawing that of any SDR currency. rights (SDR) basket (Figure 5).6 The daily trading volume of >>> Figure 5. Daily Trading Volume of Major Crypto-Assets and Currencies in Special Drawing Rights Basket Source: BIS Triennial FX Survey (2019) and CoinMarketCap. Note: BTC and ETH volume as of August 2022. 6. Yahoo Finance as of April 2022. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 An asset’s liquidity can also be gauged using the prism of Despite its impressive growth, the market capitalization trading costs. Crypto-assets are difficult and costly to trade. of Bitcoin and Ethereum, which together account for 66 Permissionless blockchains work by providing monetary percent of crypto-assets’ market capitalization, is much incentives to decentralized validators, which can lead lower than that of traditional reserve assets (see Figure 6). to congestion and high fees (see Boissay et al. 2022 for The largest stablecoins, Tether and USD Coin, have even further details). lower market capitalization. >>> Figure 6. Market Capitalization of Major Crypto-Assets and Traditional Reserve Asset Classes Source: Bloomberg indices and CoinMarketCap. Note: Latest data as of August 2022. Reserve management principles. According to the 2021 RAMP survey, safety is the most critical reserve management principle, followed closely by liquidity (Figure 7). Capital preservation is essential in reserve management activities to meet the objectives shown in Figure 4. Reserves, most needed during stress episodes, must retain value when inherently unpredictable shocks hit and markets’ ability to price assets, including crypto-assets, may break down. Central banks have interpreted this principle as a mandate to invest in low- risk instruments, a universe encompassing instruments that have low volatility and high credit quality and that are easy to safeguard, including from cybersecurity risk. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 >>> Figure 7. Reserve Management Principles (2021) Source: Third RAMP survey on the Reserve Management Practices of Central Banks (2021). Crypto-assets are inconsistent with the investment principle 2022, Bitcoin experienced seven episodes of price decreases of safety, even from a portfolio concept perspective. The exceeding 20 percent; in three of these instances, its value volatility of crypto-assets is too high and their valuations dropped by more than 40 percent. This high level of volatility are uncertain, making them risky for central banks focused is undesirable for central banks that may need to provide their on capital preservation. The standard deviation of Bitcoin is economies with foreign currency liquidity at any moment and much higher than that of any other asset class in which central thus crypto-assets cannot be considered safe from a reserve banks invest (Figure 8). Between August 2020 and August management perspective.7 >>> Figure 8. Volatility of Bitcoin, Fixed Income, and Equities Source: Bloomberg. Note: Latest data as of January 2023. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 Although some market participants suggest that reserve struggle as reserve assets if their volatility is high (see Figure managers invest in crypto-assets to enhance investment 9). Additionally, contrary to equities, for example, the valuation return, the reality is that this is a secondary objective for most of crypto-assets is uncertain in the absence of (expected) central bank reserve managers (see Figure 7). For instance, cash flows and limited utility, making it highly challenging to allocation to “riskier” asset classes, such as equity, that also establish reasonable return expectations. It can be assumed, require a longer investment horizon is low in many central then, that central banks are unlikely to move into crypto-assets bank reserve portfolios, accounting for only an average of any time soon, given their even more volatile return streams 1.7 percent (see RAMP 2021). The low average allocation to (see Figures 1 and 8). equities illustrates that even broadly accepted asset classes >>> Figure 9. Equity Returns and Volatility Source: Bloomberg. Note: Latest data as of August 2022. Finally, crypto-assets are not good portfolio diversifiers, evolving.8 In addition, in contrast to U.S. Treasuries, Bitcoin as their correlation with risk assets is volatile and recently exhibits a negligible correlation with emerging market CDS, stood above 0.5 (see Figure 10). As with any statistical suggesting crypto-assets do not increase in value exactly at analysis involving crypto-assets, however, one must recall the moment when central banks may need to use foreign that historical data is limited and that they are continuously reserves to stabilize markets. 8. Even for Bitcoin, with just over a decade in existence, it is difficult to draw firm conclusions. Other crypto-assets have even less data history, hindering effective analysis. In addition, the Bloomberg performance benchmark to reflect the return of available crypto-assets is even less helpful for the analysis, as its composition changes reg- ularly, creating structural breaks in the data. Using the Bloomberg benchmark to reflect the risk and return available for crypto-assets is therefore of limited use. For the rest of this paper, we focus our technical analysis on Bitcoin, as it has at least ten years of data. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 >>> Figure 10. Bitcoin’s Correlation with Equities Source: Bloomberg. Note: Latest data as of January 2023. Beyond crypto-assets’ high volatility of return and relative on centralized exchanges, revealing vulnerabilities in software illiquidity, they also carry specific operational risks distinct from codes. Such attacks can occur on centralized elements of the those of typical reserve assets. For example, cryptocurrency ecosystem (for example, wallets and exchanges), but they exchanges and other players in the space have observed can also arise on the consensus algorithms that underpin fraud (Prasad 2021). Moreover, smaller blockchain projects blockchain operations, particularly for smaller platforms. are vulnerable to manipulation, leading to erosion of trust if a Crypto-assets are also at risk of being used for illicit activities. single player or group of players collude to form a domineering presence. While those risks appear smaller for large, well- Taken together, these risks give pause to the highly established networks such as Bitcoin and Ethereum, they are conservative community of central banks, which are deeply not negligible. (See BIS 2022 for a discussion of additional concerned with meeting their mission goals and preserving problems that Bitcoin investors face.) their reputations. In addition, server or other outages can result in significant Determinants of currency composition. Several factors downtime, with failures and disruptions preventing the use of shape the currency composition of foreign exchange reserves services and perhaps even resulting in substantial losses of (Figure 11). The potential uses intended for the reserves customer funds. Such operational risks have coincided with significantly impact the currency composition of the liquidity periods of high transaction activity and may be due to poorly tranche (RAMP 2019). Intervention needs, payment of designed system controls. external debt claims, and asset liability management require reserve portfolio liquidity tranches composed of highly liquid Crypto-assets are also subject to cyber risks. The crypto- currencies. Financial factors such as risk diversification and asset space has seen some high-profile cases of hacking- return play a more critical role in the investment tranche, which related thefts of customer funds and compromised wallet keys has a longer investment horizon (see RAMP 2021). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 >>> Figure 11. Factors Shaping Currency Composition Source: Third RAMP survey on the Reserve Management Practices of Central Banks (2021). The factors that affect the currency composition of reserves policies or for servicing external debt obligations. These shown in Figure 11, such as intervention needs, payment factors all suggest that crypto-assets are not currently suitable of external liabilities, and asset-liability management, help investment vehicles through which central banks can achieve explain why the US dollar and the euro are the currencies with any of their reserve management objectives. the highest allocations in central bank portfolios. On average, central banks allocate 62 percent of their reserves to the US dollar and 21 percent to the euro; the allocations to other Crypto-Assets versus Gold currencies are small (see RAMP 2021). Since over 80 percent of global exports are invoiced in those currencies (Boz et al. Market participants often compare crypto-assets to gold 2022), and the dollar is the dominant funding and investment (Pfeffer 2017). This analogy may be relevant for reserve currency (Committee on the Global Financial System 2021), managers, because they have an average allocation of crypto-assets are currently not relevant for trade and capital 13 percent to this precious metal (RAMP 2021). The most flows and cannot play a significant role in the currency compelling reason for this apparent similarity may be that the composition of reserves. supply of gold and of some crypto-assets, such as Bitcoin, is relatively fixed, making them less vulnerable than fiat In summary, crypto-assets currently do not exhibit features currencies to debasement. Additionally, both are secure, sufficiently aligned with central banks’ main motivations privately held, durable, and transferable outside the traditional for holding foreign reserves, even with small allocations. international payment networks. More recently, in a context of They are illiquid and expensive to trade; their value is highly rising geopolitical tensions, gold and some crypto-assets have volatile; and they offer limited diversification benefits relative been touted as alternatives to the main reserve currencies. to other assets, as their correlation with risky assets is very high. Moreover, crypto-assets have not yet increased in Although crypto-assets do not have any industrial or ornamental value during periods of financial market stress, making them value, as gold does, some market proponents argue that impractical for self-insurance. Additionally, international trade crypto-assets are superior to gold in other ways. For example, and capital flows are usually denominated in US dollars and unlike crypto-assets, gold is difficult to store, verify, transport, euros, making crypto-assets unsuitable for foreign exchange EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 and divide into smaller parts. For central banks, however, values. Central banks invested their reserves mostly in gold, gold differs fundamentally from crypto-assets. Gold played a but they also held US dollars or other major currencies, as critical part in the history of the international monetary system, they were considered fundamentally equivalent. Only when and it is explicitly recognized and classified as a reserve the United States ran out of gold reserves to back the Bretton asset. Throughout this history, gold has supported high-value Woods agreement and suspended gold conversion in 1971 transactions. Indeed, modern central banking started in the did the current period of floating exchange rates begin, late 19th and early 20th century when national central banks reducing the international monetary system’s reliance on pegged their currency explicitly to gold and the gold standard gold (Eichengreen 2019). As a result, the past 70 years has was developed.9 Although the gold standard collapsed at the seen the role of gold in foreign exchange reserves decrease, beginning of World War I and was not fully operational during especially after the end of Bretton Woods (Figure 12).10 the interwar period, it was the basis of the Bretton Woods agreement, which lasted from 1944 to 1971. These historical precedents explain why central banks rarely hold gold for risk-return considerations and why these Under the Bretton Woods agreement, the price of gold was institutions are unlikely to replace their gold holdings for fixed to the US dollar, with a guarantee from the US government crypto-assets. Although 76 percent of central banks have that foreign central banks could exchange US dollars for gold gold in their foreign reserve portfolio, only 20 percent of those at any time. Other countries fixed their exchange rates against institutions include these assets in the traditional risk and the US dollar, making gold the cornerstone of most currency return optimization framework (RAMP 2021). >>> Figure 12. Share of Gold in Foreign Exchange Reserves (% of total) Source: International Monetary Fund, authors’ calculations. 9. The Sveriges Risksbank was founded in 1668 and the Bank of England in 1694, but their functions differed from those of modern central banks. 10. Although central banks’ gold holdings are at levels similar to those of the early 1970s (1.1 billion ounces), they have increased their fiat currency holdings significantly. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 Furthermore, crypto-assets still do not—and may never— have some of the key characteristics of gold as a store of value. Bitcoin, for instance, like gold, has a limited supply, but currently Bitcoin also has lower liquidity and higher volatility. Notably, Bitcoin does not operate in the same regulatory ecosystem as gold (Bridgewater 2021). These differences are true for any investor, but they are even more critical for central banks. Another factor favoring gold is that central banks already have the operational infrastructure to hold and trade it, which is not the case for crypto-assets. Once central banks hold gold bars that meet Good Delivery standards11 and have a reliable custodian (like the Federal Reserve or the Bank of England) and approved counterparties, gold is secure and easy to trade at a minimal cost. This system has an extremely low risk of fraud and forgery. Finally, while Bitcoin has a limited issuance quantity, it may need to compete with other crypto- assets: it could be displaced as the space evolves, and even driven out of business (see Bridgewater 2021). In summary, gold has specific properties as a reserve asset that crypto-assets currently lack. Consequently, central banks are unlikely in the near term to replace gold with crypto-assets. 11. The London Bullion Market Association (LBMA) sets the Good Delivery standards, including fine ounce weight, purity, and physical appearance; https://www.lbma.org. uk/good-delivery/about-good-delivery. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 >>> The Fundamental Changes Required for Crypto-Assets to Become Suitable for Central Bank Reserve Portfolios Although crypto-assets are currently not appropriate for central bank reserve portfolios, this may change over time given the remarkable development of the space and the pace of technological change. Illustrating just how far crypto-assets have come, institutional investors are carefully thinking through the case for investment in crypto-assets after dismissing them out of hand for years. Many knowledgeable observers also believe that private and public digital currencies and other technologies could significantly disrupt the financial services industry (Harvey, Ramachandran, and Santoro 2021). This section will reviews the characteristics reserve managers require to consider crypto-assets an eligible financial instrument (Figure 13). >>> Figure 13. Mapping Reserve Management Dimensions to Crypto-Assets Reserve Safety Currency Return management Liquidity Store of composition generation dimensions Operational value Stronger Adoption in Changes Availability Improved custody and Lower trade and required for of investable liquidity safekeeping volatility financial crypto-assets instruments solutions flows Clear regulatory treatment EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 Improved Liquidity and Larger with low volatility, like government bonds, commercial bank deposits, and money market products (RAMP 2021). Market Cap As discussed earlier, reserve managers do not broadly invest Along with issues of market manipulation, insider trading, and in equities due to their risk characteristics, including high fraud, liquidity and depth of crypto-asset markets would need volatility of returns. Only 18 percent of central banks invest in to improve significantly before central banks can consider this asset class (RAMP 2021), with an average allocation of them as eligible reserve assets. The cost to trade these assets two percent. Investing in crypto-assets, a much more volatile would also need to decrease significantly. As discussed instrument, is clearly inconsistent with these institutions’ low- above, the liquidity of crypto-assets is much lower than that of risk tolerance (Figure 8). traditional currencies and asset classes; except for the largest crypto-assets, such as Bitcoin and Ether, most crypto-assets Nonetheless, given further advances in the safety and are highly illiquid, making it unfeasible at present to allocate a transparency of stablecoins and associated legal and significant share of reserves to crypto-assets. regulatory frameworks, these may become appealing to central banks if they offer better operational efficiency than fiat At a minimum, crypto-assets would need to be similar in currencies. Since stablecoins are pegged to major currencies, liquidity to high-grade investment assets denominated in their volatility would resemble that of other traditional central currencies such as the Canadian dollar, the British pound, the bank investments. Wide adoption of stablecoins must Japanese yen, or the Chinese yuan renminbi, which typically overcome two additional challenges, however. Policy makers have low single-digit allocations in reserve portfolios. Here, are currently concerned with the inherent vulnerabilities of the liquidity of the Canadian dollar may be a good benchmark existing stablecoins, for reasons including deficiencies in the in terms of liquidity required before central banks can adopt price stabilization mechanism, the quality of reserve assets, crypto-assets as an eligible investment instrument. According disclosure, governance, and consumer protections. Moreover, to the 2021 RAMP survey, central banks hold an average of like CBDCs, stablecoins do not provide diversification one percent of their portfolios in Canadian dollars. According opportunities; being pegged to reserve fiat currencies reduces to the BIS triennial foreign exchange survey,12 the average their appeal from an investment perspective. daily trading volume of the Canadian dollar is 465 billion, compared to 328 million for Bitcoin and 158 million for Ether. Also pronounced is the gap in market capitalization of crypto- Improved Availability of Investable assets as compared to other asset classes with single-digit Instruments allocations in reserve portfolios. The market capitalization of equities (MSCI ACWI) is US$62 trillion, that of mortgage- As explained above, central banks typically choose their reserve backed securities is US$7 trillion, and that of covered bonds is currency composition based on macroeconomic factors. Once over US$1 trillion. As of August 2022, Bitcoin and Ethereum, they have made their currency allocation decision, they invest the two largest crypto-assets in the space, have a combined their currency holdings in liquid instruments such as deposits market cap of US$676 billion. and bonds. Income (e.g., interest, dividends) is typically more critical from a return perspective because the currency allocation does not often change (see RAMP 2019, 2020, Reduced Price Volatility and 2021). Central banks invest in conservative instruments. On average, reserve managers allocate 34 percent to The volatility of crypto-assets must decrease to align with the government bonds, 23 percent to bank deposits, 12 percent to low-risk tolerance of most central banks. Again, as highlighted sovereigns, supranationals, and agencies, and 10 percent to above, reserve portfolios concentrate heavily in asset classes money market products. The minimum credit rating for those 12. https://www.bis.org/statistics/rpfx22_fx_annex.pdf. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 investments is typically A- or higher. By contrast, the allocation prerequisite for inclusion in their portfolios. These flows remain to corporate bonds and equities is below three percent on denominated and executed in fiat currencies, especially the average (RAMP 2021). US dollar. Central banks are unlikely to include crypto-assets in their asset mix until such assets play a more substantial role Crypto-assets could be used to generate returns. First, in the global monetary system. Crypto-assets would need to crypto-assets operating with a Proof-of-Stake protocol (e.g., become widely accepted mediums of exchange and stores of Ethereum) can be used to provide “staking” services to value, neither of which appears likely at this point. help validate transactions and secure the network. In turn, “staked” crypto-assets provide a return stream. Second, the Stablecoins, too, are currently not widely used for payments, development of decentralized finance (DeFi) services can as they still pose various risks and regulatory uncertainty also help generate income from crypto-assets since these remains high. Although the original objective of Bitcoin services can, for example, allow investors to lend their crypto- was to become a peer-to-peer electronic cash system, few asset holdings or provide liquidity and make a return (Harvey, players use it for international transactions. As discussed, one Ramachandran, and Santoro 2021). This experimental space significant obstacle for such flows is that Bitcoin has relatively is evolving rapidly—the assets stored have grown from $1 low throughput or processing capacity. Crypto-assets such as billion at the beginning of 2020 to more than $200 billion today Ethereum promise changes to improve processing capacity (Economist 2020). Risks from fraud and other vulnerabilities and energy efficiency,13 but advances in technology alone will are still considerable, however, increasing the need for further be insufficient to spur adoption as a medium of exchange as regulation (Hicks 2021). Third, sovereign, supranational, and long as crypto-assets continue to experience high volatility in agency crypto bonds (e.g., El Salvador’s plan to issue Bitcoin their valuations. bonds) are an option, at least in theory, but these would need to become widely adopted in developed economies, the Additionally, for multiple reasons including concerns about likelihood of which currently seems rather remote. consumer protection and AML/CFT regulations, crypto-assets’ rate of adoption across countries is uneven. Nine jurisdictions, Taken together, operational, investment, and other risks including China, have banned crypto-assets altogether as associated with these options for return generation still loom a means of payment and investment, and 42 have implicit large, while the associated markets remain small, illiquid, prohibitions (Library of Congress 2021). The Democratic and largely unregulated, making crypto-assets or crypto- Republic of Congo and El Salvador are the only countries denominated instruments unattractive to central banks from a to have adopted Bitcoin as a legal tender. Still, the IMF has return generation perspective. urged these governments to reverse this decision because of the “risks to financial and market integrity, financial stability, and consumer protection.”14 Without broader adoption as a means of payment, crypto-assets are unlikely to be used for Adoption in Trade and Financial international trade and investment. Flows Even if crypto-assets were to become more important for Reserve managers consider adoption of crypto-assets in global trade and external financing, their adoption as reserve cross-border trade and investment flows to be a critical assets is likely to be slow. In the past, the move to include 13. The Bitcoin network uses a proof-of-work (PoW) algorithm that is computationally demanding by design (for details see Auer 2019). This mechanism allows the network to come to consensus, preventing users from double spending their coins. Miners must compete to solve a complicated mathematical problem, and the first to finish adds a block to the chain and is rewarded if the transactions included in the block are valid. By contrast, Ethereum is moving to a proof-of-stake (PoS) algorithm that should allow faster transaction processing. With PoS, validators stake their coins and are chosen at random to create blocks, avoiding the demanding validation process of PoW (for details, see https://ethereum.org/en/developers/docs/consensus-mechanisms/pos/). 14. https://www.imf.org/en/News/Articles/2022/01/25/pr2213-el-salvador-imf-executive-board-concludes-2021-article-iv.consultation#:~:text=Since%20September%20 2021%2C%20the%20government,also%20can%20create%20contingent%20liabilities. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 a new currency in reserve portfolios has taken a significant Clear Regulatory, Supervisory, and amount of time. For example, despite the importance of China in the global economy and international trade, central banks Oversight Treatment have only recently started adding the renminbi to their reserve portfolios. The average allocation of renminbi is close to two A clear, comprehensive, and globally consistent policy percent (RAMP 2021) on average for reserve portfolios, an framework would be another necessary—but not sufficient— insignificant amount considering that the currency has been condition before crypto-assets and crypto-asset activities can part of the Special Drawing Rights basket since 2016. One overcome reserve managers’ hesitation to use these assets. significant constraint on the renminbi’s adoption that may Currently, many crypto-asset activities are unregulated, lack be relevant for crypto-assets is that institutions must modify regulatory clarity, or do not comply with existing relevant their operational frameworks to trade the currency onshore. standards, rules, and regulations. Investment products without As discussed above, custody arrangements for crypto-assets such validation are risky and unlikely to attract conservative are also more complex than for other currencies and are still institutional investors with fiduciary duty. Before considering being developed. Custody may therefore present a continuing investing in crypto-assets, most institutional investors— additional obstacle to reserve managers’ general adoption of central banks in particular—will require appropriate regulatory crypto-assets. treatment and a significant reduction in regulatory uncertainty. The recent SEC approval of Bitcoin ETFs does not address these problems for the underlying instruments. Robust Custody and Safekeeping Regulating the crypto-asset sector could bestow Solutions unwarranted credibility on crypto-asset activities and intermediaries. However, given its rapid growth, increasing Crypto-asset safekeeping and custody crucially differ from interconnectedness with the traditional financial sector, and those for traditional financial assets and are more akin to a string of recent high-profile failures impacting thousands bearer instruments. Specifically, crypto-assets require careful of users, broad international recognition has emerged of management of the private cryptographic keys associated with the need to adequately regulate and supervise the sector. the wallet containing and allowing access to a user’s funds. Indeed, international standard setters such as the Financial Mismanagement of access to and storage of this private key Action Task Force (FATF), the Basel Committee for Banking can lead to irreversible loss of funds as there is no way to Supervision (BCBS), the Financial Stability Board (FSB), and recover the private keys and reverse transactions. As such, the International Organization of Securities Commissions accessibility for large institutional investors to obtain outright (IOSCO), as well as domestic policy makers around the exposure to crypto-assets will remain constrained by the world, are increasingly focusing on the crypto-asset space to development of sound services regarding custody, including preserve financial stability, financial integrity, sound market client asset protection (e.g. proper asset segregation) and conduct, and consumer and investor protection. Updating and insurance. Recent failures of key crypto-asset service implementing policy frameworks nonetheless remains a work providers highlight the problem: investors may encounter large in progress in many countries. losses if, among others services, proper safekeeping and client asset protection measures are not in place. Recently, The Financial Stability Board (2022, 2023a) has advocated however, several large investment managers (e.g., Blackrock, for regulatory and supervisory frameworks to preserve crypto- BNY Mellon) have begun to offer such services using a trust asset activities’ and service providers’ financial stability that structure. The prospect of “atomic” settlement (i.e., exchange use the principle “same activity, same risk, same regulation” at of crypto-assets without counterparty risk) is an attractive levels commensurate to the risks posed, both domestically and feature of crypto-assets and can facilitate trade execution. internationally. FSB (2023b, 2023c) has issued final high-level recommendations for regulating, supervising, and overseeing EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 both crypto-asset activities and markets and global stablecoin arrangements, and BCBS (2022) has also issued its final standard regarding the prudential treatment of crypto-asset exposures. IOSCO has issued various crypto-asset-related reports covering crypto-asset trading platforms (2020) and DeFi (2021); recently it has sought feedback on a set of key recommendations, including regarding conflicts of interest, market manipulation, fraud, and asset safekeeping. In 2019, the Financial Action Task Force issued a globally binding standard for regulating crypto-assets and related service providers to understand, monitor, and mitigate financial integrity risks (see Financial Action Task Force 2021). Implementation of international guidance and new binding rules is in its early stages, however, and remains inconsistent across countries, which may give rise to international regulatory arbitrage, since crypto-activity can easily transcend borders (e.g., Financial Action Task Force 2023). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 >>> Conclusion Institutional investors, including central bank reserve managers, have been intrigued by the rapid ascent of crypto-assets and assessed their investability. As a result, central banks have started to ask questions about crypto-assets, even if the large majority have no immediate plans to invest in them over the short and medium term. Central bank digital currencies (CBDCs), although fundamentally distinct from crypto-assets, would be obvious investment choices for reserve managers and could improve efficiency in payments and settlements. From a portfolio diversification perspective, however, CBDCs and stablecoins do not have much to contribute, since their value would be equivalent to currencies central banks already invest in. Crypto-assets like Bitcoin and Ether currently remain unsuitable instruments for central banks’ reserve portfolios as they do not exhibit features consistent with central banks’ motivations for holding foreign reserves. To become an eligible instrument for foreign reserve portfolios, crypto-asset markets and players must overcome multiple obstacles. A significant increase in liquidity and a reduction in trading costs would be required, as well as a meaningful reduction in price volatility, strengthened custody and safekeeping solutions, increased availability of suitable investable instruments, and widespread adoption in trade and global financial flows. The foundational requirement is for clear, comprehensive, consistent international and domestic regulatory and supervisory treatment, a precondition that cuts across all reserve management dimensions. Currently, it remains unclear whether crypto-assets will be able to meet all of these criteria in the future, even with the recent regulatory approval of Bitcoin ETFs in the U.S. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 >>> Figure 14. Summary: Mapping Reserve Management Dimensions to Required Changes for Crypto-Assets KEY DIMENSIONS CHANGES REQUIRED Safety Store of value Lower volatility. With an annualized volatility of 70 percent—significantly higher than equity and gold— crypto-asset price volatility is currently too high, making crypto-assets an unreliable store of value for helping central banks self-insure against shocks. Operational Stronger custody and safekeeping solutions. Crypto- assets are similar to bearer instruments and rely on cryptographic private keys—loss or theft of which can lead to permanent loss of funds. Industry-grade private key management and execution solutions able to withstand fraud or cyber-attacks are essential (e.g., for storage, access, authentication). Clear regulatory treatment (cross- cutting issue). Crypto-assets should Sufficient decentralization. Insufficiently decentralized be subject to regulations based on the crypto-asset projects over which a governing body or principles of “same activity, same risk, central party can exert significant control may pose risks. same regulation” and proportionality to risk. Currently, many crypto- Liquidity Improved liquidity. Crypto-assets’ liquidity and asset activities are unregulated, lack market capitalization are much lower than those of regulatory clarity, or fail to comply traditional currencies and asset classes, discouraging with relevant regulations, standards, large investors from taking and managing significant and rules. Domestic and international exposures. Liquidity of the largest crypto-assets (e.g., regulatory treatment of crypto-assets Bitcoin, Ether) has improved significantly, however, and remains unclear in other critical aspects, derivatives markets have emerged to manage risks. including institutional mandates, powers, Return generation Availability of investable instruments. Central banks and tools, although policy makers have usually invest in very safe assets (e.g., government made progress (e.g., coping with illicit bonds). Most crypto-assets do not have intrinsic value financial activity). (e.g., they do not produce an interest or dividend stream). “Staking” can produce an income stream, and DeFi applications could help generate returns on crypto- assets, but various uncertainties and risks remain in this experimental ecosystem. Currency Adoption in trade and financial flows. Use of crypto- composition assets for (cross-border) trade and investment flows is necessary if reserve managers are to gain exposure to crypto-assets to support their need for self-insurance against trade and financial shocks. Adoption of crypto- assets in such flows is virtually nonexistent. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 >>> Appendix: The Background of Crypto-Assets This appendix provides a brief overview of the different types, assets with limited supply, such as Bitcoin, conceived as a main characteristics, and market sizes of crypto-assets and medium of exchange and a store of value (i.e., “digital gold”); (2) notes some of the growing body of theoretical and empirical crypto-assets operating on smart-contract blockchains, such literature on drivers behind developing and adopting them.15 as Ethereum, with applications in numerous areas including in decentralized finance (DeFi)16 and non-fungible tokens (NFTs); and (3) stablecoins, which aim to maintain a stable value relative to a specified asset or pool of assets (e.g., the US Types of Crypto-Assets and Their dollar, gold, or another reference asset). Main Characteristics Bitcoin,17 the best-known crypto-asset with limited supply, A wide range of crypto-assets has evolved to meet varying emerged in 2009. It was the first blockchain-based crypto- needs, including speculative investment, store of value, asset and is now the most widely held, with the highest single currency conversion, and payments. Investors differentiate market value (see Table A.1). between three main types of crypto-asset: (1) unbacked crypto- >>> Figure 14. Summary: Mapping Reserve Management Dimensions to Required Changes for Crypto-Assets Current Market Cap Quantity of Tokens Maximum Amount of Cryptocurrency Release (US$ mn) Issued (mn) Tokens Issued (mn) Bitcoin 2009 451,940 19 21 Ethereum 2015 227,741 122 Unlimited Tether 2015 67,570 67,566 Unlimited USD Coin 2018 53,441 53,441 Unlimited Binance Coin 2017 50,185 161 200 XRP 2012 18,528 49,378 100,000 Cardano 2017 18,497 33,739 45,000 Binance USD 2019 17,981 17,979 Unlimited Solana 2020 14,625 349 Unlimited Dogecoin 2013 10,999 132,671 Unlimited Source: CoinMarketCap. 15. See Feyen, Kawashima, and Mittal (2022) for a summary of the theoretical and empirical literature on supply- and demand-side drivers for the adoption of cryptocurren- cies. According to the authors, supply-side drivers include profitability and costs of traditional payment services providers and the availability of infrastructures such ICT and agent networks. Demand-side factors include costs and inconvenience, confidence in financial incumbents and the government, and macro-economic conditions. The authors summarize the empirical findings for the US and importantly conclude that crypto-asset adoption in the US is not driven by distrust but rather by speculation and that crypto users tend to be educated, young, and digital natives (Auer and Tercero-Lucas 2021). 16. DeFi is an emerging financial technology based on a secure distributed ledger that removes third parties, such as banks. 17. See Prasad (2021) for an extensive review of Bitcoin technology. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 Is Bitcoin a medium of exchange? A reliable medium Is Bitcoin a store of value? As noted above, Bitcoin’s software of exchange should have value when compared with the protocol fixes the terminal supply of bitcoins to 21 million; as unit of account in which goods and services in an economy of early 2021, 18.7 million bitcoins had been “minted” and are priced (see Prasad 2021). For example, the US dollar entered circulation. The limited supply and the decline in the serves as a medium of exchange and a unit of account in the issuance rate of Bitcoin have been the main drivers behind United States.18 The US dollar is not only backed by the US the “digital gold” narrative. Like gold, Bitcoin does not pay any government, it is also a legal tender—merchants and creditors yield outright and is not a claim on any entity. At the same in the United States have a legal obligation to accept the US time, Bitcoin is globally accessible and easily portable— dollar as a means of payment. This is not the case for any valuable attributes for a store hold of wealth. While scarcity private cryptocurrency.19 Observers note that crypto-assets is insufficient to drive demand for an asset and sustain it as are unlikely to be accepted or to take hold in countries with a viable store of value, Bitcoin’s relatively long history, much stable inflation and exchange rates and credible institutions. larger relative size, and broader public profile and acceptance So far, the only countries to adopt Bitcoin as legal tender have given it a clear advantage. are the Democratic Republic of Congo and El Salvador. Households and businesses have little incentive to price or Further attributes of a store of value are (1) ability to retain save in a crypto-asset—even if it had legal tender or currency its purchasing power over time, (2) easily exchangeable for status—because of its price volatility. Some analysts also currency and other liquid assets, and (3) easily accessible. warn that making crypto-assets legal tender has significant Compared to other traditional stores of value, such as gold, implications for macrofinancial stability, consumer protection, art, and real estate, Bitcoin is much more easily exchangeable, and the environment (see Adrian, IMF Blog issued July 26, especially for individual holders. Bitcoin also appears to be 2022; Feyen, Kawashima, and Mittal (2022)). the most portable potential store of value, much more so than physical cash. Notwithstanding these attributes, since Although new payment technologies, such as the Lightning the fundamental purpose of a store of value is to preserve Network (Poon and Dryja 2016), have built on top of Bitcoin to or increase in value over time, many observers still assess address bottlenecks, Bitcoin is not currently in wide use as a Bitcoin as a highly volatile and speculative asset with no means of payment for the following reasons: (1) low transaction intrinsic value. speed, (2) high transaction costs when transaction demand is high, and (3) high volatility relative to fiat currencies. The In addition, compared to established stores of value, Bitcoin Bitcoin network can only process up to seven transactions per is not widely used as a savings vehicle or reserve asset, and second or 600,000 transactions per day. While the comparison governments and the largest institutional investors do not has limitations, Visa can handle up to 24,000 transactions as yet meaningfully participate in it.21 Furthermore, as seen per second or more than two billion transactions per day in Figure A.1, Bitcoin’s realized volatility is higher than that (Deutsche Bank 2021).20 Depending on demand, transaction of other assets held as a store of value, specifically, gold. fees for Bitcoin ranged from US$2 to US$60 per transaction While Bitcoin has a limited issuance quantity, it may need to between 2020 and 2021. Finally, Bitcoin’s price exhibits high compete with other crypto-assets and could be displaced as daily volatility, reducing its utility as a medium of exchange. the space evolves. Taken together, these factors make Bitcoin unattractive to merchants as a payment medium. 18. This is generally true for most national currencies except in countries facing high inflation or hyperinflation that erodes their currencies’ purchasing power. 19. Gorton and Zhang (2021) call this the no-questions-asked-principle, which requires that money be accepted in a transaction without due diligence on its value. 20. Each block of bitcoin’s digital ledger, i. e., the blockchain, can store only one megabyte of information, and ten minutes are needed to mine a new block. It takes at least as long for the blockchain to confirm a bitcoin payment transaction. 21. To assess the extent to which investors hold Bitcoin to store wealth, Bridgewater is looking at turnover and coin activity, concluding that the cryptocurrency has a high turnover, confirming its speculative nature (see Bridgewater, January 28, 2021). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 >>> Figure 12. Share of Gold in Foreign Exchange Reserves (% of total) Source: Bloomberg. Note: Three-year rolling using weekly data. Decentralized finance. The Ethereum blockchain was created currently mostly used as a bridge between fiat currencies in 2015 along with its native crypto-asset, Ether. A key feature and crypto-assets, as collateral for smart contracts, and to of the platform is that it enables developers to build and run facilitate trading and exchange in the DeFi space. Stablecoins distributed applications powered by Ether.22 These applications can be classified across a spectrum depending on the type can be interoperable, allowing a complex financial ecosystem of collateral and the stabilization mechanism. Fiat-based to emerge, referred to as decentralized finance (DeFi), and stablecoins are most common and are backed by traditional offer financial services such as an exchange, loans, derivatives, financial instruments that may differ in liquidity and risk profile and insurance.23 Some of these applications issue their own (e.g., ranging from bank deposits and US government bills to crypto-assets, often for owners to participate in the future corporate bonds and commercial paper) and are redeemable governance of the application (e.g., Uniswap for decentralized by the issuer at face value. A stablecoin that maintains a peg exchange services or Aave for decentralized lending and to a sovereign currency is more likely to be used as a form borrowing). Currently, most DeFi applications are built on of digital money. Asset-backed stablecoins are fully backed Ethereum, but competing platforms, such as Solana, have by non-cash equivalents (e.g., corporate bonds, commercial been set up. Market interest has grown in newer blockchains paper, commodities, and cash) and are often marketed as that use smart contracts and aim to solve the challenges of immediately redeemable at face value, although issuers may earlier blockchains by introducing new features that improve be able to defer redemption or offer in-kind redemption during scalability, interoperability, and sustainability.24 periods of stress. Finally, crypto-asset-based stablecoins are backed by other crypto-assets, while algorithmic stablecoins Stablecoins. Stablecoins aim to offer a medium of exchange seek stability through a software protocol that manages the and to store value for investors by maintaining a stable supply of coins to ensure a stable value; the recently failed value relative to a reference asset (typically the US dollar) TerraLuna project is an example of an algorithmic stablecoin. or basket of assets. In practice, however, stablecoins are Tether is currently the largest stablecoin, but its market share 22. Market participants also build crypto-tokens (unlike crypto-assets, which are native to a specific network) on the Ethereum network. Crypto-tokens can not only be used as a medium of exchange or store of value but also for governance decisions of the platform (see Goldman Sachs 2021). 23. Also referred to as smart contracts, they are self-executing with the terms of the agreement between parties written directly into lines of code. Ethereum is the most popular blockchain for running smart contracts, which are typically written in the programing language Solidity (see Goldman Sachs 2021). 24. Scalability refers to the ability to handle large transaction volumes. Interoperability is the ability to connect with other blockchains as well as with off-chain data. Sustain- ability is the ability to scale in an environmentally sustainable way. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 has declined sharply due to competition from alternatives improve in 2021, when their market capitalization quadrupled such as USDC, issued by Circle, and Binance’s BUSD, issued to more than $120 billion, and their relative price stability has by crypto exchange Binance. Stablecoin trading volume shielded users from the volatility common to other crypto- outpaces that of other crypto-assets primarily because they assets.25 Significant concerns around price stability and are usable for settlement of exchange spot and derivatives consumer protection remain, however. trades. The price stability for top stablecoins continued to >>> Table A.2. Main Characteristics of Crypto-Assets Crypto-Assets with Fixed Stablecoins DeFi Supply The national currency, commodity, Denomination Own Own or other reference assets At face value or market value of Redemption pledge None None reserves Full or partial backing by a variety Backing None None of the other crypto-assets of (fiat-based) assets • To operate on smart-contract • Medium of exchange Main design • Medium of exchange platforms • Store of value/ functions • Store of value • Governance of DeFi applications investment • Non-fungible tokens (NFTs) • Value depends on the technology platform and issuers’ ability to attract market participants to use • Intrinsic value depends on the platform or applications built Defining feature • No intrinsic value the stabilization mechanism on it and reserve assets • “Staking” rewards produce a crypto-asset cash flow (e.g., Ether) • Of limited value as a medium • Of limited value as a of exchange because of medium of exchange payment network capacity because of payment constraints • “Smart contract” and other Selected current network capacity • Design shortcomings (e.g., operational risks challenges constraints stabilization mechanism) • Interconnectedness and leverage • Store of value have already caused failures challenged by high or significant deviations from volatility the reference asset • Ethereum (smart-contract • Bitcoin • Tether platform) Examples • Litecoin • USD Coin • Uniswap (decentralized • Bitcoin Cash • LunaTerra (defunct) exchange) • Aave (lending and borrowing) Source: International Monetary Fund (2021) and authors’ assessments. 25. The pricing dynamics of stablecoins have been examined in several studies (see discussions in Lyons and Viswanath Natraj 2020). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 Options for Investors to Obtain to access crypto directly on native platforms and, in some cases, to bridge inefficiencies between crypto-linked assets in Exposure to Crypto-Assets traditional finance and their corresponding on-chain product.27 Crypto hedge funds use two alternative strategies: focusing Investors can create exposure to crypto-assets in three ways: on higher risk directional strategies or implementing more (1) outright exposure; (2) exposure to arbitrage and money- market-neutral strategies engaging in high-frequency trading, making opportunities; and (3) exposure to technological market making, and arbitrage. growth via venture capital or equities. Bridgewater (2021) offers a detailed assessment of these various options. Exposure via venture capital or equities. The number of new businesses that use blockchain technology has grown Direct exposure to crypto-assets.26 The most liquid and most rapidly. These range from new crypto-asset exchanges to firms common crypto-asset for outright exposure is spot Bitcoin or behind DeFi protocols. Other industries are also increasingly Ether (and related derivatives) traded via crypto or commodity adopting blockchain technology; examples include businesses exchanges or over the counter (OTC). Some fund products providing digital art, gaming, social networks, or sharing passively track Bitcoin, Ether, or a broader basket of crypto- economy platforms. Venture funding for cryptocurrency and assets that charge substantial fees and offer limited liquidity. blockchain companies quadrupled to over $25 billion in 2021. Nonetheless, accessibility for large institutional investors Institutional investors are increasingly gaining exposure to will remain constrained by the development of custody and these opportunities through venture capital or the few listed counterparty services, although several large investment public equities in the space. For investors with private or public managers have started to offer such services through a trust equity exposure, this form fits neatly into existing mandates structure (e.g., Blackrock, BNY Mellon). and competencies. Exposure to crypto-asset trading. High price volatility Current Investor Base and improving liquidity appear to offer some arbitrage opportunities for hedge funds and other investors. With the Apart from retail investors, institutional participation is still continued development of the crypto ecosystem, institutional primarily restricted to smaller corporates, hedge funds, investors are beginning to gain exposure to this type of and family offices rather than large traditional institutional strategy through their holdings of some hedge funds that have allocators where the market size in relevant instruments expanded into the crypto space. Emerging new crypto-specific remains relatively small (see Table A.3).28 funds specialize in investment strategies primarily intended >>> Table A.3. Institutions’ Publicly Disclosed Bitcoin Holdings BTC Holdings Market Cap % of BTC in Category Country Company Name (BTC) (US$mn) Circulation Public Company US MicroStrategy 129,699 3,066 0.68% Public Company US Galaxy Digital Holdings 40,000 946 0.21% Public Company CA Voyager Digital LTD 12,260 290 0.06% Public Company US Tesla, Inc 10,725 254 0.06% Public Company US Marathon Digital Holdings Inc 10,055 238 0.06% 26. Owning a crypto-asset can be anonymous because ownership and use of crypto-assets relies on having “private keys” stored in “wallets.” Depending on how they oper- ate, wallets can be classified as “hot” (connected to the internet) or “cold” (kept offline), as well as “hosted” (hosted by a third-party provider) or “unhosted.” “Unhosted” wallets can make it difficult or even impossible to determine who controls the crypto-assets, which in turn can allow concealment of illicit activity (see IMF, Global Stability Report, October 2021, Annex). 27. Many of the largest crypto-native active managers have both hedge funds and VC arms, which often entails both overlaps and synergies. 28. On April 26, 2022, Fidelity announced that it would allow retail investors to put Bitcoin into their 401(k)s, the first major retirement plan provider to do so. This decision allows the 23,000 companies using Fidelity to administer their retirement plans to add Bitcoin to the list of option provided to their employees (Wall Street Journal, April 26, 2022). This announcement by the largest retirement plan provider suggests crypto investing has moved deeper into the mainstream. At the same time, however, Fidelity’s announcement came a month after the Labor Department expressed its concern over including cryptocurrencies in retirement planning. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 Public Company US Coinbase Global, Inc. 9,000 213 0.05% Public Company US Square Inc. 8,027 190 0.04% Public Company CA Hut 8 Mining Corp 7,736 183 0.04% Public Company US Riot Blockchain, Inc. 6,696 158 0.04% Public Company DE Bitcoin Group SE 3,830 91 0.02% Public Company CA Hive Blockchain 3,091 73 0.02% Public Company CA Bitfarms Limited 2,021 48 0.01% Public Company US Core Scientific 1,959 46 0.01% Public Company JP NEXON Co. Ltd 1,717 41 0.01% Public Company US Exodus Movement Inc 1,300 31 0.01% Public Company GB Argo Blockchain PLC 1,295 31 0.01% Public Company TH Brooker Group’s BROOK (BKK) 1,150 27 0.01% Public Company US/CA Other Crypto Firms in North America 4,922 116 0.03% Public Company Other Crypto Firms in Rest of World 1,564 37 0.01% Private Company JP Mt. Gox 141,686 3,350 0.68% Private Company HK Block.one 140,000 3,310 0.67% Private Company CH The Tezos Foundation 17,500 414 0.08% Private Company US Stone Ridge Holdings Group 10,000 236 0.05% Private Company US Massachusetts Mutual 3,500 83 0.02% Private Company CH Lisk Foundation 1,898 45 0.01% Private Company NO Seetee AS 1,170 28 0.01% Private Company SG Luna Foundation Guard ‘313 7 0.00% Government Ukraine 46,351 1,096 0.22% Government El Salvador 2,381 56 0.01% Government Finland 1,981 47 0.01% Government Georgia 66 2 0.00% ETFs US Grayscale Bitcoin Trust 643,572 15,215 3.37% ETFs CH CoinShares/XBT Provider 48,466 1,146 0.25% ETFs CA Purpose Bitcoin ETF 25,284 598 0.13% ETFs CA 3iQ CoinShares Bitcoin ETF 21,237 502 0.11% ETFs DE ETC Group Bitcoin ETP 17,976 425 0.09% ETFs US/CA Other ETFs in North America 42,061 994 0.22% ETFs Other ETFs in Rest of World 10,092 239 0.05% Total 1,432,581 $33,868 7.32% Source: Buy Bitcoin Worldwide, August 2022. 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