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The Actuary The magazine of the Institute & Faculty of Actuaries

A capital idea?

Cryptocurrency could potentially outgrow its use as a payment mechanism and replace established methods for borrowing capital, says Ian Collier


money hands

Until recently, the accepted view of major central banks such as the Bank of England was that cryptocurrencies would have minimal impact on the formal economy and create little or no risk to domestic financial stability. These central banks have set up departments that monitor the progress of cryptocurrencies and reflect on their impact. Some have considered the consequences of issuing their own digital currencies (central bank digital currencies, or CBDCs) and have concluded that, for now, the risks of CBDCs outweigh any positives that they would create (see the IFoA paper Understanding Central Bank Digital Currencies by Sabrina Rochemont and Orla Ward, and Take the Reins by Orla Ward and Ian Collier, which appeared in The Actuary in December 2018. All authors are members of the Cashless Society Working Party).

Facebook’s June 2019 announcement that it is planning to issue its own cryptocurrency, Libra, must now challenge the negative and dismissive attitudes of central banks. It should prompt questions about how significant cryptocurrencies will become, and whether they should be treated as a currency or a capital market instrument.

Promises and rewards

Money, in the form of either bank notes or bank accounts, constitutes a form of loan. The paper cash in one’s pocket states clearly that the issuer ‘promises to pay the bearer’, and a bank deposit can be considered as a loan made by the depositor to that bank. As a reward for making that loan, as with any commercial or capital market instrument, the borrower pays a reward to the lender for that loan. Banks will usually pay an interest rate on bank accounts – although these are currently very low. Even if the interest rate is zero, the bank will provide payment and other banking services as an incentive to acquire these deposits. Banks with better perceived creditworthiness are able to offer lower rates of reward, just as their ‘paper’ pays a smaller return on the capital markets.

Other ways that banks, and indeed any borrowers, can raise money include debt issuance or equity issuance through the capital markets. Here, the trustworthiness of the borrower and the liquidity of the issued instrument determine what the market will pay or receive in order to lend that money.

The issuance of cryptocurrencies, up until now, has not satisfied traditional lending criteria. In most cases, the borrower has not even been known, let alone offered the lender the ability to assess their creditworthiness – and the liquidity of the currency is at best varied. This is not going to attract funds in the sort of size that would seriously affect economies, and it is hardly a wonder that authorities have not believed they can create a threat to financial stability.

However, what would happen if, instead of raising money through conventional capital markets, major international borrowers, corporate or public authorities were to issue currencies in return for fiat currencies, instead of issuing bonds or equities? 

Could the borrowers offer a rate of interest on their ‘coins’ linked to their creditworthiness as they do with their debt instruments, or even a share of profit akin to dividends on equities? The coins could float on foreign exchange (FX) markets, replicating the pricing of bonds or equities on capital markets.

An example 

Let us suppose a large international bank called Megabank wants to raise capital in a fiat currency. Instead of issuing bonds or equities it decides to issue its own currency, Megabank dollars (M$). This would be done by issuing a prospectus, just as it might when raising money in the capital markets. Megabank would receive fiat currencies and ‘swap’ them into M$; it could then ‘drop’ payments of M$ into a depositor’s account on a regular basis in lieu of interest. This interest could be ‘fixed’ or ‘floating’. The amount of interest paid would be similar to the rate that Megabank would have to pay on the capital markets for any debt issuance. 

Investors who might otherwise buy Megabank debt would now have the choice of purchasing Megabank bonds or M$. The latter would float in value depending on the general level of interest rates, and Megabank and others would maintain an active market for the exchange of M$ with all other currencies – an effective FX market. This would be akin to its debt or equity instruments floating in value on the capital markets. Megabank would always guarantee payment of M$ through its normal banking services at the prevailing FX rate, making this ‘loan’ more liquid for lenders (especially for small purchases) than their capital market equivalents.

As with the various capital market instruments that it might issue, Megabank might issue a number of different types of dollars. The interest-bearing dollars might attract either fixed or floating interest. Megabank could issue equity dollars, too, and it would ‘drop’ a share of Megabank’s dividends to account holders instead of making interest payments. The price of each of these equity dollars would also fluctuate according to general market conditions, just as their equity would fluctuate on capital markets.

Such disintermediation of the capital markets would require regulation, but this might be more questionable if the coins were ‘domiciled’ in territories where the regulatory regimes were light or non-existent. Prospectuses would be prepared for these coin offerings, just as is required for bonds or equities. 

Tax authorities would require similar information as they would for capital market instruments – although capital gains tax might be more difficult to calculate, as payments made in M$, no matter how small, could be considered the equivalent of disposals of an asset. A number of jurisdictions, such as the US, already recognise that regulation should come under the auspices of whichever type of authority the instrument depicts – so despite being called a currency, if it looks and acts like a capital market instrument, it should be regulated as such.

What next?

Will the cryptocurrency of the future be a payment mechanism, or will it effectively be an efficient way to borrow money? Will future issuers of cryptocurrencies need or wish to pay rewards to holders that are over and above the ability to use it to pay for goods and services? The view of the author is that once (or if) the market matures, the value at which that currency will trade on markets will reflect the ‘yield’ on that asset, much as happens with capital market instruments. Cryptocurrency’s status as a payment mechanism alone should not be sufficient to attract substantial capital to it. 

Once the market is mature, cryptocurrencies could well encroach on or even replace the traditional capital markets as a method of raising funds.

Facebook’s announcement is a wake-up call for central banks and regulatory authorities. Regulatory issues will include data privacy, anti-competitive practices and cross-border activities, and rigorous regulation will be necessary to ensure financial stability. With Libra, we are offered a cryptocurrency issuer that is a major international corporate and respected borrower, for whom the credit risk is understood. Facebook is working with payment providers, which could allow Libra to be widely accepted as a payment method, making it perhaps more liquid than current Facebook capital market debt or equity instruments. It is possible it will become a cheaper way to raise money than traditional capital markets because there will be no need to pay interest on the loan. The project has faced a series of challenges recently, with key partner organisations having pulled out and mounting regulatory opposition. But it would be negligent of authorities to ignore the possible appeal of the Libra, or future coin offerings by internationally respected borrowers. Central banks may find no alternative but to issue CBDCs in order to keep control of monetary policy – despite the risks from the resulting change to the fractional banking system, as set out in the Understanding Central Bank Digital Currencies paper.

Ian Collier is a retired actuary and chair of the Cashless Society Working Party. He has just finished a five-year term on the IFoA’s Health and Care Research Committee.