Central Banks Need to Own Bitcoin to Guard Against Speculative Attack on Their Currencies

Or so says two professors in this working paper written for the Central Bank of Barbados: http://www.centralbank.org.bb/Portals/0/Files/Working_Papers/2015/Should%20Cryptocurrencies%20be%20included%20in%20the%20Portfolio%20of%20International%20Reserves%20held%20by%20the%20Central%20Bank%20of%20Barbados.pdf

From the paper:

Given that digital currencies reduce the effectiveness of monetary policy at the country level, Plassaras (2013) argues for greater international cooperation through the International Monetary Fund (IMF). The author notes that typically central banks hold reserves to counter speculative attacks against the currency. They can also raise interest rates or intervene in the currency market. If the central bank runs out of reserves, it can draw down on its quota’s at the IMF. However, if wealthy Bitcoin investors launch a speculative attack on a currency there is relatively little that can be done at present as neither the central bank nor the IMF hold Bitcoin. Plassaras (2013) therefore argues that the Fund could either attempt to excise indirect control of the currency or it could offer the digital currency quasi-membership status. Such approaches will need to be further discussed as there are governance issues that would need to be addressed, however, given the growth of Bitcoin, there is a clear need to be prepared for potential speculative attacks and incorporate this means of payment better into the financial system.

Speculative attacks happen when the market sentiment turns massively against a given fiat currency in extreme ways. Ordinary market participants, which include members of the general public trying to protect their life savings, then seek to unload the failing currency as quickly as possible. This results in additional and accelerated currency devaluation (i.e, massive inflation). That then leads to additional panic and selling pressure which then creates further declines. Because there are no "fundamentals" backing the value of fiat currencies, this vicious cycle may persist until the currency goes to zero or a central bank successfully intervenes.

Things get extremely difficult for central banks when wealthy foreign speculators, smelling blood, recognize an opportunity to make massive profits by shorting the failing currency. These speculators may then begin to borrow massive quantities of the currency under attack, sell the borrowed currency units en masse (thus driving down the price further), and use the proceeds to purchase a stronger and more stable "holding" currency (say the US Dollar or the Japanese Yen) or, ideally, a currency (like bitcoin) that has great appreciation potential. By investing the proceeds in an appreciating currency like bitcoin, speculators potentially compound their gains, making money both from the depreciation of the currency under attack and also potential appreciation of the funding currency. Once the attacked currency has mostly or completely collapsed, the speculators close their position (purchase the now largely worthless currency and repay the loans) thereby reaping massive profits.

Normally relatively stable currencies (rather than volatile assets like bitcoin) are used to fund speculative attacks. However, the upside of using a volatile currency like bitcoin to fund an attack is potentially extreme while the downside is perhaps limited. Despite its volatility, the multi-year trend in bitcoin prices is undeniably up. Way up. To the extent that a volatile funding currency like bitcoin may decrease in value over the short term against some benchmark currency (say that US dollar) on its way to new highs, those decreases could potentially be completely (or perhaps more than completely) offset by deprecation in the currency under attack against the same benchmark. Hence, if everything goes as planned, speculators earn massively enhanced profits when the currency under attack depreciates against the benchmark while bitcoin appreciates against it at the same time, but only make a little, or perhaps break even, when both the currency under attack and bitcoin decline against the benchmark at the same time.

Central banks typically fight off speculative attacks by raising interest rates. Higher interest rates make continuing the speculative attack more costly and difficult for two reasons. First, higher rates give savers and investors a reason to hold or perhaps even acquire (rather than sell) the attacked currency, thereby supporting its value. By retaining or acquiring the currency, they can earn above-market interest rates. Second, raising rates makes borrowing in that currency (an essential element of any speculative attack) far more costly. Speculators are forced by pay extraordinarily high rates. The attack is successfully thwarted if and when interest paid by speculators to borrow exceeds the returned earned by virtue of depreciation of the attacked currency plus any appreciation of the funding currency.

However, raising rates comes at a steep price to the central bank, namely slower economic growth. Raising rates to extreme levels risks economic collapse (since ordinary investors and consumers can't afford to borrow to finance growth and even servicing existing debt can become prohibitively expensive). And yet, given the annualized historical returns on bitcoin (which could well be sustained or even accelerate into the future should bitcoin come to be used as a favored funding currency for speculative attack), fending off a speculative attack funded with bitcoin could require raising rates to truly unconscionable levels.

However, owning bitcoin before a speculative attack could give central banks much stronger protection. Namely, owing bitcoin reserves gives them another way of fighting off the attack without having to raise rates to unconsciounable levels. By using bitcoin to fund the speculative attack, speculators would likely drive up the value of bitcoin, including the bitcoin owned by the central bank. The bank could then begin to sell some of its bitcoin reserves in the open market in exchange for the currency under attack. Provided that the central bank's bitcoin reserves were sufficiently large at the outset, it's dumping of bitcoin and purchase of the attached currency could offset the purchase of bitcoin and dumping of the attached currency by speculators, thereby upholding the value of the currency under attack. At that point it becomes a game of "chicken"--who is willing to spend down their reserves the most and the most quickly in order to "defeat" the other, speculators or the central bank?

Worldwide speculators have sufficient reserves to dwarf those of small central banks like the Central Bank of Barbados. Consequently, were its currency to come under attack, the Central Bank of Barbados would certainly lose. By acquiring bitcoin now, it would not make itself bulletproof, but it would make itself a far less attractive target for speculators than another similarly -situated central bank that lacked the foresight to acquire bitcoin early. When being chased by a bear, it's not necessary to outrun the animal, just the slowest human.

Before too long central banks, beginning with some of the weakest, will have no choice but to start acquiring and holding bitcoin. Those that don't will see their currencies fall one after the other under bitcoin-fueled speculative attacks. None will be will want to be perceived as the weakest and most vulnerable, and this could lead to a bitcoin "arms race".

Until the last few months, the money supply and liquidity of bitcoin have been insufficient for it to be used effectively in speculative attacks, but that has now changed. Assuming that bitcoin continues on its upward trajectory, I suspect that we will start to see very sucessful speculative attacks no later than 2018.

And then the world will change.