Some say: “Central banks will start buying #bitcoin as international reserves and that’ll make price go up”.

Totally false.

Governments can’t use bitcoin as reserve asset, at least not now. But they could do something else instead 👇

BITCOIN IS NOT QUALIFIED AS RESERVE ASSET

Let’s be clear what international reserves are for. They are assets a country uses to:

1) pay for imports & debt,

2) buy and sell in forex market to affect exchange rate,

3) defend their currency in case of a run or attack.

So to qualify as a reserve asset, the thing needs to be liquid. Cuz when your house’s on fire, you need to sell the asset at a moment’s notice to put out the fire (Is that why they call it liquidity💦? 🤔)

Bitcoin daily transaction volume globally, both spot & futures, is less than $10 billion. That’s a far cry from the volumes of typical reserve assets like US treasures and gold.

(BTW, many crypto changes report fake volumes. If you want to dig in on details, here’s a report from Bitwise. Feel free to go crazy with it.)

A central bank like Brazil’s may sell $1 billion forex before lunch time and call it a light day. They need to intervene even more when things are chaotic. No bitcoin market can handle that kind of volume right now without the seller getting totally rekted.

Not to mention the extreme price volatility. Imagine any country losing 50% of their foreign reserves in the past three months.

Bottomline— Bitcoin as a reserve asset? No.

SO WHY MAY GOVERNMENTS WANT BITCOIN AT ALL?

The biggest reason would be to serve as a hedge against the current international reserve system.

Central banks are getting zero to negative returns on their US treasuries. The return prospect will get worse as the US becomes even more indebted.

The USD is the dominant reserve currency. This will not change by tomorrow. But the world will shift to another reserve/payment system sometime down the road. No question about it.

Although bitcoin cannot fill the shoes of USD, you can make the argument that it may be part of a new system, whatever shape it ends up taking.

So bitcoin can be thought of as hedging against current system, especially for smaller countries. But the cons are glaringly obvious. It’s a volatile, illiquid asset. It’s new. There’s still none-zero probability that it may go to zero.

For countries that have special purpose government funds, a.k.a. sovereign wealth funds, they would at least look at the thing and weigh the pros and cons. But these funds are not day traders. Capital preservation comes first. High volatility is not appealing.

HOW WOULD GOVERNMENTS GET THEIR BITCOIN?

Say a government is interested in bitcoin, would it make sense for them to buy at market price? Probably not. Price is, again, volatile. They are not in the business of timing the market. The potential gain of hedging the future does not outweigh the price risk.

The more practical way for governments to get their hands on some bitcoins is to mine it themselves, that is, if the country’s electricity cost is cheap enough to do so.

Recent data puts the the average cost to mine 1 bitcoin at $19,404 if electricity costs $5.5 cents/kWh, and $15,238 if electricity is at $3.5 cents/kWh. So if you can mine bitcoins at those cost levels, it gives you 50-60% margin of safety at current price level.

If electricity cost is higher than $6 cents, it may not be worthwhile. That limits the feasible list to about 2 dozen countries in the world.

Obviously, even if you have cheap electricity, there’s the opportunity cost. Can the government use their electricity for something else more profitable, for example, sell it to their aluminum companies?

The answer, at least for most of those two dozen countries, is no. If they have many profitable investment opportunities to apply their electricity, they wouldn’t still be a developing nation.

A few countries on the above chart are moving in this direction, or at least considering attracting private miners and taxing them heavily. I’m surprised they haven’t done it sooner.

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WHAT WOULD COUNTRIES DO WITH THEIR BITCOINS?

On the CB balance sheet, it would be part of “other foreign assets” owned by the central government or its sovereign wealth fund. But the more practical question is should they sell their bitcoins or hodl it?

Governments are strapped for cash after Covid, so the temptation for immediate selling is high. Though it goes against the motive of bitcoin as a hedge for the future in the first place.

Adding to that, the bitcoins you mine is essentially a rent on the country’s natural resources, i.e. renewable energy. It’s a windfall income no different than if you suddenly discover an oil field or a gold deposit on your land.

So all the good lessons for managing incomes from natural resources apply.

There is a wall of research documenting that countries with sudden riches from natural resources are the worst managed in the world. It’s just like the folks who won lotteries but unprepared to deal with it. They get destroyed by the money, not helped.

It’s smart to learn from the Norwegians, who largely managed to sidestep the trap set by their oil riches.

Basically, you save the money made from natural resources, invest them abroad (so it doesn’t mess with your domestic wages), earn yields from your investments, use the earnings to subsidize your living expense (ie government budget). But you never touch your principals!

The bottomline is as a government, you don’t want to go out and spend the bitcoins you mined immediately. You want to call an institutional broker to lend out your bitcoins and earn an interest, or sell them to invest in other things.

TLDR: Will governments acquire bitcoins?

  • as international reserves, no.
  • as a strategic asset for hedging, it depends.
  • they should mine it, not buy from market
  • the former is only feasible for countries w/ cheap electricity
  • the mining revenue should be saved & invested, not spent

 

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