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Consolidating sub-baskets in a Bitcoin context:

& 6)

Regression 6: Inverse of sustainable development

5. Discussion:

5.1 Consolidating sub-baskets in a Bitcoin context:

The optimisation in this paper involved finding the optimal regulatory balance between achieving the regulators’ policy goals, and mitigating the risks of Bitcoin without stifling innovation. In order to achieve this, the evaluation process was separated into two parts. It has been noted previously in this paper that a lack of existing regulation for Bitcoin meant that it was not possible to quantitatively evaluate the direct interactions between Bitcoin and specific regulations. This was mitigated in the above 4.1-4.4 sections by instead first

evaluating the impacts of the different regulations on the policy goals of regulators, the measurements of which were taken from existing assets in the use-cases under consideration.

This was done in order to first determine what the regulations’ expected effects were on the policy goals of regulators to ensure first and foremost that recommended regulations would not have a detrimental effect on the existing policy goals of regulators. Following this quantitative evaluation, it is also necessary to consider each of the significant regulations in the context of their interactions with each other and, most importantly, bitcoin itself.

In the following section, these potential interactions will be explored in a qualitative manner, allowing for the consolidation of the sub-baskets of regulation into a single unified approach, under which the regulators implement the regulations that they have contributed from their own sub-basket.

Reserve requirements

The first significant and desirable regulation served as a proxy for reserve requirements. This regulation was measured as the reserves to asset ratio of central banks by country. Under the modern fractional reserve banking system, “banks hold minimum reserves of cash or highly liquid assets equal to a fixed percentage of their deposit liabilities” (A Dictionary of

Economics, 2009). The exact reserve requirements vary over time, making it challenging to gain accurate figures. As banks make profit by lending out these cash deposits, there is a direct incentive for banks to hold as close to the minimum reserve requirement as possible.

By using the real reserve to asset ratio of banks, defined by the World Bank as “the ratio of domestic currency holdings and deposits with the monetary authorities to claims on other governments, nonfinancial public enterprises, the private sector, and other banking

institutions” (World Bank, 2020b), it is possible to approximate the reserve requirement over time. Considering Bitcoin’s potential use as a reserve currency, reserve requirements on Bitcoin would require central banks to hold a fixed amount of Bitcoin amongst their reserves.

This would function as a hedge against depreciation of the value of the country’s other reserves, allowing for more consistent pricing of inter-country transactions. Furthermore, the diminishing rate of Bitcoin minting towards 0, in conjunction with its decentralised

immutable nature provides security for countries who would typically hold the majority of their reserves in inflation-prone currencies such as the US dollar. This explicit regulation, a minimum reserve requirement, would ensure that reserves remain balanced between

countries, with sufficient liquidity always maintained to settle international transactions.

Unlike traditional reserves, Bitcoin takes up virtually no physical storage space. Whilst governments do not publish information on the cost of storing their physical reserves, considering only the physical space required to store existing reserves it is clear that Bitcoin is far cheaper. Whilst a Bitcoin reserve requirement does not directly solve the disadvantages posed by Bitcoin in its use as a reserve currency, namely its cyclically volatile price, the reserve requirement regulation was found to be jointly significant with a second regulation, Countercyclical capital buffers. This regulation and the observed interaction effect will be discussed further in the section below.

Outside of the potential interaction within the use-case for which the reserve requirement regulation was found to be significant, it is also necessary to consider how this regulation may interact with the other use-cases of Bitcoin. Whilst a reserve requirement regulation was not found to be significant in the regression on use-case 2, where Bitcoin is used as a means of day-to-day exchange, it is still necessary to consider what the effect of a reserve

requirement for Bitcoin would have, if any, on its use as a day-to-day currency. Central banks use reserve requirements as a means of controlling the money supply. This however does not work for Bitcoin, as the digital nature of it means that decreasing the circulating money supply in a geographic region is not possible. With the rising price of Bitcoin, it would also not be financially feasible for a single country to attempt to manipulate the price of Bitcoin on a wider scale, under the assumption that multiple countries would be holding Bitcoin as a form of reserve currency. The only effect on Bitcoin’s use as a means of day-to-day exchange that could occur is for the price per Bitcoin to increase, requiring smaller fractions of Bitcoin be used per transaction, this however is not a significant impact and does not require further consideration.

A reserve requirement is also unlikely to have an effect on Bitcoin’s use as an investment outside of the aforementioned potential for price increases resulting from higher demand as countries purchase Bitcoin to hold as reserves. There is therefore no concern that reserve requirements could negatively impact Bitcoin’s use as an investment or store of value.

The desirable effects of a reserve requirement regulation for Bitcoin, demonstrated both quantitatively and qualitatively suggest that it should be included in the optimised basket of regulation.

Countercyclical capital buffer

The countercyclical capital buffer regulation requires banks to increase their holdings of specific assets when they are experiencing price decline, in order to ensure that the value of assets held in reserve do not fall too far. This regulation was found to increase the liquidity of reserves, meaning that banks held a higher portion of deposits in reserve following the

implementation of this regulation, which should increase stability, and limit risk of

insufficient funds for transaction settlement. The countercyclical capital buffer regulation had an undesirable effect on policy goal 2 of use-case 1 however, decreasing the return on

reserves. Whilst the undesirable effect on policy goal 2 implies that the regulation should not be considered for application to Bitcoin, the fact that it had a desirable effect on policy goal 1, with a jointly desirable effect with the other significant regulation from policy goal 1, reserve requirements, led to its inclusion in the sub-basket for consideration regardless. The interaction effect observed makes logical sense, as reserve requirements should not

necessarily be fixed regardless of external factors. Indeed, Bitcoin’s price has been observed to follow a cyclical pattern surrounding a ‘halving’ cycle related to the reward paid to Bitcoin miners for solving computing algorithms (Cryptocurrency Series: Halving Cycles, 2021). It is possible that implementing a countercyclical capital buffer for Bitcoin in its use as a reserve currency would minimise the price fluctuations observed in the current halving cycles, as governments increase their minimum reserve requirements for Bitcoin around halvings. This jointly desirable effect on liquidity of reserves with the reserve requirement regulation indicates support for an approach wherein a minimum balance of Bitcoin is held as a reserve currency, with this base requirement fluctuating based on the temporal-proximity of the next halving cycle. This would provide greater price stability whilst protecting governments from fluctuations in other currencies held in reserve.

It was noted in section 4.1.2 that, whilst the observed effect of the countercyclical capital buffer on the return on reserves was negative, the model had a very low R-squared value, indicating that it was likely that there were many omitted variables that also influenced the dependent variable. It is possible therefore that the negative effect of the countercyclical capital buffer on the return on reserves is overexaggerated by the model. Further to this, there is merit to the argument that the central bank directly has control over the return on reserves and therefore, whilst return on reserves was indicated by the literature as an important policy goal, it is possible that this is not something that is in reality directly affected by regulation. It is therefore possible that the policy goal was poorly selected.

Outside of the significant effects observed in the regressions, the price stabilising element of the countercyclical capital buffer would extend benefits beyond just central banks dealing in large quantities of Bitcoin. Day-to-day users of Bitcoin as a currency could also see the real value of their Bitcoin stabilise, preventing runaway increases or decreases in the purchasing power of individuals’ currency. This is especially key when considering the long term effects of inflation of money supplies. If Bitcoin were to be used as a daily currency, the

countercyclical capital buffer could further stabilise real Bitcoin values so that, unlike traditional currencies, the purchasing power of a Bitcoin purchased today would be largely the same in 20, 40, or 60 years. This is also an interesting point of note when considering Bitcoin’s potential use as an investment or store of value. Growth investors may not be satisfied by attempts to stabilise the price of Bitcoin, especially based on its historic price growth, however the stability brought by a countercyclical capital buffer could be argued to increase its suitability as a long-term store of wealth.

Based on the above arguments it is clear that a countercyclical capital buffer regulation is appropriate for Bitcoin and can therefore be included in the final optimised basket of regulation.

Capital requirements for equity invested into funds

The third regulation found to be significant for use-case 1 was capital requirements for equity invested in funds. This is very similar to reserve requirements; in the context of Bitcoin this would dictate a minimum required balance of Bitcoin invested into funds be held in reserve.

At present there are very few funds that allow direct investment of Bitcoin, the most prominent being the Grayscale bitcoin trust (GBTC) (Grayscale, 2021). It should be noted however, that such funds focus purely on Bitcoin, with Grayscale themselves indicating that the “investment objective is for the value of its Shares (based on BTC per Share) to reflect the value of Bitcoin held by the Trust, less fees and expenses” (Grayscale, 2021). It is clear therefore that for such funds the goal is to hold as many Bitcoins as possible, so a capital requirement for such a fund would have no purpose. Consequently, this regulation does not fulfil any of the requirements to be considered as contributing towards the optimisation of Bitcoin regulation. On the contrary, it would be entirely unnecessary and therefore should not be implemented in the final optimised basket of regulation.

Market Abuse Directive (MAD)

One of the key disadvantages of Bitcoin is that it is prone to price manipulation by large holders of the cryptocurrency. At present there is no regulation preventing price manipulation or punishing bad actors. This is much needed for Bitcoin, as it has been reported that the price of Bitcoin is widely manipulated (Pickard, 2021). It was mentioned earlier in this paper that Bitcoin’s core programming cannot be changed, consequently regulation must rely on changing how people use Bitcoin. The Market Abuse Directive offers such a solution. MAD outlines “criminal sanctions for abuses including market manipulation, insider dealing and unlawful disclosure of inside information” (Official Journal of the European Union, 2014). If market participants face legal repercussions for price manipulation or other harmful

behaviours, then it is expected that the frequency and severity of such actions would decrease. A direct result of decreased price manipulation is the minimising of price fluctuations. Through this, a MAD-like regulation is expected to also interact with the regulations of reserve requirements and countercyclical capital buffers in a way that further minimises price fluctuations and market volatility. Consequently, a Market Abuse Directive should be included in the final optimised basket of regulation.