In a recent speech, Bank of England deputy governor Ben Broadbent opined that the key innovation underlying Bitcoin is not the unit of account itself but blockchain – the digital settlement ledger in which all transactions are recorded chronologically and publicly. This means that transfers of Bitcoins are verifiably recorded without reliance on any central authority. Blockchain is now a very hot topic. Other Bank of England researchers who were fearful in 2014 that Bitcoin could undermine central banks’ monetary policy tools, now regard blockchain technology as the “first attempt at an Internet of money”.
Central banks are well aware that multiple technology companies have recently been founded, all seeking profit from blockchain-based models of financial asset transaction and ownership record keeping. To the extent any are successful, the relevant existing ledger business will suffer. Central banks could and should welcome the potential “back office” efficiency innovations which these technology companies have been established to deliver. For example, when banks trade syndicated loan contracts with each other, they frequently involve lawyers in negotiating contracts, adopt varying back office processes, and settlement is believed to average almost three weeks. Banks are known to be evaluating the replacement of routine systems with blockchain technology, keenly aware of the cost benefits of replacing staff with technology.
However, the Bank of England appears not content merely to concentrate on these administrative and record keeping uses of blockchain. It seems determined to explore the possibility of designing and implementing a cryptocurrency managed by a public authority such as a central bank. It is easy to understand their motivation. If a central bank wants to reduce interest rates materially below zero per cent, it is widely understood there would have to be severe restrictions, even an outright ban on cash. But is the notion of a central bank issued cryptocurrency realistic?
Working together with a research team at University College in London, the Bank thinks that it has made significant progress. They claim to have designed a cryptocurrency for central banks, which they call RS Coin. Whereas Bitcoin’s ledger is maintained by users all over the world, RS Coin would be maintained only by the Bank of England. A special feature of RS Coin would be that the central bank would control its supply as well as set its interest rate. Mr Broadbent sees the benefits to consumers and businesses in terms of speed and cost of money transfers.
In effect, the Bank of England’s argument is the opposite to that advanced by proponents of Bitcoin and private sector, anonymous competitors. The latter claim that the appeal of Bitcoin is the absence of a government authority, but it is understandable that money holders might in fact be more confident in a cryptocurrency supported by a major central bank than in Bitcoin. For all the criticism heaped on central banks for debasing fiat currencies, euros and pounds sterling are issued by central banks that prepare balance sheets at least showing assets of the central bank that match the liabilities – the currency issued. Bitcoin has no concept of assets matching the currency.
Given the vibrancy of the blockchain industry – it is estimated that over $1 billion of private equity has been invested in start-ups in the past year – it is obviously dangerous to predict winning and losing ideas. However, we suspect that the Bank of England’s new RS Coin appears unlikely to be successfully implemented. The public policy initiatives required to support it will take a very long time and bring the Bank into direct conflict with powerful vested interests. It is estimated that some 10,000 firms manage the existing global payments system. These inside players will fight tooth and nail to keep their positions at the trough. One point frequently overlooked by blockchain enthusiasts is that it is not technology that has limited the progress of efficiencies in digital payments systems. Rather, the wealthy owners of legacy business models flexed their muscles.
Recent news relating to the market for bank hybrid capital instruments - Cocos – provides revealing insights into the confidence of senior bankers.
Contingent Convertible Capital bonds (“Cocos”) are junior ranking debt securities issued by banks that are treated by regulators as capital. The market may have started in 2009, but grew rapidly in 2013 when European regulators, led by the Bank of England, developed the capital rules.
Cocos count as capital because investors expose themselves to the risk of either a) forcible conversion to equity, or b) a writedown of principal, if the bank performs poorly and a “trigger event” occurs. There can be multiple triggers within a single bond, but all triggers fall into two categories: either mechanical – the bank’s ratio of capital to risk-weighted assets falls below a specified threshold; or discretionary – at the discretion of a bank supervisor. If mechanical, the trigger can either be based on book values, or market values, meaning the stock market capitalisation of the bank as a ratio of its assets. Given the concerns we expressed about the integrity of bank accounting numbers in the April Newsletter, it is easy to understand the popularity, among investors, of triggers based on market values.
Naturally, the structural complexity of Cocos has been fertile ground for academic analysis. Papers have been written analysing the incentives of managers and shareholders, and suggesting that rather than a welcome recapitalisation tool, Cocos may prove to be a destabilizing influence on the banking system. These papers have until recently largely been ignored by regulators and senior bankers, but the media have just reported that several senior bankers are now openly speaking out against Cocos. HSBC’s finance director stated in April that the fact that banks are banned in the UK from selling such bonds to retail investors “tells you all you need to know” about them. Several other banks have lobbied the ECB, claiming that these instruments undermine the stability of banks.
There are two arguments suggesting that Cocos are destabilizing. Firstly, market events of February. Markets dived on fears that Deutsche Bank might have difficulty making forthcoming coupon payments on some Coco bonds. The effect of that was to cause the entire market for Cocos to seize; prices of these Deutsche Cocos fell to 77% of face (par) value.
Secondly, the academic argument. Compared with conventional subordinated debt, investors in Cocos are in such a weak position upon the occurrence of a trigger event, that in effect a wealth transfer takes place from Coco investors to shareholders, and possibly managers. Investors in subordinated debt, on the other hand, would hold powerful cards if the bank got into trouble. Cocos can therefore incentivise shareholders and managers to have the bank assume greater reportable leverage at a time when it is already weakened, in order to trigger this wealth transfer.
Although we follow this logic, we seriously question whether, in the real world, managers would try to bring about the triggering of a Coco bond. This academic argument entirely hinges on the bank being turned around after the event has happened, in order for the wealth transfer to be enjoyed by these stakeholders. Of course the turnaround possibility is the very basis of the appeal of these instruments to regulators. However, this argument must be open to doubt given the market reaction to mere rumours about Deutsche Bank in February. It seems to us more likely that the triggering of a Coco would be seen as the first step in a more general bail-in procedure.
So why are senior bankers, and even the ECB, now turning against these instruments? We cannot be certain, but it seems likely that some of the Europe’s biggest banks now feel that conventional equity markets are reopening, and that indeed they have deleveraged and cut costs to such an extent that they are less reliant on Cocos. Clearly, banks only issue these relatively expensive debt securities in order to boost their regulatory capital. The 2013 rules had the effect of disqualifying some of the earliest Cocos from counting as capital. We will follow with interest the efforts of Lloyds Bank to redeem a 2010 issue, which has been disqualified because conversion to equity would only occur when the risk weighted capital ratio falls below 5%, a trigger now deemed too weak to count. Investors dispute Lloyds Bank’s interpretation of the redemption terms, and the case is about to come to the UK courts.