Hedging Sanctions Risk
Hedging Sanctions Risk

Hedging Sanctions Risk

Central banks may shift their international reserve holdings in order to protect themselves ex-ante against the risk of financial sanctions by fiat reserve currency issuers. (Page 1)

This paper explores the potential for Bitcoin to serve as an alternative hedging asset. I describe a dynamic Bayesian copula model to simulate the joint returns of Bitcoin and other reserve assets under a wide range of plausible sanctions probabilities. (Page 1)

If a central bank cannot acquire sufficient physical gold to hedge its sanctions risk, the optimal Bitcoin share rises further, suggesting that gold and Bitcoin are imperfect substitutes. (Page 1)

The global financial sanctions enforced against Russia following its February 2022 invasion of Ukraine are unprecedented in their scope. Never before has an economy the size of Russia’s – the 11th largest in the world – been subjected to such a comprehensive, coordinated sanctions effort. (Page 2)

I adopt a unique econometric approach to modeling cryptocurrency. Rather than assuming that the high realized returns of Bitcoin as of 2022 are likely to persist, I estimate a Bayesian model with an informative prior, whose parameters I choose to reduce the expected compound returns of Bitcoin. (Page 2)

The history of economic sanctions dates back to the blockades of World War I, following which the League of Nations began employing sanctions in support of foreign policy objectives as an alternative to war. (Page 3)

The primary non-fiat reserve asset is gold. Gold reserves under the physical control of a central bank are largely beyond the reach of financial sanctions by third parties. For example, despite facing US financial sanctions, the Central Bank of Venezuela chartered Russian aircraft to sell its gold reserves in Africa. (Page 6)

Since the Great Recession, central banks have steadily added gold to their reserves, as illustrated in Figure 1. In 2020, the gold share of international reserves reached a 20-year high of 14.4%. (Page 6)

Countries that import valuable military equipment from geopolitical rivals of the United States, particularly China and Russia, plausibly face a heightened risk of U.S. sanctions. In 2017, then-President Trump signed the Countering America’s Adversaries Through Sanctions Act, providing for sanctions on entities that transact with the Russian defense sector. (Page 9)

I obtain a sample of central bank gold shares from the World Gold Council. I filter the sample by discarding countries that do not own any gold, or whose TIV military imports from the US, China, and Russia were zero from 2017 to 2021 inclusive, resulting in 81 countries. For each country, I define a measure of political alignment, mil import diff, in Equation (1). The result is a metric ranging from -100 to 100 that indicates the extent of a country’s military-political alignment with the US (100) or rivals of the US (-100). (Page 9)

As of July 2022, Bitcoin and Ether (the second largest cryptocurrency) collectively comprise about 60% of the approximately $1.0 trillion market capitalization of all cryptocurrencies. Since 2018, the prices of Bitcoin and Ether have been highly correlated, as illustrated in Figure 4. A detailed history and technical description of cryptocurrency is beyond the scope of this paper, but Hardle, Harvey, and Reule (2020) and Halaburda et al. (2022) provide an overview. (Page 12)

Decentralized cryptocurrencies are resistant to governmental financial sanctions. A fiat currency issuer can issue sanctions against particular cryptocurrency wallets, rendering it illegal for holders of fiat currency to assist the owners of the sanctioned cryptocurrency wallets with converting their cryptocurrency into fiat currency. (Page 13)

Additionally, sanctioned individuals could participate in ”off-chain” transactions by providing the private keys to their cryptocurrency wallet in exchange for goods, services, or other forms of currency, as discussed in Luckner, Reinhart, and Rogoff (2021). For example, in April 2022, North Korean hackers continued to launder $600 million of Ether stolen during a hack of the video game Axie Infinity, eight days after the US Treasury sanctioned the digital wallet used in the hack. (Page 13)

Under a proof-of-work system, the ability to censor transactions on the blockchain requires achieving ”majority hash power,” meaning that the censor must control at least 51% of the computing power employed by all miners. (Page 14)

Under Ethereum’s proof-of-stake system, the ability to censor transactions on the blockchain requires holding a majority of staked cryptocurrency. A sufficient condition to enforce censorship on the network is the acquisition of a majority of all digital tokens in circulation. (Page 16)

In order to solve portfolio optimization problems including Bitcoin and other reserve assets, I require a means of generating samples from a plausible joint distribution of future returns of those assets. (Page 17)

According to the International Monetary Fund Guidelines for Foreign Exchange Reserve Management (2005), central banks tend to review the performance of their reserves quarterly. Therefore, I simulate quarters of returns (63 trading days) from the statistical model. I assume no leverage and no shorting. (Page 37)

The portfolio optimization process only considers financial characteristics of the reserve assets. Of course, central banks face many other considerations when allocating their portfolios. In particular, central banks may prefer to align their reserve currency composition with the currency composition of their imports, external debts, and the currency peg (if any). (Page 37)

When modeling sanctions, I treat the sanctions probabilities as exogenous relative to the central bank’s decision making. I am unaware of any instance where a central bank’s actions provided the primary impetus for a third party to freeze the central bank’s reserves. (Page 38)

The results show that an investor will blend an increasing share of a safe asset (Treasuries) with a set of risky assets (stocks and cryptocurrency) as the investor becomes more risk-averse. (Page 40)

Notably, the most risk-averse investor will diversify across all five assets, gold becomes far more attractive, Euro bonds are more appealing than US Treasuries due to their lower sanctions risk, and the optimal Bitcoin share rises to about 5%. (Page 41)

Therefore, I repeat the portfolio optimization varying only the Bitcoin share, assuming that the rest of the portfolio consists of 12% gold, 51% US Treasuries, 17% Euro bonds, and 20% world stock. (Page 42)

To explore the extent to which gold and Bitcoin are substitutes as hedges against sanctions risk, I vary both the gold and Bitcoin share, assuming that the rest of the portfolio is allocated 58% to Treasuries, 19% to Euro bonds, and 23% to world stock (approximate global averages). (Page 44)

Indeed, in the presence of sanctions, there is no totally safe asset. Cryptocurrencies offer some protection against sanctions, but introduce the risk of high price volatility. The price of gold is also more volatile than that of Treasuries or Euro bonds. Although holding physical gold also provides protection against sanctions, gold is less liquid than fiat assets, and assuming physical custody of gold entails significantlogistical and security costs. (Page 47)