- U.S. public finance issuers are showing an increasing interest in blockchain and cryptocurrency (crypto) as a new investment tool to enhance portfolio diversification, earn higher returns, and provide more efficient operations to control costs.
- Analogous to a retail consumer using a debit card for ease of electronic transfer, this technology and related innovations could aid some U.S. government entities but also introduces cybersecurity risks.
- A portfolio that includes cryptocurrency contains liquidity risk due to the high volatility of cash-out value and could affect creditworthiness because of reduced budgetary stability.
- ESG considerations include the environmental impact of high energy costs associated with blockchain operations, regulation, potential government interference, the escalated impact of possible cyber attacks, transparency, and whether companies involved in blockchain and crypto are promoting social welfare or merely seeking pecuniary benefit.
Municipal governments and other U.S. public finance (USPF) issuers are showing recent interest in investing more in alternative asset classes as traditional fixed-income investments realize low returns because of historically low interest rates. These investment classes, which are higher risk but also offer higher potential reward, have long included private equity, among other unconventional investments, but now may include cryptocurrency (crypto) and other blockchain-related activities. In addition to holding the crypto token itself, USPF issuers have considered investing a small but increasing allocation to blockchain technology companies active in the creation and promotion of cryptocurrencies that have had volatile performance but, in some cases, positive market return. In S&P Global Ratings' view, favorable investment performance in 2020 (and continuing into the current year) has helped ease pension and investment strain for municipal issuers that have included crypto in their portfolios as they recover from the COVID-19 pandemic. Over the 12 months ended Sept. 8, 2021, cryptocurrencies such as Bitcoin and Ethereum have had returns of 367% and 918%, respectively, making them an investment option that USPF issuers might find hard to ignore despite the high volatility.
With these hyper-returns comes extreme volatility risk, as evidenced in 2018 when Bitcoin and Ethereum returned negative 75% and negative 83%, respectively, for the calendar year, and a more recent pullback from all-time highs. For those issuers with higher risk tolerances, investing in blockchain technology and crypto can have clear credit risk implications, but crypto adds more to the credit story than just being simply an investment.
Crypto Has The Potential To Be More Than An Investment Strategy: It Could Offer Operating Cost Savings
Governments and other public finance issuers are showing increased interest in using cryptocurrencies as part of a continued digitalization of markets, but widespread use is likely many years away, at best. Crypto's benefits include not just use as an investment tool but also for payments due to the ease of electronic transfer (direct digital exchange) and possibly lower fees compared with current intermediaries.
Developments at the U.S. federal level have direct impact within states, local governments, and public enterprises. On June 15, 2021, the U.S. House of Committee on Financial Services held a hearing entitled "Digitizing the Dollar: Investigating the Technological Infrastructure, Privacy and Financial Inclusion Implications of Central Bank Digital Currencies." In 2020, the Federal Reserve System announced its Project Hamilton--a multiyear collaboration between the Federal Reserve Bank of Boston and the Massachusetts Institute of Technology (MIT) to code and test new technologies that could support the speed, security, privacy, and resilience required of a hypothetical central bank digital currency. Similarly, on July 27, 2021, the U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing on "Cryptocurrencies: What are they good for?"
Many states, including New York, Texas, Ohio, and Wyoming, have begun to create a legal framework that defines cryptocurrencies and how businesses within a state can use them; some states have even passed legislation. Ohio residents may now pay taxes with Bitcoin. Not surprisingly, legislative and operational acceptance varies given the relative novelty of the field and in some ways mirrors how states initially approached the taxation of internet sales. As the industry further develops, creating a more competitive landscape, states could compete for crypto-mining operations, financial services, and even depository institutions, resulting in the need for legislation and/or regulation. While not yet a typically significant credit factor due to limited digital asset adoption, economic growth from crypto operations could provide additional property tax value while unstable cryptocurrency prices could add volatility to the local economy and potentially to tax revenues.
Income for local governments comes predominantly from property taxes and sales taxes. If collection delays and operational transfer and payment risks can be reduced through a crypto payment structure, or if a stressed tax base can save some money, we might view implementation of crypto payments positively. However, with ESG factors in mind, if the structure lacks cyber protections and is untested, we could view the risks as outweighing the benefits in the near term. Typically, Bitcoin is converted to a dollar amount during a transaction, with a third-party intermediary handling the risks of coin transfer and exchange for a fee. It's not clear, at present, if third-party intermediaries will be needed in the long term. The following municipalities are small sample of those involved with crypto:
- Williston, N.D.: The city accepts crypto payments for utility bills and anticipates accepting crypto for other governmental license fees soon. Williston is expected to adopt more uses over time, due to the ease of electronic transfer, convenience, and potential cost savings.
- Jackson, Tenn.: The city's mayor has assigned a blockchain task force to study Bitcoin property tax payments as well as for payment of employee salaries.
- Miami and Miami-Dade County, Fla.: As part of a push to portray the area as "crypto-friendly," the city and county are studying crypto payments for taxes and fees, which could provide fee savings to constituents, as well for payment of employee salaries.
- New York State: Various local governments in New York State are banning Bitcoin mining because of environmental and utility demand concerns, and state senators proposed a state ban on mining from carbon-based fuel sources earlier this year.
Colleges and universities
Several well-known colleges and universities, including MIT, Stanford University, and the University of Notre Dame, have been involved in active research and also offer courses pertaining to blockchain and crypto currency development bringing together resources from their computer science, engineering, economics and finance, and law faculties to collaborate. We understand some online colleges and universities are accepting crypto for tuition payments, eliminating the typical 2%-3% discount fees such institutions have to absorb when tuition is paid by credit card. Another area where crypto has recently surfaced in higher education is in fundraising. Several donors have approached higher ed institutions with gifts of Bitcoin, Ethereum, and other cryptocurrencies. Colleges and universities have moved quickly to build infrastructure necessary to accept virtual currency or to contract with companies that can process the donations for them. Two universities involved with cryptocurrency at present are:
- California Intercontinental University: A 100% online university that accepts tuition payments made with crypto.
- The University of Pennsylvania: The university received an anonymous gift of $5 million in the form of Bitcoin--reportedly the largest cryptocurrency gift the university has ever received. A third-party intermediary helped the university process the donation through liquidation and transferring the cash back to the university.
Dispelling The Crypto Mystique
To understand crypto, it's important to look at how these digital currencies compare to the U.S. dollar regarding financial transactions. For transactions using the U.S. dollar, a bank is a central transaction authority (intermediary) and performs multiple services including preventing fraud and fending off other malicious attacks. The bank assures that the promise of payment is fulfilled and provides insurance, if needed, to maintain consumer confidence. Decentralized crypto transactions run autonomously through a codified blockchain. For more on what a blockchain is and how it might be viewed by public finance, see, " Blockchain Is Coming To Muniland, And The Changes Could Be Significant," published July 30, 2018, on RatingsDirect. While this concept seems odd at first, a simplified look at crypto transactions from the user's point of view might not appear much different than debit card transactions.
Crypto as a concept exchanges the security and familiarity provided by banks, or other intermediaries, for added privacy, control, and potential capital efficiency, but requires inventive new consensus methods (such as the initiate and affirm steps in the above graphic) to guard against cyber risks. Credit effects of crypto ownership are tied to multiple layers of cyber defense: for example, operational controls, financial security, and reputational risk. Risks can, however, be mitigated through policies and intermediaries. There are many methods coming into existence in this new technological space, but the ones most broadly uses and discussed are Proof of Work and Proof of Stake.
A High-Level Look At Consensus Methods For Transaction Verification
Proof of Work
- Concept: Block-creators, called miners, use very high processing power and energy to solve time-consuming calculations. Authenticators, called nodes, check the calculation.
- Attack: Requires 51% of the network's mining processing power for a successful attack.
- Risk: Increasingly limited as networks grow larger.
- Use case: Bitcoin is the largest crypto using this method.
- ESG: A lot of energy is required, and this might have a negative environmental impact.
Proof of Stake
- Concept: People lock up (stake) crypto funds in the network and are selected by an algorithm in the code to be either block-creator (profitable) or authenticator (not profitable), with the likelihood of profit increasing in parallel with the amount of funds staked.
- Attack: Requires 51% of the staked currency supply for a successful attack.
- Risk: Limited, given that attackers are unlikely to profit because staked funds deteriorate in value. Also, punishment for attempted attacks of forfeited funds could be built into the code.
- Use case: Ethereum is the largest cryptocurrency discussing utilization of this method, although it has not yet implemented it.
- ESG: Minimal environmental impact compared with Proof of Work, or even compared with the current financial industry.
Methods Municipal Issuers Use To Invest In Cryptocurrency
For USPF issuers looking to invest in cryptocurrencies there are several ways, each with its own associated risk profile and cost. To help monitor price movements within the sector, there are a growing number of tools to help investors, including the new S&P crypto indices (S&P Bitcoin Index, S&P Ethereum Index, and an index that combines the two). However, a key drawback in crypto investing at present relates to the paucity of accounting standards and the treatment of crypto, in many cases, as an indefinite-lived intangible asset with impairment charges necessary when valuations fall below cost, but gains are not recognized until there is an asset sale. Below are various investment methods S&P Global Ratings is observing.
Owning cryptocurrency equates to holding custody of a confidential account number, or "private key," that has complete control over these funds. Returns are achieved through comparative growth against the dollar, along with additional rewards depending on the currency and the associated underlying fundamentals. Exposure to operational and cyber risks are extremely high because any lapse in security could lead to funds being stolen with no recourse. If the private key is lost, so is the money, and there is no intermediary to help absorb the loss. From a credit perspective, increased exposure to direct crypto ownership might be viewed negatively if cyber protections are viewed as lagging behind the industry standard. Investment managers act as custodians who will directly own cryptocurrencies and use them to back their own managed funds.
A directly purchased Proof of Stake currency provides a yield in exchange for locking up funds in the network. Liquidity risk could be present as staked funds might not be easily "un-staked" depending on the network and currency. There are additional cyber risks, beyond theft, of costly penalties being incurred during disruption as staked funds might be slashed and/or rewards reduced if the verifying block-creator associated with the staked funds is not operating correctly. This is a very new concept but eventually could be viewed, from a risk perspective, as similar to bonds.
Custodians offer an alternative investment option that provides security against operational and cyber risks in exchange for a fee and acceptance of a central point of trust. In this new and volatile space, there is little to no consensus on future crypto price expectation, much less volatility, which complicates risk analysis within an entity's target asset portfolio.
Managed funds can include the following:
- State pensions: For the first time in the state, New Jersey's Common Pension Fund D, supporting the large statewide pension plans, invested a small percentage of its portfolio in blockchain and digital holdings companies, indicating a not-uncommon expectation of market growth for the sector.
- Local governments: In late 2018, two pension funds in the city of Fairfax, Va., began investing in blockchain technology and Bitcoin and continue to increase their allocations. These are generally considered the first investments in the crypto asset from a U.S. pension fund. Investments are made through private equity-type funds, considered similar to venture capital funds due to volatility and lack of liquidity. There is no plan in place at present for direct cryptocurrency ownership.
- Higher ed: A few colleges and universities and not-for-profit foundations with large endowment funds may have added cryptocurrency to their portfolios although not in any significant amount. Chief investment officers at most colleges and universities guard investment strategies closely and generally don't publicize any specific investment of a portfolio. We understand some endowment funds may have added blockchain-related technology companies or digital assets to their portfolios by buying Bitcoin through cryptocurrency exchanges.
- Insurance: Massachusetts Mutual Life Insurance Co. has sought exposure, buying $100 million worth of Bitcoin in December 2020.
The Crypto Industry Could Be An Attractive Job Market
Not that long ago, cryptocurrencies were widely believed to be a bubble lacking any intrinsic value, commonly thought comparable to a pyramid scheme or the Dutch tulip bulb market bubble of 1637. Now some public finance issuers are angling to be known as "crypto-friendly" to attract jobs in this newly developing sector, while others see it as an investment opportunity. Still others have taken the opposite approach and view the crypto industry as a risk, banning or restricting mining activities. Plattsburg, N.Y., has noted that one of the largest bitcoin operators in the world is located within the city, yet the operations have generated only a handful of jobs. As use cases for crypto increase, not only for crypto's use a currency, but in expanding new fields such as decentralized finance (DeFi), non-fungible tokens (NFTs), and internet of things (IoT) connectivity, it's becoming increasingly apparent that crypto, and the digitalization of markets, is a burgeoning new industry that has the potential to help expand state and local operations as well as economies.
- Digitalization Of Markets: Framing The Emerging Ecosystem, Sept. 16, 2021
- ESG Brief: Cyber Risk Management In U.S. Public Finance, June 28, 2021
- How Artificial Intelligence Technologies Are Changing U.S. Public Finance, June 11, 2020
- Blockchain Is Coming To Muniland, And The Changes Could Be Significant, July 30, 2018
This report does not constitute a rating action.
|Primary Credit Analysts:||Todd D Kanaster, ASA, FCA, MAAA, Centennial + 1 (303) 721 4490;|
|Ken W Rodgers, New York + 1 (212) 438 2087;|
|Geoffrey E Buswick, Boston + 1 (617) 530 8311;|
|Secondary Contact:||Alex Louie, Centennial + 1 (303) 721 4559;|
|Research Contributor:||Vikram Sawant, CRISIL Global Analytical Center, an S&P Global Ratings affiliate, Mumbai|
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