BY LIZ FARMER | AUGUST 2018
Berkeley, Calif., has always had an independent streak. It was named after Irish philosopher George Berkeley, who advanced the theory of immaterialism or the belief that material things have no objective existence. Located across the bay from San Francisco, Berkeley has long attracted people and ideas outside of the mainstream. In the 1960s, it was the birthplace of the free speech movement and hippie counterculture. In the 1990s, an advocacy group tried to bring back the bartering system in protest of economic globalization. And in the 2000s, voters overwhelmingly approved the nation’s first-ever soda tax to counteract the damage done by high-sugar drinks.
But now this city known for its out-there policies is taking perhaps its biggest risk yet: Later this year, it plans on becoming the first municipality in the country to issue municipal bonds using the blockchain technology that underpins cryptocurrency. The project is the brainchild of Mayor Jesse Arreguín and Vice Mayor Ben Bartlett and is being billed as a way to make investing in municipal bonds more accessible than ever. That’s because, unlike the minimum $5,000 bond denomination common today, “cryptobonds” can be issued in denominations as low as $5 or $10. The bonds also have the potential to open up a whole new way for the city to raise money for housing. This is an acute issue since the Trump administration has slashed the budget for the U.S. Department of Housing and Urban Development, cut funding for Section 8 housing credits and targeted sanctuary cities such as Berkeley for federal funding cuts.
In the crypto world, issuing a digital currency to raise capital is what’s called an ICO, or initial coin offering. The most well-known digital currency is bitcoin, but new ones are issued all the time. Digital currencies are based on what’s called digital ledger technology, which is often referred to as blockchain and cuts out the need for banks by allowing users to record data and transactions instantaneously in a way that is essentially unhackable. But the independence from a central bank also means the currency isn’t regulated, making its value more volatile than paper money.
Similar to a company’s initial public offering (IPO), an ICO is seen by investors as an investment in a company that might pay dividends and increase in value over time. For the last year or so, ICOs have become increasingly popular with startups. They see it as a way of coming up with money that’s cheaper to raise and faster to access than going after venture capital funding. During the first three months of 2018, ICOs raised $6.3 billion, which already beats the total raised in all of 2017, according to data collected by CoinDesk.
The public sector has taken notice. Earlier this year, Venezuela became the first country to issue its own cryptocurrency, the Petro. The debt-laden nation has struggled to raise capital amid economic sanctions from several countries, including the United States. Venezuela’s oil-backed Petro reportedly raised $5 billion from investors all over the world during a four-week period this past February and March. Estonia, which has wholeheartedly embraced blockchain technology, is also working on its own ICO. And governments from the Japanese village of Nishiawakura to the Louisiana parish of Lafayette are considering following suit.
While it sounds like one of those so-crazy-it-just-might-work ideas, there are a lot of hurdles to overcome, particularly for governments in the U.S. For starters, the municipal bond market isn’t exactly known for its speed or embrace of innovation. It’s a market that’s slow to change, murky on transparency, and populated with institutions and investors that have been around for a long time and like the way things have always been done. Introducing into this old-school world a blockchain-based cryptocurrency technology with its instantaneous transaction speeds might feel a lot like trying to perform complex calculus on an abacus.
Even if that introductory task is accomplished, cryptocurrency has historically been much more volatile than the U.S. dollar. Will the value of Berkeley’s digital currency hold over time? What if there’s investor backlash? “The risk is that you or I buy some and it ends up being worthless,” says San Francisco-based tax attorney Steve Moskowitz. “Then we turn to the issuer and say, ‘You crook, you defrauded me.’ And then the lawsuits start coming in.”
Despite these risks, Berkeley sees plenty of valid reasons to forge ahead.
Berkeley’s first cryptocurrency bond offering will be small. After that, says Vice Mayor Ben Bartlett, “the sky’s the limit.” (Anton Burrell)
Like many cities across the country -- and in the San Francisco Bay Area in particular -- Berkeley has a major affordable housing shortage. Median rents are well over $3,000 a month, and roughly 1,400 people are homeless. That’s a big number for a city that’s just 17 square miles with a population of 120,000. The situation is reaching a breaking point. In February, a fire broke out in a homeless encampment outside the Old City Hall, where the council still holds some meetings, and caused damage to the historic building. The incident forced police and city officials, who had turned a blind eye to the camp partly out of sympathy, to break up the tent city and remove about two dozen people. “It was painful, brutal,” says Bartlett. “We are known for compassion, but we’re also overwhelmed. People were really upset on all sides.”
It was around that time that Bartlett and Arreguín began talking about alternative fundraising with both Neighborly, a municipal finance startup that helps governments issue municipal bonds in small-dollar bundles, and the University of California at Berkeley’s Blockchain Lab, a research center for cryptocurrency technology. The idea to issue municipal bonds using blockchain technology was born. In May, the city council directed staff to evaluate the benefits of a pilot program in which Berkeley would offer municipal debt using blockchain technology.
Berkeley plans to start off small, says Bartlett, and issue enough cryptobonds to pay for, say, a new firetruck. The city will then smooth out the kinks, and after that, he says, “the sky’s the limit.”
Bartlett and others may have been inspired by the need to raise money to build more affordable housing, but the reality is that the technology behind the concept opens up a new world of financing public projects. Instead of selling bonds to underwriters, who resell them to institutional or retail investors, the government would sell the debt directly to citizens, who would essentially crowdfund each project. The small-size concept has been tried before in other cities in the form of so-called “mini bonds” with some success. In recent years, Denver and Cambridge, Mass., have used different bundling techniques to sell small-dollar bonds directly to residents. But the blockchain element takes this idea and ratchets it up. With blockchain technology, all transactions would be recorded on a public digital ledger where traders could buy and sell them directly and avoid brokerage markups or delays. All transactions would be recorded as soon as they are issued so there would be more transparency than is usually available in the traditional muni market.
Getting rid of the cumbersome, middle-man-laden process means that Berkeley could raise money to upgrade a park, add a bike path or any other number of small projects the community is willing to invest in. No longer would Berkeley or any city have to bundle all these projects into one larger bond just to make the cost of going to market feasible. It also has the advantage of keeping residents engaged and invested in their community. Think of it like a muni version of Kickstarter, but with a digital currency. “If this takes off, this is really going to change the way we do business,” says Ksenia Koban, vice president and municipal strategist at the investment firm Payden & Rygel. “There’s no way right now for the average person to invest in the municipal market -- you have to go through a broker or a platform, which is costly.”
And when it comes to risk, Koban believes a government-backed cryptocurrency wouldn’t be subject to the same volatility that something like bitcoin is prey to. “If I were a retail investor,” she says, “I’d look at this and think, ‘Great. Here’s an opportunity for me to be part of my community, to have a direct investment in a project that might even be next door.’”
For governments, the upside is enormous. The costs of issuing and administering bonds run up quite a tab. State and local governments spend a collective $4 billion annually on issuance overhead alone, according to the Haas Institute at UC Berkeley. Blockchain technology cuts down on the need for bond lawyers, financial advisers and standardized documents because the necessary legal information is automatically recorded whenever there’s a transaction. Bartlett says he has already had calls from all over the country and the world, including Austin, London, Miami, Paris and upstate New York. “They’re all facing the same problem: a population bulge and underinvestment in infrastructure expansion,” he says. “It’s a simple math problem we have to answer to, so we have to make up our own math.”
Bartlett’s “own math” unwittingly hits on what is perhaps the biggest hurdle for a project like this. It’s hard to shake the idea that this is all made up. Sure, Berkeley’s digital muni bonds would still work like any other municipal bond by paying out interest to investors in U.S. dollars or, if investors prefer, in Berkeley’s own cryptocurrency. The debt could also be traded in the secondary market. But despite all the hype, most people still don’t have a clue what digital currency really is. Even in a tech-savvy place like Berkeley, finding the right buyers -- locally minded folks who are comfortable with cryptocurrency -- could be a stretch.
Currency that a buyer never touches sounds like something that belongs in the world of George Berkeley’s immaterialism rather than something with real value in this world. Getting past that mental leap is the key to government ICO success. “To the average person [cryptocurrency] is like funny money: Here today, gone tomorrow,” Koban says. “But I trade bonds all day long and no actual paper is exchanged. So how’s that really different?”