Over the last few decades, little has changed in respect to the dominance of the leading fiat currencies, with the Chinese Renminbi, US Dollar and Euro forming the podium in descending order of trading magnitude. Combined, they make up approximately just over half of global currency market capitalization with the top 5 currencies, which include Pound Sterling and Japanese Yen, forming approximately two-thirds of global trade. Not all fiat currencies are heavily traded, as Figure 1 below highlights, so there is a distinction between market capitalization and trading volume.
The traditional definition of currency focuses on a universally recognized store of value, which is traded between buyers and sellers on the foreign exchange market.
The rapid emergence of cryptocurrencies has certainly been accompanied by disruptive intent, but relatively little is understood about many of them and how they may end up being adopted by corporate and government entities. Governments can no longer continue to ignore these as well-established brands and governments are now recognizing cryptocurrencies as a form of payment for their products and services, with Bitcoin and Ethereum being the largest and second-largest respectively. Regulation is slowly creeping in to address how trading and accounting should work.
However, one can easily be forgiven for not recalling a lesser-recognized form of currency, the loyalty point, which has been with us for more than four decades.
Perhaps not viewed in the same manner as the basket of traditional fiat currencies, the loyalty program point is arguably the sixth most heavily traded currency in the world, ignoring cryptocurrencies. Underpinning the economic framework of many global organizations, these loyalty points and miles are very much front and centre of the trading relationship between customer and supplier.
Figure 1: Global Traded Currencies
* Various selected sources
Bitcoin has a market capitalization of nearly USD$690 Billion, based on just over 18.7 million Bitcoins in circulation and a market value of approximately USD$36,800 per Bitcoin as of May 31st 2021.
History of Loyalty Programs
The main industry sectors that rely heavily on loyalty programs include hospitality, aviation, consumer credit cards and retail including supermarkets. The hotel, timeshare and airline sectors are dominant areas for loyalty point programs, with airline miles being treated as loyalty points for the purpose of this paper.
Historically, timeshare ownership programs were mainly based on weeks, so owners would buy into a specific week of the year for say a 2-bedroom unit in a specific territory. However, in recent years there has been a definite shift towards a points-based system with a single unit of currency exchange between cash and points. Points can then be exchanged for accommodation, a cruise or other experience depending on the program benefits.
Over time, issuing programs have managed to convert ownership programs across numerous heterogeneous platforms and geographies into a single homogenous point program. Marriott’s Vacation Club program is a fine example of this, where owners can use their Vacation Club points to purchase accommodation, cruises, adventure, and culinary experiences. Points can even be used with airline partners to purchase mileage points.
In the case of Marriott, the hotel and timeshare programs run independently, with Marriott Bonvoy points being used for hotels and Marriott Vacation Club points being used for the timeshare program.
American Airlines, which is not only the largest airline group in the world, has the most established loyalty program, called AAdvantage, which was launched in 1981.
Size of the Market
If one sums up the value of points in circulation across every airline, credit card company, hotel and timeshare group, retail company, the value of outstanding liabilities is likely to be in the hundreds of billions of US dollars.
American Airlines is the largest airline group in the world and as of the 31st of March 2020, it held a liability in its balance sheet of approximately $USD9.2 Billion in recognition of the outstanding miles in circulation. To highlight the significance of this liability, it compares with a corresponding market valuation of American Airlines of approximately USD$7.8 Billion on the same date.
Marriott International’s Bonvoy program is the world’s largest hotel loyalty program offering Bonvoy points for use across its hotels. The company held a USD$6.27 Billion liability for its loyalty program in its Balance Sheet as of December 31st, 2020.
Accounting Approach
Whilst loyalty points have a lot in common with most other currencies, there is one significant difference and that is the way in which points are accounted for.
Points are issued by the company to its customers in recognition of goods and services purchased, or as some form of loyalty reward. When these points are awarded to the customer, the issuing company sets up liability in its balance sheet to reflect a future potential claim for its products or services.
When a customer redeems the points for a hotel room or flight, the issuing company treats the reduction in total points as revenue in its financial statements. This reflects a reduction in the number of points in circulation which has a positive impact on the income statement.
In the case of hospitality, the hotel company, e.g. Marriott, is often not the owner of the hotel property, so payment must be made to the hotel property owner for use of a room on points. This fee typically varies by seasonal demand cycle as well as other drivers such as the type of room booked.
The hotel company sets aside a nominal monetary fee based on the total number of points outstanding at any accounting date. Marriott International’s Bonvoy program is the world’s largest hotel loyalty program, holding a USD$6.27 Billion liability for its loyalty program, as of 31 December 2020.
Currency Valuation and Arbitrage
It is not so clear as to how each company has valued their own respective liability, but it is assumed that these would follow prescribed accounting guidelines and be subject to external audit.
It is not certain to the company in advance, how their customers will choose to use their points. For example, what season of the year or type of cabin or room class will be purchased with points? There is likely to be a different monetary cost incurred by the company for multiple scenarios of usage for a given number of points.
With most leading Fiat currencies, it is accepted that there is an objective value placed on that currency with reference to another, e.g. USD/GBP exchange rate on a particular day. However, with loyalty points, there is less clarity on what the value of the point is to both the issuer and the holder. The utility of a point to the holder may vary from person to person, based on different utilization patterns and redemption rules.
The cash equivalent of using points in low or high season, or for economy cabin purchase versus business flight upgrade will differ. Similarly, for the issuer, the cost of point redemption will vary depending on the season or occupancy load, as well as point expiry dates. The forces of supply and demand do not drive the price of a point in the way we see in traditional money markets.
Occupancy rates for rooms and seats reflect seasonal utilization patterns and historically, point redemption requirements were more evenly distributed across seasons. This allowed well-informed users to exploit arbitrage opportunities where the same number of points could be used for a more expensive seat, room purchase or upgrade. Several specialist websites have emerged to advise consumers on the best deals and how to get the most out of their loyalty programs. One such source is “The Points Guy”, which has become a roaring success and was sold to Bankrate in 2012.
In more recent times, loyalty programs have shifted to a more dynamic pricing platform, where the point redemption requirement is based on more economic-based pricing, reflecting supply and demand based on low/high demand cycles. Issuers have become smarter in stipulating how users can redeem points. The use of stochastic modelling techniques can incorporate factors such as occupancy loads on airlines and hotels and adjust redemption rules or tweak marketing programs accordingly. Predictive analysis is also a powerful method for companies using points-based loyalty programs to model consumer buying behaviour.
Amidst the coronavirus pandemic, IHG switched its loyalty program to dynamic award pricing. This means that award prices now vary based on demand rather than having a set award rate year-round. As this change came at a time when demand was low, award rates immediately dropped.
Risks of Currency Miscalculation
During the nascent stages of loyalty program development, there were examples of marketing disasters in respect of companies miscalculating the value of loyalty program offers.
One such example was The Hoover Company launching a marketing campaign during the economic recession in the early nineties, in an effort to increase sales in the UK. Hoover offered two complimentary round-trip airline tickets to the United States, worth approximately £600, to any customer purchasing at least £100 in Hoover products.
The expectation was that customers would spend on average, much more than £100 to avail of the offer. Savvy customers viewed this as an opportunity to purchase two round-trip tickets to the United States for £100, with a vacuum cleaner thrown in for free. The offer was so popular, that Hoover took the decision to withdraw the offer and subsequently renege on the commitment to offer free tickets, leading to legal action and irreversible loss of goodwill. This also resulted in the removal of the Royal Warrant assigned and ultimately led to the sale of the UK division to rival Candy.
Although these examples are not from the points-based system of today, it does highlight the risk of not fully understanding the value of your loyalty currency.
We are likely to see continued development in the loyalty program sector, with more sophistication and adoption by a wider spectrum of industry sectors. It is highly likely that consumers and companies will view loyalty points in their digital wallets in a similar way to the cash they have been physically held in the past.
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Source: https://aeronewsx.com/economics-of-a-key-global-currency-the-loyalty-points-program/
