The ECB seeks the holy grail of cross-border payments

One of the proposed use cases for cryptocurrency and/or stablecoins is cheaper and faster alternatives to the conventional TradFi payment rails. The argument for the crypto solution as I understand it has two legs

  1. Use of superior technology
  2. Eliminating costs associated with rent seeking intermediaries

The pitches I have seen mostly seem to frame their technology as better than 1970’s based technology that the banking system uses. The problem for me with this argument is that the banking system has not been standing still and Fast Payment Systems (see here and here) are increasingly the benchmark that the crypto alternative needs to improve on, not the 1970’s ACH payment rails. It is true that the USA seems to be lagging the rest of the world in this regard but the Fed is working towards having one in place in the near future. You might still prefer the crypto option on philosophical grounds because you simply do not want to deal with a bank on principle (argument #2 above) but that is a whole different question.

The fast payment systems that have been implemented to date are however domestic payment solutions so maybe crypto has a role to play in cross border payments where high fees and delayed settlement remain a largely unresolved problem. For anyone interested in this area of finance, the European Central Bank (ECB) recently published a working paper titled “Towards the holy grail of cross-border payments”. The ECB first looks at why the “holy grail” cross-border payment solution has proved so elusive and then evaluates a range of solutions to see how close we are to the solution before offering its judgement of where the holy grail is most likely to be found.

The solutions examined are 1) Correspondent banking, 2) FinTechs, 3) Unbacked crypto-assets such as Bitcoin, 4) Global stablecoins, 5) Interlinked instant payment systems with FX conversion layer and 6) Interoperable CBDC with FX conversion layer. The ECB concludes that

  • Options 5 and 6 (Interlinked fast payment and/or CBDC systems) are the most promising alternatives
  • Options 1 and 2 (Correspondent banking and FinTech) have potential to improve on the status quo but are unlikely to achieve the “holy grail” outcome
  • Options 3 and 4 (no surprises crypto and stablecoins) are not ones the ECB wants to get behind

I am pretty sure the true believers will not be convinced by the ECB’s rationale for dismissing crypto and stablecoin solutions. The paper does however highlight the ways in which TradFi players are increasingly adopting improved technology that challenges the first plank of the argument that crypto offers superior technology.

For anyone interested in diving deeper, the paper is 50 odd pages long (excluding references). To give you a sense of whether it is worth the effort I have attached two extracts below – 1) The Abstract and 2) The Conclusion

Tony – From the Outside

Abstract

The holy grail of cross-border payments is a solution which allows cross-border payments to be (1) immediate, (2) cheap, (3) of universal reach, and (4) settled in a secure settlement medium, such as central bank money. The search for the holy grail has been ongoing for many centuries. In 2020, improving cross-border payments was set as a key priority by the G20: the G20 asked the Financial Stability Board (FSB), working with the Committee on Payments and Market Infrastructures (CPMI) and other standard-setting bodies to co-ordinate a three-stage process to develop a roadmap to enhance cross-border payments. The conclusion that it is time again for forceful measures to improve cross- border payments resulted from several considerations, namely that (i) globalisation and thus volumes of cross-border payments have continued (and indeed are forecasted) to increase; and (ii) the fact that although digitalisation has made instant cross-border communication quasi cost-free, there has not been a striking decline in the costs associated with executing cross-border payments.

This paper argues that after more than thousand years of search, the holy grail of cross-border payments can be found within the next ten years. To this end, section 2 of the paper briefly recalls a few historical elements involving the search for efficient cross-border payments and identifies a number of universal challenges across time. Through a series of financial accounts, the paper then reviews several options for enhancing cross-border payments with a view towards reaching the holy grail. Section 3 covers correspondent banking, both in its current implementation, as well as a modernised version. Section 4 reviews emerging Fintech solutions, which have already delivered in terms of offering cheaper than ever cross-border payments for certain currencies and use cases. Section 5 discusses Bitcoin, which is distinct from the alternatives as it relies on a completely different settlement asset which is not linked to any fiat currency. Section 6 turns to global stablecoins such as the one envisaged initially by Facebook (Libra/Diem). Section 7 unpacks the case of interlinking domestic payment systems through a cross-system and FX conversion layer. Finally, section 8 analyses the case of central bank digital currencies (CBDC), again interlinked cross-border through an FX conversion layer. Each of the arrangements covered in sections 3 to 8 are assessed in terms of their actual or potential efficiency, architectural parsimoniousness, competitiveness and, relating to that, preservation of monetary sovereignty. Section 9 concludes that the interlinking of domestic payment systems and the future interoperability of CBDCs are the most promising avenues, albeit subject to strong progress being made on the AML/CFT compliance side to ensure straight-through-processing (STP) for the large majority of cross-border payments.

Conclusion

The holy grail, whereby cross-border payments can be (1) immediate, (2) cheap, (3) universal in terms of reach, and (4) be settled in a secure settlement medium such as central bank money is in reach for the first time. This is thanks to the rapid decline in the costs of global electronic data transmission and computer processing, new payment system technology (allowing for instant payments), innovative concepts (such as the interlinking of payment systems including a currency conversion layer; or CBDC), and unprecedented political will and global collaboration like the G20 work on enhancing cross-border payments. 

The review of various visions as to how to achieve the holy grail suggests that Bitcoin is least credible; stablecoins, traditional correspondent banking, and cross-border Fintechs take an intermediary place, but may all contribute to improvement over the next years. From a public policy perspective, stablecoins appear somewhat more problematic than the other two options as they aim at deep closed loop solutions, market power and fragmentation. Two solutions – the interlinking of domestic instant payment systems and future CBDCs, both with a competitive FX conversion layer – may have the highest potential to deliver the holy grail for larger cross border payment corridors as they combine (i) technical feasibility; (ii) relative simplicity in their architecture; and (iii) maintaining a competitive and open architecture by avoiding the dominance of a small number of market participants who would eventually exploit their market power. Moreover, (iv) monetary sovereignty is preserved, and (v) the crowding out of local currencies is avoided due to a FX conversion layer at the border (which does not hold for Bitcoin and global stablecoins). Interlinking of domestic payment systems would also perform well in terms of preserving the universal reach of correspondent banking (although of course only for the payment areas that are actually interlinked). However, a number of challenges need to be addressed to set up these solutions, such as: 

  • the organization of an efficient competitive FX conversion layer conducive to narrow bid-ask spreads applying to the FX conversion;
  • the global addressability of accounts;
  • achieving the same degree of legal certainty for interlinked cross-currency payments as for
    domestic payments, including in the case of default of a party;

ECB Working Paper Series No 2693 / August 2022 51 

Finally, all solutions require that strong progress is made on the AML/CFT compliance side to ensure straight-through-processing (STP) for the large majority of cross-border payments. The recognition and the importance of this issue is illustrated by the significant number of building blocks devoted by the G20 to regulatory and compliance issues of cross-border payments, and also the Nexus initiative of the BIS recognizes the importance of such progress particularly for interlinked solutions. 

None of these challenges are unresolvable and for large cross-border payment corridors with significant volumes and sufficient political will, both interlinking solutions should be feasible and efficient. For smaller corridors, fixed set up costs may be too high, or the political or legal preconditions may not be fulfilled. For those, a modernized correspondent banking or solutions relying on Fintechs with presence in both jurisdictions will likely remain good and flexible solutions that can contribute significant improvements. Also, for large corridors, these two solutions may play an important role for the coming years, and the interlinking solutions still need to prove that they can deploy their advantages relative to them. 

Ranking two solutions at the top raises the question whether central banks and the industry should really work on both (i.e. the interlinking of domestic payment systems and future CBDCs), or whether only one should be selected and the other be dismissed to save on investment costs and focus all efforts to implement the holy grail as soon as possible. A number of arguments speak in favor of developing both solutions. First, there are synergies between the two in the sense that organizing competitive FX conversion layers is instrumental for both, as well as solving issues of international addressability of accounts (be it in commercial bank money or CBDC), persons and firms. Second, some FX and cross-border payment corridors are so large that they can easily support two solutions, and the eventual efficiency of cross-border payments will benefit further from the competition between two approaches. Third, for some cross-border payment corridors only one solution may eventually prevail, but this could be one or the other, and in view of the many cross-border corridors, it is favorable to have two fully efficient solutions available who can compete to become the solution for specific smaller corridors. Therefore, forceful work on both should continue, whereby for CBDC much of the energy of central banks will obviously be absorbed first for deploying them for domestic retail payments. Central banks should nevertheless keep in mind that CBDC will eventually be expected to make its contribution to efficient cross-border payments with FX conversion, and discuss at a relatively early stage the related interoperability issues. In the meantime, they should support and co-ordinate the efforts to interlink domestic payment systems for cross-border payments with competitive FX conversion. 

Crypto and credit creation

Matt Levine (“Money Stuff”) neatly captured one of the defining features of the cryptocurrency purist vision for their alternative financial system when he wrote “The basic philosophical difference between the traditional financial system and the cryptocurrency system is that traditional finance is about the extension of credit, and crypto is not”. He acknowledged that this is an exaggeration but argued that it did contain an essential truth about the two systems.

A recent opinion piece by Nic Carter offers another perspective on this philosophical difference arguing that Bitcoin needs to move past this concern with credit creation if it is to have a future. I am a Bitcoin sceptic but I do think Nic offers an interesting (pro Bitcoin) perspective on the problem that Bitcoin maximalists believe they are solving.

Here are a couple of quotes that give you a flavour of Nic’s argument…

Bitcoiners attacking lending institutions are undermining their own interests. Many adherents to the Bitcoin maximalist doctrine maintain a curious disdain for credit. They often follow a Rothbardian ideal, believing fractional reserve banking to be “fraud,” even though the idealized “full reserve banking” generally never emerges in free market conditions.

Maximalists interested in a better managed credit sector won’t achieve anything by bleating to each other about the dangers of crypto lenders. If everything is a scam to them, their warnings contain no information. They cannot extinguish the demand for credit or yield – and entrepreneurs will always emerge to fill this need.

Instead, they should start their own financial institutions, using bitcoin as a neo-gold with superior collateral qualities and setting reasonable underwriting standards. It is a mistake to view bitcoin’s success as trade-off against the creation of credit. Its future depends on it.

I remain unconvinced by the Bitcoin argument but Nic’s defence of the importance of credit creation is I think a reminder that, whatever form the future of finance takes, elasticity of credit will probably be part of that future.

Tony – From the Outside

Moneyness: How profitable is the world’s largest stablecoin?

Interesting post by JP Koning on the extent to which Tether is making any money. The short answer he concludes is not very even without the burden of conforming to regulation. The obvious question this begs is how profitable a regulated stablecoin would be.

— Read on jpkoning.blogspot.com/2022/07/how-profitable-is-worlds-largest.html

Tony – From the Outside

History of the Fed

I love a good podcast recommendation. In that spirit I attached a link to an interview with Lev Menand on the Hidden Forces podcast. The broader focus of the interview is the rise of shadow banking and the risks of a financial crisis but there is a section (starting around 21:20 minute mark) where Lev and Demetri discuss the origin of central banking and the development of the Fed in the context of the overall development of the US banking system.

The discussion ranges over

  • The creation of the Bank of England (23:20)
  • The point at which central banks transitioned from being simple payment banks to credit creation (24:10) institutions with monetary policy responsibilities
  • The problems the US founders faced creating a nation state without its own money (25:30)
  • Outsourcing money creation in the US to private banks via public/private partnership model (26:50)
  • The problems of a fragmented national market for money with high transmission costs (27:40)
  • The origin of the Federal Reserve in 1913 (31.50) and the evolution of banking in the US that preceded its creation which helps explain the organisational form it took

… and a lot more including a discussion of the rise of shadow banking in the Euromarket.

The topic is irredeemingly nerdy I know and it will not tell you much new if you are already engaged with the history of banking but it does offer a pretty good overview if you are interested but not up for reading multiple books.

Tony – From the Outside

Molly White on cryptocurrency “market caps” and notional value

Good post from Molly White discussing the topical issue of how the numbers used to describe the rise and fall of the crypto market are constructed. The post is not long and worth reading in full but here are a few extracts.

Molly starts with a bare bones outline of how the valuation numbers you read in the news are typically generated …

To get the dollar value of a pile of crypto tokens, we take the price of that cryptocurrency on an exchange and multiply it by the quantity of tokens in the pile. To get the market cap, we take the price of that cryptocurrency on an exchange and multiply it by the total number of tokens in circulation. To get the total market cap of all cryptocurrencies, we sum up all of their market caps. There are many cryptocurrency exchanges, trackers, defi platforms, and other projects out there that show the market cap of various tokens. Each of them calculates it in roughly this way, although there are variations: some use total supply or fully diluted supply to represent the number of tokens, and some employ various strategies to try to filter outlier data. CoinMarketCap is a popular tracker, and is widely cited in both crypto-specific and mainstream media when referring to specific cryptocurrencies’ market caps and the market cap of crypto as a whole, so I refer to it throughout.

She then discusses three of her primary concerns with crypto valuation

  • price
  • liquidity
  • wash trading ...

…. and most importantly the question of why does this matter

The “market cap” measurement has become ubiquitous within and outside of crypto, and it is almost always taken at face value. Thoughtful readers might see such headlines and ask questions like “how did a ‘$2 trillion market’ tumble without impacting traditional finance?”, but I suspect most accept the number.

When crypto projects are hacked, there are headlines about hackers stealing “$166 million worth” of tokens that in reality amounted to 2% of that amount (around $3 million) after hackers’ attempts to sell illiquid tokens caused the price to crash.15 I know because I’ve written some myself—it’s an easy habit to slip into.

When NFTs are stolen, large numbers are thrown around without any clarity as to whether they are the original prices paid by the victims for the NFTs, the prices netted by the thiefs when flipping them, the floor prices, or some other value.

All of this serves to legitimize cryptocurrency as though it is a much bigger industry than it is, with far more money floating around than there is. It serves to perpetuate the narratives that NFTs are “worth” far more than they could likely fetch at auction, or tend to appreciate in value quickly, encouraging more people to buy in to projects that are likely to result in losses. Stories about “crypto-millionaires” and -billionaires encourage more people to put their real money into the system—something it desperately needs—not realizing that they may be exchanging it for “gains” on a screen that can never translate into reality.

Maybe there will be greater care on the part of the journalists writing the stories you read about the exciting times in the crypto markets and maybe some greater regulation of valuation and disclosure practices – maybe not. In the interim, Molly offers a good introduction to the questions you might ask yourself as you read the news.

Let me know what I am missing

Tony – From the Outside

Deposit insurance

I recently flagged a post by Patrick McKenzie on the mechanics of the humble bank deposit. Patrick has followed that with another equally interesting discussion of deposit insurance. The post is written as a high level primer and so it does not offer any insights to anyone already familiar with the topic.

The main thing that grabbed my attention was Patrick’s emphasis on the “information insensitive” nature of bank deposits. This to my mind is a fundamental concept in analysing bank deposits but gets way less attention that I think it deserves. It is particularly important when you are looking at the question of the extent to which deposit insurance promotes moral hazard.

So it was good to see someone else promoting the importance of this concept. On the other hand, his discussion of the information insensitivity of deposits does not give as much attention to the role of “deposit preference” as I think it deserves. It is always possible of course that I have this wrong but, for me at least, the preferred claim that many jurisdictions afford bank deposits is a key part of understanding why bank deposits can be information insensitive” without necessarily creating moral hazard.

If you are interested to dig deeper ….

  • Matt Levine did a good post on the overall question of how finance uses tranching to turn a pool of risky assets into a mix of safe and risky claims on those assets where he described this as “A main move in finance” (see here for my summary of the column if you don’t have access to his column)
  • There is also a page on my website where I discuss the arguments for protecting depositors (the “why”), another where I attempt to dig a bit deeper into the technical aspects of bank deposit protection (the “how”), and this post offering an Australian perspective on the process of how bank deposits (a loan to highly leveraged company) get turned into mostly risk free assets in the hands of bank depositors.

Tony – From the Outside

The alchemy of deposits

Patrick McKenzie dropped an interesting post on the seemingly humble but actually quite awesome deposit. You can find my (Australian focussed) perspective on the mechanics of bank deposits here but who could resist learning more about “…the terrible majesty of the humble bank deposit”.

The perspective Patrick offers is not necessarily new for anyone who understands banking but a lot of this is probably not well understood by the broader public actually using bank deposits. His post is short and worth reading if only for the “pink slime” analogy.

His first point is that “deposits are money”

The actual core feature of deposits is that you can transfer them to other people to effect payments. Big deal, you might think. You can also transfer cows, sea shells, Bitcoin, an IOU from a friend, or bonds issued by Google to effect payments. But deposits are treated as money by just about everyone who matters in the economy, including (pointedly) the state. Economists can wax lyrical about what “treated as money” means, but the non-specialist gloss is probably just as useful: anything is money if substantially everyone looking at the money both agrees that it is money and agrees at the exchange rate for it. This is sometimes referred to as the “no questions asked” property; money is the Schelling point for value transfers that all parties to a transaction are already at.

This is so fundamental a feature of deposits that, in developed nations, we don’t remember that it isn’t automatic

His second point is that bank deposits are “heavily engineered structured products pretending to be simple”.

From the consumer’s perspective, deposits are “my money,” functionally riskless. This rounds to correct. From the bank’s perspective, deposits are part of the capital stack of the bank, allowing it to engage in a variety of risky businesses. This rounds to correct. The reconciliation between this polymorphism is a feat of financial and social engineering. A bank packages up its various risky businesses—chiefly making loans, but many banks have other functions in addition to the risks associated with any operating business—puts them in a blender, reduces them to a homogenous mix, and then pours that risk mix over a defined waterfall.

The simplest model for that waterfall is, in order of increasing risk: deposits, bonds, preferred equity, and common equit

The “pink slime” analogy referenced above is a colourful way of saying that deposits benefit from having a claim on a diversified pool of assets, the “homogeneous mix” in the extract above. Equally important however is the fact that deposits have a super senior claim on that diversified pool as outlined in the waterfall analogy.

Patrick has packed quite a few nice turns of phrase into his post but one of my favourites addresses the pervasive misuse of the term “deposit”

The fintech industry has not covered itself in glory here. Sometimes firms misclaim a product to be a deposit where it is not. Sometimes they actually institutionally misunderstand the nature of the product they have created. One would hope that that never happens, but … smart people are doomed to continue discovering that just because a deposit is a complex structured product involving a bank which has a stable dollar value, not every complex structured product involving a bank which appears to have a stable dollar value is actually a deposit

To repeat “…just because a deposit is a complex structured product involving a bank which has a stable dollar value, not every complex structured product involving a bank which appears to have a stable dollar value is actually a deposit”

Patrick uses the recent example of Voyager as a case in point. I don’t think it is being pedantic to argue that a “crypto bank” is an oxymoron but I don’t hold out much hope that the term will go away any time soon. A “bank” is arguably a highly regulated institution by definition and the crypto versions to date are either not regulated or subject to a less onerous form of regulation.

This is Patrick’s take on Voyager

Voyager, a publicly traded company, marketed a deposit-adjacent product to users, paying a generous interest rate. Then a cascading series of events in crypto, outside the scope of this essay, blew up a series of firms, including one which had taken out a loan of hundreds of millions of dollars from Voyager. Suddenly, the information-insensitivity of Voyagers not-deposits was pierced, the pink slime appears both undermixed and undercooked, and customers now need to follow a bankruptcy proceeding closely. … When something which was believed to be a deposit is discovered to not actually be a deposit, infrastructure around it breaks catastrophically. Matt Levine has an excellent extended discussion about how Voyager discovered that attaching the ACH payment rail to their deposit-adjacent product became a huge risk once they went under.)

As regular readers will know, I am a big fan of Matt Levine so I endorse Patrick’s recommendation to read Matt’s accounts of what is going on in the crypto world. There is one aspect of Patrick’s post however that I struggled with and that is his account of bank deposits as a cheap source of funding

Why fund the risks of a bank with deposits, as opposed to funding them entirely with bonds and equity (and of course, revenue), like almost all businesses do? From the bank’s perspective, this is simple: deposits are very inexpensive funding sources, and the capability to raise them is the one of the main structural advantages banks have vis-a-vis all other firms in the economy. 

He is correct of course in the sense that the nominal interest rate on bank deposits is quite low, commensurate with their low risk. Two observations however,

Firstly, the true cost of a bank deposit has to take account of the cost of running all the infrastructure that facilities creating a diversified pool of assets and operating the payment rails that allow deposits to effect payments.

The second is that the super senior preferred claim that bank deposits have on the waterfall makes the other parts of the bank liability stack more risky. I know that the “bail-out” or “Too Big To Fail” have traditionally created a subsidy. However, banks are now required to hold both a lot more capital and to issue “bail-in” instruments that should in principle mean that this subsidy is much reduced if not eliminated. If the other parts of the bank liability stack are not pricing in these changes then the really interesting question is why not.

So there is a lot more to this than what Patrick has written (and he has promised further instalments) but I can still recommend his post as a useful (and entertaining) read for anyone seeking a better understanding of this particular corner of the banking universe.

Tony – From the Outside

Red flags in financial services

Nice podcast from Odd Lots discussing the Wirecard fraud. Lots of insights but my favourite is to be wary when you see a financial services company exhibit high growth while maintaining profitability.

There may be exceptions to the rule but that is not how the financial services market normally works.

podcasts.apple.com/au/podcast/odd-lots/id1056200096

Tony — From the Outside

Things worth keeping as we reinvent finance

I did a post yesterday covering Matt Levine’s take on some of the less obvious ways in which the Crypto/DeFi industry is reinventing finance. At the risk of being repetitive, his column today is also worth reading if only to reinforce the point that maybe there are some elements of the existing financial system (such as a predefined loss hierarchy in which the senior stakeholders get paid first) are worth preserving.

Matt offers a summary of the options currently being pursued by some of the Crypto/DeFi players in the absence of a regulatory framework …

In crypto:

1. There are no regulatory capital requirements, and crypto banks often seem quite proud to be running at roughly zero equity. Tether, the biggest crypto bank, boasts of its 0.2% capital ratio; if the value of its assets declines by more than 0.2%, depositor money is at risk. Tether also boasts of its transparency, and while that is a bit silly, it is the case that for many other crypto-bank-type entities it is harder to guess how much equity capital they have.

2. There is no prudential supervision, and crypto banks think nothing of concentrating, like, a third of their customers’ money in a single loan. We talked last week about Voyager Digital Ltd., another crypto bank, which had about a 4.3% capital ratio but loaned out more than twice its total capital to one hedge fund that went bust.

3. Also, because there is no prudential supervision, crypto banks will sometimes concentrate their money in loans to their affiliates. The fact that Ver is both an investor in CoinFlex and a big borrower from CoinFlex is pretty standard in crypto even though it would be very bad in traditional banking. It is bad because, if your big borrower is also your big backer, you might be inclined to give him a special deal like, for instance, promising not to foreclose on his collateral even if he doesn’t meet margin calls.

Matt Levine. Money Stuff, 29 June 2022

Matt concludes …

I keep saying that crypto is having its 2008 financial crisis, but it’s much more interesting than that, isn’t it? In 2008, (1) traditional well-understood principles of credit and collateral and seniority and bankruptcy and banking law were applied to somewhat new and aggressively structured instruments, and (2) regulators invented a few novel approaches to limit the damage. In the crypto crisis, every lender and exchange can kind of make up its own principles from scratch and see what they can sell to people. In a sense crypto is having many different tiny 2008 crises all at once; the crisis is always the same — short-term demand deposits funding risky lending — but everyone gets to invent a new way to address

I am a fan of creative destruction as a force for making our financial system and economy stronger and more fit for purpose. There is clearly plenty of room for improvement but I am with Matt with regard to the importance of retaining the “traditional well-understand principles of credit and collateral and seniority and bankruptcy and banking law”. I would probably add a decent buffer of capital and liquidity and maybe a sound regulatory framework that encapsulates some of the things that traditional finance has learned over the past few centuries of trial and error.

Let me know what I am missing …

Tony – From the Outside