A (the?) main move in finance

Matt Levine’s Money Stuff column (Bloomberg Opinion) had a great piece today which, while nominally focussed on the enduring question of “Looking for Tether’s Money” is worth reading for the neat summary he offers of how finance turns risky assets into safe assets. The column is behind a paywall but you can access his material by signing up for his daily newsletter.

This particular piece of the magic of finance is of course achieved by dividing up claims on risky assets into tranches with differing levels of seniority. In Matt’s words…

Most of what happens in finance is some form of this move. And the reason for that is basically that some people want to own safe things, because they have money that they don’t want to lose, and other people want to own risky things, because they have money that they want to turn into more money. If you have something that is moderately risky, someone will buy it, but if you slice it into things that are super safe and things that are super risky, more people might buy them. Financial theory suggests that this is impossible but virtually all of financial practice disagrees. 

Money Stuff, Matt Levine Bloomberg, 7 October 2021

Matt also offers a neat description of how this works in banking

A bank makes a bunch of loans in exchange for senior claims on businesses, houses, etc. Then it pools those loans together on its balance sheet and issues a bunch of different claims on them. The most senior claims, classically, are “bank deposits”; the most junior claims are “equity” or “capital.” Some people want to own a bank; they think that First Bank of X is good at running its business and will grow its assets and improve its margins and its stock will be worth more in the future, so they buy equity (shares of stock) of the bank. Other people, though, just want to keep their money safe; they put their deposits in the First Bank of X because they are confident that a dollar deposited in an account there will always be worth a dollar.

The fundamental reason for this confidence is that bank deposits are senior claims (deposits) on a pool of senior claims (loans) on a diversified set of good assets (businesses, houses). (In modern banking there are other reasons — deposit insurance, etc. — but this is the fundamental reason.) But notice that this is magic: At one end of the process you have risky businesses, at the other end of the process you have perfectly safe dollars. Again, this is due in part to deposit insurance and regulation and lenders of last resort, but it is due mainly to the magic of composing senior claims on senior claims. You use seniority to turn risky things into safe things

He then applies these principles to the alternative financial world that has been created around crypto assets to explore how the same factors drive both the need/demand for stablecoins and the ways in which crypto finance can meet the demand for safe assets (well “safer” at least).

The one part of his explanation I would take issue with is that he could have delved deeper into the question of whether crypto users require stablecoins to exhibit the same level of risk free exchangeability that we expect of bank deposits in the conventional financial world.

Matt writes…

The people who live in Bitcoin world are people like anyone else. Some of them (quite a lot of them by all accounts) want lots of risk: They are there to gamble; their goal is to increase their money as much as possible. Bitcoin is volatile, but levered Bitcoin is even more volatile, and volatility is what they want.

Others want no risk. They want to put their money into a thing worth a dollar, and be sure that no matter what they’ll get their dollar back. But they don’t want to do that in a bank account or whatever, because they want their dollar to live in crypto world. What they want is a “stablecoin”: A thing that lives on the blockchain, is easily exchangeable for Bitcoin (or other crypto assets) using the tools and exchanges and brokerages and processes of crypto world, but is always worth a dollar

The label “stable” is a relative term so it is not obvious to me that people operating in the crypto financial asset world all necessarily want the absolute certainty of a coin that always trade at par value to the underlying fiat currency. Maybe they do but maybe they are happy with something that is stable enough to do the job of allowing them to do the exchanges they want to do in risky crypto assets. Certainly they already face other costs like gas fees when they trade so maybe something that trades within an acceptable range of par value is good enough?

What it comes down to is first defining exactly what kind of promise the stablecoin backer is making before we start down the path of defining exactly how that promise should be regulated. I do think that the future of stablecoins is likely to be more regulated and that is likely to be a net positive outcome. The term “stablecoin” however encompasses a wide variety of structures and intended uses. The right kind of regulation will be designed with these differences in mind. That said, some of the stablecoin issuers have not done themselves any favours in the loose ways in which they have defined their promise.

Matt’s column is well worth reading if you can access it but the brief outline above flags some of the key ideas and the issues that I took away from it. The ways in which seniority in the loss hierarchy creates safety (or what Gary Gorton refers to as “information insensitivity”) is I think the key point to take away. I frequently encounter papers and articles discussing the role of bank deposits as the primary form of money in developed economies. These nearly always mention prudential regulation, supervision and deposit insurance but the role of deposit preference is often overlooked. For anyone looking to dig a bit deeper, I did a post here offering an Australian perspective on how this works.

Tony – From the Outside

Reserves of top stablecoins

This graph from an IMF blog neatly summarises the considerable diversity in the asset backing of stablecoins. While the IMF blog highlights the risks associated with stablecoins, I prefer to remain open to the possibility that they represent a new vector of competition that will force traditional banking to lift its game.

That possibility does however (for me at least) require that the banking regulators develop a stablecoin regulatory model that is fit for purpose. I am yet to see any jurisdiction that appears to be offering a good model for how this might be done but welcome any suggestions on what I am not seeing.

In the interim, JP Koning did a good post summarising the regulatory models he saw being pursued by stablecoin issuers.

Tony – From the Outside

Misunderstanding Narratives: The Hero’s Journey – The Big Picture

Joseph Campbell’s “The Hero with a Thousand Faces” is a great book. It offers insights into some deep ideas about how the world does (or should) work that have influenced a wide variety of people including George Lucas and Ray Dalio and was included in Time magazine’s list of the top 100 books.

Barry Ritholz did a short, but insightful, post here where he reminds us that the timeless appeal of the narrative that Campbell explores can also mislead us.

Our narrative bias for compelling stories can prevent us from seeing the forest for trees. Dramatic tales with clearly delineated Good & Evil are more memorable and emotionally resonant than dry data and tedious facts. Try as you might, finding a singular cause of some terrible economic outcome is an exercise in futility. Instead, you will find a long history of political, economic, psychological, and (occasionally) irrational drivers that eventually led to some disaster.

We look for the spark that ignites the room full of hydrogen, instead of 1,000 other factors that created the conditions precedent. You can find example after example of disasters widely thought of as “single event causes;” upon closer examination, they are revealed as the result of far more complex circumstances and countless interactions

https://ritholtz.com/2021/09/misunderstanding-narratives-the-heros-journey/

This for me is an insight that rings very true but is often forgotten to feed our appetite for reducing complex stories to simple morality plays. I like the stories as much as the next person but the downside is that the simple appealing story distracts us from understanding the route causes of why things like the GFC happened and leave us exposed to the risk that they just keep repeating in different forms.

Tony – From the Outside

M-Pesa and the African Fintech Revolution – by Marc Rubinstein – Net Interest

You, like me, might be vaguely aware of the M-Pesa story of fintech innovation in Africa. Marc Rubinstein offers one of the best accounts I have encountered of how this came about and where it might be headed. Especially interesting is his analysis of why it took off in Kenya and the challenges it has faced in other markets.

You can find Marc’s post here – www.netinterest.co/p/m-pesa-and-the-african-fintech-revolution-3c1

Tony – From the Outside

Banks and money creation

Frances Coppola’s blog offers an interesting extension of the ways in which private banks contribute to the the “creation” of bank deposits which are in turn one of the primary forms of money in most modern economies. This is a very technical issue, and hence of limited interest, but I think it will appeal to anyone who wants to peer under the hood to understand how banking really works. In particular, it offers a better appreciation of the way in which banks play a very unique role in the economy which is broader than just intermediating between borrowers and lenders.

If you have come this far then read the entire post but this extract captures the key point …

It’s now widely accepted, though still not universally, that banks create money when they lend. But it seems to be much less widely known that they also create money when they spend. I don’t just mean when they buy securities, which is rightly regarded as simply another form of lending. I mean when they buy what is now colloquially known as “stuff”. Computers, for example. Or coffee machines.

Imagine that a major bank – JP Morgan, for example – wants to buy a new coffee machine for one of its New York offices …. It orders a top-of-the-range espresso machine worth $10,000 from the Goodlife Coffee Company, and pays for it by electronic funds transfer to the company’s account. At the end of the transaction JP Morgan has a new coffee machine and Goodlife has $10,000 in its deposit account. 

Frances Coppola – JP Morgan’s coffee machine

I am familiar with the way in which bank lending creates money but I had not previously considered the extent to which this general mechanism extended to other ways in which banks disbursed payments.

My one observation is that the analysis could have been taken a bit further to consider the ways in which the money created by the bank lending mechanism is retired. In the example of the purchase of a coffee machine that Coppola uses, I assume that there was quite a lot of bank lending or other credit involved in getting to the point that the Goodlife Coffee Company has a coffee machine in stock that it can sell to JP Morgan. Once the JP Morgan cash reaches Goodlife’s bank account it is logical to assume that some of this debt will need to be repaid such that the net increase in money created by the purchase is less than the gross amount. This cycle repeats as inventory is manufactured and then sold.

As a rule, the overall supply of money will be increasing over time in response to the net increase in private bank lending but I would assume that it will be increasing and decreasing around this trend line as short term working capital loans are created and extinguished. This is a tricky area so I could be missing something but the capacity of the money supply to expand (and contract) in response to the needs of business for working capital feels like an important feature of the banking system we have today and something to consider as we explore new decentralised forms of money.

Tony – From the Outside

Finance cartels face digital currency shake-up | Financial Times

Cross border payment is one of the areas of conventional banking where challengers believe that crypto/DLT solutions can shake up the existing order. There is little doubt that the cross border payment status quo has lots of room for improvement but Gillian Tett (Financial Times) offers a nice summary of central bank projects that are potentially introducing other vectors of innovation and competition.

— Read on www.ft.com/content/4ab25f71-78ff-40a2-b47c-e04075ea81b4

Bank regulators might be missing something with regard to Bitcoin

The Basel Committee on Banking Supervision (BCBS) released a consultation paper in June 2021 setting out its preliminary thoughts on the prudential treatment of crypto asset exposures in the banking system.

I covered the paper here but the short version is that the BCBS proposes to distinguish between two broad groups: One where the BCBS believes that it can look through the Crypto/DLT packaging and largely apply the existing Basel requirements to the underlying assets (Group 1 crypto assets). And another riskier Group 2 (including Bitcoin) which would be subject to its most conservative treatment (a 1250% risk weight).

At the time I noted that it was not surprising that the BCBS had applied a conservative treatment to the riskier end of the crypto spectrum but focussed on the fact that that bank regulators were seeking to engage with some of the less risky elements.

I concluded with my traditional caveat that I was almost certainly missing something. Caitlin Long (CEO and founder of Avanti Financial Group, Inc) argues that what I missed is the intra-day settlement risk that arises when conventional bank settlement procedures deal with crypto-assets that settle in minutes with irreversibility.

The BCBS could just apply even higher capital requirements but the better option she argues is to create a banking arrangement that is purpose built to deal with and mitigate the risk. I have copied an extract from an opinion piece she wrote that was published in Forbes magazine on 24 June 2021

Thankfully, there is a safe and sound way to integrate bitcoin and other Group 2 cryptoassets into banking systems:

– Conduct all bitcoin activities in a ring-fenced bank that is either stand-alone or is a bankruptcy-remote subsidiary of a traditional (leveraged) bank.

– Use no leverage in the bank. No rehypothecation of bitcoin held in custody. Hypothecation of assets held in custody is fine, but the bank must not permit greater than 1:1 leverage. Remember—bitcoin has no lender of last resort or clearinghouse.

– Take no credit or interest rate risk within the bank. Hold 100% reserves in cash, T-bills or similar short-term, high-quality liquid assets. The bank makes money on fees, which crypto fintechs have successfully done for years due to high transaction volume.

– Pre-fund transactions, so that the bank settles second or simultaneously instead of settling first and thereby avoid “back door” leverage caused by a counterparty failing to deliver.

– Permit no collateral substitution or commingling in prime brokerage.

– Design IT and operational processes for fast settlement with irreversibility, complete with minute-by-minute risk monitoring and reconciliation processes.

https://www.forbes.com/sites/caitlinlong/2021/06/24/bis-proposed-capital-requirements-for-cryptoassets-vital-move-but-theyre-too-low-for-bitcoin/?sh=10d0a9f22546

If you want a deeper dive Avanti lay out their arguments in more detail in a letter submitted to the Federal Reserve responding to a request for comments on draft guidelines proposed to assist Federal Reserve Banks in responding to what the Fed refers to (emphasis added) as “… an increasing number of inquiries and requests for access to accounts and services from novel institutions“.

It is quite possible that I am still missing something here but the broad argument that Avanti lays out seems plausible to me; i.e. it would seem desirable that a bank that seeks to support payments to settle crypto asset trades should employ a payment process that allows instant payments as opposed to end of day settlement.

Some parting observations:

  1. The Fed is moving towards the implementation of an instant payment system so arguments based on problems with 40 year old payment systems such as the Automated Clearing House (ACH) currently used by the USA would be more compelling if they addressed how they compare to the new systems that have been widely deployed and proven in other jurisdiction.
  2. Notwithstanding, there is still a case for allowing room for alternative payment solutions to be developed by novel institutions. In this regard, Aventi has committed to embrace the level of regulation and supervision that is the price of access to an account at the central bank.
  3. Aventi’s regulatory strategy is very different to the decentralised, permission-less philosophy that drives the original members of the crypto asset community. Seeing how these two competing visions of money play out continues to be fascinating.
  4. I still have a lot to learn in this space.

Tony – From the Outside

The Race for Stablecoin Transparency | J.P. Koning – CoinDesk

J.P. Koning notes that stablecoins have been improving their reporting on reserves, but argues that transparency is also driving changes that make an already difficult business model more complicated to execute.
— Read on www.coindesk.com/the-race-for-stablecoin-transparency

Regulatory strategies adopted by USD stablecoin issuers (continued)

One of my recent posts flagged some useful work that JP Koning had shared summarising four different regulatory strategies USD stablecoins issuers have adopted.

  1. The New York Department of Financial Services (NYDFS) trust company model [Paxos, Gemini, BUSD]
  2. The Nevada state-chartered trust model [TrueUSD, HUSD]
  3. Multiple money transmitter license model [USDC]
  4. Stay offshore [Tether]

If I read this post from Circle correctly, we can now add a fifth strategy; the Federally-chartered national commercial bank model. For those with a historical bent, this might also be labelled the “narrow bank” model or the “Chicago Plan” model.

Here is a short extract from the Circle post …

Circle intends to become a full-reserve national commercial bank, operating under the supervision and risk management requirements of the Federal Reserve, U.S. Treasury, OCC, and the FDIC. We believe that full-reserve banking, built on digital currency technology, can lead to not just a radically more efficient, but also a safer, more resilient financial system.

We are embarking on this journey alongside the efforts of the top U.S. financial regulators, who through the President’s Working Group on Financial Markets are seeking to better manage the risks and opportunities posed by large-scale private-sector dollar digital currencies.

Tony – From the Outside

Why is the United States lagging behind in payments?

… is the title of a useful paper by Christian Catalini and Andrew Lilley that digs into the puzzle of why it is that one of the (if not the) key players in the global financial system seems to lagging global best practice in terms of the cost, convenience and speed of its payment system.

It has to be noted that the authors are not neutral observers in this space. Christian Catalini is the Chief Economist of the Diem Association and Diem Networks US, and Co-Creator of Diem (formerly Libra). He is also the Founder of the MIT Cryptoeconomics Lab and a Research Scientist at MIT. Andrew Lilley is an employee of Novi Financial, Inc. who contributed to the paper as part of his work with Diem Networks US. With that caveat in mind, the paper still offers a short (12 pages) and useful summary of the ways in which the US lags best practice.

They frame the US problem as follows:

The US enjoys one of the least concentrated banking systems among the G30, but this feature has also created a fragmented and expensive payments system. Transfers between major US banks incur fees ranging from $10 to $35 for same-day wires, and up to $3 for 2-day transactions. Compare this to the UK, where individuals and businesses have access to a free, 24/7 interbank payments system which settles within seconds and supports over 8M transactions per day. While the US does have a Real Time Gross Settlement (RTGS) system, the Fedwire Funds Service carries less than 1 million transactions per day, has limited 21/5 availability, and is almost exclusively used by financial institutions and large corporations. Its fees, moreover, are larger than alternative payment methods such as ACH, creating a trade-off between cost and immediacy. Private sector alternatives are limited, and while some banks have deployed real-time solutions, these come with transaction limits and little adoption, which severely reduces their usefulness.

Catalini and Lilley (2021), Why is the United States Lagging Behind in Payments?

The paper then outlines how these limitations affect individuals, business and government and concludes with suggestions of what might be done to address the problems discussed:

There are at least three ways to remove frictions in payments and rapidly expand the number of individuals and businesses that can access the financial system and cheaply transact in real time. The first is to bring deposits on a single ledger through a Central Bank Digital Currency (CBDC), so that transfers between banks are not limited by external liquidity constraints or third-party rails. The second approach is to follow countries such as India and Mexico and increase the throughput of always-on RTGS systems. This is the model the Federal Reserve is pursuing with the introduction of FedNow, targeted for 2023. FedNow, however, is expected to have an initial transfer maximum of $25,000, which would limit its usefulness to businesses. The third approach is to facilitate the growth of interoperable, stablecoin payment rails by creating the right regulatory framework for these new types of networks to safely increase competition in payments.

While each one of these approaches presents different challenges, opportunities and trade-offs in terms of complexity, development costs and ability to expand access to segments that are currently excluded, it is important to stress that they are likely to be complements, not substitutes.

Advancing the US payments infrastructure will require both regulatory and technical developments targeted at improving market structure, lowering barriers to entry, and facilitating collaboration between public and private sector efforts in digital payments.

Catalini and Lilley (2021)

I am trying to keep an open mind on the future of payment systems but find myself drawn towards the conclusion that fast payment systems that the FedNow initiative is based on seem to have worked pretty well in other countries in terms of improving cost, speed and convenience so it is not obvious to me why either a CBDC or stablecoin solution is necessary in the United States.

If you want to explore these issues further, JP Koning recently offered a nice summary of what has been achieved by fast payment systems in other countries while a speech (“CBDC: A solution in Search of a Problem?”) by Governor Waller of the US Federal Reserve neatly summarises the issues associated with whether a CBDC is necessary or desirable (at least so far as the USA is concerned). It is important to recognise however that the conclusions that Waller draws do not necessarily apply to other countries (China being the prime example) which are responding to very different types of payment systems.

Let me know what I am missing

Tony – From the Outside