A bank run in CryptoLand

In my last post I flagged a great article from Marc Rubinstein using MakerDAO to explain some of the principles of Decentralised Finance (DeFi). One of the points I found especially interesting was the parallels that Rubinstein noted between 21st century DeFi and the free banking systems that evolved during the 18th and 19th centuries

I wound up confessing that while I am a long way from claiming any real DeFi expertise, I did believe that it would be useful to reflect on why free banking is no longer the way the conventional banking system operates.

In that spirit, it appears that the IRON stablecoin has the honour of recording the first bank run in cryptoland.

We never thought it would happen, but it just did. We just experienced the world’s first large-scale crypto bank run.

https://ironfinance.medium.com/iron-finance-post-mortem-17-june-2021-6a4e9ccf23f5

No doubt there will be plenty written on this but Matt Levine’s Bloomberg column offers a quick summary of what happened.

The core of an algorithmic stablecoin is that you have some other token that is not meant to be stable, but that is meant to support the stablecoin by being arbitrarily issuable. It doesn’t matter if Titanium is worth $65 or $0.65, as long as you can always issue a few million dollars’ worth of it. But you can’t, not always, and that does matter.

Money Stuff by Matt Levine 18 June 2021

Algorithmic is of course just one approach to stablecoin mechanics. I hope to do a deeper dive into stablecoins in a future post.

Tony – From the Outside

Money and banking in CryptoLand

Marc Rubinstein (Net Interest) recently wrote an interesting post titled “My Adventures in CryptoLand” that I found very helpful in helping me better understand what is going on in this new area of decentralised finance (DeFi). He has followed up with a post titled “Reinventing the Financial System” which explores how MakerDAO is building a “decentralised bank”. I am a bit uncomfortable with applying the term “bank” to the financial entity that MakerDAO is building but I don’t want to derail the discussion with what may be perceived as semantics so I will run wth the term for the purposes of this post.

What is interesting for students of banking is the parallels that Rubinstein notes between MakerDAO and the free banking systems that evolved during the 18th and 19th centuries. Scotland is one of the poster children of this style of banking and we can see a legacy of that system (albeit much more regulated and so not true free banking) in the form of the private bank notes that the three Scottish banks still issue in their own name. He quotes Rune Christensen (founder of MakerDAO) describing the way in which his project accidentally developed a form of fractional reserve banking”

In the very beginning of the project, I remember we didn’t even realise, in the beginning of Maker, that we were essentially just building a protocol that did the same things as fractional reserve banking, did something very similar to how a banking balance sheet works and we were just implementing that as a blockchain protocol. We thought we were doing something completely, totally different from how money usually worked in the traditional sense.” (source)

“Reinventing the Financial System” Marc Rubinstein Net Interest Newsletter, 12 June 2021

This statement should be qualified by the fact that they can only do this (i.e. replicate fractional reserve banking) because the currency of the decentralised bank is a form of money called Dai. Fractional Reserve Banking has proved to be a risky form of financial technology in the conventional banking system which has developed a range of tools to manage that risk (e.g. capital adequacy and liquidity requirements, deposit preference arrangements often coupled with deposit insurance to insulate the “money” part of the bank balance sheet from risk, high levels of supervision and other restrictions on the types of assets a bank can lend against).

MakerDAO has a stabilisation mechanism that employs “smart contracts” that manage the price of Dai by managing its supply and demand. The pros and cons of the various stabilisation mechanisms that underpin stable coins like Dai is a topic for another day.

Rubinstein describes the MakerDAO lending and “money” creation process as follows:

The bank he devised to create his money … works like this:

An investor comes into Maker DAO for a loan. He (yep, usually he) has some collateral he’s happy to keep locked in a vault. Right now, that collateral is usually a crypto asset like Ethereum. For every $100 worth of crypto assets, Maker is typically prepared to lend $66 – the gap adding a buffer of protection against a possible fall in the value of the collateral. Maker accepts the collateral and advances a loan, which it does by issuing its Dai money. 

So what?

At this stage I am not sure where this is headed. It is not clear, for example, if the purpose of this “bank” is simply to create more Dai via trading in crypto-assets or to build something that translate outside CryptoLand. Rubinstein quotes Rune Christensen himself stating that

I don’t think that it will necessarily replace everything… The traditional financial system will actually largely remain the way it is. It will just replace certain parts of it that right now are really bad and really old… those things will be replaced with DeFi and blockchain, but the actual bank itself probably will remain.”

I am a long way from figuring this out but Marc’s post is I think worth reading for anyone who want to understand where these new (or possibly reinvented) forms of finance are heading. To the extent that DeFi is reinventing things that have been tried before, I suspect it would be useful to reflect on why free banking is no longer the way the conventional banking system operates. That is another topic for another day.

Tony – From the Outside

The Basle Committee consults on bank cryptoasset exposures

The Basel Committee on Banking Supervision (BCBS) yesterday (10 June 2021) released a consultative document setting out preliminary proposals for the prudential (i.e. capital adequacy) treatment of banks’ cryptoasset exposures. A report I read in the financial press suggested that Basel was applying tough capital requirements to all cryptoassets but when you look at the actual proposals that is not correct (credit to Matt Levine at Bloomberg for picking up on the detail).

The BCBS is actually proposing to split cryptoassets into two broad groups: one which looks through the Crypto/DLT packaging and (largely) applies the existing Basel requirements to the underlying assets with some modifications; and another (including Bitcoin) which is subject to the new conservative prudential treatment you may have read about.

The proposed prudential treatment is based around three general principles
  • Same risk, same activity, same treatment: While the the BCBS does see the “potential” for the growth of cryptoassets “to raise financial stability concerns and increase risks face by banks”, it is attempting to chart a path that is agnostic on the use of specific technologies related to cryptoassets while accounting for any additional risks arising from cryptoasset exposures relative to traditional assets.  
  • Simplicity: Given that cryptoassets are currently a relatively small asset class for banks, the BCBS proposes to start with a simple and cautious treatment that could, in principle, be revisited in the future depending on the evolution of cryptoassets. 
  • Minimum standards: Jurisdictions may apply additional and/or more conservative measures if they deem it desirable including outright prohibitions on their banks from having any exposures to cryptoassets. 
The key element of the proposals is a set of classification conditions used to identify the Group 1 Cryptoassets

In order to qualify for the “equivalent risk-based” capital requirements, a crypto asset must meet ALL of the conditions set out below:

  1. The crypto asset either is a tokenised traditional asset or has a stabilisation mechanism that is effective at all times in linking its value to an underlying traditional asset or a pool of traditional asset
  2. All rights obligations and interests arising from crypto asset arrangements that meet the condition above are clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemed. In addition, the applicable legal framework(s) ensure(s) settlement finality.
  3. The functions of the crypotasset and the network on which it operates, including the distributed ledger or similar technology on which it is based, are designed and operated to sufficiently mitigate and manage any material risks.
  4. Entities that execute redemptions, transfers, or settlement finally of the crypto asset are regulated and supervised

Group 1 is further broken down to distinguish “tokenised traditional assets” (Group 1a) and “crypto assets with effective stabilisation mechanisms” (Group 1b). Capital requirements applied to Group 1a are “at least equivalent to those of traditional assets” while Group 2a will be subject to “new guidance of current rules” that is intended to “capture the risks relating to stabilisation mechanisms”. In both cases (Group 1a and 1b), the BCBS reserves the right to apply further “capital add-ons”.

Crypto assets that fail to meet ANY of the conditions above will be classified as Group 2 crypto assets and subject to 1250% risk weight applied to the maximum of long and short positions. Table 1 (page 3) in the BCBS document offers an overview of the new treatment.

Some in the crypto community may not care what the BCBS thinks or proposes given their vision is to create an alternate financial system as far away as possible from the conventional centralised financial system. It remains to be seen how that works out.

There are other paths that may seek to coexist and even co-operate with the traditional financial system. There is also of course the possibility that governments will seek to regulate any parts of the new financial system once they become large enough to impact the economy, consumers and/or investors.

I have no insights on how these scenarios play out but the stance being adopted by the BCBS is part of the puzzle. The fact that the BCBS are clearly staking out parts of the crypto world they want banks to avoid is unremarkable. What is interesting is the extent to which they are open to overlap and engagement with this latest front in the long history of financial innovation.

Very possible that I am missing something here so let me know what it is …

Tony – From the Outside

Joe Wiesenthal contrasts the differing visions represented by Bitcoin and Ethereum

Joe Weisenthal (Bloomberg) wrote an interesting opinion piece discussing the differing visions that Bitcoin and Ethereum offer for the future of finance and money. I am a self declared neophyte in the world of cryptocurrency and DeFi so it may be that the experts in those domains will find fault but I found his thesis interesting. The article is behind the Bloomberg paywall but this is what I took away from it.

  • He starts with the observation that, after a decade since its inception, we seem to have arrived at the consensus that Bitcoin is best thought of as something like a digital version of gold (or “digital gold”).
  • That was not necessarily the original intent and battles have been fought between different factions in the Bitcoin community over differing visions.
  • The most recent example being the “Blocksize War” that played out between 2015 and 2017 where an initiative to increase transaction capacity by expanding the size of each Bitcoin block was defeated by others in the community who saw this as a threat to the network decentralisation they believed to be fundamental to what Bitcoin is.
  • Weisenthal notes that other players in the Crypto/DeFi domain have a different vision – Ethereum is currently one of the dominant architects of this alternative vision (but not the only one).
  • The distinguishing feature of Ethereum in Weisenthal’s thesis is that, in addition to being a cryptocurrency, it is also a “token”
  • He argues that, whereas Bitcoin requires a fundamental act of faith in the integrity of Bitcoin’s vision of the future of money, token’s have a broader set of uses to which you can assign value.
  • Once you introduce tokens the focus shifts to what precisely do you intend to do with them – in Weisenthal’s words “… once you’re in the realm of tokens, you don’t need faith, but you still need a point
  • He notes that we have already seen some dead ends play out – Initial Coin Offerings were a big thing for a while but not any more partly due to many of the projects not stacking up but also because many of them were just another form of IPO that were still unregistered (hence illegal) securities offerings in the eyes of the law.
  • We have also seen some developments like Non Fungible Tokens that are interesting from a social perspective but not necessarily going to shake the foundations of the status quo.
  • A third possibility is that DeFi starts to become a real force that starts to shake up the existing players in the conventional financial system.
  • This third option is the one that Weisenthal (and I) find most interesting but there is still a long way to go.

This is most definitely a topic where I am likely to be missing something but Weisenthal’s article offers an interesting discussion on the contrasting visions, assumptions and objectives of the two currently dominant tribes (Bitcoin and Ethereum). Most importantly it highlights the fact that the vision of DeFi being pursued by Ethereum (or alternatives such as Solana) is radically different to the vision of the future of money being pursued by Bitcoin.

Tony – From the Outside

Australian bank capital adequacy – Roadmap to 2023

I have posted a couple of times on the revisions of the Australian bank capital adequacy framework that APRA initiated in December 2020 – most recently here where I laid out some problems I was having in understanding exactly what it will mean for an Australian ADI to be “Unquestionably Strong once the revised framework is operational. A letter to ADIs posted on APRA’s website today (2 June 2021) does not provide any answers to the questions I posed but it does give a “roadmap” outlining the steps to be undertaken to calibrate and implement the revised framework.

APRA has included a detailed indicative timeline in an attachment to the letter covering key policy releases, reporting requirements, industry workshops and the process for capital model approvals associated with the revised framework

Next steps

To provide a clear roadmap for consultation and industry engagement, APRA has set out an indicative timeline in Attachment A. The timeline covers key policy releases, reporting requirements, industry workshops and the process for capital model approvals. Over the course of 2021, APRA intends to:

• Conduct a targeted data study, to assess potential changes to the calibration of the prudential standards;

• Initiate regular workshops with industry as the standards and guidance are finalised, to provide a forum for updates and FAQs; and

• Release final prudential standards, draft prudential practice guides (PPGs) and initial details of reporting requirements by the end of the year.

Over the course of 2022, APRA intends to finalise the PPGs and reporting requirements. There are a number of related policy revisions that will also be progressed next year, including the fundamental review of the trading book and public disclosure requirements. APRA intends to conduct a parallel run of capital reporting on the new framework in late 2022.

APRA Letter to ADIs “ADI Capital Reforms: Roadmap to 2023”, 2 June 2021

Two key dates are

  • July 2021 – “Targeted Quantitative Impact Study” (due for completion August 2021)
  • November 2021 – Release of final Prudential Standards

It is not clear what, if any, information APRA will be releasing publicly between now and November 2021 when the Prudential Standards are published. I am hopeful however that the November release will be accompanied by some form of Information Paper setting out what APRA learned from the QIS and the industry workshops that it will be conducting along the way.

Exciting times for a bank capital tragic

Tony – From the Outside

My Adventures in CryptoLand – Net Interest

Marc Rubinstein lays out a detailed account of his initial explorations of decentralised finance. His professional background (like mine) is grounded in the conventional financial system so I found this very useful. Even better it is a short read with some hard numbers (time and cost) on the user experience.

My only quibble is that he calls these decentralised financial entries “banks”. Call me pedantic but none of the institutions discussed are banks and I think the distinction still matters if we want to understand how much of conventional banking will remain as this new chapter in financial innovation plays out.
Link to Marc’s blog here – www.netinterest.co/p/my-adventures-in-cryptoland

Tony – From the Outside

ECB Targeted Review of Internal Models

The European Central Bank recently (April 2021) released a report documenting what had been identified in a “Targeted Review of Internal Models”(TRIM). The TRIM Report has lots of interesting information for subject matter experts working on risk models.

It also has one item of broader interest for anyone interested in understanding what it means for an Australian Authorised Deposit Taking Institution (ADI) to be “Unquestionably Strong” per the recommendation handed down by the Australian Financial System Inquiry in 2014 and progressively being enshrined in capital regulation by the Australian Prudential Regulation Authority (APRA).

The Report disclosed that the TRIM has resulted in 253 supervisory decisions that are expected to result in a 12% increase in the aggregate RWAs of the models covered by the review. European banks may not be especially interested in the capital adequacy of their Australian peers but international peer comparisons have become one of the core lens through which Australian capital adequacy is assessed as a result of the FSI recommendation.

There are various ways in which the Unquestionably Strong benchmark is interpreted but one is the requirement that the Australian ADIs maintain a CET1 ratio that lies in the top quartile of international peer banks. A chart showing how Australian ADIs compare to their international peer group is a regular feature of the capital adequacy data they disclose. The changes being implemented by the ECB in response to the TRIM are likely (all other things being equal) to make the Australian ADIs look even better in relative terms in the future.

More detail …

The ECB report documents work that was initiated in 2016 covering 200 on-site model investigations (credit, market and counterparty credit risk) across 65 Significant Institutions (SI) supervised by ECB under what is known as the Single Supervisory Mechanism and extends to 129 pages. I must confess I have only read the Executive Summary (7 pages) thus far but I think students of the dark art of bank capital adequacy will find some useful nuggets of information.

Firstly, the Report confirms that there has been, as suspected, areas in which the outputs of the Internal Models used by these SI varied due to inconsistent interpretations of the BCBS and ECB guidance on how the models should be used to generate consistent and comparable risk measures. This was not however simply due to evil banks seeking to game the system. The ECB identified a variety of areas in which their requirements were not well specified or where national authorities had pursued inconsistent interpretations of the BCBS/ECB requirements. So one of the key outcomes of the TRIM is enhanced guidance from the ECB which it believes will reduce the instances of variation in RWA due to differences in interpretation of what is required.

Secondly the ECB also identified instances in which the models were likely to be unreliable due to a lack of data. As you would expect, this was an issue for Low Default Portfolios in general and Loss Given Default models in particular. As a result, the ECB is applying “limitations” on some models to ensure that the outputs are sufficient to cover the risk of the relevant portfolios.

Thirdly the Report disclosed that the TRIM has resulted in 253 supervisory decisions that are expected to result in a 12% increase in the aggregate RWAs of the models covered by the review.

As a follow-up to the TRIM investigations, 253 supervisory decisions have been issued or are in the process of being issued. Out of this total, 74% contain at least one limitation and 30% contain an approval of a material model change. It is estimated that the aggregated impact of TRIM limitations and model changes approved as part of TRIM investigations will lead to a 12% increase in the aggregated RWA covered by the models assessed in the respective TRIM investigations. This corresponds to an overall absolute increase in RWA of about €275 billion as a consequence of TRIM and to a median impact of -51 basis points and an average impact of -71 basis points on the CET1 ratios of the in-scope institutions.

European Central Bank, “Targeted Review of Internal Models – Project Report”, April 2021, (page 7)
Summing up

Interest in this report is obviously likely to be confined for the most part to the technical experts that labour in the bowels of the risk management machines operated by the large sophisticated banks that are accredited to measure their capital requirements using internal models. There is however one item of general interest to an Australian audience and that is the news that the RWA of their European peer banks is likely to increase by a material amount due to modelling changes.

It might not be obvious why that is so for readers located outside Australia. The reason lies in the requirement that our banks (or Authorised Deposit-Taking Institutions to use the Australian jargon) be capitalised to an “Unquestionably Strong” level.

There are various ways in which this benchmark is interpreted but one is the requirement that the Australian ADIs maintain a CET1 ratio that lies in the top quartile of international peer banks. A chart showing how Australian ADIs compare to this international peer group is a regular feature of the capital adequacy data disclosed by the ADIs and the changes being implemented by the ECB are likely (all other things being equal) to make the Australian ADIs look even better in relative terms in the future.

Tony – From the Outside

JP Koning’s “over consumptionist” theory of Bitcoin and decentralisation

Interesting post by JP Koning exploring the current debate about the value of Bitcoin and its energy demand.

There are two extreme theories about cryptocurrency energy consumption, both of them bitterly opposed to each other. The first I’ll call the big waste theory. Cryptocurrencies such as Bitcoin and Ethereum serve no useful purpose. Yet they are sucking up huge amounts of useful electricity. Let’s ban them.

The second theory is the vital cog theory. Cryptocurrencies are a useful bit of global financial infrastructure. And so the huge amounts of energy that they are consuming is beneficial. Let’s not impede them.

“The overconsumption theory of bitcoin (and decentralization in general)”, JP Koning, May 2021

Koning offers an alternative “overconsumptionist theory” – worth reading

Tony – From the Outside

Australian bank capital adequacy – building out the Unquestionably Strong framework

In this post, I lay out some problems that I have encountered in attempting to reconcile what it will mean for a D-SIB ADI to be “Unquestionably Strong” under the proposed new framework that APRA outlined in its December 2020 Discussion Paper (“A more flexible and resilient capital framework for ADIs”). Spoiler alert – I think the capital buffers adding up to a 10.5% CET1 prudential requirement may need to be recalibrated once all of the proposed changes to risk weights are tied down. I also include some questions regarding the impact of the RBNZ’s requirement for substantially higher capital requirements for NZ domiciled banks.

The backstory

The idea that Australian Authorised Deposit Taking Institutions (“ADIs” but more commonly referred to as “banks”) needed to be “Unquestionably Strong” originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian ADIs should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcementsupported by a longer information paper.

For most people, this all condensed into a very simple message, the systemically important Australian ADIs needed to maintain a Common Equity Tier 1 (CET1) ratio of at least 10.5%. The smaller ADIs have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger systemically important ADIs.

In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 APRA discussion paper (which I covered here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.

December 2020 – “Unquestionably Strong” meets “A more flexible and resilient capital framework for ADIs”

I have written a couple of posts on APRA’s December 2020 Discussion Paper but have thus far focussed on the details of the proposed changes to risk weights and capital buffers (here, here and here). This was partly because there was a lot to digest in these proposals but also because I simply found the discussion of how the proposed new framework reconciled to the Unquestionably Strong benchmark to be a bit confusing.

What follows is my current understanding of what the DP says and where we are headed.

On one level, the answer is quite simple – Exhibit A from the Discussion Paper (page 17) …

APRA DP “A more flexible and resilient capital framework for ADIs” page 17
  • For systemically important ADI (D-SIB ADIs), the Unquestionably Strong 10.5% CET1 benchmark will be enshrined in a series of expanded capital buffers that will come into force on 1 January 2023 and add up to 10.5%.
  • However, we also know that APRA has at the same time outlined a range of enhancements to risk weights that are expected to have the effect of reducing aggregate Risk Weighted Assets and thereby result in higher capital adequacy ratios.
  • APRA has also emphasised that the net impact of the changes is intended to be capital neutral; i.e. any D-SIB ADI that meets the Unquestionably Strong benchmark now (i.e. that had a CET1 ratio of at least 10.5% under the current framework) will be Unquestionably Strong under the new framework
  • However this implies that the expected increase in reported CET1 under the new framework will not represent surplus capital so it looks like Unquestionably Strong will require a CET1 ratio higher than 10.5% once the new framework comes into place.

The only way I can reconcile this is to assume that APRA will be revisiting the calibration of the proposed increased capital buffers once it gets a better handle on how much capital ratios will increase in response to the changes it makes to bring Australian capital ratios closer to those calculated by international peers under the Basel minimum requirements. If this was spelled out in the Discussion Paper I missed it.

What about the impact of RBNZ requiring more capital to be held in New Zealand?

Running alongside the big picture issues summarised above (Unquestionably Strong, Transparency, Comparability, Flexibility, Resilience”, APRA has also been looking at how it should respond to the issues posed by the RBNZ policy applying substantial increases to the capital requirements for banks operating in NZ. I wrote two post on this issue (see here and here) that make the following points

  • To understand what is going on here you need to understand the difference between “Level 1” and Level 2” Capital Adequacy (part of the price of entry to this discussion is understanding more APRA jargon)
  • The increased share of the group capital resources required to be maintained in NZ will not have any impact on the Level 2 capital adequacy ratios that are the ones most commonly cited when discussing Australian ADI capital strength
  • In theory, maintaining the status quo share of group capital resources maintained in Australia would require some increase in the Level 2 CET1 ratio (i.e. the one that is used to express the Unquestionably Strong benchmark)
  • In practice, the extent to which the Level 2 benchmark is impacted depends on the maternity of the NZ business so it may be that there is nothing to see here
  • It is hard to tell however partly because there is not a lot of disclosure on the details of the Level 1 capital adequacy ratios (at least not a lot that I could find) and partly because the Level 1 capital measure is (to my mind) not an especially reliable (or indeed intuitive) measure of the capital strength
Summing up
  • There is I think a general consensus that the Australian D-SIB ADIs all currently exceed the requirements of what it means to be Unquestionably Strong under the current capital adequacy framework
  • This implies that they have surplus capital that may potentially be returned to shareholders
  • APRA has laid out what I believe to be pretty sensible and useful enhancements to that framework (the expanded and explicitly more flexible capital buffers in particular)
  • These changes have however (for me at least) made it less clear what it will mean for an ADI to be Unquestionably Strong post 1 January 2023 when the proposed changes to Risk Weighted Assets come into effect

Any and all contributions to reducing my ignorance and confusion will be gratefully accepted – let me know what I am missing

Tony – From the Outside