Interesting post by Marc Rubinstein on the history of clearing houses and Sam Bankman-Fried’s proposal for a new approach.
This link takes you to the last of a 7 episode podcast Michael Lewis has done on the role of experts
The whole series is highly recommended but I especially like this quote in which he attempts to sum up the series
“Life eventually humbles us all. What I love about experts, the best of them anyway, is that they get to their humility early, they have to, it’s part of who they are, it’s necessary for what they are doing. They set out to get to the bottom of something that has no bottom, and so they are reminded, constantly, of what they don’t know. They move through the world focussed not on what they know but on what they might find out.”
In that spirit, let me know what I am missing
Tony – From the Outside
There has been a lot written on stablecoins in the wake of Terra’s crash. Matt Levine has been a reliable source of insight (definitely worth subscribing to his “Money Stuff” newsletter) but I am also following Izabella Kaminska via her new venture (The Blind Spot).
Maybe I am just inexplicably drawn to anything that seeks to explain crypto in Tradfi terms but I think this joint post by Izabella and Frances Coppola poses the right question by exploring the extent to which stablecoin issuers will always struggle to reconcile the safety of their peg promise to the token holders with the need to make a return. The full post is behind a paywall but this link takes you to a short extract that Izabella has made more broadly available.
Their key point is that financial security is costly so your business model needs an angle to make a return … to date the angles (or financial innovations) are mostly stuff that Tradfi has already explored. There is no free lunch.
If it’s financially secure, it’s usually not profitable
So, what was the impetus for issuers like Kwon to focus on these innovations? For the most part, it was probably the realisation that conventional stablecoins – due to their similarities with narrow banks – are exceedingly low-margin businesses. In a lot of cases, they may even be unprofitable.
This is because managing other people’s money prudently and in a way that always protects capital is actually really hard. Even if those assets are fully reserved, some sort of outperformance has to be generated to cover the administration costs. The safest way to do that is to charge fees, but this hinders competitiveness in the market since it generates a de facto negative interest rate. Another option is cross-selling some other service to the captured user base, like loan products. But this gets into bank-like activity.
The bigger temptation, therefore, at least in the first instance, is to invest the funds in your care into far riskier assets (with far greater potential upside) than those you are openly tracking.
But history shows that full-reserve or “narrow” banks eventually become fractional-reserve banks or disappear.“Putting the Terra stablecoins debacle into Tradfi context”, Frances Coppola and Izabella Kaminska, The Blind Spot
Tony – From the Outside
You may or may not agree with her stance on Bitcoin but this post offers a useful list of what Izabella has identified as the more informed contributions to the debate about stablecoins.
I have read most of these already but it offers a useful reference point for anyone trying to make sense of this corner of the financial universe.
Tony – From the Outside
Anyone moderately familiar with crypto assets is no doubt aware that the Terra stablecoin has been experiencing problems with its algorithmic smart contract controlled peg mechanism. There are lots of lessons here I am but I think Matt Levine flags one of the more interesting ones in his “Money Stuff” column (13 May 2022).
Safe assets are much riskier than risky ones.
Matt goes on to expand on why this is so …
This is I think the deep lesson of the 2008 financial crisis, and crypto loves re-learning the lessons of traditional finance. Systemic risks live in safe assets. Equity-like assets — tech stocks, Luna, Bitcoin — are risky, and everyone knows they’re risky, and everyone accepts the risk. If your stocks or Bitcoin go down by 20% you are sad, but you are not that surprised. And so most people arrange their lives in such a way that, if their stocks or Bitcoin go down by 20%, they are not ruined.
On the other hand safe assets — AAA mortgage securities, bank deposits, stablecoins — are not supposed to be risky, and people rely on them being worth what they say they’re worth, and when people lose even a little bit of confidence in them they crack completely. Bitcoin is valuable at $50,000 and somewhat less valuable at $40,000. A stablecoin is valuable at $1.00 and worthless at $0.98. If it hits $0.98 it might as well go to zero. And now it might!
The takeaway for me is to once again highlight the way in which supposedly safe, “no questions need be asked”, assets can sometimes be worse than assets we know are risky due to the potential for them to quickly flip into something for which there is no liquidity, just a path to increasingly large price falls. This is a theme that I regularly hammer (so apologies if you are tired of it) but still for me one of the more important principles in finance (right up there with “no free lunch”).
Tony – From the Outside
I recently flagged a speech by Sam Woods (a senior official at the UK Prudential Regulation Authority) which floated some interesting ideas for what he describes as a “radically simpler, radically usable” version of the multi-layered capital buffers currently specified by the BCBS capital accord. At the time I was relying on a short summary of the speech published in the Bank Policy Institute’s “Insights” newsletter. Having now had a chance to read the speech in full I would say that there is a lot to like in what he proposes but also some ideas that I am not so sure about.
Mr Woods starts in the right place with the acknowledgment that “… the capital regime is fiendishly complex”. Complexity is rarely (if ever?) desirable so the obvious question is to identify the elements which can be removed or simplified without compromising the capacity to achieve the underlying economic objectives of the regime.
While the capital regime is fiendishly complex, its underlying economic goals are fairly simple: ensure that the banking sector has enough capital to absorb losses, preserve financial stability and support the economy through stresses.
… my guiding principle has been: any element of the framework that isn’t actually necessary to achieve those underlying goals should be removed. …
With that mind, my simple framework revolves around a single, releasable buffer of common equity, sitting above a low minimum requirement. This would be radically different from the current regime: no Pillar 2 buffers; no CCoBs, CCyBs, O-SII buffer and G-SiB buffers; no more AT1.
In practice, Mr Woods translates this simple design principle into 7 elements:
1. A single capital buffer, calibrated to reflect both microprudential and macroprudential risks.
2. A low minimum capital requirement, to maximise the size of the buffer.
3. A ‘ladder of intervention’ based on judgement for firms who enter their buffer – no mechanical triggers and thresholds.
4. The entire buffer potentially releasable in a stress.
5. All requirements met with common equity.
6. A mix of risk-weighted and leverage-based requirements.
7. Stress testing at the centre of how we set capital levels.
The design elements that appeal to me:
- The emphasis on the higher capital requirements of Basel III being implemented via buffers rather than via higher minimum ratio thresholds
- The concept of a “ladder of intervention” with more room for judgment and less reliance on mechanical triggers
- The role of stress testing in calibrating both the capital buffer but also the risk appetite of the firm
I am not so sure about:
- relying solely on common equity and “no more AT1” (Additional Tier 1)
- the extent to which all of the components of the existing buffer framework are wrapped into one buffer and that “entire buffer” is potentially usable in a stress
No more Additional Tier 1?
There is little debate that common equity should be the foundation of any capital requirement. As Mr Woods puts it
Common equity is the quintessential loss-absorbing instrument and is easy to understand.
The problem with Additional Tier 1, he argues, is that these instruments …
… introduce complexity, uncertainty and additional “trigger points” in a stress and so have no place in our stripped-down concept …
I am a huge fan of simplifying things but I think it would be a retrograde step to remove Additional Tier 1 and other “bail-in” style instruments from the capital adequacy framework. This is partly because the “skin in the game” argument for common equity is not as strong or universal as its proponents seem to believe.
The “skin in the game” argument is on solid foundations where an organisation has too little capital and shareholders confronted with a material risk of failure, but limited downside (because they have only a small amount of capital invested), have an incentive to take large risks with uncertain payoffs. That is clearly undesirable but it is not a fair description of the risk reward payoff confronting bank shareholders who have already committed substantial increased common equity in response to the new benchmarks of what it takes to be deemed a strong bank.
I am not sure that any amount of capital will change the kinds of human behaviour that see banks mistakenly take on outsize, failure inducing, risk exposures because they think that they have found some unique new insight into risk or have simply forgotten the lessons of the past. The value add of Additional Tier 1 and similar “bail-in” instruments is that they enable the bank to be recapitalised with a material injection of common equity while imposing a material cost (via dilution) on the shareholders that allowed the failure of risk management to metastasise. The application of this ex post cost as the price of failure is I think likely to be a far more powerful force of market discipline than applying the same amount of capital before the fact to banks both good and bad.
In addition to the potential role AT1 play when banks get into trouble, AT1 investors also have a much greater incentive to monitor (and constrain) excessive risk taking than the common equity holders do because they don’t get any upside from this kind of business activity. AT1 investors obviously do not get the kinds of voting rights that common shareholders do but they do have the power to refuse to provide the funds that banks need to meet their bail-in capital requirements. This veto power is I think vastly underappreciated in the current design of the capital framework.
Keep AT1 but make it simpler
Any efforts at simplification could be more usefully directed to the AT1 instruments themselves. I suspect that some of the complexity can be attributed to efforts to make the instruments look and act like common equity. Far better I think to clearly define their role as one of providing “bail-in” capital to be used only in rare circumstances and for material amounts and define their terms and conditions to meet that simple objective.
There seems, for example, to be an inordinate amount of prudential concern applied to the need to ensure that distributions on these instruments are subject to the same restrictions as common equity when the reality is that the amounts have a relatively immaterial impact on the capital of the bank and that the real value of the instruments lie in the capacity to convert their principal into common equity. For anyone unfamiliar with the way that these instruments facilitate and assign loss absorption under bail-in I had a go at a deeper dive on the topic here.
One buffer to rule them all
I am not an expert on the Bank of England’s application of the Basel capital accord but I for one have always found their Pillar 2B methodology a bit confusing (and I like to think that I do mostly understand capital adequacy). The problem for me is that Pillar 2B seems to be trying to answer much the same question as a well constructed stress testing model applied to calibration of the capital buffer. So eliminating the Pillar 2B element seems like a step towards a simpler, more transparent approach with less potential for duplication and confusion.
I am less convinced that a “single capital buffer” is a good idea but this is not a vote for the status quo. The basic structure of a …
- base Capital Conservation Buffer (CCB),
- augmented where necessary to provide an added level of safety for systemically important institutions (either global or domestic), and
- capped with a variable component designed to absorb the “normal” or “expected” rise and fall of losses associated with the business cycle
… seems sound and intuitive to me.
What I would change is the way that the Countercyclical Capital Conservation Buffer (CCyB) is calibrated. This part of the prudential capital buffer framework has been used too little to date and has tended to be applied in an overly mechanistic fashion. This is where I would embrace Mr Woods’ proposal that stress testing become much more central to the calibration of the CCyB and more explicitly tied to the risk appetite of the entity conducting the process.
I wrote a long post back in 2019 where I set out my thoughts on why every bank needs a cyclical capital buffer. I argued then that using stress testing to calibrate the cyclical component of the target capital structure offered an intuitive way of translating the risk appetite reflected in all the various risk limits into a capital adequacy counterpart. Perhaps more importantly,
- it offered a way to more clearly define the point where the losses being experienced by the bank transition from expected to unexpected,
- focussed risk modelling on the parts of the loss distribution that more squarely lay within their “zone of validity”, and
- potentially allowed the Capital Conservation Buffer (CCB) to more explicitly deal with “unexpected losses” that threatened the viability of the bank.
I have also seen a suggestion by Douglas Elliott (Oliver Wyman) that a portion of the existing CCB be transferred into a larger CCyB which I think is worth considering if we ever get the chance to revisit the way the overall prudential buffers are designed. This makes more sense to me than fiddling with the minimum capital requirement.
As part of this process I would also be inclined to revisit the design of the Capital Conservation Ratio (CCR) applied as CET1 capital falls below specified quartiles of the Capital Conservation Buffer. This is another element of the Basel Capital Accord that is well intentioned (banks should respond to declining capital by retaining an increasing share of their profits) that in practice tends to be much more complicated in practice than it needs to be.
Sadly, explaining exactly why the CCR is problematic as currently implemented would double the word count of this post (and probably still be unintelligible to anyone who has not had to translate the rules into a spreadsheet) so I will leave that question alone for today.
Mr Woods has done us all a service by raising the question of whether the capital buffer framework delivered by the Basel Capital Accord could be simplified while improving its capacity to achieve its primary prudential and economic objectives. I don’t agree with all of the elements of the alternative he puts up for discussion but that is not really the point. The important point is to realise that the capital buffer framework we have today is not as useful as it could be and that really matters for helping ensure (as best we can) that we do not find ourselves back in a situation where government finds that bailing out the banks is its least worst option.
I have offered my thoughts on things we could do better but the ball really sits with the Basel Committee to reopen the discussion on this area of the capital adequacy framework. That will not happen until a broader understanding of the problems discussed above emerges so all credit to Mr Woods for attempting to restart that discussion.
As always let me know what I am missing …
Tony – From the Outside
I came across this proposal via the Bank Policy Institute’s weekly “Insights” email update
I have not read the speech yet but the summary offered by the BPI suggests that the proposal is worth reviewing in part because it highlights that a key part of the Basel III framework remains a work in progress
Here is the BPI’s summary
Prudential Regulatory Authority chief Sam Woods suggested making the U.K.’s bank capital framework simpler and more flexible. In a speech this week, Woods said regulators should make capital buffers more usable – in other words, entice banks to dip into them to lend during stressful times. The suggested framework, which Woods compared to a concept car and dubbed the “Basel Bufferati,” would be “radically simpler, radically usable, and a million miles away from the current debate but which might prove instructive over the longer term.” It centers on “a single, releasable buffer of common equity, sitting above a low minimum requirement.” It would also replace automatic thresholds with a “ladder of intervention” and feature a mix of risk-weighted and leverage-based requirements. The buffer would be determined using the results of the stress tests that would sit on top of standardized risk weights, which is a concept similar to the current U.S. regime. Therefore, “a lot of the sophistication which currently resides in modelling risk-weights would move into stress testing.”
Tony – From the Outside
In a recent post devoted to a BIS report summarising the results of interviews on what a small group of central banks had been doing with regard to Central Bank Digital Currencies, I posed the question whether central bankers might be better placed using their resources and powers to foster the development of fast payment systems rather than Central Bank Digital Currencies (CBDCs) and offered the following perspective:
the business case for a retail CBDC seems to have the most weight in the emerging market and developing economies with relatively poorly developed financial infrastructure
the business case for a retail CBDC in an advanced economy is less obvious
other initiatives such as central bank sponsorship of fast payment systems might be a better use of central bank resources
not explicitly referenced in the paper, but the recent experience with the roll out of fast payment systems in Brazil and India offer interesting case studies
the central bank focus on CBDCs seems to continue to be heavily weighted toward account based systems
token based CBDCs are mentioned in passing but do not seem to be high on the list of priorities
From the Outside – 15 March 2022 – “Central Bank Digital Currencies: A new tool in the financial inclusion toolkit”
For anyone interested in CBDC’s and fast payment systems, the BIS has published another report exploring the lessons to be learned from Brazil’s adoption of the “Pix” fast payment system. The authors identify three takeaways from Brazil’s experience which I think broadly support the thesis that fast payment systems often have the potential to achieve many if not all of the public policy objectives associated with CBDCs:
Public payment infrastructures build on the central bank’s foundational role in the monetary system by promoting competition and interoperability between payment platforms. They can reduce costs for users and promote financial inclusion.
Brazil’s recent experience with the Pix retail instant payment system illustrates the potential gains. In little over a year since its launch in November 2020, Pix has signed up 67% of adults in Brazil, with free payments between individuals and low charges for merchants.
The two key ingredients in the success of Pix are, first, the mandatory participation of large banks to kick-start network effects for users, and second, the central bank’s dual role as infrastructure provider and rule setter.
It is important to note however that these benefits do not flow automatically from just building the payment system infrastructure, the report highlights the importance of the central bank using its power to:
- mandate the participation of large banks and other large players in payment services in order to kickstart the network effects and
- to set rules that promote competition
I may be missing something here but it still feels to me like CBDCs are over-rated and (well constructed) fast payment systems under-rated. There are no doubt some economies where a CBDC has a role to play but I for one am paying more attention to the roll out of their less glamorous sibling.
Tony – From the Outside
CBDCs and stablecoins have been getting most of the attention lately. In contrast the release in late March 2022 of a draft bill titled the ECASH Act seems to have flown under the radar. The bill as I understand it is only a proposal at this stage and not something actively in the process of becoming law. It is however worth noting for a couple of reasons
- Is is a useful reminder that an account based CBDC is not the only form of government issued digital money that might be pursued (though the account based model does seem to be the model preferred by the BIS mostly due to concerns about illegal use of anonymous forms of money)
- Primary responsibility for E-Cash is assigned to the US Treasury, not the Central Bank (so technically it is not a CBDC per se)
- Although I personally am not overly concerned by the current state of Know Your Customer and related anti money laundering, anti terrorist financing requirements applied to bank accounts, I respect the views of those for whom privacy is a priority or don’t have the benefit of living in the kind of economy/society that allows me to be relaxed about these questions
- So long as the digital form of cash is subject to an equivalent set of controls on illicit activity as is applied to physical cash, then I can’t see why the digital option should be prohibited
- Adding a digital money option that is capable of operating in an off-line environment also looks to me like a useful (albeit limited) level of redundancy and resilience in a world that increasingly relies on a 24/7 supply of power and internet connectivity for money to function
Who needs e-cash?
You can find more detail about the proposal here but for those short of time the argument put up by the Act’s proponents for why someone might want to use E-Cash is summarised as those who:
1. Lack access to traditional banking/payments services;
2. Value privacy and wish to avoid surveillance and/or data-mining;
3. Are concerned about third-party censorship and/or discrimination;
3. Lack reliable internet or digital network connectivity; and
5. Are low-income and/or cannot afford high transaction, withdrawal, and exchange fees.www://https.ecashact.us/#whyuse
The Act’s proponents emphasise however that “… E-Cash, like physical cash, does not pay interest, and offers less third-party protections than traditional bank accounts or payments app (chargebacks, loss and fraud-prevention, etc).” The basic idea is that this is a complement to the existing forms of money (physical and digital) and it is not envisaged that most people will seek to hold large amounts in the form of E-Cash.
What exactly does the ECASH Act proposes?
1. Directs the Secretary of the Treasury to develop and introduce a form of retail digital dollar called “e-cash,” which replicates the offline-capable, peer-to-peer, privacy-respecting, zero transaction-fee, and payable-to-bearer features of physical cash, and to coordinate their efforts with other agencies, including the Federal Reserve through an intergovernmental Digital Dollar Council led by the Treasury Secretary;
2. Establishes an Electronic Currency Innovation Program within the U.S. Treasury to test and evaluate different forms of secure hardware-based e-cash devices that do not require internet access, third-party validation, or settlement on or via a common ledger, with a focus on widely available, interoperable architectures such as stored-value cards and cell phones;
3. Establishes an independent Monetary Privacy Board to oversee and monitor the federal government’s efforts to preserve monetary privacy and protect civil liberties in the development of digital dollar technologies and services, and directs the Treasury Secretary to, wherever possible, promote and prioritise open-source licensed software and hardware, and to make all technical information available for public review and comment; and
4. Establishes a special-purpose, ring-fenced Treasury overdraft account at the Federal Reserve Bank of New York to cover any and all government expenses related to the development and piloting of E-Cash, and directs the Board of Governors of the Federal Reserve System to take appropriate liquidity-support measures to ensure that the introduction of e-cash does not reduce the ability of banks, credit unions, or community development financial institutions to extend credit and other financial services to underserved populations, as prescribed under the Community Reinvestment Act of 1977 and related laws.
I have been a professed sceptic on the need for a retail CBDC in advanced economies with well functioning fast payment systems (see here and here) but this proposal is intriguing and one that I will watch with interest.
Tony – From the Outside
The BIS recently published a paper summarising what had been learned from a series of interviews with nine central banks exploring how these institutions were thinking about the potential of a CBDC to support the pursuit of “financial inclusion” objectives explicit or implicit in their mandates.
A lot of what the paper documents and discusses will be pretty familiar to anyone who has been following the BIS and individual central banks on this topic but I think the following observations offered by the paper about the best way to pursue financial inclusion is worth noting
It needs to be noted that many of these features [i.e. the benefits of a CBDC] can, in isolation, be offered by other payment innovations, and many gaps could be addressed through regulation and sound oversight arrangements. Combining different payment innovations – such as open application programming interfaces (APIs), fast payment services, contactless chips and QR codes – could achieve many of the same goals. This is particularly true when accompanied by robust regulatory and oversight arrangements that public authorities can use to catalyse private sector players, enforce sound governance arrangements and foster required coordination and collaboration. Adoption of relevant technologies for supervisory and regulatory compliance could also improve the efficiency and effectiveness of regulators and supervisors. What is truly different about CBDC is that it is a direct claim on the central bank. It is an open question for central banks whether CBDCs or other policy interventions are the best fit for their jurisdiction. Yet if a CBDC is to be issued (for financial inclusion or other motives), interviews with central banks clearly point to the importance of inclusive design elements to successfully promote inclusive outcomes. We discuss these elements in the next subsection.Page 13, paragraph 16
There is a narrative that sees CBDC adoption as inevitable based in part on the fact that so many central banks are looking at the question. In contrast, the BIS paper clearly states that a CBDC is not a “panacea” and that many of the outcomes a CBDC might deliver could equally be delivered by other payment innovations such as “open application programming interfaces (APIs) , fast payment services, contactless chips and QR codes”
It is also worth noting that, of the nine central banks interviewed, eight were emerging market and developing economies and only one (Bank of Canada) an advanced economy. The results should therefore be interpreted with that bias in mind.
Summing up, my take is that
- the business case for a retail CBDC seems to have the most weight in the emerging market and developing economies with relatively poorly developed financial infrastructure
- the business case for a retail CBDC in an advanced economy is less obvious
- other initiatives such as central bank sponsorship of fast payment systems might be a better use of central bank resources
- not explicitly referenced in the paper, but the recent experience with the roll out of fast payment systems in Brazil and India offer interesting case studies
- the central bank focus on CBDCs seems to continue to be heavily weighted toward account based systems
- token based CBDCs are mentioned in passing but do not seem to be high on the list of priorities
Let me know what I am missing
Tony – From the Outside