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

Matt Levine on stuff that gets lost in translation

I have been referencing Matt Levine a lot lately. No apologies, his Money Stuff column is a regular source of insight and entertainment for banking and finance tragics such as myself and I recommend it. His latest column (behind a paywall but you can access a limited number of articles for free I think) includes a discussion of the way in which the DeFi industry has created analogues of conventional banking concepts like “deposits” but with twists that are not always obvious or indeed intuitive to the user/customer.

We have talked a lot recently about how crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account.

Matt Levine “Money Stuff” column 28 June 2022 – Crypto depositors

How banks can create safe assets is a topic that I have looked at a number of times but this post is my most complete attempt to describe the process that Matt outlines above. To me at least, this is a pretty fundamental part of understanding how finance works and Matt also did a good post on the topic that I discussed here.

One of the key points is that the tranching of liabilities also creates a division of labour (and indeed of expertise and inclination) …

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.

The DeFi industry argues that they want to change the ways that traditional finance operates for the benefit of users but it also expects those users to be motivated and engaged in understanding the details of the new way of doing things. A problem is that some users (maybe “many users”?) might be assuming that some of the rules that protect depositors (and indeed creditors more generally) in the conventional financial system would naturally be replicated in the alternative financial system being created.

Back to Matt …

The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.

The problem according to Matt is ….

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.

This feels like a problem to me. As the industry becomes more regulated I would expect to see the issues of seniority and deposit protection/preference more clearly spelled out. For the time being it does seem to be very much caveat emptor and don’t assume anything.

Tony – From the Outside

How 2020 set the stage for the 2021 bitcoin bubble – Amy Castor

I try to read both sides of the crypto story – the believers and the critics. Amy Castor and David Gerard have just dropped a new post offering a detailed update of the argument that a lot of crypto (and DeFi) is mostly a Ponzi scheme.

The TL;DR is “there’s no money left, and no more coming in” according to Amy and David but their long answer can be found here and is (I believe) worth reading whatever side of the debate you sit on.

The post admittedly plays to my sceptical bias on crypto and DeFi but let me know what I am missing.

Tony – From The Outside

P.s. if you want to hear the other side then “The Breakdown”, a podcast by NLW, is one of the sources I rely on.

Two perspectives on crypto – Irony and Optimism

There has been a lot written about the crypto winter but I want to call out two perspectives I thought had something interesting to say.

The irony

One is the ever reliable, entertaining and informative Matt Levine in his Bloomberg Money Stuff column. The nominal focus is the immediate impact on Voyager Digital Ltd but his broader point is that, while crypto started as a response to the 2008 financial crisis and the associated problems with the conventional banking system, one of the more tangible achievements of the DeFi financial system system that has been built on crypto foundations has been to recreate the interconnectedness, leverage and opacity that crypto was meant to replace.

He starts with the theory …

“A Bitcoin is a Bitcoin, not the debt of some bank, so there is no buildup of leverage in the system as investors hunt for safe assets. Crypto avoids the opacity of traditional banks: Crypto transactions occur on an open transparent blockchain; there are no hidden obligations that can bring the system down. Crypto is decentralized and open; “code is law”; mistakes lead to failures, not bailouts. “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,” I wrote earlier this month. 

Matt Levine, “Money Stuff” Bloomberg 24 June 2022

… while in practice …

But the current crypto winter shows that this is amazingly untrue in practice. There is a ton of leverage and interconnection, and who owes what to whom is surprisingly opaque, and when it causes problems it is addressed by negotiated bailouts from large crypto players. Crypto has recreated the opaque, highly leveraged, bailout-prone traditional financial system of 2008.

Matt Levine, “Money Stuff” Bloomberg 24 June 2022

.. and concludes

I don’t know what to make of that. Mostly I just want to say: What an accomplishment! Rebuilding the pre-2008 financial system is a weird achievement, but certainly a difficult one, and they went and did it. One other possible conclusion is that that system was somehow … “good” might not be the word, but “natural”? Like, something in the nature of finance, or in the nature of humans, tends toward embedding opaque leverage in financial systems? Crypto was a reaction against that tendency, but as time went on, that tendency crept into crypto too.”

Matt Levine, “Money Stuff” Bloomberg 24 June 2022

… the optimistic perspective

I don’t want this to be a pile in on crypto so let me conclude on a more optimistic note courtesy of Gillian Tett at the Financial Times. Gillian, like Matt, notes that leverage and complexity are always problematic

“The companies imploding are those that feature one or all of the following traits: high leverage, opposition to regulation, excessively complex innovations and heavy spending on expansion”

Gillian Tett, “Crypto enthusiasts are betting the house on creative destruction” Financial Times 23 June 2022

Gillian however argues that this can be viewed as a healthy dose of creative destruction that is getting rid of the rubbish and allowing better versions to secure their place in the future. She concedes that this may just be “desperate spin” on the part of the DeFi and crypto industry but I do believe she makes a good point.

The individual players obviously do not like it, but every industry benefits from creative destruction and I think there is a pretty strong argument that part of the problem the conventional financial system faces is that it has been shielded from the full force of this process.

I have to confess that it is still not obvious to me what exactly crypto and DeFi will contribute to the future of finance but history shows that companies themselves often stumble on solutions that seem obvious in hindsight but were not what they set out to create. The often quoted story of rise of the personal computer is a case in point (who knew that we all needed one). All we can say at this point is that the current crypto winter is at least increasing the odds that the industry might yet deliver something useful and maybe even revolutionary.

Summing up, scepticism is a pretty sound foundation for viewing most innovations in finance but there is room for a little optimism as well.

Tony – From the Outside

“The basic philosophical difference between the traditional financial system and the cryptocurrency system …”

… according to Matt Levine (“Money Stuff”) “…is that traditional finance is about the extension of credit, and crypto is not”. He acknowledges that this is an exaggeration but argues that it does contain an essential truth about the two systems.

He uses the different ways that crypto approaches money and trading to illustrate his point.

In the traditional financial system money mostly represents an entry on the ledger of a bank. There are ways in which the risk is enhanced but people holding this form of money are essentially creditors of the bank. Crypto, Matt observes, is deeply unhappy with the idea of building money on a credit foundation and he cites Bitcoin as crypto’s attempt to build a form of money not based on credit.

In the case of trading, deferred settlement is a feature of the way that traditional finance operates whereas the crypto trading paradigm operating on a decentralised exchange is based on the principle that trade and settlement occur simultaneously.

Matt goes on to argue …

“Many advocates of crypto like this; they think that crypto’s philosophical uneasiness with credit is good. Money without debt – without fractional-reserve banking – is sounder, less inflationary and safer, they argue; trading with instant settlement is clearer and more logical and safer than trading with delayed settlement and credit risk”

I have to say that, as much as I like Matt’s overall body of contributions to deconstructing finance, I struggled with some elements of this argument. The better crypto analogue for money is I think a stablecoin (ideally one that is at least fully reserve backed and ideally has some capital as well) not a crypto asset like Bitcoin.

That said, the argument that the crypto trading model involves less credit risk than the traditional deferred settlement model does seem broadly right to me. Different context but the fact that bank supervisors have pursued Real Time Gross Settlement (RTGS) models I think illustrates the advantages of real time settlement of intraday credit risk.

There is of course a range of stablecoin business models currently being employed, but it still feels to me that anyone holding a stablecoin is probably still effectively lending fiat money to the stablecoin issuer but without the protections and enhancements that people holding money in the form of bank deposits enjoy.

The inspiration for Matt’s observations on this question was the proposal by Sam Bankman-Fried’s (SBF) proposal for changes that would allow a decentralised form of trading settlement. Matt notes that there are plans within traditional finance to move some trading exchanges to a T+1 model. That would reduce but not eliminate credit risk so the question remains as to whether the simultaneous settlement model proposed by SBF represents the future.

Matt argues that at least one consequence of moving to the crypto trading settlement model is that there will be less room (none?) for people to smooth over technical settlement failures and “market dislocations” or to reverse errors.

“There are debates about whether this is good or bad; simplistically, you’d expect the FTX model to lead to more defaults and liquidations, but for those defaults to be less bad. IN the traditional system, sometimes people will have a “technical issue”, and the exchange will “give the appropriate amount of time not to dislocate the market and create a bigger stress on that”, and it will work out fine – but occasionally it won’t work out fine, and by delaying the exchange will have caused a much bigger problem”

I don’t pretend to know the answers to the questions posed above (I am somewhat biased towards systems that favour resilience over efficiency) but I do think it is an issue that is worth putting on the radar as it plays out.

Let me know what I am missing …

Tony – From the Outside

State of play in the adoption or not of retail CBDC

This short report (7 pages) by the Kansas City Fed offers a nice summary on the state of play regarding the adoption of a retail CBDC

www.kansascityfed.org/Payments Systems Research Briefings/documents/8835/PaymentsSystemResearchBriefing22HayashiToh0526.pdf

Here is the conclusion

Several EMDEs have implemented CBDCs primarily to promote financial inclusion and improve their payments systems. Several advanced economies have made significant progress in assessing the case for a retail CBDC; though a few have identified motivations for implementing a CBDC, most have not found a compelling case to do so.Many other central banks are still at an early stage in exploring motivations for a retail CBDC, including the Federal Reserve, which recently published a report aiming to foster a public discussion with CBDC stakeholders on the potential benefits and risks of CBDCs (Board of Governors of the Federal Reserve System 2022). Through research and public dialogue, these central banks may increasingly identify motivations for a retail CBDC or scenarios in which a retail CBDC may be warranted. The motivations and scenarios will likely vary across countries, as each country has a unique set of opportunities and challenges in its economy and payment system.

Tony – From the Outside

Crypto sceptics unite

Stephen Diehl has done a post linking to a letter that a group of people working in the industry have submitted to US policy makers regarding how to engage with the crypto and DeFi movement. One of the key arguments Stephen makes is that the term “blockchain” has become so ubiquitous as to be largely meaningless.

My bias is that scepticism is virtually always the right starting place but Stephen notes that crypto scepticism is of course a broad church …

Crypto skepticism is not a homogeneous school of thought, and there is no central doctrine or leaders to this movement other than a broad north star of working to minimize fraud and protect the public from undue financial harm. There are crypto skeptics who think there might be some redeeming qualities in some crypto assets, and there are those who want it all to “die in a fire” and everywhere in between. The guiding principle of this letter is to find a middle way that at least most people can agree on and phrase it in a manner such that it can be best understood by our policymakers, who are deeply confused by even minimal jargon and technical obscurantism.

Countering the crypto lobbyists, Stephen Diehl

For what it is worth, I count myself in the camp who remain open to there being something of substance amongst the hype. Like any debate, the potential for crypto and DeFi to contribute something useful to future of finance can only benefit from agreeing on exactly what is meant by terms we use to debate the merits of the new, new thing. Stephen cites “blockchain”, to that I would add “digital money”.

Tony – From the Outside

Stablecoin business models – I need a dollar

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

Izabella Kaminska shares a stablecoin reading list

the-blindspot.com/crypto-reflexivity-and-the-ultimate-stablecoin-reading-list/

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