Tether wants to help keep the USD strong

A few months back I flagged a podcast where Grant Williams interviewed Luke Grommen discussing his analysis of the role of the USD in the international financial system. One of the issues covered was the way in which the USD pricing of oil has underwritten demand for USD and thereby supported the USD.

Tether recently released a post where it seems to be arguing that demand for Tether recycled into demand for USD safe assets can take over the role in US monetary policy that recycling demand for petrodollars has played under Bretton Woods II.

Not sure if the US government has any plans to respond formally to this generous offer but anyone interested in this latest instalment in the ongoing Tether story might find it useful to revisit Luke’s analysis of Bretton Woods II. In particular Luke’s contention that petrodollar driven demand for USD has had some downsides.

I recommend you listen to the podcast (to ensure nothing was lost in translation) but this is how I summarised Luke’s argument in my earlier post

The USD’s role as an international reserve currency has been described as an “exorbitant privilege” but Gromen argues that the arrangement has also come at a cost via the role it has played in the loss of US domestic manufacturing capacity (Triffin’s Dilemma).

The consequences of this trade off has come under greater attention post the GFC, initially as the social consequences of lost jobs started to impact domestic politics, and more recently as globalised just in time supply chains struggled to respond to the economic shocks created by the response to Covid 19

Gromen argues that the USD Department of Defence has wanted to see repatriation of the US industrial base for some time and hence will be happy to see a decline in the USD’s role as an internal reserve currency because they believe it will enhance national security

There is also the question of whether stablecoin driven demand just exacerbates a shortage of safe USD assets. I have talked about this issue here and more recently flagged a post by Steven Kelly on the same topic. This quote gives a flavour of Steven’s argument…

market- and regulation-inspired migration towards safer crypto assets is making stablecoins more popular, but that means there are more investment vehicles gobbling up the safe assets that otherwise grease the wheels of the traditional financial system. Absent rehypothecation, stablecoins will be a [giant sucking sound][1] in the financial system: soaking up safe collateral and killing its velocity.

Tony – From the Outside

Those ACH payments

One of the mysteries of finance is why the USA seems to be so slow in adopting the fast payment systems that are increasingly common in other financial systems. Antiquated payment systems in TradFi is a frequent theme in DeFi or stablecoin pitches which argue that they offer a way to avoid the claws of the expensive, slow and backward looking traditional banks.

Every time I read these arguments in favour of DeFi and/or stablecoins, I wonder why can’t the USA just adopt the proven innovations widely employed in other countries. I had thought that this was a problem with big banks (the traditional nemesis of the DeFi movement) having no incentive to innovate but I came across this post by Patrick McKenzie that suggests that the delay in roll out of fast payment systems may in fact lie with the community banks.

The entire post is worth reading but I have appended a short extract below that captures Patrick’s argument on why community banks have delayed the roll out of improved payment systems in the USA

Many technologists ask why ACH payments were so slow for so long, and come to the conclusion that banks are technically incompetent. Close but no cigar. The large money center banks which have buildings upon buildings of programmers shaving microseconds off their trade execution times are not that intimidated by running batch processes twice a day. They could even negotiate bilateral real-time APIs to do so, among the fraternity of banks that have programmers on staff, and indeed in some cases they have.

Community banks mostly don’t have programmers on staff, and are reliant on the so-called “core processors” like Fiserv, Jack Henry & Associates and Fidelity National Information Services. These companies specialize in extremely expensive SaaS that their customers literally can’t operate without. They are responsible for thousands of customers using related but heavily customized systems. Those customers often operate with minimal technical sophistication, no margin for error, disconcertingly few testing environments, and several dozen separate, toothy, mutually incompatible regulatory regimes they’re responsible to.

This is the largest reason why in-place upgrades to the U.S. financial system are slow. Coordinating the Faster ACH rollout took years, and the community bank lobby was loudly in favor of delaying it, to avoid disadvantaging themselves competitively versus banks with more capability to write software (and otherwise adapt operationally to the challenges same-day ACH posed).

“Community banking and Fintech”, Patrick McKenzie 22 October 2021

Tony – From the Outside

Matt Levine on stablecoins

Quite a lot has been written about the backing of stablecoins but Matt Levine uses the Tether use case to pose the question how much it matters for the kinds of activities that Tether is used for …

The point of a stablecoin is not mainly to be a secure claim on $1 of assets in a bank account. The point of a stablecoin is mainly “to grease the rails of the roughly $1 trillion cryptocurrency market,” by being the on-blockchain form of a dollar. We talk somewhat frequently about stablecoins that are openly backed by nothing but overcomplicated confidence in their own value; to be fair, we mostly talk about them when they are crashing to zero, but still. The thing that makes a stablecoin worth a dollar is primarily that big crypto investors treat it as being worth a dollar, that they use it as a medium of exchange and a form of collateral and value it at $1 for those uses. Being backed by $1.003 of dollar-denominated safe assets helps with that, but being backed by $0.98 of dollar-denominated assets might be good enough?

Matt draws no distinctions above but I don’t I think his argument is intended to apply to stablecoins that aim to challenge the traditional payment service providers (“payment stablecoins”) operating in the broader financial system. It does however pose an interesting question about how much stability crypto traders really require.

Tony – From the Outside

Fed Finalizes Master Account Guidelines

The weekly BPI Insights roundup has a useful summary of what is happening with respect to opening up access to Fed “master accounts”. This is a pretty technical area of banking but has been getting broader attention in recent years due to some crypto entities arguing that they are being unfairly denied access to this privileged place in the financial system. BPI cites the example of Wyoming crypto bank Custodia, formerly known as Avanti, which sued the Kansas City Fed and the Board of Governors over delays in adjudicating its master account application.

The Kansas Fed is litigating the claim but the Federal Reserve has now released its final guidelines for master account access.

The BPI perspective on why it matters:

Over the past two years, a number of “novel charters” – entities without deposit insurance or a federal supervisor – have sought Fed master accounts. A Fed master account would give these entities – which include fintechs and crypto banks — access to the central bank’s payment system, enabling them to send and receive money cheaply and seamlessly. BPI opposes granting master account access to firms without consolidated federal supervision and in its comment letter urged the Fed to clarify which institutions are eligible for master accounts.

The BPI highlights two main takeaways from the final guidelines:

The Fed does not define what institutions are eligible to seek accounts and declined to exclude all novel charter from access to accounts and services.

The guidelines maintain a tiered review framework that was proposed in an earlier version, sorting financial firms that apply for master accounts into three buckets for review. Firms without deposit insurance that are not subject to federal prudential supervision would receive the highest level of scrutiny. The tiers are designed to provide transparency into the expected review process, the Fed said in the guidelines — although the final guidelines clarify that even within tiers, reviews will be done on a “case-by-case, risk-focused basis.”

The key issue here, as I understand it, is whether the crypto firms are really being discriminated against (I.e has the Fed been captured by the banks it regulates and supervises) or whether Crypto “banks” are seeking the privilege of master account access without all the costs and obligations that regulated banks face.

Let me know what I am missing

Tony – From the Outside

Stablecoins and the supply of safe assets in the financial system

Interesting post by Steven Kelly (senior research associate at the Yale School of Management’s Program on Financial Stability) on the role of stablecoins in the financial system. The post was published in the FT (behind a paywall) but this link from his LinkedIn page seems to great access. Steven raises a number of concerns with stablecoins but the one I want to focus on is the argument that stablecoins can only be made safe by locking up an increasing share of the safe assets that have other uses in the financial system.

Here is a quote …

The market- and regulation-inspired migration towards safer crypto assets is making stablecoins more popular, but that means there are more investment vehicles gobbling up the safe assets that otherwise grease the wheels of the traditional financial system. Absent rehypothecation, stablecoins will be a [giant sucking sound][1] in the financial system: soaking up safe collateral and killing its velocity.

Steven Kelly, “Stablecoins do not make for a stable financial system”, Financial Times 11 August 2022

I am not a fan but I am also not opposed to stablecoins on principle so long as they are issued in a way that ensures their promise to holders is properly and transparently backed by safe assets. That said, I do think that Steven highlights an important consideration that needs to be thought through should stablecoins start to account for a greater share of the payment infrastructure that we all rely on.

This is an issue that I touched on previously but I do not see it getting the attention I think it deserves.

As always, let me know what I am missing.

Tony – From the Outside

The ECB seeks the holy grail of cross-border payments

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

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

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

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

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

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

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

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

Tony – From the Outside

Abstract

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

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

Conclusion

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

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

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

ECB Working Paper Series No 2693 / August 2022 51 

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

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

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

Crypto and credit creation

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

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

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

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

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

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

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

Tony – From the Outside

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

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

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

Tony – From the Outside

Molly White on cryptocurrency “market caps” and notional value

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

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

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

She then discusses three of her primary concerns with crypto valuation

  • price
  • liquidity
  • wash trading ...

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

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

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

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

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

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

Let me know what I am missing

Tony – From the Outside

The alchemy of deposits

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

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

His first point is that “deposits are money”

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

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

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

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

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

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

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

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

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

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

This is Patrick’s take on Voyager

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

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

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

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

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

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

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

Tony – From the Outside