Crypto – DeFi – Digital Money – Page 4

The Stablecoin TRUST Act

Stablecoin regulation is one of my perennial favourite topics. Yes I know – I need to get out more but getting this stuff right does truly matter. I have gone down this particular rabbit hole more than a couple of times already. This has partly been about the question of how much we can rely on existing disclosure regarding reserves (here and here for example ) but the bigger issue (I think) is to determine what is the right regulatory model that ensures a level playing field with existing participants in the provision of payment services while still allowing scope for innovation and competition.

JP Koning has been a reliable source of comment and insight on the questions posed above (see here and here for example). Dan Awrey also wrote an interesting paper on the topic (covered here) which argues that the a state based regulatory model (such as the money transmitter licensing regime) is not the answer. There is another strand of commentary that focuses on the lessons to be learned from the Free Banking Era of the 19th century, most notably Gorton and Zhang’s paper titled “Taming Wildcat Stablecoins” which I covered here.

Although not always stated explicitly, the focus of regulatory interest has largely been confined to “payment stablecoins” and that particular variation is the focus of this post. At the risk of over-simplifying, the trend of stablecoin regulation appears to have been leaning towards some kind of banking regulation model. This was the model favoured in the “Report on Stablecoins” published in November 2021 by the President’s Working Group on Financial Markets (PWG). I flagged at the time (here and here) that the Report did not appear to have a considered the option of allowing stablecoin issuers to structure themselves as 100% reserve banks (aka “narrow banks”).

Against that background, it has been interesting to see that United States Senator Toomey (a member of the Senate Banking Committee) has introduced a discussion draft for a bill to provide a regulatory framework for payment stablecoins that does envisage a 100% reserve model for regulation. Before diving into some of the detail, it has to be said that the bill does pass the first test in that it has a good acronym (Stablecoin TRUST Act where TRUST is short for “Transparency of Reserves and Uniform Safe Transactions”.

There is not a lot of detail that I can find so let me just list some questions:

The reserve requirements must be 100% High Quality Liquid Assets (HQLA) which by definition are low return so that will put pressure on the issuer’s business model which relies on this income to cover expenses. I am not familiar with the details of the US system but assume the HQLA definition adopted in the Act is the same as that applied to the Liquidity Coverage Ratio (LCR) for depositary institutions.
Capital requirements are very low (at most 6 months operating expenses) based I assume on the premise that HQLA have no risk – the obvious question here is how does this compare to the operational risk capital that a regulated depositary institution would be required to hold for the same kind of payment services business activity
Stablecoin payment issuers do not appear to be required to meet a Leverage Ratio requirement such as that applied to depositary institutions. That might be ok (given the low risk of HQLA) subject to the other questions about capital posed above being addressed and not watered down in the interests of making the payment stablecoin business model profitable.
However, in the interest of a level playing field, I assume that depositary institutions that wanted to set up a payment stablecoin subsidiary would not be disadvantaged by the Leverage Ratio being applied on a consolidated basis?

None of the questions posed above should be construed to suggest that I am anti stablecoins or financial innovation. A business model that may be found to rely on a regulatory arbitrage is however an obvious concern and I can’t find anything that addresses the questions I have posed. I am perfectly happy to stand corrected but it would have been useful to see this bill supported by an analysis that compared the proposed liquidity and capital requirements to the existing requirements applied to:

Prime money market funds
Payment service providers
Deposit taking institutions

Let me know what I am missing

Tony – From the Outside

Note – this post was revised on 14 April 2022

The question posed about haircuts applied to HQLA for the purposes of calculating the Liquidity Coverage Ratio requirement for banks was removed after a fact check. In my defence I did flag that the question needed to be fact checked. Based on the Australian version of the LCR, it seems that the haircuts are only applied to lower quality forms of liquid assets. The question of haircuts remains relevant for stablecoins like Tether that have higher risk assets in their reserve pool but should not be an issue for payment stablecoins so long as the reserves requirement prescribed by the Stablecoin TRUST Act continues to be based on HQLA criteria.
While updating the post, I also introduced a question about whether the leverage ratio requirement on depositary institutions might create an un-level playing field since it does not appear to be required of payment stablecoin issuers

The elasticity of credit

One of the arguments for buying Bitcoin is that, in contrast to fiat currencies that are at mercy of the Central Bank money printer, its value is underpinned by the fixed and immutable supply of coins built into the code. Some cryptocurrencies take this a step further by engineering a systematic burning of their coin.

I worry about inflation as much as the next person, perhaps more so since I am old enough to have actually lived in an inflationary time. I think a fixed or shrinking supply is great for an asset class but it is less obvious that it is a desirable feature of a money system.

Crypto true believers have probably stopped reading at this point but to understand why a fixed supply might be problematic I can recommend a short speech by Claudio Borio. The speech dates back to 2018 but I think it continues to offer a useful perspective on the value of an elastic money supply alongside broader comments about the nature of money and its role in the economy.

Borio was at the time the Head of the BIS Monetary and Economic Department but the views expressed were his personal perspective covering points that he believed to be well known and generally accepted, alongside others more speculative and controversial.

I did a post back in March 2019 that offers an overview of the speech but recently encountered a post by J.W. Mason which reminded me how useful and insightful it was.

The specific insight I want to focus on here is the extent to which a well functioning monetary system relies on the capacity of credit extended in the system to expand and contract in response to both short term settlement demands and the longer term demands driven by economic growth.

One of the major challenges with the insight Borio offers is that most of us find the idea that money is really just a highly developed form of debt to be deeply unsatisfying if not outright scary. Borio explicitly highlights “the risk of overestimating the distinction between credit (debt) and money” arguing that “…we can think of money as an especially trustworthy type of debt”

Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.
Borio: Page 9

I did a post here that explains in more detail an Australian perspective on the process by which unsecured loans to highly leveraged companies (aka “bank deposits”) are transformed into (mostly) risk free assets that represent the bulk of what we use as money.

Borio outlines how the central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled …

“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”
Borio: Page 5

… but also recognises the problem with too much elasticity

While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.

This is a big topic which means there is a risk that I am missing something. That said, the value of an elastic supply of credit looks to me like a key insight to understanding how a well functioning monetary system should be designed.

The speech covers a lot more ground than this and is well worth reading together with the post by J.W. Mason I referenced above which steps through the insights. Don’t just take my word for it, Mason introduces his assessment with the statement that he was “…not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker”.

Tony – From the Outside

Why Canada is cultivating an M-pesa moment for bitcoin – Izabella Kaminska

Izabella Kaminska is one of the commentators that I find reliably generates interesting and useful insights. Personally I remain sceptical on crypto but this link takes you to a post where she makes an argument that I find persuasive.

For those short of time here is an extract capturing the key points I took from her post…

My position on crypto has evolved over time to appreciate this factor. Crypto may not be an optimal system. It’s clunky. It’s energy intensive. It’s confusing. But as a back-up system for when the shit really hits the fan, it’s an incredibly worthwhile system to have in place and I increasingly think we should be grateful that some deep-pocketed individuals with concerns for freedom and privacy took the risks they did to make it become a thing.
I have in the past compared crypto to a monetary equivalent of the right to bear arms, whose main purpose, many argue, is to act as a deterrent to rising authoritarianism. Its optimal deployment is as a right that it is never actually exercised.
Crypto should be treated the same way. On a day to day basis, it’s much better for us all to trust in a centralised and properly supervised system. But having crypto there as a challenger or backup system is no bad thing. It should in theory enhance the core system by helping to keep it honest and working in our interests.
“Why Canada is cultivating an M-pesa moment for bitcoin”, The Blind Spot 18 February 2022

Tony – From the Outside

SWIFT gpi data indicate drivers of fast cross-border payments

One of the use cases for cryptocurrency and\or stablecoins is that it offers cheaper and faster alternatives to the conventional payment rails. Whether they will succeed remains to be seen but I have long believed cross country payments is one of the areas where the banking system really does need to lift its game.

Against that context, this research study released by the Bank for International Settlements (BIS) suggests that TradFi banking is making some improvements.

The study lists three key takeaways …

“- The speed of cross-border payments on SWIFT global payment innovation (gpi) is generally high with a median processing time of less than two hours. However, payment speeds vary markedly across end-to-end payment routes from a median of less than five minutes on the fastest routes to more than two days on several of the slowest routes.
– Prolonged processing times are largely driven by time spent at the beneficiary bank from when it receives the payment instruction until it credits the end customer’s account. Longer processing times tend to occur in low and lower-middle income countries, which can be partly attributed to capital controls and related compliance processes, weak competition as measured by the number of banks as well as limited operating hours of and the use of batch processing by beneficiary banks.
– Cross-border payments on SWIFT involve, on average, just over one intermediary between the originator and beneficiary banks. Each additional intermediary prolongs payment time to a limited extent, while the size of time zone differences between banks has no discernible effect on speed.”

If I am reading it correctly, the study does not capture any delays the initiating bank may introduce before it processes a payment instruction. With that caveat, it is worth noting that TradFi is not standing still – competition can be a beautiful thing.

Also worth noting the extent to which domestic payment systems are improving though not necessarily in the USA.

Tony – From the Outside

Taming Wildcat Stablecoins – Revisited

Anyone following the stablecoin debate is probably familiar with a paper by Gary Gorton and Jeffrey Zhang titled (somewhat provocatively) “Taming Wildcat Stablecoins”. I did a post back in July 2021 when it first came out and have some more detailed notes on it here.

In my initial July 2021 post I listed three things I found useful and/or interesting

The “no-questions-asked” (NQA) principle for anything that functions in practice or potential as money
Some technical insights into the economic and legal properties of stablecoins and stablecoins issuers (i.e. what is the nature of the express or implied contract between users and stablecoin issuers)
Lessons to be learned from history, in particular the experience of bank notes during the Free Banking Era in America in the early 19th century

Having reread the paper and some of the critiques it has attracted, I think these insights mostly remain valid. Of the three, the principle that money must be exchangeable on a NQA basis is (for me at least) the most useful. I must confess however that I find the lessons they draw from the Free Banking Era are muddled by the reference to “Wildcat Banking”. There are lessons for sure but you have to dig deeper into the historical record to really get a clear read on the conditions under which the uninsured liabilities of private entities can and cannot function as a reliable form of money.

This does not in itself fatally undermine the argument that stablecoins need a stronger regulatory framework to function effectively and efficiently as a form of money. It is however worth being clear on what lessons drawn from the history of private money can be usefully employed in figuring out how best to respond to the rise of stablecoins. While this post takes issue with some of analysis in the paper, I must declare that I still rate Gorton as one of my favourite commentators on banking and the NQA principle he espouses has long influenced my own views on banking.

Stablecoins according to Gorton and Zhang

At this point it might be helpful to recap the main elements of the argument Gorton and Zhang lay out in their joint paper:

Stablecoins can be viewed as the latest variation in a long history of privately produced money
The experience of the United States during the Free Banking Era of the 19th century and of Money Market Funds (MMF) during 2008 and again in 2020 suggest that “While the technology changes, and the form of privately produced money changes, the issues with privately produced money do not change – namely, private money is a subpar medium of exchange and is subject to runs“
They concede that stablecoins are not yet of sufficient size to be a systemic issue but argue that allowing them to function like a demand deposit risks making the same mistake that allowed MMFs to reach a point where the government felt compelled to step in to underwrite the MMF redemption promise
Policymakers need to adjust the regulatory framework now to be ready before these new forms of private money grow further in size and and potentially evolve like MMFs did into something that can’t be ignored
Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency

Problems with the Wildcat Free Banking analogy

As a rhetorical device the, Wildcat Free Banking analogy works pretty well as an attack on stablecoins. You don’t really need to delve into the detail, wildcat banking tells you all you need to know. It sounds pretty bad and lawless in Wild West kind of way and so, by association, stablecoins must also be problematic.

The problem is that Gorton and Zhang themselves explicitly state that wildcat banking was not as big a problem as is commonly asserted and the Free Banking system in fact functioned well from the view of efficient market theory .

For many years, the literature asserted that there were wildcat banks during this period. These were banks that either (1) did not deposit the requisite bonds, or (2) in some states, where bonds were valued at par and not market value, defrauded the public by issuing notes that they would never redeem in specie (gold or silver). Counterfeiting was a big problem, but the system was not chaos. Bank failures were not due to wildcat banking as has often been alleged. In fact, it functioned well from the point of view of efficient market theory.
Gorton and Zhang, “Taming Wildcat Stablecoins”, p28

So it appears that, notwithstanding its prominence in the title of their paper, the problem they are highlighting with Free Banking is not wildcat banks per se but rather the extent to which Free Banking in America resulted in bank notes trading at discounts to their par value …

The market was an “efficient market” in the sense of financial economics, but varying discounts made actual transactions (and legal contracting) very difficult. It was not economically efficient. There was constant haggling and arguing over the value of notes in transactions. Private bank notes were hard to use in transactions.
Page 29

OK so let’s focus on Free Banking

The fundamental lesson Gorton and Zhang draw from the Free Banking Era and the subsequent development of a national currency in America is that competition and market forces alone will not by themselves ensure that privately produced forms of money can be relied on to exchange at their face value on a NQA basis under all market conditions.

In order to better understand the other side of this debate I have attempted to dig a bit deeper into the history of Free Banking. As part of the search I came across this podcast in which Nic Carter (Castle Island Ventures) interviews George Selgin (Director of the Center of Monetary Alternatives at the Cato Institute). It is long (1 hour 12 minutes) but appears to offer a good overview of the counter arguments advanced by proponents of cryptocurrencies, stablecoins and Free Banking.

Selgin argues (convincingly I think) that quite a lot of the problems experienced with Free Banking in America were a function (ironically) of poorly designed regulations – i.e. Free Banking in America did still involve regulation though maybe not as much supervision as banks are subject to today. In particular, he calls out the prohibition on branch banking (which restricted the capacity of banks to diversify the risk of their loan books) and the requirement that bank notes be backed by state government bonds (that ultimately proved to be very poor credit risks).

The Free Banking model did result in bank notes trading at discounts to their par value – that is a problem right?

This is another area where the debate gets a bit muddled.

Selgin concedes that some bank notes did trade at discounts to their par value – one of the central claims of Gorton and Zhang’s paper – but argues that these discounts were not a function of risk differences (i.e. concerns about the solvency and or liquidity of the issuing banks) but rather a reflection of the transaction costs incurred to redeem the notes at their issuing banks.

Selgin argues that “local” notes (i.e. those circulating in the local economy of their issuing bank) did in fact exchange at their par value and that the evidence of discounts cited by Gorton and Zhang were for “foreign” notes where they reflected the transaction costs of presenting the notes back to their issuing bank in another town, city or state.

However Selgin also concedes that part of the reason we don’t see evidence of local bank notes trading at discounts is that shopkeepers and other banks simply refused to accept any note where there was real or perceived default risk

In truth, antebellum banknote discounts were for the most part neither a consequence of the lack of regulation nor a reflection of distrust of their issuers. [Default risk was sometimes a factor], to be sure. But when it was, shopkeepers and banks tended to refuse them altogether, leaving it to professional note “brokers” to deal with them, much as they dealt with notes of banks that were known to be “broken,” but which might yet have some liquidation value. Discounts on “bankable” notes, on the other hand, reflected nothing more than the cost of sorting and returning them to their sources for payment in specie, plus that of bringing the specie home. This explains why, whatever the discounts placed on them elsewhere, [most notes traded at par in their home markets].
George Selgin, “The fable of the cats”

I can’t get any sense of the relative size of the instances where shopkeepers and banks simply refused to accept notes issued by suspect banks. The fact that it happened under Free Banking regimes in America does however seem to support Gorton and Zhang’s assessment that “money” requires a support framework to be capable of being exchanged widely and freely on an NQA basis.

Based on my (so far not very deep) exploration of the Free Banking literature, it seems that its proponents also believe money requires a support framework. The key difference seems to be whether the private sector can maintain that support framework on its own or whether you require public sector involvement in the form of regulation, supervision and deposit insurance to achieve that outcome.

To properly explore what lessons we can learn about money and banking from history, we need to look beyond the American experience with Free Banking.

A Better Kind of Free Banking

Selgin and Carter point to the experience of Free Banking in a range of countries other than America as evidence that unregulated stablecoins subject to the forces of market discipline not only could work but potentially offer a better model than the highly regulated, deposit insured model that has come to dominate the modern banking status quo.

Scotland and Canada figure prominently in this alternative narrative of what history teaches us. I don’t really know enough about these eras to comment with any authority but it does appear that the notes issued by banks operating under these regimes did in fact hold their value and function effectively as the primary form of money.

Nic Carter wrote a post on the Scottish Free Banking era which listed five features which kept it stable

– Competitive ‘note dueling’
– A private clearinghouse
– Full liability partnership models
– Until 1765, clauses permitting the temporary suspension of convertibility
– Branching and diversification
Nic Carter, “Scotland, Free Banks and Stablecoins” Murmurations 19 Sep 2021

… and summarised its virtues as

There was no regulatory body…. There was simply a legal structure that discouraged excessive lending, market mechanisms through which banks could competitively keep each other in check, and a vibrant information environment the public could benefit from. The Scottish banking system during the period was remarkably stable; financial crises and panics were rare, contrasting favorably with neighboring England. The Scottish experience of lightly regulated banking shows clearly that such a model can work …

Carter proposes two lessons that stablecoin issuers might extract from the Scottish Free Banking era.

Firstly that stablecoin issuers consider cooperating to create a private clearing house

First, as exchanges (oftentimes, it’s exchanges issuing stablecoins) continue mutually accepting each others notes, they might consider a private clearinghouse. That way they can achieve efficiency in settlement – moving from real time gross settlement to a net settlement model, saving on fees and on-chain headaches. If they do this, they will be fully incentivized to surface information regarding the solvency of their counterparties. This would solve the coordination problem inherent in entities like Tether being untransparent; their clients don’t have a sufficient economic motive to diligence them. A clearinghouse might in its charter insist that stablecoin issuers disclose their collateral to the group.

Secondly that stablecoin issuers include in their terms of service the right to temporarily suspend the right to exchange coins for fiat

Second, one tool that Scottish banks developed in 1750, as an alternative to deposit insurance, was an ‘option clause’. This allowed the bank to suspend redeemability of their notes for specie for a given period of time, effectively allowing solvent but illiquid banks to honor client withdrawals (albeit on a slower schedule). For the privilege, they would pay note holders interest on the normally non-interest bearing notes. This massively reduced the risk of a bank run and it was popular until it was outlawed in 1765. Now for stablecoins to eliminate run risk, they could be structured more like Money Market Mutual Funds, in which you can only withdraw a proportional share of the underlying assets, rather than a fixed claim redeemable for $1. So as a depositor you have no incentive to be the first out the door, as you do with a bank. Or they could implement something similar to the option clause, suspending redeemability if they were faced with a liquidity crunch. Larry White has suggested this, and I believe Tether may have a similar option clause in their ToS but I’d have to double check that.

The power of markets, competition and incentives … and their limits

Whether Carter’s Free Banking based suggestions are useful contributions to the debate about what to do about stablecoins is a question for another day and another post. I am sceptical but I need more time to think through exactly what concerns me. The idea of exchanges taking on a supervisory role via a private clearing house seems to lean away from the decentralised ethos that is a strong feature of many in the crypto, stablecoin, DeFi community – but maybe I am missing something.

I also want to take the time to get a better understanding of exactly how the pure forms of Free Banking that Carter and Selgin advocate actually worked. The problems that Gorton and Zhang describe with the experience of runs on MMF’s in 2008 and again in 2020 also look to me like they still have something useful to contribute to the stablecoin regulation debate.

My scepticism is also reinforced by my professional experience working through the various iterations of the Basel capital adequacy accord. In particular Basel II which introduced the idea of 3 mutually supporting Pillars. For the purposes of this discussion, Pillar 3 (Market Discipline) is the one I want to focus on. Basel II was developed at a time when conventional wisdom placed an enormous amount of faith in the power of markets to hold everyone to account.

In practice that did not really work out the way the theory suggested it should. I do not subscribe to the view that risk based capital requirements are a total failure. The enhancements introduced under the aegis of Basel III (in particular bail-in but also higher capital and liquidity requirements) have gone a long way to make the traditional banking system stronger and more resilient but I think it is fair to conclude that market discipline alone is not a reliable basis for ensuring the stability of the banking system.

Summing up

I am a big fan of using economic history as a guide to avoiding repeating the mistakes of the past but I think the evidence from the American Free Banking Era is not especially useful as a guide to the risks of stablecoins. This does not however mean that we should embrace the unregulated rise of stablecoins as a new form of private money.

As a conceptual framework, the five features underpinning the stability of the Scottish Free Banks is a good place to start when thinking about the extent to which stablecoins might also be, or become, self regulating. The practical challenge however is that stablecoins also have to fit into the financial system we have and that is one based around prudential regulation, supervision, deposit preference and deposit insurance. It is very hard to see bank regulators giving ground on the principle of same activity same regulation. Innovation is valuable for sure but it is equally true that regulatory arbitrage never ends well.

I have disclosed my bias and, as always, it is entirely possible that I am missing something. However, at this stage I am struggling with the idea that stablecoins that aim to expand in size and scope beyond facilitating the settlement of crypto asset trading can function as money without a regulatory framework that underpins the promise of repayment made by the private entities responsible for issuing them. That regulatory framework might not be the same as that applied to depositary institutions but it does need to be consistent with it.

Let me know what I am missing …

Tony – From the Outside

Stablecoin regulation

Another good post from JP Koning on stablecoin regulation. His key point, that regulation should follow the function of the activity rather than its form, is not a new contribution to the stablecoin regulation debate. There are lots of issues, ambiguities and areas for reasonable people to take different views on the question of what role stablecoins can or should play in the future of finance but this still seems to me like a sound organising principle.

What this means in practice is yet to be decided but here are a few preliminary thoughts:

I doubt that being regulated like a depositary institution (aka “bank”), as proposed by the recent President’s Working Group report, is the right answer – stablecoin issuers have adopted a variety of business models which tend to be quite different to the fractional reserve banking model adopted by most contemporary depositary institutions.
The issues Koning raises with the US Money Transmitter framework seem valid to me so that does not look like the right model either.
I am sceptical that the Free Banking model proposed by some stablecoin advocates will work as well as claimed but I recognise there is probably a bias at work here so I need to do some more work to properly understand how the Free Banking model works.
Part of the answer (I think) lies in establishing the right taxonomy that not only defines the different types of stablecoin business models but places them in a broader context that includes money transmitter businesses, depositary institutions (both the narrow bank kind and fractional reserve based models) and also the various forms of money market funds – this taxonomy would also distinguish systemically important business models from those which can be allowed to fail in an (ideally) orderly fashion

I included a link to JP Koning’s post above but if you are time poor then this extract captures the key point

“… the key point is that while there are times when stablecoins function like PayPal and Western Union, in other circumstances they are performing a role that PayPal and Western Union never do, which is to serve as the substructure for a set of financial utilities. Which suggests that stablecoins merit a different regulatory framework, one better fit for that function.
I don’t know what framework that should be. Banking, securities law, a special stablecoin license? But the old school money transmitter framework — which has very lenient requirements governing things like the safety of the transmitters underlying assets — is probably the wrong framework. If you serve as financial bedrock, you merit more robust regulation than Western Union.

Let me know what I am missing …

Tony – From the Outside

Moneyness: DeFi needs more secrecy, but not too much secrecy, and the right sort of secrecy

Another good post from JP Koning’s “Moneyness” blog on the need for DeFi to strike a balance partly between its native potential for transparency, the desire of customers to keep some secrets and the need to meet the same kinds of Know Your Customer – Anti Money Laundering laws that the conventional banking system is required to comply with.

Here is a short extract …

To make their tools palatable for Main Street, DeFi tool makers will have to unwind some of the native anonymity (potentially) afforded by blockchains by collecting and verifying identifying information from users. This way the tools can screen out criminals, assuring legitimate businesses that their clean funds aren’t being tainted by dirty money.

The implication is that DeFi tools will have to become privacy managers, just like old-school banks are. Users will have to trust the tools to be discreet with their personal information, only breaking their privacy when certain conditions are required, such as law enforcement requests.

… and a link to source post.

Tony – From the Outside

JP Koning on stablecoins

Interesting post by JP Koning arguing that the market is progressively recognising the difference between the safer and riskier forms of stablecoins …

Tether vs the New York stablecoins http://jpkoning.blogspot.com/2022/01/tether-vs-new-york-stablecoins.html

Tony – From the Outside

The need for a Central Bank Digital Currency (CBDC)

JP Koning offers a Canadian perspective on the need for a CBDC that identifies two issues with the idea and concludes it is not a priority.

His argument rests on two planks. Firstly he argues that the existing payment infrastructure in Canada is pretty good so the obvious question is whether the CBDC is really worth the required investment of public resources. Secondly he highlights the operational and governance problems associated with payments that lie outside a central bank’s core area of competence.

His post also links to an article by David Andolfatto that arrives at similar conclusions. David however adds the qualification that a wholesale CBDC might be worth pursuing.

Neither post introduces anything radically new into the discussion of CBDC so far as I can tell but they are worth reading to get a Canadian perspective. The key points the articles reinforced for me where:

That the need for financial innovations like a CBDC (or indeed payment stablecoins) depends a lot on how good the existing payment rails are. Some countries have pretty good systems but others (which surprisingly seems to include America) are not keeping up with best practice.
Cross currency payments is an area that appears ripe for disruption and a wholesale CBDC might have a role to play in this process.

Tony – From the Outside

The problem with regulating stablecoin issuers like banks

One of my recent posts discussed the Report on Stablecoins published in November 2021 by the President’s Working Group on Financial Markets (PWG). While I fully supported the principle that similar types of economic activities should be subject to equivalent forms of regulation in order to avoid regulatory arbitrage, I also wrote that it was not obvious to me that bank regulation is the right answer for payment stablecoin issuance.

This speech by Governor Waller of the Fed neatly expresses one of the key problems with the recommendation that stablecoin issuance be restricted to depositary institutions (aka private banks). To be honest I was actually quite surprised the PWG arrived at this recommendation given the obvious implication that it would benefit the bank incumbents and impede innovation in the ways in which US consumers can access money payment services

“However, I disagree with the notion that stablecoin issuance can or should only be conducted by banks, simply because of the nature of the liability. I understand the attraction of forcing a new product into an old, familiar structure. But that approach and mindset would eliminate a key benefit of a stablecoin arrangement—that it serves as a viable competitor to banking organizations in their role as payment providers. The Federal Reserve and the Congress have long recognized the value in a vibrant, diverse payment system, which benefits from private-sector innovation. That innovation can come from outside the banking sector, and we should not be surprised when it crops up in a commercial context, particularly in Silicon Valley. When it does, we should give those innovations the chance to compete with other systems and providers—including banks—on a clear and level playing field”
“Reflections on stablecoins and Payments Innovations”, Governor Christopher J Waller, 17 November 2021

The future of payment stablecoins is, I believe, a regulated one but I suspect that the specific path of regulation proposed by the PWG Report recommendations will (and should) face a lot of pushback given its implications for competition and innovation in the financial payment rails that support economic activity.

I don’t agree with everything that Governor Waller argues in his speech. I am less convinced than he, for example, that anti trust regulation as it stands offers sufficient protection against big tech companies operating in this space using customer data in ways that are not fully aligned with the customers’ interests. That said, his core argument that preserving the capacity for competition and financial innovation in order to keep the incumbents honest and responsive to customer interests is fundamental to the long term health of the financial system rings very true to me.

For anyone interested in the question of why the United States appears to be lagging other countries in developing its payments infrastructure, I can recommend a paper by Catalini and Lilley (2021) that I linked to in this post. This post by JP Koning discussing what other countries (including Australia) have achieved with fast payment system initiatives also gives a useful sense of what is being done to enhance the existing infrastructure when the system is open to change.

Tony – From the Outside