Red flags in financial services

Nice podcast from Odd Lots discussing the Wirecard fraud. Lots of insights but my favourite is to be wary when you see a financial services company exhibit high growth while maintaining profitability.

There may be exceptions to the rule but that is not how the financial services market normally works.

podcasts.apple.com/au/podcast/odd-lots/id1056200096

Tony — From the Outside

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

Where do bank deposits come from …

This is one of the more technical (and misundersood) aspects of banking but also a basic fact about money creation in the modern economy that I think is useful to understand. For the uninitiated, bank deposits are typically the largest form of money in a modern economy with a well developed financial system.

One of the better explanations I have encountered is a paper titled “Money creation in the modern economy” that was published in the Bank of England’s Quarterly Bulletin in Q1 2014. You can find the full paper here but I have copied some extracts below that will give you the basic idea …

In the modern economy, most money takes the form of bank deposits.  But how those bank deposits are created is often misunderstood:  the principal way is through commercial banks making loans.  Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the description found in some economics textbooks:

Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.  In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

Although commercial banks create money through lending, they cannot do so freely without limit.  Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system.  Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system.  And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.

Money creation in the modern economy, Michale McLeay, Amar Radia and Ryland Thomas, Bank of England Quarterly Bulletin 2014 Q1

The power to create money is of course something akin to magic and the rise of stablecoins has revived a long standing debate about the extent to which market discipline alone is sufficient to ensure sound money. My personal bias (forged by four decades working in the Australian banking system) leans to the view that money creation is not something which banker’s can be trusted to discharge without some kind of supervision/constraints. The paper sets out a nice summary of the ways in which this power is constrained in the conventional banking system …

In the modern economy there are three main sets of constraints that restrict the amount of money that banks can create.

(i) Banks themselves face limits on how much they can lend.  In particular:

– Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market.

– Lending is also constrained because banks have to take steps to mitigate the risks associated with making additional loans.

– Regulatory policy acts as a constraint on banks’ activities in order to mitigate a build-up of risks that could pose a threat to the stability of the financial system.

(ii) Money creation is also constrained by the behaviour of the money holders — households and businesses. Households and companies who receive the newly created money might respond by undertaking transactions that immediately destroy it, for example by repaying outstanding loans.

(iii) The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the Bank of England’s monetary policy affects how much households and companies want to borrow. This occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity in the economy.  As a result, the Bank of England is able to ensure that money growth is consistent with its objective of low and stable inflation.

The confidence in the central bank’s ability to pursue its inflation objective possibly reflects a simpler time when the inflation problem was deemed solved but the paper is still my goto frame of reference when I am trying to understand how the banking system creates money.

If you want to dive a bit deeper into this particular branch of the dark arts, some researchers working at the US Federal Reserve recently published a short note titled “Understanding Bank Deposit Growth during the COVID-19 Pandemic” that documents work undertaken to try to better understand the rapid and sustained growth in aggregate bank deposits between 2020 and 2021. Frances Coppola also published an interesting post on her blog that argues that banks not only create money when they lend but also when they spend it. You can find the original post by Frances here and my take on it here.

A special shout out to anyone who has read this far. My friends and family think I spend too much time thinking about this stuff so it is nice to know that I am not alone.

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

Adam Tooze wants everyone to read “The Currency of Politics” by Stefan Eich

I have only just started reading the book myself but the outline that Adam Tooze offers suggests to me that it has a lot to say on an important topic.

At this stage I will have to quote the author for a sense of what this book is about ..

The Currency of Politics is about the layers of past monetary crises that continue to shape our idea of what money is and what it can do politically. Grappling with past crises helped previous theorists to escape the blindspots of their own time. We must do the same today.

This seems like a pretty worthwhile endeavour to me so I thought it was worth sharing for anyone else engaged in trying to make sense of the role that money (and banking) does and should play in our society.

Tony – From the Outside

Lessons from Brazil’s “Pix” fast payment system

In a recent post devoted to a BIS report summarising the results of interviews on what a small group of central banks had been doing with regard to Central Bank Digital Currencies, I posed the question whether central bankers might be better placed using their resources and powers to foster the development of fast payment systems rather than Central Bank Digital Currencies (CBDCs) and offered the following perspective:

the business case for a retail CBDC seems to have the most weight in the emerging market and developing economies with relatively poorly developed financial infrastructure

the business case for a retail CBDC in an advanced economy is less obvious

other initiatives such as central bank sponsorship of fast payment systems might be a better use of central bank resources

not explicitly referenced in the paper, but the recent experience with the roll out of fast payment systems in Brazil and India offer interesting case studies

the central bank focus on CBDCs seems to continue to be heavily weighted toward account based systems

token based CBDCs are mentioned in passing but do not seem to be high on the list of priorities

From the Outside – 15 March 2022 – “Central Bank Digital Currencies: A new tool in the financial inclusion toolkit”

For anyone interested in CBDC’s and fast payment systems, the BIS has published another report exploring the lessons to be learned from Brazil’s adoption of the “Pix” fast payment system. The authors identify three takeaways from Brazil’s experience which I think broadly support the thesis that fast payment systems often have the potential to achieve many if not all of the public policy objectives associated with CBDCs:

Public payment infrastructures build on the central bank’s foundational role in the monetary system by promoting competition and interoperability between payment platforms. They can reduce costs for users and promote financial inclusion.

Brazil’s recent experience with the Pix retail instant payment system illustrates the potential gains. In little over a year since its launch in November 2020, Pix has signed up 67% of adults in Brazil, with free payments between individuals and low charges for merchants.

The two key ingredients in the success of Pix are, first, the mandatory participation of large banks to kick-start network effects for users, and second, the central bank’s dual role as infrastructure provider and rule setter.

It is important to note however that these benefits do not flow automatically from just building the payment system infrastructure, the report highlights the importance of the central bank using its power to:

  • mandate the participation of large banks and other large players in payment services in order to kickstart the network effects and
  • to set rules that promote competition

I may be missing something here but it still feels to me like CBDCs are over-rated and (well constructed) fast payment systems under-rated. There are no doubt some economies where a CBDC has a role to play but I for one am paying more attention to the roll out of their less glamorous sibling.

Tony – From the Outside

The E-Cash alternative

CBDCs and stablecoins have been getting most of the attention lately. In contrast the release in late March 2022 of a draft bill titled the ECASH Act seems to have flown under the radar. The bill as I understand it is only a proposal at this stage and not something actively in the process of becoming law. It is however worth noting for a couple of reasons

  • Is is a useful reminder that an account based CBDC is not the only form of government issued digital money that might be pursued (though the account based model does seem to be the model preferred by the BIS mostly due to concerns about illegal use of anonymous forms of money)
  • Primary responsibility for E-Cash is assigned to the US Treasury, not the Central Bank (so technically it is not a CBDC per se)
  • Although I personally am not overly concerned by the current state of Know Your Customer and related anti money laundering, anti terrorist financing requirements applied to bank accounts, I respect the views of those for whom privacy is a priority or don’t have the benefit of living in the kind of economy/society that allows me to be relaxed about these questions
  • So long as the digital form of cash is subject to an equivalent set of controls on illicit activity as is applied to physical cash, then I can’t see why the digital option should be prohibited
  • Adding a digital money option that is capable of operating in an off-line environment also looks to me like a useful (albeit limited) level of redundancy and resilience in a world that increasingly relies on a 24/7 supply of power and internet connectivity for money to function
Who needs e-cash?

You can find more detail about the proposal here but for those short of time the argument put up by the Act’s proponents for why someone might want to use E-Cash is summarised as those who:

1. Lack access to traditional banking/payments services;

2. Value privacy and wish to avoid surveillance and/or data-mining;

3. Are concerned about third-party censorship and/or discrimination;

3. Lack reliable internet or digital network connectivity; and

5. Are low-income and/or cannot afford high transaction, withdrawal, and exchange fees.

www://https.ecashact.us/#whyuse

The Act’s proponents emphasise however that “… E-Cash, like physical cash, does not pay interest, and offers less third-party protections than traditional bank accounts or payments app (chargebacks, loss and fraud-prevention, etc).” The basic idea is that this is a complement to the existing forms of money (physical and digital) and it is not envisaged that most people will seek to hold large amounts in the form of E-Cash.

What exactly does the ECASH Act proposes?

1. Directs the Secretary of the Treasury to develop and introduce a form of retail digital dollar called “e-cash,” which replicates the offline-capable, peer-to-peer, privacy-respecting, zero transaction-fee, and payable-to-bearer features of physical cash, and to coordinate their efforts with other agencies, including the Federal Reserve through an intergovernmental Digital Dollar Council led by the Treasury Secretary;

2. Establishes an Electronic Currency Innovation Program within the U.S. Treasury to test and evaluate different forms of secure hardware-based e-cash devices that do not require internet access, third-party validation, or settlement on or via a common ledger, with a focus on widely available, interoperable architectures such as stored-value cards and cell phones;

3. Establishes an independent Monetary Privacy Board to oversee and monitor the federal government’s efforts to preserve monetary privacy and protect civil liberties in the development of digital dollar technologies and services, and directs the Treasury Secretary to, wherever possible, promote and prioritise open-source licensed software and hardware, and to make all technical information available for public review and comment; and

4. Establishes a special-purpose, ring-fenced Treasury overdraft account at the Federal Reserve Bank of New York to cover any and all government expenses related to the development and piloting of E-Cash, and directs the Board of Governors of the Federal Reserve System to take appropriate liquidity-support measures to ensure that the introduction of e-cash does not reduce the ability of banks, credit unions, or community development financial institutions to extend credit and other financial services to underserved populations, as prescribed under the Community Reinvestment Act of 1977 and related laws.

www:https://ecashact.us/#ecashact

Summing up

I have been a professed sceptic on the need for a retail CBDC in advanced economies with well functioning fast payment systems (see here and here) but this proposal is intriguing and one that I will watch with interest.

Tony – From the Outside

Central bank digital currencies: a new tool in the financial inclusion toolkit?

The BIS recently published a paper summarising what had been learned from a series of interviews with nine central banks exploring how these institutions were thinking about the potential of a CBDC to support the pursuit of “financial inclusion” objectives explicit or implicit in their mandates.

A lot of what the paper documents and discusses will be pretty familiar to anyone who has been following the BIS and individual central banks on this topic but I think the following observations offered by the paper about the best way to pursue financial inclusion is worth noting

It needs to be noted that many of these features [i.e. the benefits of a CBDC] can, in isolation, be offered by other payment innovations, and many gaps could be addressed through regulation and sound oversight arrangements. Combining different payment innovations – such as open application programming interfaces (APIs), fast payment services, contactless chips and QR codes – could achieve many of the same goals. This is particularly true when accompanied by robust regulatory and oversight arrangements that public authorities can use to catalyse private sector players, enforce sound governance arrangements and foster required coordination and collaboration. Adoption of relevant technologies for supervisory and regulatory compliance could also improve the efficiency and effectiveness of regulators and supervisors. What is truly different about CBDC is that it is a direct claim on the central bank. It is an open question for central banks whether CBDCs or other policy interventions are the best fit for their jurisdiction. Yet if a CBDC is to be issued (for financial inclusion or other motives), interviews with central banks clearly point to the importance of inclusive design elements to successfully promote inclusive outcomes. We discuss these elements in the next subsection.

Page 13, paragraph 16

There is a narrative that sees CBDC adoption as inevitable based in part on the fact that so many central banks are looking at the question. In contrast, the BIS paper clearly states that a CBDC is not a “panacea” and that many of the outcomes a CBDC might deliver could equally be delivered by other payment innovations such as “open application programming interfaces (APIs) , fast payment services, contactless chips and QR codes”

It is also worth noting that, of the nine central banks interviewed, eight were emerging market and developing economies and only one (Bank of Canada) an advanced economy. The results should therefore be interpreted with that bias in mind.

Summing up, my take is that

  • the business case for a retail CBDC seems to have the most weight in the emerging market and developing economies with relatively poorly developed financial infrastructure
  • the business case for a retail CBDC in an advanced economy is less obvious
  • other initiatives such as central bank sponsorship of fast payment systems might be a better use of central bank resources
  • not explicitly referenced in the paper, but the recent experience with the roll out of fast payment systems in Brazil and India offer interesting case studies
  • the central bank focus on CBDCs seems to continue to be heavily weighted toward account based systems
  • token based CBDCs are mentioned in passing but do not seem to be high on the list of priorities

Let me know what I am missing

Tony – From the Outside