You, like me, might be vaguely aware of the M-Pesa story of fintech innovation in Africa. Marc Rubinstein offers one of the best accounts I have encountered of how this came about and where it might be headed. Especially interesting is his analysis of why it took off in Kenya and the challenges it has faced in other markets.
Frances Coppola’s blog offers an interesting extension of the ways in which private banks contribute to the the “creation” of bank deposits which are in turn one of the primary forms of money in most modern economies. This is a very technical issue, and hence of limited interest, but I think it will appeal to anyone who wants to peer under the hood to understand how banking really works. In particular, it offers a better appreciation of the way in which banks play a very unique role in the economy which is broader than just intermediating between borrowers and lenders.
If you have come this far then read the entire post but this extract captures the key point …
It’s now widely accepted, though still not universally, that banks create money when they lend. But it seems to be much less widely known that they also create money when they spend. I don’t just mean when they buy securities, which is rightly regarded as simply another form of lending. I mean when they buy what is now colloquially known as “stuff”. Computers, for example. Or coffee machines.
Imagine that a major bank – JP Morgan, for example – wants to buy a new coffee machine for one of its New York offices …. It orders a top-of-the-range espresso machine worth $10,000 from the Goodlife Coffee Company, and pays for it by electronic funds transfer to the company’s account. At the end of the transaction JP Morgan has a new coffee machine and Goodlife has $10,000 in its deposit account.
My one observation is that the analysis could have been taken a bit further to consider the ways in which the money created by the bank lending mechanism is retired. In the example of the purchase of a coffee machine that Coppola uses, I assume that there was quite a lot of bank lending or other credit involved in getting to the point that the Goodlife Coffee Company has a coffee machine in stock that it can sell to JP Morgan. Once the JP Morgan cash reaches Goodlife’s bank account it is logical to assume that some of this debt will need to be repaid such that the net increase in money created by the purchase is less than the gross amount. This cycle repeats as inventory is manufactured and then sold.
As a rule, the overall supply of money will be increasing over time in response to the net increase in private bank lending but I would assume that it will be increasing and decreasing around this trend line as short term working capital loans are created and extinguished. This is a tricky area so I could be missing something but the capacity of the money supply to expand (and contract) in response to the needs of business for working capital feels like an important feature of the banking system we have today and something to consider as we explore new decentralised forms of money.
Cross border payment is one of the areas of conventional banking where challengers believe that crypto/DLT solutions can shake up the existing order. There is little doubt that the cross border payment status quo has lots of room for improvement but Gillian Tett (Financial Times) offers a nice summary of central bank projects that are potentially introducing other vectors of innovation and competition.
The Basel Committee on Banking Supervision (BCBS) released a consultation paper in June 2021 setting out its preliminary thoughts on the prudential treatment of crypto asset exposures in the banking system.
I covered the paper here but the short version is that the BCBS proposes to distinguish between two broad groups: One where the BCBS believes that it can look through the Crypto/DLT packaging and largely apply the existing Basel requirements to the underlying assets (Group 1 crypto assets). And another riskier Group 2 (including Bitcoin) which would be subject to its most conservative treatment (a 1250% risk weight).
At the time I noted that it was not surprising that the BCBS had applied a conservative treatment to the riskier end of the crypto spectrum but focussed on the fact that that bank regulators were seeking to engage with some of the less risky elements.
I concluded with my traditional caveat that I was almost certainly missing something. Caitlin Long (CEO and founder of Avanti Financial Group, Inc) argues that what I missed is the intra-day settlement risk that arises when conventional bank settlement procedures deal with crypto-assets that settle in minutes with irreversibility.
The BCBS could just apply even higher capital requirements but the better option she argues is to create a banking arrangement that is purpose built to deal with and mitigate the risk. I have copied an extract from an opinion piece she wrote that was published in Forbes magazine on 24 June 2021
Thankfully, there is a safe and sound way to integrate bitcoin and other Group 2 cryptoassets into banking systems:
– Conduct all bitcoin activities in a ring-fenced bank that is either stand-alone or is a bankruptcy-remote subsidiary of a traditional (leveraged) bank.
– Use no leverage in the bank. No rehypothecation of bitcoin held in custody. Hypothecation of assets held in custody is fine, but the bank must not permit greater than 1:1 leverage. Remember—bitcoin has no lender of last resort or clearinghouse.
– Take no credit or interest rate risk within the bank. Hold 100% reserves in cash, T-bills or similar short-term, high-quality liquid assets. The bank makes money on fees, which crypto fintechs have successfully done for years due to high transaction volume.
– Pre-fund transactions, so that the bank settles second or simultaneously instead of settling first and thereby avoid “back door” leverage caused by a counterparty failing to deliver.
– Permit no collateral substitution or commingling in prime brokerage.
– Design IT and operational processes for fast settlement with irreversibility, complete with minute-by-minute risk monitoring and reconciliation processes.
It is quite possible that I am still missing something here but the broad argument that Avanti lays out seems plausible to me; i.e. it would seem desirable that a bank that seeks to support payments to settle crypto asset trades should employ a payment process that allows instant payments as opposed to end of day settlement.
Some parting observations:
The Fed is moving towards the implementation of an instant payment system so arguments based on problems with 40 year old payment systems such as the Automated Clearing House (ACH) currently used by the USA would be more compelling if they addressed how they compare to the new systems that have been widely deployed and proven in other jurisdiction.
Notwithstanding, there is still a case for allowing room for alternative payment solutions to be developed by novel institutions. In this regard, Aventi has committed to embrace the level of regulation and supervision that is the price of access to an account at the central bank.
Aventi’s regulatory strategy is very different to the decentralised, permission-less philosophy that drives the original members of the crypto asset community. Seeing how these two competing visions of money play out continues to be fascinating.
One of my recent posts flagged some useful work that JP Koning had shared summarising four different regulatory strategies USD stablecoins issuers have adopted.
The New York Department of Financial Services (NYDFS) trust company model [Paxos, Gemini, BUSD]
The Nevada state-chartered trust model [TrueUSD, HUSD]
Multiple money transmitter license model [USDC]
Stay offshore [Tether]
If I read this post from Circle correctly, we can now add a fifth strategy; the Federally-chartered national commercial bank model. For those with a historical bent, this might also be labelled the “narrow bank” model or the “Chicago Plan” model.
Here is a short extract from the Circle post …
Circle intends to become a full-reserve national commercial bank, operating under the supervision and risk management requirements of the Federal Reserve, U.S. Treasury, OCC, and the FDIC. We believe that full-reserve banking, built on digital currency technology, can lead to not just a radically more efficient, but also a safer, more resilient financial system.
We are embarking on this journey alongside the efforts of the top U.S. financial regulators, who through the President’s Working Group on Financial Markets are seeking to better manage the risks and opportunities posed by large-scale private-sector dollar digital currencies.
… is the title of a useful paper by Christian Catalini and Andrew Lilley that digs into the puzzle of why it is that one of the (if not the) key players in the global financial system seems to lagging global best practice in terms of the cost, convenience and speed of its payment system.
It has to be noted that the authors are not neutral observers in this space. Christian Catalini is the Chief Economist of the Diem Association and Diem Networks US, and Co-Creator of Diem (formerly Libra). He is also the Founder of the MIT Cryptoeconomics Lab and a Research Scientist at MIT. Andrew Lilley is an employee of Novi Financial, Inc. who contributed to the paper as part of his work with Diem Networks US. With that caveat in mind, the paper still offers a short (12 pages) and useful summary of the ways in which the US lags best practice.
They frame the US problem as follows:
The US enjoys one of the least concentrated banking systems among the G30, but this feature has also created a fragmented and expensive payments system. Transfers between major US banks incur fees ranging from $10 to $35 for same-day wires, and up to $3 for 2-day transactions. Compare this to the UK, where individuals and businesses have access to a free, 24/7 interbank payments system which settles within seconds and supports over 8M transactions per day. While the US does have a Real Time Gross Settlement (RTGS) system, the Fedwire Funds Service carries less than 1 million transactions per day, has limited 21/5 availability, and is almost exclusively used by financial institutions and large corporations. Its fees, moreover, are larger than alternative payment methods such as ACH, creating a trade-off between cost and immediacy. Private sector alternatives are limited, and while some banks have deployed real-time solutions, these come with transaction limits and little adoption, which severely reduces their usefulness.
Catalini and Lilley (2021), Why is the United States Lagging Behind in Payments?
The paper then outlines how these limitations affect individuals, business and government and concludes with suggestions of what might be done to address the problems discussed:
There are at least three ways to remove frictions in payments and rapidly expand the number of individuals and businesses that can access the financial system and cheaply transact in real time. The first is to bring deposits on a single ledger through a Central Bank Digital Currency (CBDC), so that transfers between banks are not limited by external liquidity constraints or third-party rails. The second approach is to follow countries such as India and Mexico and increase the throughput of always-on RTGS systems. This is the model the Federal Reserve is pursuing with the introduction of FedNow, targeted for 2023. FedNow, however, is expected to have an initial transfer maximum of $25,000, which would limit its usefulness to businesses. The third approach is to facilitate the growth of interoperable, stablecoin payment rails by creating the right regulatory framework for these new types of networks to safely increase competition in payments.
While each one of these approaches presents different challenges, opportunities and trade-offs in terms of complexity, development costs and ability to expand access to segments that are currently excluded, it is important to stress that they are likely to be complements, not substitutes.
Advancing the US payments infrastructure will require both regulatory and technical developments targeted at improving market structure, lowering barriers to entry, and facilitating collaboration between public and private sector efforts in digital payments.
Catalini and Lilley (2021)
I am trying to keep an open mind on the future of payment systems but find myself drawn towards the conclusion that fast payment systems that the FedNow initiative is based on seem to have worked pretty well in other countries in terms of improving cost, speed and convenience so it is not obvious to me why either a CBDC or stablecoin solution is necessary in the United States.
Lately, this blog has pivoted from something I know reasonably well (bank capital adequacy) to things that I don’t – cryptoassets, stablecoins, central bank digital currencies and DeFi. My last post looked at a paper by Nic Cater and Linda Jeng titled “DeFi Protocol Risks: the Paradox of DeFI”. This week I want to flag another useful paper (well at least from my newbie perspective) written by Fabian Schär that was published in the St Louis Fed Review (Second quarter 2021).
I have to confess that I am not yet fully convinced that the DeFI applications developed to date do much more than offer novel ways of trading risk in new forms of securities or crypto assets. That does not mean that the technology will not someday add value to the financial system that will be increasingly called onto support an increasingly digital economy and ultimately the Metaverse.
Schär’s exploration of the risks of DeFI (Section 3) covers very similar ground to the Carter and Jeng paper I flagged above. What I did find useful was Section 2 that lays out the building blocks that DeFi is based on.
Schär concludes …
DeFi has unleashed a wave of innovation. On the one hand, developers are using smart contracts and the decentralized settlement layer to create trustless versions of traditional financial instruments. On the other hand, they are creating entirely new financial instruments that could not be realized without the underlying public blockchain. Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans are just a few of many examples that show the great potential of this ecosystem.
While this technology has great potential, there are certain risks involved. Smart contracts can have security issues that may allow for unintended usage, and scalability issues limit the number of users. Moreover, the term “decentralized” is deceptive in some cases. Many protocols and applications use external data sources and special admin keys to manage the system, conduct smart contract upgrades, or even perform emergency shutdowns. While this does not necessarily constitute a problem, users should be aware that, in many cases, there is much trust involved. However, if these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.
As noted above, I am not sure that all of the innovations generated by DeFi to date are going to make the world (or at least the financial system) a better place. That said, I am a traditional banker so what would I know. I remain open to the idea (indeed optimistic) that the technologies, applications and concepts being developed under the DeFi framework have the potential to deliver some value. The extent of improvement in conventional banking and finance is sometimes under appreciated but there is still plenty of room for improvement.
Shär’s paper is relatively short (roughly 20 pages) and worth a read if you are new to the topic like me and interested in this area of finance. It also has an extensive list of references that are worth reviewing for leads in areas worth exploring in more depth.
Nic Carter and Linda Jeng have produced a useful paper titled “DeFi Protocol Risks: the Paradox of DeFi” that explores the risks that DeFi will need to address and navigate if it is to deliver on the promises that they believe it can. There is of course plenty of scepticism about the potential for blockchain and DeFi to change the future of finance (including from me). What makes this paper interesting is that it is written by two people involved in trying to make the systems work as opposed to simply throwing rocks from the sidelines.
Linda Jeng has a regulatory back ground but is currently the Global Head of Policy at Transparent Financial Systems. Nic is a General Partner at a seed-stage venture capital film that invests in blockchain related businesses. The paper they have written will contribute a chapter to a book being edited by Bill Coen (former Secretary General of the Basel Committee on Banking Supervision) and Diane Maurice to be titled “Regtech, Suptech and Beyond: Innovation and Technology in Financial Services” (RiskBooks).
Linda and Nic conceptually bucket DeFi risks into five categories:
interconnections with the traditional financial system,
operational risks stemming from underlying blockchains,
smart contract-based vulnerabilities,
other governance and regulatory risks, and
… and map out the relationships in this schematic
Conclusion: “No Free Lunch”
The paper concludes around the long standing principle firmly entrenched in the traditional financial world – there is “no free lunch”. Risk can be transformed but it is very hard to eliminate completely. Expressed another way, there is an inherent trade off in any system between efficiency and resilience.
Many of the things that make DeFi low cost and innovative also create operational risk and other challenges. Smart contracts sound cool, but when you frame them as “automated, hard-to-intervene contracts” it is easy to see they can also amplify risks. Scalability is identified as an especially hard problem if you are not willing to compromise on the principles that underpinned the original DeFI vision.
The paper is worth a read but if you are time poor then you can also read a short version via this post on Linda Jeng’s blog. Izabella Kaminska (FT Alphaville) also wrote about the paper here.
Cryptocurrency, or stablecoins to be more precise, 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 suggests that ” … privately produced monies are not an effective medium of exchange because they are not always accepted at par and are subject to bank runs”
Stablecoins are not as yet a systemic issue but could be, so policymakers need to adjust the regulatory framework now to be ready as these new forms of private money grow and and potentially evolve into something that can’t be ignored
Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency
I am not convinced that a central bank digital currency is the solution. I can see a case for greater regulation of stablecoins but you need to be clear about exactly what type of stablecoin requires a policy response. Gorton and Zhang distinguish three categories …
The first includes cryptocurrencies that are not backed by anything, like Bitcoin. We call these “fiat cryptocurrencies.” Their defining feature is that they have no intrinsic value. Second, there are specialized “utility coins,” like the JPMorgan coin that is limited to internal use with large clients. Finally, there are “stablecoins,” which aspire to be used as a form of private money and so are allegedly backed one-for-one with government fiat currency (e.g., U.S. dollars)
I am yet to see a completely satisfactory taxonomy of stablecoins but at a minimum I would break the third category down further to distinguish the ways in which the peg is maintained. The (relatively few?) stablecoins that actually hold high quality USD assets on a 1:1 basis are different from those which hold material amounts of commercial paper in their reserve asset pool and different again from those which employ algorithmic protocols to maintain the peg.
However, you do not necessarily have to agree with their taxonomy, assessments or policy suggestions to get value from the paper – three things I found useful and interesting:
The “no-questions-asked ” principle for anything that functions or aims to function as money
Some technical insights into the economic and legal properties of stablecoins and stablecoin issuers
Lessons to be learned from history, in particular the Free Banking Era of the 19th century
The “no-questions-asked” principle.
Money is conventionally defined in terms of three properties; a store of value, a unit of account and a medium of exchange. Gorton and Zhang argue that “The property that’s most obvious, yet not explicitly presented, is that money also must satisfy the no-questions-asked (“NQA”) principle, which requires the money be accepted in a transaction without due diligence on its value“. They freely admit that they have borrowed this idea from Bengt Holmstrom though I think he actually uses the term “information insensitive” as opposed to the more colloquial NQA principle.
Previous posts on this blog have looked at both Holmstrom’s paper and other work that Gorton has co-authored on the optimal level of information that different types of bank stakeholders require. If I understood Holmstrom correctly, he seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggle with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between the relative value of information in debt and equity markets and its impact on liquidity.
Gorton and Zhang emphasise the importance of deposit insurance in underwriting confidence in and the liquidity of bank deposits as the primary form of private money. I think that is true in the sense that most bank deposit holders do not understand the mechanics of the preferred claim they have on the assets of the bank they have lent to but it seems to me that over-collateralisation is equally as important in underwriting the economics of bank deposits.
Insights drawn from a technical analysis of stablecoins and stablecoin issuers.
The paper delves in a reasonable amount of detail into the technicalities of whether stablecoins are economically or legally equivalent to demand deposits and the related question of whether stablecoin issuers might be considered to be banks. The distinction between the economic and the legal status is I think especially useful for understanding how banking regulators might engage with the stablecoin challenge.
The over arching point is that stablecoins that look and function like bank demand deposits should face equivalent levels of regulation. That does not necessarily mean exactly the same set of rules but something functionally equivalent.
One practical outcome of this analysis that I had not considered previously is that they deem Tether to be based on an “equity contract” relationship with its users whereas the other stablecoins they analyse are “debt contracts” (see below). The link between Tether and a money market fund and the risk of “breaking the buck” has been widely canvassed but I had not previously seen the issue framed in these legal terms.
This technical analysis is summarised in two tables (Table 2: Stablecoins and their Contracts as of June 30, 2021 and Table 3: Stablecoins, Redemptions, and Fiat Money as of June 30. 2021) that offer a useful reference point for understanding the mechanics and details of some of the major stablecoins issued to date. In addition, the appendix to the paper offers links to the sources used in the tables.
Lessons to be learned from history
It may have been repeated to the point of cliche but the idea that “those who cannot remember the past are condemned to repeat it” (George Santayana generally gets the credit for this but variations are attributed to Edmund Burke and Sir Winston Churchill) resonates strongly with me. The general argument proposed by Gorton and Zhang is that lots of the ideas being tried out in stablecoin design and DeFi are variations on general principles that were similarly employed in the lightly regulated Free Banking Era but found wanting.
Even if you disagree with the conclusions they draw, the general principle of using economic history to explore what can be learned and what mistakes to avoid remains a useful discipline for any practitioner of the dark arts of banking and money creation.
Summing up in the authors’ own words
The paper is long (41 pages excluding the Appendix) but I will wrap up this post with an extract that gives you the essence of their argument in their own words.
Tony – From the Outside
The more things change, the more they stay the same. It is still the case that regulation is being outpaced by innovation—thereby creating an uneven playing field—as it is easier and cheaper for more technologically advanced firms to offer similar products and services.
In this case, it is also true that the problems associated with privately produced money are the same as they were one hundred and fifty years ago. We stress three points from our review of history. First, the use of private bank notes was a failure because they did not satisfy the NQA principle. Second, the U.S. government took control of the monetary system under the National Bank Act and subsequent legislation in order to eliminate the private bank note system in favor of a uniform currency—namely, national bank notes. Third, runs on demand deposits only ended with deposit insurance in 1934.
Currently, it does not appear that stablecoins are used as money. But, as stablecoins evolve further, the stablecoin world will look increasingly like an unregulated version of the Free Banking Era—a world of wildcat banking. During the Free Banking Era, private bank monies circulated at time-varying discounts based on geography and the perceived risk of the issuing bank. Stablecoin prices are independent of geography but not independent of the perceived risk of their backing assets. If they succeed in differentiating themselves from fiat cryptocurrencies and become used as money, then they will likely trade at time-varying discounts as well. Policymakers have a couple of ways to address this development, and they better get going.
William’s perspective is explicitly Tether sceptical. However, he also includes a long Twitter thread from Jim Bianco attempting (in Bianco’s words) “to pushback on the FUD about USDT”. I am not sure Williams adds anything new to the sceptical view but it is useful to see the counter-narrative offered by Bianco covered in the newsletter. That said, my read of Bianco’s contribution is that it is more a defence of the general promise of a decentralised DeFi system, than it is a defence of Tether itself.
The Tether part of the newsletter is a long read at 25 pages (there is always the podcast if you prefer) but it does offer a comprehensive account of the sceptical position on Tether and a flavour of the counter argument.