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.
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.
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.
The question of whether, or alternatively how, stablecoins should be regulated is getting a lot of attention at the moment. My bias (and yes maybe I am just too institutionalised after four decades in banking) is that regulation is probably desirable for anything that functions as a form of money. We can also observe that some stablecoin issuers seem to be engaging pro actively with the question of how best to do this. There is of course a much wider debate about the regulation of digital assets but this post will confine itself to the questions associated with the rise of a new generation of money like digital instruments which are collectively referred to as stablecoins.
Dan Awrey proposes another model for stablecoin regulation
Against that background, a paper titled “Bad Money” by Dan Awrey (Law Professor at Cornell Law School) offers another perspective. One of the chief virtues of his paper (refer Section III.B) is that it offers a comprehensive overview of the existing state regulatory framework that governs the operation of many of the stablecoins operating as “Money Service Businesses” (MSB). The way forward is up for debate but I think that Awrey offers a convincing case for why the state based regulatory model is not part of the solution.
This survey of state MSB laws paints a bleak picture. MSBs do not benefit from the robust prudential regulation, deposit guarantee schemes, lender of last resort facilities, or special resolution regimes enjoyed by conventional deposit-taking banks. Nor are they subject to the same type of tight investment restrictions or favorable regulatory or accounting treatment as MMFs. Most importantly, the regulatory frameworks to which these institutions actually are subject are extremely heterogeneous and often fail to provide customers with a fundamentally credible promise to hold, transfer, or return customer funds on demand.
Awrey, Dan, Bad Money (February 5, 202o). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
Awrey also rejects the banking regulation model …
… PayPal, Libra, and the new breed of aspiring monetary institutions simply do not look like banks. MSBs are essentially financial intermediaries: aggregating funds from their customers and then using these funds to make investments. They do not “create” money in the same way that banks do when they extend loans to their customers; nor is there compelling evidence to suggest that their portfolios are concentrated in the type of longer term, risky, and illiquid loans that have historically been the staple of conventional deposit-taking banks
… and looks to Money Market Funds (MMFs) as the right starting point for a MSB regulatory framework that could encompass stablecoins
So what existing financial institutions, if any, do these new monetary institutions actually resemble? The answer is MMFs. While MSBs technically do not qualify as MMFs, they nevertheless share a number of important institutional and functional similarities. As a preliminary matter, both MSBs and MMFs issue monetary liabilities: accepting funds from customers in exchange for a contractual promise to return these funds at a fixed value on demand. Both MSBs and MMFs then use the proceeds raised through the issuance of these monetary liabilities to invest in a range of financial instruments. This combination of monetary and intermediation functions exposes MSBs and MMFs to the same fundamental risk: that any material decrease in the market value of their investment portfolios will expose them to potential liquidity problems, that these liquidity problems will escalate into more fundamental bank-ruptcy problems, and that—faced with bankruptcy—they will be unable to honor their contractual commitments. Finally, in terms of mitigating this risk, neither MSBs nor MMFs have ex ante access to the lender of last resort facilities, deposit guarantee schemes, or special resolution regimes available to conventional deposit-taking banks.
In theory, therefore, the regulatory framework that currently governs MMFs might provide us with some useful insights into how better regulation can transform the monetary liabilities of MSBs into good money.
Awrey’s preferred model is to restructure the OCC to create three distinct categories of financial institution …
The first category would remain conventional deposit-taking banks. The second category—let’s call them monetary institutions—would include firms such as PayPal that issued monetary liabilities but did not otherwise “create” money and were prohibited from investing in longer-term, risky, or illiquid loans or other financial instruments. Conversely, the third category—lending institutions—would be permitted to make loans and invest in risky financial instruments but expressly prohibited from financing these investments through the issuance of monetary liabilities
Stablecoins would fall under the second category (Monetary Institutions) in his proposed tripartite licensing regime and the regulations to be applied to them would be based on the regulatory model currently applied to Money Market Funds (MMF).
What does Awrey’s paper contribute to the stablecoin regulation debate?
Awrey frames the case for stablecoin regulation around the experience of the Free Banking Era
This is not new in itself (see Gorton for example) but, rather than framing this as a lawless Wild West which is the conventional narrative, Awrey highlights the fact that these so called “free banks” were in fact subject to State government regulations
The problem with the Free Banking model, in his analysis, is that differences in the State based regulations created differences in the credit worthiness of the bank notes issued under the different approaches which impacted the value of the notes (this is not the only factor but it is the most relevant one for the purposes of the lessons to be applied to stablecoin regulation)
Finally, the value of bank notes depended on the strength of the regulatory frameworks that governed note issuing banks. Notes issued by banks in New York, or that were members of the Suffolk Banking system, for example, tended to change hands closer to face value than those of banks located in states where the regulatory regimes offered noteholders lower levels of protection against issuer default. Even amongst free banking states, the value of bank notes could differ on the basis of subtle but important differences between the relevant requirements to post government bonds as security against the issuance of notes bank notes.
If we want stablecoins to reliably exchange at par value to their underlying fiat currency then he argues we need a national system of regulation applying robust and consistent requirements to all issuers of stablecoin arrangements
Awrey then discusses the ways in which regulation currently “enhances the credibility of the monetary liabilities issued by banks and MMFs to set up a discussion of how the credibility of the monetary promises of the new breed of monetary institutions might similarly be enhanced
He proposes that the OCC be made accountable for regulating these “monetary institutions” (a term that includes other payment service providers like PayPal) but that the regulations be based on those applied to MMFs other than simply bringing them under the OCC’s existing banking regulations
The paper is long (90 pages including appendices) but hopefully the summary above captures the essence of it – for me the key takeaways were to:
Firstly to understand the problems with the existing state based MSB regulations that currently seem to be the default regulatory arrangement for a US based stablecoin issuer
Secondly the issues he raises (legitimate I think) with pursuing the bank regulation based model that some issuers have turned to
Finally, the idea that a MMF based regulatory model is another approach we should be considering
I will wrap up with Awrey’s conclusion …
Money is, always and everywhere, a legal phenomenon. This is not to suggest that money is only a legal phenomenon. Yet it is impossible to deny that the law plays a myriad of important and often poorly understood roles that either enhance or undercut the credibility of the promises that we call money. In the case of banks and MMFs, the law goes to great lengths to transform their monetary liabilities into good money. In the case of proprietary P2P payment platforms, stablecoin issuers, and other aspiring monetary institutions, the anti-quated, fragmented, and heterogenous regulatory frameworks that currently, or might in future, govern them do far, far less to support the credibility of their commitments. This state of affairs—with good money increasingly circulating alongside bad—poses significant dangers for the customers of these new monetary institutions. In time, it may also undermine the in-tegrity and stability of the wider financial system. Together, these dangers provide a compelling rationale for adopting a new approach to the regulation of private money: one that strengthens and harmonizes the regulatory frameworks governing monetary institutions and supports the development of a more level competitive playing field.
Joseph Campbell’s “The Hero with a Thousand Faces” is a great book. It offers insights into some deep ideas about how the world does (or should) work that have influenced a wide variety of people including George Lucas and Ray Dalio and was included in Time magazine’s list of the top 100 books.
Barry Ritholz did a short, but insightful, post here where he reminds us that the timeless appeal of the narrative that Campbell explores can also mislead us.
Our narrative bias for compelling stories can prevent us from seeing the forest for trees. Dramatic tales with clearly delineated Good & Evil are more memorable and emotionally resonant than dry data and tedious facts. Try as you might, finding a singular cause of some terrible economic outcome is an exercise in futility. Instead, you will find a long history of political, economic, psychological, and (occasionally) irrational drivers that eventually led to some disaster.
We look for the spark that ignites the room full of hydrogen, instead of 1,000 other factors that created the conditions precedent. You can find example after example of disasters widely thought of as “single event causes;” upon closer examination, they are revealed as the result of far more complex circumstances and countless interactions
This for me is an insight that rings very true but is often forgotten to feed our appetite for reducing complex stories to simple morality plays. I like the stories as much as the next person but the downside is that the simple appealing story distracts us from understanding the route causes of why things like the GFC happened and leave us exposed to the risk that they just keep repeating in different forms.
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.