The ECB seeks the holy grail of cross-border payments

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

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

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

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

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

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

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

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

Tony – From the Outside

Abstract

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

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

Conclusion

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

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

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

ECB Working Paper Series No 2693 / August 2022 51 

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

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

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

Crypto and credit creation

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

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

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

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

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

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

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

Tony – From the Outside

History of the Fed

I love a good podcast recommendation. In that spirit I attached a link to an interview with Lev Menand on the Hidden Forces podcast. The broader focus of the interview is the rise of shadow banking and the risks of a financial crisis but there is a section (starting around 21:20 minute mark) where Lev and Demetri discuss the origin of central banking and the development of the Fed in the context of the overall development of the US banking system.

The discussion ranges over

  • The creation of the Bank of England (23:20)
  • The point at which central banks transitioned from being simple payment banks to credit creation (24:10) institutions with monetary policy responsibilities
  • The problems the US founders faced creating a nation state without its own money (25:30)
  • Outsourcing money creation in the US to private banks via public/private partnership model (26:50)
  • The problems of a fragmented national market for money with high transmission costs (27:40)
  • The origin of the Federal Reserve in 1913 (31.50) and the evolution of banking in the US that preceded its creation which helps explain the organisational form it took

… and a lot more including a discussion of the rise of shadow banking in the Euromarket.

The topic is irredeemingly nerdy I know and it will not tell you much new if you are already engaged with the history of banking but it does offer a pretty good overview if you are interested but not up for reading multiple books.

Tony – From the Outside

Deposit insurance

I recently flagged a post by Patrick McKenzie on the mechanics of the humble bank deposit. Patrick has followed that with another equally interesting discussion of deposit insurance. The post is written as a high level primer and so it does not offer any insights to anyone already familiar with the topic.

The main thing that grabbed my attention was Patrick’s emphasis on the “information insensitive” nature of bank deposits. This to my mind is a fundamental concept in analysing bank deposits but gets way less attention that I think it deserves. It is particularly important when you are looking at the question of the extent to which deposit insurance promotes moral hazard.

So it was good to see someone else promoting the importance of this concept. On the other hand, his discussion of the information insensitivity of deposits does not give as much attention to the role of “deposit preference” as I think it deserves. It is always possible of course that I have this wrong but, for me at least, the preferred claim that many jurisdictions afford bank deposits is a key part of understanding why bank deposits can be information insensitive” without necessarily creating moral hazard.

If you are interested to dig deeper ….

  • Matt Levine did a good post on the overall question of how finance uses tranching to turn a pool of risky assets into a mix of safe and risky claims on those assets where he described this as “A main move in finance” (see here for my summary of the column if you don’t have access to his column)
  • There is also a page on my website where I discuss the arguments for protecting depositors (the “why”), another where I attempt to dig a bit deeper into the technical aspects of bank deposit protection (the “how”), and this post offering an Australian perspective on the process of how bank deposits (a loan to highly leveraged company) get turned into mostly risk free assets in the hands of bank depositors.

Tony – From the Outside

The alchemy of deposits

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

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

His first point is that “deposits are money”

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

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

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

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

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

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

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

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

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

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

This is Patrick’s take on Voyager

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

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

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

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

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

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

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

Tony – From the Outside

Matt Levine on stuff that gets lost in translation

I have been referencing Matt Levine a lot lately. No apologies, his Money Stuff column is a regular source of insight and entertainment for banking and finance tragics such as myself and I recommend it. His latest column (behind a paywall but you can access a limited number of articles for free I think) includes a discussion of the way in which the DeFi industry has created analogues of conventional banking concepts like “deposits” but with twists that are not always obvious or indeed intuitive to the user/customer.

We have talked a lot recently about how crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account.

Matt Levine “Money Stuff” column 28 June 2022 – Crypto depositors

How banks can create safe assets is a topic that I have looked at a number of times but this post is my most complete attempt to describe the process that Matt outlines above. To me at least, this is a pretty fundamental part of understanding how finance works and Matt also did a good post on the topic that I discussed here.

One of the key points is that the tranching of liabilities also creates a division of labour (and indeed of expertise and inclination) …

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.

The DeFi industry argues that they want to change the ways that traditional finance operates for the benefit of users but it also expects those users to be motivated and engaged in understanding the details of the new way of doing things. A problem is that some users (maybe “many users”?) might be assuming that some of the rules that protect depositors (and indeed creditors more generally) in the conventional financial system would naturally be replicated in the alternative financial system being created.

Back to Matt …

The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.

The problem according to Matt is ….

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.

This feels like a problem to me. As the industry becomes more regulated I would expect to see the issues of seniority and deposit protection/preference more clearly spelled out. For the time being it does seem to be very much caveat emptor and don’t assume anything.

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