Money – From the outside

The stablecoin business model

JP Koning offers an interesting post here speculating on the reason why Wise can pay interest to its USD users but USDC can or does not. The extract below captures his main argument …

It’s possible that some USDC users might be willing to give up their ID in order to receive the interest and protection from Circle’s bank. But that would interfere with the usefulness of USDC. One reason why USDC is popular is because it can be plugged into various pseudonymous financial machines (like Uniswap or Curve). If a user chooses to collect interest from an underlying bank, that means giving up the ability to put their USDC into these machines.

This may represent a permanent stablecoin tradeoff. Users of stablecoins such as USDC can get either native interest or no-ID services from financial machines, but they can’t get both no-ID services and interest.

Let me know what I am missing

Tony – From the Outside

Deposit insurance under review

Admittedly I only managed a skim read of the FDIC report dated 1 May 2023 on “Options for Deposit Insurance Reform” but I was a bit underwhelmed given the important role deposit insurance plays in the banking system. I think the conclusion that some form of increased but “targeted” coverage makes sense but I was disappointed by the discussion of the consequences for market discipline and moral hazard that might flow from such a move.

The Report considers three options for increasing deposit insurance:

Limited Coverage under which the current system would be maintained but the deposit insurance limit might increased above the existing USD250,000 threshold
Unlimited Coverage under which all deposits would be fully insured; and
Targeted Coverage under which coverage for “business payment accounts” would be substantially increased without significantly changing the limit for other deposits.

The report:

Concludes that “Targeted Coverage … is the most promising option to improve financial stability relative to its effect on bank risk-taking, bank funding, and broader markets”
But notes there are significant unresolved practical challenges “…including defining accounts for additional coverage and preventing depositors and banks from circumventing differences in coverage”

What I thought was interesting was that the Report seemed to struggle to make up its mind on the role of bank depositors in market discipline. On the one hand the Report states

“Monitoring bank solvency involves fixed costs, making it both impractical and inefficient for small depositors to conduct due diligence. Monitoring banks is also time consuming and requires financial, regulatory, and legal expertise that cannot be expected of small depositors”
Executive Summary, Page 1

… and yet there are repeated references to the ways in which increasing coverage will reduce depositor discipline. The discussion of the pros and cons of Targeted Coverage, for example, states

“The primary drawbacks to providing greater or unlimited coverage to specific account types are the potential loss in depositor discipline and resulting implications for bank-risk taking”
Section6: Options for Increased Deposit Coverage”, Page 58

I am not in favour of unlimited deposit insurance coverage but if you accept that certain types of depositors can’t be expected to monitor bank solvency (and liquidity) then I can’t see the point of saying that reduced depositor discipline is a consequence of changing deposit insurance for these groups or that the “burden” of monitoring is shifted to other stakeholders.

What would have been useful I think is a discussion of which stakeholders are best suited to monitor their bank and apply market discipline. Here again I found the Report disappointing. The Report states “… other creditors and shareholders may continue to play an important role in constraining bank risk-taking …” but does not explore the issue in any real detail.

I also found it confusing that ideas like placing limits on the reliance on uninsured deposits or requirements to increase the level of junior forms of funding (equity and subordinated debt), that were listed as “Potential Complementary Tools” for Limited Coverage and Unlimited Coverage, were not considered relevant in the Targeted Coverage option (See Table 1.1, page 5).

This ties into a broader point about the role of deposit preference. Most discussions about bank deposits focus on regulation, supervision and deposit insurance as the key elements that mitigate the inherent risk that deposits will run. Arguably, the only part of this that depositors understand and care about is the deposit insurance.

I would argue that deposit preference also has an important role to play for two reasons

Firstly, it mitigates the cost of deposit insurance by mitigating the risk that assets will be insufficient to cover insured deposits leaving the fund to make good the loss
Secondly, it concentrates the debate about market discipline on the junior stakeholders who I believe are best suited to the task of monitoring bank risk taking and exercising market discipline.

I did a post here which discussed the moral hazard question in more depth but the short version is that the best source of market discipline probably lies in the space between senior debt and common equity i.e. Additional Tier 1 and Tier 2 subordinated debt. Common equity clearly has some role to play but the “skin in the game” argument just does not cut it for me. The fact that shareholders benefit from risk taking tends to work against their incentive to provide risk discipline and more capital can have the perverse effect of creating pressure to look for higher returns.

Tony – From the Outside

Moneyness: Zelle vs Interac e-Transfer, or why it’s so difficult to kickstart a payments network in the U.S.

One of the mysteries of life is why a country as advanced as the USA seems to be so far behind in its payment system. JP Koning suggests that the answer lies in part in the large number of banks that is a feature of the US system.

— Read on jpkoning.blogspot.com/2023/04/zelle-vs-interac-e-transfer-or-why-its.html

Tony – From The Outside

Marc Rubinstein on deposit insurance

Marc Rubinstein offers a nice summary of the history of deposit insurance in the USA. The post is short and worth reading but the short version is captured in his conclusion…

Deposit insurance was never meant to preserve wealth … It was meant to preserve the functioning of the banking system. What the correct number is to accomplish that is a guess, but it’s going up.

Banking requires mystery

Matt Levine, like me, loves discussing stable-coin business models. In a recent opinion column he concludes that there is at least some prima facie evidence that transparency is not rewarded. At least not in the short run.

I have covered this ground in previous posts but at a time when the banking industry is seemingly demonstrating a perennial incapacity to learn from past mistakes, it is worth examining again the lessons to be drawn on the role of information and transparency in banking.

So starting with the basics …

Most of the leading crypto stablecoins have a pretty simple model: You give some stablecoin issuer $1, the issuer keeps the dollar and gives you back a dollar-denominated stablecoin, and the issuer promises to redeem the stablecoin for a dollar when you want. Meanwhile, the issuer has to hang on to the dollar.

Next he dives down a bit into the mechanics of how you might go about this. Matt identifies two basic models …

1.The issuer can try to work nicely with US regulators, get various licenses, and park its money in some combination of Treasury bills, other safe liquid assets, and accounts at regulated US banks.

2. The issuer can be a total mystery! The money is somewhere! Probably! But you’ll never find out where.

In practice Matt argues we have two examples of these different strategies …

USDC, the stablecoin of Circle, is probably the leading example of the first option. USDT, the stablecoin of Tether, is probably the leading example of the second option.

Matt, like me, is a traditional finance guy who struggles with the crypto trust model…

Me, I am a guy from traditional finance, and I’ve always been a bit puzzled that everyone in crypto trusts Tether so completely. You could put your money in a stablecoin that transparently keeps it in regulated banks, or you could put your money in Tether, which is very cagy and sometimes gets up to absolutely wild stuff with the money. Why choose Tether?

But over the recent weekend (11-12 Mar 2023) of banking turmoil USDC’s transparent strategy saw USDC depegged while USDT did not. The interesting question here is whether Tether is being rewarded for better portfolio risk management choices or something else was going on.

Matt sums up …

One possible understanding of this situation is that Circle made some bad credit decisions with its portfolio (putting billions of dollars into a rickety US bank), while Tether made excellent credit decisions with its portfolio (putting billions of dollars into whatever it is putting billions of dollars into). And, by extension, the traditional regulated US banking system isn’t that safe, and Tether’s more complicated exposures are actually better than keeping the money in the bank.

Another possible understanding, though, is that banking requires mystery! My point, in the first section of this column, was that too much transparency can add to the fragility of a bank, that the Fed is providing a valuable service by ignoring banks’ mark-to-market losses. Circle does not provide that service. Circle keeps its money in a bank with financial statements, and that bank fails, and Circle dutifully puts out a statement saying “whoops we had $3.3 billion in the failed bank,” and people naturally panic and USDC depegs. You have no idea where Tether keeps its money, so you have no idea if anything went wrong. This has generally struck me as bad, but it might have some advantages.

Tony – From the Outside

What does “proof of reserves” prove?

Frances Coppola argues in a recent post that proof of reserves as practised by the crypto finance community proves nothing. I would be interested to read any rebuttals, but the arguments she advances in support of this claim looks pretty sound to me.

Frances starts with the observation that the concept of “reserves” is not well understood even in conventional banking.

In the banking world, we have now, after many years of confusion, broadly reached agreement that the term “reserves” specifically means the liquidity that banks need to settle deposit withdrawals and make payments. This liquidity is narrowly defined as central bank deposits and physical currency – what is usually known as “base money” or M0, and we could perhaps also (though, strictly speaking, incorrectly) deem “cash”.
“Proof of reserves is proof of nothing” Coppola Comment 16 Feb 2023

This certainly rings true to me. I often see “reserves” confused with capital when reserves are really a liquidity tool. If you are still reading, I suspect you are ready to jump ship fearing a pedantic discussion of obscure banking terminology. Bear with me.

If you have even a glancing interested in crypto you will probably have encountered the complaint that traditional banks engage in the dubious (if not outrightly nefarious) practice of fractional reserve banking. A full discussion of the pros and cons of fractional reserve banking is a topic for another day. The key point for this post is that the crypto community will frequently claim that their crypto alternative for a TradFi activity like deposit taking is fully reserved and hence safer.

The published “proof of reserves” is intended therefore to demonstrate that the activity being measured (e.g. a stablecoin) is in fact fully reserved and hence much safer than bank deposits which are only fractionally reserved. Some of the cryptographic processes (e.g. Merkle trees) employed to allow customers to verify that their account balance is included in the proof are interesting but Frances’ post lists a number of big picture concerns with the crypto claim:

The assets implicitly classified as reserves in the crypto proof do not meet the standards of risk and liquidity applied to reserves included in the banking measure; they are not really “reserves” at all as the concept is commonly understood in conventional banking
As a result the crypto entity may in fact be engaging in fractional reserve banking just like a conventional bank but with riskier less liquid assets and much less liquidity and capital
The crypto proof of “reserves” held against customer liabilities also says nothing about the extent to which the crypto entity has taken on other liabilities which may also have a claim on the assets that are claimed to be fully covering the customer deposits.

Crypto people complain that traditional banks don’t have 100% cash backing for their deposits, then claim stablecoins, exchanges and crypto lenders are “fully reserved” even if their assets consist largely of illiquid loans and securities. But this is actually what the asset base of traditional banks looks like.

Let me know what I missing ….

Tony – From the Outside

Hollow promises

Frances Coppola regularly offers detailed and useful analysis on exactly what is wrong with some of the claims made by crypto banks. I flagged one of her posts published last November and her latest post “Hollow Promises”continues to offer useful insights into the way traditional banking concepts like deposits, liquidity and solvency get mangled.

Well worth reading.

Tony – From the Outside

The empire strikes back?

There is a lot written about how bad the US payment system is and why crypto solutions are the future. Against that background, Tom Noyes recently published an interesting post setting out his thoughts on a project JPM Chase is running to reengineer their payment system. Tom’s posts are normally restricted to subscribers but he has unlocked the first in a 5 part series exploring what JPM Chase is doing.

His post is definitely worth reading if you are interested in the future of banking. The short version is that the traditional banking system is not sitting still while crypto and fintech attempt to eat its lunch.

Tony – From the Outside

Matt Levine on stablecoins

Quite a lot has been written about the backing of stablecoins but Matt Levine uses the Tether use case to pose the question how much it matters for the kinds of activities that Tether is used for …

The point of a stablecoin is not mainly to be a secure claim on $1 of assets in a bank account. The point of a stablecoin is mainly “to grease the rails of the roughly $1 trillion cryptocurrency market,” by being the on-blockchain form of a dollar. We talk somewhat frequently about stablecoins that are openly backed by nothing but overcomplicated confidence in their own value; to be fair, we mostly talk about them when they are crashing to zero, but still. The thing that makes a stablecoin worth a dollar is primarily that big crypto investors treat it as being worth a dollar, that they use it as a medium of exchange and a form of collateral and value it at $1 for those uses. Being backed by $1.003 of dollar-denominated safe assets helps with that, but being backed by $0.98 of dollar-denominated assets might be good enough?

Matt draws no distinctions above but I don’t I think his argument is intended to apply to stablecoins that aim to challenge the traditional payment service providers (“payment stablecoins”) operating in the broader financial system. It does however pose an interesting question about how much stability crypto traders really require.

Tony – From the Outside

Stablecoins and the supply of safe assets in the financial system

Interesting post by Steven Kelly (senior research associate at the Yale School of Management’s Program on Financial Stability) on the role of stablecoins in the financial system. The post was published in the FT (behind a paywall) but this link from his LinkedIn page seems to great access. Steven raises a number of concerns with stablecoins but the one I want to focus on is the argument that stablecoins can only be made safe by locking up an increasing share of the safe assets that have other uses in the financial system.

Here is a quote …

The market- and regulation-inspired migration towards safer crypto assets is making stablecoins more popular, but that means there are more investment vehicles gobbling up the safe assets that otherwise grease the wheels of the traditional financial system. Absent rehypothecation, stablecoins will be a [giant sucking sound][1] in the financial system: soaking up safe collateral and killing its velocity.
Steven Kelly, “Stablecoins do not make for a stable financial system”, Financial Times 11 August 2022

I am not a fan but I am also not opposed to stablecoins on principle so long as they are issued in a way that ensures their promise to holders is properly and transparently backed by safe assets. That said, I do think that Steven highlights an important consideration that needs to be thought through should stablecoins start to account for a greater share of the payment infrastructure that we all rely on.

This is an issue that I touched on previously but I do not see it getting the attention I think it deserves.

As always, let me know what I am missing.

Tony – From the Outside