Money – Page 2 – From the outside

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

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

Use of superior technology
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