Anyone following the stablecoin debate is probably familiar with a paper by Gary Gorton and Jeffrey Zhang titled (somewhat provocatively) “Taming Wildcat Stablecoins”. I did a post back in July 2021 when it first came out and have some more detailed notes on it here.
In my initial July 2021 post I listed three things I found useful and/or interesting
- The “no-questions-asked” (NQA) principle for anything that functions in practice or potential as money
- Some technical insights into the economic and legal properties of stablecoins and stablecoins issuers (i.e. what is the nature of the express or implied contract between users and stablecoin issuers)
- Lessons to be learned from history, in particular the experience of bank notes during the Free Banking Era in America in the early 19th century
Having reread the paper and some of the critiques it has attracted, I think these insights mostly remain valid. Of the three, the principle that money must be exchangeable on a NQA basis is (for me at least) the most useful. I must confess however that I find the lessons they draw from the Free Banking Era are muddled by the reference to “Wildcat Banking”. There are lessons for sure but you have to dig deeper into the historical record to really get a clear read on the conditions under which the uninsured liabilities of private entities can and cannot function as a reliable form of money.
This does not in itself fatally undermine the argument that stablecoins need a stronger regulatory framework to function effectively and efficiently as a form of money. It is however worth being clear on what lessons drawn from the history of private money can be usefully employed in figuring out how best to respond to the rise of stablecoins. While this post takes issue with some of analysis in the paper, I must declare that I still rate Gorton as one of my favourite commentators on banking and the NQA principle he espouses has long influenced my own views on banking.
Stablecoins according to Gorton and Zhang
At this point it might be helpful to recap the main elements of the argument Gorton and Zhang lay out in their joint paper:
- Stablecoins can be viewed as the latest variation in a long history of privately produced money
- The experience of the United States during the Free Banking Era of the 19th century and of Money Market Funds (MMF) during 2008 and again in 2020 suggest that “While the technology changes, and the form of privately produced money changes, the issues with privately produced money do not change – namely, private money is a subpar medium of exchange and is subject to runs“
- They concede that stablecoins are not yet of sufficient size to be a systemic issue but argue that allowing them to function like a demand deposit risks making the same mistake that allowed MMFs to reach a point where the government felt compelled to step in to underwrite the MMF redemption promise
- Policymakers need to adjust the regulatory framework now to be ready before these new forms of private money grow further in size and and potentially evolve like MMFs did into something that can’t be ignored
- Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency
Problems with the Wildcat Free Banking analogy
As a rhetorical device the, Wildcat Free Banking analogy works pretty well as an attack on stablecoins. You don’t really need to delve into the detail, wildcat banking tells you all you need to know. It sounds pretty bad and lawless in Wild West kind of way and so, by association, stablecoins must also be problematic.
The problem is that Gorton and Zhang themselves explicitly state that wildcat banking was not as big a problem as is commonly asserted and the Free Banking system in fact functioned well from the view of efficient market theory .
For many years, the literature asserted that there were wildcat banks during this period. These were banks that either (1) did not deposit the requisite bonds, or (2) in some states, where bonds were valued at par and not market value, defrauded the public by issuing notes that they would never redeem in specie (gold or silver). Counterfeiting was a big problem, but the system was not chaos. Bank failures were not due to wildcat banking as has often been alleged. In fact, it functioned well from the point of view of efficient market theory. Gorton and Zhang, “Taming Wildcat Stablecoins”, p28
So it appears that, notwithstanding its prominence in the title of their paper, the problem they are highlighting with Free Banking is not wildcat banks per se but rather the extent to which Free Banking in America resulted in bank notes trading at discounts to their par value …
The market was an “efficient market” in the sense of financial economics, but varying discounts made actual transactions (and legal contracting) very difficult. It was not economically efficient. There was constant haggling and arguing over the value of notes in transactions. Private bank notes were hard to use in transactions.Page 29
OK so let’s focus on Free Banking
The fundamental lesson Gorton and Zhang draw from the Free Banking Era and the subsequent development of a national currency in America is that competition and market forces alone will not by themselves ensure that privately produced forms of money can be relied on to exchange at their face value on a NQA basis under all market conditions.
In order to better understand the other side of this debate I have attempted to dig a bit deeper into the history of Free Banking. As part of the search I came across this podcast in which Nic Carter (Castle Island Ventures) interviews George Selgin (Director of the Center of Monetary Alternatives at the Cato Institute). It is long (1 hour 12 minutes) but appears to offer a good overview of the counter arguments advanced by proponents of cryptocurrencies, stablecoins and Free Banking.
Selgin argues (convincingly I think) that quite a lot of the problems experienced with Free Banking in America were a function (ironically) of poorly designed regulations – i.e. Free Banking in America did still involve regulation though maybe not as much supervision as banks are subject to today. In particular, he calls out the prohibition on branch banking (which restricted the capacity of banks to diversify the risk of their loan books) and the requirement that bank notes be backed by state government bonds (that ultimately proved to be very poor credit risks).
The Free Banking model did result in bank notes trading at discounts to their par value – that is a problem right?
This is another area where the debate gets a bit muddled.
Selgin concedes that some bank notes did trade at discounts to their par value – one of the central claims of Gorton and Zhang’s paper – but argues that these discounts were not a function of risk differences (i.e. concerns about the solvency and or liquidity of the issuing banks) but rather a reflection of the transaction costs incurred to redeem the notes at their issuing banks.
Selgin argues that “local” notes (i.e. those circulating in the local economy of their issuing bank) did in fact exchange at their par value and that the evidence of discounts cited by Gorton and Zhang were for “foreign” notes where they reflected the transaction costs of presenting the notes back to their issuing bank in another town, city or state.
However Selgin also concedes that part of the reason we don’t see evidence of local bank notes trading at discounts is that shopkeepers and other banks simply refused to accept any note where there was real or perceived default risk
In truth, antebellum banknote discounts were for the most part neither a consequence of the lack of regulation nor a reflection of distrust of their issuers. [Default risk was sometimes a factor], to be sure. But when it was, shopkeepers and banks tended to refuse them altogether, leaving it to professional note “brokers” to deal with them, much as they dealt with notes of banks that were known to be “broken,” but which might yet have some liquidation value. Discounts on “bankable” notes, on the other hand, reflected nothing more than the cost of sorting and returning them to their sources for payment in specie, plus that of bringing the specie home. This explains why, whatever the discounts placed on them elsewhere, [most notes traded at par in their home markets].George Selgin, “The fable of the cats”
I can’t get any sense of the relative size of the instances where shopkeepers and banks simply refused to accept notes issued by suspect banks. The fact that it happened under Free Banking regimes in America does however seem to support Gorton and Zhang’s assessment that “money” requires a support framework to be capable of being exchanged widely and freely on an NQA basis.
Based on my (so far not very deep) exploration of the Free Banking literature, it seems that its proponents also believe money requires a support framework. The key difference seems to be whether the private sector can maintain that support framework on its own or whether you require public sector involvement in the form of regulation, supervision and deposit insurance to achieve that outcome.
To properly explore what lessons we can learn about money and banking from history, we need to look beyond the American experience with Free Banking.
A Better Kind of Free Banking
Selgin and Carter point to the experience of Free Banking in a range of countries other than America as evidence that unregulated stablecoins subject to the forces of market discipline not only could work but potentially offer a better model than the highly regulated, deposit insured model that has come to dominate the modern banking status quo.
Scotland and Canada figure prominently in this alternative narrative of what history teaches us. I don’t really know enough about these eras to comment with any authority but it does appear that the notes issued by banks operating under these regimes did in fact hold their value and function effectively as the primary form of money.
Nic Carter wrote a post on the Scottish Free Banking era which listed five features which kept it stable
– Competitive ‘note dueling’
– A private clearinghouse
– Full liability partnership models
– Until 1765, clauses permitting the temporary suspension of convertibility
– Branching and diversificationNic Carter, “Scotland, Free Banks and Stablecoins” Murmurations 19 Sep 2021
… and summarised its virtues as
There was no regulatory body…. There was simply a legal structure that discouraged excessive lending, market mechanisms through which banks could competitively keep each other in check, and a vibrant information environment the public could benefit from. The Scottish banking system during the period was remarkably stable; financial crises and panics were rare, contrasting favorably with neighboring England. The Scottish experience of lightly regulated banking shows clearly that such a model can work …
Carter proposes two lessons that stablecoin issuers might extract from the Scottish Free Banking era.
Firstly that stablecoin issuers consider cooperating to create a private clearing house
First, as exchanges (oftentimes, it’s exchanges issuing stablecoins) continue mutually accepting each others notes, they might consider a private clearinghouse. That way they can achieve efficiency in settlement – moving from real time gross settlement to a net settlement model, saving on fees and on-chain headaches. If they do this, they will be fully incentivized to surface information regarding the solvency of their counterparties. This would solve the coordination problem inherent in entities like Tether being untransparent; their clients don’t have a sufficient economic motive to diligence them. A clearinghouse might in its charter insist that stablecoin issuers disclose their collateral to the group.
Secondly that stablecoin issuers include in their terms of service the right to temporarily suspend the right to exchange coins for fiat
Second, one tool that Scottish banks developed in 1750, as an alternative to deposit insurance, was an ‘option clause’. This allowed the bank to suspend redeemability of their notes for specie for a given period of time, effectively allowing solvent but illiquid banks to honor client withdrawals (albeit on a slower schedule). For the privilege, they would pay note holders interest on the normally non-interest bearing notes. This massively reduced the risk of a bank run and it was popular until it was outlawed in 1765. Now for stablecoins to eliminate run risk, they could be structured more like Money Market Mutual Funds, in which you can only withdraw a proportional share of the underlying assets, rather than a fixed claim redeemable for $1. So as a depositor you have no incentive to be the first out the door, as you do with a bank. Or they could implement something similar to the option clause, suspending redeemability if they were faced with a liquidity crunch. Larry White has suggested this, and I believe Tether may have a similar option clause in their ToS but I’d have to double check that.
The power of markets, competition and incentives … and their limits
Whether Carter’s Free Banking based suggestions are useful contributions to the debate about what to do about stablecoins is a question for another day and another post. I am sceptical but I need more time to think through exactly what concerns me. The idea of exchanges taking on a supervisory role via a private clearing house seems to lean away from the decentralised ethos that is a strong feature of many in the crypto, stablecoin, DeFi community – but maybe I am missing something.
I also want to take the time to get a better understanding of exactly how the pure forms of Free Banking that Carter and Selgin advocate actually worked. The problems that Gorton and Zhang describe with the experience of runs on MMF’s in 2008 and again in 2020 also look to me like they still have something useful to contribute to the stablecoin regulation debate.
My scepticism is also reinforced by my professional experience working through the various iterations of the Basel capital adequacy accord. In particular Basel II which introduced the idea of 3 mutually supporting Pillars. For the purposes of this discussion, Pillar 3 (Market Discipline) is the one I want to focus on. Basel II was developed at a time when conventional wisdom placed an enormous amount of faith in the power of markets to hold everyone to account.
In practice that did not really work out the way the theory suggested it should. I do not subscribe to the view that risk based capital requirements are a total failure. The enhancements introduced under the aegis of Basel III (in particular bail-in but also higher capital and liquidity requirements) have gone a long way to make the traditional banking system stronger and more resilient but I think it is fair to conclude that market discipline alone is not a reliable basis for ensuring the stability of the banking system.
I am a big fan of using economic history as a guide to avoiding repeating the mistakes of the past but I think the evidence from the American Free Banking Era is not especially useful as a guide to the risks of stablecoins. This does not however mean that we should embrace the unregulated rise of stablecoins as a new form of private money.
As a conceptual framework, the five features underpinning the stability of the Scottish Free Banks is a good place to start when thinking about the extent to which stablecoins might also be, or become, self regulating. The practical challenge however is that stablecoins also have to fit into the financial system we have and that is one based around prudential regulation, supervision, deposit preference and deposit insurance. It is very hard to see bank regulators giving ground on the principle of same activity same regulation. Innovation is valuable for sure but it is equally true that regulatory arbitrage never ends well.
I have disclosed my bias and, as always, it is entirely possible that I am missing something. However, at this stage I am struggling with the idea that stablecoins that aim to expand in size and scope beyond facilitating the settlement of crypto asset trading can function as money without a regulatory framework that underpins the promise of repayment made by the private entities responsible for issuing them. That regulatory framework might not be the same as that applied to depositary institutions but it does need to be consistent with it.
Let me know what I am missing …
Tony – From the Outside