Misunderstanding Narratives: The Hero’s Journey – The Big Picture

Joseph Campbell’s “The Hero with a Thousand Faces” is a great book. It offers insights into some deep ideas about how the world does (or should) work that have influenced a wide variety of people including George Lucas and Ray Dalio and was included in Time magazine’s list of the top 100 books.

Barry Ritholz did a short, but insightful, post here where he reminds us that the timeless appeal of the narrative that Campbell explores can also mislead us.

Our narrative bias for compelling stories can prevent us from seeing the forest for trees. Dramatic tales with clearly delineated Good & Evil are more memorable and emotionally resonant than dry data and tedious facts. Try as you might, finding a singular cause of some terrible economic outcome is an exercise in futility. Instead, you will find a long history of political, economic, psychological, and (occasionally) irrational drivers that eventually led to some disaster.

We look for the spark that ignites the room full of hydrogen, instead of 1,000 other factors that created the conditions precedent. You can find example after example of disasters widely thought of as “single event causes;” upon closer examination, they are revealed as the result of far more complex circumstances and countless interactions

https://ritholtz.com/2021/09/misunderstanding-narratives-the-heros-journey/

This for me is an insight that rings very true but is often forgotten to feed our appetite for reducing complex stories to simple morality plays. I like the stories as much as the next person but the downside is that the simple appealing story distracts us from understanding the route causes of why things like the GFC happened and leave us exposed to the risk that they just keep repeating in different forms.

Tony – From the Outside

M-Pesa and the African Fintech Revolution – by Marc Rubinstein – Net Interest

You, like me, might be vaguely aware of the M-Pesa story of fintech innovation in Africa. Marc Rubinstein offers one of the best accounts I have encountered of how this came about and where it might be headed. Especially interesting is his analysis of why it took off in Kenya and the challenges it has faced in other markets.

You can find Marc’s post here – www.netinterest.co/p/m-pesa-and-the-african-fintech-revolution-3c1

Tony – From the Outside

Banks and money creation

Frances Coppola’s blog offers an interesting extension of the ways in which private banks contribute to the the “creation” of bank deposits which are in turn one of the primary forms of money in most modern economies. This is a very technical issue, and hence of limited interest, but I think it will appeal to anyone who wants to peer under the hood to understand how banking really works. In particular, it offers a better appreciation of the way in which banks play a very unique role in the economy which is broader than just intermediating between borrowers and lenders.

If you have come this far then read the entire post but this extract captures the key point …

It’s now widely accepted, though still not universally, that banks create money when they lend. But it seems to be much less widely known that they also create money when they spend. I don’t just mean when they buy securities, which is rightly regarded as simply another form of lending. I mean when they buy what is now colloquially known as “stuff”. Computers, for example. Or coffee machines.

Imagine that a major bank – JP Morgan, for example – wants to buy a new coffee machine for one of its New York offices …. It orders a top-of-the-range espresso machine worth $10,000 from the Goodlife Coffee Company, and pays for it by electronic funds transfer to the company’s account. At the end of the transaction JP Morgan has a new coffee machine and Goodlife has $10,000 in its deposit account. 

Frances Coppola – JP Morgan’s coffee machine

I am familiar with the way in which bank lending creates money but I had not previously considered the extent to which this general mechanism extended to other ways in which banks disbursed payments.

My one observation is that the analysis could have been taken a bit further to consider the ways in which the money created by the bank lending mechanism is retired. In the example of the purchase of a coffee machine that Coppola uses, I assume that there was quite a lot of bank lending or other credit involved in getting to the point that the Goodlife Coffee Company has a coffee machine in stock that it can sell to JP Morgan. Once the JP Morgan cash reaches Goodlife’s bank account it is logical to assume that some of this debt will need to be repaid such that the net increase in money created by the purchase is less than the gross amount. This cycle repeats as inventory is manufactured and then sold.

As a rule, the overall supply of money will be increasing over time in response to the net increase in private bank lending but I would assume that it will be increasing and decreasing around this trend line as short term working capital loans are created and extinguished. This is a tricky area so I could be missing something but the capacity of the money supply to expand (and contract) in response to the needs of business for working capital feels like an important feature of the banking system we have today and something to consider as we explore new decentralised forms of money.

Tony – From the Outside

Finance cartels face digital currency shake-up | Financial Times

Cross border payment is one of the areas of conventional banking where challengers believe that crypto/DLT solutions can shake up the existing order. There is little doubt that the cross border payment status quo has lots of room for improvement but Gillian Tett (Financial Times) offers a nice summary of central bank projects that are potentially introducing other vectors of innovation and competition.

— Read on www.ft.com/content/4ab25f71-78ff-40a2-b47c-e04075ea81b4

Bank regulators might be missing something with regard to Bitcoin

The Basel Committee on Banking Supervision (BCBS) released a consultation paper in June 2021 setting out its preliminary thoughts on the prudential treatment of crypto asset exposures in the banking system.

I covered the paper here but the short version is that the BCBS proposes to distinguish between two broad groups: One where the BCBS believes that it can look through the Crypto/DLT packaging and largely apply the existing Basel requirements to the underlying assets (Group 1 crypto assets). And another riskier Group 2 (including Bitcoin) which would be subject to its most conservative treatment (a 1250% risk weight).

At the time I noted that it was not surprising that the BCBS had applied a conservative treatment to the riskier end of the crypto spectrum but focussed on the fact that that bank regulators were seeking to engage with some of the less risky elements.

I concluded with my traditional caveat that I was almost certainly missing something. Caitlin Long (CEO and founder of Avanti Financial Group, Inc) argues that what I missed is the intra-day settlement risk that arises when conventional bank settlement procedures deal with crypto-assets that settle in minutes with irreversibility.

The BCBS could just apply even higher capital requirements but the better option she argues is to create a banking arrangement that is purpose built to deal with and mitigate the risk. I have copied an extract from an opinion piece she wrote that was published in Forbes magazine on 24 June 2021

Thankfully, there is a safe and sound way to integrate bitcoin and other Group 2 cryptoassets into banking systems:

– Conduct all bitcoin activities in a ring-fenced bank that is either stand-alone or is a bankruptcy-remote subsidiary of a traditional (leveraged) bank.

– Use no leverage in the bank. No rehypothecation of bitcoin held in custody. Hypothecation of assets held in custody is fine, but the bank must not permit greater than 1:1 leverage. Remember—bitcoin has no lender of last resort or clearinghouse.

– Take no credit or interest rate risk within the bank. Hold 100% reserves in cash, T-bills or similar short-term, high-quality liquid assets. The bank makes money on fees, which crypto fintechs have successfully done for years due to high transaction volume.

– Pre-fund transactions, so that the bank settles second or simultaneously instead of settling first and thereby avoid “back door” leverage caused by a counterparty failing to deliver.

– Permit no collateral substitution or commingling in prime brokerage.

– Design IT and operational processes for fast settlement with irreversibility, complete with minute-by-minute risk monitoring and reconciliation processes.

https://www.forbes.com/sites/caitlinlong/2021/06/24/bis-proposed-capital-requirements-for-cryptoassets-vital-move-but-theyre-too-low-for-bitcoin/?sh=10d0a9f22546

If you want a deeper dive Avanti lay out their arguments in more detail in a letter submitted to the Federal Reserve responding to a request for comments on draft guidelines proposed to assist Federal Reserve Banks in responding to what the Fed refers to (emphasis added) as “… an increasing number of inquiries and requests for access to accounts and services from novel institutions“.

It is quite possible that I am still missing something here but the broad argument that Avanti lays out seems plausible to me; i.e. it would seem desirable that a bank that seeks to support payments to settle crypto asset trades should employ a payment process that allows instant payments as opposed to end of day settlement.

Some parting observations:

  1. The Fed is moving towards the implementation of an instant payment system so arguments based on problems with 40 year old payment systems such as the Automated Clearing House (ACH) currently used by the USA would be more compelling if they addressed how they compare to the new systems that have been widely deployed and proven in other jurisdiction.
  2. Notwithstanding, there is still a case for allowing room for alternative payment solutions to be developed by novel institutions. In this regard, Aventi has committed to embrace the level of regulation and supervision that is the price of access to an account at the central bank.
  3. Aventi’s regulatory strategy is very different to the decentralised, permission-less philosophy that drives the original members of the crypto asset community. Seeing how these two competing visions of money play out continues to be fascinating.
  4. I still have a lot to learn in this space.

Tony – From the Outside

The Race for Stablecoin Transparency | J.P. Koning – CoinDesk

J.P. Koning notes that stablecoins have been improving their reporting on reserves, but argues that transparency is also driving changes that make an already difficult business model more complicated to execute.
— Read on www.coindesk.com/the-race-for-stablecoin-transparency

Regulatory strategies adopted by USD stablecoin issuers (continued)

One of my recent posts flagged some useful work that JP Koning had shared summarising four different regulatory strategies USD stablecoins issuers have adopted.

  1. The New York Department of Financial Services (NYDFS) trust company model [Paxos, Gemini, BUSD]
  2. The Nevada state-chartered trust model [TrueUSD, HUSD]
  3. Multiple money transmitter license model [USDC]
  4. Stay offshore [Tether]

If I read this post from Circle correctly, we can now add a fifth strategy; the Federally-chartered national commercial bank model. For those with a historical bent, this might also be labelled the “narrow bank” model or the “Chicago Plan” model.

Here is a short extract from the Circle post …

Circle intends to become a full-reserve national commercial bank, operating under the supervision and risk management requirements of the Federal Reserve, U.S. Treasury, OCC, and the FDIC. We believe that full-reserve banking, built on digital currency technology, can lead to not just a radically more efficient, but also a safer, more resilient financial system.

We are embarking on this journey alongside the efforts of the top U.S. financial regulators, who through the President’s Working Group on Financial Markets are seeking to better manage the risks and opportunities posed by large-scale private-sector dollar digital currencies.

Tony – From the Outside

Why is the United States lagging behind in payments?

… is the title of a useful paper by Christian Catalini and Andrew Lilley that digs into the puzzle of why it is that one of the (if not the) key players in the global financial system seems to lagging global best practice in terms of the cost, convenience and speed of its payment system.

It has to be noted that the authors are not neutral observers in this space. Christian Catalini is the Chief Economist of the Diem Association and Diem Networks US, and Co-Creator of Diem (formerly Libra). He is also the Founder of the MIT Cryptoeconomics Lab and a Research Scientist at MIT. Andrew Lilley is an employee of Novi Financial, Inc. who contributed to the paper as part of his work with Diem Networks US. With that caveat in mind, the paper still offers a short (12 pages) and useful summary of the ways in which the US lags best practice.

They frame the US problem as follows:

The US enjoys one of the least concentrated banking systems among the G30, but this feature has also created a fragmented and expensive payments system. Transfers between major US banks incur fees ranging from $10 to $35 for same-day wires, and up to $3 for 2-day transactions. Compare this to the UK, where individuals and businesses have access to a free, 24/7 interbank payments system which settles within seconds and supports over 8M transactions per day. While the US does have a Real Time Gross Settlement (RTGS) system, the Fedwire Funds Service carries less than 1 million transactions per day, has limited 21/5 availability, and is almost exclusively used by financial institutions and large corporations. Its fees, moreover, are larger than alternative payment methods such as ACH, creating a trade-off between cost and immediacy. Private sector alternatives are limited, and while some banks have deployed real-time solutions, these come with transaction limits and little adoption, which severely reduces their usefulness.

Catalini and Lilley (2021), Why is the United States Lagging Behind in Payments?

The paper then outlines how these limitations affect individuals, business and government and concludes with suggestions of what might be done to address the problems discussed:

There are at least three ways to remove frictions in payments and rapidly expand the number of individuals and businesses that can access the financial system and cheaply transact in real time. The first is to bring deposits on a single ledger through a Central Bank Digital Currency (CBDC), so that transfers between banks are not limited by external liquidity constraints or third-party rails. The second approach is to follow countries such as India and Mexico and increase the throughput of always-on RTGS systems. This is the model the Federal Reserve is pursuing with the introduction of FedNow, targeted for 2023. FedNow, however, is expected to have an initial transfer maximum of $25,000, which would limit its usefulness to businesses. The third approach is to facilitate the growth of interoperable, stablecoin payment rails by creating the right regulatory framework for these new types of networks to safely increase competition in payments.

While each one of these approaches presents different challenges, opportunities and trade-offs in terms of complexity, development costs and ability to expand access to segments that are currently excluded, it is important to stress that they are likely to be complements, not substitutes.

Advancing the US payments infrastructure will require both regulatory and technical developments targeted at improving market structure, lowering barriers to entry, and facilitating collaboration between public and private sector efforts in digital payments.

Catalini and Lilley (2021)

I am trying to keep an open mind on the future of payment systems but find myself drawn towards the conclusion that fast payment systems that the FedNow initiative is based on seem to have worked pretty well in other countries in terms of improving cost, speed and convenience so it is not obvious to me why either a CBDC or stablecoin solution is necessary in the United States.

If you want to explore these issues further, JP Koning recently offered a nice summary of what has been achieved by fast payment systems in other countries while a speech (“CBDC: A solution in Search of a Problem?”) by Governor Waller of the US Federal Reserve neatly summarises the issues associated with whether a CBDC is necessary or desirable (at least so far as the USA is concerned). It is important to recognise however that the conclusions that Waller draws do not necessarily apply to other countries (China being the prime example) which are responding to very different types of payment systems.

Let me know what I am missing

Tony – From the Outside

Regulatory strategies adopted by USD stablecoin issuers

This link takes you to a short post by JP Koning which summarises some work he has done identifying the different regulatory approaches that USD stablecoin issuers have adopted

The list is not exhaustive as Koning confines his survey to USD stablecoins backed (at least in in theory) by conventional USD assets (i.e. not decentralised versions with crypto asset backing and algorithmic protocols). He notes the role “Fincel” regulation plays but argues that this is more a process of registration than of regulation and so excludes it from his assessment.

Subject to these qualifications, Koning identifies four strategies:
1) The New York Department of Financial Services (NYDFS) trust company model [Paxos, Gemini, BUSD]
2) The Nevada state-chartered trust model [TrueUSD, HUSD]
3) Multiple money transmitter license model [USDC]
4) Stay offshore [Tether]

Which approach offers stablecoin users the greatest protection? The short answer is the New York Department of Financial Services model …

So from a customer’s perspective, you are probably better off owning a stablecoin operating under either the NYDFS or Nevada model, rather than the dozens of money transmitter licenses model. Not only do the NYDFS or Nevada model have more oversight (because trusts generally face more oversight than money transmitters), but they are legally obligated to keep the interests of their customers first and foremost. And the trust model probably provides better protection in the event of bankruptcy.

There is another difference between the NYDFS model and the dozens of money transmitter licenses model. Money transmitter licenses are generic. That is, they are a regulatory umbrella for a variety of very different businesses models, including remittance companies like Western Union, wallets like PayPal or Skrill, and finally stablecoins like USD Coin.

Compare this to the NYDFS model, which explicitly recognizes stablecoins and has created a specific process for authorizing and examining these products. (Nevada has not. The Nevada model is also a generic one). If I owned a bunch of stablecoins, I’d probably prefer if the regulator of these products had acknowledged them.

Moneyness – the blog of JP Koning, 6 August 2021

The taxonomy of regulatory strategies is useful in itself and Koning’s observations all seem sound to me. It is also useful to see which approaches have been adopted by the main stablecoin issuers.

In the interests of balance, I also suggest this interview with Sam Bankman-Fried (Founder and CEO of cryptocurrency exchange FTX) and Matt Levine (Bloomberg Opinion columnist) from the Odd Lots podcast which offers a more coherent defence of Tether than the ones mounted by Tether itself (the defence starts around the 47 minute mark).

Tony – From the Outside

DeFI primer

Lately, this blog has pivoted from something I know reasonably well (bank capital adequacy) to things that I don’t – cryptoassets, stablecoins, central bank digital currencies and DeFi. My last post looked at a paper by Nic Cater and Linda Jeng titled “DeFi Protocol Risks: the Paradox of DeFI”. This week I want to flag another useful paper (well at least from my newbie perspective) written by Fabian Schär that was published in the St Louis Fed Review (Second quarter 2021).

I have to confess that I am not yet fully convinced that the DeFI applications developed to date do much more than offer novel ways of trading risk in new forms of securities or crypto assets. That does not mean that the technology will not someday add value to the financial system that will be increasingly called onto support an increasingly digital economy and ultimately the Metaverse.

Schär’s exploration of the risks of DeFI (Section 3) covers very similar ground to the Carter and Jeng paper I flagged above. What I did find useful was Section 2 that lays out the building blocks that DeFi is based on.

The DeFi Stack

Schär concludes …

DeFi has unleashed a wave of innovation. On the one hand, developers are using smart contracts and the decentralized settlement layer to create trustless versions of traditional financial instruments. On the other hand, they are creating entirely new financial instruments that could not be realized without the underlying public blockchain. Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans are just a few of many examples that show the great potential of this ecosystem.

While this technology has great potential, there are certain risks involved. Smart contracts can have security issues that may allow for unintended usage, and scalability issues limit the number of users. Moreover, the term “decentralized” is deceptive in some cases. Many protocols and applications use external data sources and special admin keys to manage the system, conduct smart contract upgrades, or even perform emergency shutdowns. While this does not necessarily constitute a problem, users should be aware that, in many cases, there is much trust involved. However, if these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.

As noted above, I am not sure that all of the innovations generated by DeFi to date are going to make the world (or at least the financial system) a better place. That said, I am a traditional banker so what would I know. I remain open to the idea (indeed optimistic) that the technologies, applications and concepts being developed under the DeFi framework have the potential to deliver some value. The extent of improvement in conventional banking and finance is sometimes under appreciated but there is still plenty of room for improvement.

Shär’s paper is relatively short (roughly 20 pages) and worth a read if you are new to the topic like me and interested in this area of finance. It also has an extensive list of references that are worth reviewing for leads in areas worth exploring in more depth.

Tony – From the Outside