Fed Finalizes Master Account Guidelines

The weekly BPI Insights roundup has a useful summary of what is happening with respect to opening up access to Fed “master accounts”. This is a pretty technical area of banking but has been getting broader attention in recent years due to some crypto entities arguing that they are being unfairly denied access to this privileged place in the financial system. BPI cites the example of Wyoming crypto bank Custodia, formerly known as Avanti, which sued the Kansas City Fed and the Board of Governors over delays in adjudicating its master account application.

The Kansas Fed is litigating the claim but the Federal Reserve has now released its final guidelines for master account access.

The BPI perspective on why it matters:

Over the past two years, a number of “novel charters” – entities without deposit insurance or a federal supervisor – have sought Fed master accounts. A Fed master account would give these entities – which include fintechs and crypto banks — access to the central bank’s payment system, enabling them to send and receive money cheaply and seamlessly. BPI opposes granting master account access to firms without consolidated federal supervision and in its comment letter urged the Fed to clarify which institutions are eligible for master accounts.

The BPI highlights two main takeaways from the final guidelines:

The Fed does not define what institutions are eligible to seek accounts and declined to exclude all novel charter from access to accounts and services.

The guidelines maintain a tiered review framework that was proposed in an earlier version, sorting financial firms that apply for master accounts into three buckets for review. Firms without deposit insurance that are not subject to federal prudential supervision would receive the highest level of scrutiny. The tiers are designed to provide transparency into the expected review process, the Fed said in the guidelines — although the final guidelines clarify that even within tiers, reviews will be done on a “case-by-case, risk-focused basis.”

The key issue here, as I understand it, is whether the crypto firms are really being discriminated against (I.e has the Fed been captured by the banks it regulates and supervises) or whether Crypto “banks” are seeking the privilege of master account access without all the costs and obligations that regulated banks face.

Let me know what I am missing

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

Red flags in financial services

Nice podcast from Odd Lots discussing the Wirecard fraud. Lots of insights but my favourite is to be wary when you see a financial services company exhibit high growth while maintaining profitability.

There may be exceptions to the rule but that is not how the financial services market normally works.

podcasts.apple.com/au/podcast/odd-lots/id1056200096

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

Stablecoin business models – I need a dollar

There has been a lot written on stablecoins in the wake of Terra’s crash. Matt Levine has been a reliable source of insight (definitely worth subscribing to his “Money Stuff” newsletter) but I am also following Izabella Kaminska via her new venture (The Blind Spot).

Maybe I am just inexplicably drawn to anything that seeks to explain crypto in Tradfi terms but I think this joint post by Izabella and Frances Coppola poses the right question by exploring the extent to which stablecoin issuers will always struggle to reconcile the safety of their peg promise to the token holders with the need to make a return. The full post is behind a paywall but this link takes you to a short extract that Izabella has made more broadly available.

Their key point is that financial security is costly so your business model needs an angle to make a return … to date the angles (or financial innovations) are mostly stuff that Tradfi has already explored. There is no free lunch.

If it’s financially secure, it’s usually not profitable

So, what was the impetus for issuers like Kwon to focus on these innovations? For the most part, it was probably the realisation that conventional stablecoins – due to their similarities with narrow banks – are exceedingly low-margin businesses. In a lot of cases, they may even be unprofitable.

This is because managing other people’s money prudently and in a way that always protects capital is actually really hard. Even if those assets are fully reserved, some sort of outperformance has to be generated to cover the administration costs. The safest way to do that is to charge fees, but this hinders competitiveness in the market since it generates a de facto negative interest rate. Another option is cross-selling some other service to the captured user base, like loan products. But this gets into bank-like activity.

The bigger temptation, therefore, at least in the first instance, is to invest the funds in your care into far riskier assets (with far greater potential upside) than those you are openly tracking.

But history shows that full-reserve or “narrow” banks eventually become fractional-reserve banks or disappear.

“Putting the Terra stablecoins debacle into Tradfi context”, Frances Coppola and Izabella Kaminska, The Blind Spot

Tony – From the Outside

SWIFT …

… has been in the news lately.

This link takes you to a blog I follow written by Patrick McKenzie that offers a payment expert’s perspective on what SWIFT is, together with Patrick’s personal view on what the sanctions are intended to achieve.

This short extract covers Patrick’s assessment of the objective of the sanctions

The intent of this policy has been described variously in various places. In my personal opinion, I think the best articulation of the strategy is “We are attempting to convey enormous displeasure while sanctioning some banks which are believed to be close to politically exposed Russians, while not making it impossible for Russian firms generally to transact internationally nor sparking a humanitarian crisis either inside or outside of Russia.”

One of the key insights is that SWIFT manages the messaging that accompanies international payments and facilities their processing, not the transfers of money per se. The sanctions do not make it impossible to transact with Russia, they mostly make it operationally very difficult and not really worth the effort, especially at scale. Especially if you are a regulated bank who cares about your long term relationship with your regulator.

Another nuance that does not always come through in the newspaper reporting of the sanctions is the extent to which the compliance functions in banks are under pressure to interpret and anticipate the intent of the regulatory sanctions

Many commentators confuse the actual effects of severing particular banks from SWIFT with what they perceive as the policy goal motivating it. More important than either is, in my opinion, what it communicates about commander’s intent to the policy arms who are responsible for enforcing it.

Specifically, it communicates that Something Has Changed and that Russian institutional money, specifically “oligarch” money, is now tainted, and not in the benignly ignored fashion it has been for most of the last few decades.

Where there is some doubt or ambiguity, banks are likely to err on the side of caution.

Patrick’s post is worth reading if you are interested in this particular aspect of SWIFT and his blog worth following if you are interested in payments more generally.

Tony – From the Outside

The elasticity of credit

One of the arguments for buying Bitcoin is that, in contrast to fiat currencies that are at mercy of the Central Bank money printer, its value is underpinned by the fixed and immutable supply of coins built into the code. Some cryptocurrencies take this a step further by engineering a systematic burning of their coin.

I worry about inflation as much as the next person, perhaps more so since I am old enough to have actually lived in an inflationary time. I think a fixed or shrinking supply is great for an asset class but it is less obvious that it is a desirable feature of a money system.

Crypto true believers have probably stopped reading at this point but to understand why a fixed supply might be problematic I can recommend a short speech by Claudio Borio. The speech dates back to 2018 but I think it continues to offer a useful perspective on the value of an elastic money supply alongside broader comments about the nature of money and its role in the economy.

Borio was at the time the Head of the BIS Monetary and Economic Department but the views expressed were his personal perspective covering points that he believed to be well known and generally accepted, alongside others more speculative and controversial.

I did a post back in March 2019 that offers an overview of the speech but recently encountered a post by J.W. Mason which reminded me how useful and insightful it was.

The specific insight I want to focus on here is the extent to which a well functioning monetary system relies on the capacity of credit extended in the system to expand and contract in response to both short term settlement demands and the longer term demands driven by economic growth.

One of the major challenges with the insight Borio offers is that most of us find the idea that money is really just a highly developed form of debt to be deeply unsatisfying if not outright scary. Borio explicitly highlights “the risk of overestimating the distinction between credit (debt) and money” arguing that “…we can think of money as an especially trustworthy type of debt”

Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.

Borio: Page 9

I did a post here that explains in more detail an Australian perspective on the process by which unsecured loans to highly leveraged companies (aka “bank deposits”) are transformed into (mostly) risk free assets that represent the bulk of what we use as money.

Borio outlines how the central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled …

“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”

Borio: Page 5

… but also recognises the problem with too much elasticity

While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.

This is a big topic which means there is a risk that I am missing something. That said, the value of an elastic supply of credit looks to me like a key insight to understanding how a well functioning monetary system should be designed.

The speech covers a lot more ground than this and is well worth reading together with the post by J.W. Mason I referenced above which steps through the insights. Don’t just take my word for it, Mason introduces his assessment with the statement that he was “…not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker”.

Tony – From the Outside

Stablecoin regulation

The question of whether, or alternatively how, stablecoins should be regulated is getting a lot of attention at the moment. My bias (and yes maybe I am just too institutionalised after four decades in banking) is that regulation is probably desirable for anything that functions as a form of money. We can also observe that some stablecoin issuers seem to be engaging pro actively with the question of how best to do this. There is of course a much wider debate about the regulation of digital assets but this post will confine itself to the questions associated with the rise of a new generation of money like digital instruments which are collectively referred to as stablecoins.

My last post linked to a useful summary that Bennett Tomlin published laying out what is currently playing out in the USA on the stablecoin regulation front. Tomlin concluded that the future of stablecoins appeared to lie in some form of bank like regulation. J.P. Koning has also collated a nice summary of the range of regulatory strategies adopted by stablecoin issuers to date.

Dan Awrey proposes another model for stablecoin regulation

Against that background, a paper titled “Bad Money” by Dan Awrey (Law Professor at Cornell Law School) offers another perspective. One of the chief virtues of his paper (refer Section III.B) is that it offers a comprehensive overview of the existing state regulatory framework that governs the operation of many of the stablecoins operating as “Money Service Businesses” (MSB). The way forward is up for debate but I think that Awrey offers a convincing case for why the state based regulatory model is not part of the solution.

This survey of state MSB laws paints a bleak picture. MSBs do not benefit from the robust prudential regulation, deposit guarantee schemes, lender of last resort facilities, or special resolution regimes enjoyed by conventional deposit-taking banks. Nor are they subject to the same type of tight investment restrictions or favorable regulatory or accounting treatment as MMFs. Most importantly, the regulatory frameworks to which these institutions actually are subject are extremely heterogeneous and often fail to provide customers with a fundamentally credible promise to hold, transfer, or return customer funds on demand.

Awrey, Dan, Bad Money (February 5, 202o). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
Awrey also rejects the banking regulation model …

… PayPal, Libra, and the new breed of aspiring monetary institutions simply do not look like banks. MSBs are essentially financial intermediaries: aggregating funds from their customers and then using these funds to make investments. They do not “create” money in the same way that banks do when they extend loans to their customers; nor is there compelling evidence to suggest that their portfolios are concentrated in the type of longer term, risky, and illiquid loans that have historically been the staple of conventional deposit-taking banks

… and looks to Money Market Funds (MMFs) as the right starting point for a MSB regulatory framework that could encompass stablecoins

So what existing financial institutions, if any, do these new monetary institutions actually resemble? The answer is MMFs. While MSBs technically do not qualify as MMFs, they nevertheless share a number of important institutional and functional similarities. As a preliminary matter, both MSBs and MMFs issue monetary liabilities: accepting funds from customers in exchange for a contractual promise to return these funds at a fixed value on demand. Both MSBs and MMFs then use the proceeds raised through the issuance of these monetary liabilities to invest in a range of financial instruments. This combination of monetary and intermediation functions exposes MSBs and MMFs to the same fundamental risk: that any material decrease in the market value of their investment portfolios will expose them to potential liquidity problems, that these liquidity problems will escalate into more fundamental bank-ruptcy problems, and that—faced with bankruptcy—they will be unable to honor their contractual commitments. Finally, in terms of mitigating this risk, neither MSBs nor MMFs have ex ante access to the lender of last resort facilities, deposit guarantee schemes, or special resolution regimes available to conventional deposit-taking banks.

In theory, therefore, the regulatory framework that currently governs MMFs might provide us with some useful insights into how better regulation can transform the monetary liabilities of MSBs into good money.

Awrey’s preferred model is to restructure the OCC to create three distinct categories of financial institution

The first category would remain conventional deposit-taking banks. The second category—let’s call them monetary institutions—would include firms such as PayPal that issued monetary liabilities but did not otherwise “create” money and were prohibited from investing in longer-term, risky, or illiquid loans or other financial instruments. Conversely, the third category—lending institutions—would be permitted to make loans and invest in risky financial instruments but expressly prohibited from financing these investments through the issuance of monetary liabilities

Stablecoins would fall under the second category (Monetary Institutions) in his proposed tripartite licensing regime and the regulations to be applied to them would be based on the regulatory model currently applied to Money Market Funds (MMF).

Awrey, Dan, Bad Money (February 5, 2020). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
What does Awrey’s paper contribute to the stablecoin regulation debate?
  • Awrey frames the case for stablecoin regulation around the experience of the Free Banking Era
  • This is not new in itself (see Gorton for example) but, rather than framing this as a lawless Wild West which is the conventional narrative, Awrey highlights the fact that these so called “free banks” were in fact subject to State government regulations
  • The problem with the Free Banking model, in his analysis, is that differences in the State based regulations created differences in the credit worthiness of the bank notes issued under the different approaches which impacted the value of the notes (this is not the only factor but it is the most relevant one for the purposes of the lessons to be applied to stablecoin regulation)

Finally, the value of bank notes depended on the strength of the regulatory frameworks that governed note issuing banks. Notes issued by banks in New York, or that were members of the Suffolk Banking system, for example, tended to change hands closer to face value than those of banks located in states where the regulatory regimes offered noteholders lower levels of protection against issuer default. Even amongst free banking states, the value of bank notes could differ on the basis of subtle but important differences between the relevant requirements to post government bonds as security against the issuance of notes bank notes.

  • If we want stablecoins to reliably exchange at par value to their underlying fiat currency then he argues we need a national system of regulation applying robust and consistent requirements to all issuers of stablecoin arrangements
  • Awrey then discusses the ways in which regulation currently “enhances the credibility of the monetary liabilities issued by banks and MMFs to set up a discussion of how the credibility of the monetary promises of the new breed of monetary institutions might similarly be enhanced
  • He proposes that the OCC be made accountable for regulating these “monetary institutions” (a term that includes other payment service providers like PayPal) but that the regulations be based on those applied to MMFs other than simply bringing them under the OCC’s existing banking regulations
  • The paper is long (90 pages including appendices) but hopefully the summary above captures the essence of it – for me the key takeaways were to:
    • Firstly to understand the problems with the existing state based MSB regulations that currently seem to be the default regulatory arrangement for a US based stablecoin issuer
    • Secondly the issues he raises (legitimate I think) with pursuing the bank regulation based model that some issuers have turned to
    • Finally, the idea that a MMF based regulatory model is another approach we should be considering
I will wrap up with Awrey’s conclusion …

Money is, always and everywhere, a legal phenomenon. This is not to suggest that money is only a legal phenomenon. Yet it is impossible to deny that the law plays a myriad of important and often poorly understood roles that either enhance or undercut the credibility of the promises that we call money. In the case of banks and MMFs, the law goes to great lengths to transform their monetary liabilities into good money. In the case of proprietary P2P payment platforms, stablecoin issuers, and other aspiring monetary institutions, the anti-quated, fragmented, and heterogenous regulatory frameworks that currently, or might in future, govern them do far, far less to support the credibility of their commitments. This state of affairs—with good money increasingly circulating alongside bad—poses significant dangers for the customers of these new monetary institutions. In time, it may also undermine the in-tegrity and stability of the wider financial system. Together, these dangers provide a compelling rationale for adopting a new approach to the regulation of private money: one that strengthens and harmonizes the regulatory frameworks governing monetary institutions and supports the development of a more level competitive playing field. 

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

Taming wildcat stablecoins …

… is the title of an interesting paper by Gary Gorton and Jeffrey Zhang which argues that:

  • Cryptocurrency, or stablecoins to be more precise, 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 suggests that ” … privately produced monies are not an effective medium of exchange because they are not always accepted at par and are subject to bank runs”
  • Stablecoins are not as yet a systemic issue but could be, so policymakers need to adjust the regulatory framework now to be ready as these new forms of private money grow and and potentially evolve into something that can’t be ignored
  • Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency
So what?

I am not convinced that a central bank digital currency is the solution. I can see a case for greater regulation of stablecoins but you need to be clear about exactly what type of stablecoin requires a policy response. Gorton and Zhang distinguish three categories …

The first includes cryptocurrencies that are not backed by anything, like Bitcoin. We call these “fiat cryptocurrencies.” Their defining feature is that they have no intrinsic value. Second, there are specialized “utility coins,” like the JPMorgan coin that is limited to internal use with large clients. Finally, there are “stablecoins,” which aspire to be used as a form of private money and so are allegedly backed one-for-one with government fiat currency (e.g., U.S. dollars)

I am yet to see a completely satisfactory taxonomy of stablecoins but at a minimum I would break the third category down further to distinguish the ways in which the peg is maintained. The (relatively few?) stablecoins that actually hold high quality USD assets on a 1:1 basis are different from those which hold material amounts of commercial paper in their reserve asset pool and different again from those which employ algorithmic protocols to maintain the peg.

However, you do not necessarily have to agree with their taxonomy, assessments or policy suggestions to get value from the paper – three things I found useful and interesting:

  1. The “no-questions-asked ” principle for anything that functions or aims to function as money
  2. Some technical insights into the economic and legal properties of stablecoins and stablecoin issuers
  3. Lessons to be learned from history, in particular the Free Banking Era of the 19th century
The “no-questions-asked” principle.

Money is conventionally defined in terms of three properties; a store of value, a unit of account and a medium of exchange. Gorton and Zhang argue that “The property that’s most obvious, yet not explicitly presented, is that money also must satisfy the no-questions-asked (“NQA”) principle, which requires the money be accepted in a transaction without due diligence on its value“. They freely admit that they have borrowed this idea from Bengt Holmstrom though I think he actually uses the term “information insensitive” as opposed to the more colloquial NQA principle.

Previous posts on this blog have looked at both Holmstrom’s paper and other work that Gorton has co-authored on the optimal level of information that different types of bank stakeholders require. If I understood Holmstrom correctly, he seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggle with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between the relative value of information in debt and equity markets and its impact on liquidity.

Gorton and Zhang emphasise the importance of deposit insurance in underwriting confidence in and the liquidity of bank deposits as the primary form of private money. I think that is true in the sense that most bank deposit holders do not understand the mechanics of the preferred claim they have on the assets of the bank they have lent to but it seems to me that over-collateralisation is equally as important in underwriting the economics of bank deposits.

If I have not lost you at this point, you can explore this question further via this link to a post I did titled “Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective“. From my perspective, the idea that any form of money has to be designed to be “information insensitive” or NQA rings very true.

Insights drawn from a technical analysis of stablecoins and stablecoin issuers.

The paper delves in a reasonable amount of detail into the technicalities of whether stablecoins are economically or legally equivalent to demand deposits and the related question of whether stablecoin issuers might be considered to be banks. The distinction between the economic and the legal status is I think especially useful for understanding how banking regulators might engage with the stablecoin challenge.

The over arching point is that stablecoins that look and function like bank demand deposits should face equivalent levels of regulation. That does not necessarily mean exactly the same set of rules but something functionally equivalent.

One practical outcome of this analysis that I had not considered previously is that they deem Tether to be based on an “equity contract” relationship with its users whereas the other stablecoins they analyse are “debt contracts” (see below). The link between Tether and a money market fund and the risk of “breaking the buck” has been widely canvassed but I had not previously seen the issue framed in these legal terms.

This technical analysis is summarised in two tables (Table 2: Stablecoins and their Contracts as of June 30, 2021 and Table 3: Stablecoins, Redemptions, and Fiat Money as of June 30. 2021) that offer a useful reference point for understanding the mechanics and details of some of the major stablecoins issued to date. In addition, the appendix to the paper offers links to the sources used in the tables.

Lessons to be learned from history

It may have been repeated to the point of cliche but the idea that “those who cannot remember the past are condemned to repeat it” (George Santayana generally gets the credit for this but variations are attributed to Edmund Burke and Sir Winston Churchill) resonates strongly with me. The general argument proposed by Gorton and Zhang is that lots of the ideas being tried out in stablecoin design and DeFi are variations on general principles that were similarly employed in the lightly regulated Free Banking Era but found wanting.

Even if you disagree with the conclusions they draw, the general principle of using economic history to explore what can be learned and what mistakes to avoid remains a useful discipline for any practitioner of the dark arts of banking and money creation.

Summing up in the authors’ own words

The paper is long (41 pages excluding the Appendix) but I will wrap up this post with an extract that gives you the essence of their argument in their own words.

Tony – From the Outside

Conclusion 

The more things change, the more they stay the same. It is still the case that regulation is being outpaced by innovation—thereby creating an uneven playing field—as it is easier and cheaper for more technologically advanced firms to offer similar products and services. 

In this case, it is also true that the problems associated with privately produced money are the same as they were one hundred and fifty years ago. We stress three points from our review of history. First, the use of private bank notes was a failure because they did not satisfy the NQA principle. Second, the U.S. government took control of the monetary system under the National Bank Act and subsequent legislation in order to eliminate the private bank note system in favor of a uniform currency—namely, national bank notes. Third, runs on demand deposits only ended with deposit insurance in 1934. 

Currently, it does not appear that stablecoins are used as money. But, as stablecoins evolve further, the stablecoin world will look increasingly like an unregulated version of the Free Banking Era—a world of wildcat banking. During the Free Banking Era, private bank monies circulated at time-varying discounts based on geography and the perceived risk of the issuing bank. Stablecoin prices are independent of geography but not independent of the perceived risk of their backing assets. If they succeed in differentiating themselves from fiat cryptocurrencies and become used as money, then they will likely trade at time-varying discounts as well. Policymakers have a couple of ways to address this development, and they better get going.