Stablecoins – 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

Moneyness: Let’s stop regulating crypto exchanges like Western Union

J.P. Koning offers an interesting contribution to the crypto regulation debate focussing on the problem with using money transmitter licences to manage businesses which are very different to the ones the framework was designed for …

The collapse of cryptocurrency exchange FTX has been gut-wrenching for its customers, not only those who used its flagship offshore exchange in the Bahamas but also U.S. customers of Chicago-based FTX US.

But there is a silver lining to the FTX debacle. It may put an end to the way that cryptocurrency exchanges are regulated – or, more accurately, misregulated – in the U.S.

U.S.-based cryptocurrency exchanges including Coinbase, FTX US, and Bianca.US are overseen on a state-by-state basis as money transmitters.

— Read on jpkoning.blogspot.com/2022/11/lets-stop-regulating-crypto-exchanges.html

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

Tether wants to help keep the USD strong

A few months back I flagged a podcast where Grant Williams interviewed Luke Grommen discussing his analysis of the role of the USD in the international financial system. One of the issues covered was the way in which the USD pricing of oil has underwritten demand for USD and thereby supported the USD.

Tether recently released a post where it seems to be arguing that demand for Tether recycled into demand for USD safe assets can take over the role in US monetary policy that recycling demand for petrodollars has played under Bretton Woods II.

Not sure if the US government has any plans to respond formally to this generous offer but anyone interested in this latest instalment in the ongoing Tether story might find it useful to revisit Luke’s analysis of Bretton Woods II. In particular Luke’s contention that petrodollar driven demand for USD has had some downsides.

I recommend you listen to the podcast (to ensure nothing was lost in translation) but this is how I summarised Luke’s argument in my earlier post

The USD’s role as an international reserve currency has been described as an “exorbitant privilege” but Gromen argues that the arrangement has also come at a cost via the role it has played in the loss of US domestic manufacturing capacity (Triffin’s Dilemma).

The consequences of this trade off has come under greater attention post the GFC, initially as the social consequences of lost jobs started to impact domestic politics, and more recently as globalised just in time supply chains struggled to respond to the economic shocks created by the response to Covid 19

Gromen argues that the USD Department of Defence has wanted to see repatriation of the US industrial base for some time and hence will be happy to see a decline in the USD’s role as an internal reserve currency because they believe it will enhance national security

There is also the question of whether stablecoin driven demand just exacerbates a shortage of safe USD assets. I have talked about this issue here and more recently flagged a post by Steven Kelly on the same topic. This quote gives a flavour of Steven’s argument…

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.

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

Moneyness: How profitable is the world’s largest stablecoin?

Interesting post by JP Koning on the extent to which Tether is making any money. The short answer he concludes is not very even without the burden of conforming to regulation. The obvious question this begs is how profitable a regulated stablecoin would be.

— Read on jpkoning.blogspot.com/2022/07/how-profitable-is-worlds-largest.html

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

“The basic philosophical difference between the traditional financial system and the cryptocurrency system …”

… according to Matt Levine (“Money Stuff”) “…is that traditional finance is about the extension of credit, and crypto is not”. He acknowledges that this is an exaggeration but argues that it does contain an essential truth about the two systems.

He uses the different ways that crypto approaches money and trading to illustrate his point.

In the traditional financial system money mostly represents an entry on the ledger of a bank. There are ways in which the risk is enhanced but people holding this form of money are essentially creditors of the bank. Crypto, Matt observes, is deeply unhappy with the idea of building money on a credit foundation and he cites Bitcoin as crypto’s attempt to build a form of money not based on credit.

In the case of trading, deferred settlement is a feature of the way that traditional finance operates whereas the crypto trading paradigm operating on a decentralised exchange is based on the principle that trade and settlement occur simultaneously.

Matt goes on to argue …

“Many advocates of crypto like this; they think that crypto’s philosophical uneasiness with credit is good. Money without debt – without fractional-reserve banking – is sounder, less inflationary and safer, they argue; trading with instant settlement is clearer and more logical and safer than trading with delayed settlement and credit risk”

I have to say that, as much as I like Matt’s overall body of contributions to deconstructing finance, I struggled with some elements of this argument. The better crypto analogue for money is I think a stablecoin (ideally one that is at least fully reserve backed and ideally has some capital as well) not a crypto asset like Bitcoin.

That said, the argument that the crypto trading model involves less credit risk than the traditional deferred settlement model does seem broadly right to me. Different context but the fact that bank supervisors have pursued Real Time Gross Settlement (RTGS) models I think illustrates the advantages of real time settlement of intraday credit risk.

There is of course a range of stablecoin business models currently being employed, but it still feels to me that anyone holding a stablecoin is probably still effectively lending fiat money to the stablecoin issuer but without the protections and enhancements that people holding money in the form of bank deposits enjoy.

The inspiration for Matt’s observations on this question was the proposal by Sam Bankman-Fried’s (SBF) proposal for changes that would allow a decentralised form of trading settlement. Matt notes that there are plans within traditional finance to move some trading exchanges to a T+1 model. That would reduce but not eliminate credit risk so the question remains as to whether the simultaneous settlement model proposed by SBF represents the future.

Matt argues that at least one consequence of moving to the crypto trading settlement model is that there will be less room (none?) for people to smooth over technical settlement failures and “market dislocations” or to reverse errors.

“There are debates about whether this is good or bad; simplistically, you’d expect the FTX model to lead to more defaults and liquidations, but for those defaults to be less bad. IN the traditional system, sometimes people will have a “technical issue”, and the exchange will “give the appropriate amount of time not to dislocate the market and create a bigger stress on that”, and it will work out fine – but occasionally it won’t work out fine, and by delaying the exchange will have caused a much bigger problem”

I don’t pretend to know the answers to the questions posed above (I am somewhat biased towards systems that favour resilience over efficiency) but I do think it is an issue that is worth putting on the radar as it plays out.

Let me know what I am missing …

Tony – From the Outside