Stablecoins – Page 2 – 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

Crypto sceptics unite

Stephen Diehl has done a post linking to a letter that a group of people working in the industry have submitted to US policy makers regarding how to engage with the crypto and DeFi movement. One of the key arguments Stephen makes is that the term “blockchain” has become so ubiquitous as to be largely meaningless.

My bias is that scepticism is virtually always the right starting place but Stephen notes that crypto scepticism is of course a broad church …

Crypto skepticism is not a homogeneous school of thought, and there is no central doctrine or leaders to this movement other than a broad north star of working to minimize fraud and protect the public from undue financial harm. There are crypto skeptics who think there might be some redeeming qualities in some crypto assets, and there are those who want it all to “die in a fire” and everywhere in between. The guiding principle of this letter is to find a middle way that at least most people can agree on and phrase it in a manner such that it can be best understood by our policymakers, who are deeply confused by even minimal jargon and technical obscurantism.
Countering the crypto lobbyists, Stephen Diehl

For what it is worth, I count myself in the camp who remain open to there being something of substance amongst the hype. Like any debate, the potential for crypto and DeFi to contribute something useful to future of finance can only benefit from agreeing on exactly what is meant by terms we use to debate the merits of the new, new thing. Stephen cites “blockchain”, to that I would add “digital money”.

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

Izabella Kaminska shares a stablecoin reading list

the-blindspot.com/crypto-reflexivity-and-the-ultimate-stablecoin-reading-list/

You may or may not agree with her stance on Bitcoin but this post offers a useful list of what Izabella has identified as the more informed contributions to the debate about stablecoins.

I have read most of these already but it offers a useful reference point for anyone trying to make sense of this corner of the financial universe.

Tony – From the Outside

“Safe” assets can be risky – check your assumptions

Anyone moderately familiar with crypto assets is no doubt aware that the Terra stablecoin has been experiencing problems with its algorithmic smart contract controlled peg mechanism. There are lots of lessons here I am but I think Matt Levine flags one of the more interesting ones in his “Money Stuff” column (13 May 2022).

Safe assets are much riskier than risky ones.

Matt goes on to expand on why this is so …

This is I think the deep lesson of the 2008 financial crisis, and crypto loves re-learning the lessons of traditional finance. Systemic risks live in safe assets. Equity-like assets — tech stocks, Luna, Bitcoin — are risky, and everyone knows they’re risky, and everyone accepts the risk. If your stocks or Bitcoin go down by 20% you are sad, but you are not that surprised. And so most people arrange their lives in such a way that, if their stocks or Bitcoin go down by 20%, they are not ruined.
On the other hand safe assets — AAA mortgage securities, bank deposits, stablecoins — are not supposed to be risky, and people rely on them being worth what they say they’re worth, and when people lose even a little bit of confidence in them they crack completely. Bitcoin is valuable at $50,000 and somewhat less valuable at $40,000. A stablecoin is valuable at $1.00 and worthless at $0.98. If it hits $0.98 it might as well go to zero. And now it might!

The takeaway for me is to once again highlight the way in which supposedly safe, “no questions need be asked”, assets can sometimes be worse than assets we know are risky due to the potential for them to quickly flip into something for which there is no liquidity, just a path to increasingly large price falls. This is a theme that I regularly hammer (so apologies if you are tired of it) but still for me one of the more important principles in finance (right up there with “no free lunch”).

Tony – From the Outside

The Stablecoin TRUST Act

Stablecoin regulation is one of my perennial favourite topics. Yes I know – I need to get out more but getting this stuff right does truly matter. I have gone down this particular rabbit hole more than a couple of times already. This has partly been about the question of how much we can rely on existing disclosure regarding reserves (here and here for example ) but the bigger issue (I think) is to determine what is the right regulatory model that ensures a level playing field with existing participants in the provision of payment services while still allowing scope for innovation and competition.

JP Koning has been a reliable source of comment and insight on the questions posed above (see here and here for example). Dan Awrey also wrote an interesting paper on the topic (covered here) which argues that the a state based regulatory model (such as the money transmitter licensing regime) is not the answer. There is another strand of commentary that focuses on the lessons to be learned from the Free Banking Era of the 19th century, most notably Gorton and Zhang’s paper titled “Taming Wildcat Stablecoins” which I covered here.

Although not always stated explicitly, the focus of regulatory interest has largely been confined to “payment stablecoins” and that particular variation is the focus of this post. At the risk of over-simplifying, the trend of stablecoin regulation appears to have been leaning towards some kind of banking regulation model. This was the model favoured in the “Report on Stablecoins” published in November 2021 by the President’s Working Group on Financial Markets (PWG). I flagged at the time (here and here) that the Report did not appear to have a considered the option of allowing stablecoin issuers to structure themselves as 100% reserve banks (aka “narrow banks”).

Against that background, it has been interesting to see that United States Senator Toomey (a member of the Senate Banking Committee) has introduced a discussion draft for a bill to provide a regulatory framework for payment stablecoins that does envisage a 100% reserve model for regulation. Before diving into some of the detail, it has to be said that the bill does pass the first test in that it has a good acronym (Stablecoin TRUST Act where TRUST is short for “Transparency of Reserves and Uniform Safe Transactions”.

There is not a lot of detail that I can find so let me just list some questions:

The reserve requirements must be 100% High Quality Liquid Assets (HQLA) which by definition are low return so that will put pressure on the issuer’s business model which relies on this income to cover expenses. I am not familiar with the details of the US system but assume the HQLA definition adopted in the Act is the same as that applied to the Liquidity Coverage Ratio (LCR) for depositary institutions.
Capital requirements are very low (at most 6 months operating expenses) based I assume on the premise that HQLA have no risk – the obvious question here is how does this compare to the operational risk capital that a regulated depositary institution would be required to hold for the same kind of payment services business activity
Stablecoin payment issuers do not appear to be required to meet a Leverage Ratio requirement such as that applied to depositary institutions. That might be ok (given the low risk of HQLA) subject to the other questions about capital posed above being addressed and not watered down in the interests of making the payment stablecoin business model profitable.
However, in the interest of a level playing field, I assume that depositary institutions that wanted to set up a payment stablecoin subsidiary would not be disadvantaged by the Leverage Ratio being applied on a consolidated basis?

None of the questions posed above should be construed to suggest that I am anti stablecoins or financial innovation. A business model that may be found to rely on a regulatory arbitrage is however an obvious concern and I can’t find anything that addresses the questions I have posed. I am perfectly happy to stand corrected but it would have been useful to see this bill supported by an analysis that compared the proposed liquidity and capital requirements to the existing requirements applied to:

Prime money market funds
Payment service providers
Deposit taking institutions

Let me know what I am missing

Tony – From the Outside

Note – this post was revised on 14 April 2022

The question posed about haircuts applied to HQLA for the purposes of calculating the Liquidity Coverage Ratio requirement for banks was removed after a fact check. In my defence I did flag that the question needed to be fact checked. Based on the Australian version of the LCR, it seems that the haircuts are only applied to lower quality forms of liquid assets. The question of haircuts remains relevant for stablecoins like Tether that have higher risk assets in their reserve pool but should not be an issue for payment stablecoins so long as the reserves requirement prescribed by the Stablecoin TRUST Act continues to be based on HQLA criteria.
While updating the post, I also introduced a question about whether the leverage ratio requirement on depositary institutions might create an un-level playing field since it does not appear to be required of payment stablecoin issuers

SWIFT gpi data indicate drivers of fast cross-border payments

One of the use cases for cryptocurrency and\or stablecoins is that it offers cheaper and faster alternatives to the conventional payment rails. Whether they will succeed remains to be seen but I have long believed cross country payments is one of the areas where the banking system really does need to lift its game.

Against that context, this research study released by the Bank for International Settlements (BIS) suggests that TradFi banking is making some improvements.

The study lists three key takeaways …

“- The speed of cross-border payments on SWIFT global payment innovation (gpi) is generally high with a median processing time of less than two hours. However, payment speeds vary markedly across end-to-end payment routes from a median of less than five minutes on the fastest routes to more than two days on several of the slowest routes.
– Prolonged processing times are largely driven by time spent at the beneficiary bank from when it receives the payment instruction until it credits the end customer’s account. Longer processing times tend to occur in low and lower-middle income countries, which can be partly attributed to capital controls and related compliance processes, weak competition as measured by the number of banks as well as limited operating hours of and the use of batch processing by beneficiary banks.
– Cross-border payments on SWIFT involve, on average, just over one intermediary between the originator and beneficiary banks. Each additional intermediary prolongs payment time to a limited extent, while the size of time zone differences between banks has no discernible effect on speed.”

If I am reading it correctly, the study does not capture any delays the initiating bank may introduce before it processes a payment instruction. With that caveat, it is worth noting that TradFi is not standing still – competition can be a beautiful thing.

Also worth noting the extent to which domestic payment systems are improving though not necessarily in the USA.

Tony – From the Outside