Saturday, October 9, 2021

Embargoed by MasterCard/Visa, kratom vendors turn to crypto and eChecks

I spend a fair amount of time tracking real-world use cases for cryptocurrencies. I'm not talking about silly speculation, or millionaire crypto hobbyists using their bitcoins to buy Teslas, or illegal dark web markets that use Monero for payments. I'm talking about actual licit businesses that have turned to cryptocurrency payments -- not because they particularly care about crypto -- but because they need to.

To date, the retail kratom industry is one of the best examples I've been able to find of broad non-speculative licit cryptocurrency adoption. Kratom is a plant that grows in southeast Asia. The kratom leaf can be ground into a green powder that, when ingested, acts as a stimulant. In the U.S., online kratom stores are ubiquitous.

I'm not going to get into whether kratom is dangerous or has medicinal value, or whether it should be legal or not. (For that sort of discussion, I'd suggest visiting the FDA, WebMD, or the Mayo Clinic.) The main point I want to make in this post is that kratom is legal in the US (although several states have banned it).

Although kratom is legal, MasterCard and Visa have decided to prohibit kratom sales from their networks. This poses big problems for online kratom shops. Because the card networks dominate online payments, exile by these oligopolies causes serious financial damage to the unfortunate targets. To survive, the kratom industry has been forced to turn to backup payments systems.

MasterCard's Business Risk Assessment and Monitoring (BRAM) policy, for instance, lists a number of impermissible activities:

Source: Netpay

Most of the prohibited transactions listed by MasterCard are illegal, such as the sale of child pornography. But some are legal, including the sale of "certain types of drugs or chemicals." MasterCard specifically mentions salvia divinorum, a legal drug that has hallucinogenic properties. Although it isn't listed as an example, kratom is usually considered to fall into the same category as salvia.

Acquirers, the financial institutions that connect businesses to the card networks, face large penalties if Visa or MasterCard catch them facilitating prohibited card transactions. To reduce this risk, acquirers will often hire what are called Merchant Monitoring Service Providers, or MMSPs, to scan through retailer data and spot anything that looks dangerous. MMSPs such as LegitScripts are very aggressive about rooting out kratom sales.

Despite the card networks disallowing kratom sales, many of the 20 or so sites that I scanned through still offer card payments. According to my research, kratom sites have a number of ways of securing card availability, one of which is called transactions laundering. That is, a kratom site camouflages its prohibited product sales by routing them through a front store that sells legitimate goods. Eventually these prohibited transactions get caught by the card network or the acquirer, and the site's card network access is revoked. It then has to scramble to build another front.

One commenter on Reddit describes kratom transaction laundering thusly:

"...we can do manual credit cards (as I can) over the phone because we use standard processors that don’t know it’s kratom. We do this by creating Dba’s that have fake web presences selling other products and they don’t find out it’s kratom for a while. Usually we can get a processor to work for 3-12 months before it gets shut down."
(Note: Dba refers to "Doing Business As". A DBA is a business pseudonym or a “fictitious name filing.”)

Another route that kratom sites take to get access to the card networks is to use an overseas aggregator. Kratom Crazy, a website that has since closed for business, describes how and why:

"International is the only way to go because card schemes are less aggressive on banks in international communities. This doesn’t mean they can’t be fined or shut down – oh because they can and still do. No aggregate account we have ever seen has lasted over 6 months before being shut down. The major downside is these accounts are usually 9% fees and up plus 10% rolling reserve over 6 months. So the merchant takes 19%+ off the top immediately plus they have to wait for 2-3 weeks before seeing the first days processing payout. Its a bad deal all around and a massive risk for losing money. In addition, when these accounts get shut down, there is usually no payout to the merchants."
So the upshot is that the sort of card network access that many kratom sites have managed to secure is unreliable and spotty. Indeed, many sites don't accept cards at all, including (at the time of writing) OG Botanicals, Canada Kratom Express, Krypto Kratum, and Rhizohm. Rhizohm's payments page goes to some pains to explain how it would rather be honest than lie to get card access:

Source: rhizOhm

Which gets us to cryptocurrency. Almost all of the kratom sites, including those that haven't been able to sneak themselves into the card networks, accept cryptocurrencies including Bitcoin, Ethereum, Litecoin, XRP, Stellar Lumens, or some other one. Third-party crypto processors like CoinPayments or Coinbase Commerce are typically used for payments processing.

When they accept cards, kratom sites often offer discounts for cryptocurrency payments. For instance, Happy Hippo's checkout page offers a 20% discount:

It's easy to understand why kratom sites would offer such discounts. It's expensive to use overseas aggregators for card payments. By steering a customer to Bitcoin or Ethereum, a kratom vendor saves itself the pain of a 10-15% card processing fee.

But cryptocurrency isn't the only payments option that kratom sites fall back on. Even more popular than crypto is eChecks, a traditional "fiat" form of payment that gets processed via an automated clearing house, or ACH. A kratom buyer inputs their bank routing and account numbers into the payments page, the payment then gets routed to the ACH network and, once cleared & settled, the funds arrive in the kratom merchant's bank account.

In the same way that a business must work with a card acquirer to get access to Visa or MasterCard payments, they must work with an eCheck acquirer in order to accept eCheck payments. But onboarding standards seems to be much looser with eCheck acquirers than card acquirers. For instance, in the screen shot below an eCheck acquirer is actively soliciting all sorts of high-risk industries, including not only kratom but also CBD oil and MLM-based businesses.  

Many kratom sites also accept a bespoke payments method called GreenBean Pay. Users open an account with GreanBean Pay and submit their banking account information. The service then uses Plaid -- a piece of financial plumbing that allows apps to hook into banks -- to link to the buyer's bank account and process the kratom payment.

Lastly, a bunch of kratom sites accept person-to-person payments options such as Cash App, Venmo, Zelle, and Interac eTransfer. (This probably goes against these services' terms of service, which generally limit usage to person-to-person payments).

While these backup options have become vital for connecting kratom retailers to the public, they are not really a great substitute for a card network connection. Cryptocurrency is clunky, awkward, and risky. eCheck is slow. By not offering the convenience of card payments, kratom sites lose out on a steady stream of would-be buyers. And this is evident by how desperate they are to find hacks that get them back into the Visa and MasterCard walled gardens.

In closing, I want to touch on something I mentioned in my previous post on MasterCard and porn. A big reason that card networks refuse to process legal transactions for things like kratom (or, similarly, for salvia divinorum, which I wrote about here) is they don't want to damage their brand. These substances may be permitted by law but they are controversial, and so the networks refuse to touch them.

All businesses have the right to protect their brands. But the card networks are oligopolies, and thus necessary for online survival. And so in my view the card networks should be required to forfeit their right to protect their brands. That is, Visa and MasterCard (insofar as they retain their oligopolistic powers) should not be be allowed to police vendors for what they deem to be controversial but legal products.

Which is not to say that I'm a champion of kratom. I'm only suggesting that the appropriate way to control such a product is not by card network bans, but by the Drug Enforcement Agency declaring it to be a scheduled drug.

The good news is that these sorts of situations are very rare. The card companies allow almost every legal transaction under the sun on to their networks, save a few outliers like kratum. This means that the population of licit businesses that need to use a back-up system like cryptocurrency payments (or echecks) is not very big. But examples like this still warrant our attention. Even if we don't particularly care about kratom, one day a product that we regularly consume could get censored by Visa or MasterCard.

Tuesday, October 5, 2021

MasterCard as censor

Governments have incredible powers to dictate what people buy online.

By virtue of being oligopolies, the two payments networks -- MasterCard and Visa -- exercise the same powers as governments do. If MasterCard bars your business from its network, you effectively don't exist.  

We may not agree with how governments set rules about what things we can buy, but at least there is a somewhat transparent and democratic process -- however flawed -- behind the government's decisions. Visa and MasterCard's rulings, on the other hand, are opaque and driven by card executives, not voters. It is important to monitor these networks to see how they are exercising their powers of online censorship.

In this spirit, here are some thoughts on MasterCard's new rule change, AN 5196, which governs websites that provide adult content. Now, it could be that you don't particularly care about porn. But even then, it's worthwhile to pick through the rule change to see how the scope of online commerce is about to be narrowed. As I wrote in my recent article for the Sound Money Project, the sex industry exists at the edge of the payments universe and thus serves as a useful barometer for the general state of payments inclusion.

Issued earlier this year, AN 5196, or Revised Standards for New Specialty Merchant Registration Requirements for Adult Content Merchants, requires adult sites to obtain consent from all models who are depicted in a video or image. Sites must also verify the identity and age of all models. These systems must be in place by October 15, 2021. It is the job of acquirers, those companies that connect adult sites to the MasterCard network, to ensure that rules are being followed. Sites that don't comply will be disciplined or banned.

Here is how one site, JustForFans, is implementing the changes:

In addition to collecting information, MasterCard will now require that content be reviewed by sites prior to publication to ensure that it is not illegal and that it does not "otherwise violate the Standards." If the content is a real-time stream, the site must be able monitor it and take it down immediately.

AN 5196 will also require porn sites to provide their acquirer with monthly reports including a list of all content flagged as "potentially illegal or otherwise in violation of the Standards," as well as the actions taken to address these violations.

Although MasterCard's actions are designed to reduce the amount of illegal adult content, it will also result in less legal adult content being available online.

Let's start by going through the justification for MasterCard's censoring of illegal content. This decision isn't entirely up to MasterCard, as I'm going to show.

Many nations have laws that prohibit various types of adult content. Child pornography is universally illegal. Revenge porn, or the posting of pornographic images of a partner without permission, is also prohibited in many jurisdictions, either explicitly via anti-revenge porn laws or through anti-privacy and/or anti-cyberharassment laws. Sex trafficking, which includes cases such as Girls Do Porn, (a company that used fraud and intimidation to recruit non-professionals to pose in porn videos) is also illegal. Obscenity is prohibited in many jurisdictions, too.

Society has generally gone one step further than punishing the people who are responsible for committing crime. To help further reduce crime, we also punish the financial institutions that facilitate these illegal transactions. If a bank knowingly provides services to a child pornography site, for instance, that bank may be held criminally liable for laundering money.

To avoid being punished for accepting the proceeds of crime, financial institutions make an effort to filter out illegal payments, say by implementing customer due diligence, or know-your-customer (KYC), requirements. By demonstrating to law enforcement that they have filters in place, bankers can avoid prosecution for money laundering.

It is courtesy of this filters that financial institutions like MasterCard help project society's laws about content, however imperfect, onto online commerce. MasterCard performs this role of censor because we (i.e. voters and politicians) have delegated it that role.

Which gets us back to AN 5196.

A 2020 exposé by the New York Times revealed that one of the world' biggest porn sites, PornHub, had allowed child sexual abuse material and other non-consensual videos to appear on its site. (I wrote about this event here.) Because card acquirers must ensure that the businesses they connect to the MasterCard network are not selling illegal content, Pornhub should never have been allowed to host this content in the first place.

MasterCard's response was AN 5196. Prior to the Pornhub incident, acquirers were obligated to stop illegal porn from being transacted on the MasterCard network, but they were allowed to devise their own methods for doing so. The new rules impose explicit and uniform procedures across all acquirers. (I've already described what they are above, including collecting identification.)

AN 5196 will almost certainly reduce the amount of illegal content being transacted along the MasterCard network, and thus the amount of illegal content available on the internet. Some illegal content will inevitably flow to alternative adult sites that use cryptocurrencies or eChecks for payments. But without the ease of a card transactions, this content won't attract the same number of eyeballs as before.  

Unfortunately, AN 5196 has a blast radius. It will also reduce the amount of legal adult content available on the internet. Because adult sites will now have to collect the personal data of all people appearing in videos and other images, content makers who worry about being doxxed by insiders at porn site, or who fear losing their data to hackers who compromise sites, will stop providing content. (To be fair, some adult sites were already requiring identification prior to MasterCard's rule change.)

It might be possible to reduce the amount of law-abiding models who self-censor themselves out of fear of losing personal data. But this would require a different, more privacy friendly, approach to managing identity. That's a whole other conversation.

MasterCard's ban will also reduce the amount of legal but risqué/controversial material that is available online. 

You'll notice that AN 5196 requires adult sites to preview all content not only for potentially illegality but also for violations of "the Standards." 

What are MasterCard's standards?

In addition to prohibiting illegal material, MasterCard has long prohibited any transactions that may hurt its brand or "damage the goodwill of the Corporation." It provides a bit more clarity on this in 5.12.7 (2) of its rule book, where it declares the following activities to be in violation of its rules:

"The sale of a product or service, including an image, which is patently offensive and lacks serious artistic value (such as, by way of example and not limitation, images of nonconsensual sexual behavior, sexual exploitation of a minor, nonconsensual mutilation of a person or body part, and bestiality), or any other material that the Corporation deems unacceptable to sell in connection with a Mark."

I'm not entirely sure how MasterCard or its acquirers determine what is "unacceptable" or lacking "serious artistic value." Whatever the case, AN 5196 is likely to lead to an increase in brand-related censorship. The new set of rules requires that adult sites peruse each individual bit of content prior to publication. With sites applying more attention to content than ever before, this increases the likelihood of legal material being removed out of concern over MasterCard's reputation.

In addition, sites must now file monthly reports with their acquirers in which they list all content flagged as illegal or in violation of the Standards. The pressure to demonstrate that they are protecting MasterCard's brand will probably lead adult sites to apply harsher censoring standards than before.

If I may editorialize a bit, all businesses have the right to protect their brands. But MasterCard is an oligopoly, and thus necessary for online survival. And so it should be required to forfeit that right. That is, MasterCard shouldn't be allowed to police content for what it deems to be controversial material that could hurt its reputation. Governments have to provide services to every citizen, even ones who look funny or do strange things. The same should apply to MasterCard. 

So to sum up, the scope of online commerce is about to be narrowed. AN 5196 will reduce the amount of content available online by: 1) reducing illegal adult content; 2) reducing legal adult content being produced by those preferring anonymity, and; 3) reducing legal content that is deemed to be brand-damaging.

As far as I know, this is the first time that a card network has forced a set of content providers to adopt a know-your-customer requirement. For now, MasterCard has limited this requirement to adult sites. But who knows, one day it may require other types of content providers (i.e. social media?) to adopt the same standards as porn. While there may be benefits to this sort of policy, let's not forget the costs.

Monday, September 27, 2021

Cross-checking ShadowStats

Last week I wrote about Balaji Srinivasan's idea of creating a decentralized version of the Billion Prices Project. The post got me thinking again about the topic of alternative inflation indexes.

One of the most well-known of the alt-inflation indexes is John Williams' ShadowStats, often cited by gold bugs and bitcoin maximalists. As of August 2011, ShadowStats puts U.S. inflation at 13% versus official inflation of 5%, as illustrated in the chart below.

Source: ShadowStats

That's a huge gap. One of the two data series has to be wrong.

I've always dreamt about writing a blog post on ShadowStats, but never had the gumption or statistical chops for it. So I was happy to see that economist Ed Dolan announced on Twitter that he was  republishing a 2015 blog post in which he carefully critiqued ShadowStats. It's such a good article that I'm not going to bother writing my own ShadowStats post anymore.

ShadowStats attracts a lot of sneers from the econ commentariat. What makes Dolan's post so effective is that he gracefully takes Williams' arguments on their merits and then proceeds to analyze them. Put differently, he doesn't try to damn ShadowStats with straw man arguments. He steel-mans it (or steelwomens it).   

Anyways, do read the post. 

Dolan saves his best criticism for the end. When Dolan was writing his post in 2015, the gap between official inflation and ShadowStats inflation was a whopping 7% (see chart above). What Dolan finds is that the majority of this 7% gap can be attributed to a simple double-counting error committed by Williams. By correcting this double-counting error, the ShadowStats inflation number shrinks. And so the gap between it and the official CPI is actually far less menacing than Williams' anti-government fans like to make out.

Dolan challenges Williams to correct his double-counting mistake. But you can see why Williams might find this difficult to do. He has been selling his data for many years on a subscription basis. Admitting that his product contains errors could anger his customer base.

The other part of Dolan's blog post that I want to draw attention to is a set of simple cross-checks he performs to see whether official inflation or ShadowStats is more accurate. For instance, taking grocery prices from a 1982 advertisement and projecting them forward with both inflation indexes, Dolan finds that the official CPI does a better job of predicting where modern grocery prices actually ended up.

It would be unfair to do just one set of crosschecks. Which is why Dolan does a bunch of them. It's worth reading through each one. ShadowStats does not make out well. (For instance, in order for ShadowStats to be right, you've got to believe that the U.S. economy has been in a recession for the last two decades.)

To finish my blog post off, I'm going to add to Dolan's list of cross-checks by adding one of my own. This cross-check is meant specifically for one of the main consumers of ShadowStats data: gold bugs.

If gold investors think ShadowStats data is right, and many of them do, then they also have to accept that gold has lost 91% of its value since January 1980 (see chart below of the gold price adjusted for ShadowStats inflation). Which means that the yellow metal is an awful hedge against inflation, and anyone who buys it for that reason is making a big mistake.

Source: Bullionstar

The far more reasonable position to take is that the ShadowStats data is wrong, and that gold has actually been a decent hedge against inflation since 1980. Using official inflation numbers rather than ShadowStats, the price of gold today is almost even with its 1980 level.

So gold bugs, you can relax. You haven't lost your sanity -- gold is not an awful inflation hedge. Rather, ShadowStats is an awful measure of inflation.

Tuesday, September 14, 2021

A decentralized version of MIT's Billion Prices Project

Balaji Srinivasan, an angel investor, wants to kick start an updated version of MIT's Billion Prices Project. He will invest $100,000 in the project that best envisions how to create a publicly-available decentralized inflation dashboard, one that relies on scraped data from retailer websites.

Many years ago I was a big fan of the MIT's Billion Prices Project, so I perked up when I read about Srinivasan's contest. Created by economists Roberto Rigobon & Alberto Cavallo, the Billion Prices Project collected, or scraped, data from retailers' websites and used it to generate an alternative version of various government-tabled consumer price indexes. (I wrote about the Project here.) Members of the public could get access to Billion Prices U.S. data, albeit with a small delay.

This was incredibly useful! Because government consumer price indexes are published monthly, but websites can be scraped 24/7, the Billion Prices Project was far more responsive to price changes than government consumer price indexes are. It gave you insights into tomorrow's CPI announcement, today.

The Billion Prices Project also garnered attention because it revealed how Argentinean authorities had distorted official statistics to make inflation appear more muted than it really was. Conversely, the Billion Prices Project regularly confirmed the accuracy of U.S. Bureau of Labor Statistics' consumer price indexes, making it a useful tool for whacking gold bugs and inflation truthers over the head.  

While I like Srinivasan's general idea of bringing real-time scraped inflation data to the masses, I see three big problems.

The first problem is over-reliance on scraped data. Scraping is fast and cheap, but only a portion of the global economy's prices are scrape-able. Amazon and Walmart may sell almost every type of physical good under the sun here in Canada and the U.S., but they don't sell services. So while it's easy to find scraped prices of laptop computers, forget about prices for haircuts, rent, or healthcare.

That leaves a pretty big hole. Government statistical agencies such as the Bureau of Labor Statistics (BLS) or Statistics Canada are able to capture services prices because they send out human inspectors to check the prices of things like haircuts and back-rubs. Lacking price data on these items, Srinivasan's inflation dashboard will never be as accurate as the dashboards published by Statistics Canada or the BLS.

Consider too that goods in many developing and undeveloped countries are not available online. Amazon, for instance, isn't going to provide any clues into what is going on with vegetable prices in Afghanistan, or shoe prices in Yemen. Srinivasan says that he wants an "internationally useful" dashboard, but he's certainly not going to get one by relying on scraping alone. He's going to get a rich folks' dashboard.

Which leads into the second problem: the business model won't work. Compiling inflation indexes is costly, but Srinivasan wants his decentralized inflation dashboard to be made public, and presumably free. That's just not possible.

Rigobon & Cavallo's own Billion Prices Project is a good example of this dilemma.

Mere grants weren't enough to fund the Billion Prices Project. Yes, scraping may be cheaper than using physical data collectors, but it's still expensive to compile price indexes. Bills had to be paid. And so the whole Billion Price Project sold out. It was folded into a company called PriceStats and sold as a proprietary product to rich investors and central banks.

At first PriceStats continued to offer some free public dashboards. But this was never going to last. Rigobon & Cavallo's data had commercial value because it was quicker than government data, and could be used by traders to beat the market. Making even a portion of that data available to the public destroyed its commercial value. And so over time the public-facing parts were all discontinued. The Billion Prices Project, at least the public service side of it, is effectively dead. 

How data from PriceStats/The Billion Prices Project overlapped with US consumer price indexes [source]

Srinivasan's proposal faces the same tradeoffs as the Billion Prices Project. Price data is expensive to collect, compile, store, and process. Government agencies like the BLS are funded by taxes, not profits, and so they can give it away for free. We all benefit from this public service. But the calculus is different for private companies. To fund data collection, they must implement some sort of pay-wall. Srinivasan wants to make a public inflation dashboard, much like the BLS does. But he can't. He's not a government. 

(And no, an inflation dashboard won't be able to rely on advertising revenues, say like how Coinmarketcap does. Frenetic gamblers are addicted to checking coin prices. Inflation data doesn't attract eyeballs).

The last problem with Srinivasan's project is the basket problem. The introductory page that describes the project focuses on how to scrape for data. But this omits one of the biggest challenges to compiling any consumer price index: determining what the consumer price basket actually is. That is, what exactly is the "basket" of goods and services that the average consumer consumes each month?  

Government statistics agencies such as the Bureau of Labor Statistics solve this problem by conducting national surveys. For instance, the BLS's baskets are based on interviews with 24,000 Americans each quarter about their spending habits. The BLS gets even more precise data by having 12,000 of those participants keep a detailed diary that lists all expenses for a week.

But that's an incredibly resource-intensive process.

To avoid having to run costly surveys in order to build a representative consumption basket, the Billion Prices Project had a simple solution: it borrowed the BLS's baskets. But Srinivasan's project has declared this solution to be out of bounds. The project's website describes inflation as a "government-caused problem," and so the project can't rely on "government statistics."

Which means that Srinivasan's project will have to build its own representative price basket using its own surveys. Unless it can bring the same amount of financial resources to bear as the BLS, I don't see how it can pull this off.

Alternatively, the project will have to use the BLS's "untrustworthy" data. But that means contradicting its stated philosophy.

To sum up, Srinivasan envisions his decentralized inflation dashboard as being a superior alternative to untrustworthy government dashboards. But government consumer price indexes are far better than he is making them out to be, given the huge amount of money, time, and expertise committed to statistics agencies. (Yes, there are exceptions like Argentina). If any inflation dashboard is likely to be untrustworthy, I fear it will be Srinivasan's built-on-the-cheap dashboard.

(By the way, you'll notice I didn't discuss the decentralized aspect of the inflation dashboard. The project has enough challenges already, before even getting to the decentralized bit.)

All that being said, I'm in the same camp as Srinivasan. Scraped inflation data is neat and useful, and I think the public should be getting access to it. But my preferred solution is different than the one put forth by Srinivasan. Hey, BLS and Statistics Canada! When are you ever going to unveil some sort of free real-time consumer price index that relies on scraped data?

Srinivasan responds. Joe Weisenthal blogs.

Tuesday, August 31, 2021

The afghani could split into two (and other possibilities for Afghanistan's currency)

The new Governor of the DAB, Abdul Qahir Idrees, is introduced to staff.  [Source][Source]

Last week I made the case that the Afghanistan's currency, the Afghan afghani, might hyperinflate. In this post I'm going to take a different tack. In a chaotic economy, the afghani—or at least some version of the afghani—may be one of the country's more reliable elements. I'm going to look to several exotic currency scenarios including that of the 1990s Iraqi dinar, which split into an unstable Saddam dinar and a stable Swiss dinar, as a possible template for what might happen in Afghanistan.

My blog post from last week was about the assets owned by Da Afghanistan Bank (DAB), Afghanistan's central bank. The Taliban, which just took over control of the country, discovered to its chagrin that most of the DAB's US$9.5 billion in assets are held overseas and controlled by the U.S. and institutions like the IMF. And now those assets have been frozen.

Here is the former central banker, Ajmal Ahmady:

With a wedge being driven between the afghani banknotes that are circulating in Afghanistan and the New York-domiciled assets backing those notes, I went on to suggest in my post that the notes—now rudderless—could only fall in value.

What follows is my counter-argument, to myself.

Yes, the Taliban-controlled DAB has been cut off from its New York assets. But Taliban officials are about to learn (if they haven't already) that they have also been severed from the global banknote printing market. This means that the Taliban-controlled DAB can't issue any new banknotes. Cash is the dominant form of money in Afghanistan. With the supply of afghanis now fixed, and the demand for them rising over time along with population growth, Econ 101 tells us that the afghani's purchasing power should strengthen, or at least not fall by very much.

Like many other smaller countries, Afghanistan doesn't print its own notes. The DAB signed a contract in 2020 with the Polish Security Printing Works, Poland's state-owned money printer, to provide it with new cash. The first batch of new Polish-made afghani notes arrived earlier this year, with more due to arrive through 2022. 

The Taliban's takeover makes it unlikely that subsequent batches will be delivered, at least not without U.S. approval. Thus the stock of afghani banknotes is locked with no timetable for unlocking it.

Nor can the Taliban-controlled DAB print up its own series of afghani banknotes. Banknote printing is a complex affair due to anti-counterfeiting features, exotic substrates on which notes are printed, and designer security inks. I doubt the Taliban can acquire high quality presses, materials, or the requisite expertise to operate them.

Might a rogue foreign printer produce notes for the Taliban?

This is where things get interesting. We can look to other countries like Yemen, Libya or Iraq for ideas about what might happen if this happens (more on these countries at bottom).

Say that a shortage of notes pushes the Taliban to try and secure new ones. The Taliban-controlled DAB might contact an ally such as Pakistan to get some new notes printed up in secret. The rogue Pakistani printer will probably do a better printing job than the Taliban would on its own, but it still won't be able to make perfect replicas of the Polish series (or prior series). And the Taliban may not want replicas anyways. It may ask for an entirely new note design to commemorate its coming to power. Once the Taliban has received the Pakistani-printed notes, it will proceed to put these not-quite-replicas into circulation.

Now the ball is in the U.S.'s court.

If the U.S. decides to publicly disapprove of the rogue notes, then people in Afghanistan will refuse to treat old notes and new notes as being fungible, or equal to each other. The old approved notes will be seen as being tied to the billions of assets held in rich New York, the new unapproved being linked to a destitute Taliban. So the unapproved notes will trade at a discount to approved notes. At that point Afghanistan will have two afghanis: a strong Yankee one and a bad Taliban one. (This would be a situation similar to the bad Saddam dinars circulating in 1990s Iraq. More on that later.)

The Taliban may react by trying to restore fungibility. Afghan citizens would be required to treat the two unequal banknotes as equals. That is, local stores and banks would be forced to accept both the new and old notes at par on pain of execution.

But these measures would only partly work. People would adapt by limiting all their official compliant purchases to be made using the weaker unapproved banknotes. They would hoard the good approved ones, perhaps for use on the black market (where they will fetch their true value) or for export to regions of Afghanistan that are not controlled by the Taliban, and where the Taliban's one-for-one afghani rule has no effect. (Much like how stable Swiss dinars circulated in Kurdish-controlled Northern Iraq).

So a strategy of rogue printing could very well mean the emergence of a strong and a weak afghan. (Some of you will recognize this as Gresham's law in operation). That sounds like sci-fi, but as I've been hinting at throughout this post, this sort of strange currency divorce isn't all that new. I wrote about Iraq's experience here

The short version is that prior to the 1991 Gulf War, Iraqi dinar notes had been printed by a private printer, De La Rue. De La Rue's printing plates were manufactured in Switzerland. Cut off from De La Rue after the war, Iraq's leader Saddam Hussein had a new series printed up locally. These were known as the Saddam dinar and circulated at a discount to the Swiss dinar.

Iraq isn't the only example of currency separation. I've written about Libya's near split in 2016. More recently, I described the Yemeni rial breaking into two.

The possibility of a dramatic rupture of the afghani might be enough to get the Taliban to swear off the rogue printing option altogether. It may seek to work with the U.S. (i.e. submit to certain U.S. demands) in order to get access to both its Polish-printed notes and New York assets.

As for the U.S., it may agree to work with the Taliban-run DAB for humanitarian reasons, subject to certain conditions (i.e. limits on how banknotes can be issued). This compromise between enemies might lead to a surprising amount of stability for the Afghan afghani.

I've now written two blog posts about the Afghan afghani, both of them describing wildly different scenarios. What's evident is that the situation is a volatile one. It could proceed along any of vast number of arcs.

Tuesday, August 17, 2021

What happens to the Afghanistan central bank's assets?

The Afghanistan story is a tragic one and I don't have much to add to it apart from my ability to read central bank financial statements and balance sheets. Here's a quick analysis of the balance sheet of Afghanistan's central bank, da Afghanistan Bank. And following that, I'll provide some thoughts on what this means for Afghanistan. As always, feel free to add your opinions and data in the comments section.

Da Afghanistan Bank issues the Afghan afghani, the currency symbol of which is the Af. 

At year-end 2020 the central bank had 781 billion Afs worth of assets, which comes out to around US$9.5 billion at the current exchange rate of US$1-to-86 Afs. That's a lot of resources. No doubt the incoming Taliban regime is keen to access this $9.5 billion. But it will be tough for the Taliban to do so.

Here is what the assets section of the central bank's audited balance sheet looks like, in Afs:

Source: DAB

(Note: For the rest of this article, I will assume that da Afghanistan Bank's 2020 year-end numbers are similar to those prevailing as it is taken over by the Taliban.)

In what follows I'm going to analyze the four biggest components of da Afghanistan Bank's balance sheet: gold reserves, foreign currency cash reserves, due from banks, and investments.

1. To repeat, da Afghanistan Bank lays claim to 781 billion Afs worth of assets. Of this amount it reports holding 703,000 troy ounces of gold, worth 101.77 billion Afs, or 13% of da Afghanistan Bank's assets. At the current gold price, this comes out to a whopping USD$1.25 billion.

But a quick peek at the notes to the financial statements reveals that da Afghanistan Bank's gold is held on the other side of the world, at the Federal Reserve Bank of New York. With the Taliban taking over the central bank, my guess is that this gold will be frozen by the U.S. government. That is, the incoming Taliban regime won't be able to access a single ounce of the yellow metal.

2. The next big line item on da Afghanistan Bank's balance sheet is foreign currency cash reserves. A glance at the notes to the central bank's financial statements reveals that this refers to actual physical banknotes. This stock of currency seem to be held at the Presidential palace and the central bank's head office as well as its branch offices. Most of it U.S. dollars:

Source: DAB

The central bank presumably holds a big stock of U.S. banknotes because it also offers U.S. dollar accounts to locals, and account holders surely want to withdraw money in physical form to make payments. Afghanistan is mostly a cash economy.

At year-end 2020, da Afghanistan Bank held 34 billion Afs of foreign physical cash, or US$400 million. That's not as big as the gold line item, but it still accounts for another 4% of da Afghanistan Bank assets.

My guess is that this US$400 million in cash was quickly whisked away by the outgoing regime on one of the many planes departing Afghanistan, probably for eventual deposit at the Federal Reserve Bank of New York. So that's another big chunk of central bank assets wrested away from Taliban control.

3. Having dealt with gold and physical cash, the next line item is Due from banks and financial institutions. This amounts to 254.7 billion Afs (US$3.2 billion), or 33% of da Afghanistan Bank's assets. Looking through the notes to financial statements, much of this is comprised of various types of deposit accounts held at foreign banks:

Source: DAB

It is likely that these bank deposits are protected from the incoming Taliban regime, depending on the jurisdiction of the bank. If deposits are held in U.S. banks, I suspect they will have already been frozen. But if they are socked away in a place like Switzerland, perhaps the Taliban will be able to use them? I don't know enough about international politics to be sure. If the U.S. quickly institutes some sort of sanctions regime against da Afghanistan Bank, then even neutral foreign jurisdictions will have to lock down the assets of a Taliban-led central bank.

4. The fourth and last line item is investments, best described as a portfolio of U.S. government securities. These investments comprise the biggest chunk of da Afghanistan Bank's assets, summing up to 369 billion Afs (US$4.2 billion), or 47% of the total.

One more glance at the notes to the financial statements tells us that da Afghanistan Bank's investment portfolio is mostly managed by the Federal Reserve Bank of New York and the World Bank's International Bank for Reconstruction and Development (IBRD). A small chunk is run by the Bank for International Settlements. 

Source: DAB

If the chunk held at the Federal Reserve isn't already frozen, I suspect that it will quickly be rendered unusable. I don't know enough about the politics of the World Bank or the BIS to pass comment, but I'd bet that these institutions will also prevent the Taliban from getting access to the funds.

So let's do the math. Gold + foreign cash + due from banks + investments sums up to 760 billion Afs, or 97% of da Afghanistan Bank's assets. That's US$8.8 billion worth of funds. So effectively all of the central bank's assets is either already frozen or capable of being frozen.  

One thing I worry about is that a Taliban-led Afghanistan will quickly experience hyperinflation.

Here's the logic. Da Afghanistan Bank has issued around 293 billion Afs worth of Afghani-denominated coins and banknotes into circulation, for use by regular Afghans for payments. (That's around US$3.5 billion worth of cash). Banks and other customers hold another 106 billion Afs worth of electronic Afghani accounts at the central bank.

Up till now the Afghani notes and electronic deposits that the central bank has issued have been stabilized by its underlying investments, including the gold and dollars held at the New York Fed. Treasury securities yield income. So do bank deposits. Along with gold, these assets can also be used to repurchase issued Afghani currency, thus supporting the Afghani's value. 

But U.S. officials are justifiably worried about what other things the Taliban might do with those assets. What if the Taliban wants to sell $50 million of the central bank's stock of Treasury bills or gold ounces to buy more weapons? A blanket ban on accessing all of da Afghanistan Bank's funds will prevent the Taliban from using those assets to finance itself.

But with these assets being frozen, they can no longer be effectively put to work as stabilizers. And so the Afghani can only fall. In theory I suppose that the Taliban could find replacement backing, but in practice I doubt it has the resources to do so.

As far as developing nation currencies go, the Afghani has been fairly stable against the dollar for the last decade. Inflation has remained low. Freezing da Afghanistan Bank's assets hurts the Taliban, but it also means ensuring that a painful hyperinflation falls on regular Afghani people. This will be an abrupt departure from what Afghans have become used to, and a lot to bear on top of what they are already enduring.

Friday, August 6, 2021

Stablecoin regulatory strategies

Critics of stablecoins often describe them as unregulated. But that's not accurate.

Over the last few months I've been familiarizing myself with the various financial regulatory strategies stablecoin issuers have been adopting. I thought I'd share my findings in a blog post. Perhaps journalists, investors, and others will find this information useful. (For those not interested in stablecoins, I apologize. This will mostly be gobbledygook to you.) I'll most definitely make a few mistakes in this post, so readers: do not hesitate to provide feedback in the comments section.

I tweeted out the short version of this post last month:

As you can see I've isolated four regulatory strategies that the major U.S. dollar stablecoin issuers have adopted. In this post I'll provide some details on each strategy.

My guess is that when people criticize stablecoins for being unregulated, they have the fourth strategy in mind: stay offshore. But they are ignoring or unaware of the other three.

A few caveats before starting. I'm only going to deal with U.S. dollar stablecoins in this post. Which means I'm ruling out euro-based stablecoins that operate within the EU's e-money regulatory framework. But there aren't really any big non-U.S. dollar stablecoins, so focusing on U.S. stablecoins covers most of the market.

Second, I won't be talking about Dai, Terra USD, Frax or any of the more exotic decentralized stablecoins. I'm sticking to centralized stablecoins: Tether, USD Coin, Gemini Dollar, HUSD, Binance USD, Paxos Standard, and TrueUSD. By centralized, I mean that the stablecoin's backing assets are compromised of traditional assets like Treasury bills, commercial paper, or deposit accounts held at a bank. Redemption or creation of new stablecoin tokens occurs via underlying bank infrastructure.

Lastly, this post doesn't address so-called "FinCEN regulation." Stablecoins will sometimes market themselves as being regulated by the Financial Crimes Enforcement Network, a department of the US Treasury that oversees America's anti-money laundering regulations. In the tweet below, a Tether executive makes this claim:

However, this is mis-marketing. When stablecoins interface with FinCEN, they are best described as being registered with FinCEN, not regulated by FinCEN.

Further more, FinCEN registration doesn't qualify as operating under a financial regulatory framework. A financial regulatory framework sets out the rules an issuer has to follow in order to ensure that the product is safe for consumers. It is at this level that fraudsters are caught and poorly designed stablecoins pre-empted. A financial regulatory framework may also address issues like overall stability of the financial system. For its part, FinCEN has nothing to do with financial regulation. It is a money laundering watch dog.

So let's start.  

1. The New York DFS model

The first stablecoin regulatory model is the New York Department of Financial Services (NYDFS) model. The NYDFS regulates money transmitters, trust companies, and banks that do business in the state of New York.

The NYDFS has created an explicit framework for regulating stablecoin issuers. Two issuers currently conform to this model, Paxos Trust and Gemini Trust. Paxos issues its own Paxos Standard stablecoin. It also manages Binance USD (BUSD) on behalf of Binance, a large offshore cryptocurrency exchange. For its part, Gemini Trust issues the Gemini Dollar stablecoin.

Under the NYDFS model, a would-be stablecoin issuer first secures a limited-purpose trust company charter from the NYDFS. This means that it must comply with the NYDFS rules concerning trusts and submit to ongoing oversight.

Once chartered as a trust, the institution can then seek additional NYDFS approval to issue a "price-stable cryptocurrency – commonly known as 'stablecoin'– pegged to the U. S. dollar." The NYDFS says that its approvals for individual stablecoins are based on "stringent requirements for these products," and follow a "comprehensive and rigourous review." Post approval, the stablecoins are subject to continuing "examination and inspection" by DFS examiners.

2. The Nevada Trust model  

The second regulatory framework I have encountered is the Nevada trust model. There are two stablecoins that have chosen to use Nevada as their regulatory jurisdiction: HUSD and TrueUSD.

Let's deal with each stablecoin separately, because they use slightly different versions of the Nevada trust model.

Huobi Technology Holdings, the company that owns both the HUSD stablecoin and the Huobi cryptocurrency exchange, also owns a trust company, Huobi Trust Company. This trust company has been chartered by the Nevada Department of Business and Industry, or DBI. The Nevada DBI is Nevada's counterpart to New York's DFS.

The second stablecoin operating under the Nevada model is TrueUSD. TrueUSD has adopted a rent-a-charter, or multi-layered regulatory model. The TrueUSD stablecoin itself is owned by Techteryx, a Chinese company. But this isn't the layer at which the financial regulatory framework is applied; that occurs several steps removed.

Tecteryx has hired another company, TrustToken, to manage the stablecoin. TrustToken has in turn hired a third company, Prime Trust, a Nevada DBI chartered trust to manage the stablecoin's finances. Prime Trust acts as the regulated container for TrueUSD.

Prime Trust and Huobi Trust are regularly examined by the Nevada DBI to make sure that they are in compliance with Nevada's rules and regulations surrounding trusts.

What makes the Nevada model different from the New York model is that the NYDFS has explicitly acknowledged that New York trust companies can engage in stablecoin-related business. The NYDFS has a process in place to approve the stablecoins themselves, and provides continual inspections of these stablecoins.

The Nevada DBI has not explicitly acknowledged that trusts may (or may not) engage with stablecoin issuers. Unlike the NYDFS, the DBI has not explicitly familiarized itself with stablecoins, and has not set up additional procedures in place to regulate trusts that are engaged in stablecoin business.

For consumers and investors, it may be preferable to own stablecoins that have received explicit regulatory approval.

You'll notice that both the New York and Nevada models are based on trust companies. A trust company is what is known as a fiduciary. That is, it has a legal obligation to place customers' interests above the company's own interests.

The fiduciary nature of the relationship between stablecoin customer and stablecoin issuer is important. When Gemini Trust, Paxos Trust, Prime Trust, or Huobi Trust take in customer funds, their duty as fiduciaries prevents them (in theory) from investing this money in risky high-yielding investments. Were they to do so, they would be breaking their fiduciary duty to end users, the stablecoin owners, and could lose their charter.

The trust structure also protects customer funds in the case that the parent company, which owns the stablecoin, goes bankrupt. That is, if Binance or Tecteryx were to go bankrupt, BUSD or TrueUSD stablecoin owners needn't worry about fighting with other creditors for a piece of the company's resources. Their funds are protected at the trust company level.

3. The dozens of money transmitter licenses model

The only stablecoin that has adopted the dozens of money transmitter licenses regulatory model is the world's second largest stablecoin, USD Coin, issued by Circle. This is the same model that is used by well-known non-bank payments companies such as Square, PayPal, Skrill, Payoneer, Transferwise, Western Union, and Moneygram.

To operate under this model, an issuer gets a money transmitter license from each and every state that requires firms that engage in the business of money transmittal to be licensed. Montana is one of the states that lets money transmitters operate without a license. A few states such as Wyoming have exceptions for firms involved in crypto.

For its part, Circle has obtained 44 money transmittal licenses.

State licensing boards impose audit requirements on money transmitters and conduct examinations. Each state sets its own unique requirements, too. These include what sorts of investments money transmitters are permitted to make, capital requirements, and the size of the surety bond they are required to post. Some states are lenient, others are strict. (Dan Awrey has a good paper on the state-by-state requirements.) 

But in general, my understanding is that the requirements placed by states on money transmitters are not as demanding as those that they impose on trust companies and banks. So pound for pound, a dollar issued under the NYDFS or Nevada trust model will have more oversight than a dollar issued under the dozens of money transmitter licenses model.

That's not the only advantage of the trust model relative to the dozens of money transmitter licenses model.

Circle is not regulated as a trust company, and thus it doesn't have a fiduciary obligation to its customers. That is, the funds Circle receives to back its stablecoins can be invested in such a way that may be good for Circle's investors and not necessarily good for Circle's customers. By contrast, issuers operating under either the New York or Nevada trust models are fiduciaries and must prioritize the customer's financial interests. Presumably that means that trusts can't put stablecoin customers' money in unsegregated accounts or risky instruments – but Circle can.

In addition, if Circle were to go bankrupt it's not apparent whether USD Coin holders would have better rights to Circle's remaining resources than other unsecured creditors. At least with the trust company model, stablecoin customers are insulated from the bankruptcy of the parent.

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 as fiduciaries 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.

One last difference worth noting is that USD Coin must get 44 money transmitter licenses to operate across the U.S., but stablecoins operating under the Nevada and New York trust models seem to only need that one charter. Why is that?

A state chartered trust is typically exempt from having to get a money transmitters license in its home state. Depending on the circumstances, they may also be able to do business in other states without having to be independently chartered or licensed as a trust and/or money transmitter in those states. This seems to depend on whether the trust's home state has negotiated a reciprocity agreement with other states. Alas, I don't have a list of these agreements.

In any case, because trust company charters have a degree of portability, a single trust company charter seems capable of doing the work of 44 money transmitter licenses.

4. Stay offshore

The largest of the stablecoins, Tether, has adopted the last regulatory strategy: stay offshore. That is, Tether operates from the Cayman British Virgin Islands where it issues a U.S. dollar stablecoin. Tether's Cayman's-based Bahamas-based bank, Deltec, manages Tether's banking needs. And thus Tether avoids the necessity of setting up a New York or Nevada trust, or acquiring 44 money transmitter licenses.

The drawback of this structure is that that Tether can't operate in the U.S. Tether's terms of service prohibits "U.S. persons" from using the product.


In sum, those are the four regulatory strategies I've seen stablecoins pursue. Whereas stablecoins are often criticized for being unregulated, I think my post suggests the opposite. Yes, Tether can be criticized as such. But the New York and Nevada trust company models stand out for providing a significant amount of safety to stablecoin consumers, the NYDFS's approach particularly so because it has explicitly named and recognized stablecoins as products.

If you have comments or criticisms, do share them in the comments section of this post.


You'll notice that the first three strategies all operate at the state level. That is, the financial regulatory framework under which the major stablecoins are currently operating is governed by state licensing boards, and not at the national level by Federal banking regulators.

Might stablecoins eventually jump from a state-by-state framework to the national one?

One of the major financial banking regulators, the Office of the Comptroller of the Currency (OCC), has suggested that Federal financial institutions can support stablecoin transactions, but only if they involve "hosted wallets." A hosted wallet is a digital account hosted by a third-party financial institution. An unhosted one is controlled by the consumer.

But all of the big stablecoins I've mentioned in my blog post allow oodles of unhosted activity, so I suspect that Federal banks regulated by the OCC can't do business with them. Paxos, for instance, has recently secured a national trust bank charter from the OCC. But it appears that Paxos won't be using this national charter as the regulatory home for either the Paxos Standard and Binance USD stablecoins. Its NYDFS-chartered trust company will continue to be the regulatory anchor for its two stablecoin products.

Monday, July 26, 2021

Are the Bank of Canada's bond purchases illegal?

Pierre Poilievre, Conservative MP for Carleton, alleges that the Bank of Canada's bond buying program contravenes the Bank's powers enunciated in the Bank of Canada Act.

Allegations that the Bank of Canada has broken the law should be taken very serious. They should not be made lightly, either. We give our public servants at the Bank of Canada a wide range of powers to enact monetary policy, but only within the bounds that we permit them.

Poilievre has been actively criticizing the Bank of Canada's pandemic response ever since Covid-19 hit in 2020. I can't say I've ever seen as much Bank of Canada-targeted criticism emanating from a single Canadian politician since Poilievre began his campaign. It breaks with a long Canadian political tradition of staying (mostly) silent on the Bank of Canada's operations.

I have mixed feelings about Poilievre's approach. Yes, it's great to have more public discussion about arcane topics like the Bank of Canada Act. On the other hand, up till now Canada has avoided most of the hyperbole and conspiracies that bedevil U.S. central banking. It would be nice if things stayed that way.

Poilievre's allegations were first aired in Parliament in June. A month later he posted them on Twitter, where I became aware of them. (They garnered over 900 retweets, which is a lot for a tweet about an arcane issue like the Bank of Canada Act!) Poilievre's claims are based on his reading of Section 18(j) of the Bank of Canada Act. Section 18(j) allows the Bank to make loans to the Federal government, but those loans should not "exceed one-third of the estimated revenue of the Government of Canada for its fiscal year."

Poilievre calculates that given 2021 government revenue estimates, this would cap Bank of Canada loans to the Federal government at $118 billion. Poilievre then points to the Bank of Canada's purchases of Government securities, which have pushed the Bank's holdings of Federal government debt above the $400 billion level. Poilievre suggests that this contravenes 18(j).

The allegations caught the attention of columnist Andrew Coyne, who takes a dig at Poilievre:

In fairness to Poilievre, it's not unimaginable that the Bank of Canada has done something illegal and no one has noticed but him. 

Back in August 2007, after all, the Bank of Canada announced its intention to extend its purchases of certain kinds of securities. It was responding to the first signs of a nascent crisis in credit market. Unfortunately it lacked jurisdiction to purchase these instruments. Its actions were unwound by September 2007 in order to bring the Bank back in compliance with the Bank of Canada Act.

I only know this because I phoned the Bank of Canada up that August wondering what legal justification it had for its actions. Several awkward conversations later, it was apparent that a mistake had been made by bank officials.

My observations made their way into a report that December for the CD Howe Institute. From there a process to update the Bank of Act began. After discussions in Parliament (including a contribution from then-governor Mark Carney here) the eventual result was an update to the Act in the spring of 2008. Tucked into Bill C-50, changes included striking out Section 18(k) and rewriting Section 18(g).

These modifications to the Bank of Act made it permissible for the Bank of Canada to conduct the purchases it had originally set out to do in August 2007, and prepped it for the much bigger fallout to come: the September 2008 credit crisis.   

So maybe Poilievre has caught a breach of law. It's happened before. That being said, echoing Coyne (who cites economist Mike Moffatt), I'm not convinced by the meat of Poilievre's argument.

In response to Poilievre's allegations about 18(j) being broken, Bank of Canada officials would probably respond that their large-scale asset purchases are authorized under Section 18(g).

The Bank of Canada's ability to make securities purchases for monetary policy purposes is set out in Section 18(g), which replaced the much narrower 18(k) in 2008. The scope of Section 18(g) is very broad. First, it is open-ended about what instruments it allows the Bank to purchase. These securities can include bonds, stocks, commercial paper, mortgage-backed securities, and more.* Second, 18(g) doesn't say anything about the Bank's purchases needing to happen in the open market. If necessary, the Bank of Canada can buy straight from the issuer.

The bit of legalese that Poilievre points to, 18(j), only applies Bank of Canada loans to the Government, say a line of credit or some other type of credit facility. Because the Bank has limited its interaction with the government to buying securities, 18(j) hasn't been triggered. And so Poilievre's allegations are just that, allegations.

Section 18(j) was devised to prevent the Bank of Canada from financing the government and preserving the Bank's independence, as Poilievre rightly points out here. And I think that's a laudable goal.

In that spirit, it's worth considering that most (but not all) of the Bank of Canada's purchases of government bonds have occurred in the open market. That is, most of the securities in the Bank's government bond portfolio were bought only after the public had initially purchased them from the Government. So in a sense, the Bank has prudently removed itself from the initial price discovery process.  

More specifically, the Bank has purchased $362 billion in Government bonds since March 2020. Of that amount, $303 billion, or 84%, was bought in the open market. The remaining $59 billion was bought directly from the Government.

Even when the Bank does participate in bond auctions, it does so on a non-competitive basis. That is, the Bank pays the average of all competitive bids submitted to the auction. The competitive bids are provide by banks and other primary dealers. This practice further prevents the Bank of Canada from playing an active role in setting the government's cost of capital.

So to sum up, I think the Bank of Canada is on firm legal ground. Furthermore, I also think the spirit of 18(j), a prohibition on financing the government, remains intact.

* The one security that Section 18(g)(i) deems to be off limits are instruments that "evidence an ownership interest or right in or to an entity." If I recall correctly refers to certain types of asset-backed commercial paper (ABCP).

Thursday, July 22, 2021

The dollar isn't a meme

"Currencies are not memes that only have value because governments say they do," writes Brendan Greeley for the Financial Times. 

I agree with him.

The dollar-as-meme claim is often made by cryptocurrency enthusiasts. That this idea would emanate from the cryptocurrency community makes sense, since cryptocurrency prices are a purely meme-driven phenomenon. There is no cryptocurrency for which this is more apparent than Dogecoin, a cryptocurrency started as a joke and sustained by shiba inu gifs, but it applies equally to Doge's older cousin, Bitcoin. The harder you meme the higher a cryptocurrency's price, as the image at top suggests.

And so for cryptocurrency analysts, getting a good understanding of a given coin's value is a matter of picking through its underlying memes and meme artists. 

But if cryptocurrency analysis is ultimately just meme analysis, what sort of analysis applies to dollars?

Dollars issued by banks are secured by the banks' portfolio of loans, Greeley reminds us. And so they are subject to credit analysis, not meme analysis. An analyst appraises the quality of the bank's investments in order to determine the soundness of the dollar IOUs the bank has issued.

As for central banks like the Fed, they are just special types of banks, says Greeley, and so the dollars they issue are also subject to credit analysis.  

The idea that the money issued by central banks—so-called fiat money—is subject to the same credit analysis as any other type of debt security is a point I've also made on this blog. There are certainly some odd features about Fed dollars or Bank of Japan yen, but ultimately they are just another form of credit.

What sort of credit is fiat money? There are many different kinds of credit instruments, from bonds to deposits to banknotes, each with its own unique features. To see where central bank money fits, I've made a chart that illustrates how credit instruments differ across three different criteria (click to expand).

The first criteria along which to compare credit instruments is whether the instrument is redeemable on demand by the holder or not. That is, if I own a given credit instrument, or IOU, can I bring it back to the issuer, or debtor, at a time of my choosing and redeem it for something?

The second category concerns the instrument's maturity. Does it stay outstanding forever i.e. in perpetuity? Or is it term debt? When a credit instruments has a term, that means that it expires after a predefined period of time, the debtor cancelling it and paying back the the original amount lent.

The final category is whether the instrument pays interest or not.

By toggling these various features, we arrive at the eight different types of credit instruments, examples of which I've listed on the right side of the graphic.

As you can see, the Fed's dollars, the ECB's euros, and the Bank of Japan's yen are type 5 and type 6 credit instruments. Central banks issue two types of money: physical banknotes and electronic balances (sometimes known as reserves). Electronic central bank reserves pay interest. Banknotes do not.

Apart from that, banknotes and electronic balances are very similar instruments. Neither of these two credit instruments is redeemable on demand. That is, you can't bring a banknote back to the issuer at 5:30 PM Friday and redeem it for something. (This same lack of on-demand redeemability characterizes bonds and certificates of deposits.) And they are both perpetual, much like a perpetual preferred share or non-expiring coupons/gift certificates.

Removing a credit instrument's redemption-on-demand feature doesn't stop it from being a credit instrument. It just changes it into a different type of credit instrument. Yes, probably an inferior one, but a credit instrument nonetheless.

For instance, if a retractable bond (type 3) suddenly loses its retractability feature (and is no longer redeemable on demand by its owner) it doesn't stop being a credit instrument. It simply switches to being a regular bond (type 7). Likewise, if a perpetual puttable preferred share (type 1) loses its puttability, it doesn't stop being an IOU. It becomes a new type of credit instrument, a regular perpetual preferred share (type 5).

This same principal applies to those credit instruments we call money. Decades ago the Fed's dollars were redeemable on demand into gold, and thus they were a type 1 or 2 credit instrument. When the Fed removed redemption back in 1934, dollars didn't become mere memes. Rather, they were converted into a different type of credit instrument, a type 5 or 6 credit instrument.

Once a credit analyst has figured out what kind of credit instrument they are dealing with, their work is only half done. Next they have to go back and look at the underlying issuer. How solid is it? Does it have sufficient assets to guarantee the credit instruments it has issued? Do it generate enough income to keep paying interest? Is the issuer linked to affiliates, parents, or other third-parties who might strengthen or diminish the issuer's credit?

As you can see, none of this is meme analysis. It is credit analysis.

To recap, dollars issued by the Federal Reserve are perpetual credit instruments that lack an on-demand redemption feature. To determine how solid the Fed's perpetual non-redeemable credit instrument are, you'd want to do an analysis of the Fed's finances. That should also include investigating the soundness of the Fed's parent, the U.S. government. Does the parent's finances further enhance the Fed's credit, or detract from it?

So dollars don't only have value because the government says they do. Just like Tesla's financial health determines the value of Tesla bonds, the financial health of the issuing central bank (and its parent) is  key to determining the value of central bank money.

If you want to do meme analysis, stick to Dogecoin and Bitcoin.