Wednesday, September 2, 2020

Different bitcoins different prices


Not all bitcoins are the same. If someone steals 100 bitcoins from a cryptocurrency exchange and tries to sell them, they'll have to price them at a discount to the market price in order to compensate the buyer for the risk of laundering them. Different bitcoins different prices.

This isn't just a bitcoin phenomenon. There are two wholesale markets for banknotes, too. The legitimate one is comprised of banks, retailers, and cash-in-transit companies like Brinks that exchange notes at par. And the illegitimate one is made up of mob lawyers, drug dealers, and note brokers exchanging dirty notes at 20 or 30 cents on the dollar. Different dollars different prices.

You can find this same fractionalization everywhere: in electronics or prescription medicine or used cars. There is a licit and illicit price in each market.

But the difference between dirty and clean prices isn't the dichotomy that interests me in this post. Could we see a two-tiered market develop for clean bitcoins? In other words, could a situation arise in which Jerry's 100% legitimate bitcoin's are worth more than Elaine's 100% legitimate bitcoins?

I'd argue that the precedent already exists in the gold market.

Last month I wrote a quick explainer on the London Bullion Market Association, or LBMA, for CoinDesk. The LBMA is a standards-setting body for the gold market. It defines what constitutes a London "good delivery" gold bar and what doesn't. These standards include physical details like purity, weight, height, and appearance. Increasingly, the LBMA's standards are being stretched to include details about sourcing. Has the miner extracted the metal in an environmentally friendly and ethical way? Are they laundering money for Mexican drug lords?

Good delivery bars can only be stored in a handful of London-based vaults. A strict paper trail is maintained to ensure that nothing gets in (or out) of this walled-garden. The moment a bar is withdrawn from a London vault, it loses it's good delivery status.

This has the effect of creating a two-tiered licit gold market, one in which London gold is worth more than non-London gold.

Consider that the world's largest buyers congregate in London to trade gold. A 400-ounce gold bar fabricated by a refiner that doesn't have the LBMA's stamp of approval can't access the incredibly liquid London market. And so it won't be worth as much as an LBMA-approved 400-ounce bar. (No one wants to buy your metal if it can't be immediately on-sold in London.)

To be granted London "good delivery" status, an unapproved bar must go through a process of being anointed. That means bringing the bar to a refiner on the LBMA's approved refiner list. The refiner vets the bar owner to check for money laundering, much like a banker would. Only then can the bar be melted down and reformed into an entirely new and approved bar. But all of these steps are costly.

As my CoinDesk article suggests, we might one day see the same sort of fractionalization emerge in the bitcoin market. A core group of exchanges and custodians would begin to define what qualifies as a "good delivery" bitcoin. Standards would mostly apply to the provenance of bitcoins. Since the history of bitcoin transactions can be easily monitored, it is relatively easy to cast aspersions on certain flows of bitcoins, perhaps because they happen to pass through suspicious addresses or are  mixed by coin tumblers. (As Izabella Kaminska suggested a while back, bitcoin has a lien problem. Tim Swanson has been writing about this for a while, for instance in A Kimberly Process for Cryptocurrency.)

Should a bitcoin be withdrawn from this "walled garden" of approved exchanges and custodians it would fall out of the Bitcoin Marketing Association's "chain of custody" and, as such, would no longer have access to core liquid markets. And so unapproved bitcoins would be forced to trade in lower quality venues with lax vetting standards, and less liquidity.

An online retailer might not want to take the risk of selling their products for unapproved bitcoins (i.e. ones that come from non-vetted personal wallets). Sure, it might be possible for the retailer to accept non-approved flows with the intention of re-depositing them into the Bitcoin Marketing Association's system in order to get the Bitcoin Marketing Association price. But there would always be the risk of an unexpected blockade or freeze of a customer's unapproved bitcoins. And so retailers would ask their customers to only spend approved bitcoins straight from their Coinbase wallets.

By the way, the sort of LBMA-driven dichotomy that exists in gold (and could one day exist in bitcoin) does not exist in banknote markets. There is no such thing as a good & expensive $20 bill and a good but cheap $20 bill. Cash, as we say in the monetary biz, is pretty much fungible.

Why do we see a two-tiered gold market but just a single-tiered banknote market?

There are probably many reasons for this, but a big difference is the sorts of people that occupy each market. The gold market is populated by investors, the most dominant of which are large institutional investors and central banks. These big players do not want the risk of having their gold being tarnished in any way. They don't want their $50 million in gold bars to end up being fake, or subject to a court dispute, or frozen by law enforcement due to money laundering concerns. That's why the LBMA standards exist; to make gold safe for big institutional buyers.

But cash is different. Warren Buffett and Ray Dalio don't occupy this particular market. The market for coins and notes is dominated by regular people. Furthermore, banknotes are primarily used in small day-to-day retail purchases, not financial speculation. This sort of activity is not conducive to the emergence of a centralized marketing association. Cash transfers are done too quickly, and in small amounts, and by folks who don't have deep enough pockets to pay for verification.

The market for banknotes is literally everywhere (each corner store in town will accept them), whereas the market for gold tends to clump up in a certain specific physical locations. This centralization makes standardization easier.

Bitcoins are more like a gold bars than a banknotes. Let's face it, it's been ten years since bitcoin appeared on the scene and no one really use bitcoin it as money (just like they don't use gold as money). The majority of bitcoin demand is a demand to hoard the stuff for price exposure, much like the yellow metal. And like gold, the market for bitcoins has coagulated around exchanges. It's not an everywhere market, not like the market for banknotes.

So to sum up, the market for bitcoins is very much like that for gold. Given that a standardized gold market has evolved, I wouldn't be surprised to see the same happen to the bitcoin market, especially if big financial institutions start arriving.

Wednesday, August 26, 2020

18 things about Tether stablecoins


Before I start my list, a bit of introduction.

Tether is a stablecoin. It happens to be the most popular stablecoin in the world.

A stablecoin is a digital IOU that is implemented on a blockchain. In Tether's case, it takes the form of a U.S. dollar-denominated IOU implemented on the Ethereum blockchain. Tether holds U.S. dollars in a traditional bank account. It issues digital blockchain-based Tethers that are convertible into those bank account dollars at a 1:1 rate. This promise is what stabilizes them. And so a user can send some Tethers to another Tether user, say as payment, and neither party need worry about bitcoin-style price disruption.

If you didn't understand any of that, think of Tether as basically PayPal, except on a decentralized database instead of a centralized one.

Thoughts, facts, questions, and interesting tidbits in no particular order:


1. According to Coin Metrics, a financial data provider, Tether is now doing around $3.3 billion per day in transfer value. It just flipped bitcoin's daily volume of $2.94 billion.

2. PayPal did $222 billion in total payment volume last quarter. That's around $2.47 billion per day. So Tether at $2.94 billion is moving more value each day along its network than PayPal is (!).

3. There is a popular theory in the cryptocurrency community that expansions in the supply of Tether are being used to manipulate the price of bitcoin. I don't subscribe to this theory. It strikes me as far-fetched, much like the theories about gold price suppression.

4. U.S. citizens and residents are prohibited from using Tether's version the U.S. dollar (with one small exception).

Tether legal disclaimer [source]

5. Does anyone know who regulates Tether? (Yes, Tether Limited is regulated by the U.S's FinCEN. But who regulates Tether International Limited? Its terms of service says that it is based in the British Virgin Islands. But a search of the BVI's Financial Services Commission doesn't indicate that Tether International Limited has been registered as a money services business.)

6. According to a report by Chainalysis, a blockchain analytics company, Tether is probably being used to evade Chinese capital controls. Chainalysis estimates that $50 million Tethers leave East Asia each day.

7. One reason Tether is popular is because it doesn't collect information about ~99% of those who deal in Tethers. It only does due diligence on the minority who want to cash-out of Tethers (i.e. withdraw Tether dollars in a bank account) or cash-in to them (i.e. deposit dollars into Tethers via a bank account). So if you are content to just accept them and then pass them on, Tether shrugs. This makes Tether stablecoins an incredibly hands-off way to interact with digital U.S. dollars. (By the way, almost all stablecoin issuers adopt the same unknown-wallet-to-uknown-wallet policy as Tether.)

8. In its recent report on "so-called" stablecoins, the so-called Financial Action Task Force hinted that stablecoins must abide by the same diligence requirements as a bank. So I doubt that Tether's "hands-off" policy can last much longer.

9. This hands-offness attracts unsavory users. I've written before about MMM BSC, a global ponzi game that uses PAX stablecoins. (PAX is a smaller stablecoin). According to Coinmetrics, Tether stablecoins on Tron (a blockchain platform) are often used for "dividend schemes." However, I have not run across a single ransomware operator that uses Tether for ransom payments. Bitcoin (and to a lesser extent Monero) still dominate the ransom market.

10. Tether freezes a lot of addresses, according to Eric Wall. More than any other stablecoin.

11. I have never used Tether. (For the sake of experimentation I have tried PAX, a smaller U.S. dollar stablecoin).

12. The collapse of global interest rates since COVID-19's arrival has helped popularize stablecoins. A Tether stablecoin yields 0%. So post-collapse they have become more competitive with dollars in a bank account. Ironically, the collapse in rates also hurts stablecoin issuers. Issuers can't make as much interest on the reserves they hold to back their stablecoins. (More here).

13. Tether was initially launched as RealCoin in July 2014. It rebranded later that year. I speculated about the emergence of Tether-like instruments in 2013. I didn't call them stablecoins. I called them stable-value cryptocoins and stable-value crypto-currency. (Forgive my self-promotion).

I believe it was Vitalik Buterin who coined the term stablecoins?

14. The popularity of Tether hints at the dominance of the U.S. dollar. No one seems to be using euro, yen, or yuan stablecoins.

15. There are currently $13 billion worth of Tethers in circulation. There are currently around $31 billion PayPal dollars in existence (PayPal refers to these balances as "Funds payable and amounts due to customers").

PayPal Q2 2012 report [link]

16. Tether can't be used in... Singapore? (Also Cuba, North Korea, Iran, Syria, Venezuela, Crimea). Anyone know why?

17. It's common knowledge that the dollar-denominated assets that Tether holds to back Tether stablecoins are questionable. Shenanigans have occurred. (I wouldn't touch them. I wouldn't want family touching them.) But people still hold Tethers and deal in them. Why? Many institutions and trading outfits use Tethers as a bridging mechanism for arbitraging the price of cryptocurrencies across various exchanges. Given that Tether is their preferred medium for this, it speaks to the poor level of due diligence in the industry. It also speaks to the network effects enjoyed by first movers. So-called sophisticated crypto traders are using dodgy Tethers rather than safer but newer stablecoins because much of the liquidity has already attached itself to Tether. 

18. A big part of the cryptocurrency trading universe is denominated in Tethers, not actual U.S. dollars. So if Tether starts to collapse, cryptocurrency prices would actually hyperinflate. (Real cryptocurrency prices wouldn't budge.)

19. Tether has co-opted the unicode currency symbol for the Mongolian tugrik, ₮.

Feel free to add your own factoids in the comments.

Friday, August 21, 2020

The case for banning gold mining

The Kalgoorlie Super Pit Mine in Australia

Does the world need gold mining?

Let's think about what a world without farming look like. If all farming came to a stop, we'd soon use up all of our inventories of wheat, soy, rice, and vegetables. Mass starvation would rapidly ensue. A world without crude oil production wouldn't be much better. We have plenty of the stuff above-ground. But since oil products are destroyed in usage, we'd run out pretty quick. Society would grind to a halt.

But if gold mining were to suddenly stop, nothing bad would happen.

The unique thing about gold is that it doesn't get used up. The main way we consume the yellow metal is by storing it, say in vaults or by wearing it as jewellery. Compared to how we use an industrial metal like copper, this sort of usage is very safe. Copper parts in machinery, for instance, are dissipated by abrasion and wear. But gold just sits there, untouched.

Nor does gold depreciate. Unlike most materials, it is almost indestructible. Copper corrodes, steel rusts, wood rots, and concrete crumbles. But a gold coin from 200BC is still perfectly lustrous.

Nor does the yellow metal suffer from technological obsolescence. Gold keeps doing the same thing it has done for thousands of years.

And obviously we don't eat the stuff.

The upshot of all of this is that most of the gold that has ever been mined continues to exist in the form of bullion or jewellery. The World Gold Council estimates this amount to be around 190,000 tonnes. This above-ground stock of the metal dwarfs the amount of new mine production, which runs around 3,000 tonnes per year.

Were this 3,000 tonne trickle were to come to an end, we'd still have plenty of the yellow metal to meet our needs. The existing stock of gold is incredibly flexible and can repurposed into whatever form we want. Gold fillings can be melted down to mint coins, which can be recycled to produce circuits. Circuitry can be melted down to form bars, which can be melted down to gold fillings.

There is a second reason why we don't need new gold mining.

Our demand for most things is defined in terms of physical units. But our demand for gold is expressed in terms of dollars.

Let me give a better explanation for this difference. To make breakfast for a gathering of friends, say that I plan to get a package of bacon, a dozen eggs, and a litre of milk. When I arrive at the grocery store I discover that the price for these things is higher than I thought, and I can't afford everything on my list. It'll be a disappointing breakfast for my friends.

But our demand for gold is different. Say that I want to buy some gold to hold in a vault. It doesn't make a difference to me that the price is higher than I planned for. If the price is $1000, I'll buy 1 ounce. If it's risen to $2000 I'll buy 0.5 ounces. Either way I end up with the same $1000 worth of gold. I'm perfectly indifferent between these two states of the world.

Because our demand for gold is expressed in dollar amounts, there can never be a shortage of the stuff. If everyone on earth suddenly wakes up wanting to own twice as much gold as before, the price of gold can rise to whatever price is necessary to meet that demand. Not so with pork, or eggs, or milk. If everyone suddenly wants to eat twice as much pork, there's nothing that can satisfy that demand except for a huge ramp up in production.

So to reiterate, society doesn't need new gold mining. The stuff is virtually indestructible, and any increase in demand can be instantly satisfied by a rise in price, not new production.

By the way, I'd have a different opinion on this if we were still on a gold monetary standard. Under a gold standard, all goods & services prices are defined in terms of a fixed amount of gold. A steady stream of new gold from mines would help mute large fluctuations in the demand for gold, thus making the general level of consumer prices more stable. But ever since 1968 the gold link has been severed.

Now let's go onto the next issue. If we don't need new gold, why not just ban gold mining?

Mining imposes many costs on society. To begin with, mining is incredibly invasive. Pascua Lama, a project in Chile that has yet to be developed, originally envisioned relocating entire glaciers to get at the underlying gold formations. The Donlin mine in Alaska involves moving "one mountain to another." Clearing out mine sites destroy forests, wetlands, and displaces wildlife.

When rock is processed to retrieve gold, the uneconomic reminder, known as the tailings, must be kept in large reservoirs know as tailings ponds. Dangerous chemicals like cyanide are required to "leach" gold from rock. The breach of a tailings pond at the Mt Polley gold mine in British Columbia, Canada led to 10 million cubic metres of water contaminated with arsenic leaking into nearby lakes and rivers.

Mt Polley before and after a tailings pond leak

Earthworks, an environmental group, calculates that 20 tons of toxic waste are produced for every 0.333-ounce gold ring.

Finally, the various steps in producing gold—mining, milling, and smelting—create large amounts of green house gases, as does the associated usage of electricity to power a mine.

So to review, banning gold production won't hurt society—we don't need more of the stuff. To boot, we'd be getting rid of an activity that hurts the environment.

Yes, there are drawbacks to a ban, too.

Mining provides employment. Not only would a ban destroy the livelihood of hundreds of thousands of miners. All the related businesses that depend on the local gold mine, say restaurants or local retailers, would collapse.

To avoid mass dislocation, gold mining bans would have be carried out slowly. Perhaps existing mines could be allowed to operate until they are no longer economic, but gold prospecting, mine extensions, and new mines banned. These policies would have to be accompanied by large budgets for relocation and retraining. 

But even if dislocation could be managed, there remain other problems.

The production of drugs like cocaine is illegal, but this hasn't stopped drugs from being produced. The same applies to gold. No doubt production bans would be fairly effective in countries like Canada and the U.S., but what about Kazakhstan and Guyana?

Unfortunately, a ban on global gold mining could end up replacing relatively safe and clean gold production with dirtier and more dangerous types of mining. A small but significant chunk of global production is carried out by artisanal miners; family-run outfits that do not exist in an official capacity. Because they are small and agile, artisanal producers could more easily evade a ban. Unfortunately these black market producers are not likely to be held to the same environmental and labour standards as large multinational miners.

A ban on gold production could create a more general problem. Historically we have banned products that are dangerous to consumers, say like drugs. But in this case we'd be introducing a new set of criteria for instituting a ban; because some product serves no purpose. Maybe you think that zombie movies are a waste. Does that mean we should stop allowing producers to make new zombie films? This may be a door we don't wish to open.

So as you can see, banning gold production has merits and warts.

But in theory, the idea makes a lot of sense. If something is indestructible, and we only want dollar amounts of it rather than ounces, why the devil are we wasting time and resources producing it? As long as we can successfully shift gold mining communities to other forms of employment, then ending global gold production makes a lot of sense.

Tuesday, August 18, 2020

Bitcoin is an account, not a token



When economists talk about payments, they often make a distinction between token-based and account-based payment systems. In a recent post at the New York Fed's Liberty Street blog, Rodney Garratt & cowriters argue that new payments technologies like bitcoin and central bank digital currency may not fit into these traditional categories. Perhaps it's time for a reorg?

In an account-based system, some sort of database stores account information. For a payment to occur across this database the payer needs to prove that they own a spot in that database, and that this spot has sufficient funds.

With a token-based system there is no database. Instead, objects are used to pay (say banknotes or gold coins). The key feature of a token-based system is that the recipient must verify that the object is valid and not counterfeit.

In short, tokens involve identifying the object. Accounts involve identifying the individual.

Garratt et al argue that a digital currency such as bitcoin is a mix of the two, token and account. Bitcoin is an account-based system because some sort of "proof of identity," specifically a private key, is needed to transact. This puts bitcoin in the same category as a bank account, which also has a process for verifying the identity of users. (Instead of public key cryptography, bank customers must go through a due diligence process, and after that must produce a PIN.)

I think Garratt et al are right about bitcoin being an account-based system. But I don't think that bitcoin also qualifies as a token-based system.

Not a token

A token is an object. And objects can be counterfeited. That's why when Alice pays Bob a $20 note, Bob is responsible for carefully checking it.

Account-based systems don't suffer from counterfeiting problems. It's impossible for a Alice to pay Bob with fake dollars from her Wells Fargo account. Wells Fargo dollars aren't independent objects in the same way that banknotes are. They are entries in a well-secured database. The same goes for bitcoins. There is no way for Alice to make a fake bitcoin entry and send it to Bob.

In addition to counterfeitability, I'd argue that another key feature of a token is that it can be lost by one person, found by another, and then reused for payment. If Bob loses either his $20 banknote or his gold Krugerrand, Alice can find them and spend them.

But account-based systems don't have this feature. Wells Fargo dollars are database entries. It'd be impossible for Alice to lose a Wells Fargo database entry or Bob to find one and reuse it. And the same goes for bitcoins. Alice can't lose 0.2234 bitcoins, nor can Bob find Alice's 0.2234 bitcoins.

Gift cards: account or token?

What about gift cards, say like those iTunes cards that they sell at pharmacies?

Because gift cards come in physical form they may seem like tokens. But the card is just one element in an account-based system. A $20 iTunes balance exists in a database run by the gift card system operator, Apple. Whereas a $20 banknote can be used without the authorization of the central bank, an iTunes card has to be granted permission before it can initiate purchase. If the database entry to which an iTunes card is linked is empty, then a payment will be denied.

Like other account-based systems, counterfeiting isn't a problem with gift cards. Database entries can't be produced with an inkjet printer. (Sure, an iTunes card can be lost and reused by the finder. And so it seems like it should be classified as a token. But that's only because the "key word" or "password" is literally baked onto the card. Losing an iTunes card is like losing one's private bitcoin key.)

Bitcoins and gift cards can be turned into tokens

There is an interesting situation in which gift cards or bitcoins can be converted from account-based systems into token-based systems.

Instead of using her $20 banknote to pay Bob, Alice may choose to pay Bob by passing him a $20 iTunes card. Or maybe she gives him a physical Opendime hardware wallet that holds $20 in bitcoin. Bob could in turn pass these devices on to Charlie, to whom he owes $20, and Charlie on to Dave, etc.


In both cases, accounts are being repurposed as tokens. What is happening is the physical object, or key, that provides access to underlying bitcoin or gift card database entries is being moved from one person to another. But the actual database entries to which the Opendime and iTunes card are linked are not being updated.

Bob will have to treat both of these proffered instruments like cash. He'd be worried about counterfeits, and would want to verify that neither the gift card nor the Opendime device are fake.

Let's vizualize all of this into a table:


The table suggests that bitcoin exists in a totally different category than a banknote (unless those bitcoins are embodied in the form of an Opendime device). You'll also notice that the table differentiates between open accounts and closed ones. Let's get into that next...

Bitcoin and Wells Fargo are different types of accounts-based systems

If bitcoin qualifies as an account-based system, it is certainly different from Wells Fargo's system. I'd argue that Wells Fargo operates a "closed account" system while Bitcoin functions as an "open account" system. The key feature of an open system is that anyone can get an account. As Jerry Brito would put it, they are permissionless. A passport or driver's license isn't required to gain access, so even fraudsters can climb aboard.

Gift cards, non-reloadable prepaid cards (like Vanilla cards), and e-gold (a 1990-2000s era payments system that didn't require people to use real names) are also open account systems. Anyone can self-initiate account opening and start to make payments. No one gets kicked off. (We could further differentiate between centralized and decentralized open account systems, with gift cards being the former and bitcoin the latter.)

What qualifies something as a closed account system is that not just anyone can get access. Want to use a Wells Fargo account for making payments? You'll have to make it through Wells Fargo's application process, which involves giving up plenty of personal information. And only when a Wells Fargo employee has opened an account can payments be made.

Turning bitcoins, gold, and cash into closed account systems

Incidentally, it's also possible to convert tokens and open accounts into closed accounts. The London Bullion Market Association (LBMA) manages a walled garden of gold bars. Each bar is carefully vetted prior to entry into the system, and once in the system all movements are tracked by monitoring serial numbers. LMBA gold has ceased to be a token and has become a closed account. (I recently wrote about the LBMA system for Coindesk.)

Central bans could do the same with cash. They could set up an online bank note registry, and all cash users would be required to sign-up and record the serial numbers of note each time they receive a new one.

As for bitcoin, many people already keep their bitcoin in at regulated services like Coinbase that require customer ID. One day it may only be possible to send bitcoins from one regulated service to another, in which case a big chunk of the Bitcoin network will have become a closed account system, not an open one.

Why does all this matter?

Specialists need to be able to have conversations about their subject matter. Categorization is one of the ways to make these conversations flow without chaos. Are the categories we use for conversing on the topic of the economics of payments still sufficient? The world has changed. We've got new entrants like bitcoin and central bank digital currency. Garratt et al suggest that aging categories can "slow down progress in understanding intrinsic differences between the growing set of digital payment options and technologies."

But this case I think the old taxonomy are still useful, albeit with some tweaks.



P.S. Lawyers, regulators, users, and developers will all have different taxonomies for payments. Inter-taxonomic conversations are difficult, since a single term can mean something totally different. So stay within your taxonomy to avoid confusion.

Friday, July 31, 2020

How the pandemic has clogged the global economy with paper currency


The outbreak of Covid-19 has caused a global increase in the amount of cash in the economy. I think I've got a pretty neat explanation for why.

But before I tell you what it is, let me show what the cash build-up looks like. Here's what has happened to banknotes in circulation in Canada so far in 2020:

Meanwhile, here is the US:

And here is the UK:
Each chart shows an unusual increase in banknotes in the economy starting in March or April, when the pandemic first hit western countries. These cash bulges show no signs of shrinking. And they are quite big. In the case of the U.S., I'd estimate that there are $150 billion extra paper dollars in circulation thanks to the virus.

I recently came up with a surprising explanation for why this is happening. But before we get to it, we need to review what determines the amount of cash held in the economy. Here's an analogy. Think about how the water level in a reservoir might rise. There are two ways this can happen. More water can run into the reservoir, or less water can flow out. (Conversely, the water level can fall when either less water enters, or more is withdrawn.)

The same principle applies to the amount of cash held in the economy. If more people are taking cash out from ATMs and banks then the amount of cash in the economy will grow. But the amount of banknotes in the economy can also grow without a rise in withdrawals. That can happen when the public (i.e. individuals & businesses) returns less of the stuff than before to ATMs and banks. So more of it stays floating around in the economy.

Now, I must confess that in previous blog posts and tweets I had assumed that the big increase in cash-in-circulation during the pandemic was due to an increase in withdrawals. People were worried about the virus, I thought, so they wanted to take more banknotes out of their bank accounts and hold it under their mattresses. "Cash restocking makes sense in an emergency like the one we are living through," I wrote back in April. And here: "The coronavirus reminds us of the fragility in our infrastructure. And so we rebuild some of our banknote balances."

But now I think that I was wrong. The big increase in cash-in-circulation is not due to an increase in withdrawals of cash. Sure, some people are taking out a few more $50s or $100s to hold under their mattress. But with the virus shutting down the economy, most of us are making less purchases than before. The few transactions that we continue to make tend to be digital, say like buying from Amazon with a card. The net effect is that since March we have been withdrawing far less cash than normal.

If so, then why has the level of cash in the economy jumped? The only explanation is that there is much less cash being returned to banks and ATMs. Businesses and individuals simply aren't redepositing their banknotes. There's some sort of clog or blockade that is gumming up the system and preventing a regular flow of returns. I'll try and explain the precise nature of this clog, but first lets look at some data that confirms that returns of cash have dried up.

The European Central Bank (ECB) is unique. Most central banks only provide public data on the net amount of cash that is in circulation. But the ECB goes the extra step and offers data on both the flow of banknotes being issued into the economy and the flow being withdrawn from the economy. And so we can actually see which half of the equation is responsible for the big jump in cash: more withdrawals or less returns.

As you can see, Europe has seen a large and anomalous jump in cash-in-circulation in 2020, just like Canada, the US, and UK. I've charted this below:


Now let's see what the ECB's disaggregated data has to say:


In general, withdrawals of euro banknotes (the blue line) has exceeded returns (the orange line) from 2007 to 2020. That's why the amount of cash in the European economy has generally increased over time. During the 2008 credit crisis, there was a big jump in withdrawals, no doubt to worries about the safety of the banking system. But during the pandemic, cash withdrawals (blue line) have actually fallen, not increased. In fact, the level of withdrawals is at its lowest point in over a decade!

Returns of cash (orange line) have plunged by even more than withdrawals. They are at their lowest level ever!

So what does this mean? Thanks to the pandemic, European individuals & businesses have become less interested in taking cash out of the bank. But they are even less interested in returning cash to the bank. It is this outsized collapse in returns, the orange line, that is causing the big build-up in euro banknotes in circulation.

For those who like analogies, let's revisit our reservoir imagery for a moment. The amount of water (i.e. cash) flowing into the reservoir (i.e. the economy) has slowed to a trickle. Normally this trickle would lead to a fall in the water level. But because even fewer people are removing water (i.e. doing cash returns) from the reservoir, the incoming trickle is sufficient to push the water level higher.

I think there's a good chance that what is happening in Europe is happening in the U.S., Canada, and U.K. too. Thanks to the virus, no one is redepositing their banknotes. But I'd have to see the data to be sure.

Now we can finally get to my theory for what is clogging up the system. The peculiar feature we need to explain is people are so much less willing (or able) to return their notes during the pandemic than they are willing to withdraw them. Or put differently, why did the orange line fall so much more dramatically than the blue line did? It suggests some sort of asymmetry in people's usage of cash. My theory is that this asymmetry can be found in the nature of the black market, illegal drug markets, the mob, the underground economy, etc.

The specific asymmetry is this: it is quite easy for a drug buyer to withdraw $200 from an ATM to buy heroin or cocaine. Banks don't surveil people who are taking out cash. But it is far more complicated for a drug seller to redeposit that $200. Redeposits are surveiled. To get banknotes back into the system a crook has to launder them, say be sneakily mixing the drug money with legitimate cash earned by cooperating cash-intensive businesses like restaurants, casinos, or cornerstores.

Let's work through how this specific asymmetry has collided with the pandemic. It's unlikely that drug users have stopped buying drugs during the pandemic. (Maybe people are buying even more drugs? Thanks to shut downs, there's not much to do!) So the flow of cash from a drug users' ATMs to a drug dealers' pockets has not slowed at all during the pandemic.

But the network of restaurants and other businesses that drug dealers rely on to launder their funds have all shut down thanks to virus fears and lockdowns. These closures would have put drug dealers, crooks, the mob, etc. in a tough position. Throughout the pandemic they have been accumulating ever more cash from drug using customers, with no place to offload it.

So to sum up, the big increase in cash in the economies of Canada, Europe, US, and the UK is probably being driven by an unwanted accumulation of cash by crooks. Their regular money laundering arrangements aren't functioning.

I don't have any personal experience with being a criminal. But it's fun to speculate about what their lives have been like during the pandemic. The Tony Sopranos, Walter Whites, and Stringer Bells of the world are currently scrambling around for safe places to store their ever burgeoning stores of physical cash. In their houses, at a warehouse storage unit, or at a bank.

And since they can't convert their cash hoards into spendable money in a bank account, I'd imagine these crooks are having problems paying legitimate bills like mortgage payments and the cost of sending their kids to posh schools. With criminal enterprise handling so much extra cash, I'd also imagine that law enforcement agencies are seizing record amounts of cash via civil forfeiture. We could also be seeing a big jump in gang warfare as competing drug outfits raid each other for cash. To recover all of these extra costs of doing business, criminals are probably jacking up drug prices. Yep, I'd imagine it's not an easy time to be a criminal.

As the pandemic subsides and restaurants and other confederate businesses start to open, criminals will be able to restart their money laundering operations. But they won't be able to return their entire accumulated hoard at once. If they were to do so, the cash receipts of the businesses they are using for laundering would stick out, potentially drawing the attention of the tax authority and law enforcement. No, they'll have to slowly reintroduce their dirty money.

Which means the big global jump in banknotes that I illustrated in my first set of charts will take much longer to be worked off than it was accumulated.



PS: I wonder if we can get some other good insights from the data, specifically about the size of the underground economy. Looking at my topmost chart, I'd estimate that the amount of cash in the Canadian economy is about $6 billion higher than it would otherwise be. Let's say that this bulge is entirely due to criminals being unable to launder their drug proceeds. We know Canada has 32 million adults. So Canadians have spent $6 billion on illegal drugs since the pandemic began, or around $200 per adult. That's about $12 billion a year. Seems reasonable, no? (Yes, I am making a load of assumptions here.)  

Tuesday, July 21, 2020

Pennies as state failure


We can all think of examples of state failure. The most obvious include the inability to protect citizens from criminals, failure to provide drinkable water, and incapacity to cope with a public health crisis like COVID-19. I would argue that the ongoing existence of the penny within a nation's borders is another example of state failure.

The poster child for this particular example of state failure is the U.S. and its Lincoln penny. Many (though not all) developed nations have already rid themselves of their lowest denomination coin. (Well-run New Zealand has managed to cancel two of them, the penny in 1989 and the nickel in 2006!) My own country, Canada, was a disappointing failure on this front. But in 2012 we worked up our resolve and put an end to our orange one-cent discs.

In this post I'm going to explore why this particular example of state failure continues to plague the U.S. 

But first, let me make the argument for why pennies constitute a failure of the state.

Any government that still provides pennies is hurting its citizens

Most examples of state failure occur when the government doesn't provide a service or poorly provides one. In the case of the penny, the U.S. Mint, is ably providing us with a service, pennies. But this particular service is a frivolous one, sort of like offering free high fives or back slaps.

Actually, it's worse than silly. Pennies impose a tiny burden on each given individual. But when summed up across the entire population, each of those tiny burdens becomes a huge societal inconvenience. 

Let's take a moment to explore the penny supply chain. The U.S. Mint allocates a large chunk of its manpower and resources to producing pennies, as if these precious little discs were some sort of vital national service. Of the 4.9 billion coins the Mint has produced in 2020, 55% have been pennies.

Fresh pennies then get transported to banks. Stores dutifully buy the tiny discs from banks so that they can give them out as change to customers. But pennies are of too little value to be of any use to us shoppers. We mostly throw them in the garbage or forget them in jars. The conscientious among us redeposit them into the system using Coinstar machines or at the bank. This penny charade goes on and on and on, every hour of the day.

It's a costly charade. The U.S. Mint expends 1.6 cents for each penny it produces. But that's only a small part of the waste. Large quantities of time and resources are expended by all of us—banks, shops, transport companies, consumers—in moving pennies, storing them, counting them, sorting them, and moving them again.

Get rid of the penny and this whole charade ends. Everyone can stop pretending they are providing and/or enjoying an important public service.

So why hasn't the U.S. managed to exorcise itself of the penny? There are two theories. The most popular one is corporate capture. I'll explore that one first. My own personal theory, which I'll get into after, is American monetary populism. This populism gets in the way of the most basic of monetary reforms. (The two theories aren't mutually exclusive.)

The corporate capture theory of the penny

If you explore the oral history of the penny, you quickly learn about the penny lobby. Tennessee-based Jarden Zinc Products (recently rebranded as ARTAZN) is one of the largest producers of coin blanks in the world. Jarden is owned by One Rock Capital Partners, a private equity firm. Its main customer is the U.S. Mint, which buys and converts Jarden's zinc blanks into pennies.

We can dig into the U.S. Mint's financial statements get a good idea how much Jarden earns from the penny. In 2019 the U.S. Mint's costs of goods sold for pennies came out to around $124.9 million (2018: $145.7 million). I get that from the Mint's 2019 Annual Report (see screenshot below with yellow highlights). As the sole supplier of one-cent blanks to the Mint, Jarden Zinc Products gets most (if not all) of this $124 million stream of income. That's a big contract!

Source: US Mint 2019 Annual Report

Jarden has spent decades lobbying Congress to keep the penny in circulation. Below are its annual lobbying expenses going back to 2006, which I get from OpenSecrets. As you can see, Jarden paid its lobbyist, one Mark Weller, $120,000 in 2019. So far it has paid him $50,000 in 2002 2020. That doesn't seem like a bad investment if you want to protect a $124 million revenue stream.

Data from OpenSecrets

Below I've screenshotted a list of all the issues that Mark Weller has addressed in the first quarter of 2020 on behalf of Jarden. Most glaringly, he lobbied the Senate, Treasury, and House of Representatives on "issues related to the one cent coin." This issue consistently appears in each quarterly lobbying report going back to as early as 2009.

Another interesting item on Jarden's list of issues is the Payment Choice Act of 2019, which if passed would oblige retailers to always accept cash. No doubt Jarden is a big supporter of this particular bit of legislation; millions of retailers and banks would be forced to continue stocking one-cent coins, and that would mean more profit for Jarden shareholders.

Lobbying activity for Jarden Zinc in the first quarter of 2020. Data from OpenSecrets.

Nor is Jarden the only corporate culprit.

Coinstar, the company which provides Americans with ubiquitous coin-cashing machines, also benefits from the penny. Earlier this year Coinstar lobbied the government on both the Payment Choice Act of 2019 and the Cash Always Should be Honored Act, or CASH Act, which would make it unlawful for any physical retail establishment to refuse to accept cash as payment. Coinstar also regularly lobbies law makers on "issues related to minting and coinage." I'm going to assume this has something to do with keeping the penny and nickel in circulation, and perhaps converting the paper dollar into a coin. (Note that Coinstar's corporate name was changed to Outerwall in 2013).

Below is a chart showing how much Outerwall (i.e. Coinstar) has paid to its lobbyist going back to 2014.

Coinstar is owned by Outerwall Inc. Data is from Opensecrets

So according to the corporate capture theory, companies like Jarden Zinc Products and Coinstar have managed to twist the legislative process to serve their own agenda.

I should point out that a counter-lobby exists. Citizens to Retire the Penny is an anti-penny group run by MIT physics professor Jeff Gore. Here is its website. But according to the corporate capture theory of the penny, heroes like Gore lack the resources and expertise to out-muscle a slick Washington lobbyist like Mark Weller. The set of groups who are harmed by the penny—banks, citizens, shops—are too diffuse to provide much of a push-back.  And thus the final result is state failure. The U.S. citizenry is being mis-served by its penny-issuing government.

Just because I've shown numbers proving the existence of the penny lobby doesn't mean that the U.S.'s failure to remove the penny is necessarily a result of lobbying. We need more to complete the picture.

After all, we also have lobbyists up here in Canada. And we Canadians still managed to get rid of the penny. Australia, New Zealand, and Singapore also have lobbyists, but none of those fine countries have pennies anymore. To complete the story we need to be able to show that U.S. policy makers are more beholden to special interests than policy makers in other countries. And if so, that would explain why the U.S. is stuck with its orange burden, but the rest of us aren't. But I'm not an expert on differences in national lobbying, so I'll defer on this topic. Anyone have any good insights into this?

Now let's get to our second theory: monetary populism.

The monetary populist theory of the penny

I've spent about ten years writing about both the Canadian and U.S. monetary systems. And one of the consistent differences between the two countries is that Americans of all backgrounds have strong opinions about monetary issues. We Canadians generally don't express much interest on the topic of money and central banking.

I think it's great that Americans get so involved in these issues. Americans are critical and curious and want to know what their central bank, the Federal Reserve, is up to. Canadians' lack of engagement sometimes worries me. To ensure that institutions like the Bank of Canada are serving Canadians, we need to be constantly auditing and debating everything that they do.

Let me offer an anecdote. During the 2007-08 credit crisis I was indirectly involved in the Bank of Canada Act being updated. To help cope with the credit crisis, it was deemed that the Bank of Canada needed to be able to buy a wider range of securities than the law permitted it to. Even though Canada had a minority government at the time, the requisite legislation was quickly shepherded through various committees and then onto the floor of Parliament. Voila, with almost no fuss the Bank of Canada Act was updated and the Bank could buy more assets. I recall press coverage being minimal.

The same process in the U.S. would have attracted massive amounts of press coverage. Think tanks from all parts of the spectrum would have chimed in. The political sniping between Republicans and Democrats would have been loud and vigorous.

If Americans hold a wide range of views on monetary issues, many of these views are anti-establishment. I'm thinking the End the Fed movement in particular. (There is no equivalent End the Bank of Canada movement.) We Canadians tend to be more trusting of our monetary institutions and the elites that run them.

But American skepticism about monetary institutions often slides into knee-jerk conspiracy theories. And that's where I prefer wishy-washy Canadians and their lack of engagement. Whereas there are umpteen U.S. monetary conspiracy theories, there are almost no Canadian ones.

For instance, American monetary conspiracy theorists are currently wildly excited about the national coin shortage. Due to a number of reasons (which I go into here, and Will Luther explores here) there are not enough coins to meet public demand. This shortage is temporary and unplanned. But American monetary conspiracy theorists have reworked this incident into some sort of coordinated effort by the powers-that-be to force Americans onto a cashless digital dollar and ultimately, into subservience to a one world government.

Here is Twitter:  

And here is Facebook:

Source

Or here. I could provide many more examples. The coin shortage conspiracy theory has gone viral.

And so now I can finish off my theory. A society with a broad range of opinions about the monetary system (many of which are erroneous conspiracies and lies) is going to be much harder to change than a society that is neutral or uninterested about the monetary system. In the U.S., a fix as simple and smart as removing the penny will inevitably be misinterpreted (often willfully so) by crowds of monetary populists. And so any wise bureaucrat or legislator who wants to remove the penny will have to expend huge amounts of extra time combating misinformation. So maybe they won't bother.

And thus the state has failed Americans, and they are stuck with the penny. But we trusting (and perhaps naive) Canadians have been saved.



PS: In writing this I forgot to mention my last theory for the U.S. penny. American monetary experts tend to be inward-looking. Foreign monetary experts tend to be much more outward-looking. That is, an American analyst will generally know a lot about the Federal Reserve, but not much about the rest of the world's monetary institutions. But a foreign expert will generally be much more bilingual with respect to monetary systems. As a Canadian, for instance, I'm forced to know a lot about both my own monetary institutions and a list of American ones. A Swede monetary analyst is likely to be trilingual: comfortable with the Riksbank (Sweden's central bank), the European Central Bank, and the U.S. Federal Reserve. 

I worry that this inwardness leads to an incapacity on the part of the U.S. to learn from the successes of other monetary systems. The following nations have rid themselves of their lowest monetary unit: Canada, Australia, New Zealand, Switzerland, Singapore, Finland, Netherlands, Italy, Belgium, Ireland, Sweden, Norway, and more. That's a lot of playbooks to draw from. But many Americans won't know about this--they're too focused on themselves.

Friday, July 10, 2020

Bitcoin is more like ham radio than the early internet


People in the bitcoin community often make fun of me as a nocoiner. That is, I don't have any bitcoins and am vocal about that fact. (Neither of which is true, by the way).

The truth is that I have no problem with bitcoin. It is a solid protocol that has survived handily for eleven years. When I come off as being critical, it's usually because I'm attacking the various narratives, or fan fictions, that have sprung up around bitcoin. Don't get me wrong, all movements rely on some sort of internal mythology to help drive their progress. Bitcoin is no different in this respect. But there is a big difference between accurate self-perception and fantasy.

Bitcoin's wrongest narratives are its triumphal ones. Most of them paint bitcoin as some sort of heir apparent, waiting on the wings to inevitably replace regular money: Bitcoin is the internet in 1991, just on the cusp of mass adoption... Bitcoin is email... Hyperbitcoinization is one year away... Bitcoin as monetary revolution...etc. I'm sure you've run into these proclamations.

No, bitcoin isn't going to become a mainstream kind of money. It's too awkward for most people. Crazy price gyrations are far too wicked for the regular money-using public to tolerate.

Nor should bitcoiners want bitcoin to go mainstream.

If five years from now everyone in the world has become a bitcoin user, that could only be because something very very bad has happened to the regular monetary system. Perhaps hostile aliens have enslaved us and are using the payments system to control what we can buy, sort of like Margaret Atwood's Compucounts in her dystopic Handmaid's Tale. And so bitcoin has gone mainstream, but only because we have all been forced to become under-the-table bitcoin users in order to buy stuff we need.

Surely no bitcoiner would actually want such a dark future.

I think the ham radio community provides bitcoiners with fertile ground for cultural appropriation. As I suggest in my recent Coindesk article, Bitcoin and ham radio are quite similar. They are both clunky and old-fangled. Neither technology is particularly easy to use relative to more mainstream options: ham radio's user experience is trumped by Whatsapp's, and Zelle is smoother to use than bitcoin. Go to Youtube an you'll find thousands of videos explaining how each technology works.

The very feature that makes both ham and bitcoin so confusing is also its strength. They are both decentralized. That is, neither relies on a single omnipresent service provider. Rather, the actual user is 100% in charge of operating the tool. No account necessary. This lack of a gate keeper means that there is no one to soften the user experience. It also means that no one can be excluded from broadcasting a radio message, or transferring some bitcoins. That's a neat feature.

The ham radio community seems to be quite comfortable with its nicheness. Ham radio operators don't huddle together and talk about "overthrowing the totalitarian system of smart phones" or "displacing evil email." There is no ham radio fixes this meme on twitter.

And no wonder. If ham radio were to have gone mainstream by 2025, it would only be because some sort of massive natural disaster, say a meteor strike, has crippled all other forms of communication. No sane ham radio operator would wish this sort of doom scenario on the world.

When I was researching my Coindesk piece, I learned that there is a large community service element to ham radio. Hurricanes and other natural disaster often knock out cell phones and 911 call centres. As a robust decentralized communications network, independent ham radio operators become first responders. They locate desperate people and relay their needs on to emergency care providers. For instance, in the image below ham radio aficionado Josh Nass aka KI6NAZ is doing rounds of his neighborhood to see if any families have been knocked out by a (mock) disaster.

Source: Youtube

I really liked the ethos that Josh stands for. It's warm and cuddly and heroic. There also seems to be a good dose of humility among ham radio operators. The community thinks of itself as a group of civic-minded hobbyists, not revolutionaries on the cusp of tearing down the system.

Perhaps bitcoiners can learn from this. A hobbyist mentality is required to learn all the obscure things one must do with one's bitcoins: how to custody one's own keys, make bitcoin transactions, run a node, and set up Lightning. Between kids and jobs, most people won't have the time. Or maybe we're just lazy. When the regular monetary & payments system is compromised, say Visa or Zelle or Swish have gone down, perhaps these bitcoin hobbyists—like their ham radio cousins—can leap into action and help others by enabling them to route transactions around the blockages.

Better this sort of narrative than to be fooled by fantasies saying that bitcoin is destined to rule the world. In the long run, bad narratives lead to disillusionment, and disillusionment kills a movement.

To sum up, bitcoin isn't the next email. It seems more akin to ham radio, a civic-minded and wonkish hobby that comfortably exists alongside its more mainstream centralized cousins. When the regular payments system suffers from a rare interruption, that's bitcoin's turn in the spotlight. But when regular service is restored, it becomes a hobby again. And that's fine.

Monday, June 29, 2020

Is fiat money to blame for the Iraq war, police brutality, and the war on drugs?

I often encounter memes claiming that fiat money is to blame for all sorts of government evils. Here is one example from Kraken bitcoin strategist spokesperson & bitcoin meme factory Pierre Rochard:

The rough idea behind this family of memes is that the Federal Reserve, the world's largest producer of "fiat" money (i.e. irredeemable banknotes), is responsible for financing all sorts of examples of government over-reach, say foreign invasions, police brutality, and the twin wars on terrorism and drugs. It does so by producing seigniorage, or profit, which it passes on to the state. Replace fiat-issuing central banks like the Fed with bitcoin or a gold standard, and seigniorage would cease to exist. With the government's purse strings having been cut, a relatively peaceful society would be the result.

This meme's premise is wrong. In practice, central bank seigniorage in both the U.S. and other developed nations is a very small part of overall  government revenues. And so even if fiat money were to be displaced, say by bitcoin or a gold standard, it wouldn't change the state's ability to fund the war on drugs and adventures in the Middle East.

Let's look at the U.S. Below are two charts showing how much income the Federal Reserve has contributed to the Federal government's overall receipts going back to 1950. (Beware. One chart relies on a regular axis, another a logarithmic axis. But they use the same data). The Fed's contribution has been steadily growing over time. In 2019, it sent about $53 billion to the Federal government.


You may be wondering how the Fed generated $53 billion in profit, or seigniorage, in 2019. Most of this income comes from issuing banknotes, or cash. For each $1 in banknotes that it issues to the public, the Fed holds an associated $1 of bonds in its vault. These bond have typically yielded 3-4% in interest. But the Fed only pays 0% interest to the owners of its banknotes. Which means that it gets to keep the entire 3-4% flow of bond interest for itself. It forwards this income to the Federal government at the end of the year.*

Seigniorage tends to grow over time. (But not always. Below I'll show how Sweden's seigniorage has been shrinking). The larger the quantity of banknotes that the public wants to own, the more interest-yielding bonds the Fed gets to hold, which means more seigniorage. In general, banknote demand increases with economic and population growth.

Interest rates are another big driver of seigniorage. If bond interest rates rise from 4% to 8%, the Fed earns more on the bonds it owns in its vault. Banknotes continue to yield 0% throughout, so the Fed keeps the entire windfall for itself (and ultimately for the Federal government).

By the way, a big driver of nominal interest rates is inflation. If inflation is expected to double, then bond owners will require twice the interest to compensate them for inflation risk. So inflation boosts seigniorage (because it boosts the interest rate that the Fed earns on the bonds in its vaults), and deflation hurts seigniorage (because it reduces interest rates). In the chart above, the one with the logarithmic axis, you can see how the Fed's seigniorage increased during the inflationary 1970s. It flatlined from the mid-1980s to the early early 2000s, which coincides with inflation subsiding.

US seigniorage is relatively small. In addition to enjoying revenues from the Federal Reserve, the U.S. Federal government also gets money from individual and corporate income taxes, social insurance and retirement receipts, excise taxes, duties, and more. Below I've charted the relative sizes of these contributions.


As you can see, the Fed's contribution (the grey line) is a rounding error.

Below is a chart showing what percentage of total government revenue is derived from the Fed.


In 2019 the Fed contributed just 1.5% of total U.S. Federal government receipts. This contribution has hovered between 1% to 3% over the last four decades. So the meme that fiat money abetted the Iraq War, the expansion of the police state, or the U.S.'s military industrial complex is mostly hyperbole.

What about other developed nations?

The Bank of Canada provided $1.2 billion in earnings to the Canadian Federal government in 2018. But the Federal government took in $313 billion in revenues that year, which means that the Bank contributed a tiny 0.4% fraction of total revenues. The reason for the big gap between the Bank of Canada's tiny 0.4% contribution and the Fed's 1.5% contribution is the global popularity of the US$100 bill. Canadian cash doesn't enjoy a big foreign market.

I mentioned Sweden earlier. Below is a chart of seigniorage earned by the Swedish central bank, the Riksbank.

Sweden is one of the only countries in the world where banknote ownership has been falling. This de-cashification is compounded by interest rates that have fallen close to 0%. Which means that the Riksbank's bond portfolio isn't earning as much as it used to. This combination has just decimated the Riksbank's seigniorage. In 2018 its seigniorage amounted to a paltry SEK 267 million (US$29 million). This is just 0.00003% of all Swedish central government receipts.

So in sum, central banks in places like the US, Canada, and Sweden are not a big source of government funding. If you want to stop governments from engaging in bad policies like the war on terror, the war on drugs, and foreign meddling, you've got to work within the system. Vote, send letters, go to protests. Sorry, but buying bitcoin or gold in the hope that it somehow defunds these activities by displacing the Fed is not a legitimate form of protest. It's a cop-out.



P.S. By the way, I am not saying that control of the nation's money supply hasn't been used to finance wars in the past. Obviously it has. Greenbacks helped pay for the Union's war against the Confederates. Henry VIII paid for his wars by dramatically reducing the supply of silver in the English coinage.

*The Fed enjoyed a big spike in seigniorage after the 2008 credit crisis. This is because it issued a bunch of deposits to bank (known as reserves) via quantitative easing. The Fed only had to pay 0.25% interest on these reserves, but the bonds that backed them were earning 2-3%. This QE-related income has declined as the Fed has unwound QE (since reversed) and long-term interest rates have declined.

Wednesday, June 24, 2020

Banks are slow to increase rates on savings accounts, but quick to reduce them

Chase Sunset & Vine, 2012. Painting by Alex Schaefer

There is a fundamental asymmetry to banking. Banks don't like to share higher interest rates with their customers who have checking and savings accounts. But they are quick to pass off lower interest rates to us.

This asymmetry is good for bank shareholders, but bad for customers.

To illustrate this asymmetry, I'll start by showing how banks modified interest rates on savings and checking accounts as the Federal Reserve, the U.S.'s central bank, went through a long period of hiking interest rates from 2015 to 2019.

The Federal Reserve's first rate increase (from 0.25% to 0.5%) was in December 2015. It increased rates once more in 2016 and three times in 2017. But the interest rate on the average U.S. savings account and interest checking account didn't start to rise till spring 2018, two and a half years after the Fed's first rate hike.

This irked me and I tweeted about it over a year ago:

If you're like me, you'd assume some sort of direct linkage between: 1) the interest rate that the Federal Reserve pays its customers (i.e. banks) and 2) the rate that these same banks pay their customers, you and me. Just like we have a checking account at a bank, banks maintain checking accounts at the Federal Reserve. They earn interest on balances held in those accounts. This rate is known as the Fed's interest rate on reserves, or IOR. As the Fed increases the interest rate that it pays on these checking accounts, the banks earn more from the Fed. But for some reason the banks are slow in passing these earnings on to the public.

Although the delay in pass-through irked me, I didn't take it too seriously, figuring it was due to some sort of institutional inertia. Banks are slow monolithic beasts. If they're slow to increase rates, at least they're slow to chop them, too, right? So on net, we customers aren't any worse off over the full economic cycle.
 
But if banks are slow to increase rates, is it indeed the case that they are also slow to reduce rates? Well, the results are in. The Fed began to cut rates in mid-2019, just around the time of my initial tweet. There were another few cuts in the latter half of 2019. Then COVID-19 hit in March, and the Fed rapidly ratcheted the rate it pay banks down from 1.6% to 0.1%. Banks went from earning around $38 billion in interest on their checking accounts at the Fed (in fiscal year 2018) to almost nothing.

If banks are generally lethargically about passing on rate changes to their customers, it should have taken them three or four years to reduce rates on savings and checking accounts back to where they had started. Nope. In just a month or two, the banks obliterated all the interest rate gains that customers with savings account had enjoyed since 2018:

So no, banks aren't lethargic beasts that are universally slow to change interest rates enjoyed by savers. They seem to have a strategy of increasing rates slowly, and then reducing them rapidly. Assholes.

Note that the savings rate I am using is from the Federal Deposit Insurance Corporation's website. FDIC takes the simple average of rates paid by all insured depository institutions and branches for which data are available.

By the way, this data probably doesn't represent the experience of the minority of financial sticklers who make an effort to locate high-interest rate savings accounts at online-only banks. JP Morgan's Goldman Sachs's Marcus currently offers 1.03%, much higher than the 0.10% that the Fed pays to Goldman JP Morgan. Ally offers 1.10%. But the average savings account holder doesn't bank at these institutions. They stick to Bank of America or Wells Fargo, which both offer a measly 0.01%.

This asymmetry is not a new phenomenon. In "Sticky Deposits", Federal Reserve economists John Driscoll & Ruth Judson found that rates are "downwards-flexible and upwards-sticky."

More specifically, the authors used proprietary data from 1997 to 2007 to show that interest rates on bank accounts and other retail deposits adjust about twice as frequently during periods of falling Fed interest rates as they do in rising ones. They estimate that this sluggish pass-through from rising Fed rates to customer rates costs American consumers around $100 billion per year!

My favorite chart from Driscoll & Judson is below:

Source: Judson & Driscoll

At left, we see the number of weeks it takes for banks to decrease the rate on interest checking accounts in response to a cut in the Fed's interest rate. At right we see the converse, how long it takes increase rates in response to higher Fed rates. Decreases tend to happen quickly (the purple bars in the left chart congregate closer to zero weeks) whereas increases are slow (the purple bars in the right chart congregate close to 100 weeks).

More specifically, during Fed easing cycles, checking deposit rates are updated on average every 22 weeks, but during tightening cycles it takes an average of 50 weeks.

So what explains this asymmetry? A lack of competition perhaps? If I had to guess, I'd say low financial education and dearth of customer attention. Banks can afford to be assholes because most customers either don't understand what is happening, or don't notice.

If the banks are taking advantage of their customers' ignorance and inattention to the tune of $100 billion per year, should something be done?

One option would be to provide a government savings option that 'corrects' for this asymmetry. Like digital savings bonds. Or maybe a government prepaid debit card with a built-in savings account. These cards would offer an interest rate that is linked to the Federal Reserve's interest rate, but only available to those below a certain income ceiling.

Or what about setting statutory minimum interest rates on savings accounts? In Brazil, for instance, banks are obligated to link the rate they pay on savings accounts to the central bank's interest rate:

Or maybe it starts with education. As part of its new financial literacy drive, Ontario will teach children how to identify Canadian coins and bills and compare their values in Grade 1, saving and spending from Grade 4, how to budget starting in Grade 5, and financial planning starting in Grade 6. If the result is a more savvy population, banks may face more pressure to pass on higher interest rates.

Or maybe nothing. In which case one hopes that over time the combination of better financial technology, branchless banking, and competition from Silicon Valley will eventually result in better pass-through and more symmetry in interest rates.