How the Bank of Canada's balance sheet went from $118 billion to $440 billion in eight weeks

Ever since the coronavirus hit, the Bank of Canada's balance sheet has been exploding. In late February its assets measured just $118 billion. Eight weeks later the Bank of Canada has $440 billion in assets. That's a $320 billion jump!

To put this in context, I've charted out the Bank of Canada's assets going back to when it was founded in 1935. (Note: to make the distant past comparable to the present, the axis uses logarithmic scaling.)

The rate of increase in Bank of Canada assets far exceeds the 2008 credit crisis, the 1970s inflation, or World War II. Some Canadians may be wondering what is going on here. This blog post will offer a quick explanation. I will resist editorializing (you can poke me in the comments section for more colour) and limit myself to the facts.

We can break the $320 billion jump in assets into three components:

1) repos, or repurchase agreements
2) open market purchases of Federal government bonds
3) purchases of Treasury bills at government auctions.

Let's start with repos, or repurchase operations. Luckily, I don't have to go into much detail on this. A few weeks back Brian Romanchuk had a nice summary of the Bank of Canada's repos, which have been responsible for $185 billion of the $320 billion jump.

With a repo, the Bank of Canada temporarily purchases securities from primary dealers, and the dealers get dollars. This repo counts as one of the Bank of Canada's assets. Some time passes and the transaction is unwound. The Bank gets its dollars back while the dealers get their securities returned. The asset disappears from the Bank of Canada's balance sheet.

The idea behind repos is to provide temporary liquidity to banks and other financial institutions while protecting the Bank of Canada's financial health by taking in a suitable amount of collateral. If the repo counterparty fails, at least the Bank of Canada can seize the collateral that was left on deposit. This is the same principle that pawn shops use. The reasons for providing liquidity to banks and other financial institutions is complex, but it goes back to the lender of last resort function of centralized banking. This is a role that central banks and clearinghouses inherited back in the 1800s.

How temporary are repos? And what sort of collateral does the Bank of Canada accept? In normal times, repos are often  unwound the very next day. The Bank also offers "term repos". These typically have a duration of 1 or 3-months. The list of repo collateral during normal times is fairly limited. The Bank of Canada will only accept Federal or provincial debt. That's the safest of the safe.

But in emergencies, the Bank of Canada is allowed to extend the time span of its repos to as long as it wants. It can also expand its list of accepted collateral to include riskier stuff. Which is what it did in March 2020 as it gradually widened the types of securities it would accept to include all of the following:

Source: Bank of Canada

That's a lot of security types! (The list is much larger if you click through the above link to securities eligible for the standing liquidity facility, see here. Nope, equities are not accepted as collateral.)

As for the temporary nature of these repos, many now extend as far as two years into the future. See screenshot below:

Source: Bank of Canada

(Note that the Bank of Canada has a very specific procedure for moving from "regular" purchases to "emergency" purchases. Part of this was implemented due to its initial reaction in 2007 to the emerging credit crisis. It accidentally began to accept some types of repo collateral that were specifically prohibited by the Bank of Canada Act. The legislative changes implemented in 2008 remedied some of the problems highlighted by this episode and codified the process for going to emergency status. Yours truly was involved in this, click through the above link.)

Anyways, we've dealt with the $185 billion in repos. Now let's get into the second component of the big $320 billion jump: open market purchases of long-term government bonds, or what the Bank of Canada refers to as the Government of Canada Bond Purchase Program (GBPP). This accounts for another $50 billion or so in new assets.

Whereas a repo is temporary, an outright purchase is permanent. Some commentators have described the purchases that the GBPP is doing as "quantitative easing". But the Bank of Canada has been reticent to call it that. When it first announced the GBPP, it said that the goal was to "help address strains in the Government of Canada debt market and enhance the effectiveness of all other actions taken so far."

This is a non-standard reason. Large scale asset purchases are normally described by central bankers as an alternative tool for stimulating aggregate demand. Usually central banks use interest rate cuts to get spending going. But when interest rates are near 0% they may switch to large scale asset purchases. (The most famous of these episodes were the Federal Reserve's QE1, QE2, and QE3). But the Bank of Canada seems to be saying that its large scale purchases are meant to fix "strains" in the market for buying and selling government bonds, not to stoke the broader economy. 

Together, the GBPP and repos account for $235 billion of the $320 billion jump.

Let's deal with the last component. Another $65 or so billion in new Bank of Canada assets is comprised of purchases of government Treasury bills (T-bills). A T-bill is a short term government debt instrument, usually no more than one year. This is interesting, because here the Bank of Canada can do something a lot of central banks can't.

Most central banks can only buy up government debt in the secondary market. That is, they can only purchase government bonds or T-bills that other investors have already purchased at government auctions. The Bank of Canada doesn't face this limit. It can buy as much government bonds and T-bills as it wants in the primary market (i.e. at government securities auctions).

Since the coronavirus crisis began, the Federal government under Justin Trudeau has revved up the amount of Treasury bills that it is issuing. As the chart below illustrates, in the last two Treasury bill auctions (which now occur weekly instead of every two weeks) it has raised $35 billion each.

For its part, the Bank of Canada bought up a massive $14 billion at each of these auctions. That's 40% of the total auction. In times past, the Bank of Canada typically only bought up around 15-20% of each auction. This 15-20% allotment was typically enough to replace the T-bills that the Bank already owned and were maturing.

By moving up to a 40% allotment at each Treasury bill auction, the Bank of Canada's rate of purchases far exceeds the rate at which its existing portfolio of T-bills matures. And that's why we're seeing a huge jump in the Bank of Canada's T-bill holdings.

(So who cares whether the Bank of Canada buys government bonds/T-bills directly at government securities auctions instead of in the secondary market, as it is doing with the GBPP?  It's complicated, but part of this controversy has to do with potential threats to the independence of the central bank. But as I said at the outset, I'm resisting editorializing.)

These three components get us to $300 billion. The last $25 billion is due to other programs. I will list them below and perhaps another blogger can take these up, or I will do so in the comments section or in another blog post:

+$5 billion in Canada Mortgage Bonds
+$5 billion in purchases via the Provincial Money Market Purchase Program (PMMP)
+$1 billion in Provincial bonds
+$8 billion in bankers' acceptances via the Bankers' Acceptance Purchase Facility (BAPF)
+$2 billion in commercial paper
+$1 billion in advances

And that, folks, is how the Bank of Canada's assets grew to $440 billion in just two months.

One country, two monetary systems

I often write about odd monetary phenomena on this blog. Here's a new contender, Yemen's dual banknote system.

Yemen uses the Yemeni rial as a unit of account. As one of the poorest countries in the world, Yemen still relies mostly on banknotes to make transactions, which are issued by the Central Bank of Yemen, or CBY.

One of the convenient features of banknotes is their fungibility. This means that one banknote is perfectly interchangeable with another. For a few months now, something strange has happened to Yemen's banknotes. Old rials and new rials have ceased to be fungible. Any rial note that was printed prior to 2016 is now worth around 10% more than newer rial notes.

More generally, the entire Yemeni monetary system has split on the basis of banknote age. From a Western perspective, it would be as if every single U.S. banknote issued with a Steve Mnuchin signature on it, the current Treasury Secretary, were worth 10% less than bills signed five years ago by his predecessor Jack Lew.

Conflicts are always complicated. What follows is a short but drastically simplified explanation of how Yemen's banknote problem began.

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In 2014, the northwestern part of Yemen was taken over by rebel Houthis. They also managed to capture the capital, Sana'a. Meanwhile, an internationally-recognized government occupies the south, the port city of Aden being its capital. Very few people live in eastern Yemen.

Source: Aljazeera

The Central Bank of Yemen has always been located in the capital, Sana'a. It tried to be a neutral party between the two warring sides. This sounds like it must have been a very awkward role to play.

For instance, before the war started the central bank was responsible for paying government salaries, including the army. When the war kicked off some soldiers supported the rebels in the north while others joined the internationally-recognized government in the south. According to Mansour Rageh & coauthors, this meant that the central bank was simultaneously paying the salaries of both sides of the conflict. That's touchy.

This balancing act eventually broke down in 2016 when the internationally-recognized government forced the central bank to move to Aden. Rageh et al explain how this happened. In short, the government convinced the international community to block the Sana'a branch's access to foreign reserves. It also prevented the branch from getting new banknotes printed.
 
So by late 2016 we've got two different branches of the central bank, one controlled by the rebels and the other by the internationally-recognized government. The latter controls most monetary functions.

With the stage set, we can now start to get into the meat of why old rial notes are worth more than new ones. After the Aden branch of the CBY had established itself in 2016, one of the first things it did was order a bunch of new banknotes to be printed up by Russian note printer Goznak. These arrived in Aden in early 2017. They looked like this:

Source: Banknote News

You can see that there are some differences between the new 1000 rial note and the old one, pictured below:

Source: Banknote News

The rebels were not happy with the new notes. It's easy to guess why. Fresh money could be used to pay government fighters, not rebel fighters. This "blood money" would then cheekily flow north via trade. Since anyone who holds a banknote is by definition funding the government that issues it with a no-interest loan, the rebel north was financing its own enemies. (The technical term for this sort of financing is seigniorage).

In 2017, the rebels began to limit the ability of northern civilians to use the newly issued banknotes. This mostly affected banks and other large businesses in the northern Yemen, which were now required to avoid dealing in the new notes. Anthony Biswell of the Sana'a Center for Strategic Studies has a much weightier explanation of this transition. Do read his article if you want to learn more about this topic.

Anyways, on December 18, 2019 the rial spat crescendoed into a full out ban. The rebel government announced that everyone in the north had thirty days to turn over new notes at any of 300 agents located across the region. In return they would get an equivalent amount of old banknotes, if available, up to 100,000 rials per person. That's around US$170.

Anything above this 100,000 rial limit would have to be converted into a digital rials. These would be supplied by one of three privately provided electronic wallets. Unfortunately, Yemen has almost no digital payments infrastructure, so these balances wouldn't be of much use.

Thanks to the December 2019 ban, the price of old and new rial banknotes has completely diverged. Below is a chart from the World Bank.

Source: World Bank

We can surmise why a big gap has developed between the two types of notes. The stock of old pre-2016 banknotes is fixed. It can't grow. But the supply of new banknotes is not fixed. The Aden branch of the CBY can get Goznik to print as many notes as it wants. So the rare rials, the old ones, are worth more.

I'd expect Gresham's law to kick in, too. Gresham's law says that if a government stipulates that two payment instruments are to circulate at the same rate, but one is worth fundamentally more than the other, then the "bad" one drives out the "good". More specifically, the undervalued money will be hoarded (or exported), leaving only the overvalued one in circulation.

In Aden's case this is likely to translate into "bad" rials (the post-2016 ones) driving "good" rials (the pre-2016 notes) out of circulation. Since the Aden government treats both old and new banknotes as interchangeable, but old ones are worth more, the old ones will all be exported to the north.

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Where might all this lead? With the Sana'a branch having declared war on new notes, the Aden branch may do the opposite and try to hurt the old ones. This would involve orphaning all of its pre-2016 banknotes. That is to say, the Aden branch will demonetize them; cease accepting old notes as its liability or obligation.

But even if they were to be demonetized, orphaned rials would still circulate.

The topic of "orphaned" currency has popped up before on this blog. The Somalian central bank ceased to exist in 1991. Yet even though the Somali shilling now lacked a central bank sponsor, they continued to be used in Somalia as a medium of exchange, as recounted by Will Luther here.

A new Somali central bank has stated that it will re-adopt these old shillings and replace them with new currency. To date, this hasn't happened.

Along these same lines, even though Saddam Hussein disowned Iraqi dinars that had been printed in Switzerland, these so-called "Swiss Dinars" continued to circulate in northern Iraq. After Saddam was deposed by the Americans in 2003, the new central bank re-adopted all of the orphaned Swiss dinars.

If the Aden government is going to disown old Yemeni rials, I wouldn't expect them to remain orphaned for long. The Sana'a branch of the Central Bank of Yemen would quickly adopt them as their own obligation. At which point Yemen's unofficial two-currency system would become official. The Sana'a branch might even try to get its own version of the rial printed up. If so, it would have to rely on printers other than Goznak.

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Yemenis already face so many difficulties. The sudden emergence of a dual-currency regime only compounds their plight. Prices are a language. We become fluent in this language as we engage in our commercial habits of buying, selling, and appraising. The sudden rial split forces Yemenis to start "speaking" in two different price arrays (three if the U.S. dollar is included). It's terribly inconvenient.

There are also costs to renegotiating rial-denominated debts. If one Yemeni owes the other, are they to pay in old rials or new ones? Debtors will always prefer the debased currency, new rials, but creditors will ask for the stronger one, old rials. Somehow a decision will have to be made.

Finally, a dual currency regime means that Yemenis will be forced to convert from one type of currency to another to make payments. That means incurring fees, hassles, and waiting time.

In the west, we take fungibility for granted. To achieve monetary standardization, a big investment in technology and coordination is required. The fact that a dollar is worth the same in Los Angeles as it is in New York, or Vancouver as it is in Halifax, is worth celebrating.

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P.S. Yemen's old rials are really old. See image below. Dilapidated banknotes are a major problem. They make trade harder and allow for easier counterfeiting.

ولا شي لا تفتجعش، بياس ابو خمسين pic.twitter.com/ljMmZuTxjY

— فرانز عبدالستّار النمساوي (@DerOsterreicher) May 20, 2020

Why Fedcoin

Six years ago I wrote a blog post about Fedcoin. Fedcoin is a type of central bank digital currency, or CBDC. (I called it Fedcoin at the time, but it could be any central bank that issues it, not just the Federal Reserve.)

So why Fedcoin?

The rough idea was that it might make sense for the Federal Reserve to create a digital version of the banknotes it issues. To do so it would use a blockchain, much like the blockchains that power Ethereum or Bitcoin. Anonymous users all over the world could download Fedcoin software and run it on their computers. In the same way that anyone can use a U.S. banknote (or bitcoin), anyone could get some Fedcoins and spend them.

Why a blockchain?

Public blockchains have many well-known problems. Because they are decentralized, they rely on work-intensive methods to process transactions. This reduces the throughput they can achieve. Transactions start to lag and they system becomes unusable.

To avoid these capacity issues, people generally advocate an alternative approach to CBDC. If a central bank is going to issue digital money that regular folks can hold, best to do so by providing a basic bank account. Sort of like PayPal, except run by the Fed. It would be faster and more efficient. 

Fedcoin has some benefits that Fed PayPal doesn't, though.

Like I said earlier, Fedcoin would replicate many of the features of a banknote. The banknote system already operates in a decentralized manner. This means that it is fairly robust. If the Fed is hit by a computer virus and has to close down for two weeks, the banknote system will continue to function just fine. That's because we banknote users—individuals, businesses, banks—operate large parts of the cash system, independently of the Fed.

Fedcoin would be similarly decentralized, thanks to its blockchain. And so hopefully it would still function when disasters, hacks, and invasions knock the Fed out of action. At least, more so than a PayPal account hosted on Fed servers.

More controversially, if the U.S. is going to create a digital currency, should it should be an anonymous one?

PayPal-like accounts at the Fed aren't anonymous. I mean, the Fed could allow people to sign up anonymously. Sort of like how egold, the anonymous PayPal that operated in the 2000s, allowed pseudonymous usage. But account holders would never really know what the Fed was doing behind the scenes. Might it be tracing everyone's account activity such that it could build an accurate portrait of each user?

No, if it wants to provide anonymous payments, then the Fed probably needs to give people a means of verifying that its technology is actually doing the job.

With Fedcoin, everyone could download and run the software, poke and prod it, audit it etc. This would allow the public to confirm that no one was operating behind the curtains. What you see is what you get. Sort of like how a $100 banknote is obviously anonymous. Just pull it apart. No surveillance technology. Just cotton, ink, and a security ribbon. I doubt the Fed could provide that sort of transparency with a Fed version of PayPal.

A fully anonymous digital dollar would have some good properties. It would protect us from surveillance by governments and corporations. In a recent article for Coin Center, Matthew Green and Peter Van Valkenburgh explore how this might work.

But anonymity is no panacea.

An anonymous Fedcoin would be the perfect medium for fraudsters and extortionists. Granny extortion schemes are a big business right now. (Head over to Kitboga to see how they work). These boiler-room operations, many of which are run from India, rely on awkward payments methods like Western Union or Walmart gift cards to get granny's money.

But imagine how easy things would be for an extortionist if they could get granny to convert her $100,000 portfolio of savings bonds into sleek & anonymous Fedcoins, and then send them instantly to India.

Or take ransomware. Criminals plant a virus on a corporation's servers and then demand a ransom to free their files. Ransomware operators—most of whom operate from Russia—rely entirely on bitcoin for payment, which is illiquid, volatile, and traceable. But imagine if the criminal could get paid in anonymous digital dollars. That would make the ransom process much easier.

So as you can see, anonymity is messy. It helps good people to avoid harm. But it helps bad people evade good rules.

One way to tidy up this mess might be an anonymity tax. (In my last paper for R3, I explored this idea. And in a previous blog post, I talked about an anonymity tax on banknotes). Briefly, the Fedcoin system would be designed so that anyone can get as much anonymous money as they want, and use it however they like. But they'd have to pay for this privilege. One technique for setting a tax is to charge an hourly fee, or a negative interest rate, on anonymous balances. Another option, which I get from Ilan Benshalom, is to implement a withdrawal fee, say 5%, on anonymous Fedcoins.

By taxing anonymity, the tax revenues from Fedcoin usage might be used by the government to offset the negative effects of payments anonymity. For instance, it could be used to bolster the budgets of fraud departments at the FBI, or to compensate victims of ransomware.

But even this remedy is messy.

An anonymity tax puts regular people and criminals into the same bucket. That hardly seems fair. And it subtly ostracizes licit users of anonymous Fedcoin. We want anonymous payments to be a regular good, not something icky or tainted.

That's where I'll leave it. Sorry, no neatly wrapped and bowed conclusion. With anonymity, there are never clean options. Just kludges. Hopefully some are less kludgy than others.