Monday, April 12, 2021

The Biden stimulus and the big jump in cash

Since mid-March, the stock of U.S. banknotes has surged by $45 billion. That's a 2.1% increase in just 30-days.  

This jump surprised me (ht to David Beckworth, who brought it to my attention). That's because cash demand patterns are typically quite predictable. We always see a seasonal Christmas/New Year's rush for cash. After Christmas vacation is finished the stock of cash always falls as notes and coins are returned to banks. For the rest of the year the stock of notes slowly rises. During crisis (i.e. Y2K, 9/11, the 2008 credit crisis, and the coronavirus panic) the demand for cash spikes.

But there shouldn't be a cash surge in the middle of a quiet March.

To see how odd this spring's jump in the stock of cash is, I've plotted banknote data from the period beginning November 2020 to now and compared it to equivalent November-to-October periods from 2013-2019. (I've omitted 2020 due to coronavirus-induced oddities). To better facilitate comparison, I've set the opening banknote balance for each period to 1.

The large increase in cash beginning in mid-March 2021 goes far beyond the range set between 2013 and 2019. (Also, take a look at the strange out-of-season pattern in January. We'll get into that further down.)

Here's what I think is happening. On March 13 the Biden stimulus checks started to arrive. For the next few months around 150,000 Americans are expected to receive individual payments of $1400. Those with a child dependent will receive an additional $1400. According to the Congressional Budget Office, the total amount of stimulus is budgeted at $411 billion. By now most of this amount has already been sent out, either in the form of direct deposit, a paper check, or a plastic prepaid debit card.

We'd expect Americans to withdraw a chunk of the $411 billion in stimulus in the form of cash. After all, many people still like to use cash for payments. And many businesses still operate on a cash-only basis. As the chart shows, that's exactly what has happened.

Because banknote patterns are stable, we can use data from previous years to get a pretty good idea about what the stock of cash would be absent stimulus checks. Using weekly data from 2013 to 2019 to infer 2021 numbers, I estimate that there would normally be around $2.067 trillion in banknotes outstanding by mid-April. But this number is clocking in at $2.101 trillion. So thanks to the Biden stimulus, there appears to be $34 billion in extra notes that wouldn't otherwise be there. This averages out to $100 per American.

There are a lot of assumptions in this estimate. I'm assuming that the Biden checks are the only factor explaining the difference between the actual stock of banknotes and an imputed "no stimulus" stock. But this assumption could be wrong.

Cash being withdrawn into circulation is a sign that the stimulus is working. As Claudia Sahm writes here, one goal of a stimulus is to kick-start a self-reinforcing spending loop. My spending on goods & services at your businesses encourages you to spend on goods & services, which gets the next person to do the same. The big jump in cash-in-circulation shows that people are indeed spending their $1400 stimulus rather than saving it in their bank accounts. Put differently, if we didn't see any increase in cash-in-circulation we'd be worried that the $1400 stimulus was being hoarded, not spent.

By the way, we can also see the effects of Trump's earlier stimulus on cash demand in the above chart. The Consolidated Appropriations Act, signed into law in late December 2020, entitled all American adults to a one-time $600 plus $600 per child dependent. The CBO set the total cost of Trump's stimulus checks at $164 billion. This round of checks began to arrive in bank accounts on December 30 and continued into January.

But here things get a bit more complicated. The $600 stimulus payments began to be distributed around New Year, thus overlapping with the traditional unwinding of the big Christmas/New Year splurge in cash. This year the Christmas/New Year effect may have been muted given that many families avoided vacationing and travel due to COVID-19. But in any case, the two effects have counterbalanced each other. The traditional post-New Year's slump in the banknote stock didn't occur this January. Instead, banknotes-in-circulation slowly grew thanks to the stimulus check effect.

The chart shows that by late February 2021 the stock of banknotes had returned to its 2013-2019 average. This suggests that all of the extra Trump stimulus that had been withdrawn as cash had been spent at shops, only to be redeposited at banks, and then the Federal Reserve.

I suspect that the same thing will likely happen with the Biden stimulus. By June, the big bulge in cash will have shrunk. Having been spent, the notes will be sent back by retailers to their bank via Brinks trucks, and then on to the Fed.

One would hope that not all of it disappears. As I suggested earlier, stimulus is supposed to set off a multiplier effect. When this effect has played out, prices and/or output should all have risen by a bit. This means that the ending stock of cash should be a bit higher than before. After all, if the economy has improved, then we all need to hold a bit more cash in our pockets to support our new spending habits.

Wednesday, March 31, 2021

From Circle-of-Gold to Mega$Nets to Bitcoin

We tend to dismiss chain letters as mere scams or frauds. In this post I want to get readers thinking about chain letters as a type of financial innovation, one that has been steadily updated over the decades.

Chain letters are lists. That list is governed by a rule: the first people on the list are to be paid by the latecomers. The chain letter stop working, or paying out, when no one else wants to join up.

The amount of money flowing to early-birds who joined the list is equal to the amount arriving from latecomers. No additional value gets created. That's why chain letters are zero-sum games.

The greatest technological strength of a chain letter is its decentralization. Each node, or participant, is independently responsible for receiving, copying, updating, distributing, and marketing the chain letter. Without a central schemer to indict, it's almost impossible for the authorities to stop it from propagating. Think of chain letters as the honey badgers of the financial world: tough, indestructible, and durable.

One of the most famous chain letters was the Circle of Gold letter. It reportedly started out in San Francisco and ripped through the rest of the U.S. in 1978. Here's how it worked:

In brief, I'd buy a copy of the Circle of Gold letter from you for $50 cash, and then mail $50 to the name at the top of the list, for a total outlay of $100. I'd then make two copies (removing the name at the top of the list an inserting my own at the bottom) and sell each for $50 to friends/family, for a total of $100, thus breaking even. The buyers in turn made copies and sold them on, the chain continuing. At some point my name would arrive at the top of the list and the money would begin to arrive in my mailbox.

Law enforcement declared the Circle of Gold letter to be illegal. But there was little they could actually do to stop it.

Chain letters like Circle of Gold may be difficult to eradicate, but they suffer from two big problems. I'll explain each of these problems, and also show how they were eventually fixed.

If decentralization is a chain letter's greatest strength, it is also the root cause of its main weakness. A buyer of a Circle of Gold letter had an incentive to break the rules by sneaking their name to the top of the list. Without a centralized administrator, there is no single authority who is powerful enough to prevent players from cheating.

Let's call this the dishonesty problem of chain letters. The dishonesty problem undermines a chain letter's credibility. If everyone knows that cheating will be rampant, why bother getting involved at all. Thus the odds of a letter widely propagating itself is always going to be quite low.

To help make a chain letter more transmissible, what is needed is some sort of procedure that solves the dishonesty problem while preserving decentralization.

Enter Mega$Nets.

Mega$Nets was an ingenious 1990s-era chain letter that relied on software to prevent cheating. Here's how it worked:

I buy a $20 Mega$Nets disk $20 from you
After booting up the software I'd be asked to input my name and address, which was now locked into the program
Before I could make copies of the disk, I had to mail $20 in cash to five others above me on the list. Once the $20 was received, these people would mail a code back to me.
Only after I had entered the codes into the software could I duplicate the disk and sell it for $20. If the chain grew and my name worked up the list, I'd eventually start receiving a stream of $20 payments in the mail.

Thus Mega$Nets software prevented names and addresses from being erased and preserved the list order. Importantly, it solved the dishonesty problem without compromising the decentralized nature of a chain letter. After all, Mega$Nets software ran independently on each individual machine, not from a central server.

Source: Donald Watrous's chain letter links

If Mega$Nets solved the dishonesty problem of chain letters, it didn't stay around very long. Eventually a programmer hacked Mega$Nets and figured out how to cheat the system. To undermine trust in the chain letter, he published his crack to the internet so that others could download it.

But even if a chain letter manages to solve the honesty problem, it still suffers from another big weakness: lack of fungibility.

Fungibility is the idea that all members of a population are perfectly interchangeable with each other. Rice is fungible because one grain of rice is pretty much identical to another. My Tesla shares are fungible with yours. Dollar bills are fungible.

But positions in a chain letter like Mega$Nets are not fungible. A spot at the top of a chain is more valuable than a spot further down. And a spot on branch A of the Mega$Nets chain may have a different value than a spot at an equivalent height on branch B of Mega$Nets.

This lack of fungibility impinges on a players' ability to sell their spot in the chain letter to someone else. With every position in a chain letter being radically different, it's a huge chore for potential buyers to evaluate the market value of any single spot. And so a healthy resale market for chain letter spots can never develop.

Why would we want to be able to sell out of a chain letter? One of the big attractions of buying stocks, ETFs, bonds, gold, or currency is that we can resell these instruments, maybe two minutes later, maybe two decades later. If we are locked into an investment forever, we probably wouldn't want to invest very much in the first place. Likewise with chain letters. If a spot in a chain letter can be easily resold at a later time, then making an initial investment in the chain letter becomes a much more attractive proposition.

But is it possible to design a fungible chain letter? And if so, can we also solve the honesty problem while preserving decentralization? It sounds impossible.

Enter bitcoin, the world's first honest & fungible chain letter.

The novelty with bitcoin is that all the spots in the list are created at inception.* New players can only join by purchasing a pre-existing position in the chain.** This approach is different from a more traditional chain letter like Mega$Nets or Circle of Gold. With Mega$Nets, the list is dynamic, not static. It starts out small and expands organically as people join up, append their name, and generate a new spot in line. No need to buy someone's position out. Just add your own.

By creating all spots at t=0, no spot is superior or inferior to the others. All bitcoin positions are fungible from the get-go. Not so with traditional chain letters like Mega$Nets, which operate on the principle that new spots are subservient to old spots.

As with all chain letters, people "win" at Bitcoin by being early. The difference is that with bitcoin, winning is achieved by being one of the first to buy up a spot in a fixed non-hierarchical list. With a traditional chain letter like Mega$Nets, winning is achieved by creating one of the first entries in a hierarchical list that lengthens over time. Either way, the earlier one arrives, and the more latecomers who join up down the road, the richer one gets.

Because every single spot on the bitcoin list is fungible, buyers can easily appraise the worth of any single bitcoin (i.e. chain letter spot). And so a robust secondary market for bitcoins has developed where early bitcoin players fluidly auction off their positions to newer players. This marketability is one of the things that has turned bitcoin into such a contagious chain letter.

Bitcoin doesn't just solve the fungibility problem. It also fixes the honesty problem. Bitcoin software ensures that it is impossible for anyone to conjure up a new spot on the bitcoin list, or re-arrange the distribution of existing spots. (Some people describe this as solving the double-spending problem of electronic cash, but in this blog post it is the honesty problem of chain letters that is being fixed).

Finally, bitcoin achieves all this while being just as decentralized as its chain letter predecessors. 

Bitcoin is decentralized because individual participants can buy and sell bitcoin (i.e. spots in the list) in bilateral pairwise meetings. No need to rely on a central planner to distribute funds from late entrants to early birds. Secondly, much like Mega$Nets software, bitcoin software is deployed on thousands of computers all over the world. No central server. So like its traditional chain letter predecessors, bitcoin is very difficult for the authorities to attack.

In conclusion...

At first blush bitcoin seems like an entirely novel financial technology. But as I suggested in my post, it's just a meaner & badder version of chain letters like Circle of Gold and Mega$nets. 

What is revolutionary about bitcoin is how it has modified the chain letter model in order to solve the honesty and fungibility problems. Until bitcoin arrived in 2009, we had never seen the full capabilities of the chain letter model. Sure, chain letters regularly popped up, but they never lasted for more than a year or two. If anyone played them, it was weirdos like Uncle Bob's cousin's strange friend.

By solving the dishonesty and fungibility problems, bitcoin has radically dialed up the contagion factor for chain letter technology to a degree never experienced before. Bitcoin has become the first chain letter to go mainstream. It is the first chain letter to go global. Your sister is playing, your cousins are in, and so is your neighbour. We've almost arrived at the point where the normies are the folks who play bitcoin. The abnormal ones are those who haven't secured a spot in line.


*Bitcoin has a 21 million cap. These 21 million coins were not created at inception. However, the protocol sets out the rules for their creation ahead of time.

** Players can also join by "mining" bitcoins. Mining is one of the processes that updates & secures the chain letter. Computers that engage in mining are rewarded with new bitcoins and/or a small fee out of the existing stock of bitcoins.

Monday, March 15, 2021


1. Over the last month or two I've been following an interesting archaeological debate over the discovery of coinage. I thought I'd share it with you.

2. It's generally accepted by archaeologists and numismatists that the first coins were invented in Lydia, modern day western Turkey, in the 7th Century B.C.E. (i.e. 610 B.C.E. or so). The idea quickly spread to Greece. The Lydians used electrum, a strange silver/gold mix, to make their discs. (I wrote about electrum coins here). I've included an example below.

Electrum coin from Ephesus, 625–600 BC [Source]

We don't know exactly why the Lydians used electrum, or even if they treated their discs in the same way that future generations would use coins. But when the Greek city states copied Lydian coinage in the 6th Century, they didn't use electrum. Their coins were pure silver.

3. Lydia's electrum coins aren't the topic of this post. The debate that I'm going to describe revolves around the belief among some archaeologists that a form of proto-coinage had been invented prior to the Lydians and their electrum coins. This proto-coinage came in the form of sealed and regulated bags of hacksilver (more on hacksilver later).

Others archaeologists disagree. They are adamant that Lydia remains ground zero for coinage.

For lack of better terminology, I'll call the first group of archaeologists, those who think there was a predecessor sort of coin, the proto-coiners.

So relax and follow along.

4. By the way, mine is an outsider's account on the archaeology of money and coinage. I am not an archaeologist, so I will certainly get a few things wrong. Nevertheless, I am hoping that my regular monetary economics readership will enjoy learning how archaeologists attack the problem of money.

5. How popular was silver in ancient society?

"Silver served as the main measure of value, the means of payment and credit, and as an indirect form of exchange in Near Eastern economies from the mid-3rd millennium onward," write archaeologists Tzilla Eshell, Ayelet Gilboa, Naama Yahalom-Mack, and Ofir Tirosh (Eshel et al) in a 2018 article entitled Four Iron Age Silver Hoards from Southern Phoenicia. The Near East is a catch-all term for modern-day Israel, Iraq, Iran, Jordan, and Syria. I will return later to Eshel and coauthors' paper.

Morris Silver, an economist who researches ancient economies, describes Mesopotamian texts of the middle of the second half of the third millennium that show silver being used by street vendors, to pay rent, purchase dates, oil, barley, animals, slaves, and real estate.

According to archaeologists Seymour Gitin & Amir Golani (2004), Assyrian economic texts from the 7th C B.C. show that the majority of all types of payments were already being made in silver, including those for tribute, craftsmen obligations, and for conscription and labor commutations.

Cuneiform tablet, loan of silver [Source: The Met]

The Old Assyrian cuneiform tablet above from around 1900 B.C.E. says that 6 minas (c. 3 kg) of silver are owed by two men to the merchant Ashur-idi. One third of the loan must be paid by the next harvest and the rest at a later date. If it is not repaid by that time it will accrue interest charged at a monthly rate.

6. If silver had already become a sort of medium of exchange sometime between 3000 B.C.E. and 2000 B.C.E., it wasn't in coin form, but as hacksilver. By hacksilver, what is usually meant by archaeologists is silver ingots, hacked pieces of ingot, silver scrap, and cut up bits of silver jewellery.

Below are some examples of hacksilver:

7. One reason for the hacking or cutting-up of silver may have been to make small change. If 2 grams of silver was required to make a payment, but a payee only had a single 10 gram ingot, then a small part of it had to be cut off.

8. Another less obvious reason for hacking, suggested by Eshel & coauthors, is that it may have been a way for merchants to check for quality. Pure silver is soft. Mixing copper into silver makes for a harder ingot. A solid smash to the ingot may have been the accepted way of verifying whether an ingot was good silver or not.

9. It wasn't till 610 BC or so that the Lydians made the first coins. So for over a thousand years, silver circulated as a medium of exchange, in hacked form.

10. The big innovation with coins is the stamp. Because we trust the issuer's brand, we needn't weigh out or assay (i.e. smash/hack) silver prior to engaging in trade. So trade was much more fluid.

If you think about it, branding metal is a pretty big step for a society to take. It means that laws, norms, and institutions have become established enough for people to be confident in something as abstract as an issuer's emblem. Too much fraud, warfare, and lawlessness, and branding breaks down—you've got to go back to weighing and hacking silver yourself.  

11. The proto-coiners don't agree that Lydia was the first to "brand" silver. They suggest that bagged and sealed hacksilver was already circulating in a way similar to coins. Some authority, perhaps a government administrator or a merchant, pre-weighed a certain amount of good hacksilver, bagged it, and affixed their seal to it. And so anyone who was offered the bag in trade could treat it just as they would a coin. As a verified amount of silver, it needn't be weighed or hacked. The bag would have been accepted according to whatever information was inscribed on the seal.

12. If the proto-coiners are right, that means our ancestors were better monetary innovators than we originally thought. It pushes the effective date of coinage technology back by 500 or so years.  

13. It's a fascinating debate, especially because it invokes a set of mysterious old hoards that archaeologists have discovered over the years. These hoards are typically hidden in clay jars underneath the floors of houses by their owners, probably for safekeeping. And then they were forgotten or some disaster befell their owner, only to be rediscovered thousands of years later. Who were these people? Why did their hoard get forgotten?

14. One of the key hoards around which the debate revolves is the Tel Dor hoard, which was found north of Haifa in Israel. It was excavated in the 1990s by Ephraim Stern, an Israeli archaeologist at the Hebrew University of Jerusalem. One element of the Dor hoard is an old jug filled with silver, below.

The Tel Dor hoard (a) as displayed in The Israel Museum and (b) in situ, looking east [Source: Eshel et al]

15. Stern's description of this jug (published in this 2001 paper) quickly filtered into the archaeological community. Christine Thompson, archaeologist and co-founder of the Hacksilber Project, used Stern's findings to build a proto-coinage argument. It's worth getting into the details of her argument (and subsequent rebuttals) to see how archaeologists think. You can find it in her 2003 paper, Sealed Silver in Iron Age Cisjordan and the ‘Invention’ of Coinage.

Thompson (channeling Stern) tells us that the Tel Dor hoard dates to somewhere between 1000 B.C.E and 900 B.C.E. The hoard consists of a jug containing 17 bundles of hacksilver wrapped up by linen cloth (see photo of one of the bundles below).

16. Together the silver weighs 8.5 kilograms, which at today's silver price is worth around $8,000. But that's not a great way to think about how much this hoard was worth. According to a very readable article by Tzilla Eshel, a half-gram of silver was equivalent to a day-worker's wage. So the entire hoard was the equivalent of forty-six years of labour. In modern day terms, that would value the purchasing power of the hoard at well above $1 million.

17. Stern has speculated that the hoard may have belonged to a Phoenician merchant who used the silver to build and equip ships, or to buy merchandise for eventual exchange with countries in the western Mediterranean.

18. Most of the linen wrapping in the Tel Dor hoard has long since disintegrated. Thompson notes that the bundles were closed with bullae, or clay seals. (See below). But these seals do not contain a name, just a pattern.

One of the silver bundles found at Tel Dor, and an illustration of a clay bulla, or seal. Source: Ephraim Stern in The Silver Hoard from Tel Dor [pdf]

19. If the bundles found in the Dor hoard were treated by their owner as coins, then one would expect them to weigh a standard amount, just like all modern nickels and quarters weigh the same. And that is the gist of Thompson's argument. According to her, the 17 bundles all appear to be the same weight. .
20. One of these bundles had been removed by Stern to be weighed. It registered at 490.5 grams. Thompson suggests that this 490.5 grams might align with usage of the Babylonian shekel unit of account. Under this archaic weight standard, each shekel weighed 8.3g, and 60 shekels was worth 1 mina. Thus a mina would have weighed 500 grams.

So the 490.5 gram bundle found at Dor comes close to an even mina. It's as if the bundle was a very large denomination mina coin. Thompson attributes the missing 10 or so grams to loss of a few small pieces due to disintegration of the cloth.

21. The purity of the Dor hoard is quite high, notes Thompson, suggesting that the bagged silver, like a coin, had been checked and regulated.

22. Thus Thompson has created a plausible theory about bags of silver being treated as coins. Like a coin, the sealed bags of hacksilver found at Dor had a certain purity and weight. Presumably people who received them in payment didn't have to weigh the silver. Nor did they have to assay the silver by hacking or smashing it.

23. It's a convincing theory. Now for the counter-theory.

24. Raz Kletter, an archaeologist at University of Helsinki, is not convinced by the idea of a proto-coinage. In a 2004 paper, he points to the nearby Tell Keisan hoard, dated to around 1000 B.C., which also contained wrapped hacksilver bundles. The hoard includes 6 or 7 bags of cloth, says Kletter. Two of them weighed in at 24.5 and 25 grams, suggesting that they may have conformed to the same denomination. But two of the other bags measured at a 32 and 100 grams respectfully, which muddies the waters. Moreover, Kletter says that the weights of the bags does not correspond clearly to any known standard of weights and measures.

25. Tel Dor hadn't finished telling its story, either. Recall that at the time Thompson was writing, 2003, only one of Dor's 17 bundles had been weighed. It came in at 490.5 grams, and Thompson ascribed to this bundle the possible value of a clean mina of 500 grams, less a few grams due to thousands of years of wear and tear.

But in 2018, Eshel & co-authors opened a second Dor bundle. They found that it measured just 420.6 grams, which doesn't conform as closely to a mina. So that undermined some of the arguments in favor of proto-coinage.

26. That's not all. Eshel & co-authors did a chemical analysis of four hoards including both Tel Dor and Tell Keisan. Recall that Thompson suggested that the purity of Tel Dor silver indicated a degree of regulation, much like a mint controls the silver content of a coin. But Eshel & co-authors found that the silver from Tell Keisan, though "piously" packed in sealed bundles, was not so pure. It contained large amounts of copper, suggesting that it was a forgery. (See photo below). If the whole point of bagging and sealing was to create a trustworthy medium of payment, the deliberately-alloyed Tell Keisan silver seems to contradict this.

A bundle of hacksilver from Tel Keisan. Its green colour betrays its copper content. When silver corrodes it tarnishes black, but copper produces a green rust. Source: The Torah

27. This collection of counter-observations somewhat weakens the argument for an early proto-coinage in the Near East. But there are probably plenty of yet-to-be discovered hoards. Who knows, perhaps the next one will contain bundles of provably standardized hacksilver. It certainly is a provocative idea.

28. If the role of bundling and sealing of hacksilver wasn't to create a proto-form of coinage, than what was its function? Eshel & co-authors suggest that bagging was little more than a convenient manner of storing one’s wealth. Taking out a single cloth bundle and weighing it would have been much less awkward than removing individual pieces one-by-one and weighing them. 

If you're interested in learning more about the ancient hacksilver economy, I'd suggest reading How Silver Was Used for Payment, recently published in The Torah. Tzilla Eshel, the archaeologist who co-authored one of the papers I cite in my blog post, is the author and has written it with the lay-person in mind.

Saturday, March 6, 2021

Tether, a bigger badder PayPal

My recent article on Tether, a stablecoin, was just published at Coindesk. In the article I commented on Tether's recent settlement with the New York Attorney General's office. Because the settlement forces Tether to adopt a bunch of new practices, I think it's a win for stablecoin consumers.

Why have I been focusing so much of my time on Tether stablecoins? Diligent readers will recall I wrote about it twice last month. (1 | 2 ).

First, I've been writing about stablecoins for a long time now, and Tether has always been the biggest of the bunch. So it merits our attention. But it isn't just the biggest stablecoin. These days it's also becoming big by regular fintech standards. According to its website, Tether recently passed $35 billion in deposits, ranking it above PayPal's $34 billion. Which means that by my estimates it is now the largest U.S. dollar non-bank payments platform in the world ranked by customer funds.

Tether imprints dollars onto a blockchain. PayPal registers dollars in a centralized database. But apart from that, they're technically the same beast. Both keep some dollars (or not) on deposit with their banker and then issue dollar IOUs to their customers. And customers can in turn use these IOUs to make payments amongst each other.

The second reason I've been writing about Tether is that it is dubious. As I wrote here, it avoids U.S. money transmitter regulation by locating itself offshore. And it has somehow managed to wrest first spot away from PayPal despite doing very dangerous things with its customers' funds.

Its impropriety is a matter of public record. Even before last month's settlement with the New York Attorney General we already knew that, among other things, the firm had invested millions of dollars of customer money in a fraudulent third-party payments processor, all the while informing users that Tethers were backed by dollars "safely deposited in our bank accounts." If you want to get into this in more detail, Bennett Tomlin has been exploring these things in far more detail than I.

I am fascinated by this strange combination of popularity and sketchiness. And I'm not the only one. Tether analysis is a growing sub-field of cryptocurrency analysis.  

Tether is imbued with an aura of Trumpian invincibility. Hey, look at all these bad things we do. But we're getting away with it. The market keeps buying. We're bigger than PayPal! Tether's success makes outside observers wonder whether up is down, or bad is actually good.

But I want to dispel some of this seeming invincibility.

As I suggested in my Coindesk article, much of Tether's stablecoin dominance is probably due to network effects. That is, Tether was the first stablecoin to market, and so a Tether standard of sorts emerged. Like any standard, once everyone plugs into it it's hard to move away to a better standard. New and safer stablecoins—ones that have been licensed under a financial regulatory framework—have certainly emerged, including Paxos Standard, TrueUSD, Gemini Dollar, Binance USD, and USD Coin. But Tether enjoyed a four-year head-start, and so even if it murdered someone in the middle of 5th Avenue it would still be the leading stablecoin.

For instance, Tether is the only stablecoin that doesn't provide regular attestations.

Why doesn't Tether make an effort to adopt an industry-wide practice? It could be that it is just too sketchy to be able to hire an accounting firm to provide attestations. Alternatively, maybe its position as the standard stablecoin means it needn't bother. It gets to coast while everyone else has to peddle.

But if it's difficult to move away from a given standard, its not impossible. The first example that pops to mind is how the international monetary system was on a British sterling standard in the 1800s, but now we use U.S. dollars. Somehow sterling dominance evaporated. The same can happen with Tether's dominance.

In fact, I'd argue that we're already seeing a movement away from the Tether standard, particularly in decentralized finance, the set of financial protocols established on the Ethereum network.

It's hard to underestimate how much decentralized finance, or DeFi, dislikes Tether. Consider the biggest DeFi lending platforms, Compound and Aave. Both platforms allow USD Coin stablecoins to serve as collateral. (USD Coin is the second largest stablecoin). But these platforms say no to Tether. That is, if you want to get a loan from Compound or Aave, you can't use your stash of Tether as security. As I pointed out in my article, Compound's decision is based on reports that Tether is “undercollateralized” and has the “potential to collapse at any time.”

MakerDAO, a combined stablecoin/lending protocol and one of the top-three DeFi tools, has also adopted a say-no-to-Tether policy . It sets a hawkish 8% borrowing rate and 150% collateralization ratio on anyone who wants to take out a Tether-backed loan. That may sound like gibberish, so let me translate. For a $100 loan from Maker you've got to lock-up a hefty $150 in Tethers. You'll pay 8% in interest each year on the loan.

But if you want to take out a USD Coin-backed loan (remember, USD Coin is one of the newer safer coins), Maker's terms are far more dovish. It'll cost 0% and 101%. So to get a $100 loan, you need only provide $101 in USD Coin. And the interest costs is nil.

Given Maker's policy, there's absolutely no reason why you'd take out a Tether-backed loan rather than a USD Coin one. And that's why to this day Maker has a measly $700 in Tether sitting in its smart contracts versus a massive $700,000,000 in USD Coin. Below is an abridged list of collateral that has been deposited in Maker as security. The top red circle highlights how much USD Coin (USDC), that it holds. And the bottom circle indicates its Tether (USDT) holdings.

Source: Makerburn

It's worthwhile to revisit the policy meetings where Maker originally established its Tether policy. Citing Tether's "history of opaqueness and fractional reserve," administrators recommended conservative parameters in order to "protect Maker." At the same time, looser parameters were suggested for Paxos Standard stablecoins because it was "significantly more transparent."

In another discussion, Maker community members disapprovingly cited a tweet in which Stuart Hoegner, Tether's lawyer, jokes about Tether's approach to safeguarding customer funds. I've screenshotted it below.

Source: MakerDAO forum

Maker voters went on to approve a stringent approach to policing Tether, and rightly so given Tether's cavalier approach to managing customer funds. Defi grew exponentially in 2020. So did Maker. But almost all of its thirst for stablecoins was directed into non-Tether stablecoins. That's why there's still just $700 in Tether in Maker.

A back-of-the envelope calculation reveals how much money Tether may have missed out on. Had Tether taken pains to become safer to consumers, say by providing regular attestations and/or applying for a money transmitter license (like USD Coin and other competitors have done), it might have around $300 million Tethers sitting in Maker right now. Assuming that it invested this extra $300 million at an interest rate of 1%, Tether would be earning $3 million more each a year. 

And that's just one platform. Do the same for Compound, Aave, and more, and Tether's reputation has cost it tens of millions of dollars in profit.

Below I've charted out the ratio of the total value of all Tether stablecoins in existence to the total value of all USD Coins.The Tether-to-USDC ratio typically registered around 10 Tethers to each USDC through 2019 and early 2020, but this month it fell below 4 for the first time. USD Coin is steadily catching up to Tether for the title of largest stablecoin.

We all like the idea of justice. If you shoot someone in the middle of 5th Avenue, people should be appalled. In the case of a financial company, if you manage your customers' funds in a reckless manner and avoid informing them about the mistakes you made (and then joke about it after), then the market should discipline you, not reward you.

In the case of Tether, that is happening. As the chart above illustrates, Tether's poor stewardship of customer funds means that it is inexorably being replaced by safer stablecoins. Gresham's law, the adage that bad money pushes out good money, does not apply. The good is slowly pushing out the bad.

Monday, February 22, 2021

Ponzis and bitcoin as a response to a bad economy: the case of Nigeria

Usually when I think about gambling and speculative excess, I've always associated it with giddy prosperity. When an economy is doing well, productivity is improving, new technology is being introduced, and unemployment is low, people have extra income that they can throw away at the casino. Or they put it into their brokerage account and, with the help of margin, generate speculative bubbles.

But lately I've been rethinking this view. Speculative bubbles and over-gambling are just as likely to be driven by sick and decaying economies as they are by prosperous ones. And Nigeria is a prime example of this.

Nigeria, one of Africa's largest major oil producer, plunged into recession in 2015 as oil prices collapsed. It saw only anemic growth from 2017 to 2019 before COVID-19 pushed it back into a much deeper recession.

Over that period Nigeria has seen an explosion of ponzi schemes. It started with MMM in 2016. Since then Ultimate Cycler, Icharity Club Nigeria, Get Help World Wide, Givers Forum, Twinkas, Crowd Rising, and Loom have all ripped through the country. Jack & Ibekwe (2018) provide a full list below, although it misses a large chunk of ponzis since it doesn't go past 2018.

Jack & Ibekwe (2018)

Jack & Ibekwe's paper is just one in a burgeoning Nigerian academic literature on ponzi schemes. This body of work provide us with plenty of useful information about what sorts of Nigerians are participating in ponzis and why.

How many Nigerians participate in ponzis? In a survey of 287 Port Harcourt business students, Bupo & Abam-Smith (2017) found that an astonishing 72% of students were involved in various ponzi schemes. Onoh's (2018) survey of 230 Nigerians found a participation rate of 78%.

The high participation rates that Bupo & Abam-Smith and Onoh pinpoint are confirmed in a 2016 poll run by NOIPolls, an established Nigerian polling agency. After querying 1000 Nigerians, NOIPolls found that 68% of survey participants had either participated in a ponzi, or knew someone who did. I would find a 5-10% national ponzi participation rate to be mindbogglingly high. But if the above data is correct, Nigeria far exceeds this. Given a population of over 200 million, tens of millions of Nigerians have participated in ponzis.

Who are the Nigerians that are playing? In their survey of 135 ponzi investors, Jack & Ibekwe found that young Nigerians aged 20-29 were most likely to be involved in ponzi schemes. Participants tended to be students and had post-secondary education. In a 2018 survey of 190 ponzi investors in the city of Calabar, Agba et al (2018) reported similar results. Most investors were unemployed, held a Bachelor of Science degree, and had a low income.

Another fact that blew my mind away is that many of the Nigerians who are involved in ponzis are self-conscious ponzi investors. That is, these aren't dupes. They know the nature of the game they're playing.

For instance, 66% the university students that Bupo & Adam Smith surveyed were aware that they were participating in a scam, one that would soon crash, but they played anyways, presumably because they believed they were skilled enough to get out before the end. Onoh found somewhat less ponzi self-consciousness in his survey of 230 Nigerians, with 34% realizing at the outset that the scheme made high returns by re-cycling contributions. But that's still a lot of savvy players.


Let's back up a bit and define the term ponzi scheme. A ponzi is a type of zero-sum game, much like a lottery or a casino game such as roulette. By zero-sum, I mean that nothing of value is created. For each person who makes a profit, there is necessarily someone who loses. Put differently, ponzis and lotteries don't generate funds, they redistribute funds.

All zero-sum games have an algorithm, or sorting method, for figuring out who will lose and who will win. A lottery, for instance, redistributes funds from all losing ticket numbers to the winning ticket. A poker game redistributes the pot from bad card hands to good hands. A ponzi scheme's unique algorithm is to pay early entrants at the expense of late entrants.

What attracts people to zero-sum betting games is the allure of massive returns. Buy the right lottery ticket and your life will change. Choose the right number on the roulette table and you earn an immediate 3400% return on your investment. Get in early on the right ponzi, and you'll be vaulted into a totally different socioeconomic class. Of course, on net these schemes don't generate any wealth.


Back to Nigeria. What the Nigerian ponzi scheme literature suggests is that ponzi schemes were self-consciously used by Nigerians as a coping mechanism for economic malaise.

For instance, in their survey of ponzi investors Jack & Ibekwe found that 60.3% cited harsh economic conditions as their reason for joining ponzi schemes. In a survey of 384 ponzi investors, Obamuyi et al (2018) found that one of the most popular reasons for participating in ponzis was the "current economic situation." And in Bupo & Abam-Smith's analysis of 287 Port Harcourt business students, 231 agreed that the scheme helped reduce the impact of the present recession.

So let me paint a picture. Nigeria has always been a highly unequal country. The poor are very poor, the rich are very rich. There is plenty of poverty (although this is improving) and not much of a government-run social security net. Nigeria also suffers from endemic corruption, and this impedes the ability of regular folks to improve their lot.

The yearning and frustration that this creates gives rise to a constant demand for quick financial escapes, or zero-sum games. But what sorts of zero sum games? Nigerian authorities take a relatively paternalistic approach to gambling. Depending on the game, Nigerian law either prohibits it outright or limits it. For instance, Nigeria has only three land-based casino for 200 million people. Non-skill based card games are illegal. Apart from sports betting, online casinos are prohibited, and many foreign websites don't accept Nigerians. 

So a big part of the demand to play life-changing betting games gets channeled into whatever the underground market can provide, like ponzi schemes.

If you start with a large population of unhappy young people who want to play life-changing zero-sum games, combine that with limitations on legal gambling, and add in a massive economic collapse which only makes their lives worse, you're going to get a big wave of illegal ponzi schemes cropping up.

Canada and the US also have problems with inequality and poverty, albeit not as extreme as Nigeria. Our economies have also been hit by the biggest shock in decades.

But unlike Nigeria, Canada and the US have well-developed capital markets. So when desperate Canadians and Americans look for long shot life-changing bets, they needn't limit themselves to traditional gambles like lotteries, casinos, or online poker. Online brokerages like Robin Hood and Wealthsimple make it easy for us to make hundred-to-one bets in options markets or leverage up on Tesla or GameStop stock.


In addition to embracing ponzi schemes, Nigerians have also become the world's most prolific owners of cryptocurrencies, as the chart below illustrates. This data comes from Global Web Index via this article.


I've been tracking bitcoin usage in Nigeria for a while now. We know that bitcoin is being used in combination with gift cards by Nigerian-based business email compromise and romance scammers as a convenient way to repatriate extorted funds:

We also know that Nigerians living in the US are making remittances to their Nigerian friends and family using this same combination of gift cards and bitcoins. Buying gift cards and exchanging them for bitcoin and then Nigerian naira may sound like a circuitous way to make remittances. But it is economical because families get the superior black market exchange rate rather than the official rate.

Nigerians who shop at foreign online stores face monthly card limits, some as low as US$100. Again, this is because Nigeria's central bank rations access to foreign exchange. Cryptocurrencies may be a hack around this. Also, Nigerian importers have been using cryptocurrency as a trade currency for Chinese imports. Rather than having to rely on acquiring carefully-rationed foreign exchange from the Central Bank of Nigeria, they can offer a Chinese exporter some bitcoins and the goods will be shipped.

So cryptocurrency is certainly being used as an alternative form of doing payments. But this can't explain why 20% of Nigerians (around 40 million people) hold some of the stuff. After all, unofficial imports, scams, and remittances are a small part of economic activity.


I'd suggest that Nigeria's cryptocurrency adoption is a natural extension of its earlier ponzi scheme addiction. 

Like a poker game or roulette or the lottery, cryptocurrencies such as Bitcoin or Litecoin are zero-sum betting games. They redistribute a fixed pot among participating players. Of all types of zero-sum games, cryptocurrencies are most similar to ponzi schemes. Both use an "early bird" redistribution algorithm: late entrants' funds are paid out to early birds. But cryptocurrencies are not quite ponzi schemes. Whereas ponzis such as MMM or Ultimate Cycler are centrally managed by a coordinator, a cryptocurrency is spontaneous and decentralized.

In the same way that young Nigerians turned to ponzi schemes as an economic drug for coping with the 2015 collapse and ensuing lack of opportunity, they may be doing the same with cryptocurrencies. COVID-19 has pushed Nigerian unemployment to its highest level in a decade, the young being hurt the most. And so once again desperate Nigerian students are on the hunt for life-changing zero-sum bets. This time they've settled on cryptocurrency, the decentralized nature of which renders them almost impossible for authorities to stop.

My "ponzi" interpretation of Nigerian cryptocurrency adoption runs counter to the crypto-optimist view.

Cryptocurrency advocates see adoption of cryptocurrencies in developing nations like Nigeria as a vindication of cryptocurrency-as-monetary technology. Their thesis is that legacy payments systems and central banks in developing countries are failing at their task, and so cryptocurrencies like bitcoin are being adopted because the offer a better monetary alternative.

The crypto-optimist view overestimates the usefulness of cryptocurrency-as-currency. There are certainly some cases where Nigerians are using cryptocurrencies for payments, and I presented them above. But the main reason that cryptocurrencies are popular is why any zero-sum game is popular: they intoxicate players with the promise of huge price gains.

Viewed in this light, Nigerian adoption of cryptocurrencies isn't a bitcoin fixes this moment. Rather, it's a repeat of Nigeria's earlier adoption of MMM and Ultimate Cycler. That these games keep sweeping through Nigeria is a symptom of underlying economic misery. Desperate to escape their plight, young Nigerians are once again making last-ditch bets on zero-sum betting games.


There is a silver lining.

Traditional ponzi schemes are often run by scammers rather than honest game managers. In an honest ponzi, 100% of the invested funds are paid out by the manager before the game closes down. But in a ponzi scam, the game manager absconds with the pot. And so ponzis often collapse before coming to their inevitable, natural end.   
Cryptocurrencies aren't run by a central game manager. As long as players custody their own coins, there is no one who can abscond with players' funds. So a desperate Nigerian student who wants to make a potentially life-changing zero-sum bet may do a bit better buying ₦10,000 of bitcoins than putting ₦10,000 into the next version of Ultimate Cycler, since bitcoin is more secure. (See this post for more).

But let's not kid ourselves. A nation of desperate gamblers, ponzi players, and cryptocurrency punters is a sad development. It is a symptom of a sick economy, one in which unemployed young people are flocking to make zero-sum bets because that is the only way they see their lot in life improving.

Thursday, January 28, 2021

Defining the "regulated" in "regulated stablecoin"

1/n This is a thread on what is means to be a "regulated stablecoin." (This was originally meant for Twitter, but I didn't feel like wrestling with the 240-word limit and threading, plus it got a bit long, so now it's a blog post).

2/n People in the cryptocurrency space often use the term of art "regulated stablecoin." No one has a monopoly over what "regulated stablecoin" means. It is a community-defined term. It's not terribly well-defined. But it should be. 

3/n It should be well defined because when newcomers enter the crypto space, and they have to choose what stablecoins to adopt, they may assume that those stablecoins that are tagged as "regulated stablecoins" are products that offer a degree of government-provided consumer financial protection.

4/n But are there government agencies that actually provide consumer financial protection to stablecoin users? If so, which agencies? What is the nature of this protection? And what stablecoin should you buy if you want to benefit from this protection?

5/n Novices can take heart. In the U.S., state financial agencies such as the New York Department of Financial Services (NYDFS), Florida Office of Financial Regulation, and Texas Department of Banking do in fact check the assets, investments, and reserves of financial institutions that issue stablecoins and/or other payments instruments. The also vet executives and directors of these payments companies, conduct examinations, and ask for audited financial statements.

6/n For instance, below is a screenshot of "eligible securities" as set out by California's Department of Financial Protection & Innovation (DFPI). When a customer deposits funds with a payments company operating in California, this list circumscribes how that company can invest those funds. In theory this should stop a payments provider from betting their customers' savings on wild and dangerous speculations, and losing it all.

California Money Transmission Act [source]

7/n So what companies do these regulators supervise? PayPal is licensed by the NYDFS. So are stablecoin issuers Paxos Trust, Circle, Coinbase, and Gemini Trust. 

PayPal, Coinbase and Circle are also regulated by the Florida Office of Financial Regulation, the Texas Department of Banking, California's DFPI, and a number of other regulators.

8/n To repeat, all of these state departments provide users of supervised payments instruments and stablecoins with an extra layer of financial protection. 

9/n Other countries may have agencies that also provide customers of payments platforms with a degree financial protection. For instance, in Singapore the Monetary Authority of Singapore (MAS) provides a financial regulatory framework for payment companies. In the U.K., the Financial Conduct Authority (FCA) does. 

However, many jurisdiction do not have an established regulatory frameworks for protecting customers of payments companies. These are unregulated jurisdictions.

10/n So to qualify as a "regulated stablecoin," a stablecoin issuer should be licensed with a regulatory body like the NYDFS or DFPI in the U.S., MAS in Singapore, the FCA in UK, or any other similar body. 

11/n FinCEN-registration isn't sufficient for qualification as a "regulated stablecoin." The U.S Financial Crimes Enforcement Network (FinCEN) does not get involved in consumer financial protection. FinCEN is an anti-money laundering watchdog.

12/n Which gets us to a recent article I wrote for Coindesk about one particular stablecoin, Tether. A spokesperson for Deltec, Tether's banker, suggests that Tether should be included in the category "regulated stablecoin." He puts forward Tether's FinCEN registration as the basis for inclusion.

13/n Deltec further invokes Tether's FinCEN-registration to say that Tether's regulation is just as iron-clad as its stablecoin competitors. Paolo Ardoino, a Tether executive, approves, saying: "It's deceitful how some competitors claim to be 'more regulated' as part of their pitch. No such thing."


14/n Unlike its competitors, Tether is not regulated by an agency that provides consumer financial protection.

15/n That is, Tether appears to operate from a jurisdiction that does not have a financial regulatory framework for payments companies.

16/n Meanwhile, Tether's stablecoin competitors such as Paxos, Coinbase, and Circle have gone to great lengths to be approved by agencies that do in fact offer these assurances to consumers (i.e the NYDFS). These stablecoins are, in short, better regulated than Tether, which lacks a license from a regulator that provide consumer financial protection.

17/n  Tether's counsel disagrees with my article.

By the way, I think it's laudable that Tether is registered with FinCEN and has a solid anti-money laundering (AML) program. As best as I can tell, Tether is based in the British Virgin Islands, which would mean that it is legally obligated to follow AML standards set by the British Virgin Island's anti-money laundering authority. Presumably it has doubled-up by also registering with FinCEN.

18/n However, to earn the moniker "regulated stablecoin", an issuer shouldat a minimumcombine registration with an anti-money laundering agency like FinCEN AND supervision by an agency that provides a degree of consumer financial protection. That way a crypto novice's expectations of "regulated", i.e. offering a degree of government-controlled consumer protection, do in fact correspond with reality. I'm afraid Tether doesn't make the cut. But USD Coin, Gemini Dollar, and Paxos Standard do.

19/n That isn't to say that Tether isn't safe for consumers to use. Over the course of history there have been many well-run financial institutions that have not operated under a specific financial regulatory framework.

20/n In fact, to this very day Canada still does not have a financial regulatory framework for payments companies. So whereas PayPal USA operates under a financial regulatory framework that provides consumers a degree of financial protection, PayPal Canada operates as an unregulated payments company, just like Tether. But even though PayPal Canada is unregulated, I still use it.

21/n In last week's blog post, I brought up the Banque d'Hochelega, a successful private Canadian note-issuer in the 1800s, an era with minimal financial regulation. I gave some examples about how the Banque d'Hochelaga managed to communicate to the public how safe their payments media were.

22/n To demonstrate how well Tether consumers are protected, Tether could borrow from the Banque d'Hochelega's bag of tricks. Why not start providing the public with more verified financial information?

23/23 Alternatively, it could seek to become a "regulated stablecoin." That is, it could try to get licensed in a jurisdiction that has a financial regulatory framework that protects customers.


Friday, January 22, 2021

The fabrication of trust in various types of dollars

How are we consumers to know whether the dollars that financial institutions provide us aren't fraudulent dollars? On what basis can we assume that the funds we hold at PayPal, for instance, or in Cash App, are "good money"?

It's an age-old problem. If you were alive in 1889 and someone offered to pay you with a $10 note from Banque d'Hochelaga (see below), a privately-owned Montreal-based bank, how could you know the issuer wasn't a fraud and that it had enough assets on hand to always redeem notes with gold and/or silver?

1889 $10 note, Source: Bank of Canada

The question of fabricating trust in dollars also applies to today's rapidly growing stablecoin sector. Stablecoins are dollars issued on public blockchains like Ethereum or Tron. Tether has an astonishing $24 billion in U.S. dollar stablecoins in circulation, up from just $1 billion three years ago. Competitor USDC has issued about $5 billion in stablecoins, up from $0.5 billion at the beginning of 2020. On what basis can a potential user trust these stablecoin dollars? How do we know that the $500 in Tethers or USDC that someone wants to send us won't melt to $0 a few days from now?

Consumers use simple rules of thumb to differentiate between good dollars and bad ones. We'll call them:

- everyone's using it
- Warren Buffett owns some
- JP Morgan trusts them
- show us the money
- big brother is watching

The first rule of thumb is the everyone's using it approach. If all your friends and family are using Tethers or PayPal or Banque d’Hochelaga notes, then it's probably safe for you to do so too.

There is plenty of wisdom in everyone's using it. If there are thousands of Tether users, then it's likely that at least a few of the more diligent ones have already dug deeper to ascertain the issuer isn't fraudulent, and so we can all piggy-back off of their work. This saves us the hassle of doing our own audit.

Everyone's using it is by no means a fail-proof method of determining the validity of a dollar. If no single user has done sufficient due diligence, then everyone is operating blindly. That's how Bernie Madoff managed to keep things going for so long.

The second rule that consumers use to validate dollars is the Warren Buffett owns some approach. Similar to everyone's using it, the Warren Buffett owns some approach piggy-backs off the work of others. But rather than relying on other users, it free-rides off of the expertise of sophisticated investors.

To see how this works, let's head back to 1880s Canada. In addition to having a set of noteholders, the Banque d’Hochelaga also had bondholders and shareholders. These investors, often prominent members of the community, would have had plenty to lose if Banque D’Hochelaga failed—not just money, but community standing. And so prior to investing in the bank they would have carefully scanned its financial statements, investigated its managers and directors, and verified the quality of its biggest customers. If these well-known and sophisticated stock & bond investors thought it was safe to buy Banque d’Hochelaga securities, then noteholders—without having to do any sophisticated analysis of their own—could assume that it was safe to hold its banknotes too.   

Likewise, in modern times should Warren Buffet decide to invest in Tether or PayPal securities, then users of these platforms could be assured that the firm's financials have been thoroughly vetted, and thus by transitivity Tether stablecoins and/or PayPal balances should also be safe. 

But Warren Buffett owns some isn't fool-proof. Even Warren Buffett can be tricked. Alternatively, shareholders may have been in on the scam from the start.

A third way for outsiders to gauge the quality of a dollar is the JP Morgan trusts them approach. Like the previous two methods, this one piggy-backs off of other people's due diligence, but in this case it relies on banks & other dollar issuers. In theory, no one should be a better judge of the quality of a dollar issuer than a competing dollar issuer.

In 19th century Canada, for instance, banking giants the Bank of Montreal, Royal Bank, and Dominion Bank all allowed their customers to bring Banque d’Hochelaga notes in for deposit. These bigger banks would have then redeposited said notes the very next day at the Banque d’Hochelaga for conversion into gold/silver. Until the banknotes had been converted, however, the Bank of Montreal, Royal Bank, and Dominion Bank were effectively creditors, or lenders, to the Banque D’Hochelaga. That's a dangerous position to be in. So prior to adopting a policy of accepting deposits of Banque D'Hochelaga notes, these big banks would have audited the smaller bank's books.

Thus a 19th century consumer could trust that Banque D’Hochelaga notes were solid. Competing banking behemoths had already vetted the bank.   

The JP Morgan trusts them route to trust formation doesn't quite work with stablecoins or PayPal balances. The issuer of USDC, the Centre consortium, doesn't accept Tether deposits, or vice versa. Nor do PayPal and Cash App interchange deposits with each other. And so unlike Canada's 19th century banks, none of these dollar-issuing platforms operate in an environment in which they are constantly auditing each other's credit worthiness.

Other banks do enter into the picture, but it is in a different, less effective, way. PayPal, Tether and USDC have reserves that they use to secure their dollars. They deposit these reserves at an underlying bank. That bank doesn't act as a creditor to the platform (it acts as the debtor), and so it needn't worry about its customers' credit risk. But it does have to worry about a customer being fraudulent, since this could damage the bank's reputation. Thus we can take some comfort from the fact that Wells Fargo, PayPal's bank, is keeping an eye on PayPal, and that Tether's bank, Deltec, is watching Tether. But this is weak medicine compared to the assurances that Banque d'Hochelaga noteholders enjoyed.

JP Morgan trusts them is a pretty good rule of thumb, but it isn't fool proof. Even bankers can be fooled. Or maybe the bank and its shareholders are themselves in on the scam.

Luckily, a dollar user has yet another way of forging trust in various types of dollars, one that doesn't piggy-back off of others. Let's call it the show us the money approach. Just take a look at the firm's financial statements. The Banque d'Hochelega made it easy for the public to get this information, going so far as to flaunt its capital on its banknotes. See below, where it advertises having $1 million in capital.

1898 $10 note. Source: Bank of Canada

It also bragged about its financial strength on its bank passbooks, those little books that account holders had to bring to the bank when they made deposits or withdrawals:


Finally, the Banque D'Hochelaga even took out full page advertisements in newspapers and other publications showcasing its capital and reserves. Below is an ad from a 1910 tourist guide published for visitors to the 21st International Eucharistic Congress, hosted in Montreal:


Show us the money also works in the 21st century. Don't trust PayPal's reserves? Scan its audited balance sheet. PayPal is a publicly-traded company, and so it is obliged to post quarterly audited financial statements. As for USDC, each month it voluntarily attests to how many reserves it holds. Grant Thornton, an accountancy, verifies its numbers.

In many cases, however, the public can't rely on show us the money. Tether, for instance, doesn't publish audited financial statements or attestations.

Which leads us to our final rule of thumb. Consumers can build trust in dollars via the big brother is watching approach, i.e. government regulation. Banque d'Hochelaga operated at a moment in history when government regulation of banks was very light. This lack of regulation worked fine. The Canadian public trusted private banknotes and only rarely did they suffer from bank failures.

But today, regulation is far more pervasive. PayPal and USDC are regulated in the U.S. on a state-by-state level as money transmitters. Each state has different money transmitter legislation, but in general all states require transmitters to limit their investments to a range of permissible securities, to post a surety bond or letter of credit with the regulator as security, and/or to maintain minimum net worth requirements. Transmitters must also provide their state banking regulator with yearly audited financial statements and submit to examinations. 

These rules are by no means homogeneous. Dan Awrey, Lev Menand, and James McAndrews have published an interesting comment that gets into some of the nuances of state-by-state money transmitter regulation. The map below, for instance, shows how net worth requirements differ across states.


Even though the U.S. lacks standardized rules, a base level of regulation exists, and so owners of USDC stablecoins and PayPal balances can muster an additional layer of confidence in the safety of their dollars.

But big brother is watching doesn't always apply. 

Tether, for instance, doesn't serve U.S. customers, presumably to avoid having to secure state money transmission licenses. Thus it needn't submit itself to state-by-state permissible investment lists, net worth requirements, security deposits, audits, examinations, etc. One might assume that Tether is regulated elsewhere and thus must abide by a different set of strict rules. But that's not necessarily true. Many nations do not have regulatory frameworks for money transmitters. (Canada, my home country, doesn't). Since Tether is likely domiciled in one of these light touch jurisdictions, Tether users cannot rely on big brother is watching to build trust in Tether's dollars.

Indeed, Tether has admitted that a large chunk of its reserves are in the form of a multi-year loan to an affiliate, Bitfinex. The Bitfinex loan would probably not be a permissible asset under most U.S. state money transmitter laws. Put differently, I doubt either USDC or PayPal—which are obliged to follow state law—could have done what Tether did.

Having worked through the rules of thumb that the public uses to establish trust in various types of dollars, let me end with the Tether situation in particular.

Social media is filled with Tether critics. Some of their criticism is weak, and Tether's many supporters on social media are quick to point this out. But the counter-criticisms that Tether's supporters provide are just as shoddy.  Apart from their reliance on everyone's using it and a pale version of JP Morgan trusts them, supporters can't give much good evidence for why Tether should be trusted.

And that's because Tether hasn't provided much solid footing for its protectors to stand on. By contrast, there are very few rumours in social media about the solidity of PayPal or USDC. That's because both of these platforms have gone to great lengths to remove all the raw tinder that might cause innuendo to spark and spread in the first place. 

If Tether wants to stop public criticism, it need only need copy what its competitors have done and provide something other than everyone's using it as the basis for fabricating trust. It can pick and choose from any of the following: provide the public with audited financial statements or verified attestations; bank at a higher profile bank than Deltec; secure a well-known and highly respected investor; go public; or get licensed as a money transmitter in a few U.S. states. Any of these would help asphyxiate the rumours.

It could be that Tether doesn't have solid enough finances to do any of the things I've listed. Or maybe it does, but it doesn't actually care about rumours. After all, even after years of criticism, Tether continues to grow and dominate the stablecoin sector. The community of stablecoin users seem quite content to rely on everyone's using it. For now, at least.

Thursday, December 31, 2020

The unbanked, the post office, and fintech in the 1880s

"A large population of people are excluded from the financial system because they don't have bank accounts. Fintechs compete to connect them and parallel plans emanate from the government to reach the unbanked, including postal banking."

What year am I describing in the above paragraph? 

It could be 2021. But it also describes 1870s. 

It's 2021 and the U.S. still has a large population of unbanked, those who have so little money that banks would rather not serve them. An astonishing 5.4% of Americansthat's 7.1 million householdsdo not have bank accounts.

Financial technology companies (aka fintechs) like PayPal and Facebook's Libra have well-meaning plans to connect the American unbanked population. Government-run proposals abound too. Postal banking is probably the most popular option, but more exotic solutions like central bank digital currency (CBDC) have also been floated. But many economists are wary that these government efforts will cripple the private sector.

None of this is new. Concerns over the unbanked, fintech, and a government participation in the payment system were all present back in England in the 1880s. Since I enjoy when the past resurfaces in the present, I'll tell the story.


Britain in the 1870s had a very sophisticated chequing system. Because banks were the only way for people to access cheques, and banks preferred to limit accounts to rich people and wealthy merchants, the poor and middle class were often left out. 

Luckily, the 1870s version of fintech came to the rescue. The PayPal of the day was something called the Cheque Bank. Established in 1873, the Cheque Banklike PayPal todaywas a bank-on-top-of-a- bank. What do I mean by this?

PayPal is a customer of Wells Fargo, a large commercial bank. Wells Fargo provides PayPal with banking and payments services. PayPal in turn passes these services on to PayPal account holders, folks who might not otherwise qualify as customers of Wells Fargo or, if they could, prefer the way PayPal rebundles underlying Wells Fargo services.

Stock certificate for the Cheque Bank, Limited

The Cheque Bank operated on the same principles. It opened accounts at bank branches all across United Kingdom and overseas. Like PayPal, it passed through underlying banking services to its unbanked customers. The Cheque Bank's main product was cheques, which today might seem quaint. But back then they were cutting edge.

Anyone could buy a book of Cheque Bank cheques at a stationer or cigar store, the Cheque Bank redepositing the cash it received with its bankers. The customer could then spend those cheques at stores, send them to family via the mail, or hold them as a form of saving in lieu of cash (which was always at risk of being stolen). People who accepted a Cheque Bank cheque as payment could promptly take the document to any bank and cash it.

Much like PayPal does today, the Cheque Bank held 100% reserves. That is, for every $1 in cheques it issued, it kept $1 locked up with its bankers. And so its cheques were considered to be as safe as cash. Put differently, regular banks engage in both lending and payments. But fintechs like PayPal and the Cheque Bank don't lend at all. They deposit all of their assets at an underlying bank and focus on offering the payments side of the banking business to their customers.

The Cheque Bank attracted the attention of William Stanley Jevons, one of the most important economists of the day and still very much a household name among economists today. Jevons was one of three economists (along with Carl Menger and Leon Walras) to discover the principle of marginal utility, a key economic principal which had eluded even Adam Smith. 

In his 1875 book Money and the Mechanism of Exchange, Jevons devotes a full chapter to the Cheque Bank, describing it as a "very ingenious attempt" to "extend the area of banking to the masses." Here is what one of the Cheque Bank's cheques looks like:

1899 cheque issued by the Cheque Bank [source]

The cheques could only be filled to an amount printed on the document, writes Jevons. So the above cheque, which had been purchased for £5, could be written out for anything up to £5, although in this particular case the cheque writer (H.L. Stevens) chose the sum of 3 pounds 3 shillings. 

Jevons isn't the only notable economist to write about the Cheque Bank. It also pops up over a hundred years later in economist Edward S. Prescott's work, who describes it as a "highly interesting experiment in extending the use of checks to the lower and middle classes." Prescott suggests that the ability to write a specific amount on the face of one of these cheques would have greatly facilitated payments through the postal service since there was no need for change. Unlike a regular cheque, which also offered this flexibility, the recipient of one of the Cheque Bank's cheques needn't worry about it bouncing.

Jevons was excited by the Cheque Bank. But he was not a fan of a subsequent competing payments innovation, the postal order.

The British Post Office, owned by the government, had long been engaged in the business of transmitting money orders, unofficially since 1792 and officially since 1838. A customer would walk into any money order office, put down, say, £2 and 2 shillings, and get a £2 2s money order. The recipient's name was then written on the order. It could then be sent via post to a distant office, upon which the recipient could take the money order to the counter to be cashed. The officer would first confirm the payment by referring to a separate letter of advice. This letter, sent from post office to post office, served an an extra layer of security against fraud. Only then would the £2 and 2 shillings be paid out.

The problem, according to then Postmaster General Henry Fawcett, is that the money order wasn't very useful to people who only wanted to send small amounts. "If a boy wanted to send his mother the first shilling he had saved, he would have to pay twopence for the order and a penny for postage," wrote Fawcett. In other words, to send a 12 penny (i.e. one shilling) money order, three penniesa massive 25%had to be sacrificed in fees. (A shilling in 1880 was worth around US$8 today.) And so it would have been an expensive payments option for the poor.

Prior to his appointment as Postmaster General in 1880, Fawcett had been both parliamentarian and the first professor of political economy at Cambridge. And while he wasn't as illustrious an economist as Jevons (he hasn't left us any bits of economic theory), Fawcett did write what was one of the popular textbooks of the day.

But if Fawcett wasn't going to change the study of economics, he did intend to change the payments system. As Postmaster General, Fawcett proposed complementing the money order with a new product called a postal note, or postal order. (The postal order had been earlier conceived of by George Chetwynd, the Receiver and Accountant General of the Post office). Like the cheques issued by the Cheque Bank founded just seven years before, postal orders would have a fixed denomination printed on them. These increments were to start at 1 shilling and go up to 20 shillings (US$8 to US$160 in 2019 dollars).

By contrast the post office's traditional payment product, the money order, was open-faced and had no denomination. Because postal orders would be issued in smaller amounts, the Post Office needn't bother sending separate letters of advice as a security measure, which meant that they would be far cheaper to process. And so the fees could be lower for postal orders than money orders, broadening the pool of customers.

In an 1880 essay, William Stanley Jevons blasted the idea of postal orders, which hadn't yet received legislative assent. Singling out Fawcett, Jevons wrote:

"The fact of course is that not only from the time of Adam Smith, but from a much earlier date, it has always been recognized that a Government is not really a suitable body to enter upon the business of banking. It is with regret that we must see in this year 1880 the names of so great a financier as Mr. Gladstone, and so sound an economist as Professor Fawcett, given to schemes which are radically vicious and opposed to the teachings of economic science and economic experience."
So that lays out the cast of characters in 1880. It includes exclusionary banks, hoards of unbanked, a set of opposed economists in Jevons and Fawcett, fintechs like the Cheque Bank, and a post office on the verge of issuing a novel product; postal orders.

2020 seems very much like 1880. To help connect the large population of American unbanked to the financial system, a number of modern day Fawcetts (Morgan Ricks, Mehrsa Baradaran, Rohan Grey) have floated public payments solutions including a return of postal banking, central bank digital currency (CBDC), or central bank-accounts-for-all.

Our modern day equivalents to the Cheque Bank includes non-banks such as prepaid debit card issuers Walmart and Netspend, both of which are trying to reach unbanked Americans. Online wallet companies like PayPal and Chime are also in the mix. And stablecoin issuers such as Facebook's upcoming Libra project talk a big game when it comes to financial inclusion. To round things out you've got your modern day Jevonses; economists who don't buy the idea that the government should get into banking (Larry White, George Selgin, Diego Zuluaga).

So how did things end up in 1880? Despite opposition from Jevons and the Economist, Fawcett's postal order dream came to fruition. After receiving legislative approval, the world's first postal orders were issued in 1881:

Postal orders would go on to become very popular. They largely displaced money orders, except for large amounts. Other postal systems including that of New Zealand, Canada, Australia, and the U.S. would go on to copy the idea. The UK's modern day incarnation of the post, the Post Office, still offers a version of the product.

And what about the Cheque Bank? Digging through old documents, Edward Prescott discovered that the Cheque Bank failed in the late 1890s. According to liquidation proceedings reported in the Banker’s Magazine, it was plagued by forgery problems and increased competition for less wealthy depositors from banks. Perhaps the emergence of the postal order also played a part.

I'm not invoking the 1880s as a prediction of what will occur in the 2020s. Rather, it fascinates me because it reveals how old these payments dilemmas are. The same tensions between public and private payments were present then as they are now. And it's also interesting to see how economists have always been engaged in questions of financial inclusion. Not just Fawcett but Jevons too, who we know primarily for his work on monetary theory. 

And over a hundred years later, Edward Prescott delved into the topic, too. In a 1999 paper (which mentions the Cheque Bank), Prescott discusses the idea of opening up an inexpensive type of bank account called an Electronic Transfer Account (ETA) so that all Americans, particularly the unbanked, might receive Federal benefit payments digitally. (Prescott was skeptical that ETAs might work out. The program, introduced in 1999, was discontinued in 2018 and has been replaced with a prepaid debit card program.)

In closing, the topic of how to help the unbanked is a complicated one with many moving parts. Which is why we should explore how things played out in different times. Perhaps history can get us to see the debate in a new light.

Merry Christmas and a Happy New Year!

P.S. If you're interested in learning more about Jevons's thinking on payments, he was a big champion of the idea of creating an international coin standard. I wrote about it here. Think of it as a proto-version of the Euro. Jevons came up with a "tidy English solution" for fitting Britain into this proposed international coin union. The project never came to fruition.