Thursday, March 23, 2023

Does FedNow mean quicker bank runs?

The Federal Reserve is introducing its first instant retail payments system this summer, FedNow. Retail is a catch-all term for small payments made by (and to) regular folks like you and me. Think bill payments, transfers to friends and family, salary, and more. Up till now, the retail crowd hasn't had a Fed-provided instant payments options.

The U.S. is also in the middle of a banking crisis.

Putting a banking crisis together with instant payments, some commentators fear that future U.S. bank runs will proceed even quicker than before.

I don't think so.

A bit of background. Up till now, the Fed's flagship retail payments system has been FedACH. (ACH stands for automated clearinghouse). FedACH is not a real-time system. Historically it has taken a day or two for ACH payments to settle, but even with the recent addition of a "same-day" ACH option, it still takes several hours for funds to land in a recipient's account.

Now that the Fed is building an instant system, the fear is that banking customers can presumably execute a run on their banks much faster than before.

One of the big gaps in this argument is that retail customers are generally sticky. The types of customers most likely to run on their bank are large depositors such as corporations, funds, and wealthy individuals. But these actors have always had Fedwire at their disposal, the Fed's large-value payments system. And Fedwire is already a real-time system; the moment a transaction request is sent to Fedwire, it gets settled. 

So the addition of FedNow to the arsenal of Fed instant payments systems doesn't add much in terms of runnability. Large U.S. depositors have always been able to execute rapid bank exits.

Fedwire closes at nights and on the weekends, though, whereas FedNow will be open 365/24/7. Won't this offer more temporal scope for runs?

I still don't think so. As a payments option for retail customers, FedNow payments will likely be capped, say at $25,000. Limits on the weekend and at night will likely be even lower than that. This is how other real-time systems like UK's Faster Payments have been managed, the idea being to cut down on fraud. If you're a large business with millions deposited in the banking system, a tiny $25,000 aperture isn't going to cut it.

So long story short, FedNow won't speed up bank runs. And that's because it won't serve as an additional exit for the most run-prone bank depositors, who already have Fedwire at their disposal.

The threat of a weekend or midnight bank run only begins when Fedwire itself starts to operate on a 365/24/7 basis. That's just a matter of time. India's large value payments system switched over in 2020; and the U.S. is generally a few years behind India when it comes to payments.

Tuesday, February 14, 2023

Weak nations with strong currencies

Two unlikely currencies were among the world's strongest currencies in 2022: the Yemeni rial and the Afghan afghani. Yemen is currently in the middle of a civil war and Afghanistan is a failed state, so neither is your typical candidate for a buoyant currency.

Both countries share a peculiarity, however: unlike most nations, neither can increase the supply of their paper currency. That may explain their odd bout of strength against the dollar.

Let's start with Afghanistan.

It's worth reading this blog post I wrote back in 2021, but if you don't have time the gist is that Afghanistan's central bank – Da Afghanistan Bank (DAB) – is effectively cut off from the global banknote printing market thanks to sanctions. Cash is the dominant form of money in Afghanistan. With the supply of afghani notes fixed and the demand for them rising over time along with population growth, my guess at the time was that the afghani's purchasing power could be fairly stable. "In a chaotic economy, the afghani—or at least some version of the afghani—may be one of the country's more reliable elements."

And that seems to be what is happening. According to Bloomberg, the afghani gained 5.6% against the U.S. dollar in 2022, one of the strongest performances of any currency in the world.

The stock of afghani notes is not entirely fixed. Late in 2022 the DAB was permitted to accept one batch of new banknotes, according to Reuters.

However, the new notes didn't add to the stock of notes circulating in Afghanistan. Rather, they were used to replace existing notes, which are often "torn in shreds or held together with cellotape." The LA Times had a good article on the shabby state of the Afghan money supply, including pictures like this one:

"Afghanistan’s money is crumbling to pieces, just like its economy" [source] copyright LA Times

As for Yemen, diligent readers may recall from my two previous blog posts (here and here) that a civil war has split the Yemeni rial into two different currencies. The Houthi rebels in the North control one branch of the central bank, the Sana branch, and have adopted rial banknotes printed before 2016 as the region's official currency. The Saudi-backed government in the South runs the other branch and has claimed all notes printed after 2016.

The two rials are not longer fungible, their price having diverged over time as the chart below from ReliefWeb illustrates. The rebel's old rials, the ones printed before 2016 (in blue) have held their value against the U.S. dollar, and even risen a bit in 2022. But the value of the Saudi backed regime's rials (in orange) has plunged:

The U.S. dollar exchange rate of the rebel-controlled Yemeni rial and the official rial [Source: ReliefWeb]

The reason? The rebel North is isolated from the rest of the world and can't contract with printers for new notes. Not only that, but the stock of pre-2016 notes is by definition locked in time. A note printed in 2023 can't masquerade as a pre-2016 note, at least not easily so. The official regime even printed up a batch of fakes last year and tried to sneak them over the border in order to undermine the rebel economy, a story I recounted here. But the rebels spotted the difference and refused to accept them.

So like Afghanistan, if you start with a weak economy and a fixed note supply, then add population growth, you end up a strong currency.

Unlike the rebels, the official regime in south Yemen has access to the global banknote printing market, and has ordered new notes and spent them into circulation. Which explains why the official regime's Yemeni rial has steadily declined in value.

Friday, February 3, 2023

Hey bitcoin owners, how are you paying for bitcoin's energy costs?

Bitcoin miner in La Doré, Quebec via L'Étoile du Lac

In what form do bitcoin holders bear bitcoin's huge energy costs?

For the Bitcoin network to be secure, it requires miners to do a lot of work, and those miners will only do that work if they are compensated. The creation of new bitcoins every 10 minutes is the main method of paying them. The question in this post is how these mining costs get passed on to people who hold bitcoin. Bitcoin is bloody expensive, after all. Owning it can't be free.

Let's explore the problem by looking for an analogy in traditional finance. In the place of bitcoin, let's introduce CashCo. CashCo owns $100 in cash. It has 100 shares outstanding. For simplicity's sake, let's assume that the shares trade at fundamental value, so each share is worth $1 ($100 / 100 shares) and the company's market capitalization is $100.

Let's introduce Jack, who holds one share of CashCo, worth $1.

Next, let's make CashCo resemble Bitcoin by introducing a mechanism that functions like bitcoin rewards. On January 1, CashCo announces that it will henceforth issue a single new share at the end of every day to an independent entity to validate CashCo's database. CashCo will do this each day for the next 30 days.

Like Bitcoin rewards, the additional CashCo shares are created out of nowhere and are paid to an external validator. Furthermore, the policy is time-limited, in the same way that bitcoin rewards will no longer be paid after some terminal point in time.

This is how it looks. At the end of Day 1, CashCo will issue one new share to the independent entity. At that point CashCo will have 101 shares outstanding. The fundamental value of each share will be $0.99 ($100 cash in the bank / 101 shares). But the fundamental value of the company as a whole would stay the same, since CashCo would still have $100 cash in the bank.

As for Jack, he still holds one share at the end of Day 1, but the fundamental value of his share will have fallen to $0.99.

At the end of Day 2, CashCo will issue another share to the validator, who now owns two shares. CashCo will now have 102 shares outstanding. The shares will have a fundamental value of 98 cents ($100 / 102 shares). But the total fundamental value of the company will still be $100, since it remains backed by $100 in cash.

The fundamental value of Jack's single share will have fallen to $0.98.

Fast forward 30 days, and there will be 130 shares outstanding. Each share will have a fundamental value of 76.9 cents, but the fundamental value of the firm remains at $100.

Jack is a forward-thinking individual. When the new policy is announced on Day 0, he quickly runs through the above calculations and sees that the fundamental value of his single share will be marked down from $1 to 76.9 cents over the next 30 days. Aghast, he immediately tries to sell it. But the policy being common knowledge, everyone else will make this calculation this too. No one will pay Jack more than 76.9 cents for his share, knowing that in 30 days its fundamental value will be 76.9 cents.

And so on Day 0, the moment the announcement is made the value of CashCo shares falls to around 76.9 cents. That is, the new information about future costs of paying the validator gets brought forward in time and is quickly baked into the current price of CashCo shares.

Bitcoin operates along the same principles as CashCo.  

The schedule of new bitcoins to be paid to miners is already known. Because bitcoin buyers are like Jack and forward-thinking, this cost is effectively brought forward in time such that it is already built into bitcoin's price. That is, the original bitcoin owners (and all owners after them) prepaid for security the moment that the Bitcoin network was brought into existence.

So let's conclude by getting back to my original question. In what form do bitcoin holders bear bitcoin's huge energy costs?

Holders bear bitcoin's costs the same way that Jack bears CashCo's validation costs: in the form of foregone price appreciation.

Jack's share is worth 76.9 cents, but if CashCo suddenly found a way to avoid paying an external validator, his shares would immediately vault from 76.9 cents to $1. So the form in which Jack absorbs validation costs is through a lower-than-potential price for CashCo.

The same goes for bitcoin. We can think of the price of bitcoin as being much lower than it would otherwise be in a world where those costs didn't exist.

So bitcoin owners, the form in which you absorb bitcoin's huge energy prices is via a permanent discount on the value of your bitcoin stash. Instead of bitcoin being worth, say, $35,000 or $45,000, it's only worth $23,000 you're effectively missing out on a big one-time jump in the price.


Here's an exercise for you. Does this same logic apply to proof-of-stake coins like ether or tezos? Is the schedule of future Ethereum staking rewards already baked into today's price of ether, just like bitcoin mining rewards are baked into bitcoin's price? Yes? No? Provide your work. 

Wednesday, February 1, 2023

Why I prefer perpetual/premium bonds to the platinum coin

1877 $50 Thirty-year Registered 4% Consol [link]. (A consol is a perpetual bond.)

If I had to choose one of the tricks for getting around the debt ceiling, I'd go with premium bonds/perpetual bonds over the platinum coin.

I've known about the platinum coin idea for over a decade (Here's an old blog post I wrote on it back in 2013.) But I only recently found out about the premium bond idea courtesy of Ivan the K on Twitter. (Little did I know there's a long intellectual pedigree for this idea on the blogosphere.) Related is the idea of issuing perpetual bonds, or consols, to get around the ceiling (which seems to have first been discussed at the now defunct Monetary Realism blog, by Beowulf, the person who figured out the platinum coin loophole?).

The premium/perpetual bond trick, in short, is to get around the debt ceiling by issuing new bonds either at a premium to face value (premium bonds) or with no face value at all (perpetuals). Both types of bonds get around the debt ceiling because apparently only the face value of a bond counts to the ceiling.

I prefer issuing premium and/or perpetual bonds to the platinum coin because the former options don't encumber the Fed's balance sheet. The latter does. Evading the debt ceiling with any of the proposed tricks is already a dicey proposal. Choosing as your method a trick that also handicaps the Fed only multiplies the drawbacks of the whole thing.

Encumbering the Fed's balance sheet would reduce the Fed's independence, and independence is a good thing. The Fed's job is to set a target for the national monetary unit, the dollar, which along with the mile or the pound is one of the most important components of the U.S.'s system of weights & measures. To do it's job of calibrating the dollar unit, the Fed should be protected from the day-to-day ambitions of politicians, at least more so than other government institutions.

If you recall, the platinum coin requires the President to ask the U.S. Mint to manufacture a $1 trillion coin made of platinum and then deposit it at the Fed. The Fed then instantiates $1 trillion in deposits which the government can proceed to spend.

The platinum coin trick does neuter the debt ceiling. However, in the process the Fed has issued $1 trillion more dollars than it would have otherwise. This extra issuance is in turn secured by an illiquid non-interest earning asset on its balance sheet; the platinum coin. The Fed is hobbled. For a central bank to be independent, it helps to have a consistent stream of revenue to pay for expenses. That's where interest-earning assets are key. Liquid assets are also vital, because they can be sold in a snap to market participants if necessary for monetary policy purposes. Either way, a 0%-yielding trillion dollar platinum coin doesn't make the cut.

Compare this to the alternative of issuing premium bonds or perpetuals directly to the market.

In this scenario, the Fed's balance sheet hasn't changed at all. The Fed hasn't issued an extra trillion dollars into existence. And it still holds the same portfolio of highly-liquid interest-earning assets as before. Yet the debt ceiling has been evaded.

In sum, with premium and/or perpetual bonds, you get all of the debt ceiling evasion punch with none of the decline in central bank independence. It seems to me to be clearly the better of the two options. (Unless you're not a fan of Fed independence. If you aren't, the platinum coin conveniently shoots two birds with one stone: not only does it get around the debt ceiling, but it also short-circuits the independence of the central bank.)

Tuesday, January 31, 2023

A big chunk of crypto is gambling. Why not regulate it that way?

[This article was published last week in CoinDesk.]

The Pluses and Minuses of Regulating Crypto as Gambling

In the wake of FTX's shocking collapse, a new idea for regulating crypto has begun to take form: Let's regulate crypto like we regulate gambling.

Todd Baker, a Senior Fellow at the Richman Center for Business, Law and Public Policy at Columbia University, recently writes that "crypto trading should be regulated for what it is – gambling emulating finance and not what its advocates say it is or what people believe it to be."

The European Central Bank's Fabio Panetta suggests that "regulation should acknowledge the speculative nature of unbacked cryptos and treat them as gambling activities." And here is a recent American Banker article on the topic.

There are some good aspects to the idea of regulating crypto as gambling, and some bad.

First, the bad.

Crypto is too diverse for one regulatory framework

Any claim that we should regulate crypto as X isn't very helpful, and that's because the stuff we call "crypto" has long ceased to be a single-issue product that can be conveniently boxed into any one framework. Maybe back in 2012 and 2013 it could have been. And gambling might very well have been the best fit back then.

But, at its core, crypto consists of a bunch of programmable databases, which means they can host all sorts of applications – not just gambling applications. Zoom forward to 2022 and the range of activities occurring in the crypto space has become quite broad and diverse.

Take MakerDAO, for instance. MakerDAO is built on a blockchain, and so it falls under the “crypto” umbrella. But it isn't a gambling product. Functionally, MakerDAO is a bank that makes loans by issuing deposits in the form of dai (DAI), a stablecoin.

To make things more complicated, ownership of MakerDAO is represented in the form of MKR tokens, also residing on a blockchain, which allow holders to vote on how the bank operates. MKR also provides holders with a claim on bank earnings. In effect, MKR tokens are like shares in Wells Fargo or Bank of Montreal. They are investments.

To regulate MakerDAO and the tokens associated with it – DAI and MKR – as gambling products just wouldn't make sense, for the same reason that regulating Wells Fargo or its underlying shares as a casino would be a clumsy fit.

Or take decentralized tools Aave and Compound, which have been built on blockchains. Both are lenders. While these two tools certainly service a gambling clientele, they aren't themselves gambling apps and shouldn't fall into that category.

Or consider centralized exchanges such as Coinbase. Coinbase lets customers directly buy and sell crypto with cash, combining in one platform the roles of a traditional broker like E-Trade with a trading venue like Nasdaq. However, we apply securities regulation to E-Trade and Nasdaq, not gambling regulation, and should probably do the same for Coinbase.

In sum, to regulate crypto it'll take more nuance than just throwing it all into the gambling category. There are many different existing regulatory frameworks that can be applied to emergent blockchain-based products, of which gambling is just one.

Next, here’s what’s good about regulating crypto as gambling.

A long overdue recognition of crypto problem gambling

Dai, MKR, Aave and Compound may not be gambling. But a large proportion of crypto is gambling. That's because a big chunk of the people who engage with blockchains are doing little more than betting on the very volatile prices of first-generation unbacked volcoins like dogecoin, floki inu, and shiba inu. Let's not forget bitcoin, bitcoin cash, litecoin, xrp, and ether.

The crypto industry has tried its hardest to elevate volcoin betting from gambling to "investing." Coinbase, for instance, loftily sees its mission as to "increase economic freedom in the world."

But if you look under the hood, a volcoin such as dogecoin is little more than a never-ending 24/7 lottery on what average opinion thinks the price of dogecoin will be. This same recursive betting process is what drives the prices of bitcoin, litecoin and other volcoins. Users can sell their position in these never-ending lotteries to other players, and in some cases the casino chips get used as a payment token – but the payments functionality of volcoins has always run a distant second to their primary lottery function.

The benefit of officially recognizing volcoin-based betting as a form of gambling is that it would import into the world of crypto society’s already-existing protections for problem gamblers and children.

Problem gambling is a disorder characterized by a persistent and uncontrollable urge to gamble despite negative consequences or attempts to stop. It can lead to financial difficulties, relationship problems, and mental health issues such as depression and anxiety.

In many jurisdictions, gambling operators are required to address problem gambling by implementing self-exclusion programs that allow customers to voluntarily ban themselves from gambling establishments or betting sites. By regulating volcoins as gambling, venues that offer these products – say like Coinbase, PayPal and Kraken – would be required to set up exclusion programs of their own.

Gambling venues are often required by law to display responsible gambling messages such as "Play Responsibly. Remember, it’s just a game." The MegaMillions play responsibly page, for instance, provides information about problem gambling and a confidential 24-hour hotline.

Applying these messaging standards to crypto, it would no longer be permissible to represent volcoin purchases to clients as a form of investment. Rather, venues like Coinbase and PayPal would have to provide disclaimers along the lines as: "Play bitcoin responsibly. Remember, it’s just a game."

In many jurisdictions, a recognition of volcoins as gambling would limit opportunities for public advertising. In 2021, ads for floki inu flooded London. "Missed Doge? Get Floki," the ads said, appealing to peoples’ base fears of missing out. However, the United Kingdom has a very strict code surrounding gambling advertisements. Had floki and other volcoins been properly categorized at the outset as betting games, then floki’s advertising campaign would have had to pass many more hurdles.

Or take Matt Damon's notorious "fortune favors the brave '' ad for from early 2022. The ad tried to analogize volcoin buyers to intrepid explorers. By regulating volcoins as betting, ad creators could no longer draw these sorts of dubious analogies in an attempt to attract bettors to their platforms.

In particular, gambling regulatory frameworks in places such as the U.K. explicitly prevent gambling operators from reaching out to children through advertising. If volcoin betting were to be deemed a form of gambling, then crypto platforms that court users under the age of 18 (say like Block and Kraken have done in the past) would be required to put an end to this practice.

Finally, some U.S. states limit the ability of gamblers to fund their activities by credit, as does the United Kingdom. The idea is to prevent a problem gambler's addiction from snowballing into a much larger crisis for the family's finances. Translating this rule over to crypto could mean no longer allowing customers to buy volcoins with credit cards and/or restricting access to margin.

To sum up, the idea of applying crypto regulation to crypto needs to be fleshed out. There are many blockchain-based activities that are not gambling, and shouldn't be regulated as such. But a big chunk of what occurs on blockchains is gambling, and it's about time we recognized it as such – and regulated it accordingly

Tuesday, January 10, 2023

Why the steepest borrowing rate may be the best rate

(This isn't a piece of financial advice. It's more of a fun parable about interest rates.)

So here's an interesting financial riddle. Let's say I want to buy a used car for $1000. 

First, I need a loan. Say that there are two floating rate loans available to me: one that currently costs 3.2% per year, and another that costs 2.3%. Logic dictates that I should take the cheaper 2.3% option, right? But I don't. Instead I take the more expensive one, figuring to myself that the expensive 3.2% loan is actually the cheaper loan.

Why on earth did I do that?

The rates in question are from the website for Aave, a tool for borrowing and lending cryptocurrencies, including stablecoins:

The cost of borrowing two different stablecoins on Aave [source]

If I borrow 1000 Tether stablecoins from Aave to fund my purchase of the $1000 car, it'll cost me 3.2%. But if I borrow 1000 USD Coins, it'll cost me just 2.3%. Those are floating rates, not fixed. (I could also borrow stablecoins on a fixed basis. A fixed-rate Tether loan would cost me 12.26% on Aave, a USD Coin loan 10.69%. Again, it's more expensive to borrow Tether.)

Why would I pay 3.2% to borrow one type of U.S. dollar, Tether, when I can get another type of U.S. dollar, USD Coin, at a cheaper rate? I mean, they're both dollars, right? They each do same thing; that is, they both provide me with the means to buy a $1000 car.

To see why I might prefer the more expensive Tether loan, we need to understand why the rates on Tether and USD Coin differ:

If I borrow 1000 stablecoins to buy a $1000 car, eventually I'll have to buy those 1000 stablecoins back in order to repay my loan. Wouldn't it be nice if, in the interim, the stablecoin I've borrowed loses its peg and falls in value? Because if it were to do so, I'd be able to buy back the 1000 stablecoins on the cheap (say for $400 or $500), pay back my 1000 stablecoin loan, and keep the $1000 car. 

In short, I'd be getting a $1000 automobile for just $400-$500 plus interest.

By contrast, if I were to borrow a more robust stablecoin in order to purchase the car, then that'd reduce the odds of its price being weak when it comes time to repay my loan, thus making the entire transaction more expensive to me. 

A $1000 car would cost me... $1000 plus interest.  

We can imagine that all potential borrowers are perusing Aave's loan list with that exact same thought in mind. Jack wants to finance a house for $250,000 by getting a stablecoin loan on Aave. Jane wants to borrow $100 in stablecoins on Aave to pay off her credit card debt. All three of us would really, really, really, like to borrow a stablecoin that fails, reducing the net cost of our purchase. So we all do our respective research and select what we believe to be the stablecoin with the worst prospects, the one most likely to be worth just 40 or 50 cents when it comes time for us to repay our debt.

The competition between the three of us to borrow the worst stablecoin will cause borrowing rates for the worst stablecoins to rise. Conversely, borrowing rates on the stablecoins with the best prospects will fall.

And that's what I suspect is happening on Aave. Tether is seen as the riskier stablecoin. And so from the perspective of the borrowing public, a Tether loan is superior to a USD Coin loan. Jack, Jill, and myself are all scrambling for the privilege of borrowing Tether, in the process pushing the cost of borrowing Tether 0.9% above the cost of borrowing USD Coin.

Now we can get back to the original riddle. Even though the rate to borrow Tether is higher than the rate to borrow USD Coin, it may be worthwhile for me to go with the a Tether loan if I think that the odds of Tether failing justify the higher financing cost.

We can even go a bit further and say that the 0.9% premium on a Tether loan is the market's best estimate of the odds of Tether losing its peg relative to USD Coin losing its peg. So for all those would-be stablecoin analysts out there, keep your eye on Aave's USD Coin-Tether spread. It's a good indicator of stablecoin risk.

P.S: The difference between the cost of borrowing Tether and USD Coin could also be due to the liquidity premium on Tether being larger than the liquidity premium on USD Coin. I'm not going to get into that possibility in this post, but if you're curious ask me about it in the comments. 

P.P.S: Does this same logic apply to borrowing from banks? Would I rather borrow from a bank that's about to fail rather than a solid respectable bank?

P.P.P.S: Some Dune dashboards tracking he Tether-to-USD rate premium: here and here.

Thursday, January 5, 2023

Is crypto just gambling?

Is crypto just gambling? That's a point I made in my recent "let it burn" blog post. (And I notice that the ECB's Fabio Panetta recently said the same thing, describing crypto as a "gamble disguised as an investment.") In this short post I want to clarify what I mean.

What the word "crypto" means (in my universe, at least) is the array of financial applications built on a new kind of database, otherwise known as a blockchain. Some blockchains include Bitcoin, Ethereum, Solana, Tron, and Dogecoin. What makes these databases novel is that they are open(ish) and decentralized(ish). Contrast this to my bank's SQL database, which is 100% under my bank's control.

Before blockchains came along, financial providers were already housing all sorts of applications on their closed internal databases. These financial applications included banking, stock trading, money transfer, brokerage, and insurance, as well as less savory financial applications like gambling, betting, and triple-levered ETFs. And of course, our pre-2009 databases also hosted downright illegal financial applications like pyramid schemes and ponzis.

Then blockchains arrived, beginning with bitcoin in 2009. And people started to replicate on blockchains the financial applications that had previously only been built on regular databases.

And now we can get to why I say that crypto is just gambling. To date, the most popular financial applications being hosted on blockchains are all gambling applications.

The dominant form that blockchain-based gambling takes is betting on the prices of various unbacked tokens including dogecoin, shiba inu, xrp, cardano, ether, litecoin, and bitcoin. The price of these tokens is arrived at via a purely self-referential process whereby players gamble on what "average opinion expects the average opinion to be." The resulting price is so spectacularly erratic that a good player can buy some dogecoin at the beginning of February and make 100% by the end of the month, or 10,000% by December.

Gambling isn't the only financial application to be built on blockchains. A number of interesting non-gambling blockchain-based financial applications have emerged, too. These include applications that offer banking (MakerDAO), trading (Uniswap), non-bank lending (Aave), and money transfer (USD Coin and Tether).

However, the aforementioned non-gambling financial applications that have been built on blockchains mostly serve people who are themselves gambling on the prices of dogecoin, bitcoin, shiba inu, and other unbacked tokens. Most of MakerDAO's loans, for instance, have historically been to gamblers who want to speculate on the price of ether.

And so once again, that's why I say that crypto is just gambling. Most people who use blockchains are either directly gambling on unbacked token prices, or are providing financial services to these gamblers.

At the moment crypto may just be gambling, but that doesn't mean it'll always be just gambling. Eventually what we'd like to test is whether blockchain-based financial applications have the ability to emerge from the self-contained gambling cocoon they currently occupy in order to (safely!) serve the massive population of non-gambling financial consumers. For instance, in the future might it be possible for a small business to get an unsecured loan from MakerDAO as easily and cheaply as they can from a local bank or credit union?

For now, we don't know the answer to this test. It could be that blockchain-based financial applications simply lack the moxie to transcend the earthly gambling plane into something more broadly useful, and offering gambling on unbacked coin prices and services to those gamblers is all they'll ever amount to. Or maybe not. It'll be interesting to see the results of the test.

Tuesday, January 3, 2023

How Tether can stop being the stablecoin that everyone sells in a panic

The not-so-stable price of Tether in 2022 on the Kraken exchange

[Republished below is my latest article from CoinDesk.]

How Tether Can Be a More Stable Stablecoin

The crypto economy has suffered two major crypto failures this year: the collapse of Luna/TerraUSD in May and the failure of FTX in November. In both instances, the world's largest stablecoin, Tether, was caught in the blast radius as waves of redemptions poured into the company. It shrunk by $18 billion, or 21%, in May and June and by another $4 billion, or 6%, in November.

Stablecoins shouldn't be the instruments that the public sells in a panic. They're supposed to be the opposite; the life vest that people grab on to. Competing stablecoins USD Coin and Binance USD performed as one would have expected. Neither experienced a barrage of redemptions during these two episodes.

Here are four things that Tether can do to ensure that the next time the crypto economy undergoes a shock, tether stays steady.

1) Tether needs to get rid of its corporate bonds, funds and "other investments."

A stablecoin's number one job is to be steady, and that demands holding safe assets like cash and Treasury bills. But some of the line items on Tether's balance sheet – including commercial paper, corporate bonds and funds, secured loans and "other investments” – suggest that Tether operates more like a hedge fund or venture capital firm than a stablecoin.

Tether has been slowly addressing this problem. It spent much of 2022 replacing its massive $30 billion horde of commercial paper with Treasury bills, finally bringing the tally down to zero just prior to the FTX catastrophe.

But even after this cleansing, Tether still suffered from a wave of redemptions in November. Realizing it hadn't gone far enough, Tether executives made a pledge earlier this month to reduce its $6 billion in secured loans to zero.

That's great, but the company has been silent on what many analysts consider to be its sketchiest assets: its $2.6 billion in other investments and $3 billion or so in corporate bonds and funds. What is the rating and duration of these corporate bonds? Who are the borrowers – are they crypto firms? Are its other investments and funds composed of crypto-specific tokens?

Fear that these investments could sour is the best explanation for why the last two general cryptocurrency panics have inspired temporary runs on Tether. Best to get out of Tether now, goes the thinking, in case the company no longer has enough funds on hand to redeem all Tether tokens.

To put an end to this pattern, Tether needs to sell all of its risky assets and move to a 100% safe-asset allocation. Next time a crisis hits, users will be less likely to unload their Tether tokens.

2) Tether needs to cancel its 0.1% redemption/withdrawal fee.

While the prices of competing stablecoins Binance USD and USD Coin are well-anchored to $1 on major exchanges around the globe, the price of Tether tends to fluctuate randomly. This lack of stability hurts the company’s reputation. At heart is Tether's 0.1% redemption fee. Time to get rid of it.

Tether charges anyone who wants to redeem or withdraw Tether tokens a 0.1% fee. So if you own 1 million tether tokens and want to redeem them, you'll only get $999,000 back after paying the $1,000 fee to Tether. Likewise, if you wire $1 million in fiat to Tether in order to get stablecoins, you'll only get $999,000 USD back.

The other big stablecoin issuers, Circle and Paxos, do not charge these fees.

It may not sound like much, but the 0.1% fee leads to the price of tether weaving randomly in a wide band around $1 rather than staying locked.

The price at which any stablecoin trades on exchanges like Binance and Kraken is set by arbitrage. If the price falls too low below $1, arbitrageurs buy stablecoins on the exchange and transfer them to their issuers for redemption at $1, earning a small profit. They execute the inverse when a stablecoin’s price is too high.

Competition among arbitrageurs to execute these trades at a profit is what locks the price of stablecoins on key exchanges at a price close to $1.

Tether's 0.1% fee adds to an arbitrageur's costs of carrying out this trade. Factoring in this cost, it only really becomes profitable to buy tether tokens when they've fallen to $0.999, and sell them when they've risen to $1.001. Tether’s price randomly floats within this relatively wide band.

This lack of rigidity attracts bad press, rumors, innuendo and speculation. It makes Tether look particularly bad during broader crypto meltdowns when its price inevitably falls to the bottom of its trading band, mirroring the performance of other risky crypto tokens rather than holding strong at $1. Meanwhile, other stablecoins like USD Coin and Binance USD, which don't have redemption fees, hold strong.

It's time for Tether to get rid of this fee in order to create more confidence-inspiring trading patterns on third-party exchanges.

3) Tether needs to open redemptions up to more people by removing its $100,000 floor.

Tether is unique among stablecoins in putting a $100,000 floor on the amount of tether that can be redeemed or withdrawn at source. Other stablecoin issuers like Circle and Paxos allow people to withdraw or deposit any amount.

This floor creates perverse trading patterns on exchanges like Binance and Kraken, which further exacerbate fears about Tether.

In short, Tether's $100,000 minimum pushes the majority of USDT users who want to sell en-masse on exchanges. In theory, well-heeled arbitrageurs are supposed to buy these users' unwanted tokens on these exchanges and redeem them at Tether, thus anchoring Tether's price close to $1.

But it is precisely during broad crypto panics that this arbitrage mechanism breaks down: arbitrageurs back off out of fear of losing their capital, exchanges halt withdrawals as activity overwhelms them, and blockchains get congested. And so panicked on-exchange sales of tether overwhelm the mechanisms that are supposed to anchor tether, and its price falls below the lower end of its $0.999 band.

Far below. In May, Tether fell to 92 cents on Kraken. In October, it fell to under 93 cents. These depegging events engender more fear, leading to more sales of tether, leading to larger declines in price and more panic.

If Tether removed its $100,000 minimum and allowed everyone to redeem at source, then tether users wouldn't have to flock en masse to exchanges in order to offload their tether. They could simply send their 100 tether directly to the company and get $100.

This would relieve price pressure on exchanges and bring an end to Tether's crazy on-exchange price movements.

4) Tether needs to be more transparent.

Lack of transparency is an old criticism of Tether, but it deserves to be re-enunciated. Tether falls short of the current standard for stablecoin transparency. This lack of transparency helps create a trust gap that leads to Tether selloffs during market panics.

The stablecoin industry's current transparency standard has been established by the New York Department of FInancial services (NYDFS). Auditors attest to the state of the stablecoin's investments on a monthly basis, these reports being published on the issuers' websites. In addition to an end of month test of an issuers’ investments, the NYDFS requires stablecoins operating under its framework to be tested on one random day during the course of the month.

That's 24 tests per year. Alas, Tether reports on a quarterly basis. So its auditor is only testing the company’s investments four times per year. That's not good enough.

The NYDFS also requires stablecoin issuers to have an auditor examine its internal controls once a year. Internal controls are the rules and procedures that companies adopt to prevent mistakes and fraud such as separation of duties, verification of invoices and controlled access to financial reporting systems.

Tether's auditor has not examined the company's internal controls.

By bringing its disclosure practices up to industry standard, Tether will grow trust and users will be less likely to dump Tether tokens come the next crypto panic.

To sum up, tether has become that stablecoin that everyone sells when panic hits. But this doesn’t have to be the case. By selling its risky assets and only holding safe t-bills, removing its 0.1% redemption fee, allowing all users to redeem at source and improving transparency, tether can transition into a much more stable stablecoin.

Wednesday, December 28, 2022

Let it burn

I sympathize with parts of the let it burn thesis. The thesis goes a bit like this:

Crypto is mostly gambling. It provides very little of social value, and may even be a net negative. The recent collapse of the FTX crypto exchange is illustrative of this. It would be a travesty for us to wade in after the fact and lever public resources to regulate crypto. To do so would grant undeserved credibility to the stuff. Thankfully, the collapse of FTX didn't spread into the real economy. Let's keep crypto unregulated and isolated. Leave it to die of its own accord.

Four quick push backs:

1. Crypto is not going to burn down because of FTX. We know this because it has already collapsed multiple times (2011, 2014, 2018) yet each time people come back and want to play the Dogecoin or Shiba Inu or Bitcoin games. Dozens of crypto trading venues have collapsed over the last decade due to fraud and incompetence, yet burnt customers keep coming back to the table to play. 

Crypto is fun and exciting. It's here to stay. Maybe it's time to set up some guard rails.

2. Yes, crypto is mostly gambling. But we already allow all sorts of gambling activities, including sports betting, online casinos, and speculation on double-leveraged VIX ETFs. We set requirements on providers of these activities in order to protect users from fraud and wrongdoing. Let's do the same for crypto.

Start with the venues that facilitate crypto gambling: so-called "exchanges" like Kraken, Binance,, and Coinbase. These platforms provide both brokerage and exchange services, combining two functions that regular finance has traditionally separated. Require these crypto broker-exchanges to comply with the same basic consumer financial protections that currently apply to non-crypto brokers and exchanges. This includes segregation of customer funds, third-party custody, regular auditing, and insider trading prevention.

The idea is to let people engage in risky gambling, but to do so as safely as possible.

Canada and Japan have already taken these steps. That's why Canadians and Japanese are much less likely to be on the list of those hurt by FTX's collapse than folks in Australia and U.S., which haven't yet gone down the road to regulating crypto broker-exchanges.

3. The failure of a casino or sport-betting site is rarely systemic. Likewise, regulated crypto venues will probably never pose significant systemic risk. Even if a crypto venue were to somehow became so integral to finance that its failure would be catastrophic, we have tools for this, like designating venues as systemically important financial institutions.

4. It's possible that the value that crypto provides to society one day transcends gambling. Crypto could  become a way to get a consumer loan or finance a startup. If so, better to hold a given type of crypto venue to whatever set of regulatory standards are the most appropriate, and do so now rather than later. If a crypto platform quacks like a bank, for instance, then regulate it as a bank, perhaps tailoring the rules a bit here and there to account for the peculiarities of crypto. If it quacks like a broker-dealer, then regulated it as a broker-dealer.