Sunday, March 31, 2019

Prepaid debit cards. The other anonymous payments method

When it comes to financial privacy, good old fashioned banknotes and privacy cryptocurrencies like Zcash & Monero get all the attention. But as I recently wrote for the Sound Money Project, let's not forget about prepaid debit cards.

Having written a bunch of posts over the last two years about financial privacy, I recently decided that it was time to step up my own personal financial privacy game. A few months ago I walked into my local pharmacy and bought my first non-reloadable prepaid debit card (i.e. gift card), a Vanilla card.

You've probably seen the rack of prepaid cards near the front of pharmacies and department stores. Some of them are closed-loop cards. They can only be used to buy things at the issuer, say Tim Horton's or Starbucks. But some of them, like my new Vanilla Prepaid card, are open-loop cards. That means they can be used wherever Visa or MasterCard are accepted. In Canada, Vanilla cards are sold in denominations from $25 to $250.

The Vanilla card that I bought doesn't have my name on it, nor did I have to show any ID to buy it. I paid for it in cash. This means that whenever I use my card, my identity won't be associated with the purchase. My card is backed by dollars held in a pooled account at Peoples Trust Company, a Canadian bank. It gives me the right to anonymously route my portion of the pooled funds along the MasterCard network to a retailer who operates a MasterCard terminal.

Given that authorities and banks have spend decades constructing a vast financial surveillance apparatus (the Bank Secrecy Act, FATF, AML, CFT, suspicious transaction reporting etc), it seems odd that this small window for accessing the digital payments system anonymously would have remained intact. To comply with Canadian anti-money laundering requirements, card-issuing banks require that the prepaid card seller (my pharmacy) collect the buyer's personal information if the face value of the card exceeds $1000. For amounts below that, due diligence is waived. The same practice is followed in the U.S. This regulatory exemption is why I didn't have to give up my anonymity when I bought my card.

The idea motivating the sub-$1000 exemption is that small amounts of anonymity can't easily facilitate criminal activity, but larger amounts can. (Note that I can convert my non-reloadable Vanilla card into reloadable format—i.e. a card that I'll be able to add money after the first batch is used up—but I'll have to register and forfeit my information. Only non-reloadable cards below the $1000 cap are exempt from due diligence.)

I'm not obsessed with privacy. I still use my information-laden credit card for a big chunk of my day-to-day purchases. But from time-to-time I want to have the option of shielding my data from outside observers. Cash is good for that. I already use banknotes and coins to pay for about half of my face-to-face purchases. This is usually for the sake of convenience, but sometimes it's because I'd prefer not to give up too many of my personal details to the retailer (especially small shops I've never been to before).

By adding a non-reloadable prepaid debit card to my wallet, I've gained an extra degree of protection. Say that I've used up all of the cash in my wallet, or I need to make a purchase in a place that doesn't accept cash, or I want to buy something online—well, a prepaid gift card offers me a way to make a transaction while still protecting my data.   

Law abiding citizens who are conscious of their financial privacy are a pretty small demographic. Sellers of non-reloadable prepaid cards have much larger markets in mind, specifically: 1) people looking to buy convenient gifts for friends and family or; 2) the unbanked and underbanked, i.e. those who don't have bank accounts or have them but don't use them. By allowing people to buy prepaid cards without identification, those without formal credentials such as driver's licenses, social insurance numbers, or credit scores can still make digital payments. Think the homeless, children and teenagers, immigrants, and refugees.

The post-9/11 brigade of security-at-all-costs zealots would love for regulators to shut the prepaid anonymity window. They worry that terrorists and money launderers will abuse prepaid cards. The anonymous prepaid window has only stayed open because these zealots have been countered by a collection of banking lobbyists who want to keep doing business with the unbanked and politicians who care about the disadvantaged.

I'm neither unbanked nor underbanked. I've got several bank accounts that I often use. Nor am I buying these cards as gifts. So I'm not really the target market for non-reloadable debit cards. My ability to get anonymous access the digital payments system is really just a by-product of the wider effort to make it easy for the unbanked to plug in. This is a precarious position for a privacy-conscious individual to be. In the U.S., where only ~93% of the population is banked, the constituency for anonymous prepaid access is relatively large. But in places where the banked population is approaching 100% (Canada, Finland, Germany, Netherlands, Denmark, Belgium, Sweden, UK), there is probably diminishing political support for providing anonymous access to the banking system.

In Europe, for instance, the window for anonymous access to digital payments seems to be closing. When the EU's 4th Anti-money laundering directive was passed in 2015, up to €250 in electronic money (the EU's term for prepaid instruments that reside on a device, say a card or a phone) could be bought without being asked to give up personal information. With the passage of the 5th Anti-money laundering directive in 2018, this amount has been reduced to just €150. And a new ceiling on online purchases of €50 was introduced. As I wrote in my recent Breakermag article, such a tiny amount of anonymity just isn't that useful.

One thing I've noticed about prepaid financial anonymity is that it is expensive. My first Vanilla card had a face value of $25. But I had to pay an onerous $3.95 to activate it. Buying higher value cards defrays this expense, but it still costs $7.50 to activate a card with a face value of $250. That's a 3% levy. Keep in mind that when I use an anonymous prepaid card not only am I paying the activation fee, I am also forgoing 2% cash back that my not-so anonymous credit card would otherwise provide me with.

Think about it this way. Let's say I decide to buy my groceries anonymously using a prepaid card. My $250 only gets me $242.50 worth of goods ($250 less the $7.50 activation fee). With my credit card, I can get $255 worth of food ($250 plus $5 cash back). That's an extra $12.50 in spending power if I decide to go the non-anonymous route. Sure, by using a prepaid card I've prevented my grocery store from being able to collect information about my eating habits. But is the $12.50 I've given up worth it? (Incidentally, this calculation also indicates how costly it is to be unbanked!)

While prepaid anonymity is handicapped by a low ceiling and high fees, the drawbacks don't stop there. Non-reloadable prepaid debit cards are great for buyers who want small amounts of privacy, but they don't help out retailers who want to shield themselves. In a recent article, privacy advocate Timothy May made a great distinction between buyer privacy and seller privacy:    

If someone is selling a controversial product (May uses birth control information as an example), they must always be wary of snitches who make a purchase only to "out" the seller, either by reporting the transaction to the authorities or posting it to social media. Controversy-wary payments providers will quickly cut the seller off. To protect themselves, sellers need a payments method that doesn't leave a paper trail. They also need a payments system from which they can't be censored. Cash is a good example—it doesn't leave a paper trail and is censorship resistant. So are privacy-friendly cryptocurrencies. But prepaid cards don't cut it. The seller can easily be reported to the network and banished.

The last drawback of non-reloadable prepaid debit cards is that they can't be used to make anonymous person-to-person payments. As far as I know, there is no technical reason that I shouldn't be able to use my Vanilla debit card to anonymously send $100 to anyone else with a Visa card, just by inputting their card number and clicking send on a website. In theory, this payment should get pushed across the Visa network.

But there are regulatory reasons that I can't do so. In the U.S., the Financial Crimes Enforcement Network (FinCEN) prohibits anonymous debit cards from offering person-to-person capabilities, and I believe the same rule applies in Canada. Meanwhile, cash and privacy-friendly cryptocurrencies do allow for anonymous person-to-person payments.

In sum, non-reloadable prepaid debit cards allow for a small extension of one's financial privacy. But in an age where the ability to make payments without someone snooping is getting increasingly rare, I suppose we have to take whatever crumbs we can get.

Thursday, March 28, 2019

Should governments finance themselves through their central bank?

In places like the U.S. and Europe, it is actually difficult—if not impossible—for a government to have its central bank pay for government programs. All government spending must be financed by issuing bonds to the public or collecting taxes.

Canada, my home country, is an interesting counter-example. The financial relationship between the Federal government and the Bank of Canada—our central bank—is fairly permeable. The government has the authority to ask the Bank of Canada to directly fund a portion of its spending.

This avenue is rarely taken, however. Justin Trudeau, our current Prime Minister, currently uses bonds and taxes to fund almost all of the Federal government's spending. Just one small and unknown government program is directly funded by the Bank of Canada: the prudential liquidity management plan, an old Stephen Harper-era program. (I wrote about it here and here). The goal of the prudential liquidity plan is to provide a cash cushion that the Federal government can rely on to “safeguard its ability to meet payment obligations in situations where normal access to funding markets may be disrupted or delayed.”

The details of the program aren't really that important. The point I want to make is that the Federal government hasn't had to issue bonds to the public in order to fund the prudential liquidity management plan, nor has it had to wait for taxes to be paid. All it did was tell the Bank of Canada to create some dollars for it out of nothing, and the Bank of Canada shrugged and complied.

So would it make sense for Justin Trudeau to have the Bank of Canada fund other programs than just the prudential liquidity management plan? Why not get it to fund the Federal government's share of health spending, or national defence, or Old Age Security?

Let's take the example of national defence. Say that the Trudeau government has been planning to follow conventional funding procedure and intends to issue $400 million in new treasury bills to pay the salaries of our soldiers for the months of April and May. But Trudeau changes his mind and tasks the Bank of Canada to create $400 million in fresh deposits for the government, ex nihilo. As the soldiers' salaries come due, the dollars will be wired to the commercial banks where the soldiers do their banking, these banks in turn crediting the soldiers' accounts.

Are there any real differences between the two funding scenarios? Under both the treasury bill and Bank of Canada routes, the soldiers will get paid. What about cost savings? The Bank of Canada is obligated to pay interest to banks on the $400 million in new balances it has created. It pays a rate of 1.75% or so, which is pretty much equivalent to what the government would have paid on $400 million in new treasury bills.

Thus, from a cost savings perspective there's really no difference between the two scenarios. Either way, the government is going to be paying 1.75% in interest to whomever happens to be holding the instruments it has issued.

So my initial reaction is: meh, who cares which way Trudeau funds soldiers' salaries.


There is one asymmetry that might worry me as a citizen. Treasury bills are a useful instrument for individuals and businesses (like insurers) because they are quite safe. Bank of Canada deposits are likewise very safe, but whereas anyone can buy a treasury bill, deposits are exclusive. Only commercial banks can keep an account at the central bank. So if our soldiers are to be paid $400 million by the Bank of Canada, the supply of treasury bills will contract by $400 million leaving folks like me with fewer options for investing.

But there's an easy way to fix this shortage. Introduce central bank accounts for all. In short, allow non-banks like insurers and individuals to keep accounts at the Bank of Canada. A similar fix would be to provide a means for commercial banks to establish 100%-reserve pass-through accounts. Life insurers and individuals who open a pass-through accounts at a bank would be assured that these accounts are 100% backed by Bank of Canada deposits, the interest flowing straight from the Bank of Canada to the account holder. These accounts would function just like treasury bills.


There is one other potential asymmetry. It has to do with the unit-of-account function of money.

Like the metre, kilogram, or minute, the dollar is a key element of Canada's system of weights and measures. The dollar is by far the most complex of these standardized measurements. Unlike metres, kilograms, or minutes, Canadian prices are measured in terms of a set of items—banknotes and Bank of Canada deposits—that are constantly fluctuating in value. By carefully regulating these items, the Bank of Canada tries to keep the pricing standard as stable as possible.

Treasury bills have no role to play in the pricing standard. If a car has a sticker price of $10,000, this indicates ten thousand one-dollar banknotes, or a thousand ten-dollar banknotes. The "$10,000" indicated on the sticker is not represented by a given quantity of treasury bills.

This has important implications. If all Canadians simultaneously decide that they want to reduce the quantity of Bank of Canada notes and deposits that they hold, then every price in the Canadian economy will have to rise. After all, these instruments are the standard media that people use for describing prices. But if all Canadians decide they want to hold fewer treasury bills, goods and services prices needn't adjust—treasury bills aren't the media that Canadians use to describe the dollar. Only the price of treasury bills will have to adjust.  

So if Trudeau decides to use Bank of Canada deposits for financing, he is involving himself with the standard itself. Every price in the Canadian economy may have to adjust to his actions. But if Trudeau relies solely on treasury bills/bonds for financing, he avoids implicating himself in Canada's pricing standard, and so his influence will be much more muted. It would be better if Trudeau's political ambitions couldn't entangle Canada's system of weights and measures... more on this later.


It may be useful to work through an example in which Trudeau decides to use the Bank of Canada for a large percentage of government spending. Say that Justin is fighting for his political survival, so he comes up with a bright idea. Let's increase the number of Canadian provinces by occupying Burkina Faso. That way Canadians will have a warm place to go in the winter. Trudeau promises voters that he will carry out the invasion without burdening Canadians with new taxes. That very month he tells the Bank of Canada to start creating billions in new deposits and quickly spends them on military equipment.

At some point the recipients of these new deposits (anyone with a Bank of Canada account) will suffer deposit bloat. They will try to get rid of their excess, and as they do so prices across the Canadian economy will start to rise.

In order to preserve the standard unit, the Bank of Canada has a useful tool for halting this incipient inflation. It can increase the interest rate it pays on reserves. A higher reward will coax those who would otherwise have spent their unwanted Bank of Canada deposits into keeping them on ice. And this should alleviate the pressure on prices.

But what happens if Trudeau keeps on spending? His next idea is to send a fully-manned space mission to Pluto without raising taxes or issuing treasury bills to fund the mission. He tells the Bank of Canada to create $50 billion and immediately starts to spend it on building a rocket.

The Bank of Canada can of course raise rates again. But if you think about it, the Bank of Canada gets the money to pay higher interest by issuing more brand new dollar deposits. If the underlying cause of the inflation is Trudeau bringing too much money into existence, issuing even more of the stuff as an inducement to hold what has already been created doesn't seem like a long-term solution. At some point, the Bank of Canada will have to attack the root of the problem--the bloat of deposits itself--by reducing the supply.

There are a couple of ways to reduce the supply of deposits. The first would be to "sterilize" Trudeau's spending. The Bank of Canada can try and coax depositors to lock their funds into central bank term deposits rather than keeping them in their regular Bank of Canada accounts. Transferring the funds to a term deposit renders them non-spendable and removes the bloat, at least temporarily.

But Trudeau keeps on spending new Bank of Canada deposits, this time on the construction of a 5-metre high border wall between Canada and U.S. The Bank of Canada will have to convince an ever-growing crowd of deposit owners into locking away their funds. At some point the demand for term deposits will be saturated, and the Bank of Canada will have to increase the carrot they provide by raising term deposit rates. Additional deposits will have to be created to generate this reward. But as before, fixing an excess of deposits with more new ones only kicks the can down the road.

The Bank of Canada has a permanent way of removing the deposit bloat: it can buy deposits back and cancel them. But to do this, it needs to have some real assets sitting in its vaults. Gold, property, mortgage-backed securities, bonds, etc. Because Trudeau has been spending deposits into the economy willy-nilly, the Bank of Canada simply doesn't have assets to carry out a buy-back.

Which leaves the Bank of Canada with one last option for removing supply. Rather than repurchasing deposits, it can just destroy them outright. By declaring that x% of all deposits that have been issued will simply cease to exist, it can remove the bloat once and for all. Thus ends the inflation.

But the Bank of Canada doesn't have the power to annihilate depositors' funds. This would basically constitute a tax, and democracies don't generally give central bankers the power to tax (understandably so). Which means that only Trudeau can carry this operation out on behalf of the Bank of Canada.

To do so, he will have to levy a new tax and then destroy the proceeds. (He can't re-spend the deposits, this would only recreate the problem). Once destroyed, the deposit bloat has been remedied. But if Trudeau is determined to follow through on his vote gathering strategy of spending on programs without raising taxes, then he won't see much to be gained in carrying out the annihilation. So the inflation will continue.


I think that all of these threads can be brought together to provide an argument for why we don't want Trudeau to rely too much on the Bank of Canada for funding.

Low and consistent inflation is valuable to Canadians. Just as our measures of time, volume, and weight stay consistent (the metre doesn't get longer or shorter from one year to the next), the dollar unit should be reliable. If we all have a pretty good idea where average prices will be down the road, we can better coordinate our long-term plans. Price stability is also the fairest way to ensure neither debtors nor creditors benefit at the other's expense.

The Bank of Canada has all the tools to provide this service to the public, save one. In the extreme event that the Prime Minister decides to resort to the Bank of Canada for financing of a bunch of novel government services, and the inflation target is exceeded, the Bank of Canada can't salvage things by resorting to the definitive response: annihilating deposits. Instead it must rely on Trudeau to destroy deposits on its behalf via a tax. If the Prime Minister refuses to do this, then the reliability of the unit of account is effectively sacrificed.

Were Trudeau to rely on treasury bills and bonds rather than central bank financing to invade Burkina Faso, send a rocket to Pluto, and build a border wall with the U.S., then the Bank of Canada would never have to ask the Prime Minister to annihilate deposits in order to hit its inflation target. And so the dependability of the unit of account would be assured. Instead of every price in the economy having to adjust to Trudeau's new programs, only the market price of treasury bills and bonds would have to bear the burden of adjustment.

So should governments finance themselves through their central bank? In general, it's probably harmless. For instance, it makes no difference whether the prudential liquidity plan is financed by the Bank of Canada, the taxpayer, or government-issued treasury bills.

But in a scenario where the government is being wildly imprudent, a degree of separation between the Prime Minister and the Bank of Canada is advisable. Imagine if the whims of Canada's politicians could cause metre sticks all over Canada to grow or shrunk a bit each year. That would make for a confusing system of weights and measures, wouldn’t it? The dollar is one of Canada's most important weights & measures. It too deserves to be immunized from the political process.

Monday, March 4, 2019

Swish > cash and bitcoin

Ok, another Sweden post. I keep returning to Sweden because no country has gone further down the road to being cash-free. Since all of us seem to be following the same trajectory, we should probably be paying attention.

Lucky for us, every two years the Riksbank—Sweden's central bank—-carries out a payments survey and puts the data up on its website. One of the most interesting questions that is asked is "which of the following payments methods have you used in the last month?"

I plotted out some of the data and tweeted the result:

What follows are a few observations.

Swish beats cash

Only 61% of Swedes used cash in the last month, down from 94% just eight years ago. But 62% now use a service called Swish. Swish is a mobile payments app that Swedes use to pay each other in real-time and on the weekend. Think Venmo or Zelle in the US, or Interac e-Transfer in Canada. These sort of payments options are not really used much at the point-of-sale. They're a person-to-person (P2P) payments technology.

Swish was developed by Sweden's banks, not by an upstart tech company. Incidentally, both Zelle and Interac e-Transfer are also owned by banks. (Venmo is owned by PayPal, a fintech). Which goes to show that banks aren't always the slow moving monoliths that a lot of people make them out to be. They'll protect their turf.

Swish was introduced in 2012, around the time that Sweden's legacy banknotes were all being scheduled to be replaced by a new issue of notes. By any measure, the timetable that the Riksbank selected for the switch over was inconvenient for cash-users. Rather than allowing for permanent note switches (like we do in Canada and the US) or a long window (like Sweden did in the 1980s and 1990s), the Riksbank gave Swedes only a year or two to make the swap. In the case of the 1000 kroner note, they'd have to do two swaps in five years. Due to the inconvenience of the changeover, many more Swedes chose to go cashless than would otherwise have been the case. I make this point in an earlier post which I called Swedish betrayal.

The Riksbank chose this timetable because it was recommended to them in 2012 by a collection of private financial institutions including Sweden's big banks. This was at the same time that the banks were introducing Swish. Since Swish and banknotes are direct competitors in the P2P payments space, an inconvenient note switch would have given banks quite the helpful tail-wind.

So Swish's success (at the expense of cash) probably isn't solely a function of enlightened consumer choice--it also benefited from a gentle nudge from the Riksbank (and the private sector, who advised the central bank). 

Debit card way more popular than credit cards

Canada is the land of credit cards. According to a recent Bank of Canada survey, around 39% of all retail payments are made with credit, or 56% of all value spent. Debit is a distant 26%. While debit is more popular in the U.S., credit cards aren't far behind.

So why is debit card usage so popular in Sweden? I'd guess low interchange fees. An interchange fee is how much a retailer must pay for each transaction that a customer makes using a card. In Sweden, interchange fees for credit cards are set at 0.3% while debit is 0.2%. In Canada, credit card interchange fees vary between 1%-2.5% compared. For debit, they are set at 0.25%.

Canadian banks can use the income from credit card interchange fees to fund handsome reward programs and 2% cash back. Swedish banks can't because credit card interchange fees are so low. So from a Canadian shopper's perspective, why use you debit card to buy $100 in groceries when you can use you credit card to get the same groceries and also get $2 cash back? Swedes don't face this same payments calculus—low mandated interchange fees mean that credit card can't come equipped with massive amounts of rewards. So buying 1000 kronor worth of groceries with a credit card doesn't provide any advantages to a debit card.

What happened to the bitcoin payments revolution?

If you want an example of a payments revolution, Swish is it—not bitcoin. Only six out of 2011 Swedes surveyed by the Riksbank used bitcoin to make a payment over the course of the month. That's an adoption rate of just 0.3%.

That being said, it's not as if bitcoin is unpopular in Sweden. Stockholm's Nasdaq/OMX exchange has the distinction of listing Bitcoin Tracker One, the world's first (and one of its only) exchange-traded bitcoin financial products. Bitcoin Tracker One is one of the exchange's most active tracking certificates. At the peak of the bitcoin bull market in December 2017, assets under management ballooned to $600 million.

These statistics illustrate the odd nature of bitcoin's success. Bitcoin was supposed to be a payments, or monetary technology. But this vision has never panned out. Rather, bitcoin has taken off as a great way for Swedes (and everyone else) to gamble. I took up this theme in a recent article for the Sound Money Project:
"Forget online payments; Bitcoin has become the most successful gambling technology to be invented since Henry Orenstein introduced the poker pocket cam in 1999. The pocket cam allowed viewers to see players' cards, revolutionizing the way people watched the game of poker and launching the 2000s poker frenzy.

In what sense did Bitcoin succeed as a gambling technology? At its core, Bitcoin is a pure Keynesian beauty contest. People try to guess what other people guess other people guess Bitcoin's value will be. The price that results from this contest is incredibly unsteady. But these explosive rises and stunning falls provide a fun, challenging, and addictive bet for casual gamblers and deep-pocketed professional speculators alike."
With bitcoin's first and primary function being gambling, a small minority of Swedes (six out of 2011) have been able to piggy back off it and use it for payments. An analogy can be made to other products that have alternative uses, say like how tooth paste's primary use case is to clean teeth, but a few people might use it to remove carpet stains.

The problem is that the very feature that makes bitcoin such a great gamble—its beauty contest nature—interferes with its serviceability as a payments system. I don't think this problem is solvable. Which is unfortunate because in theory at least, bitcoin seemed to have several features that would have made it a decent replacement for cash.