Saturday, March 28, 2020

Alphabet soup

It's that time of the economic cycle. Financial writers are flocking to the phrase alphabet soup again. This was a phrase we all adopted in 2008 to describe the hodge podge of credit facilities created by the Federal Reserve to deal with the credit crisis. Twelve years later, alphabet soup applies just as well to the Fed's response to the coronavirus crisis.

As in 2008 the Fed is currently trying to get funding into as many nooks & crannies of the credit system as it can. The easiest way to do this would be for the central bank to create a slew of new deposits and either lend them directly to corporations (and other counterparties like municipalities) or buy up already-issued corporate bonds and other debt instruments.

But things aren't that easy. The Fed's money is taking a somewhat tortuous route into credit markets.

Like 2008, the Fed has reacted to the crisis by incorporating a bunch of special purpose vehicles, or SPVs. An SPV is a subsidiary or corporation that is legally distinct from the Fed, but controlled by it. The Fed has then been lending fresh money to the SPV. And then the SPV on-lends this money to corporations, or buys up their bonds and other debt instruments.

To illustrate, take the Fed's newly unveiled Primary Market Corporate Credit Facility (PMCCF). The Fed is using this facility to lend to an SPV, this SPV in turn purchasing bonds directly from corporate issuers, like Walmart. The hope is that by providing Walmart with direct access to Fed credit, the retailer will be better able to maintain business operations during the pandemic.

Why doesn't the Fed just directly purchase Walmart bonds?

About all the Federal Reserve can legally buy are Treasury bills and other safe government securities. The Federal Reserve Act prohibits the central bank from purchasing Walmart bonds or any other type of corporate debt.

But a Fed-created SPV isn't really subject to the same set of rules as the Fed, right? If it is legally remote enough from the Fed, an SPV can "lawfully" buy all the Walmart bonds that the Fed can't, no? That's basically the strategy that the Fed took in 2008, and it is taking it again.

But that SPV still needs to be funded. Luckily for the Fed, Section 13(3) of the Federal Reserve Act allows it to exercise broad lending powers in an emergency. So the Fed invokes 13(3), lends funds to the SPV, and then has the SPV buy Walmart debt. Voila, the Fed has purchased Walmart bonds without actually buying Walmart bonds. All the legal i's have been dotted, the t's crossed.

The SPV structure isn't just a legal hack. It also allows the Fed to protect itself.

Each of the five or six SPVs that have been created over the last two weeks is backed up by the U.S. government. This means that if the SPV's loans or bond portfolio falls in value, the central bank needn't worry. The Federal government will promise to make it whole.

Take the aforementioned Primary Market Corporate Credit Facility, or PMCCF. The Treasury has currently invested $10 billion in the SPV to which the PMCCF will lend. So if the Fed buys $10 billion in Walmart bonds via the SPV, and Walmart goes bankrupt and its bonds become worthless, the Fed still gets $10 billion back. It's the Treasury that loses its investment, not the Fed. The SPV structure is a tidy way to formalize the Treasury's support.

To get more context about this protection, let's compare the PMCCF to another facility created by the Fed, the Primary Dealer Credit Facility, or PDCF. The goal of the PDCF is to get funds to primary dealers, large financial institutions that make markets in all sorts of assets including the all-important US government securities market.

To create the PDCF, the Fed has also invoked Section 13(3) of the Federal Reserve Act. The Fed's interactions with primary dealers are limited by law to buying and selling government-issued assets. The central bank can't lend to dealers, certainly not on the basis of exotic sorts of collateral. But the emergency powers embedded in Section 13(3) allow the Fed it to open a broad lending channel to primary dealers.

Unlike the rest of the alphabet soup of facilities that invoke Section 13(3), the Primary Dealer Credit Facility is not set up as an SPV, nor does it enjoy $10 billion in protection from the U.S. Treasury. I have it on good authority that the Fed doesn't believe that a firewall is necessary. A strict process is already in place to vet primary dealers. Furthermore, the Fed has an ongoing relationship with dealers because they mediate all central bank purchases and sales of government securities.

But the Fed knows very little about the counterparties that it will lend to under the other facilities it has created, like the PMCCF. To make up for this extra risk, it wants to get some protection from the Treasury should those counterparties fail.

And in a nutshell, that's why the Fed has taken such a circuitous route to get funds into the credit system.

The bigger picture is that you've got a very old set of laws embodied in the Federal Reserve Act. Many of these rules were designed back in 1913 when America was still mostly a farming economy. Debts were almost always short-term back then, usually in the form of a bill of exchange, a debt instrument that doesn't really exist anymore. Heck, a whole section of the Act is about discounting "agricultural paper". That section probably hasn't been invoked in fifty years.

Meanwhile, a massively complex financial system has evolved over the last century. All sorts of new exotic credit instruments have emerged, say like asset-backed commercial paper. Farming, once a dominant sector, now accounts for a tiny part of the US economy. In a modern crisis like the one we are in, Federal officials believe that they need to be able to deal in these new types of securities. And reach new industries. Because the Act is mostly designed for a previous era, Fed lawyers have had to drill a strange new path to the credit markets via Section 13(3), SPVs, and Treasury support.   

I'm going to leave off now. Readers will obviously have a lot of unanswered questions.  

Should the Fed be lending such a massive amount of money to such a wide variety of borrowers? (I don't have a good answer).
Why is the Money Market Mutual Fund Liquidity Facility called the MMLF and not the MMMFLF? (Nathan Tankus deals with this and much more in his two part overview of what the Fed has done up till now).
Aren't the Treasury backstops a waste of ammo? (George Selgin has a good explanation about why they exist, and I am inclined to agree with him. They're not a gimmick.)
Aren't the SMCCF and PMCCF unprecedented? (Yes, they are. These facilities fund SPVs that either lend directly to corporations or buy corporate bonds in secondary markets. The Fed never went this far in 2008). Are they a good idea? (In a recent blog post, Stephen Cecchetti  & Kermit Schoenholtz argue that they aren't.)
Shouldn't the Fed limit its support to buying bonds in the secondary market rather than lending directly to corporations? (Narayana Kocherlakota says no. He is opposed to the PMCCF, but likes the SMCCF. George Selgin and I don't see much difference between the SMCCF and PMCCF.)

Saturday, March 7, 2020

The bitcoin-to-salvia divinorum trade route

I am now writing editorial articles for Coindesk. In my first piece I explored Strike, a new app that intends to bring bitcoin payments to a mainstream audience. Coindesk allows me to repost articles after a delay. Rather than putting up the whole thing, I'm just going to take a few bits from it and try to create something new.

We've been discussing bitcoin-as-money on this blog for almost eight years now. Since then the stuff has always been just one design flaw away from taking off as a way for regular folks to make payments. So when I heard about Strike, my curiosity was piqued. Is it bitcoin's killer app, the one that that covers up enough of bitcoin's nuisances that it brings bitcoin payments to a mainstream audience? Or is bitcoin so intrinsically awkward that it will always be consigned to being a niche payments rail?

The rough idea is that Strike will make bitcoin more friendly by standing as gateway between normies who prefer to pay with fiat and savvy bitcoin users. To better understand what this means, here's an example:
"Say you’d like to buy an antique vase for $100 at your neighbor’s garage sale. You don't have any cash on hand. But you do have your credit card. Needless to say, your neighbor doesn’t have a card terminal set up. But she does have a lightning channel open. Strike allows the two of you to connect. The $100 flows from your bank account to Strike’s bank account, upon which Strike sends 0.01 bitcoins to your neighbor via lightning.

That’s it. Without even knowing it, you've paid your neighbor with bitcoin. No volatility. And no need to learn how to use a strange new payments network. The entire experience simply piggybacks off of your existing knowledge of how to use a debit card.

As for your neighbor, with just a lightning address, she can immediately accept non-reversible payments from debit card holders all over the world."
This sort of hybrid fiat-to-bitcoin system is a pretty neat idea. Regular folks get to keep buying stuff with their debit cards but without even knowing it are settling in bitcoin. But how popular could Strike get?

I want to back up a bit and focus on the seller in a hypothetical fiat-to-bitcoin payment. In my set-up above, I envisioned a neighbour who is holding a garage sale. Without a point-of-sale terminal, a card can't be used. This opened the field up to bitcoin. But what I omitted in my example was the option to use popular person-to-person payments app like Venmo, Zelle, or Square Cash. Why would the neighbour bother accepting bitcoin (i.e. Strike) if she can just get dollars instantly delivered via the Zelle app?

Let me formulate this question more generally. If someone says that they can either pay you in bitcoin or fiat money, which of the two would you choose to receive?

Most people will choose to receive fiat, not bitcoin. Bitcoin is a recursive, self-referential guessing game. This results in an incredibly volatile price. Regular folks are simply too scared to play the bitcoin guessing game, even if it's just for a few minutes or hours. Fiat is stable and comfortable.

If we normies are going to gamble (say by playing poker in the evenings or buying lottery tickets on Mondays), we usually don't want to mix those habits with our day-to-day payments activities. There's a time and a place for gambling. And there's a time and a place for receiving salary payments and holding garage sales. But as a rule, we aren't generally comfortable combining our gambling habits with our payments routines, say by accepting lottery tickets (or bitcoins) as salary.

That being said, given the question I posed above, there will always be some folks who choose bitcoin over fiat. What sorts of people might these be?

They have to be the sort of people willing to put up with bitcoin's volatility. Bitcoin hobbyists are one demographic who fall in this category. Those with huge risk appetites are another. But these aren't big markets.

A larger audience can be found among people who sell illegal products. These sorts of transactions can't be processed by fiat payments systems like Visa or MasterCard. Bank-to-bank payments leave a paper trail. Accepting bitcoin (and putting up with its volatility) may be their only safe choice for selling illegal goods & services.

Connecting hundreds of millions of debit card owners to the illicit economy would constitute a massive market. In practice, however, this probably isn't a connection that a regulated payments processor like Strike can facilitate. Say Strike starts to link cocaine-using debit card owners to anonymous bitcoin addresses controlled by cocaine dealers. Politicians, law enforcement, and regulators would be furious.

To cut down on transactions for illegal goods & services, I suspect Strike would have to start verifying the identities of the owners of the bitcoin addresses it connects to. But then underground users would shun the Strike network. Not entirely, of course. Even if Strike were to implement identity checks, small illicit trades would still continue. After all, even though Venmo users must identify themselves, Venmo still attracts plenty of of drug transactions.

There is another group of people that would choose bitcoin over fiat. Consider vendors that sell legal goods but have nevertheless been cut off by mainstream payments networks.

If you look through MasterCard's Business Risk Assessment and Monitoring (BRAM) policy, for instance, you can see a list of impermissible activities:

Source: Netpay

Most of the activities listed in MasterCard's BRAM are illegal. But some are legal, including the "sale of certain types of drugs or chemicals (such as synthetic drugs, salvia divinorum, psilocybin mushrooms and spores, and nitrite inhalants)."

Take salvia divinorum, a leaf that has hallucinogenic properties but is legal in most U.S. states. Neither MasterCard nor Visa will let their networks to touch it.

If you take a look at three Salvia vendors located in the U.S.—The Best Salvia, Salvia Extracts, and Salvia Hut—none of them accept credit cards. They can't. "Do you accept credit or debit cards?" Nope. We will get fined by Visa or Mastercard if we accept credit or debit cards," says Salvia Hut's page. But all three stores accept bitcoin.

So here is a market that could certainly use Strike as a bridge to its card-paying customers. Instead of having to go out and buy bitcoins, a Salvia buyer could pay with their card via Strike, the bitcoin leg of the transaction being processed invisibly in the background. That's pretty convenient.

But salvia isn't a very big market. And as a visit to the three salvia stores will show you, bitcoin shares the Salvia payment market with e-checks (a bank-to-bank ACH option). One of the stores (see below) accepts Western Union money orders as well as PayPal and Square Cash. (I suspect that this is probably against the terms & conditions of PayPal and Square Cash). This goes back to my original question. Why would a garage sale transaction (or a salvia transaction) be expedited via bitcoin rails if the counterparties to the deal can use fiat routes like e-checks or Venmo/Square Cash/Zelle?

So let's encapsulate the conundrum. MasterCard's BRAM allows it to process almost every legal transaction under the sun, save a few outliers like salvia. This means that the population of underserved licit users that would need to use a back-up system like Strike's hybrid fiat-to-bitcoin payments app is not very big.

But this is a familiar conclusion to anyone who's been reading my posts over the years. When it comes to bitcoin-as-money, the same old problems keep cropping up. Crippled by its recursive, self-referential nature, volatile bitcoin never plays more than a niche role as a payments network.

That's probably better than nothing. When fringe vendors are temporarily cut off by the likes of Visa and MasterCard, and their Venmo account is frozen, and e-checks are off limits, at least these folks will always have an option for making transactions.