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.