Monday, July 26, 2021

Are the Bank of Canada's bond purchases illegal?

Pierre Poilievre, Conservative MP for Carleton, alleges that the Bank of Canada's bond buying program contravenes the Bank's powers enunciated in the Bank of Canada Act.

Allegations that the Bank of Canada has broken the law should be taken very serious. They should not be made lightly, either. We give our public servants at the Bank of Canada a wide range of powers to enact monetary policy, but only within the bounds that we permit them.

Poilievre has been actively criticizing the Bank of Canada's pandemic response ever since Covid-19 hit in 2020. I can't say I've ever seen as much Bank of Canada-targeted criticism emanating from a single Canadian politician since Poilievre began his campaign. It breaks with a long Canadian political tradition of staying (mostly) silent on the Bank of Canada's operations.

I have mixed feelings about Poilievre's approach. Yes, it's great to have more public discussion about arcane topics like the Bank of Canada Act. On the other hand, up till now Canada has avoided most of the hyperbole and conspiracies that bedevil U.S. central banking. It would be nice if things stayed that way.

Poilievre's allegations were first aired in Parliament in June. A month later he posted them on Twitter, where I became aware of them. (They garnered over 900 retweets, which is a lot for a tweet about an arcane issue like the Bank of Canada Act!) Poilievre's claims are based on his reading of Section 18(j) of the Bank of Canada Act. Section 18(j) allows the Bank to make loans to the Federal government, but those loans should not "exceed one-third of the estimated revenue of the Government of Canada for its fiscal year."

Poilievre calculates that given 2021 government revenue estimates, this would cap Bank of Canada loans to the Federal government at $118 billion. Poilievre then points to the Bank of Canada's purchases of Government securities, which have pushed the Bank's holdings of Federal government debt above the $400 billion level. Poilievre suggests that this contravenes 18(j).

The allegations caught the attention of columnist Andrew Coyne, who takes a dig at Poilievre:

In fairness to Poilievre, it's not unimaginable that the Bank of Canada has done something illegal and no one has noticed but him. 

Back in August 2007, after all, the Bank of Canada announced its intention to extend its purchases of certain kinds of securities. It was responding to the first signs of a nascent crisis in credit market. Unfortunately it lacked jurisdiction to purchase these instruments. Its actions were unwound by September 2007 in order to bring the Bank back in compliance with the Bank of Canada Act.

I only know this because I phoned the Bank of Canada up that August wondering what legal justification it had for its actions. Several awkward conversations later, it was apparent that a mistake had been made by bank officials.

My observations made their way into a report that December for the CD Howe Institute. From there a process to update the Bank of Act began. After discussions in Parliament (including a contribution from then-governor Mark Carney here) the eventual result was an update to the Act in the spring of 2008. Tucked into Bill C-50, changes included striking out Section 18(k) and rewriting Section 18(g).

These modifications to the Bank of Act made it permissible for the Bank of Canada to conduct the purchases it had originally set out to do in August 2007, and prepped it for the much bigger fallout to come: the September 2008 credit crisis.   

So maybe Poilievre has caught a breach of law. It's happened before. That being said, echoing Coyne (who cites economist Mike Moffatt), I'm not convinced by the meat of Poilievre's argument.

In response to Poilievre's allegations about 18(j) being broken, Bank of Canada officials would probably respond that their large-scale asset purchases are authorized under Section 18(g).

The Bank of Canada's ability to make securities purchases for monetary policy purposes is set out in Section 18(g), which replaced the much narrower 18(k) in 2008. The scope of Section 18(g) is very broad. First, it is open-ended about what instruments it allows the Bank to purchase. These securities can include bonds, stocks, commercial paper, mortgage-backed securities, and more.* Second, 18(g) doesn't say anything about the Bank's purchases needing to happen in the open market. If necessary, the Bank of Canada can buy straight from the issuer.

The bit of legalese that Poilievre points to, 18(j), only applies Bank of Canada loans to the Government, say a line of credit or some other type of credit facility. Because the Bank has limited its interaction with the government to buying securities, 18(j) hasn't been triggered. And so Poilievre's allegations are just that, allegations.

Section 18(j) was devised to prevent the Bank of Canada from financing the government and preserving the Bank's independence, as Poilievre rightly points out here. And I think that's a laudable goal.

In that spirit, it's worth considering that most (but not all) of the Bank of Canada's purchases of government bonds have occurred in the open market. That is, most of the securities in the Bank's government bond portfolio were bought only after the public had initially purchased them from the Government. So in a sense, the Bank has prudently removed itself from the initial price discovery process.  

More specifically, the Bank has purchased $362 billion in Government bonds since March 2020. Of that amount, $303 billion, or 84%, was bought in the open market. The remaining $59 billion was bought directly from the Government.

Even when the Bank does participate in bond auctions, it does so on a non-competitive basis. That is, the Bank pays the average of all competitive bids submitted to the auction. The competitive bids are provide by banks and other primary dealers. This practice further prevents the Bank of Canada from playing an active role in setting the government's cost of capital.

So to sum up, I think the Bank of Canada is on firm legal ground. Furthermore, I also think the spirit of 18(j), a prohibition on financing the government, remains intact.

* The one security that Section 18(g)(i) deems to be off limits are instruments that "evidence an ownership interest or right in or to an entity." If I recall correctly refers to certain types of asset-backed commercial paper (ABCP).

Thursday, July 22, 2021

The dollar isn't a meme

"Currencies are not memes that only have value because governments say they do," writes Brendan Greeley for the Financial Times. 

I agree with him.

The dollar-as-meme claim is often made by cryptocurrency enthusiasts. That this idea would emanate from the cryptocurrency community makes sense, since cryptocurrency prices are a purely meme-driven phenomenon. There is no cryptocurrency for which this is more apparent than Dogecoin, a cryptocurrency started as a joke and sustained by shiba inu gifs, but it applies equally to Doge's older cousin, Bitcoin. The harder you meme the higher a cryptocurrency's price, as the image at top suggests.

And so for cryptocurrency analysts, getting a good understanding of a given coin's value is a matter of picking through its underlying memes and meme artists. 

But if cryptocurrency analysis is ultimately just meme analysis, what sort of analysis applies to dollars?

Dollars issued by banks are secured by the banks' portfolio of loans, Greeley reminds us. And so they are subject to credit analysis, not meme analysis. An analyst appraises the quality of the bank's investments in order to determine the soundness of the dollar IOUs the bank has issued.

As for central banks like the Fed, they are just special types of banks, says Greeley, and so the dollars they issue are also subject to credit analysis.  

The idea that the money issued by central banks—so-called fiat money—is subject to the same credit analysis as any other type of debt security is a point I've also made on this blog. There are certainly some odd features about Fed dollars or Bank of Japan yen, but ultimately they are just another form of credit.

What sort of credit is fiat money? There are many different kinds of credit instruments, from bonds to deposits to banknotes, each with its own unique features. To see where central bank money fits, I've made a chart that illustrates how credit instruments differ across three different criteria (click to expand).

The first criteria along which to compare credit instruments is whether the instrument is redeemable on demand by the holder or not. That is, if I own a given credit instrument, or IOU, can I bring it back to the issuer, or debtor, at a time of my choosing and redeem it for something?

The second category concerns the instrument's maturity. Does it stay outstanding forever i.e. in perpetuity? Or is it term debt? When a credit instruments has a term, that means that it expires after a predefined period of time, the debtor cancelling it and paying back the the original amount lent.

The final category is whether the instrument pays interest or not.

By toggling these various features, we arrive at the eight different types of credit instruments, examples of which I've listed on the right side of the graphic.

As you can see, the Fed's dollars, the ECB's euros, and the Bank of Japan's yen are type 5 and type 6 credit instruments. Central banks issue two types of money: physical banknotes and electronic balances (sometimes known as reserves). Electronic central bank reserves pay interest. Banknotes do not.

Apart from that, banknotes and electronic balances are very similar instruments. Neither of these two credit instruments is redeemable on demand. That is, you can't bring a banknote back to the issuer at 5:30 PM Friday and redeem it for something. (This same lack of on-demand redeemability characterizes bonds and certificates of deposits.) And they are both perpetual, much like a perpetual preferred share or non-expiring coupons/gift certificates.

Removing a credit instrument's redemption-on-demand feature doesn't stop it from being a credit instrument. It just changes it into a different type of credit instrument. Yes, probably an inferior one, but a credit instrument nonetheless.

For instance, if a retractable bond (type 3) suddenly loses its retractability feature (and is no longer redeemable on demand by its owner) it doesn't stop being a credit instrument. It simply switches to being a regular bond (type 7). Likewise, if a perpetual puttable preferred share (type 1) loses its puttability, it doesn't stop being an IOU. It becomes a new type of credit instrument, a regular perpetual preferred share (type 5).

This same principal applies to those credit instruments we call money. Decades ago the Fed's dollars were redeemable on demand into gold, and thus they were a type 1 or 2 credit instrument. When the Fed removed redemption back in 1934, dollars didn't become mere memes. Rather, they were converted into a different type of credit instrument, a type 5 or 6 credit instrument.

Once a credit analyst has figured out what kind of credit instrument they are dealing with, their work is only half done. Next they have to go back and look at the underlying issuer. How solid is it? Does it have sufficient assets to guarantee the credit instruments it has issued? Do it generate enough income to keep paying interest? Is the issuer linked to affiliates, parents, or other third-parties who might strengthen or diminish the issuer's credit?

As you can see, none of this is meme analysis. It is credit analysis.

To recap, dollars issued by the Federal Reserve are perpetual credit instruments that lack an on-demand redemption feature. To determine how solid the Fed's perpetual non-redeemable credit instrument are, you'd want to do an analysis of the Fed's finances. That should also include investigating the soundness of the Fed's parent, the U.S. government. Does the parent's finances further enhance the Fed's credit, or detract from it?

So dollars don't only have value because the government says they do. Just like Tesla's financial health determines the value of Tesla bonds, the financial health of the issuing central bank (and its parent) is  key to determining the value of central bank money.

If you want to do meme analysis, stick to Dogecoin and Bitcoin.

Monday, July 12, 2021

Those 70s ACH payments

Here is Facebook's David Marcus, who has been involved in rolling out Facebook's much-touted Libra/Novi/Diem payments system:

By ACH, Marcus is referring to automated clearinghouse payments. If you want to pay your phone bill, the payment gets sent to a clearing house, which batches your payment together with many other payments and then settles it the next day. These systems were built in the 60s and 70s.

I don't want to pick on Marcus, since he isn't the only one with this view. But modern money no longer moves at the pace of early 70s ACH. His critique would have made sense maybe 6 or 7 years ago, and only in the US. But that's not the case in 2021.

The speeding up of modern payments is a great success story. Let me tell you a bit about it.

To begin with, central banks and other public clearinghouses have spent the last 15-or-so years blanketing the globe with real-time retail payments systems. Europe has TIPS, UK has Faster Payments, India has IMPS, Sweden has BiR, Singapore FAST. There must be at least thirty or forty of these real-time retail payments system by now. 

The speed of these new platforms get passed on to the public by banks and fintechs, which are themselves connected to these core systems. In the UK's case, for example, consumers can bypass the slower ACH system, BACS, which takes three days to settle, by choosing to make their bank payment proceed via the Faster Payments system.

The U.S. is lagging. The Federal Reserve's FedNow retail payment system, which will facilitate real-time retail payments, won't be in place till 2024, more than 15 years after UK's Faster Payments was introduced. So Marcus's tweet could just be a function of having a U.S.-centric viewpoint.

However, the Fed's private competitor, The Clearing House, has had a real-time settlement system in place since 2017, the Real-Time Payments (RTP) network. Roll-out has been slow, but as of July 2021 The Clearing House claims that RTP reaches 56% of U.S. checking accounts. 

RTP illustrates that it's not just central banks that are facilitating real-time payments. Private players are too. Visa and MasterCard, for instance, built their own proprietary real-time person-to-person payments platforms, Visa Direct and MasterCard Send, on the back of their debit card networks.

As Arturo Portilla points out, Visa Direct and MasterCard Send don't actually settle payments in real-time. They only clear them. From the perspective of the consumer, however, it makes little difference. Ned can send Jenny $100 using a Visa Direct enabled account, and Jenny can then spend that $100 within moments of receiving it. (Ned and Jenny's banks settle up the next day.)

In 2017 U.S. banks debuted Zelle, a now ubiquitous instant person-to-person bank payments option. Zelle was built using the Visa Direct and MasterCard Send networks. And now Zelle is being connected to The Clearing House's RTP network, too. Which means that settlement can be done in real-time.

Perhaps Marcus's ACH critique is limited to non-domestic transactions. But even cross-border payments are also going quicker.

Remittance companies like Western Union and MoneyGram are leveraging Visa Direct and MasterCard Send to do instant cross-border transfers. As of late 2020, Western Union was facilitating real-time payouts to 80 countries. MoneyGram recently announced that 575 corridors from 25 countries in Europe would go instant thanks to an integration with Visa Direct, complementing its existing instant payments options from the US.

Transferwise, another global remittance company, is dispatching up to 38% of its remittances instantly. Whereas Western Union and MoneyGram are building on top of Visa Direct and MasterCard Send, my understanding is that most of Transferwise's success in speeding up remittances comes from integrating with the new retail real-time payments systems I listed above, like Singapore's FAST and UK's Faster Payments.

Let's not forget SWIFT gpi, which is bringing a new speed standard to corporate cross-border payments.

Even the ACH network that Marcus criticizes is upping its game. ACH payments have typically not settled till a day or two after origination, which meant consumers have had to wait for salaries and bill payments to settle. But in 2017, same-day ACH was introduced. It's taken some time for this option to gain adoption. As of the first quarter of 2021, only 2% of all ACH transactions are done on a same-day basis.

But same-day ACH is getting better. In 2020, the limit for same-day payments was raised from $25,000 to $100,000. Just this year a third window for clearing and settling same-day ACH payments was introduced, 6:30 PM EST, making same-day ACH even more convenient for Californians and others in later time zones. Next year, limits will be raised from $100,000 to $1 million.

Lastly, Marcus maligns slow in his tweet. But remember, slow can be a good thing, too. Slowing down transactions allows us to batch them together and cancel out reciprocating payments, thus reducing the amount of work our payments systems must do. And this makes our payments systems cheaper. (I've written two articles on this topic, here and here.)

The ideal payments ecosystem isn't slow or fast. It provides a combination of slow, medium, and fast options. The Libra/Diem/Novi project project that David Marcus is working on will fit in somewhere on this spectrum. The more options, the better off are consumers. But 70s ACH is no longer a very realistic way to describe modern money.