Thursday, June 1, 2023

Why is Binance leaving Canada?

Binance, the world's largest crypto exchange, announced last month that it would be exiting Canada. At the time, it blamed "new guidance" issued by Canada's securities regulators. We now have an even more detailed explanation from Binance about the nature of this "new guidance."

First, Binance says that Canadian securities regulators refused to approve its BUSD stablecoin.

If you explore this claim more closely, it just doesn't hold water. Canadians use Canadian dollars for almost everything, but BUSD is a U.S. dollar stablecoin. There's no way that any exchange's strategy for attracting Canadian customers would depend to any significant degree on providing us with U.S. dollars. (And if this was a major part of Binance's Canadian strategy, what on earth were its executives thinking?)

The other reason this excuse is a flimsy one is that the BUSD stablecoin was already due to be retired by February 2024, on orders emanating from the New York Department of Financial Services. Surely Binance's entire Canadian strategy didn't rely on a stablecoin that was destined to become defunct anyway.

The second excuse Binance gave for its departure was new guidance that its token BNB (if approved) would be subject to "investment limits." What Binance is presumably referring to is the regulatory line that most Canadian securities regulators drawn between restricted crypto assets and specified crypto assets. If a crypto asset is a specified asset, exchanges can let their customers buy it without limit. But restricted crypto faces a $30,000 ceiling, waived only if you are an eligible or accredited crypto investor.

So long story short, Binance says it was blindsided by BNB being deemed a restricted crypto asset.

But surely this couldn't have come as a sudden surprise to Binance. Twenty-three crypto exchanges have sought Canadian regulatory approval over the last three years, and in each case the list of approved specified assets (i.e. those not subject to buying limits) has been consistently confined to bitcoin, ether, bitcoin cash, and litecoin. It seems very unlikely that Binance's entire strategy for entering Canada depended on trying to add BNB to what has always been a set-in-stone list.

If Binance didn't leave because of a prohibition on BUSD or limits on BNB, then why did it leave?

One possibility is that Binance may have got wind of a recently unveiled Ontario Securities Commission's investigation into Binance's practices, and decided to cut its losses.

Alternatively, Binance may have belatedly realized that it simply didn't have the institutional chops to comply with Canada's regulatory framework. For instance, in order to protect customers from malfeasance, exchanges that want to deal with Canadians must keep 80% of all crypto at a third-party custodian. Binance doesn't currently use a third-party custodian, so it would have had to build a new platform for Canadians.

Realizing only after it had launched itself on a path to regulated status that it couldn't comply, Binance needed a face-saving reason to cut & run. When Canadian regulators provided Binance with the first round of feedback this spring, the exchange seized on this "new guidance" as its pretext for leaving, thus allowing it to blame regulators rather than blaming itself.

Sunday, May 28, 2023

The gold trick, the 2023 edition

Along with the trillion dollar platinum coin and premium/perpetual bonds, the gold trick lies in the genre of strange-accounting-tricks-to-evade-the-US-debt-ceiling.

With the debt ceiling getting closer every day, gold bugs like James Rickards are calling for the U.S. to trigger the gold trick with "just one simple phone call."

I've explained the gold trick three times before [ here | here | here ]. I don't really feel like rehashing the intricacies of it again, so reread my posts if you want to absorb all the complexities.

The idea, in brief, is that by increasing the U.S.'s official price of gold, which currently lies at $42.22, to the current market price of $2000 or so, the accounting value of the U.S. Treasury's stock of gold would suddenly be worth hundreds of billions more. The Treasury could then take the newly-realized extra value of its gold (known as "free gold") and submit it as collateral at the Fed, in the form of gold certificates. Once that collateral is submitted, the Fed can in turn instantiate a bunch of fresh dollars that the Treasury can spend.

Since none of these gold-related accounting changes qualifies as an increase in the official debt, voila, the Treasury can spend without running into the debt ceiling.

There's one big caveat. Rickards, for instance, goes off the rails when he writes: "one phone call from the Treasury to the Federal Reserve could reprice the Treasury’s gold from $42.22 per ounce."

It's just not that easy. All previous gold price increases, including the 1934 increase to $35, the 1972 increase to $38, and the 1973 increase to $42.22 required approval from Congress. Given that it is Congress that is the impediment to a straight debt ceiling increase, why would that very same Congress consent to a pseudo-increase via an change in the official gold price?

I suppose there may be enough gold-loving Republicans that the bill would pass. But as you can see, the gold trick is just not as effective as the premium bond/perpetual bond trick or the platinum coin trick, both of which avoid Congressional approval altogether.

The official price of gold illustrated:

Thursday, May 18, 2023

The UK can't figure out if crypto is gambling or a financial service. Why not both?

The UK is wresting with how to regulate crypto. Should it be treated as a financial service or as gambling?

The Conservative government wants to regulate crypto as a financial service. That is, it wants to bring cryptoassets within the framework established by the Financial Services and Markets Act, which governs the regulation of a wide range of financial services.

But a Treasury Committee made up a cross-party group of MPs criticized this approach yesterday, calling for consumer trading in "unbacked crypto" to be regulated as gambling. They say that regulating unbacked crypto as a financial service will create a halo effect that leads consumers to believe that this activity is safer than it is.

I don't think this needs be an either/or thing. The UK should regulate crypto as both a gambling product and a financial service. Here's how and why:

First, the argument for regulating it as financial service. Take a crypto platform like Coinbase. Coinbase does what regular investment dealers and stock exchanges do. It provides a set of order books, much like a stock exchange, and holds customers' crypto, much like a broker. The UK's existing financial services regulatory framework will be best equipped for ensuring these activities are safe, including having rules for custody, market manipulation, appropriateness, insider trading, and more.

Sure, in an effort to protect consumers you could in theory task the UK's Gambling Commission with regulating these sorts of capital markets activities, but it has no experience doing so and will be far out of its depth. Best to go with the closest-fitting regulator.

Second, here's why crypto should also be regulated as gambling. The Treasury Committee is right; much of the activity occurring on a venue like Coinbase is really just gambling. Unbacked crypto like bitcoin, dogecoin, ether, shiba inu, and floki are fast, fun, and potentially addictive 24/7 recursive betting games. (Not all crypto falls in the unbacked category. For instance, MKR tokens are backed, much like an equity.)

As a facilitator of unbacked coin betting, Coinbase should be subject to some of the same regulations as a casino or poker site, including rules surrounding gambling addiction, advertising, and underage access. The UK's Gambling Commission will be the best-equipped body for applying these requirements, certainly better than the UK's financial regulator. Furthermore, recognition of unbacked crypto trading as gambling would diminish any 'halo effect' brought on by bringing venues like Coinbase under the ambit of financial regulation.

So crypto shouldn't be either gambling or a financial service, but a one-two punch of both, with the appropriate regulator taking responsibility for that facet of crypto for which they have the best expertise.

Tuesday, May 16, 2023

If Wise can pay interest, why can't USDC?

Wise, a fintech, is now offering its U.S. customers 4.13% interest as well as FDIC deposit insurance. Meanwhile, the native yield on USDC stablecoins is still at 0%. Nor is USDC insured.

If Wise can offer interest and insurance to customers, why can't Circle (the issuer of USDC) do the same?

Wise and Circle are alike in a legal sense. Neither is a bank. Both are licensed as money transmitters. So why can one money transmitter offer a valuable set of services, but the other seemingly can't?

To be more accurate, it's not Wise itself that is offering these services. Wise is neither a bank nor a money market fund, so I'm pretty sure it is legally prevented from paying interest. And since it's not a bank, it can't be a member of FDIC. Rather, it is Wise's own bank, JP Morgan Chase, that is offering these services to Wise customers. Wise simply passes on the interest along with the insurance coverage.

So if Wise is just a feeder for JP Morgan, connecting its customer base to the bank, why can't Circle perform the same feeder role with its own bank, BNY Mellon, and USDC users?

I suspect one factor preventing this is the pseudonymity of stablecoins. There are many users of USDC, but Circle has only collected ID from a small fraction of them. A big chunk of USDC's pseudonymous user base is comprised of financial machines, or smart contracts, for which the concept of identification is meaningless. As for individuals or businesses who hold USDC, they may not be willing to, or can't, pass through a traditional verification process. Banks, however, have very strict onboarding rules. They must collect the ID of every single customer.

In short, it's probably quite tricky for Circle to feed USDC's mostly pseudonymous user base into an underlying bank in order to garner interest and insurance, at least much harder than it is for Wise to feed its base of known users into a bank.

It's possible that some USDC users might be willing to give up their ID in order to receive the interest and protection from Circle's bank. But that would interfere with the usefulness of USDC. One reason why USDC is popular is because it can be plugged into various pseudonymous financial machines (like Uniswap or Curve). If a user chooses to collect interest from an underlying bank, that means giving up the ability to put their USDC into these machines.

This may represent a permanent stablecoin tradeoff. Users of stablecoins such as USDC can get either native interest or no-ID services from financial machines, but they can't get both no-ID services and interest.

Thursday, May 11, 2023

Back to 1875

The last time I wrote about settlement speed was back in 2017. In that article I published a chart of the history of U.S. securities settlement speed, which I only recently had the chance to update. 

Well, here it is:

You'll sometimes catch technologists making the claim that settlement speed is a function of societal advancement. That is, in the old backward days of yore, settlement used to proceed at horse-and-carriage like pace, but as technology improves we gain the capacity to quicken settlement up to hours, then minutes, seconds and finally zero.

But as the chart illustrates, the technological explanation of settlement speed isn't right. We're about to return to t+1 (or next-day settlement) in 2024, the same pace we had back in 1875. Settlement speed isn't dictated by technological advancement, folks, it's the end result of a conscious choice that takes other factors into consideration, such as efficiency.

I was going to write an article explaining this more clearly, but I was reminded of a post I wrote for AIER back in 2021, and hadn't yet re-published here, which already makes this point more than adequately. So without further ado, read on:

In Finance, Slow is Good

In an age of instant communications, a stock trade takes a leisurely two days to settle. That is, if you buy some shares of Tesla on Monday, your brokerage won’t receive the shares (or pay the cash) until Wednesday. In industry speak, this is called T+2.

This seems an achingly long time to settle a transaction. Indeed, last month, the CEO of Robinhood, a discount brokerage, went so far as to suggest that there is no reason why “the greatest financial system the world has ever seen cannot settle trades in real time.”

In fact, there is a very good reason to eschew real-time settlement. Going slowly is a way to capture one of the world’s great natural financial forces: netting. Go too fast and you lose out on it.

To understand the magic of netting, let’s consider a world without it. Imagine a world with real-time settlement, where if I buy Tesla on Monday at 10:49 it settles at 10:49.

Say that I buy $100 worth of Tesla shares from you. We each use a different brokerage. With settlement proceeding in real time, the moment after the trade is made your brokerage will transfer the Tesla shares to my brokerage. My brokerage will simultaneously wire your brokerage the $100.

That’s two transactions between the brokerages.

Now let’s say that thirty minutes later, Jill decides to buy $100 worth of Tesla from Tom. Tom and I are clients of the same broker, while you and Jill are clients of the second broker. As before, the brokerages will have to settle up immediately. Tom’s brokerage will have to transfer the Tesla shares to Jill’s brokerage, and Jill’s brokerage will have to wire Tom’s brokerage the $100.

The two brokers now have to do four transfers between each other.

But if settlement is slowed by just a little bit, then the participants to this trade get to enjoy the magic of netting.

Let’s repeat all those transactions, but wait an hour before settling up accounts. When the hour is up, the brokers have two trades to settle up. But instead of processing both separately, they can just cancel them out. In this example, the inter-brokerage flows perfectly counterbalance each other. Our $100 Tesla trade is offset by that of Jill and Tom. And so the two brokerages needn’t do any transactions with each other. The first brokerage simply balances Jack’s and my account while the second brokerage balances Jill’s and your account.

And that’s why netting is so powerful. By making everyone wait just a little, it cuts down on the amount of work the system must do, in this case reducing brokerage-to-brokerage transfers from four to zero.

The netting afforded by T+2 settlement is so efficient that it allows the National Securities Clearing Corporation, which processes all trades involving U.S. equities, to reduce average daily equity volume of around $1.7 trillion by about 98%, leaving just a tiny $38 billion to be settled.

Faster is often better. But, in finance, a bit of tardiness can be a good thing. That’s why we should be wary of Robinhood’s call for real-time settlement. It would put an end to netting.

In fact, we already have financial systems that have gone real time only to double back and reintroduce slowness. It’s an interesting story, one worth recounting if only to show why real-time stock settlement is no panacea.

In the 1990s, central banks around the world began to roll out a new type of large-value payment system: real-time gross settlement systems (RTGSs). People like you and I use banks to make payments. But banks in turn must make payments amongst each other––very large payments––and for that they use their national central bank’s large-value payments system. This bit of central bank infrastructure is one of the most important, unsung pieces of any nation’s plumbing.

For decades, large-value payment systems operated on a deferred net settlement basis. Settlement was slow by design. Throughout the day, banks initiated payments to each other using the central bank platform. When 5:00PM finally rolled around, all reciprocating debits and credits were netted off and then settled between banks. Deferring settlement to the end of the day allowed for the number of bank-to-bank payments to shrink to a tiny fraction of total business transacted. It was incredibly efficient, albeit slow.

With the arrival of RTGSs in the ’90s, large-value payments were settled instantly, rather than at the end of the day. When Wells Fargo pays Citibank $100 million at 9:52AM, this involves an immediate transfer of $100 million in settlement balances at the Federal Reserve.

The ability to make a real-time payment is valuable. Sometimes you really need to wire funds to someone by 2:31PM, not 2:45PM.

However, real-time settlement at the central bank meant doing without the benefits of netting. So RTGSs had to process a lot more transactions than the deferred net settlement systems that they replaced. To keep up with this payments firehose, banks had to maintain a much larger hoard of central bank money on hand.

In an effort to reduce this hoard, banks adopted a strategy of waiting for an incoming payment to arrive before making an outgoing payment. Unfortunately, with all banks adopting this strategy, the result has been that payments often get pushed towards the end of the day. Many payments experts worry that this pattern isn’t healthy, since it increases the banking system’s vulnerability to operational problems.

The solution that emerged in the mid-2000s was the introduction of a new piece of central bank architecture: liquidity savings mechanisms (LSM). Central banks still allowed banks to settle payments in real time via the RTGS, but they also provided the option of submitting payments to an LSM, or central bank queue. A payment might wait in the LSM for 1 minute, 10 minutes, or 1 hour, until offsetting payments from another bank arrived to cancel it out.

By slowing down settlement, LSMs reintroduced the wonders of netting. And as a result, banks no longer had to keep such a big hoard of central bank money on hand. The Bank of England, UK’s central bank, estimates that after installing its LSM in 2013, the amount of liquidity that UK commercial banks required to make payments fell by 20%. So the same amount of business was being conducted over the Bank of England’s large-value payments system, but much less work was being expended to conduct that business.

LSMs have made the financial system safer by encouraging banks to make payments earlier in the day. After all, the quicker that a bank submits a payment to the LSM, the more time it will have to be matched. This is a neat little paradox. Queues, notorious for causing delay, actually speed things up.

Having taken a detour through central bank large-value payments systems, let’s return to the original debate over two-day stock settlement. Sure, stock markets could follow Robinhood’s advice and introduce real-time settlement. But before long, we’d all start to miss the magic of netting. Just as central banks reintroduced delays by building LSMs, stock markets would likely take steps to bring back slow.

If anything, what the central bank RTGS/LSM two-step teaches us is that we need a good balance between fast and slow. Sure, real-time settlement is a nice feature. But let’s also have delayed settlement. If brokerages have a choice to use some combination of two-day and real-time settlement, we may arrive at a socially optimal stock settlement rate.

Monday, May 8, 2023

A YIMBY approach to bitcoin mining

The Biden government has adopted a NIMBY approach to bitcoin mining. But I think YIMBY (with a twist) would be a better policy.

In an attempt to have U.S. crypto miners pay "their fair share of the costs imposed on local communities and the environment," President Biden has recently proposed a tax on miners equal to 30% of the cost of the electricity used. The White House believes that a national tax would be better than leaving it up to individual states, because that would ensure that mining is "not simply pushed from one local community to another."

The inconsistency here (and the White House seems to recognize it) is that the tax will push miners to "relocate abroad," often to places with "dirtier energy production." So on net, Biden's NIMBY approach may actually increase the fallout from bitcoin and other mined coins (a list that includes not only bitcoin but litecoin, zcash, and dogecoin).

The White House tries to get out of this contradiction by listing other countries that are moving to "restrict crypto asset mining," including China, so presumably it thinks that if everyone adopts the same NIMBY approach, then mining will effectively be eradicated. But I'm not buying that argument. There will always be some bloc of countries willing to host miners.

If the Biden government is genuinely concerned about the effects of crypto mining, it should scrap its current plan and adopt a YIMBY approach to crypto mining. But it should twin this YIMBY approach with an environmental handling fee on end-users of mined coins.

Widespread crypto mining is a symptom of something deeper: casual crypto speculation. Speculators drive up the prices of bitcoin and other mined coins, which pulls mining capacity online. Instead of attacking the symptom, like Biden proposes, better to go straight to the root, the actual gambling. When faced with a tax or handling fee on purchases of mined coins (unmined ones wouldn't be affected), Americans would opt for alternative bets. This would induce the global prices of bitcoin, dogecoin, zcash, and litecoin to fall. Lower prices would in turn push the mining industry to shrink, not only only in the U.S., but all over the world.

A mining industry would still exist, albeit on a smaller-scale. This is where YIMBY comes in. For efficiency's sake, the much slimmer mining industry should be allowed to operate wherever it sees the most opportunity. If that happens to be the U.S., then so be it. Leave it be.

The Biden administration claims that it is concerned about the environmental costs of mined crypto. Alas, its NIMBY policy will only lead to the same amount of mining, except dirtier and less efficient. With YIMBY and a tax, not only is mining reduced; what's left is the better kind of mining.

Thursday, May 4, 2023

Comparative cross-border payments: Wise vs USDC

image via Guy J. Abel and Stuart Gietel-Basten

 A popular response to my recent tweet about remittance company Wise went like this: "but JP, stablecoins are better for remittances; they're instant and cheap!" In this post I want to talk about comparative remittance costs. The problem with most of the responses to my tweet is that they incorrectly compare the cost of making a plain-vanilla stablecoin transfer to a traditional cross-border payment.

Can't do that folks! That's an apples-to-oranges comparison.

A traditional remittance, say like those offered by banks or transfer companies such as Wise, is made up of a bundle of four services. By contrast, a stablecoin transfer (I'll use USDC as my example) offers just one service. To accurately compare USDC to a remittance platform like Wise, you've got to add back the three missing services, and their associated costs.

Here are the four bundled services that Wise offers when you make a cross-border transfer:

1) verification and on-ramping: first, a sender must pass a series of Wise checks so that they can use Wise's platform. Think of this as Wise justifying your money to regulators. Next, Wise pulls your funds from your bank and onto its platform.
2) the transfer itself: once your funds have arrived at Wise, a lattice of databases moves your funds across Wise's platform towards their final destination.
3) a foreign exchange conversion: along the way, Wise converts the sender's currency to the recipient's currency.
4) off-ramping: Wise takes the funds off its platform and deposits them to the recipient's bank account.

By contrast, USDC offers just one of these services; the transfer itself (#2). In order to be verified and onramp into USDC (#1), convert from U.S. dollars to local currency (#3), and offramp back into spendable fiat (#4), both the sender of USDC and the recipient will need to use a third-party, most likely a cryptocurrency exchange. Alas, crypto exchanges extract their pound of flesh.

As an example of how to do an apples-to-apples comparison, I recently looked into the economics of a USDC remittance to see if that option made sense for me. I often sell stuff in U.S. dollars and need to repatriate my funds and convert them into Canadian dollars to pay for living expenses.

Here's what my own personal USDC calculation looks like:

Say someone in the United States owes me US$2,000 for services rendered. As payment, they offer to transfer me 2,000 USDC. I provide them with an address at my crypto exchange, BitBuy, and they send the payment. 

Next, I'll have to do a foreign exchange swap on BitBuy, trading out of USDC and into Canadian dollars. Alas, BitBuy's USDC-to-Canadian dollars market isn't very liquid, and the best rate I could get when I checked yesterday was 1.3569 (compared to the institutional rate of 1.3598). The loss from a loose bid-ask spread is called slippage, and it represents an implicit but very real C$6 fee.

On top of that I'd have to pay a 2% trading fee to BitBuy, or C$54. (If I was a high-volume trader, the fee would be much lower, but I'm not.) Next, I have to move my Canadian dollars off the exchange and into my bank account. Alas, BitBuy charges a 1.5% withdrawal fee, so that adds another C$40.

All those fees works out to C$100. That's not cheap, basically eating up 3.7% of the entire transfer. My current remittance route, which uses a U.S. dollar bank wire and a uniquely Canadian kludge called Norbert's Gambit (buying a ETF with US dollars and selling it for Canadian dollars) is significantly cheaper.

Some Canadian crypto exchanges offer better rates. With NDAX, for instance, I'd be paying around $10 on USDC-to-Canadian dollar slippage, $5.60 on trading fees, and $5 to withdraw to my bank, for a total of $20.60. That's an improvement.

However, keep in mind that what I'm describing (i.e. using BitBuy or NDAX to convert USDC to Canadian dollars) represents just the second leg of the entire remittance route. I haven't even included the fees that my U.S. sender must incur to onboard into USDC, nor have I accounted for any on-chain fees. By contrast, Wise will do both legs of this transfer for just US$14. That's tough to beat.

Your own personal estimation for whether to go with a traditional remittance or stablecoins will differ from mine, of course, depending on how cheap your local cryptocurrency exchange is (as well as that of your counterparty), and the availability and price of options like Wise or Western Union. Just make sure you include all stablecoin-related fees so that you're not mistakenly comparing apples to oranges. Stablecoins don't work for me, but they might for you.

Monday, May 1, 2023

The myth of crypto exceptionalism

"It is widely recognized – including by a sitting SEC Commissioner – that existing SEC registration and disclosure requirements are incompatible with digital assets, which differ fundamentally from the stocks, bonds, and investment contracts for which the securities laws were designed and that the SEC traditionally has regulated. The SEC at a minimum must set forth how those inapt and inapposite requirements are to be adapted to digital assets. But the SEC has refused to do even that."

- Coinbase, Inc.'s petition for writ of mandamaus to the United States Securities and Exchange Commission, April 2023 [pdf]

The claim that Coinbase makes in the above quote is a perfect example of what I call crypto exceptionalism.

The idea of crypto exceptionalism begins with the belief that crypto assets are fundamentally different from any sort of financial asset that preceded them. And so existing laws and regulations are inappropriate, (or "inapt," as described by Coinbase) and new rulemaking is required. This sounds right, at least on the surface, but it's a myth.

Stepping back in time, what happened in 2009 with the emergence of Bitcoin was not the creation of a fundamentally new type of asset. Rather, a new sort of financial database emerged: the blockchain. Others blockchains soon followed Bitcoin. But these new databases host the very same breadth of financial assets that pre-blockchain financial databases have always hosted: scams, stocks, deposits, ponzis, loyalty points, derivatives, gambling, bonds, loans, coupons, voting rights, and more.

There is nothing new under the sun. Go back to Ancient Rome or 1720s Paris and you can already find all of today's financial assets in use, including those currently traded on blockchains. That's why financial regulations created long ago (the ones Coinbase decries as "inapposite") remain relevant; they apply to financial typologies that are essentially eternal.

If you haven't recognized it, what I'm describing is just the digital substrate agnosticism approach that I sketched out in my previous post. We shouldn't treat the digital substrate on which financial assets are printed, or hosted, as being overriding. A blockchain is just another digital substrate, with one or two quirky characteristics. Rather, it's the assets themselves that should be the determining factor in the application of financial law.

If Coinbase's crypto exceptionalism is wrong, and changes in database technology do not create entirely new assets and thus don't merit new rules, what Coinbase does deserve is the following: rule makers need to show how the existing frameworks built to govern our eternal financial typologies map onto these new databases. While there's not much difference between an Azure or Oracle database, blockchains are quirky enough to merit a few extra pages of guidance, and perhaps a bit of tailoring where appropriate.

Wednesday, April 26, 2023

A quick defence of digital substrate agnosticism (or, why banks should be able to issue stablecoins)

In principle, I'm pro banks-issuing-stablecoins.

I think banks should be able to issue dollar IOUs on whatever digital substrate they see fit, whether that be an Azure SQL database, an Oracle database, or a blockchain. And they should be allowed to get deposit insurance for any of those dollars, regardless of the substrate on which those dollars are recorded. The medium should be irrelevant.

Banks should also be able to run their blockchain-based dollars on a fractional reserve basis, just like they already do with their Oracle and Azure-based dollars. That's right. Bank stablecoins shouldn't be required to operate on a full-reserve basis.

So when I see the following recently-announced initiatives, I sort of shrug and say, sure, that's fine. In Japan, three banks are going to test stablecoins while in Europe, Societe Generale wants to issue a stablecoin called EUR CoinVertible.

The Japanese example is notable, because it stems from recent amendments to Japan's Banking Act, the Payment Services Act, and the Trust Business Act allowing banks, fund transfer companies, and trusts to issue stablecoins.

Meanwhile, in the U.S., the Fed and its sister regulators have taken a different path than the FSA, recently suggesting that issuing tokens on a blockchain is "inconsistent with safe and sound banking practices." That doesn't mean that U.S. banks can't issue blockchain-based dollars, but I suppose it's a stern enough put-down that they won't ever bother.

I'm not a fan of the U.S.'s approach. Banking authorities don't say: hey, Bank of America, we'd prefer you use an Oracle database instead of an Azure one for your IOUs. Likewise, they shouldn't get to say: hey, Bank of America, don't use an Ethereum database instead of an Oracle one.

Mind you, unlike the crypto idealists, I don't think blockchains are the revolution that they are often made out to be. They're just another database, one with some quirky characteristics, so let banks figure out on their own whether they are a worthwhile medium or not. There's a high likelihood that blockchain-based dollars won't be successful with customers, but banks won't really know until they experiment.

One last point on this topic. In the same vein of substrate neutrality, if banks are going to use some sort of blockchain to issue dollars, they should be required to subject their blockchain-based dollars to the same anti-money laundering checks to which their non-blockchain based dollars are beholden. 

That means identifying all their users. This would be a departure from current practice among blockchain-based dollar issuers (like Tether and Circle) whereby they do KYC on just some users. A defence of substrate agnosticism suggests that the current KYC-lite touch isn't enough.

Monday, April 24, 2023

Zelle vs Interac e-Transfer, or why it's so difficult to kickstart a payments network in the U.S.

It's difficult to grow a payments product to universality in the United States, and that's partly due to the fact that the U.S. has a stunning 4,127 banks, 4,760 federal credit unions, and 579 savings & thrifts institutions, for a total of 9,466 depository institutions.*

Let's compare that to Canada. The rule of ten applies to most Canadian/U.S. comparisons. That is, the U.S. has around 10 times the population, so to get Canadian equivalents just divide by ten. (For example, there are 13,515 McDonald's restaurants in the U.S. Meanwhile, Canada has 1,363. That's almost perfectly in-line with the rule of ten's prediction.)

The rule of ten suggests that if the U.S. has 9,466 depository institutions, then Canada should have 946. But that isn't the case. Canada has 81 regulated banks and around 208 credit unions, for a total of just 289 depositories. (I am counting the 213 credit unions belonging to the Desjardins co-operative federation as one entity.)**

The rule of ten particularly fails with respect to banks. Canada has just 81 banks, not 412 as suggested by the rule. Banks are more influential than credit unions because they tend to be much larger.

So why is this data relevant to payments? A payments network is really only useful if it has a lot of participants on it, but a lot of participants aren't going to be on it in the first place if it isn't useful. That's the chicken-and-egg problem of payments networks.

To solve the chicken-and-egg problem, it helps to have a few large actors a vanguard commit to using the network at the outset, which kickstarts its usefulness, and then everyone else gets dragged into joining up. Voila, universal payments.

When you've got 9,466 depository institutions, it's hard to build a strong vanguard group in order to drive quick adoption of a new payments network.

Take The Clearing House's Real-Time Payments (RTP) network, for instance, a U.S. payments network which was launched in 2017. Out of the U.S.'s 9,466 depositories, RTP has attracted just 285 participating institutions, effectively limiting RTP's reach to 65% of all U.S. checking accounts. (The 65% number is from RTP's website.)*** That's not bad, but it's not great.

Another example is Zelle, a U.S. bank-owned person-to-person payments network that was introduced in 2017. By 2021, Zelle boasted 1,700 banks and credit unions on its bank-to-bank payments network. That's better than RTP, but according to Zelle, this still only represented 74%, or 577 million of all U.S. checking accounts, in 2021. (As of early 2023, Zelle reports having 1,900 financial institutions on its network, so it probably now connects 75-80% of all U.S. checking accounts.)

In Canada's case, with just 81 banks and 208 credit unions, it's much easier to build a vanguard group to drive a payments network forward.

For instance, Interac e-Transfer is the Canadian equivalent to Zelle, providing instant person-to-person transfers via bank and credit unions. As of 2023, Interac e-Transfer has 250 participating banks and credit unions. (It lists Desjardin Group, a federation of 213 credit unions, as a single entity). That's almost all of Canada's 289 depositories, and effectively 100% of all Canadian chequing accounts. That's ubiquity for you.

Admittedly, Interac e-Transfer has been around a lot longer than Zelle and RTP, having debuted in 2003, and so it has had more time to spread into all the cracks. (I wrote about Canada's big head start in instant payments a few years ago.) But even at the outset of the adoption process, e-Transfer enjoyed buy-in from Canada's five biggest banks (Royal, TD, Scotiabank, CIBC, and Bank of Montreal), which together owned 86% of all Canadian banking assets at year-end 2003. That's a huge vanguard group. The chart below, which uses 2022 data, gives a good feel for how significant this is.

The above chart also illustrates how small any U.S.-equivalent vanguard group will ever be. Zelle's 2017 group of 30 first-adopters may have seemed large on the face of it. After all, it included America's largest banks: JP Morgan Chase, Bank of America, Wells Fargo, Citibank, US Bank, PNC, and Capital One. Yet this vanguard still only constituted 52% of total U.S. banking assets, much less than the 86% committed to Interac e-Transfer on day one.

The diffuse nature of U.S. banking (and the concentrated nature of Canadian banking) will play into the upcoming launches of FedNow and Real-Time Rail (RTR), two instant retail payments system belonging to the Federal Reserve and Bank of Canada, respectively. I'd expect RTR usage to amp up quickly, given that Canada's big-5 banks will likely help sponsor it. FedNow adoption will lag. It's just not that easy to get 9,466 institutions on the same page.

* Number of US banks and savings/thrifts is from FDIC. Data on credit unions is from the NCUA
** Number of Canadian banks is from OSFI. Number of credit unions is from CCUA
*** A tweet where I list my data source for RTP data

Thursday, April 20, 2023

How stablecoin opacity and sloppy reserve management paid off (for now)

[I wrote this article for CoinDesk earlier this month and am republishing it here.]

USDC Boasted Transparency but It Didn't Help When Silicon Valley Bank Got Into Trouble

The weekend of March 10, 2023, was a profound test of how well stablecoins hold up under pressure. Now that everything has settled, some odd lessons have been passed on, namely: Transparency doesn't seem to be a good thing. And forget about prudent management of reserves – it's just not worth it.

Opacity and sloppy reserve management win the day. Or, at least, so it would appear.

Leading up to Friday, March 10, the issuer of second-largest stablecoin USD coin (USDC), Circle, was probably the industry's most transparent issuer.

It provided daily updates to investors through its BlackRock-managed money market fund, which backstops the stablecoin. On top of that, Circle had just adopted the New York Department of Financial Services’ guidance for stablecoin transparency, which required two attestation-of-reserves tests each month.

In contrast, Circle’s arch-competitor, Tether, which publishes attestation reports on a less-frequent quarterly basis, lagged far behind on transparency.

To boot, in its attestation reports Circle disclosed all sorts of useful information to users, such as each individual Treasury bill’s CUSIP number and where it banks. On that list was Silicon Valley Bank.

It was the last bit of data – Circle's banking relationships – that seems to have caught everyone's attention that Friday. After experiencing a run through most of the week, Silicon Valley Bank shares were halted at 9:30 a.m. local time after plunging 62% in premarket trading. Just before noon, the Federal Deposit Insurance Corporation (FDIC) announced that it would be shutting the bank down.

Keen-eyed social media commentators scanning Circle's disclosures noticed the mention of deposits held at Silicon Valley Bank. Tweets were issued.

They certainly had cause for concern. When a bank fails and the Federal Deposit Insurance Corporation (FDIC) takes it over, depositors are only protected up to $250,000 per account. Anything above that amount is at risk. The implication was that if Circle had funds stuck at Silicon Valley Bank, it could suffer big losses. That meant potentially being insolvent. And that raised the possibility that USDC holders might not be made whole.

Social media began to demand a statement out of Circle. CoinDesk picked up on Circle's Silicon Valley Bank problem after lunch. Curve's massive 3pool, an important source of stablecoin liquidity, began to be drained as fearful traders swapped their USDC for USDT. By that evening, 3pool was empty and Binance, the world's largest crypto exchange by trading volume, suspended 1:1 conversions between Binance USD (BUSD) and USDC, indicating a significant amount of stress in the market.

By 7 p.m. ET, a slight USDC depegging from the U.S. dollar occurred on trading markets, and after 10 p.m. Circle finally issued a statement. It revealed that $3.3 billion of USDC’s reserves was in limbo at Silicon Valley Bank. The market was stunned. USDC's price began a sickening plunge to below 90 cents.

The irony of this is that neither of Circle's competitors, Tether and Paxos, disclose where they bank. And so commentators on social media didn't have enough dirt on Tether and Paxos to start asking questions. While USDC collapsed on exchanges, the prices of the Tether and Paxos stablecoins held solid.

Had Circle been as opaque as its competitors, no one would have known that Silicon Valley Bank was its banker and the weekend run on USDC probably would never have occurred.

The lesson would seem to be: Don't be transparent or, if you need to be transparent, don't be transparent about your shortcomings.

How might Circle have managed its reserves differently?

Paxos, which issues the Paxos dollar (USDP) stablecoin and, until recently, BUSD, offers some cues. According to the Paxos attestation reports on USDP, Paxos keeps hundreds of millions worth of deposits with banks, but all of those deposits are insured.

It bypasses the $250,000 limit in two ways.

First, some of Paxos' deposits are invested through placement networks. The way this works is that Paxos' bank farms money out to other partner banks in $250,000 blocks. Each of these blocks is completely covered by FDIC insurance. Although there are 4,333 FDIC-insured banks in the U.S., providing a theoretical coverage ceiling of $1.08 billion, in practice Paxos only uses deposit networks for part of its deposit balance.

For the remaining unprotected part, Paxos has contracted with an insurance company to be covered by private deposit insurance. Of the $270 million in cash reserves used to back USDP going into the crisis, $72 million was privately insured.

And that, folks, is how to prudently manage large cash balances. It's a pain. You can't just casually stash your billions at a bank; you've got to go out of your way to properly secure it.

Which leads us into the second irony. If it didn't pay for Circle to be transparent, it also didn't pay for Paxos to be prudent.

On Sunday evening, March 12, the FDIC announced that the $250,000 limit on insurance would be waived. All deposits held at Silicon Valley Bank would be extended a blanket guarantee. Circle's $3.3 billion was safe. In moments, the price of USDC rocketed back up to its $1 peg.

The crypto sector had just benefited from its first federal bailout, and not a small one at that. According to FDIC, the 10 largest deposit accounts at Silicon Valley Bank held a combined $13.3 billion, implying that Circle was the largest beneficiary of the bailout.

The moral of this part of the story is that the government's official cap of $250,000 was never very serious; unofficially, FDIC protects everything. Paxos' careful deployment of private insurance and deposits networks seems to have been a waste of time and resources, and its competitors' "don't think, just deposit" strategy the right one.

In the aftermath, Circle now advertises USDC as "a stablecoin with GSIB cash." That means no longer keeping a big chunk of its cash reserves at mid-size banks like Silicon Valley Bank but lodging most of it at Bank of New York Mellon, a global systemically important bank, one almost certain to benefit from a bailout should it fail. That also means Circle probably won’t bother going through the process of negotiating private deposit insurance.

As for Tether, which issues the least transparent of the big stablecoins going into March 10, it wasn't terribly prudent, either. Its public attestation reports give no indication that it routes its $5 billion or so in cash through deposit networks, nor does it resort to non-FDIC insurance. It fully absorbs the risk of its bankers going bust.

Yet, the amount of USDT in circulation has exploded by around $9 billion, or 11%, since that weekend.

On a long enough timeline, another significant stablecoin test, like the one that faced USDC, is inevitable. The reasons for the next one will be difficult to predict, and likely different from the last one. While opacity and a nonchalant approach to reserve management may not have been punished this time around (indeed, they seem to have been rewarded), if issuers internalize these lessons, then the next stablecoin crisis will only come sooner, and at a much larger scale.

Wednesday, April 19, 2023

In which I catch Canadian banks paying more interest to customers than US banks do

TD Bank operates on both sides of the border, yet pays more in interest on one side than the other. Source: TD

Long-time readers will know that I like to muse on the competitiveness of U.S. and Canadian banking. In my last post on the topic, I was surprised to see how Bank of Montreal's net interest margins a measure of how much a bank is squeezing out of its customers were far lower in Canada than the U.S. The fact that Bank of Montreal is squeezing more out of Americans than Canadians suggests that competition is stiffer north of the border than south of it.

The idea that Canadian banking is more competitive than U.S. banking goes against what I'll call the "standard view." In short, this view is that while Canadian banks are safer and better-regulated than U.S. banks, this comes at a steep price. Up here in Canada, we've ended up with a few big oligopolistic institutions capable of charging exorbitant fees and paying unnaturally low interest rates, which hurts the consumer. Meanwhile, there are many more banks in the free-wheeling U.S., and while this makes for more bank failures and runs, the public benefits from lower fees and receives higher interest rates.

Anyways, I recently stumbled on another anecdotal piece of evidence that contradicts the standard view. TD Bank operates on two sides of the border, as the screenshot at the top of this blog post shows. Yet it pays depositors a different rate, depending on what country they live in:

As the chart shows, TD Bank consistently pays higher interest rates to its Canadian depositors. Why a persistent interest rate differential? You can't blame it on central bank policy rates being higher in Canada, since over much of this time frame policy rates were higher in the U.S. Is it possible that TD has to be more competitive in Canada in order to attract deposits?

An alternative explanation for the differential is that TD's deposits are of a different character in Canada. A big chunk of TD's Canadian deposits are fixed-term deposits that mature in 12-months or more, whereas its U.S. base of fixed-term deposits is typically shorter term, usually 3-12 months. Because it costs more in interest to convince depositors to stick around for longer periods of time, could it be that it is the difference in term and not competition that explains why TD's interest costs are so much higher in Canada?

Not quite. Even if we compare U.S. and Canadian interest rates for the same fixed term, Canadian banks still pay more interest to depositors. In Canada, the term of art for a fixed-term deposit is a guaranteed investment certificate, or GIC. In the U.S., it's a certificate of deposit, or CD. In the chart below, I've charted out the interest rate that Canadian banks pay for 1-year GICs compared to what U.S. banks pay for a 1-year CDs.

(For more on the data, see footnote*). 

You can see that over the last few years, the big-6 Canadian banks have consistently paid more to 1-year fixed-term depositors than U.S. banks have. Again, you can't pin this on central bank policy rates being higher in Canada. 

Canadian banks not only consistently pay more interest, they are also far more responsive to central bank policy rate increases. Both nations' central banks, the Fed and the Bank of Canada, began to hike rates in lockstep with each other beginning in March 2022, starting from close to 0% and rising to 4.75% and 4.5% respectively as of today. Yet Canadian banks began to pass-off these increases months before U.S. banks did. They have also done so far more completely; the 3.0% on a 1-year GIC is far closer to central bank policy rates of 4.5%-4.75% than the 1.5% on an equivalent CD. (And by the way, I wrote about sticky U.S. deposit rates last year.)

Could it be (gasp) that Canadian banks are more competitive?

Trust me, I don't like this conclusion. I quite enjoy thrashing Canadian banks for being noncompetitive. So if you have some good counter-evidence, please send it my way.

By the way, the above data confirms an anecdote from last year. I caught Canada's largest bank, Royal Bank, paying much more to Canadian depositors than U.S.'s largest bank, Chase, pays its American depositors:

It's very possible that the standard view is wrong, and the tug of war between Canada's 6 nationwide heavyweights result in a more competitive price than in the U.S. where although there are more than 4,000 banks they are often small and regional and lack the heft to engage in high calibre competition.

If so, it appears you can have your cake and eat it too. Not only can a country have a safe and robust banking system, but that needn't come at the price of less competition.

*A note on my data sources for this chart. Canadian data comes from the Bank of Canada, which is compiled from posted interest rates offered by the six major chartered banks in Canada. The number is the statistical mode of the rates posted, which may explain the series' choppiness. U.S. data comes from FDIC, which compiles the data from S&P Capital IQ Pro and SNL Financial Data. Certificate of deposit rates represent an average of the $10,000 and $100,000 product tiers. Averaging across dozens or hundreds of banks would explain the smoothness of the U.S. series.

There are a number of complexities that are not explained by either data source. For instance, is the Bank of Canada's GIC data made up of non-redeemable GICs only, or do they include redeemable GICs, too? As for the U.S., banks like Chase offer a "relationship rate" to customers that far exceeds the non-relationship rate. Which rate is the FDIC collecting? I've suggested in my blog post that the difference in U.S. and Canadian 1-year fixed term deposits rates could be explained by competition, but it could also come down to data artifacts like these.

Thursday, April 13, 2023

Payments stablecoins vs trading stablecoins

Circle's Gordon Liao recently sketched out a new distinction between 'payment stablecoins' and 'trading stablecoins,' and then places Circle's stablecoin, USD Coin, in the former category, while confining competitors Tether, Dai, and Binance USD to the trading bucket.

I don't know about you, but I'm not convinced. 

According to the article, a payments stablecoin is defined as a stablecoin that has a low ratio of daily trading volume to circulation and has little correlation to the price of Ethereum. The suggestion is that any stablecoin that sports these statistics isn't being used for cryptocurrency speculation, and so by default it must be getting used for payments. By contrast, any stablecoin that has a high trading-volume-to-circulation ratio and is more closely correlated to Ethereum's price is defined as a trading stablecoin; its primary function is speculation, not payments.

You can sorta see where this is going. Speculation is unsavory whereas payments (the article cites cross border remittances in particular, but you can also put retail point-of-sale payments in that category) are wholesome & useful. As a stablecoin issuer, it's probably better to be slotted in the payments bucket, since that's the bin that regulators, politicians, critics, and economists will take more kindly to. Who knows, it might even merit a more beneficial regulatory touch.

And so no surprise that the article finds that USD Coin, or USDC, qualifies as a payments stablecoin, one that has "minimal speculative exposure."

Having watched stablecoins markets for a while now, my internal library of anecdotal evidence tells me that USDC isn't used much in payments, but mostly for trading. It's just that one of the big roles USDC plays in trading is a relatively sedentary one, as a form of collateral in decentralized finance (or DeFi), and so its turnover is relatively low. By contrast, stablecoins like Tether and Binance USD are less popular as DeFi collateral and more popular as trading chips for centralized exchanges (like Binance), and that's why they have such high turnovers.

My anecdotal database also tells me that the most payments-ish of the stablecoins is probably Tether. Don't get me wrong, Tether is still mostly used for trading, specifically as a proto-dollar on exchanges like Binance and Bitfinex to support crypto gamblers. But when you do hear stories about stablecoins being used for cross-border payments, it tends to be Tether that's involved, not USDC.

For the time being, I think that a payments stablecoin is a fable. Everyone wants to be in that category, but an actual payments stablecoin, one who's main use-case is remittances and POS payments, doesn't exist. Stablecoins remain primarily used for trading, gambling, and speculation.

Saturday, April 1, 2023

FedNow is not a tool for freezing money

I've been seeing a lot of misunderstanding about FedNow, a new retail payment system built by the Federal Reserve (the FED), but the one I want to deal with right now is the allegation that FedNow has the ability to freeze accounts.

Balaji Srinivasan, for instance, suggests that FedNow could "facilitate Cyprus-style deposit seizure at the speed of light":

That's not quite right, and let me show you why. 

Let's set the stage. Say you do something illegal. Maybe some light treason, or better yet, investment fraud. You've got all of your victims' funds in your Wells Fargo account, and law enforcement wants to quickly stop you from making a getaway.

The authorities won't bother sending a court order to the FED to freeze your money. FedNow is a communications system between member bank, allowing them to quickly and accurately update their databases. It has no control over Wells Fargo's database, which is where the stolen funds reside.

To freeze the funds, the authorities have always had a much more powerful tool at their disposal. They will send a court order directly to Wells Fargo. And then Wells Fargo will lock your account. At that point you'll no longer be able to ask your bank to send FedNow transfers (or any other sort of transfer for that matter.) The FedNow network is closed to you, my friend.

But it wasn't the FED that carried out the freeze, it was your bank.

Next, let's broach the allegation that authorities might be able to order the FED to block any FedNow message mentioning your name, in essence marooning your funds at Wells Fargo. In his Twitter exchange with me Balaji seems to think this is possible, although he provides no real proof of his claim.

Even if this was possible (and I doubt it is), that's a fairly ineffective tool. You could get around a FedNow blockade by having Wells Fargo transfer the stolen funds via any non-FedNow network. There are many of them, including one of the ACH networks, Zelle, The Clearinghouse's RTP system, or one of the Visa/MasterCard debit networks. Alternatively, wire it overseas via SWIFT. Or send the funds internally to a confederate's Wells Fargo account and have them evade the blockade. Or, if you're feeling old fashioned, you could withdraw cash, maybe even write out a paper check. How about using your debit card to buy gold or crypto or a yacht if that's your thing?

As you can see, you've got so many ways to exit stolen funds from your Wells Fargo that blocking just one of the holes, FedNow, provides the authorities with no extra ability to freeze funds. FedNow or not, the authorities have the same very powerful tool they've always had: block funds at the bank level by deputizing bankers to do it.

(And that's not a bad thing. Freezing funds before they can get dissipated is one of the best tools for protecting fraud victims.)

As further proof that I'm right about FedNow's alleged freezing ability being a nothing-burger, here's a reality check: When 280 convoy-linked individuals were frozen out of the Canadian payments system by the Federal government last year, did the authorities ask the Bank of Canada to configure its various payments systems to carry out this order? 

No, they didn't. They delegated freezing responsibility to Canada's banks and credit unions. And guess what? It worked like a charm.

In summary, let's not get too worked up about FedNow's alleged freezing ability. It's not the tool for the job.

Thursday, March 23, 2023

Does FedNow mean quicker bank runs?

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

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

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

I don't think so.

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

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

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

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

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

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

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

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

Tuesday, February 14, 2023

Weak nations with strong currencies

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

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

Let's start with Afghanistan.

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

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

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

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

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

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

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

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

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

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

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

Friday, February 3, 2023

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bitcoin operates along the same principles as CashCo.  

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

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

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

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

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

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


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