Tuesday, January 31, 2023

A big chunk of crypto is gambling. Why not regulate it that way?

[This article was published last week in CoinDesk.]

The Pluses and Minuses of Regulating Crypto as Gambling

In the wake of FTX's shocking collapse, a new idea for regulating crypto has begun to take form: Let's regulate crypto like we regulate gambling.

Todd Baker, a Senior Fellow at the Richman Center for Business, Law and Public Policy at Columbia University, recently writes that "crypto trading should be regulated for what it is – gambling emulating finance and not what its advocates say it is or what people believe it to be."

The European Central Bank's Fabio Panetta suggests that "regulation should acknowledge the speculative nature of unbacked cryptos and treat them as gambling activities." And here is a recent American Banker article on the topic.

There are some good aspects to the idea of regulating crypto as gambling, and some bad.

First, the bad.

Crypto is too diverse for one regulatory framework

Any claim that we should regulate crypto as X isn't very helpful, and that's because the stuff we call "crypto" has long ceased to be a single-issue product that can be conveniently boxed into any one framework. Maybe back in 2012 and 2013 it could have been. And gambling might very well have been the best fit back then.

But, at its core, crypto consists of a bunch of programmable databases, which means they can host all sorts of applications – not just gambling applications. Zoom forward to 2022 and the range of activities occurring in the crypto space has become quite broad and diverse.

Take MakerDAO, for instance. MakerDAO is built on a blockchain, and so it falls under the “crypto” umbrella. But it isn't a gambling product. Functionally, MakerDAO is a bank that makes loans by issuing deposits in the form of dai (DAI), a stablecoin.

To make things more complicated, ownership of MakerDAO is represented in the form of MKR tokens, also residing on a blockchain, which allow holders to vote on how the bank operates. MKR also provides holders with a claim on bank earnings. In effect, MKR tokens are like shares in Wells Fargo or Bank of Montreal. They are investments.

To regulate MakerDAO and the tokens associated with it – DAI and MKR – as gambling products just wouldn't make sense, for the same reason that regulating Wells Fargo or its underlying shares as a casino would be a clumsy fit.

Or take decentralized tools Aave and Compound, which have been built on blockchains. Both are lenders. While these two tools certainly service a gambling clientele, they aren't themselves gambling apps and shouldn't fall into that category.

Or consider centralized exchanges such as Coinbase. Coinbase lets customers directly buy and sell crypto with cash, combining in one platform the roles of a traditional broker like E-Trade with a trading venue like Nasdaq. However, we apply securities regulation to E-Trade and Nasdaq, not gambling regulation, and should probably do the same for Coinbase.

In sum, to regulate crypto it'll take more nuance than just throwing it all into the gambling category. There are many different existing regulatory frameworks that can be applied to emergent blockchain-based products, of which gambling is just one.

Next, here’s what’s good about regulating crypto as gambling.

A long overdue recognition of crypto problem gambling

Dai, MKR, Aave and Compound may not be gambling. But a large proportion of crypto is gambling. That's because a big chunk of the people who engage with blockchains are doing little more than betting on the very volatile prices of first-generation unbacked volcoins like dogecoin, floki inu, and shiba inu. Let's not forget bitcoin, bitcoin cash, litecoin, xrp, and ether.

The crypto industry has tried its hardest to elevate volcoin betting from gambling to "investing." Coinbase, for instance, loftily sees its mission as to "increase economic freedom in the world."

But if you look under the hood, a volcoin such as dogecoin is little more than a never-ending 24/7 lottery on what average opinion thinks the price of dogecoin will be. This same recursive betting process is what drives the prices of bitcoin, litecoin and other volcoins. Users can sell their position in these never-ending lotteries to other players, and in some cases the casino chips get used as a payment token – but the payments functionality of volcoins has always run a distant second to their primary lottery function.

The benefit of officially recognizing volcoin-based betting as a form of gambling is that it would import into the world of crypto society’s already-existing protections for problem gamblers and children.

Problem gambling is a disorder characterized by a persistent and uncontrollable urge to gamble despite negative consequences or attempts to stop. It can lead to financial difficulties, relationship problems, and mental health issues such as depression and anxiety.

In many jurisdictions, gambling operators are required to address problem gambling by implementing self-exclusion programs that allow customers to voluntarily ban themselves from gambling establishments or betting sites. By regulating volcoins as gambling, venues that offer these products – say like Coinbase, PayPal and Kraken – would be required to set up exclusion programs of their own.

Gambling venues are often required by law to display responsible gambling messages such as "Play Responsibly. Remember, it’s just a game." The MegaMillions play responsibly page, for instance, provides information about problem gambling and a confidential 24-hour hotline.

Applying these messaging standards to crypto, it would no longer be permissible to represent volcoin purchases to clients as a form of investment. Rather, venues like Coinbase and PayPal would have to provide disclaimers along the lines as: "Play bitcoin responsibly. Remember, it’s just a game."

In many jurisdictions, a recognition of volcoins as gambling would limit opportunities for public advertising. In 2021, ads for floki inu flooded London. "Missed Doge? Get Floki," the ads said, appealing to peoples’ base fears of missing out. However, the United Kingdom has a very strict code surrounding gambling advertisements. Had floki and other volcoins been properly categorized at the outset as betting games, then floki’s advertising campaign would have had to pass many more hurdles.

Or take Matt Damon's notorious "fortune favors the brave '' ad for Crypto.com from early 2022. The ad tried to analogize volcoin buyers to intrepid explorers. By regulating volcoins as betting, ad creators could no longer draw these sorts of dubious analogies in an attempt to attract bettors to their platforms.

In particular, gambling regulatory frameworks in places such as the U.K. explicitly prevent gambling operators from reaching out to children through advertising. If volcoin betting were to be deemed a form of gambling, then crypto platforms that court users under the age of 18 (say like Block and Kraken have done in the past) would be required to put an end to this practice.

Finally, some U.S. states limit the ability of gamblers to fund their activities by credit, as does the United Kingdom. The idea is to prevent a problem gambler's addiction from snowballing into a much larger crisis for the family's finances. Translating this rule over to crypto could mean no longer allowing customers to buy volcoins with credit cards and/or restricting access to margin.

To sum up, the idea of applying crypto regulation to crypto needs to be fleshed out. There are many blockchain-based activities that are not gambling, and shouldn't be regulated as such. But a big chunk of what occurs on blockchains is gambling, and it's about time we recognized it as such – and regulated it accordingly

Tuesday, January 10, 2023

Why the steepest borrowing rate may be the best rate

(This isn't a piece of financial advice. It's more of a fun parable about interest rates.)

So here's an interesting financial riddle. Let's say I want to buy a used car for $1000. 

First, I need a loan. Say that there are two floating rate loans available to me: one that currently costs 3.2% per year, and another that costs 2.3%. Logic dictates that I should take the cheaper 2.3% option, right? But I don't. Instead I take the more expensive one, figuring to myself that the expensive 3.2% loan is actually the cheaper loan.

Why on earth did I do that?

The rates in question are from the website for Aave, a tool for borrowing and lending cryptocurrencies, including stablecoins:

The cost of borrowing two different stablecoins on Aave [source]

If I borrow 1000 Tether stablecoins from Aave to fund my purchase of the $1000 car, it'll cost me 3.2%. But if I borrow 1000 USD Coins, it'll cost me just 2.3%. Those are floating rates, not fixed. (I could also borrow stablecoins on a fixed basis. A fixed-rate Tether loan would cost me 12.26% on Aave, a USD Coin loan 10.69%. Again, it's more expensive to borrow Tether.)

Why would I pay 3.2% to borrow one type of U.S. dollar, Tether, when I can get another type of U.S. dollar, USD Coin, at a cheaper rate? I mean, they're both dollars, right? They each do same thing; that is, they both provide me with the means to buy a $1000 car.

To see why I might prefer the more expensive Tether loan, we need to understand why the rates on Tether and USD Coin differ:

If I borrow 1000 stablecoins to buy a $1000 car, eventually I'll have to buy those 1000 stablecoins back in order to repay my loan. Wouldn't it be nice if, in the interim, the stablecoin I've borrowed loses its peg and falls in value? Because if it were to do so, I'd be able to buy back the 1000 stablecoins on the cheap (say for $400 or $500), pay back my 1000 stablecoin loan, and keep the $1000 car. 

In short, I'd be getting a $1000 automobile for just $400-$500 plus interest.

By contrast, if I were to borrow a more robust stablecoin in order to purchase the car, then that'd reduce the odds of its price being weak when it comes time to repay my loan, thus making the entire transaction more expensive to me. 

A $1000 car would cost me... $1000 plus interest.  

We can imagine that all potential borrowers are perusing Aave's loan list with that exact same thought in mind. Jack wants to finance a house for $250,000 by getting a stablecoin loan on Aave. Jane wants to borrow $100 in stablecoins on Aave to pay off her credit card debt. All three of us would really, really, really, like to borrow a stablecoin that fails, reducing the net cost of our purchase. So we all do our respective research and select what we believe to be the stablecoin with the worst prospects, the one most likely to be worth just 40 or 50 cents when it comes time for us to repay our debt.

The competition between the three of us to borrow the worst stablecoin will cause borrowing rates for the worst stablecoins to rise. Conversely, borrowing rates on the stablecoins with the best prospects will fall.

And that's what I suspect is happening on Aave. Tether is seen as the riskier stablecoin. And so from the perspective of the borrowing public, a Tether loan is superior to a USD Coin loan. Jack, Jill, and myself are all scrambling for the privilege of borrowing Tether, in the process pushing the cost of borrowing Tether 0.9% above the cost of borrowing USD Coin.

Now we can get back to the original riddle. Even though the rate to borrow Tether is higher than the rate to borrow USD Coin, it may be worthwhile for me to go with the a Tether loan if I think that the odds of Tether failing justify the higher financing cost.

We can even go a bit further and say that the 0.9% premium on a Tether loan is the market's best estimate of the odds of Tether losing its peg relative to USD Coin losing its peg. So for all those would-be stablecoin analysts out there, keep your eye on Aave's USD Coin-Tether spread. It's a good indicator of stablecoin risk.

P.S: The difference between the cost of borrowing Tether and USD Coin could also be due to the liquidity premium on Tether being larger than the liquidity premium on USD Coin. I'm not going to get into that possibility in this post, but if you're curious ask me about it in the comments. 

P.P.S: Does this same logic apply to borrowing from banks? Would I rather borrow from a bank that's about to fail rather than a solid respectable bank?

P.P.P.S: Some Dune dashboards tracking he Tether-to-USD rate premium: here and here.

Thursday, January 5, 2023

Is crypto just gambling?

Is crypto just gambling? That's a point I made in my recent "let it burn" blog post. (And I notice that the ECB's Fabio Panetta recently said the same thing, describing crypto as a "gamble disguised as an investment.") In this short post I want to clarify what I mean.

What the word "crypto" means (in my universe, at least) is the array of financial applications built on a new kind of database, otherwise known as a blockchain. Some blockchains include Bitcoin, Ethereum, Solana, Tron, and Dogecoin. What makes these databases novel is that they are open(ish) and decentralized(ish). Contrast this to my bank's SQL database, which is 100% under my bank's control.

Before blockchains came along, financial providers were already housing all sorts of applications on their closed internal databases. These financial applications included banking, stock trading, money transfer, brokerage, and insurance, as well as less savory financial applications like gambling, betting, and triple-levered ETFs. And of course, our pre-2009 databases also hosted downright illegal financial applications like pyramid schemes and ponzis.

Then blockchains arrived, beginning with bitcoin in 2009. And people started to replicate on blockchains the financial applications that had previously only been built on regular databases.

And now we can get to why I say that crypto is just gambling. To date, the most popular financial applications being hosted on blockchains are all gambling applications.

The dominant form that blockchain-based gambling takes is betting on the prices of various unbacked tokens including dogecoin, shiba inu, xrp, cardano, ether, litecoin, and bitcoin. The price of these tokens is arrived at via a purely self-referential process whereby players gamble on what "average opinion expects the average opinion to be." The resulting price is so spectacularly erratic that a good player can buy some dogecoin at the beginning of February and make 100% by the end of the month, or 10,000% by December.

Gambling isn't the only financial application to be built on blockchains. A number of interesting non-gambling blockchain-based financial applications have emerged, too. These include applications that offer banking (MakerDAO), trading (Uniswap), non-bank lending (Aave), and money transfer (USD Coin and Tether).

However, the aforementioned non-gambling financial applications that have been built on blockchains mostly serve people who are themselves gambling on the prices of dogecoin, bitcoin, shiba inu, and other unbacked tokens. Most of MakerDAO's loans, for instance, have historically been to gamblers who want to speculate on the price of ether.

And so once again, that's why I say that crypto is just gambling. Most people who use blockchains are either directly gambling on unbacked token prices, or are providing financial services to these gamblers.

At the moment crypto may just be gambling, but that doesn't mean it'll always be just gambling. Eventually what we'd like to test is whether blockchain-based financial applications have the ability to emerge from the self-contained gambling cocoon they currently occupy in order to (safely!) serve the massive population of non-gambling financial consumers. For instance, in the future might it be possible for a small business to get an unsecured loan from MakerDAO as easily and cheaply as they can from a local bank or credit union?

For now, we don't know the answer to this test. It could be that blockchain-based financial applications simply lack the moxie to transcend the earthly gambling plane into something more broadly useful, and offering gambling on unbacked coin prices and services to those gamblers is all they'll ever amount to. Or maybe not. It'll be interesting to see the results of the test.

Tuesday, January 3, 2023

How Tether can stop being the stablecoin that everyone sells in a panic

The not-so-stable price of Tether in 2022 on the Kraken exchange

[Republished below is my latest article from CoinDesk.]

How Tether Can Be a More Stable Stablecoin

The crypto economy has suffered two major crypto failures this year: the collapse of Luna/TerraUSD in May and the failure of FTX in November. In both instances, the world's largest stablecoin, Tether, was caught in the blast radius as waves of redemptions poured into the company. It shrunk by $18 billion, or 21%, in May and June and by another $4 billion, or 6%, in November.

Stablecoins shouldn't be the instruments that the public sells in a panic. They're supposed to be the opposite; the life vest that people grab on to. Competing stablecoins USD Coin and Binance USD performed as one would have expected. Neither experienced a barrage of redemptions during these two episodes.

Here are four things that Tether can do to ensure that the next time the crypto economy undergoes a shock, tether stays steady.

1) Tether needs to get rid of its corporate bonds, funds and "other investments."

A stablecoin's number one job is to be steady, and that demands holding safe assets like cash and Treasury bills. But some of the line items on Tether's balance sheet – including commercial paper, corporate bonds and funds, secured loans and "other investments” – suggest that Tether operates more like a hedge fund or venture capital firm than a stablecoin.

Tether has been slowly addressing this problem. It spent much of 2022 replacing its massive $30 billion horde of commercial paper with Treasury bills, finally bringing the tally down to zero just prior to the FTX catastrophe.

But even after this cleansing, Tether still suffered from a wave of redemptions in November. Realizing it hadn't gone far enough, Tether executives made a pledge earlier this month to reduce its $6 billion in secured loans to zero.

That's great, but the company has been silent on what many analysts consider to be its sketchiest assets: its $2.6 billion in other investments and $3 billion or so in corporate bonds and funds. What is the rating and duration of these corporate bonds? Who are the borrowers – are they crypto firms? Are its other investments and funds composed of crypto-specific tokens?

Fear that these investments could sour is the best explanation for why the last two general cryptocurrency panics have inspired temporary runs on Tether. Best to get out of Tether now, goes the thinking, in case the company no longer has enough funds on hand to redeem all Tether tokens.

To put an end to this pattern, Tether needs to sell all of its risky assets and move to a 100% safe-asset allocation. Next time a crisis hits, users will be less likely to unload their Tether tokens.

2) Tether needs to cancel its 0.1% redemption/withdrawal fee.

While the prices of competing stablecoins Binance USD and USD Coin are well-anchored to $1 on major exchanges around the globe, the price of Tether tends to fluctuate randomly. This lack of stability hurts the company’s reputation. At heart is Tether's 0.1% redemption fee. Time to get rid of it.

Tether charges anyone who wants to redeem or withdraw Tether tokens a 0.1% fee. So if you own 1 million tether tokens and want to redeem them, you'll only get $999,000 back after paying the $1,000 fee to Tether. Likewise, if you wire $1 million in fiat to Tether in order to get stablecoins, you'll only get $999,000 USD back.

The other big stablecoin issuers, Circle and Paxos, do not charge these fees.

It may not sound like much, but the 0.1% fee leads to the price of tether weaving randomly in a wide band around $1 rather than staying locked.

The price at which any stablecoin trades on exchanges like Binance and Kraken is set by arbitrage. If the price falls too low below $1, arbitrageurs buy stablecoins on the exchange and transfer them to their issuers for redemption at $1, earning a small profit. They execute the inverse when a stablecoin’s price is too high.

Competition among arbitrageurs to execute these trades at a profit is what locks the price of stablecoins on key exchanges at a price close to $1.

Tether's 0.1% fee adds to an arbitrageur's costs of carrying out this trade. Factoring in this cost, it only really becomes profitable to buy tether tokens when they've fallen to $0.999, and sell them when they've risen to $1.001. Tether’s price randomly floats within this relatively wide band.

This lack of rigidity attracts bad press, rumors, innuendo and speculation. It makes Tether look particularly bad during broader crypto meltdowns when its price inevitably falls to the bottom of its trading band, mirroring the performance of other risky crypto tokens rather than holding strong at $1. Meanwhile, other stablecoins like USD Coin and Binance USD, which don't have redemption fees, hold strong.

It's time for Tether to get rid of this fee in order to create more confidence-inspiring trading patterns on third-party exchanges.

3) Tether needs to open redemptions up to more people by removing its $100,000 floor.

Tether is unique among stablecoins in putting a $100,000 floor on the amount of tether that can be redeemed or withdrawn at source. Other stablecoin issuers like Circle and Paxos allow people to withdraw or deposit any amount.

This floor creates perverse trading patterns on exchanges like Binance and Kraken, which further exacerbate fears about Tether.

In short, Tether's $100,000 minimum pushes the majority of USDT users who want to sell en-masse on exchanges. In theory, well-heeled arbitrageurs are supposed to buy these users' unwanted tokens on these exchanges and redeem them at Tether, thus anchoring Tether's price close to $1.

But it is precisely during broad crypto panics that this arbitrage mechanism breaks down: arbitrageurs back off out of fear of losing their capital, exchanges halt withdrawals as activity overwhelms them, and blockchains get congested. And so panicked on-exchange sales of tether overwhelm the mechanisms that are supposed to anchor tether, and its price falls below the lower end of its $0.999 band.

Far below. In May, Tether fell to 92 cents on Kraken. In October, it fell to under 93 cents. These depegging events engender more fear, leading to more sales of tether, leading to larger declines in price and more panic.

If Tether removed its $100,000 minimum and allowed everyone to redeem at source, then tether users wouldn't have to flock en masse to exchanges in order to offload their tether. They could simply send their 100 tether directly to the company and get $100.

This would relieve price pressure on exchanges and bring an end to Tether's crazy on-exchange price movements.

4) Tether needs to be more transparent.

Lack of transparency is an old criticism of Tether, but it deserves to be re-enunciated. Tether falls short of the current standard for stablecoin transparency. This lack of transparency helps create a trust gap that leads to Tether selloffs during market panics.

The stablecoin industry's current transparency standard has been established by the New York Department of FInancial services (NYDFS). Auditors attest to the state of the stablecoin's investments on a monthly basis, these reports being published on the issuers' websites. In addition to an end of month test of an issuers’ investments, the NYDFS requires stablecoins operating under its framework to be tested on one random day during the course of the month.

That's 24 tests per year. Alas, Tether reports on a quarterly basis. So its auditor is only testing the company’s investments four times per year. That's not good enough.

The NYDFS also requires stablecoin issuers to have an auditor examine its internal controls once a year. Internal controls are the rules and procedures that companies adopt to prevent mistakes and fraud such as separation of duties, verification of invoices and controlled access to financial reporting systems.

Tether's auditor has not examined the company's internal controls.

By bringing its disclosure practices up to industry standard, Tether will grow trust and users will be less likely to dump Tether tokens come the next crypto panic.

To sum up, tether has become that stablecoin that everyone sells when panic hits. But this doesn’t have to be the case. By selling its risky assets and only holding safe t-bills, removing its 0.1% redemption fee, allowing all users to redeem at source and improving transparency, tether can transition into a much more stable stablecoin.