Thursday, April 11, 2024

Why I'm in favor of financial illiteracy

 
I'm not a fan of mandatory investor education classes. The issue was brought up recently by former chair of FDIC, Sheila Bair, who sees early financial education as ways to stop future FTX-style disasters.

The model of finance I've been using for many years is the fairly dismal dark forest model. The financial industry is a shadowy forest full of sly foxes waiting to prey on retail investors. The list of sly foxes is long: all sorts of Samuel Bankman-Frieds, IRS scammers, internet ponzi schemers, stock con-artists, bankers hocking high-fee products, fly-by-night gold mine promoters, and shady crypto platforms. It's truly horrifying out there.

So why not implement mandatory high school financial literacy classes to upgrade the retail class's defences against this dark forest?

My first concern is that high school students can only absorb so much. Mandatory financial literacy classes will inevitably come at the expense of learning other very important things like math, writing, and science, which are at the base of so many vital disciplines.

Second, while I'm sure financial literacy classes might help a bit to protect us against the dark forest, I don't think they'll do much. The prototypical retail investor's single biggest weakness is that we are all incredibly busy people. As we rush through the dark forest we simply don't have enough time to familiarize ourselves with its many arcana. This incapacity to pay sufficient attention makes us easy pickings, no matter whether we've had a few financial literacy classes or not.  

The dark forest preys not only on our rushed lives, but also our need to keep up with the Joneses, our precarious and stressful financial situations, and our worries for loved ones. I'm just not convinced that a few years of high-school financial literacy classes will release us from these eternal and very-exploitable emotions.

Luckily, we have two other major defences against the dark forest: the competitive market and the government.

The government can make the dark forest safer by flushing out bad actors and pushing fraudsters to the nether regions, then nudging us retail investors towards the parts made safe. It does so by regulation, standard investor protections, licensing requirements, and through law enforcement and the court system.

As for the market, its competitive nature gives rise to a class of trained and experienced financial professionals who are generally equipped to lead retail investors through the dark forest.

If we get these two defences right, then we can afford ourselves a great luxury: a retail investor class that gets to remain relatively ignorant of finance while being safe in its ignorance. This ignorance is a thing of beauty. Instead of folks having to waste time and energy learning about the forest's fox population, its patois, and its dangerous pathways, they can focus on their own very busy lives, families, studies, hobbies, and careers. That's what we want them to do. We don't want a world where the average person needs to give up an hour or two each week slogging through financial literacy 101. We want them to blithely use financial products and take for granted they will be safe, and then get on with more important things.

Alas, if we get these two defences wrong, then we get disasters like Sam Bankman-Fried's FTX, which destroyed the financial lives of thousands of innocent retail investors. 

What happened with FTX? In the case of FTX's offshore exchange, there was a complete absence of government regulation. Not so FTX's US arm. Alas, FTX-US operated under a bare-bones regulatory framework courtesy of state licensing boards, which are simply not appropriate for overseeing a trading venue like FTX, and are more equipped for watching over remittance companies like Western Union. (See my article Let's stop regulating crypto exchanges like Western Union.) This was the dark forest at its darkest.

To see how see this first line of defence can be properly deployed, take a look at what happened in Japan when FTX collapsed. FTX's Japanese customers were made 100% whole a few months after the debacle. (American ones are still waiting). That's because Japan got things right and forced FTX Japan to adopt appropriate regulation, effectively preventing the sly fox Bankman-Fried from preying on Japanese citizens. (See my article Six reasons why FTX Japan survived while the rest of FTX burned.) 

The second defence against predators like Sam Bankman-Fried, a market-supplied legion of trained and experience financial professionals, was lacking, too, since stuff like dogecoin and dogwifhat is outside the ambit of the financial professional class, and deservedly so. Had seasoned institutional investors and other financial professionals been operating in the sector, they would have used their training to suss out the FTX fraud much earlier, guiding folks away to safer exchanges.

The two defences entirely lacking, the result was a wave of innocent retail investors left free to venture into into the dark forest. But mandatory financial literacy classes don't fix this. Government regulation and elite financial professionals do. 

Friday, March 29, 2024

The effects of Russian sanctions as portrayed in YouTube videos

Last month American provocateur Tucker Carlson visited a Russian grocery store. Because it was filled to the brim with food, Carlson claims that western sanctions placed on Russia aren't having an effect. "We've been told sanctions on Russia have had a devastating effect on its economy," writes Carlson. "We visited a grocery store in Moscow and found a very different situation."

Carlson's video is just one of many in a strange genre of "sanctions aren't working" videos produced by Westerners visiting or living in Russia. (Here is a good rebuttal to Carlson's video by Russian YouTuber NFKRZ.) In another video, Dutch-Canadian farmer Arend Feenstra, who has recently moved to Russia with his wife and nine children, walks through a hardware store full of tools. "Sanctions???" he quips.

Don't let the videos fool you. Sanctions have had a big effect on Russia. And by sanctions I'm referring not only to the official sanctions levied by coalition governments, but also self-sanctions imposed by Western companies. Self-sanctioning occurs when companies like Lego, Coke, or McDonald's choose to leave Russia, not because their government says they must, but because their customers and employees have pressured them to leave, or out of a general sense of solidarity with Ukraine. (Here is a list of companies that have left.)

While Carlson and Feenstra's videos of store shelves suggest prosperity, what they don't show is how many resources Russian businesses have been forced to sacrifice in order to re-order their affairs so as to provide Russians with full shelves. These businesses have had to go out and build new relationships with manufacturers in places like China or Turkey. The alternative products that have been introduced often aren't as good, or as familiar, or as useful to customers. 

Many of the "sanctions don't work" videos spotlight the contraband Western goods that are often found on Russian store shelves. This video, for instance, shows Coke being sold at Spar, a grocery store. Coke is banned in Russia, so the message here is presumably that the sanctions are a waste of time. But what they don't show is that the prices for these contraband goods will be higher than before. The Coke products in the video are no longer made in Russia but must be smuggled in via third-parties such as Poland, Afghanistan, and Kazakhstan, the extra shipping and handling costs being incorporated into their final price. Think of this as a sanctions-induced smuggling tax.

Put differently, coping with sanctions and self-sanctions is costly for Russia; in Carlson's videos we only see the final product, full shelves, but not all the hassle and resources that have gone into producing that state of affairs. Nor is the set of full shelves on display in his video necessarily as desirable as the set of full shelves that existed prior to sanctions.

A much more realistic illustration of the effect of sanction is provided in a recent video by Arend Feenstra, the Dutch-Canadian farmer, of a visit he makes to a Russian tractor dealership.


I watched it so you don't have to. What follows is a quick summary of the relevant bits. It starts out with an excited Feenstra driving out to is what he believes to be a Case/New Holland dealership. Since the Case and New Holland tractor brands are popular in Canada, Feenstra's previous home, he will get to see some brands that he is familiar with. Ah, nostalgia.

(A side note: As a Dutch-Canadian myself, I find it jarring that someone of my ilk has decided to emigrate to Vladimir Putin's Russia. But digging deeper, we learn that Feenstra is a bigot: he doesn't like the LGTBQ community. Given that Russia's regime considers the "international LGBT movement" to be a terrorist organization, I suppose there's a natural fit for folks like him in Russia.)

Unfortunately for Feenstra, when he arrives at the dealership he discovers that it no longer sells Case or New Holland tractors. Both brands of farm equipment are built by CNH, a UK-headquartered equipment manufacturer, and along with most other Western farm companies CNH pulled out of Russia in 2022, effectively ending all its Russian dealership relationships. 

The only new tractors that the dealership has available are Chinese-built YTOs, which the dealership was forced to turn to in 2022 to fill the sudden gap in its show room.We learn in the video that YTOs are a regression in terms of technology. Feenstra points out throughout that the Chinese tractors have less electronics than their western equivalents and more mechanical parts. Instead of electronic shifting, for instance, the YTOs use mechanical shifting. The fuel pumps are mechanical too. It's like stepping back in time.

A regression to mechanical components is a nuissance, but it's not awful. However, things get worse. Enter the triple mower problem.

A tractor with a triple mower

Prior to the sanctions, we learn that the dealership's most popular tractors were larger horsepower products like the New Holland 210. These larger tractors are particularly desired by farmers in the region for their ability to accept an attachment known as a triple mower, says the employee. A triple mower is designed to cut a wider swath of grass or crops compared to a single mower. This allows farmers to cover more ground in less time, improving overall efficiency during harvesting or haymaking operations.

Alas, the Chinese-made YTOs can't use a triple mower, the employee tells us. The dealer is in talks with the manufacturer to make changes to the frame to accommodate them, but there's no indication when this will occur. Feenstra is not impressed by any of this.

Feenstra checking out a YTO tractor

In the meantime, the dealer tells Feenstra that if he needs a new tractor with triple mower compatibility, he will have to import a Western one via the parallel market. This will involve buying a tractor in Europe and sending it through a third-party transit country, like Turkey, then moving it to Russia. But the whole process will be expensive, warns the employee, including paying VAT three times.

Russian farmers who bought New Holland or Case tractors prior to the sanctions are no better off, we learn, because they now face hurdles getting spare parts for their tractors. Prior to the self-sanctions they could rely on the Case/New Holland dealership for a steady supply of Case and New Holland parts, but with the dealer having lost its relationship with CNH, the only way to get parts is by smuggling them in. Alas, smuggling adds uncertainty and a higher price tag.

Another conversation between Feenstra and the employee centres around a piece of machinery known as a baler, which can be attached to the back of a tractor in order to convert a row of hay into a convenient bale. According to the employee there are a number of Russian companies that make balers, but they are "not very good". The video reveals that one Western-made baler brand is available for purchase, a German-made Kuhn. (Is Kuhn one of those rare European farm companies that has chosen not to self sanction?) But the Kuhn baler it is quite expensive, more than the cost of an entire tractor.

Stepping back, Feenstra's video is great illustration of the costs imposed on Russia by sanctions and self-sanctions. The dealership is struggling to fill the void left by departing Western brands. Its customers, Russian farmers, are stuck with the option of an inferior replacement for Western-made tractors, like the YTO, or a more expensive smuggled products. The dealership and its customers seem to be getting by, but they are clearly worse off than before.

Feenstra isn't the only western farmer in Russia to be producing "sanctions don't work" videos. An Australian family that has moved to Russia in order to start a farm also makes YouTube videos on the topic. "So, the sanctions really haven't been bad for Russia," says the family patriarch, John, standing in a Russian mall. "If they have done anything, they have been great for Russia."

But another video (see below) suggests the opposite. In it the Australians are paying a visit to a nearby John Deere tractor dealership. We learn from an employee that this particular dealership is part of a Russian dealership network that, prior to the sanctions, was the largest John Deere distributor in all of Europe. John Deere is a U.S. equipment manufacturer.


Near the start, John optimistically films a large sign boasting the dealership's many relationships with western manufacturers, including JCB, Pottinger, Väderstad and Haybuster. But as he learns later on, the sign is no longer meaningful. Along with most other farm product companies, John Deere and JCB exited Russia in 2022. The dealership has lost its dealer status and can no longer sell either John Deere or JCB products, nor most of the other brands that are advertised on its sign.

To fill the void, the dealership now offers Turkish-made Basak tractors and Chinese-made Noma tractors. An employee who shows the family around the dealership grouses to John about the quality of the Chinese tractors that he stocks, saying: "I don't know what we will do with it, because if I sit inside of the cabin and look down I can see the ground because there in a gap in the floor." The tractor is the technological equivalent of a first generation John Deere, he complains.

Interestingly, the owner of this particular network of Russian dealers, known as EkoNiva-Technika, is based in Germany and produces public financial statements. I dug through the numbers to get a better feel for how the dealership is doing. 

In 2021, prior to self-sanctions, the EkoNiva-Technika dealership network sold 403 tractors. Then Russia invaded Ukraine, and the dealership's sales fell to 263 tractors in 2022. In 2023 it sold just 131 tractors. That's a big fall.

The German parent blames the decline in tractor sales on a "significant drop in demand" for new agricultural machinery by Russian farmers, as well as the loss of its main suppliers, which were replaced by alternatives from China and Turkey whose "products fell far short of the previous sales figures." Meanwhile, the dealer's spare parts business saw a big jump in revenue thanks to an intensification in demand for Western parts and higher parts prices, no doubt due to having to resort to costly transshipment routes. Spare parts have gone from 24% of the dealership network's revenues prior to sanctions to 49% of revenues in 2023.

Back to John, the Australian farmer. When he does eventually buy a tractor, we find out that it's a used Japanese-made Yanmar tractor. All the controls are written in Japanese and he can't read the manual. Compounding matters, Yanmar has officially left Russia, so John will likely find that getting parts is a pain. Again, that's the nuissance of sanctions. Rather than getting the first-best, the only option is often second- or third-best.

John and his new Japanese tractor

Given all the anecdotes I've assembled, what is the bigger picture?

Prior to being sanctioned, Russia's farming sector had evolved towards a particular pattern of specialization and trade comprised of middlemen dealerships, their relationships with Western manufacturers, and the farmers they served. The sanctions (and self-sanctions) immediately upended that pattern, forcing dealers and farmers to undergo a massive and costly recalculation event.

The new pattern of specialization and trade that the Russian farm sector has arrived at doesn't appear to be as good as the initial pattern. 

To begin with, the alternative brands that have filled the void seem to be a downgrade. The Chinese YTOs that the first dealer is selling won't accept a triple mower while the tractors the second dealer stocks have holes in the floors. Spare parts that were once widely available thanks to dealerships' stable relationships with their western suppliers are harder to come by. Dealership resources are now being diverted to smuggling in contraband parts, which means higher prices for farmers. Finally, as suggested by the dealership's financials, farmers are refurbishing old tractors rather than investing in new tractors. This slowdown in capital investment will presumably hurt crop yields in the long term.

In sum, contrary to Tucker's video and many other "sanctions aren't working" videos on YouTube, the videos made by expatriate Canadian and Australian farmers suggest that the opposite: sanction are having an effect. And it isn't a good one.

Monday, March 18, 2024

How PayPal can use stablecoins to avoid AML requirements and make big profits


There's a new financial loophole in town: stablecoins. Stablecoins are dollar, yen, or pound-based payments platforms that are built using crypto database technology.

Financial institutions are always looking for loopholes to game the system. Typically this has meant avoiding capital requirements or liquidity ratios in one jurisdiction in favor of a looser standards elsewhere. The new stablecoin loophole allows for a different set of financial standards to be avoided, society's anti-money laundering regulations.

I'll explain this new loophole using PayPal as my example.

PayPal now offers its customers two sorts of regulated platforms for making U.S. dollar payments. The first type will be familiar to most of us. It is a traditional PayPal account with a U.S. dollar balance, and includes PayPal's flagship platform as well as PayPal-owned platforms Xoom and Venmo. These all have strict anti-money laundering controls.

The second type is PayPal's newer stablecoin platform, PayPal USD, which has loose anti-money laundering controls. PayPal USD is built on one of the world's most popular crypto databases, Ethereum. Dollars held on crypto databases are typically known as stablecoins, the most well-known of which are Tether and USDC.

What do I mean by fewer anti-money laundering controls?

If I want to transfer you $5,000 on PayPal's traditional platform, PayPal will first have to grant both of us permission to do so. It does so by obliging us go through an account-opening process. PayPal will carry out due diligence on both of us by collecting our IDs and verifying them, then running our information against various regulatory blacklists, like sanctions lists. Only after we have passed a gamut of checks will PayPal allow us to use its platform to make our $5,000 transfer.

Contrast this to how a payment is made via PayPal's new stablecoin platform.

First, we both have to set up an Ethereum wallet. No ID check is required for this. That now allows us to access PayPal's stablecoin platform. Next, I have to fund my wallet with $5,000. I can get these these funds from a third-party who already holds money on PayPal's stablecoin platform, say from a friend, or from someone who buys goods from me, or from a decentralized exchange. Again, no ID is required for this transaction to occur. Once I have the funds, PayPal will process my $5,000 transfer to you.

Can you spot the difference? In the transaction made via PayPal's legacy platform, PayPal has diligently got to know everyone involved. In the second transaction, PayPal makes no effort to gather information on us. And lacking our names, physical addresses, email addresses, or phone numbers, it can't do a full cross-check against various regulatory black lists.  

More concretely, PayPal's legacy platform does its best to stop someone like Vladimir Putin, who is sanctioned, from ever being able to sign up and make payments. But if Putin wanted to use PayPal's new stablecoin platform, PayPal makes almost no effort to stop him from jumping on.

One of the biggest expenses of running a legacy financial platform is anti-money laundering compliance. Programmers must be deployed to set up onboarding and screening processes. Compliance officers must be hired. If a transaction is suspicious, that may trigger a halt, and the transaction will have to be painstakingly investigated by one of these officers. The platform is hurt by lost customer goodwill  no one likes a delay.

That's where the stablecoin loophole begins.

PayPal can reduce its costs of getting to know its customer by nudging customers off its traditional platform and onto its PayPal USD stablecoin platform. Now it can onboard them without asking for ID. Since it no longer collects personal information about its user base, fewer transactions trigger flags for being suspicious, and only rarely do they register hits on sanctions blacklists. That means fewer halts, delays, and costly investigations. PayPal can now fire a large chunk of its compliance staff. The reduction in costs leads to a big rise in earnings. Its share price goes to the moon.

For now, PayPal's stablecoin platform remains quite small. Only $150 million worth of value is held on the platform, as the chart at the top of this post shows. The company's legacy platforms are much larger, with around $40 billion worth of balances held. Given the compliance cost difference, though, I suspect PayPal would love it if its stablecoin platform were to grow at the expense of its legacy platform.

I've used PayPal as my example, but the same calculus works for the financial industry in general. If every single bank in the financial system were to convert over to a stablecoin platform for the delivery of financial services, and no longer use their legacy platforms, the industry's total anti-money laundering compliance costs would plummet.

So far I've just explained this all from the perspective of financial institutions, but what about from the viewpoint of the rest of us? Society has set itself the noble goal of preventing bad actors from using the financial system. A large part of this effort is delegated to financial institutions by requiring them to incur the expense of performing due diligence on their platform users. This requires a big outlay of resources. Many of these costs are ultimately passed on to us, the users.

If institutions like PayPal switch onto infrastructure that doesn't vet users, then resources are no longer being deployed for the purposes we have intended, and the broader goals we have set out are being subverted. Is that what we want? I'd suggest not.



Some followup thoughts:

1. PayPal's stablecoin platform employs fewer anti-money laundering controls than its regular platform. On the other hand, its stablecoin platform has stricter standards in other areas, including the safety of its customer funds. I wrote about this here: "It's the PayPal dollars hosted on crypto databases that are the safer of the two, if not along every dimension, at least in terms of the degree to which customers are protected by: 1) the quality of underlying assets; 2) their seniority (or ranking relative to other creditors); and 3) transparency."

2. The pseudonymity of stablecoins is something I've been writing about for a while. In a 2019 post, I worried that at some point this loophole would lead to "hyper-stablecoinization," a process by which every bank account gets converted into a stablecoin. I'm surprised that almost five years later, this loophole still hasn't been closed.

3. The typical riposte to this post will be: "But JP, stablecoins are implemented on blockchains, and blockchains are transparent. This prevents bad actors from using them, and so stablecoins should be exempt from standard anti-money laundering rules." I don't buy this. Bad actors are using stablecoin platforms, despite their pseudo-traceability. "Its convenient, it's quick," say a pair of sanctions breakers about payments made via Tether, the largest stablecoin platform. Society has deputized financial institutions to perform the crucial task of vetting all their users. By not doing so, stablecoin platforms are shirkers. Trying to outsource the policing task to the public or to the government by using a semi-transparent database technology doesn't cut it.

Wednesday, March 13, 2024

Have the sanctions on Russia failed?

I very much enjoy economist Robin Brooks's tweets, especially his charts showing how sanctions imposed on Russia have affected regional trade patterns. While direct trade between Europe and Russia has collapsed thanks to Russia's invasion of Ukraine and subsequent sanctions, the chart below shows a suspicious-looking countervailing boom in European trade with Kyrgyzstan.

A big chunk of these European goods are presumably being on-shipped from Kyrgyzstan to Russia.

Now, you can look at this chart and arrive at two contradictory conclusions. The first is that the EU's sanctions are not working because they are being avoided via third-party nations like Kyrgyzstan. (This is Steve Hanke's take on Robin's charts.) Or you can see the charts as evidence that the sanctions are working, for the following reasons.

Sure, prohibited goods are filtering through to Russia  that was always going to be the case. But consider all the extra nuisances and frictions that now exist thanks to sanctions. For instance, instead of JCB tractors being shipped directly from factories in Europe to Russia, they have to be transferred to a third-party country, like Armenia, then perhaps re-routed to yet another country for the sake of obfuscation, say UAE, prior to those tractors finally entering Russia. (One of Robin's charts illustrates the rise of the EU-Armenia-UAE-Russia nexus).

These new roundabout trade routes introduce all sorts of additional costs including taxes, customs fees, shipping, insurance, and warehousing, not to mention extra palms to grease. There is also the extra risk of getting caught somewhere along this chain. A dealer involved in moving tractors to Russia via a third-party country, for instance, might be blacklisted by JCB (which has voluntarily chosen to exit Russia), losing their dealer status.

These combined costs get built into the final sticker price that Russian must pay for contraband American and European imports. Think of this extra wedge as a "sanctions tax." This sanctions tax leaves Russians with less in their pocket. And that means fewer resources for Putin to wage war than if the sanctions had never been levied.  

So when I see Robin's charts of various transshipment routes, they suggest to me that sanctions are effective courtesy of the sand-in-the-gears effect I just explained.

Now, this doesn't mean that I think the coalition's existing sanctions program is sufficient. We are in a sanctions war with Putin, and that necessitates constantly opening up new economic fronts in order to throw Putin off guard and make it harder for him fund his war. The transshipment points illustrated in Robin's charts are a sign to me that existing sanctions are working, but they also seem like a great target for future sanctions.

And in fact, the coalition has already taking two steps to pressure transshipment to Russia.

The U.S. Treasury recently imposed secondary sanctions on any foreign financial institution that facilitates transactions involving Russia's military/industrial complex. (I wrote about this here). What this means, for example, is that banks in transshipment points like Kyrgyzstan will have to be more careful when they deal with Russian entities. Any trade involving the military-industrial sector that passes through Kyrgyzstan will likely grind to a halt. Other non-military trade transiting through Kyrgyzstan, say JCB tractors, will probably continue to make it through, but thanks to heightened sanctions risk, banks will pass on this risk to Russians in the form of a higher sanctions tax.

The second step is the EU's new and very provocative "no-Russia clause." It requires EU exporters to contractually prohibit their trading partners from re-exporting certain restricted goods to Russia. If caught, fines must be paid or the contract voided. That adds more sand in the gears.

One hopes that the coalition of nations arrayed against Russia continues to increase its pressure on transshipment points. For instance, the EU could widen the range of goods subject to the no-Russia clause, the current list being somewhat limited. For now, though, my guess is that Robin's charts will show that the coalition's sanctions program is doing a better job in 2024 than it did in 2023, with the EU's no-Russia clause and the U.S.'s secondary sanctions being the proximate cause of that improvement.

Tuesday, March 5, 2024

It's time to get rid of "crypto"

Call me a pedant, but I'm not a fan of the word "crypto". It may have been a serviceable category back in 2011 when there was only one type of crypto thingy  bitcoin. But it's ceased to be a meaningful term and, if anything, it causes a regression in understanding.

Source: Fidelity

Case in point is the above diagram from Fidelity, which suggests that clients should conservatively invest 40% of their wealth in "equity," 59% in "fixed income", and the other 1% in "crypto."

These categories are nonsensical because in many cases, crypto *is* equity. (And in other cases, crypto *is* fixed income.) Fidelity's buckets are not mutually exclusive.

For instance, take MKR tokens, which are inscribed on the Ethereum blockchain and are a top-100 asset listed on CoinGecko. MKR may sound like it deserves to fall in the crypto bucket, but hold on a sec. As a MKR holder, you enjoy a right to the earnings of MakerDAO, which is effectively an offshore bank. You enjoy buybacks, voting control, and a residual claim on assets after creditors in case of windup or bankruptcy. Guess what, folks. That's equity! Yep, buying MKR shares is economically equivalent to buying shares in Bank of America.

Likewise with Dai tokens, the payments instrument aka stablecoin  that MakerDAO issues to customers on the Ethereum blockchain and the 25th largest asset on CoinGecko. Sounds like crypto, no? But along with being pegged to the U.S. dollar, Dai pays interest of 5%. That puts it firmly into the fixed income bucket, very much like an uninsured interest-yielding account at the Bank of America.

What exactly is crypto, then?

The word "crypto" describes a database technology, not an asset class. Various asset classes  equity, bonds, options, and savings accounts (or various combinations of these)  can be recorded and stored on crypto databases, much like how MKR shares are served up on Ethereum, one of the most popular crypto database. These crypto databases fall in the same bucket as an Azure SQL database or an Oracle databases, both of which record assets but neither of which belongs itself to an asset class.

So now you can see why Fidelity counseling its customers to invest 99% in equity + fixed income and 1% in crypto is absurd. It's a category mistake, like if Fidelity advised folks to hold 99% in equity + fixed income and 1% in assets stored on Oracle databases.  

Telling customers to invest 1% of their wealth in generic assets stored in Oracle databases isn't just a category mistake; it's downright reckless. All sorts of wild financial stuff appears on Oracle databases, including sports bets and zero day options. Conservative investors have no business touching these. As for crypto databases, they are particularly notorious for holding financial fluff like ponzis and digital chain letters (i.e. litecoin, dogecoin, floki inu and their various ancestors and cousins); none of which Fidelity should be hocking to serious customers.

Crypto doesn't refer to an asset class, it describes the database technology on which assets appear. Better yet, let's just get rid of the word altogether. It's beyond repair.

Thursday, February 29, 2024

Why my favorite coinage is Byzantine coinage

What do I like about Byzantine coinage?

Most people probably admire the Byzantine solidus, a gold coin that maintained its weight and purity for over 600 years, which is quite remarkable for a coin. The solidus was exported all over the world, including to Europe, which lacked gold coinage at the time, making it the U.S. dollar of its day.

That's neat, but it's not the solidus that impresses me. It's Byzantium's small change that I like.

The availability of small change is vital to day-to-day commercial life. Alas, the minting of low-value coins has often been neglected by the state. Small change isn't sexy. And it has often been unprofitable to produce. But that didn't stop the Byzantines. After a monetary reform carried out by Emperor Anastatius in 498 AD, Byzantium began to issue a number of well-marked and differently-sized bronze coins of low value. Anastatius, who had been an administrator in the department of finance prior to becoming an Emperor, appears to have had a fine eye for monetary details.

Let's start with the follis, worth 40 nummi. (The nummus was the Byzantine unit of account.)


The follis in the above video was minted in 540 AD by Justinian I, some forty years after Anastatius's monetary reform. At 23 grams, it contains an almost comically-large amount of material. For comparison's sake, that's the same heft as four modern quarters. Allocating so much base metal to a single coin illustrates the Byzantine's dogged commitment to producing a usable set of low denomination coins for the population.

The decision to go with the hulking follis was better than the small change strategy that the English would pursue hundreds of years later. English monarchs either neglected small change altogether, forcing the public to hack up silver pennies into smaller chunks by hand. Or, if they did produce low value coins, did so in the form of silver halfpennies and farthings, the smallest English denominations. Which was not a good idea. Silver has a much higher value-to-weight ratio than bronze, so the half-penny and farthing ended up being absurdly tiny, as illustrated in the video below from the Suffolk Detectorist.  



"Weighing only three troy grains each, these were 'lost almost as fast as they were coined,'" writes monetary economist George Selgin of the farthing. And because the two coins were so small, almost no information could be conveyed on their face. No, as far as small change goes, the Byzantine's bronze coins were the way to go.

Anastatius had another theoretical option available to him, one which wouldn't have tied up so much raw material. He could have made a token coin. With a token coin (say like James II's tin halfpennies, which came almost a thousand years later, and which I wrote about here), the value of the coin doesn't rely on the metal in it, but on the ability of the issuer to repurchase it at the stipulated weight. By issuing the follis as a token, the Byzantines could have been able to make it smaller, say half the size, yet still rate it at 40 nummi, thus saving large amounts of bronze for alternative uses.

But the Byzantines appear to have been committed metallists, abiding by the principle that the value of money comes from the value of the metal in it. And so they bequeathed the world the monster-sized follis.

In additions to the follis, Anastatius introduced lower denomination bronze coins, including the half-follis (20 nummi), quarter-follis (10 nummi), and pentanummium (five nummi). They are illustrated below. Later emperors would add a three-quarter follis, or 30 nummi coin, to the mix. At times, a tiny 1 nummus coin was issued too.

Follis (40 nummi), half-follis (20 nummi), quarter-follis (10 nummi), and pentanummium (five nummi). Source: Cointalk

The decision to produce a full array of base coins illustrates Anastatius's sensibility to the transactional needs of the common person, for whom the gold solidus would have been far too valuable to be relevant to their economic lives, almost like a $1,000 bill. Oddly, Anastatius chose not to mint any silver coins. But as the English farthing example illustrates, silver was too valuable to be useful for the lower end of day-to-day commercial life, better destined to act like a modern $50 bill than a humble $1 or $5 bill.

Another neat feature of Byzantine coinage is how Anastatius and his successors used each coin's surface area to convey useful information rather than to aggrandize god & state. The obverse of each coin bore the obligatory image of the Emperor, but the reverse side provides loads of monetary data: the denomination, the date of the Emperor's reign in which the coin was minted, the name of the mint, the number of the workshop of the mint. Compare this to Roman coinage, for instance, which often bore expressive portraits on either side of the coin, but next to no data.

If you're interested in getting a longer description of how to read Byzantine coins, check out Augustus Coins.  

A particularly unique feature of Anastatius's monetary reform was his decision to inscribe the unit of account directly onto his coins. As you can see, the follis has a big "M" on its reverse side, which is Greek for 40. The half follis has a "K", which means 20, and the quarter follis an "I", which is 10. Finally, the pentanummium displays an "Є", equal to 5. All of these numbers indicate the value of the coin in terms of the Byzantine unit of account, the nummus.

Nowadays, we take this format for granted. The coins in your pocket all include the coin's value on their face, just like Anastatius's coins did. But what you need to realize is that the coinage of most civilizations, both before and after the Byzantines, rarely displayed how many pounds or shekels or dinars that coin was worth. Take a look at Rome's Imperial era coinage. There's plenty of religious symbolism to be found on the sestertius, as, and dupondius. The monarch's face appears, as do dates and names. But there's not a single digit to indicate how many units of account the coin is worth. The same goes for most medieval European coinage. (A lone exception is Roman coinage from the Republican period beginning around 211 BC).

Anastatius's decision to stamp the denomination directly on the coin represents a big improvement in usability. No need for transactors to seek an external source to determine how many nummi a follis was worth. It was right there for everyone to see.

Some of you may be wondering: why did so many civilizations avoid numbering their coins? 

Ernst Weber, an economist, has put forward one possibility. A lack of "value marks" may suggest that coins were intended to circulate at "market determined exchange rates" according to their metal content. Coins might have had varying amounts of metal due to inadequate manufacturing technology, people preferring to weigh them prior to payment so as to assess their market value. In this context of non-fungibility, striking a universal unit of account on each coin would be a nuissance, or at least a waste of time.

According to Weber's theory, Anastatius may have had so much confidence in the ability of his mints to produce durable and homogeneous bronze coins that he dared to affix the nummi unit-of-account onto them.

Another reason for not numbering coins may be that a blank slate gave authorities a degree of flexibility to set monetary policy. If a coin isn't indelibly etched with a value, a monarch can alter a coin's purchasing power, or rating, by mere proclamation. This was known as a crying up or a crying down of a coin's value. For instance, an English king might wake up one day and declare a certain type of already-circulating coin that had been worth £0.10 the day before to be worth £0.09 today, thus decreasing its purchasing power. This sort of abrupt change in value would be awkward to implement if said coin already had £0.10 struck on its face.

A ruler might have good monetary policy reasons for wanting this flexibility. But this same malleability could be abused, too, in order to profit some at the expense of others. Anastatius decided to forfeit this flexibility by freezing his coin's value in time. The Byzantine public no longer had to deal with the uncertainty of coins being suddenly revalued.

Unfortunately, the full array of Byzantium small change introduced by Anastatius would only survive for two or three centuries. As time passed, weights would be reduced and workmanship would become "increasingly slovenly," according to numismatist Philip Grierson. The quarter follis and pentanummia would be discontinued by Constantine V (741–775). The half-follis ceased under Leo IV (775–780).

As for the follis, it would stick around for a few more centuries, but around 850 AD, Theophilus would drop the emblematic M in favor of the unhelpful inscription "Emperor Theofilos, may you conquer," writes Grierson. Thus ended the great period of Byzantine low-value coinage. But during the brief period of time after Anastatius, Byzantine produced one of the best examples we have of good small change, presaging the coins we carry in our pockets today.

Thursday, February 22, 2024

The first round of U.S. secondary sanctions on Russia is working

Turkish banks halted transactions with Russian banks last month and are only slowly reintroducing payments for a narrow range of products that are on a so-called "green list," reports Ragip Soylu. This broad debanking of Russia by Turkey is part of the fallout from President Biden's first round of secondary sanctions, announced on December 22. 

Ukraine/sanctions watchers around the world are breathing a sigh of relief. At last the cavalry has arrived! While the Russian sanctions program has often been described by the press as the "world's strictest", in actuality it has been (till now) alarmingly light-touched due to its lack of the toughest tool of financial warfare: secondary sanctions.

Primary sanctions vs secondary sanctions

Secondary sanctions, especially when applied to foreign banks, are far more damaging than primary sanctions, which to date have been the dominant type of sanction levied against Russia. 

With primary sanctions, it is the "primary" layer  U.S. citizens and companies  that are cut off from dealing with the designated Russian target(s). However, primary sanction don't prevent non-U.S. individuals or non-U.S. companies, say a Turkish bank, from filling the void left by departing American counterparts, often acting as a re-router of the very U.S. goods that can no longer be moved directly to Russia by U.S. firms. So rather than reducing the amount of Russian trade, primary sanction often lead to little more than a displacement of trade from one route to another. That's a nuissance for the targeted country, but hardly a game changer.

Secondary sanctions are an effort to combat this displacement effect. They do so by extending the trade prohibitions placed on the primary layer, U.S. actors, to the second layer, that is, to non-U.S. actors. In the case of Biden's December order, foreign banks can no longer facilitate certain Russian transactions that have already been off bounds to Americans for several years.

So far, Biden's secondary sanctions appear to be working. In addition to halting all transactions with Russia for a month, Turkish banks have completely stopped opening accounts for Russian customers. According to Reuters, Turkish exports to Russia fell 39% year-on-year in January. In China, reports say that banks have "heightened scrutiny" of Russian transactions, in some cases going so far as to cut off Russian banks. UAE banks have also begun to restrict linkages to Russia.

Why comply with the U.S.?

Why do non-U.S. actors bother complying with U.S. secondary sanctions? After all, if you're a Turkish banker in Istanbul, Biden has no jurisdiction over you. America can't put you in jail, or fine you.

The way that the U.S. is able to sink a hook into non-U.S. actors is by threatening to take away access to the U.S. economy. Foreign banks, for instance, are told they will be exiled from the all-important U.S. banking system if they don't severe or constrict their Russian relationships. Since access to the Ne York correspondent banking system is so important relative to the small amounts of sanctioned Russian business they must give up, foreign banks are quick to fall into line.

Biden's secondary sanctions on foreign banks only apply to a narrow range of transaction types, specifically those that support Russia's military-industrial base. In short, any foreign bank that is found to be conducting transactions involving military goods destined for Russia can be penalized. Those foreign banks that deal in, say, Russian food imports needn't worry.

In addition to obviously prohibited military items, like missiles and fighter jets, the U.S. Treasury has provided a list of not-so obvious items, such as oscilloscopes and silicons wafers, that it deems fall under the category of military-industrial goods. I've appended this list below. The Treasury suggests that these additional items might be used for, among other things, the production of advanced precision-guided weapons.

Source: OFAC

That's quite an extensive list.

Turkish banks appear to have overcomplied by dropping any transaction that even has a whiff of Russia. This de-risking effect is a common by-product of various banking controls, both sanctions and anti-money laundering, whereby banks cease dealing not only with prohibited customers but certain legitimate customers that are superficially similar to prohibited customers that they are deemed too risky and expensive to touch.

According to reports, Turkish banks have reintroduced transactions for green-listed products such as agricultural products, which aren't actually targeted by the U.S. secondary sanctions.

Turkish financial institutions may be particularly sensitive to U.S. sanctions given the fact that an executive of Halkbank, a Turkish government-owned bank, was sentenced to 32-months in U.S. jail in 2018 for helping Iran evade U.S. sanctions and money laundering. One of his evasion routes was the notorious gold-for-gas trade, which I wrote about here. Halkbank itself was indicted in 2019 for sanctions evasion; the case against it is ongoing.

An unforgiving legal standard

An important element of any alleged crime is the mental state of the alleged criminal, or their "intent." This gets us to another reason for the rapidity and breadth of the debanking of Russian trade. Biden's secondary sanctions have a novel legal feature. The legal standard on which they rely, strict liability, does not require that the prosecution prove intent.

Up till now, U.S. secondary sanctions have not deployed this sort of a strict liability standard. To demonstrate that a foreign bank has engaged in evading secondary sanctions on Iran, for instance, U.S. prosecutors have been required to show that the foreign bank did so knowingly. If the banker conducted prohibited Iranian transactions unknowingly (i.e. inadvertently or unintentionally), then they couldn't be found guilty of sanctions evasion.

Under the strict liability standard set out in Biden's December 22 order, there is no onus on U.S. sanctions authority to show that a foreign bank has knowingly conducted transactions linked to Russia's military-industrial complex. Even an unintentional transaction can be punished. Because this strict liability standard makes it so much more likely that foreign banks run afoul of sanctions and get cut off from the U.S. banking system, bankers are rushing to comply.

What's next?

When the U.S government asked domestic entities to stop dealing with Russia a few years ago, many of these transactions were quickly displaced to third-parties like Turkey. By deputizing foreign banks to be equally vigilant, secondary sanctions will likely crimp the original displacement effect, resulting in a big and permanent decline in Russian trade.

To get an idea for what might happen to Russia's military-industrial goods trade, take a look at how Iran's oil exports were halved after Obama imposed secondary sanctions on Iran in 2012, leapt when they were lifted in 2016, and crumbled again when Trump reimposed them in 2018.


The lesson is that secondary sanctions on foreign financial institutions can be very effective.

Evasion efforts will begin very quickly. When secondary sanctions were first placed on Iran in 2012, Turkish bank Halkbank introduced a forged document scheme in an effort to disguise trade in sanctioned crude oil shipments as legitimate food transactions. The U.S. will have to step up its enforcement efforts to plug these holes. Without proper enforcement, the effect of the secondary sanctions will remain muted.

Using the secondary sanctions on Russia's military-industrial complex as a model, there are many more sectors of the Russian economy on which secondary sanctions might be placed. The next round could extend to Russian automobile imports, its central bank, or the diamond industry.

Secondary sanctions to strengthen the oil price cap 

Even more useful would be to use secondary sanctions to strengthen the most important piece of financial artillery heretofore deployed against Russia: the $60 oil price cap

The price cap endeavors to force Russia to accept a below-market price for the oil that it ships, thus hurting its ability to finance its invasion of Ukraine. The cap is currently underpinned at the primary level by threatening banks, insurers, shippers and other businesses located in the EU, U.S., and other G7 countries ("the Coalition") with penalties if they trade in Russian oil above $60. Because Russia has historically been dependent on Coalition service provides for shipping oil, it has been getting less revenue for its oil then it would otherwise receive. 

However, over time a growing chunk of Russia's oil exports has been diverted away from Coalition service providers to third-parties in jurisdictions like Turkey and UAE that are not subject to the cap. This has allowed Russia to sell at prices in excess of $60 and thus recover much of its forgone revenues. If the cap were to be applied not only at the primary Coalition layer, but also at the secondary layer by requiring foreign financial institutions to join in via the threat of secondary sanctions, then much more Russia oil would brought back under the $60 ceiling, and Russia's ability to finance its war against Ukraine would be significantly crimped.

Wednesday, January 31, 2024

What does the recent ruling on the Emergencies Act mean for your banking rights?


A Federal judge ruled last week that the emergency banking measures taken to end the Ottawa convoy protest in 2022 contravened the protestor's rights. In this post I want to provide my reading of this particular ruling and what is at stake for Canadians and their bank accounts. 

To be clear, Justice Mosley's ruling touched on far more than the banking measures, and extended to the broader legality of the government's invocation of the Emergencies Act on February 14, 2022, subsequently revoked on February 23. However, since this is a blog on money, I'm going to limit my focus to the banking bits of the court ruling.

(By the way, I've written about emergency banking measures a few times before.)

To remind you, there were two emergency banking measures enacted in February 2022 that affected regular Canadians. The most well-known measure was the freezing of bank accounts. The RCMP collected the names of protestors, and forwarded these to banks and credit unions, which used this information to locate protestors' accounts and immobilize their funds. In the end, 280 bank accounts were frozen.

The second and less well-known banking measure was the requirement that banks share protestors' personal banking information with the RCMP and the Canadian Security Intelligence Service (CSIS), including how much money the protestor had in their account and what sorts of transactions they made.

Justice Mosley has ruled that these banking measures  both the freezing and the sharing  violated the Canadian Charter of Rights and Freedoms. Specifically, they contravened Section 8 of the Charter, which specifies that everyone has the "right to be secure against unreasonable search or seizure."

The best way to think about Section 8 is that all Canadians have privacy rights. These rights cannot be trodden on by the government. The police can't conduct unjustified personal searches of your body or home, say by snooping on your credit card transactions. Nor can they seize your bank statements or your computer in order to gather potentially incriminating information on you.

This doesn't mean that a Canadian can never be subject to searches and seizures. Section 8 doesn't apply when the person who is subject to a search or seizure has no privacy rights to be violated. So for example, if I leave my old bank statements in the trash on the curb, it's likely that I've forfeited my privacy rights to them, and the police can seize and search them without violating Section 8 of the Charter.

An interesting side point here is that Canadians don't forfeit their privacy rights by giving up their personal information to third-parties, like banks. We have a reasonable expectation of privacy with respect to the information we give to our bank, and thus our bank account information is afforded a degree of protection under Section 8 of the Charter.

My American readers may find this latter feature odd, given that U.S. law stipulates the opposite, that Americans have no reasonable expectation of privacy in the information they provide to third parties, including banks, and thus one's personal bank account information isn't extended the U.S. Constitution's search and seizure protections. This is known as the third-party doctrine, and it doesn't extend north of the border.

Canadians can also be lawfully subject to searches and seizure by the police if these actions are reasonable, as stipulated in Section 8 of the Charter. There are a number of criteria for establishing reasonableness, including that a search or seizure needs to be authorized by law, say by a judge granting a warrant. In addition, the law authorizing the warrant has to be a good one. (Here is a simple explainer.)

Before we dive into why Justice Mosley ruled that the government's bank account freezes and information sharing scheme violated Canadians' rights, we need to understand the government's side of argument.

On the eve of invoking the emergency measures, Prime Minister Justin Trudeau promised that the government was "not suspending fundamental rights or overriding the Charter of Rights and Freedoms." He reiterated this a week later after the Emergencies Act had been revoked:


But what about the legal specifics of the banking measures? Were they compliant with the Charter, and how? Government lawyers argued from the outset that the requirement for banks to share personal banking information with the RCMP and CSIS did not violate Section 8 of the Charter. While the sharing order constituted a search under Section 8, it was a reasonable search, they said, and reasonable search is legitimate.

As for the freezes, and here things get more complicated, the government maintained that they did not constitute seizures at all, and thus weren't protected under Section 8. The government begins with a literal argument. The funds in the 280 frozen bank accounts were not taken or seized; rather, banks were simply asked to "cease dealing" with some of their customers in such a way that these customers never lost ownership of their funds. This was a mere freeze, the government claims, rather than a harsher sort of government "taking" of funds , say like a Mareva injunction, warrant of seizure, or restraint order, all of which are seizures under Section 8 of the Charter.

As back up, the government offered a more technical argument. According to Canadian legal precedent, it is only certain types of government searches and seizures that trigger Section 8 protections. These are laid out in a case called Laroche v Quebec (Attorney General). Specifically, only those seizures occurring in the process of an investigation and prosecution of a criminal offence are protected. The government maintains that the freezes it placed in February 2022 were not related to a criminal offence  they were merely designed to "discourage" participation in the protest  and so they were not the sorts of seizures protected by the Charter. (The government's full argument that it laid out for Justice Mosley here.)

The invocation of the Emergencies Act required the independent inquiry be launched, the results of which were released in February 2023. The commissioner of that inquiry, Justice Rouleau, ended up siding with the government's assessment of the legality of the bank account freezes. The freezing of accounts was "not an infringement" of section 8 of the Charter, wrote Rouleau, because they were not a seizure.

Here I'm going to briefly inject my own personal thoughts as a citizen blogger.

Look, I think it's a good thing that the government has various financial buttons at its disposal that it can press to lock or restrict my funds, like restraint orders. But I also think its a good thing that these buttons are subject to certain controls, one of which is that they must respect my basic rights, even in an emergency situation. I find it somewhat worrying that in this particular case the government seems to be arguing that it has at its disposal a new type of "immobilize funds" button that is completely exempt from charter oversight due to the fact that it, somewhat arbitrarily, escapes definition as a seizure. This seems like a distinction without a difference to me.
 
Disagreeing with both Justice Rouleau and the government's logic, Justice Mosley in his judicial review ends up siding with the counter-arguments deployed by two civil liberties organizations that opposed the government in the case. (Their respective arguments are laid out here and here).

First, regarding the sharing of information with the RCMP and CSIS, Mosley rules this constituted a search covered by Section 8. Contra the government, these searches were not reasonable, and thus they violated the protestors' Charter rights.

While the government had argued that the searches were reasonable due to their limited duration and targeted focus, the judge finds that they lacked an "objective standard." Banks only needed a "reason to believe" that they had the property of a protestor before reporting the information to the RCMP or CSIS, but according to Mosley this criteria was too wide and ad hoc to qualify as reasonable. Would a hunch or a rumour qualify as a "reason to believe"? Perhaps.

The searches were also unreasonable, according to Justice Mosley, because they had none of the other well-defined standards for reasonable search, including a lack of prior authorization for each search by a neutral third party like a judge. In February 2022 it was bankers, not judges, that carried out the searches, assembly line-like.   

As for the freezes, Justice Mosley disagrees with the government's arguments, finding that the freezing of bank accounts did indeed constitute a seizure of the sort protected by Section 8. Adopting the viewpoint of a regular Canadian, he first argues that a "bank account being unavailable to the owner of the said account would be understood by most members of the public to be a 'seizure'."

Mosley proposes an alternative opinion that it was the forced disclosure of the financial information by banks to the RCMP and CSIS that constituted a seizure. In this reading, what was being seized was personal payments and ownership data. The protestors had a "strong expectation of privacy" in these financial records, and thus Section 8 is applicable.

So to sum up, a Federal court has deemed that the bank accounts freezes placed on protestors in February 2022 were indeed seizures, and not some other strange sort of freeze-not-a-seizure, and therefore they were subject to the Charter. As for the searches, they were unreasonable (as were the seizures). The government will be appealing to the Federal Court of Appeal, so these arguments will be re-litigated. Stay tuned.

My take is that Justice Mosley's rulings are reasonable and helpful guidelines for future governments seeking to levy banking measures in subsequent emergencies. The ruling doesn't expressly ban the levying of bank freezes, and that's probably a good thing. Let's not forget that the requirement for banks to cease dealings with protestors, albeit illegal in this particular case as per Justice Mosley, was a fairly effective measure. The threat of having their money immobilized helped get the protestors to leave, right? And not a single person was injured. Think of bank account freezes as the domestic version of foreign sanctions, a way to bloodlessly defuse an emergency situation and avoid sending in the more deadly cavalry. This seems like a good tool, no?

The catch, as Mosley suggests, is that the government needs to tighten up the the process of freezing bank accounts come next emergency so that they are constitutional. How tight? One might argue that the standard for freezes shouldn't be as high as a regular restraint order on funds during a non-emergency. On the other hand, freezes shouldn't become some sort of dark tool for circumventing the Charter.

Wednesday, January 24, 2024

Do bitcoin ETFs conflict with bitcoin's original ethos?


Some folks are suggesting that a bitcoin ETF is absurd because it doesn't fit with Bitcoin's original ethos. On the contrary, I think it's a nice snug fit.

It would be a misunderstanding of bitcoin's history to assume that it was the idealism of cypherpunk-ism that gave birth to the Bitcoin movement. Bitcoin would never have got off the ground without a massive amount of old fashioned greed. In bitcoin-speak, this greed usually goes by the term number-go-up, and it was crucial from the start. The new bitcoin ETFs are certainly not cypherpunk, but they are very much in the founding spirit of number-go-up.

One of the main goals of the 1990s cypherpunks, if you recall, was to create anonymous digital cash. And while bitcoin certainly has some roots in cypherpunk ideals, the ethos of number-go-up clashes with the dream of digital cash: after all, an asset with a volatile price makes for an awful medium of exchange. Before long, number-go-up had drowned out the cypherpunks.

I recall walking into Montreal's Bitcoin Embassy in 2014, which was located on the busy intersection of St-Laurent and Prince-Arthur. I had already been researching and writing about bitcoin for a few years, but decided to play it dumb to see how the folks at the Embassy would approach the task of teaching a newbie about bitcoin. Instead of preaching to me about how to make a bitcoin payment from my own self-custody wallet, the ambassador walked me over to a large screen showing bitcoin's price. "Look, it's rising," he said in awe.

That, in short, sums up bitcoinism. Like 1980s televangelism with its gold-plated cowboy boots, mansions, private jets, and a dose of God on the side, bitcoin is all about the price chart with a small helping of cypherpunk ideology.

Number-go-up has always required getting ever more people into the game. Bitcoin, after all, is itself sterile. Unlike a publicly-traded business, it doesn't generate a stream of improving profits, so the only way for its price to keep rising is to recruit more players, much like a pyramid or a chain letter. From the early days, getting access to traditional financial and banking infrastructure has been crucial to making this recruitment process go as smoothly as possible.

Docking bitcoin to the existing financial edifice began in 2010 with the first bitcoin exchanges, which hooked into the crucial global bank wire systems like SWIFT, as well as local wire systems like the Federal Reserve's Fedwire system and Europe's SEPA system. These integrations were key to pumping the initial rounds of money into the game, and pushing the number above $1, and then $10, $100, and $1000.

Later on, bridges to the Visa/MasterCard debit card and credit card networks brought an even tighter fusion between bitcoin and the regular world, more inflows, and more number-go-up. The addition of bitcoin purchases to mobile payment apps like PayPal and Cash App came after. Viewed in this context, ETFs are nothing new, really; they only represent the next coupling between the two worlds.

As for regular old finance, it isn't complaining. The task of players like Visa is to generate profits  they want nothing more than to add new products like bitcoin to the list of products they already connect. The curious result is that no chain-letter style product has ever gone as mainstream as bitcoin has.

Now that bitcoin ETFs exist, number-go-up demands even more linkages to traditional finance and banking. What's next? One possibility: expect the bitcoin community to lobby for federally-chartered banks to be allowed to offer bitcoin products alongside savings deposits and retirement accounts. Banks offering bitcoin to their retail client base may seem inconsistent with bitcoin's more cypherpunk-y dreams of replacing the banking system, but on the contrary: its hard to imagine a more fantastic recruitment tool for number-go-up.

Monday, January 8, 2024

It's time to impose Iran-calibre sanctions on Russia

Russia is sometimes described as the world's most sanctioned nation. And while that's true, the long list of sanctions that the G7 coalition has placed on Russia in response to its attack on Ukraine are surprisingly light compared to the fewer but far more-draconian sanctions placed on Iran over the last decade or so.

This ordering of sanctions precedence is a mistake. With its all-out invasion of Ukraine, Russia has moved past Iran into top slot at world's most dangerous nation. Vladimir Putin merits a sanctions program that is at least as onerous as Iran, if not more so, yet for some reason he is getting off lightly. It's time to apply Iran-calibre sanctions to Russia.

What makes a draconian sanctions program draconian?

What makes the Iranian sanctions program so draconian is that many of the sanctions are so-called secondary sanctions, a feature that has been mostly absent in the Russian sanctions program.

When the U.S. or EU levy primary sanctions on an entity, they are saying that American individuals, banks, and businesses (and European ones, too) can't continue to interact with the designated party. This hurts the target, but it leaves foreign individuals, banks, and businesses with free reign to fill the void left by departing American and European actors, thus undoing part of the damage.

Secondary sanctions prevent this vacuum from being occupied. The U.S. government tells individuals or businesses in other nations that they, too, cannot deal with a sanctioned entity, on pain of losing access to U.S. economy. It's either us, or them.

When applied to foreign financial institutions (i.e. banks) secondary sanctions are particularly potent. The U.S. tells foreign banks that if they continue to provide banking services to sanctioned Iranians, the banks' access to the all-important U.S. financial system will end. Since the U.S. financial system is so crucial, foreign banks quickly offboard all sanctioned Iranian individuals and businesses. The sanctioned Iranian entity finds that it has now been completely removed them from the global financial system. This financial shunning effect is much more powerful than the effects created by primary sanctions or secondary sanctions on non-banks.

Notice that I've limited my commentary on secondary sanctions to the U.S. Since it first began to use secondary sanctions in 1996, the U.S. Treasury has become a master of the art, whereas as far as I know they are a tool the EU has long resisted adopting.

The bank-focused secondary sanction placed on Iran over the last decade-and-a-half have been particularly devastating because they target a broad sector of Iranian society, most crucially the Iranian oil sector, the life blood of Iran's economy. Secondary sanctions prevent foreign banks from processing Iranian oil trades on pain of losing access to the U.S., and so most foreign banks have chosen to cease interacting with the Iranian oil companies.

The chart below illustrates the effectiveness of this approach. When President Obama placed the first round of bank-focused secondary sanctions on Iran's oil industry in 2012, the nation's oil exports immediately cratered from around 2 million barrels per day to 1 million barrels. When he removed them in 2016, they quickly rose back up. And when Trump reapplied the same secondary sanctions in 2018, they collapsed once again, almost to zero.

Source: CRS [pdf]


In short, U.S. secondary sanctions imposed huge body blows on the Iranian oil industry. These same forces have not been brought to bear on Russia's oil industry.

A dovish Russian sanctions program

While the Russian sanctions program is often portrayed as being strict, it is far lighter than other sanctions programs, including the one placed on Iran, because it is comprised almost entirely of primary sanctions. (For a good take on this, see Esfandyar Batmanghelidj here). While a small list of secondary sanctions have been placed on Russia, for the most part they have not been of the banking type.*

The second reason why the Russian sanctions program is dovish is that the oil component of the EU and U.S. sanctions campaign has been particularly lenient. Take a look at the above chart of Iran oil exports and you can see very real evidence of damage from sanctions. Scan the chart of Russian oil exports below, however, and it suggests business as usual.

Source: CREA

Sure, the EU and other coalition partners have cut Russian oil imports to almost nil, and that's great. But overall, this effort hasn't done much harm to Putin, since over time the coalition's respective share of Iranian oil exports has simply been taken up by nations like India and China. Both before and after the 2022 invasion of Ukraine, Russia reliably shipped around 1,000 kt/day of crude oil and crude oil products.

Underlying this leniency, G7 businesses are still allowed to engage in the Russian oil trade, as long as this doesn't involve bringing the stuff back to the EU. For instance, foreign buyers of Russian oil (say like Indian refiners) are allowed to hire European insurers and shipping companies to import Russian oil.

There is a limitation on this. European insurers and shippers can only be used by an Indian refiner, or some other foreign buyer, if the purchase price of Russian oil is set at $60 or below. This is what is known as the G7 oil price cap.

Because the insurance and shipping industries of the UK, EU, and U.S. have a large share of the market, Russia has had little choice but to rely on coalition intermediaries for selling at least some of its oil at $60. This has come at a cost to Russia; it must sell at below-market prices. And that certainly makes Russia worse off than a world in which there was no oil price cap.

But the very fact that these purchases are occurring at all, compared to a world in which Iran-calibre sanctions would prevent them from ever taking place, illustrates how weak the oil price cap is. 

Russia's oil export income is the life-blood of Putin's war economy. These funds gets funneled directly to the front-line in the form of weapons and supplies. It's time to get serious about Russian sanctions, remove the dovish oil price cap, and apply to Russia the same calibre of secondary sanctions that so effectively crimped Iranian oil exports.

We may have to deescalate sanctions on Iran in order to escalate them on Russia

What has prevented the U.S. and its allies from applying draconian Iran-style sanctions to Russia? One of their main worries is that taking a major oil exporter out of the market will have major macroeconomic impact. 

Russia currently exports around 4 million barrels of crude oil per day, as well as a large amount of refined products such as gasoline. Assuming that half of this were to be removed by secondary sanctions, world oil prices would probably rise. Voters in the EU and US would get angry. Neutral countries dependent on oil imports  China, India, Brazil  would push back against the colation, because they'd have to scramble to replace a major supplier. Secondary sanctions aren't just a nuisance for these neutral parties. Due to their extraterritorial  nature, secondary sanctions impinge on the sovereignty of neutral nations. This creates hostility, understandably so, the negative blowback eventually flowing back to the U.S.

So if the EU, U.S. and the rest of the coalition are going to get serious about sanctioning the Russia's oil industry, and thus removing a few million barrels of oil per day from the world market, they may need to counterbalance that in order to soften the blow. One way to do so would be to free up more Iranian oil exports, which means softening the sanctions on Iran.

That doesn't mean not applying sanctions to Iran. A version of the $60 price cap on Iranian oil probably makes a lot of sense. However, a fully armed financial battleship  i.e. bank-focused secondary sanctions directed at a major crude oil exporter's oil industry  may be something that has to be reserved for one country only: Russia.

Now, I could be wrong about the world being unable to bear draconian sanctions on two major oil exporters. Maybe I'm creating a false dichotomy, and in actuality the choice is less stark and the coalition can actually apply draconian oil sanctions on both Iran and Russia. If so, I stand corrected.

Either way, Russia's oil industry has skated through the invasion and resulting sanctions remarkably unscathed, as the Iranian counterexample illustrates. It's time to cut off Russia's main source of revenues by putting the same set of secondary sanctions that Iran has faced on Russia's oil patch. 



* There are a few bank-focused secondary sanctions placed on Russia. Notably, Section 226 of CAATSA (2017) requires foreign financial institutions, or FFIs, to avoid certain sanctioned Russians or sectors on pain of losing access to the U.S. banking system. (See here, for example.) However, the U.S. must not be enforcing Section 226 very tightly because I haven't found a single case of a bank being punished under 226.

This December, another round of secondary sanctions was imposed on FFIs. Any foreign bank that facilitates transactions involving Russia’s military-industrial base may be cut off from the U.S. financial system. Additionally, any bank that conducts transactions for specially designated nationals who operate in Russia's technology, defense and related materiel, construction, aerospace or manufacturing sectors may face punishment. Note that both rounds of secondary sanctions leave the Russian oil industry untouched.