How the Bank of Canada's balance sheet went from $118 billion to $440 billion in eight weeks

Ever since the coronavirus hit, the Bank of Canada's balance sheet has been exploding. In late February its assets measured just $118 billion. Eight weeks later the Bank of Canada has $440 billion in assets. That's a $320 billion jump!

To put this in context, I've charted out the Bank of Canada's assets going back to when it was founded in 1935. (Note: to make the distant past comparable to the present, the axis uses logarithmic scaling.)

The rate of increase in Bank of Canada assets far exceeds the 2008 credit crisis, the 1970s inflation, or World War II. Some Canadians may be wondering what is going on here. This blog post will offer a quick explanation. I will resist editorializing (you can poke me in the comments section for more colour) and limit myself to the facts.

We can break the $320 billion jump in assets into three components:

1) repos, or repurchase agreements
2) open market purchases of Federal government bonds
3) purchases of Treasury bills at government auctions.

Let's start with repos, or repurchase operations. Luckily, I don't have to go into much detail on this. A few weeks back Brian Romanchuk had a nice summary of the Bank of Canada's repos, which have been responsible for $185 billion of the $320 billion jump.

With a repo, the Bank of Canada temporarily purchases securities from primary dealers, and the dealers get dollars. This repo counts as one of the Bank of Canada's assets. Some time passes and the transaction is unwound. The Bank gets its dollars back while the dealers get their securities returned. The asset disappears from the Bank of Canada's balance sheet.

The idea behind repos is to provide temporary liquidity to banks and other financial institutions while protecting the Bank of Canada's financial health by taking in a suitable amount of collateral. If the repo counterparty fails, at least the Bank of Canada can seize the collateral that was left on deposit. This is the same principle that pawn shops use. The reasons for providing liquidity to banks and other financial institutions is complex, but it goes back to the lender of last resort function of centralized banking. This is a role that central banks and clearinghouses inherited back in the 1800s.

How temporary are repos? And what sort of collateral does the Bank of Canada accept? In normal times, repos are often  unwound the very next day. The Bank also offers "term repos". These typically have a duration of 1 or 3-months. The list of repo collateral during normal times is fairly limited. The Bank of Canada will only accept Federal or provincial debt. That's the safest of the safe.

But in emergencies, the Bank of Canada is allowed to extend the time span of its repos to as long as it wants. It can also expand its list of accepted collateral to include riskier stuff. Which is what it did in March 2020 as it gradually widened the types of securities it would accept to include all of the following:

Source: Bank of Canada

That's a lot of security types! (The list is much larger if you click through the above link to securities eligible for the standing liquidity facility, see here. Nope, equities are not accepted as collateral.)

As for the temporary nature of these repos, many now extend as far as two years into the future. See screenshot below:

Source: Bank of Canada

(Note that the Bank of Canada has a very specific procedure for moving from "regular" purchases to "emergency" purchases. Part of this was implemented due to its initial reaction in 2007 to the emerging credit crisis. It accidentally began to accept some types of repo collateral that were specifically prohibited by the Bank of Canada Act. The legislative changes implemented in 2008 remedied some of the problems highlighted by this episode and codified the process for going to emergency status. Yours truly was involved in this, click through the above link.)

Anyways, we've dealt with the $185 billion in repos. Now let's get into the second component of the big $320 billion jump: open market purchases of long-term government bonds, or what the Bank of Canada refers to as the Government of Canada Bond Purchase Program (GBPP). This accounts for another $50 billion or so in new assets.

Whereas a repo is temporary, an outright purchase is permanent. Some commentators have described the purchases that the GBPP is doing as "quantitative easing". But the Bank of Canada has been reticent to call it that. When it first announced the GBPP, it said that the goal was to "help address strains in the Government of Canada debt market and enhance the effectiveness of all other actions taken so far."

This is a non-standard reason. Large scale asset purchases are normally described by central bankers as an alternative tool for stimulating aggregate demand. Usually central banks use interest rate cuts to get spending going. But when interest rates are near 0% they may switch to large scale asset purchases. (The most famous of these episodes were the Federal Reserve's QE1, QE2, and QE3). But the Bank of Canada seems to be saying that its large scale purchases are meant to fix "strains" in the market for buying and selling government bonds, not to stoke the broader economy. 

Together, the GBPP and repos account for $235 billion of the $320 billion jump.

Let's deal with the last component. Another $65 or so billion in new Bank of Canada assets is comprised of purchases of government Treasury bills (T-bills). A T-bill is a short term government debt instrument, usually no more than one year. This is interesting, because here the Bank of Canada can do something a lot of central banks can't.

Most central banks can only buy up government debt in the secondary market. That is, they can only purchase government bonds or T-bills that other investors have already purchased at government auctions. The Bank of Canada doesn't face this limit. It can buy as much government bonds and T-bills as it wants in the primary market (i.e. at government securities auctions).

Since the coronavirus crisis began, the Federal government under Justin Trudeau has revved up the amount of Treasury bills that it is issuing. As the chart below illustrates, in the last two Treasury bill auctions (which now occur weekly instead of every two weeks) it has raised $35 billion each.

For its part, the Bank of Canada bought up a massive $14 billion at each of these auctions. That's 40% of the total auction. In times past, the Bank of Canada typically only bought up around 15-20% of each auction. This 15-20% allotment was typically enough to replace the T-bills that the Bank already owned and were maturing.

By moving up to a 40% allotment at each Treasury bill auction, the Bank of Canada's rate of purchases far exceeds the rate at which its existing portfolio of T-bills matures. And that's why we're seeing a huge jump in the Bank of Canada's T-bill holdings.

(So who cares whether the Bank of Canada buys government bonds/T-bills directly at government securities auctions instead of in the secondary market, as it is doing with the GBPP?  It's complicated, but part of this controversy has to do with potential threats to the independence of the central bank. But as I said at the outset, I'm resisting editorializing.)

These three components get us to $300 billion. The last $25 billion is due to other programs. I will list them below and perhaps another blogger can take these up, or I will do so in the comments section or in another blog post:

+$5 billion in Canada Mortgage Bonds
+$5 billion in purchases via the Provincial Money Market Purchase Program (PMMP)
+$1 billion in Provincial bonds
+$8 billion in bankers' acceptances via the Bankers' Acceptance Purchase Facility (BAPF)
+$2 billion in commercial paper
+$1 billion in advances

And that, folks, is how the Bank of Canada's assets grew to $440 billion in just two months.

Euros without the Eurozone

This 2 euro coin is issued by Monaco, which is not a member of the Eurozone

Grexit isn't what people take it to be. The standard narrative is that Greece is approaching a fork in the road. It must either stay in the euro or adopt a new currency. I don't think this is an entirely accurate description of the actual fork that Greeks face. Over the next few months, Greece will either:

• A) stay a member in good-standing of the institution called the "Eurozone" and continue to legitimately use that institution's currency, the euro, or
• B) leave the Eurozone while continuing to use the euro 'illegitimately.'*

This means either the status quo of de jure (official) euroization or de facto (unofficial) euroization. In both cases, the euro stays.

The probability of a new drachma emerging is awfully low. The widespread idea that a sick country can rapidly debut a new currency and, more importantly, have that currency be universally adopted as a unit of account is magical thinking. Greece has been using the euro as a universal "language of exchange" for fifteen years. Switching over to a new unit is about as unlikely as Greeks suddenly beginning to speak German, network effects and all. Consider too the fact that Greeks don't want the drachma—they have consistently voted for euros. Syriza has no mandate to bring a new unit into existence. ***

Option B isn't an odd one. All sorts of countries 'illegitimately' piggy-back off the currencies managed by others. Zimbabwe, Ecuador, and Panama use the U.S. dollar without being card carrying members of the Federal Reserve System while Andorra, Kosovo, Montenegro, Monaco, San Marino, Vatican City use euros without being part of the Eurozone. Nor can the Eurozone can do anything to prevent de facto adoption of the euro by Greece. It's a decision that Greeks get to make themselves.

If Greece leaves the Eurozone on a de jure basis while staying a euro user, what will it be giving up?

The Greeks would NOT be losing the price stability and commonality already provided by Eurozone membership. These are presumably the features that lead most Greeks to declare in polls that they want to stay in the euro.

However, Greece would no longer get access to Eurozone lender of last resort facilities. One could argue that the nation would be better off without these facilities, given the discipline that a true 'no bailout' policy would enforce on both the banks and the government. Greece also loses direct access to the monopoly supplier of euro banknotes. A Greek banker can currently ask to have their Eurozone account be debited and a batch of freshly printed paper euros trucked over to their vault. Gone is that functionality. Panama has survived, even prospered, for decades without access to the Fed's discount window or Fed cash facilities.***

Greece would also lose its seat on the ECB Governing Council and therefore any say in determining monetary policy. Greece's one seat probably never gave it much influence anyways, especially compared to Germany's dominant influence in ECB decision making. Nor would Greek data be considered as an input into Eurozone policy decision should Greece leave. However, as it clocks in at just 2% or so of the Eurozone's total size, Greece's data could never have had much influence on the aggregates that ECB policy makers watched to begin with. Official user of euros or unnoffical, Greece will always lack an independent monetary policy.

Another concern is that Greece might not be allowed to use the ECB's Target2 real time settlement mechanism anymore. However, Denmark, Bulgaria, Poland, and Romania all connect to Target2, despite not being Eurozone members. Surely Greece would qualify. If not, it wouldn't be too complicated for Greek banks to set up their own payments system.

Lastly, Greece would forfeit all seigniorage revenues. Eurozone members currently get a share of the profits that the ECB earns on its monetary monopoly. I don't see this loss as being a big deal. Seigniorage has long since been eclipsed by taxes as the key source of a modern government's revenue.

The upshot is that whether Greece remains a legitimate member of the Eurozone or an unofficial user of the Eurozone's chief monetary product, the implications are about the same. There is no fork in the road, at least not from a monetary policy perspective; just a continuation of the same euro path as before.

I've left two features out. If Greece leaves, the claims and liabilities it has on the Eurozone must be unravelled and settled. Having invested around 200 million euros in the ECB when it was formed, Greece would have to be bought out by remaining Eurozone members at a reasonable price. Counterbalancing this would be Greece's obligation to unwind the debt that it has amassed to the Eurozone in the interim. This debt, known as its Target2 deficit, currently clocks in at around 100 billion euros, far in excess of the capital it is owed. It would take an incredible outlay of resources to pay this amount off. The advantage to the Greek population of staying in the Eurozone is that their debt need never be settled. After all, Target2 debts are by nature perpetual. Only by leaving do they face a final day of reckoning.

However, if Greece puts little-to-no cost on squelching on its debts, it may as well just leave the Eurozone without paying back the 100 billion it owes. It gets to continue to ride piggy-back on top of the euro, enjoying (almost) all the same benefits of being a Eurozone member, without being on the hook for anything. Why not perpetually bum cigarettes rather than pay for them?

Which is why Greece has a certain degree of power over the remaining Eurozone members. Should it shrug and leave, the remaining members are on hook for its unpaid tab. And once Greece goes down the de facto euroization path, how long before the next largest debtor to the rest of the Eurozone decides to shrug and leave? As Nick Rowe says, the last one holding a common currency is the sucker since they'll be left with everyone's bad debts. To keep the system going, the Euro project's architects need to do their best to ensure that Greeks aren't incentivized to just shrug and bum a free ride on the euro. I don't envy them their task, it's a difficult one.

The other aspect I've left out is the Greek banking system, which is probably insolvent. Once cutoff from the central bank that prints the stuff, Greek banks simply wouldn't be able to meet the rush to convert deposits into euro banknotes. The only way to return the banking system to functionality would be to chop the quantity of Greek bank deposits down to size so that the banks' asset base would be sufficient to absorb the run into cash. We're talking a multi-billion euro "bail-in" of depositors. The prospect of such a hit certainly tilts the decision between A and B back towards A.**


* Having been cut off from additional ECB lending, one might argue that Greece has already gone halfway towards exiting the Eurozone.
**  Paragraph added July 2.
*** Added cash facilities on July 2.
**** Added last two sentence to this paragraph on July 3.
Note: apologies for the constant additions, but this subject is complex and the situation getting more complex by the day, so rather than writing two or three posts I'm adding bits to the original.

Fear of illiquidity

There are thousands of fears, from arachnophobia to globophobia (fear of balloons) to zoophobia (fear of animals). What might the fear of market illiquidity look like?

Say that you are petrified that a day will come when markets will be too illiquid for you to convert your wealth into the things you need. There are two ways for you to buy complete peace of mind.

The first strategy involves selling everything you own now and buying checking deposits, the sine qua non liquid asset. Get rid of the house, the bonds, the stocks, the car, your couch, and your books. Use some of the proceeds to rent a house and a car, borrow books, and lease furniture. In renting back the stream of consumption benefits that you've just sold, your level of consumption stays constant. Negotiate the rental arrangements so that the lessor—the owner—cannot cancel them, and so that you can walk out of them at a moment's notice. Structuring things this way ensures that rental obligations in no way inhibit your ability to stay liquid. With your hoard of highly liquid deposits and array of rental agreements, you've secured a state of perfect liquidity. Relax. Breathe in. Enjoy your life.

The second way to perfectly hedge yourself from illiquidity risk would be to buy liquidity insurance on everything you own. For instance, an insurer would guarantee to purchase your house whenever you want to sell at the going market price. Same with your stocks, and bonds, your car and couches and your books. With every one of your possessions convertible into clean cold cash upon a moment's notice thanks to the insurer, you can once again relax, put your legs up, and lean back on the couch.

Since both strategies lead you to the same infinitely liquid final resting place, arbitrage dictates that the cost of pursuing these two strategies should be the same. Consider what would happen if the liquidity insurance route was cheaper. All those desiring a state of infinite liquidity would clamor to buy insurance, pushing the price of insurance higher until it was no longer the better option. If the checking deposit/rental route was cheaper, then everyone would sell all their deposits and rent stuff, pushing rental prices higher until it was no longer the more cost-efficient option.

Now I have no idea what liquidity insurance should actually cost. But consider this: liquidity option #1 is a *very* expensive strategy. To begin with, you'd be forgoing all the interest and dividends that you'd otherwise be earning on your bonds and stocks. Checking deposits, after all, offer no interest. Compounded over many years, that comes out to quite a bit of forfeited wealth. Second, you'd have to rent everything. And the sort of rent you'd have to negotiate would be costlier than normal rent. Last time I checked, most landlords require several months notice before a renter can be released from their rental obligation. But the rental agreements you have negotiated require the owner to accept a return of leased property whenever *you* want—not when they want. And that feature will be a costly one.

Since option #1 is so expensive, arbitrage requires that option #2 will be equally expensive. Let's break it out. Option #2, liquidity insurance, allows you to keep the existing flows of income from stocks and bonds as well as saving you from the obligation of paying high rent (you get to keep your house and all the other stuff). Not bad, right? Which means that in order for you to be indifferent between option #1 and #2, the cost of insurance must be really really high. If it wasn't, everyone would choose to go the insurance route.

So who cares ? After all, liquidity insurance doesn't exist, right? Wrong. Central banks are significant providers of liquidity insurance. They insure private banks against illiquidity by promising to purchase bank assets at going market prices whenever the bank requires it. This isn't full and complete liquidity insurance— there are a few assets that even a central bank won't touch—but it's close enough.

The upshot is that banks are well-protected from illiquidity. They get to keep all their interest-yielding assets and at the same time can rest easy knowing that the central bank insures that those assets will always be as good as cash. Consider what things would be like for private banks if the central bank were to get out of the liquidity insurance business. Now, the only way for bankers to replicate central bank-calibre liquidity protection would be for them to pursue option #1: sell their loan books and bond portfolios for 0%-yielding cash. But then they'd be foregoing huge amounts of income. They might not even be profitable.

With logic dictating that the cost of buying liquidity insurance needs to be pretty high, are modern central banks charging sufficiently stiff rates on liquidity insurance? I'm pretty sure they aren't. Regular insurers like lifecos require periodic premium payments, even if the event that said insurance covers hasn't occurred. But the last time I read a bank annual report, there was no line item for liquidity insurance premiums. It seems to me, and I could be wrong, that central banks are providing liquidity insurance without requiring any sort of quid pro quo. Feel free to correct me in the comments section.

Say that I'm right and that central banks are providing private banks with underpriced liquidity insurance. Central banks are ultimately owned by the taxpayer, which means that taxpayers are providing private banks with artificially cheap liquidity insurance. And that's not a fair burden to put on them. Nor is the underpricing of insurance a good strategy, since it results in all sorts of institutions getting insurance when they don't necessarily deserve it.

Does anyone know if central banks have any sort of rigorous model for determining the price they charge for liquidity insurance. Or are they just winging it? ... it sure seems like it to me.

More monetary lunacy from Mugabe

In a recent speech leading up to an end-of-month national election, Zimbabwe's President Robert Mugabe hinted at the possibility of introducing a gold-backed Zimbabwe dollar.

This is from the Mail & Guardian:

Then there is the business about the Zim dollar, that one issue that makes every Zimbabwean wake up in a cold sweat, and one that every candidate should really avoid. We cannot use the US dollar forever, he [Mugabe] begins. We will have to look at ways of bringing back our currency, sometime in the future. There are uncomfortable murmurs. Mugabe appears to be thinking out loud. "Should we, should we not?" he asks himself. "What if we back our currency with all our gold? Wouldn't it be strong enough? Maybe not now, of course, but sometime in the future. Maybe we will talk to [Gideon] Gono, the Reserve Bank governor."

I'm sure the memories of the hyperinflation are too fresh in the minds of Zimbabweans for them to buy into the folly of letting the insane duo of Mugabe and his central banker, Gideon Gono, once again have their own printing press, even if that press is to be constrained by gold convertibility. Let's take a quick glance through the 2007 Reserve Bank of Zimbabwe (RBZ) annual report [link] for a refresher of what the two of them got up to the last time around. By then in the midst of a severe hyperinflation, the RBZ's 2007 report kicks off with a boilerplate disavowal of any responsibility for the plunge in the Zim dollar's purchasing power, blaming it on "supply side constraints, speculative activities, and adverse expectations."

The report goes on to describe a dizzying number of "support" programs set up by the RBZ. These include in no particular order:

A) Farm Mechanization Program: to provide farmers with the funds to purchase tractors, combines, plows, and sprayers.
B) Agricultural Sector Productivity Enhancement Facility: to provide low cost funds to support producers of beef, pigs, and poultry
C) Parastatals Reorientation Program: aid to suffering government-owned businesses including Cold Storage Co of Zimbabwe, Tel One, and Net One.
D) Basic Commodities Supply-Side Intervention Facility: targeted financial support to ensure a quick return of basic goods to supermarket shelves
E) Tourism Development Facility: funds for hotels, lodges, and tour operators
F) Seed Development Program: funding to procure maize, soybean, and sorghum seed
G) National Cattle Herd Restocking Program: the purchase of breeding cattle for onlending to farmers
H) Rural Business Facility: funds for rural retailers including hardware shops, wholesalers, and butchers.
I) and more...

A large quantity of the support provided via these RBZ programs went straight to Gono and Mugabe's friends and allies. Coincidentally, it would seem that Gono, while RBZ governor, has become one of the biggest chicken farmers in Zimbabwe, recently boasting in the press that he expects to be Africa's first chicken-farming billionaire. Even if Gono didn't fund his farming dreams by diverting funds from RBZ agricultural support programs to himself, his suppliers, or purchasers, the conflict of interest presented by Gono's twin roles as chicken farmer and chicken farm financier is breathtaking. It would be like putting Jamie Dimon in charge of the Fed, without requiring Dimon to resign from and sell his shares in JP Morgan.

Most of the RBZ's special lending programs, as well as the direct financing of the government carried out by the RBZ, were granted at rates far cheaper than the market rate. Whenever a central bank keeps its rate perpetually below the market rate, hyperinflation is the inevitable result. But in Gono and Mugabe's Alice in Wonderland world, their so-called support programs weren't the cause of the hyperinflation, but rather the cure to hyperinflation. How did the pair square this very odd circle? Here is Gono explaining the Farm Mechanization Program:

Many may wonder why Your Central Bank gets involved in some of these activities which, on the face of it, appear to be outside our core mandate of inflation fighting. Your Excellency, inflation remains our number one enemy and core business. Thirty three percent (33%) of that inflation relates to Food and Food items alone. It follows therefore that our attempts to boost agricultural productivity in collaboration with Government and other stakeholders is actually an ancillary and incidental part of our core business.

According to Gononomics, inflation is not something created by a central bank but an external enemy that must be fought. The RBZ's cheap loans to the farm sector didn't set off inflation, but rather they improved productivity and reduced food prices, thereby reining in inflation. Reality, of course, had something stern to say about this. The Zim dollar continued to plunge in value, eventually hitting zero a year after Gono's speech. Gono and Mugabe were appropriately stripped of their printing press by the course of events, and that is how the situation should stay.

I'll deal with a few reasons that might be put forward for the resurrection of the Zim dollar, and why these reasons are not sufficient to counterbalance the danger of giving our two hyperinflationistas their own currency.

1) First, many people complain of a "small change" problem in Zimbabwe. A paucity of US dollar coins in circulation means that it is difficult for someone purchasing, say, $1.85 worth of food with $2.00 to get back 15c in change. While we in the West might consider change to be an inconvenience -- it is heavy and clinks around -- in a country like Zimbabwe where the average daily income is only a few dollars, the lack of coinage is a major problem.

This is hardly an issue that needs to be solved by a new Gono dollar, though. One route that Zimbabwean shopkeepers have taken to make things easier is to provide change in by the form of gum, candy, or other small items. This isn't an ideal solution, but it is a start of sorts. Private bus owners give change in the form of coupons that can be redeemed for transportation at some later date. These coupons don't appear to be highly liquid, though. The South African five rand coin has been recruited to serve the role of a 50 cent piece, regardless of the actual exchange rate between rand and US dollars. This is fine for now, but as the USD-ZAR exchange rate changes over time, the use of rand coins as change in US dollar transactions may become computationally burdensome.

A better solution would be to allow private Zimbabwean banks to coin or print 10c, 25c, and 50c tokens/coupons that, when brought back to the issuing bank, might be converted into their dollar equivalent. This would require the regulatory blessing of the RBZ. The RBZ, unfortunately, seems to be extremely jealous of those who would print or coin currency. In a bizarre story from this spring, two "prophets" claimed to be able to create US dollars from scratch, those in their audience reportedly receiving "miracle money" in their pockets. Gono immediately investigated the duo, eventually clearing them of any wrongdoing. If so-called miracle money receives such scrutiny from the RBZ, one can be sure that bank-produced small change would have to jump through incredibly high hoops before being permitted.

Lars Christensen has also discussed the small change problem in Zimbabwe, noting the potential for e-money to fill the gap. I won't go into any depth on this possibility since Lars has covered it in some detail.

2) A second purported reason for introducing a new Zim dollar is to provide for the lender of last resort. Since the RBZ can't print US dollars willy nilly, Zimbabwe banks can't turn to their nation's central bank when they need liquidity support.

We've grown so used to the idea of a lender of last resort that we rarely stop to consider that such a lender is not a necessary feature of an economy. Panama has been effectively dollarized since 1904 and for that entire time has been without a lender of last resort. Panamanian banks have adapted by holding relatively high levels of liquid assets as self-insurance [link]. Bank failures have been small and infrequent, with the only major crisis event being related to the Manuel Noriega incident in the late 1980s. [link]

Like Panamanian banks, Zimbabwean banks will adapt to the lack of lender of last resort by modifying their own banking practices to ensure that their balance sheets are sufficiently flexible to deal with liquidity crisis.

In sum, Zimbabwe's currency situation is better than it has been in years and will only improve as technologies and practices evolve to deal with the small change problem, and as banks position themselves to deal with potential liquidity shortfalls. A Mugabe/Gono attempt to bring back the Zim dollar, whether it be gold-backed or not, is thoroughly unnecessary. Should the duo succeed in linking a new currency to gold, it is probable that they'll quickly close the gold window in order to get back to their old ways,  a scenario that no one wants. With any luck, Zimbabweans will throw the scoundrels out onto the street come election time. Mugabe and Gono certainly deserve it.

Don't shackle Target2

Like Guntram Wolff over at the Bruegel blog, I hope that the much-rumoured capital controls on Cypriot deposits don't get enacted. So far the Euro authorities seem to have done everything right, albeit in a slow and circuitous manner. Insolvent banks are being closed, uninsured depositors, unsecured creditors, and shareholders are being bailed in, and solvent banks are slated to reopen.

Wolff's main concern is that capital controls threaten the very meaning of a monetary union:

With capital restrictions, the value of a euro in Cyprus is no longer worth the same as a euro held by any other bank in the eurozone. A euro in Nicosia cannot be used to buy goods in Frankfurt without limits. Effectively, it means that a Cypriot euro is not a euro any more.

Enact capital controls and we'd see the emergence of an entirely new currency trading pair CYP€:onshore€, with Cypriot euros trading at a discount. The discount would emerge since the ability of CYP€ to buy things outside of the island of Cyprus is limited. It would be a less liquid euro than "mainland" euro, and therefore would get penalized with a liquidity discount.

A Eurosystem in which euros are heterogeneous would technically be workable. For an analogy, look at China. The Chinese yuan has several different prices. Mainland yuan (CNY) typically trades at a discount to yuan in Hong Kong(CNH) and yuan in Taiwan (CNT). I've cribbed a chart below that shows the spread. Chinese capital restrictions prevent arbitrage forces from reducing the gap. Foreigners would prefer to buy cheaper CNY than more expensive CNH and CNT, but they can't because restrictions on capital inflows into China prevent them from doing so. Chinese companies would like to borrow in Hong Kong rather than China since they'd be borrowing high-value CNH and repatriating it, thereby lowering their cost of funding. But capital outflows are also limited.*

Source: HSBC Global Research

Just like capital controls prevent the closing of the CNY-CNH spread, the introduction of European capital controls would lead to the emergence of the CYP€-€ spread. What are the dangers of Europe adopting a Chinese model of multiple prices for the same currency?

As Wolff points out, the Eurosystem already has a tool to deal with flight from banks: the ECB's incredibly powerful Target2 clearing system. When Cypriot banks reopen and depositors start to transfer deposits to Germany, Target2 will accommodate these flows by stepping between the two banking systems, simultaneously acting as a creditor to Cyprus and a debtor to Germany. Like any lender of last resort, Target2 will be vigorous in lending, providing whatever assistance is required to Cypriot banks facing liquidity shortfalls.**

The great thing about Target2 is that its mere presence has the ability to prevent a bank run from ever being kick-started. If Cypriot depositors know at the outset that the incredibly powerful Target2 will accommodate their fears, why should they be fearful? Target2 is like Chuck Norris, as Nick Rowe and Lars Christensen would say. Its mere presence is enough to create powerful self-fulfilling counter-effects.

Cyprus wants to soften potential deposit flight with capital controls rather than leaving Target2 to do all the work. One wonders if these controls would help at all. Controls are porous, and investors will find cunning ways to get around them.

Worse is the precedent this sets. If capital controls are used as a substitute for Target2, the Euro risks losing a major stabilizing force come the next crisis. Say that it is 2016 and doubts spring up concerning Finland's banking system. If Finnish depositors know that Target2 will accommodate all deposit outflows from solvent Finnish banks, then they realize that they have nothing to fear, and the panic will subside on its own accord. But if Finnish depositors think that Cyprus-style capital controls will be put in place to prevent deposit outflows, the panic will only be exacerbated as people try to withdraw money from Finland before capital controls cause FIN€ to trade at a discount. Anyone who gets through the gate before it closes can't lose, so everyone tries to get through the gate. This effect is perverse, since the very rumour of capital controls leads to their actual adoption. With capital controls, a European bank panic is self-fulfilling—with Target2, that same panic is self-correcting.

Leave Target2 free to be the regulator of European liquidity flows—don't use capital controls. Haven't we already learnt this lesson? It was Draghi's speech about Euro convertibility from last summer that helped reduce yield spreads and stop the intra-European bank run. Gavyn Davies read that speech as a reaffirmation of unlimited Target2 power, and so did I.*** Never shackle Target2.
_______________________

* The Chinese are moving to less capital controls. Spreads are already declining, and at some point the CNY-CNH/CNT differential will be no more. 

** The provision of these LOLR services is subject to Cypriot banks providing collateral. But the winding up of insolvent Cypriot banks and the haircutting of depositors *should* have insured that the remaining quantity of Cypriot banking liabilities have been pruned so that they equal the quantity of remaining collateral.

*** See this comment as well as my first Never Shackle Target2 post.

Financial deepening and currency internationalization, the bitcoin edition

Much of the conversation about bitcoin adoption focuses on its use in goods and services transactions. Breaking bitcoin news, for instance, draws attention to the fact that the Internet Archive will be giving employees the option to be paid in bitcoin. This focus on brick & mortar transactions means that the role that bitcoin financial instruments—stocks, bonds, and derivatives—have to play in promoting bitcoin adoption often gets overshadowed.

I'm currently reading Barry Eichengreen's Exorbitant Privilege which goes into the mechanics of what it takes to create a truly international currency. Eichengreen points out that prior to World War I the dollar played a negligible role relative to the pound sterling in world markets, but by the mid 1920s it was the dominant unit for invoicing payments and denominating bonds. Eichengreen's theory is that the US dollar became the world's go-to currency because of the emergence of a very specific financial instrument—the banker's acceptance.

An acceptance is much like a bill of exchange, a financial instrument I explained in my last post. Say a merchant decides to pay for a shipment of goods with a personal IOU, or bill. If a bank first "accepts" the bill i.e. if it agrees to vouch for the IOU, then this gives the bill more credibility. It is now a banker's acceptance.

According to Eichengreen, around 1908 or 1909, a concerted effort to foster the growth of the US acceptance market began. Up till then, US banks had been prohibited from dealing in acceptances and branching abroad—both these limitations would be removed by new legislation. To promote liquidity and backstop the acceptance market, the Federal Reserve, established in 1914, was given authority to buy and sell acceptances via open market operations. Furthermore, these acceptances could legally "back", or collateralize, the Fed's note issue. This feature was particularly helpful. Although the Fed was also legally permitted to purchase government securities, government securities could not "back" the note issue. Acceptances, therefore, became the more flexible and preferred asset for Fed open market operations, at least until 1932 when the limitations on government collateral were removed. According to Eichengreen, the Fed was the largest investor in the acceptance market and sometimes held the majority of outstanding issues on its balance sheet.

By the mid-1920s foreign acceptances denominated in dollars exceeded those denominated in sterling by a factor of 2:1 and more central banks held US forex reserves than sterling. London was on the way out, and New York on the way in. By 1929, the amount of outstanding foreign public bonds denominated in dollars (excluding the Commonwealth) exceeded sterling bonds. The lesson here is that a key step in the sequence of internationalizing a currency is getting it to be used in financial markets. This involves the development of deep, liquid, and accessible markets in securities denominated in that currency.

What sort of financial deepening do we see in the bitcoin universe, and how might we compare it to the dollar's emergence in the 1910s and 20s?

There are a number of healthy signs of financial deepening. I count five competing bitcoin securities exchanges that provide a forum for trading bitcoin-denominated stocks and bonds. These include Cryptostocks, BTCT, MPEx, Havelock, and Picostocks. A sixth, LTC-Global, provides a market in litecoin securities, a competing altchain. Holders of bitcoin needn't cash out of the bitcoin universe in order to get a better return. Instead, they can buy a bond or a stock listed on any of these exchanges.

The largest publicly-traded company in the bitcoin universe is SatoshiDice, a bitcoin gambling website listed on MPEx. With 100 million shares outstanding and a price of 0.006 BTC, SatoshiDice's market cap is ~600,000 BTC which comes out to around $17 million. SatoshiDice IPOed last year at 0.0032 BTC. With bitcoin only trading at $12 back then (it is now worth $29), the entire company would have been worth $4 million. Given today's $17 million valuation, SatoshiDice shareholders have seen a nice return over a short amount of time—much of it provided by bitcoin appreciation.

While SatoshiDice certainly provides some depth to bitcoin financial markets it has the potential to shallow them out too. Because MPEx charges large fees to trade on its exchange, a few of the competing exchanges have created what are called SatoshiDice "passthroughs". Much like an ETF, a passthrough holds an underlying asset—in this case SatoshiDice shares on MPEx—and flows through all dividends earned to passthrough owners. As a result, investors can get exposure to SatoshiDice without having to pay MPEx's expensive fees. BTCT, for instance, lists two different SatoshiDice passthroughs (GSDPT and S.DICE-PT) which together account for more trading volume than all other stocks and bonds listed on BTCT.

SatoshiDice's sheer size is to some extent problematic since Bitcoin financial markets are not as deep as they might appear. Should something ever happen to SatoshiDice, a big part of the bitcoin financial universe's liquidity will be wiped out, and this would ripple out across the entire field of bitcoin securities. The same might have happened to banker's acceptances in their day, except for one difference—the Fed was willing to back the acceptance market up. In the bitcoin universe, there's no buyer of of last resort to provide liquidity support to SatoshiDice shareholders.

Another impediment to deeper bitcoin markets is the hazy legality of the bitcoin securities exchanges. The first major bitcoin securities exchange, GLBSE, was closed in October 2012 with no prior warning. According to this article, potential regulatory and tax liabilities convinced GLBSE's founder to shut it down on his own behest. If any of the existing bitcoin exchanges were to grow too noticeable, one could imagine the SEC (or its equivalent) knocking on their door and forcing the exchange-owner to pull the plug. This sort of regulatory uncertainty can only dampen the liquidity and depth of bitcoin financial markets.

US authorities, on the other hand, didn't need to heed the rules when they built the banker's acceptance market. They created the rules. If financial deepening in the Bitcoin universe is to proceed it will happen despite regulations and not because of them.

The last headwind to bitcoin financial deepening is bitcoin's volatility. Eichengreen writes that the seesawing of the pound sterling during the war period encouraged financial markets to search for a more stable unit in which to express debts. The pound had always been anchored to gold (or silver), but it was unpegged from its century's long gold tether when the war broke out. Although it was repegged in January 1916, this time to the dollar, this did not secure confidence in the sterling's value since the peg was dependent on American support. When this support was withdrawn at war's end, sterling fell by a third within a year. Through all of this, the dollar continued to be defined in terms of gold, a feature which no doubt attracted issuers.

Bitcoin, on the other hand, has more than doubled in just two months. Back in June 2011, it fell by 50% in just two days. Like pound sterling during the war, bitcoin's lack of stability will do little to promote deeper financial markets.

Although I've stressed the difficulties that bitcoin markets face in developing more depth, the sheer amount of financial innovation I'm seeing from those involved in the various bitcoin securities exchanges is impressive. I wish them the best. The more they build up bitcoin securities markets, the better an alternative bitcoin presents to competing currency units.


Disclaimer: I am long SatoshiDice and several bitcoin mining stocks.

A visual review of the lending facilities created by the Fed during the credit crisis

I'm currently updating my History of the Fed chart. As a side project, here's what's happened to the various Federal Reserve credit programs initiated during the crisis. Most of them have rolled off the Fed's balance sheet. Even the most toxic of them - Maiden Lane I and III - seem set to be paid off.

Go to scribd to see a higher resolution pdf. Alternatively, my public gallery has a high-res GIF.

This chart illustrates one role of a central bank, that of lender of last resort role. A central banking facing a crisis is supposed to lend to everyone on any sort of collateral and buy all sorts of assets. If you read through the fine print of the chart, you'll see that the Fed's new facilities accepted a broad range of assets - from commercial paper to CDOs to RMBS, and opened themselves up to a fairly wide array of counterparties.

What is really happening here is that the Fed is providing liquidity insurance. Liquidity insurance is like any other form of insurance - home insurance, car insurance, credit default insurance, whatever. Given the possibility of a fire, people buy house insurance to compensate  for that outcome. Given the possibility that one might be required to do a fire-sale into a thin market, it might be a good idea to purchase liquidity insurance ahead of time. Both are products that can be provided by insurance companies competing in the market.

Unfortunately the Fed can never know if it is providing liquidity insurance at the right price because it is the monopoly provider and has no competition. During the credit crisis, a lot of firms were extended liquidity insurance by the Fed even though they never paid for it ahead of time. In the future, one would hope that the free market takes over the Fed's role of liquidity insurance provider, leaving the Fed to operate the clearing system and set a few interest rates.

The free banking alternative to the centralized provision of lender of last resort services

Inspired by Perry Mehrling and Fischer Black:

I think I'd take your future ideal financial model even further (slide 9). The C5 in your model provides what you call liquidity puts. I see no reason why these liquidity puts need be provided by a central bank. In the future, financial products called liquidity options - the option to buy or sell some asset (say Apple stock) at a guaranteed point in the bid-ask spread - would be popular financial products traded on organized exchanges. Just as Apple CDS allow investors to split off Apple credit risk and distribute it across the economy, so would Apple liquidity options split away the liquidity risk of transacting in Apple stock in the secondary market and evenly distribute this risk to those willing and capable of holding it.

A private liquidity options market has some advantages over a monopoly last resort system. Liquidity would be competitively priced and no longer supplied in an opaque manner. Central banks would either vacate the market for liquidity services or price their liquidity products off the private liquidity options market. Subsidies to or penalties on institutions anxious for liquidity insurance would be a thing of the past.

If central banks were to cease providing liquidity options, their sole role in the future would be as managers of the clearing and settlement system. The provision of paper money can be easily fulfilled by private banks. I guess central banks would also have to manage the price level.

The above is a free-banking view of the world. The lender-of-last resort role is transferred from central banks to private markets. It is distilled into just another financial product.

Did the Canadian government subsidize the big banks? The problem with pricing liquidity

Nick Rowe had a good comment on the CCPA's recent allegation that Canada's big banks were subsidized by taxpayers. In the comments I pointed out the difficulty of determining whether a subsidy or penalty had been paid to the banks because we lack a way to properly price and therefore compare the provision of liquidity services.

In effect, a government program called the Insured Mortgage Purchase Program (IMPP) announced it would buy $125 billion worth of insured NHA-MBS from the banks. It eventually bought $69 billion worth. In an alternative world, the same result is arrived at when

NHA-MBS liquidity options are sold by private actors to holders of NHA-MBS. These options allow NHA-MBS holders to sell all MBS back to the option writer at any time at a liquidity-protected price (some favourable point in the bid-ask spread). In a liquidity crisis bid-ask spreads increase, so the value of these options would quickly rise. The CMHC/IMPP provided MBS holders with a liquidity option, but we'll never know if they required MBS holders to pay the market price for this option.

Hey Nick, am I making any sense here?

If the Fed pegged to the loonie

Nick Rowe had an interesting post here. He asks how the Bank of Montreal would be different from the Federal Reserve if the Fed decided to peg it's currency to the Canadian dollar. I think the difference would be that BMO has access to Canadian Payments Association's LVTS (Canada's monopoly payments clearinghouse) and LOLR services provided by the Bank of Canada, whereas the Fed would have neither benefit.

More on the comparison of the Federal Reserve and ECB settlement mechanisms

Michiel Bijlsma and Jasper Lukkezen have a very good article on the Bruegel blog that deals with the question: why is there no Target2 debate in the US?

If Iceland were to adopt the Canadian dollar

Nick Rowe brings up the topic.

There are plenty of interesting comments there on how this would work. In particular, how would the Icelandic banks secure liquidity if they were to move to a Canadian  dollar standard? It seems to me that local Canadian banks could act as lenders of last resort to the Icelandic banking system.

Alternately, if Icelandic banks were willing to submit to Canadian regulation, then perhaps things could proceed one step further and get admittance to the Canadian Payments Association, Canada's central clearing system. As members they would get Bank of Canada lender of last resort assurance.

LOLR, ECB, and "too complicated for people to complain about"

Interesting post on Marginal Revolution, What is the difference between LOLR to banks and LOLR to governments?

Cowen: “Is this transfer of the subsidy to the sovereign a bug or a feature of the plan? Perhaps this is how the EU/ECB, viewed for a moment as a consolidated entity, will circumvent EU law to finance troubled governments. Is it possible that by changing collateral requirements they can alter the flow of funds to governments in a discretionary, ever-changing, and relatively non-politicized fashion? Does this satisfy the “too complicated for people to complain about” provision?”

Reply:

Good post. It is probably a feature, not a bug, and it is surely “too complicated for people to complain about,” at least for now.

This isn’t a new thing, though. The ECB has been lightening up collateral requirements for a few years now, presumably in part to finance weak governments through the back door. Remember when the ECB broke its rules and began accepting BBBminus-rated collateral?

Relevant Link:
Peter Garber, Deutsche Bank. The Mechanics of Intra Euro Capital Flight

Bagehot, Liquidity Insurance, and LOLR

Commented at Macromania on "On Bagehot's Penalty Rate".

 I think you have captured an inconsistency in the Bagehot principle. If the guiding rule is to lend at a penalty rate, then during a liquidity crisis how can the central bank ever fulfill its duty as lender of last resort? The rate that the market requires will rise but the penalty rate will rise even more, such that the central bank effectively prices itself out of the market. After all, if you can transact with the market at x%, why transact at x+1% with the LOLR? Some liquidity provider that is.

 At the same time, I'm sure we can all agree that the job of a LOLR is to provide liquidity, not set market prices.

 I think the problem here is that we haven't learnt how to properly understand and measure liquidity, and therefore can't price it and provide adequate liquidity insurance policies. Central banks certainly aren't great at it. Because their tools are so blunt, as an unfortunate by-product of acting as LOLR they clumsily prop up asset prices. And that gets everyone angry, and justifiably so.

 The best solution would be to devolve the provision of liquidity insurance to the market. Financial products would be developed to provide superior measures of liquidity, and the prices of liquidity for various assets would become public. Taxpayers would no longer have to worry about subsidizing sloppy efforts to provide liquidity to those who may not have paid the market price for the benefits the Fed provided them.

Some relevant links:

Liquidity Options by Golts and Kritzman
Liquidity and risk: liquidity as the value of an option to sell at the market price at WWCI (see bob's comments in particular)