Coinbase: "What if we call them rewards instead of interest payments?"

Here's a question for you: which U.S. financial institutions are legally permitted to pay interest to retail customers?

We can get an answer by canvassing the range of entities currently offering interest-paying dollar accounts to U.S. retail customers. It pretty much boils down to two sorts of institutions:

• Banks
• SEC-regulated providers like money market funds.

There seem to be a few exceptions. Fintechs like PayPal and Wise are neither of the above, and yet they offer interest-yielding accounts to retail customers. But if you dig under the hood, they do so through a partnership with a bank, in Wise's case JP Morgan and in PayPal's case Synchrony Bank. (Back in the 2000s, PayPal used a money market mutual fund to pay interest). So we're back to banks and SEC-regulated entities.

And then you have Coinbase.

Coinbase will pay 5% APY to anyone who holds USD Coins (USDC), a dollar stablecoin, on its platform. (Coinbase co-created USDC with Circle, and shares in the revenues generated by the assets backing USD Coin.) The rate that Coinbase pays to its customers who hold USDC-denominated balances has steadily tracked the general rise in broader interest rates over the last year or so, rising from 0.15% to 1.5% in October 2022, then to 4% this June, 4.6% in August, and now 5%.

Coinbase isn't a bank, nor is it an SEC-approved money market mutual fund. And unlike Wise and PayPal, Coinbase's interest payments aren't powered under the hood by a bank.

So how does Coinbase pull this off?

In short, Coinbase seems to have seized on a third-path to paying interest. It cleverly describes the ability to receive interest as a "loyalty program", which puts it in the same bucket as Starbucks Rewards or Delta's air miles program. The program itself is dubbed USDC Rewards, and in its FAQ, customers are consistently described as "earning rewards" rather than "earning interest."

This strategy of describing what otherwise appears to be interest as rewards extends to Coinbase's financial accounting. The operating expenses that Coinbase incurs making payments on USDC balances held on its platform is categorized under sales and marketing, not interest expense. 

Oddly, this key datapoint isn't disclosed in Coinbase's financial statements. Instead, we get this information from a conference call with analysts last year, in which the company's CFO described its reasoning for treating USDC payouts as rewards:

Source: Coinbase Q4 2022 conference call

 

The flow of "rewards" that Coinbase is currently paying out is quite substantial. Combing through its recent financials, Coinbase discloses in its shareholder letter that it had $1.8 billion of USDC on its platform at the end of Q2. Of that, $300 million is Coinbase's corporate holdings, as disclosed on its balance sheet. So that means customers have $1.5 billion worth of USDC-denominated balances on Coinbase's platform.

At a rewards rate of 5%, that works out to $75 million in annual marketing expenses. (Mind you, not everyone gets 5%. We know that MakerDAO, a decentralized bank, is only earning 3.5% on the $500 million worth of USDC it stashes at Coinbase). In any case, the point here is that the amounts being rewarded are not immaterial.

Interestingly, Coinbase does not pay rewards on regular dollar balances held on its platform. It only provides a reward on USDC-denominated balances. This gives rise to a yield differential that seems to have inspired a degree of migration among Coinbase's customer base from regular dollar balances to USDC balances. 

For instance, at the end of Q1 2023, Coinbase held $5.4 billion in U.S. dollar balances, or what it calls customer custodial accounts or fiat balances. (See below). By Q2 2023 this had shrunk to $3.8 billion. Meanwhile, USDC-on-platform rose from $0.9 billion (see below) to $1.5 billion.

Source: Coinbase Q1 2023 shareholder letter

As the above screenshot shows, Coinbase has tried to encourage this migration by offering free conversions into USDC at a one-to-one rate. It has also extended the program to non-retail users like MakerDAO, although its non-retail posted rates are (oddly) much lower than its retail rates. Institutional customers usually get better rates than retail.

Incidentally, Coinbase isn't the only company to have approached MakerDAO to sign up for its fee-paying loyalty program. Gemini currently pays MakerDAO monthly payments to the tune of around $7 million a year, but calls them "marketing incentives." Paxos has floated the same idea, referring to the payments as "marketing fees" that would be linked to the going Federal Funds rate. The aversion to describing these payments as a form of interest is seemingly widespread.

There's two ways to look at Coinbase's USDC rewards program. The positive take is that in a world where financial institutions like Bank of America continue to screw their customers over by paying a lame 0.01% APY on deposits when the risk-free rate is 5.5%, Coinbase should be applauded for finding a way to offer its retail clientele 5%.

The less positive take is that USDC Rewards appear to be a form of regulatory arbitrage. Given that Coinbase uses terms like "APY" and "rate increase" to describe the program, it sure looks like it is trying to squeeze an interest-yielding financial product into a loyalty points framework, which is probably cheaper from a compliance perspective. If Coinbase was just selling coffee, and the rewards were linked to that product, then it might deserve the benefit of the doubt. But Coinbase describes itself as on a mission to "build an open financial system," which suggests that these aren't just loyalty points. They're a financial product. And financial products are generally held to strict regulatory standards in the name of protecting consumers.

We've already seen hints of regulatory push back against the rewards-not-interest gambit so popular with crypto companies. In the SEC's lawsuit against Binance, it named Binance's BUSD Rewards program as a key element in Binance's alleged effort to offer BUSD as a security, putting it in violation of Federal securities registration requirements. Like Coinbase's USDC Rewards program, BUSD Rewards offered payments to Binance customers who held BUSD-denominated balances at Binance. BUSD is a stablecoin that Binance offered in conjunction with Paxos.

Coinbase's lawyers seem to have anticipated this argument and have already prepared the legal groundwork to rebut it. The SEC sent a letter to Coinbase in 2021 that asked why USDC Rewards was not subject to SEC regulation. In its response, Coinbase had the following to say:

Here's an interesting bit in which Coinbase goes into some detail why it believes USDC Rewards isn't a security: https://t.co/ZzXxvNkBsv I think it bears out the idea that once a firm starts offering a return, it risks straying into other regulatory frameworks. pic.twitter.com/DMC7l3Et33

— John Paul Koning (@jp_koning) August 4, 2022

Now, I have no idea whether this is a good argument or not. Having observed securities law from afar over the last few years, I'm always a bit flummoxed by the degree of latitude it offers. It seems as if a good lawyer could convincingly argue why my Grandma's couch is a security, or that Microsoft shares aren't securities.

If you think about it more abstractly though, loyalty points and interest are kind of the same thing, no? In an economic sense, they're both a way to share a piece of the company's revenue pie with customers. Viewed in that light, why shouldn't a program like USDC Rewards inherit the same legal status as Starbucks Rewards or air miles?

If Coinbase's effort to shape its USDC payouts as rewards ends up surviving, others will no doubt copy it. Wise and PayPal might very well stop using a bank intermediary to offer interest-paying accounts, setting up their own loyalty programs instead. A whole new range of investment opportunities marketed as loyalty programs might pop up, all to avoid regulatory requirements.

But it's possible to imagine the opposite, too. In a column for Atlantic, Ganesh Sitaraman recently described airlines as "financial institutions that happen to fly planes on the side." If loyalty points and interest are really just different names for the same economic phenomena, then maybe airline points, Starbucks Rewards, and USDC Rewards should all be flushed out of the loyalty program bucket and into stricter regulatory frameworks befitting financial institutions.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

How might Circle have managed its reserves differently?

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

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

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

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

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

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

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

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

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

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

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

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

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

Are Argentinians paying for Uber rides with bitcoins?

Earlier this month the following tweet elbowed its way onto my Twitter timeline:

The tweet comes from Anthony Pompliano, aka Pomp, who works at Morgan Creek Digital Asset where he runs a cryptocurrency fund.

So, have I been wrong all along about bitcoin? As anyone who has been reading me for a while will know, I've been skeptical of the bitcoin-as-money story. Rather than fulfilling Satoshi Nakamoto's vision as being a next generation medium of exchange, bitcoin has gone mainstream as a new type of gambling technology—an exciting decentralized zero-sum financial game. This is a somewhat useful role, but let's face it, it's not quite as revolutionary as digital cash.

But if Argentinians are indeed hailing rides and paying drivers directly with bitcoins, as Pompliano seems to be saying, then maybe I've been too quick to dismiss the bitcoin-as-money scenario. Paying for stuff is exactly what Satoshi Nakamoto intended bitcoin to do, right? So I dug further into the tweet.

Twitter: Couldn't find anything in the news about this. Anyone got a solid source?
Pomp: https://cointelegraph.com/news/uber-switches-to-bitcoin-in-argentina-after-govt-blocks-uber-credit-cards
Twitter: Pomp that was 2 years ago
Pomp: Does that make it less important?

And that's how Pomp left things. So it looks like I've got some work to do.

Here's the fine print. In 2016, the City of Buenos Aires ordered the major credit card companies to block Uber's App. Stanford Law School's WILmap project has a detailed post on this. So Argentinians suddenly found that while their MasterCard and Visa cards worked for everything else, they could no longer be used to get an Uber ride.

Contra Pompliano, Uber did not respond by allowing users to purchase rides with bitcoin. Rather, the company pointed out that anyone who had a certain type of pre-paid debit card could sneak by the Uber embargo.

To carry out the hack, the first thing that an Argentinian had to do was to apply for a prepaid debit card from any of Entropay, EcoPayz, Payoneer, or ZapZap. These are non-Argentinean payments companies. Entropay, for instance, is based in Europe and issues Visa-branded debit cards in partnership with a Malta-based bank, Bank of Valletta. Once Entropay had approved an Argentinean for an account, either a physical debit card would be sent by mail to the applicant's address in Argentina or a virtual card would be instantly created. An Argentinean could then log on to Entropay's website and use their local credit card, the same one that had had been neutered by the Uber embargo, to top up the Entropay prepaid debit card. With the debit card now funded, it could be used locally to pay for Uber rides.

Under the hood, prepaid cards issued by Entropay are really just regular Visa cards. So when an Uber ride was requested in Buenos Aires, an Entropay card would have used the same Visa rails that a regular Argentinean credit card used. Why would an Entropay Visa card be accepted but a regular Visa card denied?

The nub seems to be this: the ban seems to only have applied to payments instigated by domestically-issued cards. When payments to Uber originated from Entropay or any of the cards listed above, they were earmarked as originating internationally, in Entropay's case probably from Malta-based Bank of Valetta, and so Entropay payments were able to squeak by. Voila, by swapping domestic cards with international ones, Argentinians could avoid the blockade.

A number of bitcoin debit cards also enabled the hack, including Xapo and Satoshi Tango. Maybe this is what Pomp is referring to in his tweet. But it would be wrong to say that these cards allowed Argentinians to "purchase rides with Bitcoin," as he claims.

Prior to paying for an Uber ride, an Argentinian had to load U.S. dollars onto the bitcoin debit card by selling bitcoins for dollars on a bitcoin exchange. Either the card owner did this manually, or the card provider rapidly sold bitcoin in the very same instant that the payment was requested. In either case, bitcoins weren't flowing from the card holder to Uber. A fiat currency had been pre-loaded onto the card, and everything after that was just a  regular transfer over the Visa or MasterCard network.

These bitcoin debit cards are really no different from gold-based debit cards. Nor are they any different from the cheque-writing and debit card privileges provided by some U.S. money market mutual funds. Neither bitcoins nor gold not mutual fund units are being transferred from the card holder to the seller. Rather, each item is being quickly sold and turned into fiat, then processed along the same rails as any other payment.

In theory, all sorts of assets might be debit card-ized in this way. Buy a coffee with your Facebook debit card, for instance, and underneath the transaction's hood your Facebook share(s) are being quickly sold on the stock market for dollars, those dollars being the medium that ultimately settles the payment between you and the cafe. Complicating matters is that Facebook shares, which trade at $165, can't be cut into fractions, unlike bitcoins or fractions of a gold bar, so paying for a $3 coffee might get a bit awkward.

So returning to the tweet, recall that Pomp proclaimed that "more companies will begin using Bitcoin to fight back against corruption." But this wasn't the case with Uber. As you can see from the above, the company fought back by pointing to a neat hack of the existing credit card networks. The reason that Xapo and Satoshi Tango bitcoin cards were able to enable Uber purchases in Argentina wasn't because of their unique bitcoin nature. In Xapo's case, the card was issued by Wave Crest Holdings, a Gibraltar-based company. Like a regular fiat-based Entropay card, the incoming Xapo card payment was classified as an international one, and thus it escaped the domestic blockade.

Most bitcoin debit cards are no longer functional. Wave Crest, the card provider through which most bitcoin firms partnered, was suspended by Visa for non-compliance with Visa's rules in early 2018. If you go to VoyEnUber.com, an independent Argentinean website that reports on Uber, you'll see that it has delisted Xapo and Satoshi Tango from its list of ways to pay for Uber. The non-bitcoin prepaid debit cards are still there. So Pomp's tweet is twice wrong: 1) not only were Argentinians not using bitcoin to pay for Uber rides in 2016, but; 2) by the time of his tweet, they are not even making Xapo card payments, since Visa has cut that option off.

In addition to using foreign cards to pay for Uber rides, it seems that people in Buenos Aires are also paying with cash. According to the article, when riders pay with banknotes, there is no way for Uber to collect its 25% commission, so driver's are increasingly indebting themselves to the company. Or put differently, drivers are accepting cash, then paying Uber with a personal IOU. The irony here is that a combination of old fashioned fiat banknotes and trust-based IOUs—not bitcoin—are being used to "fight back against corruption."

So be careful what you read, folks. This sort of reminds me of the Zimbabwe bitcoin story from last year, which was seen as a crystallization of the long-held dream that bitcoin would help unbanked Africans. I rebutted that particular myth here.

Pompliano seems like a nice guy, so I'll just assume that excitement got the best of him. I normally try to avoid someone is wrong on the internet posts, but since he has over a 100,000 followers on twitter, and this particular meme has been retweeted over 2,000 times, I feel like it's my duty to try undo some of his error. The good thing with twitter is you can untweet retweets, feel free to go ahead and do that right now. :)

ETFs as money?

Blair Ferguson. Source: Bank of Canada

Passive investing is eating Wall Street. According to 2015 Morningstar data, while actively managed mutual funds charge clients 1.08% of each dollar invested per year, passively managed funds levy just a third of that, 0.37%. As the public continues to rebalance out of mutual funds and into index ETFs, Wall Street firms simply won't be able to generate sufficient revenues to support the same number of analysts, salespeople, lawyers, journalists, and other assorted hangers-on. It could be a bloodbath.

Here is the very readable Eric Balchunas on the topic:

Because when an inv switches from active to passive, it basically means a 70% drop in revenue for industry. #DOLrule https://t.co/HntHyDi3rJ

— Eric Balchunas (@EricBalchunas) April 7, 2016

Any firm that faces declining profits due to narrowing margins can restore a degree of profitability by driving more business through its platform. In the case of Wall Street, that means arm-twisting investors into holding even more investment products. If Gordon Gecko can get Joe to hold $3000 worth of low margin ETFs then he'll be able to make just as much off Joe as he did when Joe held just $1000 in high margin mutual funds.

How to get Joe to hold more investments? One way would be to increase demand for ETFs by making them more money-like. Imagine it was possible to pay for a $2.00 coffee with $2.00 worth of SPDR S&P 500 ETF units. Say that this payment could occur instantaneously, just like a credit card transaction, and at very low cost. The coffee shop could either keep the ETF units as an investment, pass the units off as small change to the next customer, use them to buy coffee beans from a supplier, or exchange them for a less risky asset.

In this scenario, ETF units would look similar to shares of a money market mutual fund (MMMF). An MMMF invests client money in corporate and government debt instruments and provides clients with debit and cheque payments services. When someone pays using an MMMF cheque or debit card, actual MMMF shares are not being exchanged. Rather, the shares are first liquidated and then the payment is routed through the regular payments system.

Rather than copying MMMFs and integrating ETFs into the existing payment system, one idea would be to embed an ETF in a blockchain, a distributed digital ledger. Each ETF unit would be divisible into thousandths and capable of being transferred to anyone with the appropriate wallet in just a few moments. One interesting model is BitShares, provider of the world's first distributed fully-backed tracking funds (bitUSD tracks the U.S. dollar, bitGold tracks gold, BitCNY the yuan, and more). I wrote about bitUSD here. Efforts to put conventional securities on permissioned blockchains for the purpose of clearing and settlement are also a step in this direction.

Were ETFs were to become a decent medium of exchange, people like Joe would be willing to skimp on competing liquid instruments like cash and bank deposits and hold more ETFs. If so, investment managers would be invading the turf of bankers who have, until now, succeeded in monopolizing the business of converting illiquid assets into money (apart from money market mutual fund managers, who have tried but are flagging).

Taken to the extreme, the complete displacement of deposits as money by ETFs would get us to something called narrow banking. Right now, bankers lend new deposits into existence. Should ETFs become the only means of payment, there would be no demand for deposits and bankers would have to raise money in the form of ETFs prior to making a loan. Bank runs would no longer exist. Unlike deposits, which provide fixed convertibility, ETF prices float, thus accommodating sudden drops in demand. In other words, an ETF manager will always have just enough assets to back each ETF unit.

Two problems might emerge. Money is very much like an insurance policy—we want to know that it will be there when we run into problems. While stocks and bonds are attractive relative to cash and deposits because they provide superior returns over the long term, in the short term they are volatile and thus do not make for trustworthy money. If we need to patch a leaky roof, and the market just crashed, we may not have ETF units enough on hand. Cash, however, is usually an economy's most stable asset. So while liquid ETFs might reduce the demand for deposits, its hard to imagine them displacing traditional banking products entirely.

A fungibility problem would also arise. Bank deposits are homogeneous. Because all banks accept each others deposits at par and these deposits are all backed by government deposit insurance, we can be sure that one deposit is as good as another. And that homogeneity, or fungibility, means that deposits are a great way to do business. ETFs, on the other hand, are heterogeneous. They trade at different prices and follow different indexes. Shopkeepers will have to pause and evaluate each ETF unit that customers offer them. And that slows down monetary exchange—not a good thing.

Somewhat mitigating ETF's fungibility problem is the fact that the biggest ETFs track the same indexes. On the equity side, three of the six largest ETFs track the S&P 500 while on the bond side, the two largest ETFs track the Barclays Capital U.S. Aggregate Bond Index. Rather than just any ETF becoming generally accepted media of exchange, the market might select those that track the two or three most popular indexes.

In writing this post, I risk being accused of blockchain magical thinking—distributed ledgers haven't yet proven themselves in the real world. All sorts of traditions and laws would have to be upended to bring the world of securities onto a distributed ledger. Nevertheless, it'll be interesting to see how the fund management industry manages to squirm out of what will only become an increasingly tighter spot. Making ETFs more liquid is an option, though surely not the only one.

---

PS. Here is the blogosphere's own Tyler Cowen (along with Randall Kroszner) on "mutual fund banking" in 1990:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

With the rise of ETFs and blockchain technology, the modern version of mutual fund banking would be something like distributed ETF banking described in the above post,

Shadow banks want in from the cold

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out.

In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers.

To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as far as removing these requirements, it did reduce them and allowed workarounds like "sweeps." But the shadow banking system never stopped growing.

In negative rate land, everything is flipped around. Central bank reserve requirements no longer act as a tax on banks, they can be a subsidy. The Danmarks Nationalbank, Swiss National Bank and Bank of Japan have resorted to a strategy of tiering, where only a small portion of bank reserves are charged a negative rates (say -0.5%) while the rest (the inframarginal amount) can be deposited at the central bank where it earns 0%. Setting a 0.5% penalty on the marginal amount has been enough to drive interest rates on short term government bills and overnight lending rates to -0.5%. Banks that can invest some portion of their funds at 0% rather than the going market rate of -0.5% are getting a nice gift. They can in turn pass this windfall on to their customers by protecting them from negative rates. Shadow banks, which don't have  access to these subsidies because they don't have accounts at the central bank, are at a competitive disadvantage; they must invest all their funds at the going market rate of -0.5% and will therefore have to share the pain with their customers by reducing deposit rates into negative territory. This growing deposit rate gap should lead to retail and corporate flight from shadow bank deposits into protected regulated bank deposits.

We've certainly seen this in Japan. Around ten MMMFs quickly closed their doors to new funds after the Bank of Japan reduced rates to -0.1%. And now money reserve funds (MRFs) are clamouring for protection from negative rates. So while it used to be a disadvantage to be a subjugated bank and good to be a shadow bank, in negative rate land it's the exact opposite. Better to be shackled than to be free.

By the way, I'm wondering if this is why the ECB decided not to introduce tiered deposit rates last week, pointing to the "complexity of the system." Europe has a relatively large MMMF industry compared to Japan; perhaps it wanted to avoid any financial turbulence that might be set off by subsidies that benefit one set of bankers but not the other.

Hike rates when you hear the creak of inflation at the door, not when you see the whites of its eyes

A common argument against the Fed raising interest rates next week is the asymmetry in risks that it faces. If it keeps rates low too long and sets off inflation, no problem: it can quickly hike rates a few times to bring prices back in line. However, if it boosts rates too early and an unintended slowdown sets in, the Fed won't have room to cut a few times in order to fix its mistake. That's because the Fed is at the zero lower bound, the edge of the world in monetary policy terms. To avoid this conundrum, the Fed should hold off as long as possible before raising, at least until it "sees the whites of inflation's eyes."

As Paul Krugman points out, the asymmetry argument is only a recent one. Historically U.S. interest rates have hovered far above zero. If the Fed made a mistake, it didn't have to worry about falling off the edge of the world in order to fix the situation, it could simply ratchet rates down a few times. Rather than waiting till the last minute to see the whites of inflation's eyes before hiking, the FOMC only had to hear the creak of inflation at the door.  

I don't buy the current asymmetry argument. I might have bought it back in 2013, but the data has changed.

Over the last year, Sweden, Switzerland, Denmark, and the ECB have all demonstrated to the world that central banks can safely lower rates into negative territory without setting off the sorts of ill effects that economists have always feared, the main one being a race into 0% yielding cash. The theory here is that if a central bank reduces rates to, say, -0.1%, then paper cash—which pays a superior 0% return—starts to look pretty attractive. An arbitrage process begins whereby central bank deposits are converted into cash until all deposits have disappeared. Thus rates can't be reduced below 0%.

Evidence over the last 12 months shows otherwise. Denmark's Nationalbank has kept its deposit rate at -0.75% since early February. Danes, however, are not scrambling for banknotes, as the chart below shows. After seven months of negative rates, cash and coin outstanding are growing at a rate that lies pretty much at its two decade average.

The Swiss National Bank has maintained a -0.75% overnight rate since January, yet there's been no spike in Swiss paper franc demand, as the next chart shows. In fact, cash outstanding seems to be growing at one of its slowest rates in years.

We'd expect the demand for Swiss cash to be especially sensitive when interest rates fall below zero because the SNB issues the world's largest value banknote; the hefty 1000 sFr. The more valuable the banknote the lower the cost of storing wealth in cash form. These carrying costs are particularly important in determining the profitability of flight into cash at negative interest rates. A central bank can push rates a sliver below 0% without setting off a flight out of deposits into banknotes as long as there are inconveniences in storing cash. The greater these inconveniences, the larger that sliver.

The fact that the SNB has been able to keep rates at -0.75% for seven months now without setting off a stampede into 1000 notes indicates that the burdens of holding Swiss currency are higher than everyone had previously thought. It would seem that investors would rather lose 0.75% each year than bear the costs of storing 1000s. At some negative interest rate, maybe -1.5%, the flight into Swiss notes will start. But it hasn't yet. As for the U.S., its highest value banknote is the lowly $100, so it's fair to assume that the costs of storing U.S. paper money are significantly higher than Swiss money. Which means that if the Swiss can safely cut to -0.75% without setting off cash arbitrage, the Fed should be able to descend to at least -1.0% before panic ensues.

The second greatest fear surrounding sub zero U.S. rates has always concerned money market mutual funds. The worry here is that should the Fed reduce rates too deep, a financial intermediary known as a money market mutual fund (MMMF) will 'break the buck,' causing panic and terror among ordinary investors.

MMMFs are like regular mutual funds except their share price stays fixed at US$1.00. Investors can cash out at that price whenever they want, enjoying low but steady dividend payments until then. MMMFs maintain par conversion by investing in safe, highly liquid short term debt. However, if the Fed were to drive short term rates into negative territory, MMMFs would be forced to invest in assets that promise a negative return. $1000 invested in t-bills, for instance, would be worth only $999 upon maturity. That means that an MMMF simply wouldn't have a sufficient quantity of assets to allow everyone to redeem their shares at US$1.00. The fund will "break the buck," or mark its share value down to something like 99 cents to allow for full redemption. Since MMMFs are supposed to be cash-like—in fact, many of them offer cheque-writing capability—such a development would be disastrous, or so goes the story.

I don't consider breaking the buck to be a terrible outcome, but even if it is, European money market mutual funds—faced with negative interest rates—have already found an ingenious way to avoid it; a Reverse Distribution Mechanism. Rather than reducing redemption below par, MMMFs simply dock the number of shares that each shareholder has in his or her account. For example, as rates slide below zero, instead of 100 units being worth only $0.99 each, a shareholder forfeits one unit and ends up with 99 units worth $1.00 each. The deeper rates fall, the less units each investor owns. The genius of this patch is that the purchasing power of each share stays constant, but the negative interest rate is efficiently passed on to the owner of the MMMF.

So fears of a dash into cash at 0% and a collapse of MMMFs are just bogeymen. If the Fed hikes to 0.5% this month—and this proves to be a mistake—it still has plenty of room to make things right. Given how well Europe has coped over the last twelve months, the Fed can easily cut rates another 1.5% to -1.0%; that's six quarter-point reductions or thirty ten-point cuts. Only when rates falls beyond Swiss or Danish levels, say to -1.0%, will the Fed find itself in truly asymmetrical territory. (If necessary, here are some simple ways to allow for even more negative rates).

To be clear, that doesn't mean I think the Fed should hike rates next week. The fact that the FOMC continues to undershoot its 2% core inflation target would seem to indicate that holding off might be the right thing to do. Rather, I don't think that Fed policy makers need to wait to see the white's of inflation's eyes before they hike, they need only wait to hear the creak of inflation at the door.

Stablecoin

The whippersnappers who work in the cryptocurrency domain are moving incredibly fast.

As I've been saying for a while, assets like bitcoin (or stocks) are unlikely to become popular as exchange media; they're just too damn volatile relative to incumbent fiat currencies. There's a new game in town though: stablecoin. These tokens are similar to bitcoin, but instead of bobbing wildly they have a fixed exchange rate to some other asset, say the U.S. dollar or gold.

Now this is a promising idea. If a crypto-asset can perfectly mimic a U.S. dollar deposit's purchasing power and risk profile, and do so at less cost than a bank, then the monopoly that banks currently maintain in the realm of electronic payments is in trouble. Rather than owning a Bank of America deposit, consumers may prefer to hold an equivalent stablecoin that performs all the same functions while saving on storage and transaction fees. To compete, banks will either have to bribe customers with higher interest rates on deposits, thus putting a crimp in their earnings, or go extinct.

Let's look at these stablecoin options more closely.

Type A: One foot in the legacy banking sector, one foot out

The unifying principle behind each type of stablecoin is the presence of some sort of backing, or security. Bitcoin, by way of comparison, is not backed. Stablecoin backing is typically achieved in two ways. With type A stablecoin, an organization creates a distributed ledger of tokens while maintaining a 1:1 reserve of dollars at a traditional bank. Owners of the tokens can cash out whenever they want into bank dollars at the stipulated rate, thus ensuring that the peg to the dollar holds. Until then, the tokens can be used as a stable medium of exchange. Examples of this are Tether and Ripple U.S dollar IOUs.

Could stablecoin be a bank killer?

We can think of a bank as enjoying stock and flow benefits from its deposit base. The existence of a stock of deposits provides it with a cost of funding advantage while the flow of those deposits from person to person generates fees.

Type A stablecoin pose no threat to the stock benefits that banks enjoy. After all, each stablecoin is always backed by an equivalent bank deposit held in reserve. If people want more stablecoin, the deposit base will have to grow, and that makes traditional bankers happy.

The flow benefits, however, are where the fireworks start. At the outset, people who receive stablecoin--through lack of familiarity--will probably choose to quickly cash out into good old fashioned deposits. But if stablecoin provides an extra range of services relative to deposits, rather than "kicking" back into the bank deposit layer, more people may choose to keep their liquid capital in the overlying stablecoin layer. Merchants will have more incentives to accept stablecoin, only adding to the snowball effect. Once all transactions are routed through the stablecoin layer, underlying deposits will have become entirely inert. While banks will continue to harvest the same stock benefits that they did before, they'll have effectively yielded up all the flow benefits to the upstarts.

So while Type A stablecoin doesn't kill banks, it certainly knocks them down a few wrungs.

By constructing a new layer on top of the deposit layer, stablecoin pioneers would be cribbing off the same playbook that bankers have been using since the profession emerged. Centuries ago, the first bank deposit layer was built on top of an original base money layer. Base money consisted then of gold and silver coin, but in more recent times it morphed into central bank banknotes and deposits. Because bank deposits inherited the price stability of base money (thanks to the promise to redeem in base money), and were highly convenient, bankers succeeded in driving transactions out of the base coinage layer and into the deposit layer. That's why gold and silver rarely appeared in circulation in the 19th century, being confined mostly to vaults. Perhaps one day stablecoin innovators will succeed in confining bank deposits to the "vault" in favour of mass stablecoin circulation. If this sort of displacement hadn't already been done before, I'd be more skeptical.*

Type B: Both feet out of the banking sector

More ambitious are type B stablecoin, which try to liberate themselves entirely from the traditional banking layer. Rather than using old-fashioned bank deposits as backing, a pre-existing issue of distributed digital tokens is used to secure the stablecoin's value.

As an example, take bitShares, a brand of bitcoin-like unbacked tokens. These tokens are every bit as volatile as bitcoin, up 10% one day and down 10% the next. Here's a chart. So far nothing new here, there are literally hundreds of bitcoin look-alikes.

The unique idea is to turn volatile water into stable wine by requiring that a varying amount of bitShares be used to back a second type of token, bitUSD. A bitUSD is a digital token that promises to provide its owner with a U.S. dollar-equivalent return. As long as each bitUSD is secured by, say, $3 worth of bitShares, the owner of one bitUSD will be able to cash out (into one U.S. dollar worth of bitShares) whenever they want and the peg to the U.S. dollar will hold.**

My understanding is that bitUSD, which debuted last year, is coming close to consistently hitting its peg. If bitUSD were to catch on as an alternative transactions layer, banks would lose not only their flow benefits but also stock benefits. After all, a bitUSD-branded stablecoin is not linked to an underlying deposit. We're talking complete devastation of the banking industry.

The system has some warts, however. If the market price of bitShares starts to fall, the scheme requires that more collateral in the form of bitShares be stumped up by the issuer of a bitUSD. This makes sense, it protects the peg. But what if the value of bitShares falls so much that the total market capitalization of bitShares is insufficient to back the total issue of bitUSD? At that point, bitUSD "breaks the buck." A bitUSD will be only worth something like 60 cents, or 30 cents, or 0 cents. Breaking the buck is what a U.S. money market mutual fund is said to do when it can't guarantee its one-to-one peg with the U.S. dollar.   

I'm skeptical of type B stablecoin for this very reason. Cryptocoin like bitcoin and bitShares are plagued by the zero problem; a price of nothing is just as good as a price of $100. They thus make awful backing assets, and any stablecoin that uses them as security has effectively yoked itself to the mast of the Titanic. A breaking of the buck isn't just probable, it is inevitable. Stability is an illusion. Maybe I'd get a bit more bullish on type B stablecoin if there emerged a brand that used digital backing assets not subject to the zero problem.

Anyways, keep your eye on these developments. Like I say, the young whippersnappers who are working on these projects aren't slowing down.

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*In principle, type A stablecoin ideas are very similar to m-Pesa and Paypal. Both of these services construct new banking layers, but keep one leg back in the the existing banking infrastructure by ensuring that each Paypal or m-Pesa deposit is fully backed by deposits held at an underlying brick & mortar bank. See Izabella Kaminska, for instance, on m-Pesa.
 ** For those who like central bank analogies, this is an example of indirect convertibility, whereby a central bank sets market price of its liabilities in terms of, say, a bundle of goods, but only offers redemption in varying amounts of gold. See Woolsey and Yeager.  
*** Another working examples of Type B stablecoin is NuBits. Conceptual versions include Robert Sam's Seignorage Shares, the eDollar, and Vitalik Buterin's Schellingcoin.