What's the relationship of payments and monetary policy?

Payments and Monetary Policy

A

B

A

B

0

+

\(-\)

Payments and Monetary Policy

A

B

0

+

\(-\)

Option 2: borrow from another bank

Payments and Monetary Policy

The Impossible Trinity (macroeconomics)

free flow of capital

Control exchange rate

Control interest rate

Stablecoins

pulled from Nick Carter's talk on "Will stablecoins serve or subvert U.S. interests?"

What makes a Stablecoin stable?

What makes a Stablecoin stable?

• stablecoin (SC)
  • 1 SC = 1 fiat unit (FU)
• But: stablecoins trade on markets
  • 1 SC \(\approx\) 1 FU
  • \(\to\) 1 SC \(\lessgtr\) 1FU
• How do we get it "close" all the time?
  • Arbitrage mechanism!
• \(\to\) there is an alternative mechanism to exchange SC against FU

Case 1: price(1 SC) \(>\) 1 FU \(\to\) SC expensive

collateralized stablecoin

arbitrageur

issuer

market

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

collateralized stablecoin

arbitrageur

issuer

market

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

under-collateralized stablecoin

arbitrageur

issuer

market

Case 2: price(1 SC) \(>\) 1 FU \(\to\) SC cheap

arbitrageur

issuer

• for fully decentralized algo/smart contract stablecoin: there is no dollar to give!

The Case of Luna-Terra

market

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

arbitrageur

issuer

• for fully decentralized algo/smart contract stablecoin: there is no dollar to give!

The Case of Luna-Terra

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

• exchanges these \(q_s\) UST for LUNA at dollar-price for LUNA
•  network value not affected:
  \[Q_lp_l=(Q_l+q_l)p_l'\]
• solve this to get\[p_l'=p_l-\frac{q_s}{Q_l}.\]

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

• \(p_l'\) cannot drop below \(\underline{p}_l\)
• Maximum feasible quantity forUST: \[\overline{q}_s=Q_l(p_l-\underline{p}_l)\]
• \(\overline{q}_s=\) collateral value of aggregate LUNA tokens
  • \(Q_s\le\overline{q}_s\):  UST  is fully collateralized
  • \(Q_s>\overline{q}_s\) UST is under- collateralized & \(\exists\)  price deviation that would cause a collapse of LUNA and UST.

Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap

• Can compute maximal price deviation
• \(q_s\)  that restablishes depends on peg-deviation price \(p_s\) and \(\sum\) UST \(=Q_s\)
• minimum price (1-price is max deviation)
  \[\underline{p}_s=\left(1- \frac{Q_l}{Q_s}(p_l-\underline{p}_l )\right)^2\]
  
   

Stablecoin use cases

What do central bankers think about stablecoins?

What do central bankers think about stablecoins?

Stablecoin use cases

• stablecoins as payments compete with existing rails
• factors for adoption are
  • price
  • convenience
  • reach/applications
  • interoperability (e.g., credit availability, acceptance)

Source: On-chain Foreign Exchange and Cross-border Payments by Austin Adams, Mary-Catherine Lader, Gordon Liao, David Puth, Xin Wan (2023) [team from UniSwap Labs]

• Canada has 800,000 international students
   
• admits around 300,000-400,000 annually
   
• Government of Canada: "We estimate that in 2017 and 2018 respectively, international students in Canada spent $18.4 billion and $22.3 billion on tuition, accommodation, and discretionary spending."
   
• Most of these funds are transferred from foreign countries to Canada in large sums.
   
• Students regularly get harrassed by tellers/banks about the source of their funds.

Canada is a country of international students

Risks to Financial Stability

Broad Blockchain Risks to Financial Stability

Stablecoin Run Risks

Stablecoin Run Risks

• currently
  • borrowing and lending is balance sheet based
  • Central Bank and Risk Regulators (e.g. OSFI and OCC) effectively ensure fungibility of bank money
• private stablecoins
  • would spread across applications, wallets, and functions
  • \(\to\) stablecoin failure would disrupt every aspect of commerce 

Stablecoin Run Risks

Source: "Stablecoin Runs and the Centralization of Arbitrage," by Ma, Zeng, Zhang, 2023

• existing stablecoins
  • issued by firms (Circle, Tether) in a primary market at price \(p_p=\$1\)
  • creation/redemption by limited parties (arbitrageurs)
  • stability mechanism: 
    • buy stablecoin from issuer if \(p^s>1\)
    • redeem at issuer if \(p^s<1\)
    • \(\to\) arbitrageurs are liquidity providers in secondary market
• why run: Dymand-Dybvig-stype framekwork
  • issuers' reserves are somewhat illiquid hold 
  • run occurs if fear that arbitrageurs leave market when issuer stops redemptions

Stablecoin Run Risks (2)

Source: "Stablecoin Runs and the Centralization of Arbitrage," by Ma, Zeng, Zhang, 2023

• key mechanism: limited number of arbitrageurs
• two opposing effects:
  • many
    • easy to sell
    • more efficient pricing
    • but: fast depletion!
  • few (=harder to redeem and more market power)
    • hard to sell
    • more price impact in the secondary market
    • then: pre-emptive running more expensive

volatility (USDT)\(>>\)volatility (USDC)

stylized facts reg arbitrageurs

• USDT \(\approx\) 5
• USDC \(\approx\) 500

"haircuts proxy for the discount incurred when illiquid assets are converted into cash at short notice"

Stablecoins and Deposit Markets

Stablecoins and Deposits

• Circle
  • issued $338B
  • redeemed $302B
• supported >T$10 transaction volume
• prior to SVB held 20% in deposits
  • \(\to\) high movements that are beyond the control of issuer
  • \(\to\) not everyone can redeem
• during the SVB crash (on March 9) Circle requested the transfer of about $5B away from SVB

Source: Jeremy Allaire testimony to the U.S. Congress , June 14, 2023 https://www.circle.com/executiveinsights/payment-stablecoins-support-the-dollar-and-u.s.-economic-competitiveness

Crypto-assets incl. Stablecoins and Deposits

Canadian Banks' Financing with Retail Deposits

Stablecoins and Deposits

• Best backing for a stablecoin? 
  • \(\to\) reserves!
  • \(\to\) makes a stablecoin issuer a "narrow bank"
• What if DeFi applications serve "real" finance?
  • DeFi Lending
  • DEX trading

Source of savings: 

• better risk sharing among liquidity providers
• better use of capital

AMMs applied to equity trading could save \(\approx\) 30% of transaction costs

Source: "Learning from DeFi: Would Automated Market Makers Improve Equity Trading?" working paper, Malinova & Park 2023

Automate Investment Strategies for Lending Pool Deposits

A Consequence of Liquidity Mining: Yield Aggregators

Stablecoins and Deposits

• DeFi applications for "real" finance
  • DeFi Lending?
    • Lending club on blockchain? (incl. personal loans etc)  
    • pools would be mostly stablecoin-based
  • DEX trading?
    • tokenized stocks require cash and stock deposits
    • on chain FX require stablecoins in multiple currencies

Small Open Economy Risks

Currency Competition

Source: "The Coming Battle of Digital Currencies," Will Cong and Simon Mayer, 2022

• paper with CBDCs, private stablecoins, and cryptocurrencies
• dominant, strong, and weak fiat currencies
• assumes CBDCs would transcend brokers

• non-USD, solid fiat currencies benefit from CBDC introduction
• dominant country CBDC (widely available) or stablecoin: weak countries face digital dollarization
• weakest countries benefit from crypto adoption

Findings

Source: "Decrypting new age international capital flows", C. Graf von Luckner, Carmen M. Reinhart, Kenneth Rogoff, JME 2023

Weak Fiat vs. Crypto: Some Empirical Evidence

Cracking the Code: How the US Government Tracks Bitcoin Transactions By YoonJae Chung Seoul International School (2019)

no fungible tokens allowed, but NFTs OK.

Cyberattacks and Hacks

Risk is in every layer of the tech stack!

• Network Layer
  • DDoS attacks etc.
• Blockchain Layer
  • Sybil attacks
  • MEV
• Smart Contract Layer
  • Malicious code
  • Bug exploits
• Interface Layer
  • Oracle attacks
  • Malicious plug-ins (e.g., malicious wallet installation etc.)

Cyberattacks and DeFi-Thefts

Tech Overload: Solana

Special Use Case: New Forms of Prudential Regulation without Regulators?

Fundamental Problem for centralized exchanges

• Assets: cash in bank accounts and crypto assets in exchange wallets

• Liabilities:  customers' crypto and cash deposits

Proof of Assets & Liabilities

Money Laundering and Crime

Basic FINTRAC Rules for Money Services Businesses

• Basic rule: for any virtual currency transaction money services businesses need to verify and record the identity of the person involved
   
• Transactions over $10,000 need to be reported
   
• lots of smaller rules surrounding suspicious activties

\(\Rightarrow\) the rules are "tight"

Big Picture Concern

• tight KYC and monitoring rules make it hard for criminals to use illicitly obtained funds
   
• tight rules raise the risk of detection
   
• tight rules make people's lives harder
  \(\to\) trade-offs
   
• no rules will make it impossible to move illicit funds
   
• specific concern in the digital world: giving criminals SCALE

Banned addresses (usually by OFAC order)

Tornado cash

August 8, 2022: OFAC sanctions Tornado Cash

Chainalysis Crime Report

The Common View

Summary on Concerns regarding Stablecoins

back to Nick Carter's talk on "Will stablecoins serve or subvert U.S. interests?"

Asset Tokenization

Key Institutional Features of Equities

• listed equities are
  • securities by definition
    • restrictions on who can hold them
    • exchange and trading rules
    • knowledge of ownership
    • reporting requirements
  • well-established custody and ownership transfer with regulated roles
  • difficult for beneficiary owner to "use" asset other than transfer

• If held on a blockchain, what challenges arise and what would need to change?

Blockchain Ownership Attribution

• for the blockchain, an asset is always owned by
  • externally owned account
  • smart contract
• externally owned accounts can be "reached" by, e.g., blockscan
• smart contract ownership is trickier

Institutional Differences: The Investment Process

Asset Tokenization or
"The Creation of Asset-Linked Tokens"

Tokenization of stocks is nothing new: American Depository Receipts

Blockchain Tokenization has many options

existing investor/
issuer

Token Standards

• ERC-20 = fungible token with minimal features such as
  • balanceOf: how much does an address own?
  • totalSupply: how many is there?
  • approve: (contract owner allows token withdrawal)
  • transfer: allows a holder to send a token).
• ERC-721 = non-fungible (has meta-data to describe the token; e.g. website URL or data hash)
• ERC-1155 = limited units of non-fungible
• there are other standards that allow e.g.:  
  • ERC-1726 dividends
  • ERC-4626 interest payments
  • ERC-1400/1404
  • ERC-3643/ERC-621: restricts initial distributions

Some basic facts

Fact 1: Ownership of tokenized asset can be

• a person/legal entity
• a smart contract

Fact 2: By default issuers do not know who owns their tokens 

Fact 3: Investors who hold tokens in DeFi smart contracts have fluctuating holdings.

Fact 4: General ownership restrictions are almost impossible to enforce, and transfer restriction would negate advantages of tokenization

Problems that require solving

ADR issuing bank handles

• shareholder communications
• dividend payments
• other recording-keeping

Some remedies for communication and dividends

Problems that require solving

ADR issuing bank handles

• shareholder communications
• dividend payments
• other recording-keeping

Remaining FIs handle

• trading and transfer rule enforcement of ADRs

Broader Implications for the Financial Industry and the Financial System

Asset tokenization would likely create a massive expansion in demand for stablecoins 

Business Risk to FIs: Customers choose what's best for them

Effects on the IO of Financial Services

Last Words

Summary

• From a conceptual and efficiency standpoint, the advantages of tokenization are a no-brainer
• The current legal and regulatory environment needs to adapt
• There are still many tech problems to be solved
• There will be impacts on the movement of money \(\to\) financial stability

Central Bank-Issued Digital Currencies

Evolution

The State strikes back: CBDCs

CBDC = Central Bank issued Digital Currency

not a cryptocurrency \(\to\) just a "normal" liability on central banks balance sheets

• BIS Jan 2019: "Proceed with caution"

• BIS Jan 2020: "Impeding Arrival"

Is it coming?

Source: CBDCtracker.org

What's the problem and what should a CBDC look like?

current problems

future concerns

crib sheet

too slow

too expensive

not flexible

lack of competition

disintermediation
by new players (Libra)

data harvesting
with no way out

ineffectiveness
of monetary policy

demise of the Loonie

two-tiered world in Canada

fast

cheap

flexible/programmable

universally accessible

 

Possible CBDC architectures

Source: BIS Quarterly Review, March 2020

Why issue a CBDC?

CBDC: Token vs Accounts

token-based

identification of the object being transferred as a means of payment

account-based

identification of the individual whose account is being debited

example: cash

example: ETH

Should the central bank issue e-money? Kahn, Rivadeneyra, Wong, Bank of Canada working paper 2019

What is "disintermediation"?

two types of money

government:

• reserves

• cash

commercial

• each commercial loan \(\to\) deposit

cash withdrawl

convert commercial money into government money

lowers bank's balance sheet

disintermediation \(=\)

Would a CBDC destabilize the banks?

Are CBDCs desirable?

Discussion Points

1. How will you introduce it and run it?
   • Go alone?
   • Partner with banks?
2. What is the business case?
   • Why problem do you want to solve?
   • Can a CBDC solve the problem?
   • Will you solve the problem?
3. What is the best-case outcome?
   What is the worst? 

Discussion Points: how will you introduce and run it? Concerns

• first CBDC (Finland, early 90s) failed for the tiniest of reasons
• you have only one shot to get it right
• are you prepared to be customer-facing (in Canada: 40M+)?
• can you do it?
• what more than money are you offering?
• you bring the government very close to people with AML supervision

go alone
and do self

partner with banks \(=\)
use them for distribution and operation

• why would they support a competitor to their highly profitable payments?
• what does a CBDC do that fast payments cannot? (case may be different in Europe)

The Year is 2008: what the Toronto a la cart program teaches us about CBDCs

The Canadian Government and the Digital World

• Canada related:
  • Bank of Canada research: works with MIT
  • Toronto Star article for DoF: "significant impact for financial sector" 
  • BIS Innovation Hub Toronto for North American CBDC work
  • Budget 2022: $17M to DoF/BoC for CBDC work over 4 years

• Worldwide (incomplete list)
  • US: Executive order to study intro of CBDC
  • China: deployment during Olympics
  • Project Dunbar (AUS, Malaysia, Singapore, SA)
  • Group of Seven report
  • Hoover report on China \(\leftrightarrow\) US & CBDCs

What's the future of digital money?

• countries/regions with strong economies and dominant currencies
   
• countries with strong economies and non-dominant currencies
   
• countries with weak currencies

• fiat
   
• CBDC
   
• private digital money

What's the future of digital money?

• countries/regions with strong economies and dominant currencies
   
• countries with strong economies and non-dominant currencies
   
• countries with weak currencies

Cong & Meyer 2022: The Coming Battle of Digital Currencies

What digital money?

Why digital money?

Bank of Canada specs in 2021

My personal take

very bad policies

governments with good intentions

the stuff of distopian nightmares: tools that bad governments can use to turn on its citizens

Where do CBDCs fall in and under what conditions?

And then there's the economics

• long-and-short of it: two-sided platforms with externalities behave funny
• an increase in competition can reduce welfare

And then there's the economics

Source: "Regulating Competing Payment Networks", LuluWang, Northwestern Kellogg

simplified version

but the market is two-sided!

Source: "Regulating Competing Payment Networks", LuluWang, Northwestern Kellogg

but the market is two-sided!

Source: "Regulating Competing Payment Networks", LuluWang, Northwestern Kellogg

Why should we worry about private money? The Case of Tether

Historically: “Tether Platform currencies are 100% backed by actual fiat currency
assets in our reserve account.”

Text

IS BITCOIN REALLY UN-TETHERED?
JOHN M. GRIFFIN and AMIN SHAMS
Journal of Finance 2020

vs.

Text

IS BITCOIN REALLY UN-TETHERED?
JOHN M. GRIFFIN and AMIN SHAMS
Journal of Finance 2020

vs.

Text

IS BITCOIN REALLY UN-TETHERED?
JOHN M. GRIFFIN and AMIN SHAMS
Journal of Finance 2020

Flow of events

• Tether is authorized
• moved to Bitfinex 
• then slowly distributed to other Tether-based exchanges (Poloniex and Bittrex)
• \(\to\) almost no Tether returns to the Tether issuer to be redeemed
• Kraken (major exchange for Tether\(\to\) USD) accounts for only a small proportion of transactions

Figure 1. Aggregate Flow of Tether between Major Addresses

If Tether is printed independently
of demand and pushed onto the market then ...

• \(\nearrow\) money supply in crypto
• \(\nearrow\) cryptocurrency prices through artificial demand 
• if traded strategically, Tether can further impact and manipulate Bitcoin prices

Is the Price Effect Economically Important?

the "normal-times" returns

CBDC: Token vs Accounts

A Taxonomy

Bech and Garratt (2017)  

• who is the issuer (central bank or other)
• what is its form (electronic or otherwise)
• who can access and/or hold it (universal or not)
• how is it transferred (centralized or decentralized).

Prevailing view: account-based central bank e-money system is unlikely to be the preferred choice of policymakers

Tokens or Accounts?

Prevailing view: account-based central bank e-money system is unlikely to be the preferred choice of policymakers

• expensive to operate
• CB has no comparative advantage for operation
• CB directly competing with commercial bank accounts
• system was feasible even before the advent of DLT

Why not?

Some history on private money

• free banking era in the US:
  • "discounts" between different state-chartered banks prior to 1863
  • discounts between notes vary with distance to the location of the issuing bank and its risk-taking behaviour
• Canada, between 1817 and 1890:
  • commercial bank notes and provincial notes (later Dominion notes) circulated simultaneously
  • discounts until the Bank Act of 1890 (insurance scheme for the redemption of notes of failed banks)
• regulation and supervision of financial intermediaries are necessary to control the discounting between alternative means of payments, counterfeiting and manage price stability.

CBDC: Impact of "Global" Money

CBDC: Impact of "Global" Money

Cryptocurrencies, Currency Competition and the Impossible Trinity
Benigno, Schilling, Uhlig (2020)

Old: impossible trinity

New: with free capital and global currency, equalization of national policy interest rates

\(\to\) less of a point of national currency

Platform Economics

Examples of platform markets

gamers

users

“eyeballs”

cardholders

videogame platform

operating system

portals, newspapers, TV

debit & credit cards

game developers

application developers

advertisers

merchants

buyer

platform

seller

Platform pricing

Source: Jean Tirole's Nobel Lecture

Implications for the platform business model

Source: Jean Tirole's Nobel Lecture

• account for what each side can bear
• account for externalities
• \(\to\) skewed pricing

Simple Example: heterosexual clubbing

assumption: people go clubbing to meet the opposite gender

common problem: imbalance of people from each gender

common solution: differential pricing (including free entry) for one side of the market

Regulation?

Question: is it a must-use arrangement or do people have alternatives?