Blockchain 1: Stablecoins and CBDCs for MFRM

What's the relationship of payments and monetary policy?

Payments and Monetary Policy

A

B

$-$

0

+

A

B

0

+

$-$

Option 1: borrow from BoC

lending rate:

deposit rate:

target rate

target rate$+$25bps

target rate$-$25bps

Payments and Monetary Policy

A

B

0

+

$-$

Option 2: borrow from another bank

target rate

Payments and Monetary Policy

The Impossible Trinity (macroeconomics)

free flow of capital

Control exchange rate

Control interest rate

Basic macroeconomics: you can have TWO out of THREE

Why? The inconvenience of markets ...

Stablecoins

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

BTC, ETH

HQLA: USD, EUR

asset (gold)

fee-backed

Seigniorage

Crypto

Traditional

Algorithmic

Collateral-Backed

Taxonomy of Stablecoins

DEPOSITS

other assets

JPM coin

USDC

USDT

TUSD

DAI, FEI

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

in crypto:

fully collateralized

issuer

under-collateralized

smart contract

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

every issued token has a corresponding HQLA amount

Algorithmic Stablecoin: UST on Terra

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

under-collateralized stablecoin

arbitrageur

issuer

market

arbitrageur purchases should raise price in market
BUT:
- will is rise fast enough?
- does the issuer have enough funds or, rather have funds for long enough?
for fully decentralized algo/smart contract stablecoin: there is no dollar to give!

Case 1: 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

exchange LUNA for newly minted UST tokens at the prevailing $ market rate

market

LUNA 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

exchange SC for newly minted LUNA tokens at the prevailing $ market rate

market

LUNA market

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

DISCUSSION

backing/collateral is the value of the LUNA/Terra Network
- $\to$ must have value(Terra)$\ge\sum$ SC
when you issue new LUNA tokens
- shift value from current to new owners
- create inflation$\to$ price(Luna)$\searrow$

POTENTIAL PROBLEMS

value(Terra)$<\sum$ SC
- could be pre-drop SC
when SC<FU, LUNA token holders
- know price(LUNA) will drop
- $\to$ pre-emptive selling
- more LUNA issued
- $\to$ more inflation
- $\to$ more price drops
- $\to$ DEATH SPIRAL!!!

So far there has never been an algorithmic stablecoin that did not collapse.
Disclaimer: I am not aware of a mathematical proof that an algo stableconin cannot work.

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

now let's do the maths carefully:
- price UST: $p_s$
- Assume $p_s<1$
- Arbitrage mechanism:
  1. Borrow $
  2. use $ to buy UST
  3. Sell UST for LUNA at $ price $p_l'$
  4. sell LUNA token for $$
  5. Repay $ loan, keep profit

assumptions
- arbitrageur trades max $q_s$ so that $p_s=1$
- $q_s$ UST buy for Luna with price $p_l'$ \[\frac{q_s}{p_l'}~\text{LUNA}\]
- redeemed UST destroyed, LUNA newly minted
  - $\to$ dilution.
  - $\to$ assume MKT anticipated extra quantity of LUNA $q_s/ p_l'$
assume: TERRA network value unaffected
except: validation costly $\to$ minimum viable price $\underline{p}_l$
network collapses if $p_l<\underline{p}_l$

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

define $Q_d=Q_sp_s$ aggregate UST $-value
arbitrageur buys $q_s$ such that\[1=\frac{Q_d+P(q_s)}{Q_s-q_s}\]
assume AMM pricing (for simplicity): \[q_s=Q_s(1-\sqrt{p_s})\]

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)
\[\underline{p}_s=\left(1- \frac{Q_l}{Q_s}(p_l-\underline{p}_l )\right)^2\]

MakerDAO's DAI

user perspective

4 ETH
(1 ETH = $375)
(Oct 15, 2020)
$\approx$ $1,500

$\vdots$

1,500 DAI
(1 DAI = $1)

formally: this smart contract is a collateralized debt position (CDP)

user perspective

fractional collateral $\to$ collateralization factor $=$ 150%

\begin{array}{rcl} &&\textsf{maximal amount of DAI in \$}\\\\ &=&\frac{\textsf{\$ equivalent of ETH in escrow}}{\textsf{collateralization factor}}\\\\ &=&\frac{1,500}{150\%}=\$1,000 \end{array}

total collateral = $1,500

maximum loan = $1000

overcollateralization = $500

actual loan (example) = $500

buffer = $500

user perspective: what happens if the price of ETH rises?

ETH $\nearrow$ $500

value of ETH collateral = $2,000

maximum loan = $2,000/150%=$1,333

total collateral = $2,000

maximum loan = $1,333

overcollateralization = $667

actual loan (example) = $500

buffer = $500

overcollateralization = $667

new loan capacity= $333

user perspective: what happens if the price of ETH falls?

ETH $\searrow$ $187.5

value of ETH collateral = $750

maximum loan = $750/150%=$500

total collateral = $750

maximum loan = $500

overcollateralization = $250

actual loan (example) = $500

buffer = $0

for reference: former value of collateral

user perspective: what happens if the price falls & max loan is exceeded?

Maker DAO

ETH $\searrow$ $150

value of ETH collateral = $600

maximum loan = $600/150%=$400

total collateral = $600

maximum loan = $400

required overcollateralization = $200

actual loan (example) = $500

buffer = -$100

for reference: former value of collateral

$\Rightarrow$ triggering of liquidation auction by "keeper"

sell 3.33 ETH=$500=500 DAI

repay $500=500 DAI loan

retain incentive

return remainding ETH to vault owner

Maintaining the Peg: monetary policy

Maker DAO

stability fee
DAI savings rate (DSR)
debt ceiling

borrowers of DAI need to pay interest $\to$ stability fee

if too much minting (=too much DAI) then
$\to$ interest $\nearrow$ $\to$ cost of DAI $\nearrow$
$\to$ minting $\searrow$ $\to$ supply DAI $\searrow$

DSR paid on "locked" DAI

DAI deposited to specific contract (demand $\nearrow$)
funded by stability fees
$\to$ SF>DSR

total amount of debt (or DAI) outstanding is limited

Sidebar: how is this decided?
$\to$ special "governance" token MKR

Value locked Oct 27, 2021

Maker DAO

Source: daistats.com (Oct 27, 2021)

Source: daistats.com (Oct 26, 2022)

The March 12, 2020 "BlAck Thursday" Drama

Maker DAO

some crypto prices dropped more than 50%
cascading liquidations in leveraging platforms
network congestion: some liquidations done at near-zero prices
collateral shortfall in DAI
MakerDAO sold new DAO tokens to collect collateral
odd: DAI became riskier but high demand for DAI to trigger liquidations!

PEG stability module (PSM)

Maker DAO

The Problem:

in extreme bull/bear runs, the peg may no longer work
example: March 2020
- ETH dropped significantly and suddenly
- a rush occurred to (a) get out of ETH into save assets and (b) to collect DAI to get keeper fee
- upward pressure on price of DAI

The Solution:

Peg stability module
swap a given collateral type directly for DAI at a fixed rate (no minting/borrowing)
like regular vault type with a zero stability fee and a liquidation ratio of 100%
accessed through a user-facing smart contract containing the relevant swap functions (no ownership, just straight swap)

Note: In May 2021, ETH prices dropped again by >30% but no drama in DAI

The frontier: DAI loans for real-world assets

Maker DAO

Stablecoin use cases

What do central bankers think about stablecoins?

BIS Survey of Central Banks:

What do central bankers think about stablecoins?

Stablecoin use cases

Domestic
- developed world: do things you otherwise can't do
- developing world: everything

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

International
- move assets faster and cheaper
- do things banks can't/won't do

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]

DeFi fees:

fiat to crypto on ramp: 0%-1%
exchange fees 1-5bps
network fee: $0.001-5$
off-ramp fee: 0%-1%
total: from close to 0 to 2%+$5

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

To get admitted & get a visa you need to
- make a sizeable deposit
- prove that you have funds for tuition and sustaining your life
How??? $\to$ expensive brokers and other shady arrangements

Risks to Financial Stability

Broad Blockchain Risks to Financial Stability

Lending capacity & Monetary transmission

Deposit mobility

AML/CFT/Sanction evasion

Dollarization

Failures/runs

New cyber-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

Result: lower concentration can have higher run risk

volatility (USDT)$>>$volatility (USDC)

stylized facts reg arbitrageurs

USDT $\approx$ 5
USDC $\approx$ 500

USDT $\approx 4\%$

USDC $<1\%$

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

Empirical calibration of run risk (dates/months signify important changes in reserve assets):

USDT in March 2022: 3.45%

USDC October 2021: 0.14%

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

Collapse of Anchor (as part of the TERRA-Luna debacle)

max TVL:
top 20

max lending:
top 50

current lending:
top 100

Crypto-assets incl. Stablecoins and Deposits

Canadian Banks' Financing with Retail Deposits

BoC analysis (August 2020):

[banks] are well-positioned to absorb potential temporary negative effects on profitability and liquidity
Banks[can] absorb the shock under plausible adoption scenarios.
[No] threat to the stability of the financial system or to banks’ competitiveness in terms of ROE.
banks will maintain healthy liquidity levels, and liquidity could become a concern only in the most extreme scenario.

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

scenario:
- widespread tokenization
- defi applications widely used
$\to$ need a lot of stablecoins to support this economy

Automate Investment Strategies for Lending Pool Deposits

"yield aggregator:" push capital where rate of return is highest

Yield Aggregators create very mobile liquidity

Source: "Phantom Liquidity in DeFi Lending", Park and Stinner (2023) working paper

A Consequence of Liquidity Mining: Yield Aggregators

Idea:

strategy to systematically take advantage of token issuance (liquidity mining) programs
like pooling funds to take advantage of banks deposit incentives

liquidity flees quickly
"mirage" effect: yield aggregators borrow what they deposit

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

\}

huge demand for continuously available "high quality" money

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

"there is already a growing market for using crypto as vehicle currency for transactions in developing economies and emerging markets, especially for international capital flight and evading exchange controls."

Idea:

Identify Bitcoin trades used for cross-border wealth transfers and payments;
= trades on LocalBitcoins that are of equal size in short time windows
crypto vehicle trades in the data set $\approx \ge$ 11.1%

Weak Fiat vs. Crypto: Some Empirical Evidence

Fig. 5. Example of Bitcoin market expansion coinciding with capital controls in Argentina Source: LocalBitcoins.com API, BlueDollar.net, Authors’ Calculations.

Fig. 2. The World's 25 biggest Crypto Vehicle Channels. Circles: Origin, Triangles: Destination. Line-width: Channel volume as share identified trade volume in Origin Currency Sources: LocalBitcoins.com API, Paxful.com API, Authors’ Calculations.

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

run by Jump Trading a very sophisticated, tech-savvy HFT firm

$\Rightarrow$ many threat vectors

Wallet Hacks

hardware wallet attacks via SIM attacks
unencrypted data explots
local device hacks (keylogging, overlay)
Man-in-the-middle attack (e.g., hacking of exchanges)
exploits of private key generators

Hacker remotely stole validator private keys

Bridge attack

Hacker minted WETH out of thin air on Solana's contract

Signatures were not verified! Bridge attack....hmmm

Tech Overload: Solana

PS: Bitcoin has never been down, but Ethereum had some major slowdowns

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

Recurring Core problem QuadrigaCX:

QuadrigaCX:
- Gerry Cotton sold people crypto he did not have
FTX:
- auto-execution of margin calls for all except Alameda
- SBF used customer funds to hide "short" market maker Alameda

Fundamental Problem for centralized exchanges

IN FINANCE TERMS

hedge = off-setting position
here: unhedged/"leverage"

Solution

prove aggregate positions
prove assets & liabilities
asset = liabilities $\Rightarrow$ solvency

New trend: data providers check assets

Assets: cash in bank accounts and crypto assets in exchange wallets
Liabilities: customers' crypto and cash deposits

Proof of crypto assets
- publish all exchange wallets
- proof of control: shift assets from one address to another at a pre-determined time

Proof of crypto liabilities
- public customer balances - customer can check
  - own holding
  - sum of all
Problem: privacy (adequate solutions exist)

Proof of Assets & Liabilities

Might be a model for bank stability?

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)

criminals don't use USDC - why are we so worried?

Tornado cash

August 8, 2022: OFAC sanctions Tornado Cash

Chainalysis Crime Report

extra info:

2019: PlusToken Ponzi scheme
numbers depend on known addresses, e.g., 2021 report listed ~.3% for 2020 and upped to .65 now

The Common View

The Reality

no evidence that Hamas has received significant volumes of crypto donations.
full understanding of blockchain analysis and context is needed
Elliptic: Wall Street Journal [must] correct misinterpretations of the level of crypto fundraising by Hamas.
in discussions with Senator Warren to ensure parties have a proper appreciation of the complexities and nuances of analyzing these wallets.

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?

Institutional Differences: Crypto Asset Ownership, Accounts, Wallets, and Self Custody

Smart contract accounts

controlled by code
decentralized applications
tokens

Externally owned accounts

controlled by private keys

private
key

public
key

(seed phrase)

public
address

wallet = software to keep and use private keys

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

issuers

investors

funding
record-keeping
instruments

custody
advice
trading

services
needed & provided

takes care of custody and allows self-custody
allows instrument creation
enables record-keeping
allows circumvention of existing institutions

A general purpose value management infrastructure:

intermediaries

separate institutions

asset custodians
broker-dealers
trading platforms

The blockchain reality:
new institutions
will emerge

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

Tokenization of stocks is nothing new: American Depository Receipts

foreign investor/
issuer

domestic bank with foreign representation

ADR issuing bank handles

shareholder communications
dividend payments
other recording-keeping

Is this a workable model for blockchain- tokenization of existing assets?

foreign representation of domestic bank/ its custodian

domestic depository bank

S.E.C.

registration with form F-4

domestic broker

issues and cancels ADRs

domestic investor

lets investors own and trade ADRs

domestic
market

deposits shares

Blockchain Tokenization has many options

existing investor/
issuer

token issuance platform

investor
wallet

instruct to create tokens

deposits shares

custodian bank

deposits shares

creates tokens and sells to investors

centralized or decentralized
market

S.E.C.

registration

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

How are these functions performed with crypto-assets?

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

It is possible to determine block-by-block EOA holders
$\to$ can send dividends directly
but not very economical

One can reach holders via EOA chat functions and disseminate information (e.g., chat.blockscan.com)
$\to$ opt-in for communcation

good practice from DAOs is to lock tokens in contract and then do voting and dividend payments
can also administer splits/reverse splits

Some remedies for communication and dividends

All this needs a legal framework that adapts to a decentralized, digital world

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

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

Legal and regulatory frameworks currently rely on intermediaries and are not prepared for self-custody

Broader Implications for the Financial Industry and the Financial System

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

Business risk for existing FI: super-easy entry

idea: create new mutual fund like asset

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

"yield aggregator:" push capital where rate of return is highest

Yield Aggregators are very mobile liquidity

Source: "Phantom Liquidity in DeFi Lending", Park and Stinner (2023) working paper

FIs would lose the role of providing access to the financial infrastructure
less sticky capital
new asset managers

Investors continue to need advice

breakup of bundled services is tricky

Effects on the IO of Financial Services

paying for advice is tricky

losing income sources will affect equity valuations and room to maneuver for FIs in liquidity provision

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

2008

2014/5

2019

2020

Source: CBDCtracker.org

Possible CBDC architectures

Source: BIS Quarterly Review, March 2020

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

Cautionary tales for central bank innovation

Finland:
- Avant card failed
China:
- people are unimpressed with the e-Yuan
- trust AliPay/WeChatPay vs. CCP
Mexico:
- QR code pay uptake <5%
  (not CBDC)

what people want

what we got

a program designed by city departments
no regard for business owners or customers
burdensome regulation
a truck ("cart") designed by committee that did not work
program essentially died after 2 years

Features of Digital Money

instantaneous 24/7 payments
digital = borderless
money that is compatible with digital applications, digital finance, internet of things etc
privacy protection
peer to peer transfers
transfers of money without the involvement of a commercially interested third party
non-fee digital payments

fast money

CBDC run by
Central Bank

CBDC on new communually run system

bank-issued stablecoin on public blockchain

What?
24/7 instantaneous
borderless
programmable
privacy
p2p
no commercial 3rd party
nominal fee

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?

players (inter alia)

China: kinda-sorta running; provinces prep own initiatives
U.S.: has bigger problems and is always a last mover
UK: preparing
Canada: contingency planning (it'll happen within two years)
EMU: It's coming (Christine Legarde)

players (inter alia)

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

Why issue a CBDC?

Would a CBDC improve the efficiency of its currency function?
Would CBDC improve the efficiency and safety of both retail and large-value payment systems?
Is CBDC an appropriate policy response to payment innovations such as privately issued e-money and digital currency to achieve its monetary policy goals and to implement policies promoting financial stability?

"Central Bank Digital Currencies: A Framework for Assessing Why and How " Fung and Hallaburda 2016, BoC Working Paper

the use of bank notes were to continue to decline to a point where Canadians no longer had the option of using them for a wide range of transactions; or
one or more alternative digital currencies—likely issued by private sector entities—were to become widely used as an alternative to the Canadian dollar as a method of payment, store of value and unit of account.

When would the BoC issue a CBDC?

Contingency Planning for a Central Bank Digital Currency (BoC website)

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?

BoC analysis (August 2020):

[banks] are well-positioned to absorb potential temporary negative effects on profitability and liquidity
Banks[can] absorb the shock under plausible adoption scenarios.
[No] threat to the stability of the financial system or to banks’ competitiveness in terms of ROE.
banks will maintain healthy liquidity levels, and liquidity could become a concern only in the most extreme scenario.

Are CBDCs desirable?

Discussion Points

How will you introduce it and run it?
- Go alone?
- Partner with banks?
What is the business case?
- Why problem do you want to solve?
- Can a CBDC solve the problem?
- Will you solve the problem?
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

Cautionary tales for central bank innovation

Finland:
- Avant card failed
China:
- people are unimpressed with the e-Yuan
- trust AliPay/WeChatPay vs. CCP
Mexico:
- QR code pay uptake <5%
  (not CBDC)

what people want

what we got

a program designed by city departments
no regard for business owners or customers
burdensome regulation
a truck ("cart") designed by committee that did not work
program essentially died after 2 years

Chrystia Freeland Justin Trudeau

of all things crypto and digital in Canada

The Canadian Government and the Digital World

from the Budget 2022

Addressing the Digitalization of Money
safe and secure financial system
digitalization of money [...] creates a number of challenges that need to be addressed.
high-profile examples where digital assets and cryptocurrencies have been used to avoid global sanctions and fund illegal activities.
promote fair competition, protect the finances of Canadians and our national security.
legislative review focused on the digitalization of money and maintaining financial sector stability and security.

UK Government: "wider plans to make Britain a global hub for cryptoasset technology and investment."

What has happened in the CBDC space since August?

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

highest incentive to launch CBDC to gain tech advantage

nip crypto stablecoin in the bud

adopt crypto (likely stablecoin relating to dominant country)

Cong & Meyer 2022: The Coming Battle of Digital Currencies

Which one is Canada?

What digital money?

fast money

real time rails run by chartered banks

CBDC

run by
chartered banks

run by
Bank of Canada

new communually run system

Stablecoin

private firm (e.g. Facebook)

CBDC on public blockchain

chartered bank-issued on public blockchain

Why digital money?

instantaneous 24/7 payments
digital = borderless
money that is compatible with digital applications, digital finance, internet of things etc
privacy protection
peer to peer transfers
transfers of money without the involvement of a commercially interested third party
non-fee digital payments

fast money

CBDC run by
Bank of Canada

CBDC on new communually run system

bank-issued stablecoin on public blockchain

What?
24/7 instantaneous
borderless
programmable
privacy
p2p
no commercial 3rd party
nominal fee

Bank of Canada specs in 2021

Notes

Central bank has no obligation to privacy
CB cannot allow criminals to use money

Components

Onboarding & KYC
Transactions processing & AML compliant
Connection to legacy FIs without FIs
Must be available to all Canadians

Features

Privacy protection
No direct interaction with customers
Enable innovation in payments market

Hard Problems

offline payments
connection to rest of world
visitors
minors
people of low means or low mental capacity

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

Source: "Regulating Competing Payment Networks", Lulu Wang, Northwestern Kellogg

Quick background:
normal payments infrastructure

And then there's the economics

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

simplified version

here: one-sided market

entrant competes and merchant fees drop
merchant happy and may lower prices

but the market is two-sided!

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

VISA pays rewards so that customers use their cards
very few merchants shun VISA

but the market is two-sided!

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

VISA cranks up the rewards

merchant raises prices - for everyone!

benefit of a CBDC as a competing payments tool is unclear

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

on April 30, 2019: Tether does not have cash reserves equal to 100% of the outstanding Tethers.
May 15, 2019 court hearing: Tether did invest in instruments beyond cash, including Bitcoin

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

Text

Today: "The Tether Platform is fully reserved when the sum of all tethers in circulation is less than or equal to the value of our reserves."

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

vs.

Why does that matter?

Tether = ‘pushed’
- print an unbacked digital dollar to purchase Bitcoin.
- $\to$ additional supply of Tether creates unwarranted inflation in Bitcoin price

Text

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

vs.

Tether = ‘pulled’
- driven by legitimate demand from investors who use Tether as a medium of exchange
- $\to$ the price impact of Tether reflects natural market demand

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

Figure 3. Aggregate Flow of Bitcoin between Major Addresses.

Top Accounts Associated with the Flow of Tether from and Bitcoin to Bitfinex

three main Tether exchanges, Bitfinex, Poloniex, and Bittrex, have considerable cross-exchange Bitcoin flows
cross-exchange Bitcoin flows on Bitcoin closely match Tether flows

one large player has >50% of the exchange of Tether for
Bitcoin at Bitfinex
$\to$ distribution of Tether into market from ONE large player and not many different investors

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

the 1% of hours with the strongest lagged Tether flow are associated with 58.8% of the Bitcoin buy-and-hold return over the period.

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

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?

Payments and Monetary Policy

Payments and Monetary Policy

Payments and Monetary Policy

The Impossible Trinity (macroeconomics)

free flow of capital

Control exchange rate

Control interest rate

Basic macroeconomics: you can have TWO out of THREE

Why? The inconvenience of markets ...

BTC, ETH

HQLA: USD, EUR

asset (gold)

fee-backed

Seigniorage

Crypto

Traditional

Algorithmic

Collateral-Backed

Taxonomy of Stablecoins

DEPOSITS

other assets

every issued token has a corresponding HQLA amount

user perspective

user perspective

user perspective: what happens if the price of ETH rises?

user perspective: what happens if the price of ETH falls?

user perspective: what happens if the price falls & max loan is exceeded?

Maker DAO

Maintaining the Peg: monetary policy

Maker DAO

Value locked Oct 27, 2021

Maker DAO

The March 12, 2020 "BlAck Thursday" Drama

Maker DAO

PEG stability module (PSM)

Maker DAO

The frontier: DAI loans for real-world assets

Maker DAO

Canada is a country of international students

Recurring Core problem QuadrigaCX:

IN FINANCE TERMS

Solution

Banned addresses (usually by OFAC order)

Tornado cash

Chainalysis Crime Report

The Common View

The Reality

Possible CBDC architectures

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?

players (inter alia)

players (inter alia)

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

Why issue a CBDC?

When would the BoC issue a CBDC?

token-based

account-based

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?

The Canadian Government and the Digital World

What has happened in the CBDC space since August?

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

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