Algorithmic Stablecoins

Originally sent to VIXCONTANGO subscribers on July 16th, 2021

In the last newsletter, I covered Central Bank Digital Currencies (CBDC) and stablecoins (USDT, USDC and BUSD) which is what Wall Street, central banks and governments around the world are talking about right now. In this piece, I want to talk about stablecoins as the crypto industry views them because they are a completely different animal. I will call these “algorithmic stablecoins” to differentiate from the proper stablecoins like USDC. It is important for you to understand what is going on with the algorithmic stablecoins because you can lose a lot of money there and very quickly at that. One thing I want to mention is that algorithmic stablecoins have gotten no market traction and practically nobody is using them. All the real action is in proper stablecoins like USDT and USDC and that is what regulators currently are concerned about and looking to regulate. Algorithmic stablecoins aren’t really on the regulators radar yet because they are not big enough. But still you need to know about them because the crypto media talks about them incessantly and many people have been duped and lost money in them.

According to the ethos of the crypto world stablecoins like Tether’s USDT carry at least 3 different “centralization” risks: the collateral is a risk, the collateral manager/management is a risk and the custody is a risk. What does that mean? In Tether’s USDT, Paolo Ardonio is the fund manager of the assets (commercial paper, treasuries, cash deposits, etc) that back the USDT stablecoin. Paolo Ardonio may decide to sensor some USDT holders and invalidate their holdings of USDT without their knowledge (make the addresses holding USDT invalid). He may do it because some government is forcing him to do it. This is “custodial risk”. Paolo Ardonio makes discretionary decisions about what collateral to back USDT with. He may stop buying commercial paper and instead buy more risky financial instruments without telling anybody. This is “collateral management risk”. And finally, Paolo Ardonio may own commercial paper but then the commercial paper issuers decide to not redeem their paper for US dollars because the government told them to stop doing business with Tether. This is “collateral risk”.

A stablecoin like USDT presents all kinds of problems for crypto people who believe in censorship-resistance. That was the original idea behind Bitcoin – the government can’t take it from you or at the very minimum you can evade government controls quickly. Serious DeFi applications don’t like Bitcoin as a settlement currency because it is very volatile vs US dollar which is what proper businesses pay taxes in. DeFi apps want to use a settlement currency that is more stable. That is what led to the rise of USDT and USDC over the past 2 years. But for some crypto users they are not good enough because they are too centralized along these 3 vectors. So degens have made a number of different attempts to create algorithmic stablecoins that decentralize custodial risk, collateral risk and collateral management risk. Please note that in some white papers/articles about stablecoins, the word “collateral” is replaced with “reserve”. I am going to mostly use the world “collateral” here but “reserve” and “collateral” mean the same thing.

Decentralized Custody

The first type of algo stablecoin is the one that tries to decentralize custody. The custody of the collateral is algorithmic and can’t be influenced by a single individual. Maybe you have a DAO (decentralized autonomous organization) that makes decision about the algorithm’s main parameters but by and large the custody is done programmatically by a decentralized network of computers. In other words, the FBI can’t go and order that protocol to freeze your assets like they could do with Paolo Ardonio. Such algo stablecoin is DAI on Ethereum network. And pretty much all algo stablecoins feature decentralized custody.

Decentralized Collateral/Reserve Management

This type of algo stablecoin looks to take Paolo Ardonio (the stablecoin fund manager) out of the selection process of fiat assets that back the stablecoin. Instead, an algorithm is used that automatically buys and sells the financial instruments backing the stablecoin depending on market conditions. Such a stablecoin is again DAI. DAI is over-collateralized – in other words, they might take commercial paper but it will take $1.20 of commercial paper to issue $1 DAI. Then the algorithm monitors the market conditions of the commercial paper and if the price starts to go down towards $1, it liquidates it (sells it) and gives the commercial paper back and gets 1 US dollar. Then 1 DAI can be redeemed for $1. DAI automates both the custody and collateral management but the collateral is still fiat assets like commercial paper, US treasuries or stablecoins like USDC. Many people consider DAI to be the equivalent of an algorithmic fiat bank. Note that all major algo stablecoins like Empty Set Dollar (ESD), Frax (FRAX), Fei Protocol (FEI) or TerraUSD (UST) also feature decentralized/algorithmic collateral management.

Decentralized Collateral/Reserve

In addition to automating the collateral management process, degens want to decentralize the collateral itself. They don’t want it to be the US dollar. They want a synthetic US dollar – some kind of combination of assets that adds up to 1 US dollar. That combination of assets can be of 3 different kinds:

• Fractional fiat backing – this is equivalent to fractional banking. You don’t have a full $1 of assets as collateral, instead you have some US dollar assets (let’s say 25%) but the rest are crypto assets (75%). Then the algorithms buys and sells the crypto according to market conditions to maintain the peg. Such a coin is Frax (FRAX) or TerraUSD (UST). This approach hasn’t worked very well for Frax at all. For UST, the implementation is considered to be more successful probably because the protocol’s invests in POS (proof-of-stake) coins and their rewards are help to stabilize the crypto portion of the collateral.
• Full crypto backing – in this type of stablecoin there is no fiat backing in USDC or any other fiat asset at all. Crypto coins like Ethereum (ETH) are used to back the coin and then the ETH held in reserve is being bought and sold to keep the peg at $1. Such coin are Empty Set Dollar (ESD). ESD has been quite the debacle. ESD currently trades at 11 cents and has been a non-stop trip down.
• No collateral at all – in this type of stablecoin there is no collateral held in reserve at all. Not even crypto as collateral. Instead there is some buying and selling of some protocol created token that supposedly keeps the price at $1. Such a coin is Fei Protocol (FEI). A normal person would ask – how can that be? How can there be no collateral? I ask the same question myself and I don’t understand it. All you need to know though is that FEI dropped a lot on the day of issuance and many people lost a ton of money. FEI came out around April 1^st and after this debacle the crypto market topped. A lot of Ethereum people lost a lot of money in that fiasco and the disappearance of those funds certainly hurt the crypto rally. I think FEI is closer to $1 and seems to maintaining the peg but again, this is a “synthetic” US dollar. There is nothing behind it. FEI usage has remained very low.

Decentralized Peg / Universal Value Stablecoin (UVS)

The final type of algo stablecoin is one with decentralized custody, collateral and collateral management but one which is not pegged to the US dollar or any other sovereign currency. Instead it is its own entity which has been programmed to have low volatility against the US dollar or other sovereign currencies. You can think of it as similar to the Chinese Yuan in that the Yuan is kind of pegged to the US dollar but can move against with some pre-determined daily volatility. Also the Yuan can strengthen or weaken against the US dollar over time but generally speaking within 2-3% annual volatility. There maybe years where the Yuan strengthens or weakens against the US dollar by 5 to 10% but those years are rare. A universal value stablecoin will behave like this – with limited daily and annual volatility. The Facebook’s Libra (currently called Diem) concept is something similar – a stablecoin not pegged directly to any specific currency but is pegged to a basket of sovereign currencies. In the UVS case, the backing will be a basket of cryptocurrencies (Bitcoin, Ethereum, Cardano, etc) and the reserve management mechanism will be swapping in and out of those to keep that universal value stable and not very volatile against the US dollar.

No such UVS exists currently as far as I can tell, but Cardano’s Charles Hoskinson just teased a whitepaper for a stablecoin called the Djed Stablecoin which might attempt to have this design. Hoskinson envisions that stablecoin to be the settlement currency inside the Cardano DeFi ecosystem. Hoskinson does not view ADA as a settlement currency for Cardano – he views it correctly as a token which represents share of the usage of the Cardano network. Nor does he view the US dollar as a settlement currency for Cardano. I haven’t read the Djed paper because it is not out yet, but from preliminary descriptions by Hoskinson, I assume the above description is somewhat representative.

Summary

I haven’t covered algo stablecoins over the past 2 years for a reason, even though there has been a lot of action in that space. The simple reason is that I think algo stablecoins are a total scam. While maybe you can technically come up with a formula that prints digital US dollars out of other digital tokens (whether they are fiat or crypto), the LEGAL and ECONOMIC reality is that you are printing unauthorized liabilities of the US government. Which you simply can’t do. You can’t conjure up liabilities of the US government out of thin air (or out of crypto). Only the US government (or more specifically the Fed) can print US dollars. No other private or public entity in the world can print US dollars. So my issue with algo stablecoins is that they are the modern equivalent of alchemy. Before modern times, aristocrats were trying to convert lead to gold by hiring chemists. This is the same thing – trying to convert digital tokens to US dollars. You simply can’t do it. If the digital token is fully backed by dollar denominated stable assets and redeemable to $1 like USDC, yes, then it is a digital dollar. Any other combination simply can’t yield $1 even if the math works out. Fractional backing is a scam. All crypto backing is a scam. No backing is an even bigger scam. At best algo stablecoins create a “synthetic” US dollar. It is not real. If you could print synthetic US dollars, you can devalue the US dollar to zero tomorrow by printing digital tokens. That’s obviously not going to happen. And the US government will not only delegitimize these attempts in law but will also hunt down and incarcerate the people making and trading these synthetic dollars. Creating counterfeit US dollars is a serious crime. The US government doesn’t allow its paper currency to be forged why would it allow the digital representation to be forged? It won’t. And the penalties for forgery are pretty rough. So I have never taken any of these attempts seriously and I wouldn’t touch them with 10 foot pole. FRAX, FEI, ESD, UST, I am not going anywhere near these. These are counterfeit US dollars. They are illegal in every sense of the world.

An algo stablecoin that can’t be pegged to the US dollar is the only viable attempt at this. The peg must be decentralized. Maybe it can have limited volatility versus the US dollar but it most certainly can’t be pegged against it and perceived as a liability of the US government. A universal value stablecoin also can’t have sovereign currencies as a collateral like Diem does. A private entity would be creating liabilities for all the governments involved which it simply can’t do. That’s why I have always been skeptical of Diem. However, a non-pegged stablecoin backed by a basket of digital tokens can make sense.

Long story short – use USDC for US dollar stablecoin and avoid all the unbacked Ethereum experiments. Also avoid Diem.

Stablecoins vs Central Bank Digital Currency (CBDC) Debate

Originally sent to VIXCONTANGO subscribers on July 1st, 2021

The big discussion this summer in Fed and Wall Street circles is outlining a digital strategy for the US dollar. The topic of the Jackson Hole conference this year is central bank digital currencies (CBDC) as Jay Powell has already announced. The US is hardly the only country looking to create a central bank digital currency. Country after country (most notably China) is making announcements on that topic. Over in crypto world, degens are trying to create an all-together different kinds of stablecoin. I will look at both what is happening at central banks and the crypto industry and give you a framework for how to understand the debate and the topics involved. The algorithmic stablecoins by the degens will be discussed in subsequent mailer.

History of Public Sector Money vs Private Sector Money

Before I dive in, I want to preface with a quick run down through the evolution of money technology through history. I think this is needed to understand correctly the CBDC vs stablecoin debate. The origins of money in pre-historic man is trade – trade a horse for a cow for example. We have exchange of value for value. Obviously, once distances got bigger trade required travel and the roads became full of danger. Various power structures (armies, bandits, warlords) would demand a tariff (or a tax) if a merchant wanted to pass through their territory with his valuable goods safely. Obviously, taking everything would cause trade to halt completely and 100% of zero is zero so the warlords had to keep the tariff to a reasonable level where merchants would still have an incentive to pass and enrich both themselves and the warlord. Feeding an army isn’t cheap. However, a warlord can only get so many in-kind payments such sheep and cows. Warlords are mobile so they have to be able to carry their wealth around with them. Or actually better yet – hide it somewhere. Obviously cows are hard to hide. Overtime, warlords started demanding to be paid in precious metals like Gold and Silver because these metals are easy to carry and more importantly – easy to protect and hide. They don’t rust, can be subdivided and also molded into jewelry and other status symbols that can be worn (self custodied). Overtime warlords became kings and created governments. The tariffs became taxes. Their accumulated gold started to reside in the King’s treasury where it was protected by an army. That treasury was then used to buy armies who would then conquer enemies and then take their gold. To incentivize the population to work, the kings issued coins from the king’s treasury and then demanded them back as tax payment. For a couple of millennia Gold was money in the form of government issued coins – both a store of value, unit of account and medium of exchange. However, once all enemies are conquered, you have to dig Gold out of ground and that got more and more difficult and expensive over time (in terms of human effort). As population grew, there wasn’t enough Gold to go around. So Kings started to devalue their gold coins. They put less Gold in them and more of other less valuable and less scarce metals like Bronze and Silver.

Fast forward to the invention of the printing press and the Medici in the 1500s figured out that you can use paper as medium of exchange instead of a gold or silver coins which were heavy to carry around. So the Medici’s put all their clients gold in a building with an army around it and gave out paper certificates of ownership. Voila – the world’s first private sector bank. Medici’s were the first merchants to become bankers and then heads of state since before that was primarily the province of military aristocracy. There were able to survive all the attacks by the military folks because the economy during their reign was good. How were they able to expand the economy? Through fractional banking. They figured out that people just keep the Gold in their bank forever and never actually use it as medium of exchange to make payments. People would use the paper certificates to make payments (bad money crowds out good money principle). They were clever enough to decide to issue more paper than the Gold they had on hand giving birth to fractional banking. And because they literally conjured up money out of thin air they were able to expand the economy beyond the supply of Gold reserves that they had. Their aristocratic opponents were completely befuddled – the Pazzis never could calculate where the heck this money is coming from. Obviously, that was a good trick until others figured out and when they did that is when bank runs started. If people figured out that the bank doesn’t have enough gold for all the redemptions, they would rush to be the first to drain the gold reserves of the bank.

Medici style private bank credit decisions in relation to their gold reserves was what created money in the economy (instead of just gold and silver mines like before the Medicis) for a few more centuries until we arrive at Abraham Lincoln and Treasury Secretary Salmon Chase and the Civil War. To finance the Civil War, Lincoln needed the banks to lend him money to build an army and they did that on the promise that they will get income from taxation of the conquered Southern territories. The banks bought war bonds (ie gave money to Lincoln to build army) and in return got paper certificates (Treasuries) that gave them a right to collect interest payments from the US treasury. This created a dual system of money in the United States where you had public money issued by the US treasury and private money issued by banks. They were both called US dollars but where different. Once was a private bank note representing a client deposit, the other was a US treasury note. One is a liability of the bank (ie the bank owes the deposit to its client), the other is an asset of the US government (they can collect it via tax and also backed by the US government’s gold). One I call Medici money (private sector bank deposits), the other I call Lincoln money (public reserves financed from taxation). One is private sector money (Medici), the other public sector money (Lincoln). In the Guilded Era, we have quite a few bank runs on these private banks but no runs on the US treasury and fast forward to 1914 and we have the Fed created to stop these constant bank runs by merging the Medici (private sector) and Lincoln (public sector) money into one Central Bank which will guarantee all money in the United States including private sector bank money up to a point (it is called federal deposit insurance today and bank deposits are insured up to $250,000).

Fast forward to 1974 where Nixon completely decouples the US dollar from Gold after a few international bank runs from Europe to drain the US treasury from its Gold. US dollar now has no linkage to Gold (ie it is not redeemable for Gold) which was considered base money for a couple of millennia and was what fractional banking was based on originally. That doesn’t mean that Gold doesn’t have value or that it isn’t a monetary asset. Quite the opposite. It remains a bank reserve asset and its value skyrocketed. However, it now has to share the status of bank reserve asset alongside US treasuries. It is not the only money anymore as JP Morgan once said. Now the ability to tax the US population is just as much money as Gold (libertarians cringe in horror here).

Notice that despite the gold delinking, the dual system of money never left the US. You still have private sector money and public sector money. That is why bankers are as powerful as they are. You have private property rights, their money is theirs – not the government’s. Bank deposits (ie private sector money) to this day remain the vast majority of money in the US economy. Countries with successful economies delegate money creation/credit creation decisions to their banks. The USSR centralized credit creation decisions in a central bank and failed miserably over a period of 50 years. Guess what China did? The opposite. They decentralized credit creation decisions to a thousand banks in 1980 after observing the failure of the centralized banking system in the USSR. And as a result the Chinese economy thrived. As much as communists want to get rid of the private sector, that’s a road to ruin. And as much as libertarians want to get rid of the public sector, that is also a road to ruin. The truth is somewhere in the middle, a thriving economy needs both a public and private sector and thus both public and private sector money. That’s why the FOMC board has consists of bank appointees (Regional Fed Presidents) representing private sector money and government appointees (Governors) representing public sector money.

Fast forward to 2008 – the Financial Crisis. The banks turned out to be horrible stewards of private sector money and after the Housing Bubble pops, there is a massive run on the banks. The Fed has to step in and start printing central bank reserves to stem the bank run and literally stuff the private sector bank balance sheets with public sector money in order to restore confidence in the fractional banking system and make sure that all redemptions are paid. In other words, Lincoln money (public sector money) became more powerful and Medici money (private sector money) became less powerful because the bankers screwed up.

The US dollar now has more backing by the US government’s ability to tax as opposed to the private sector economy. The US dollar is more Lincoln than Medici now. This is a sad result but that is what the private sector gets for making massive mistakes like 2008. Because Medici money is weaker that is why Gold has gone nowhere for many years. For Gold price to go up, you need Medici money to be more powerful than Lincoln money (see 70s). Because there is fewer private sector money to go around, that kills the price of Gold. On the other hand, there is more Lincoln money to go around and that makes Treasuries very expensive (ie yields are low). I know people want interest rates to be higher (or Lincoln money to be cheaper) but that’s not how it works. The US government has to screw up and the private sector has to become dominant for that to happen. Unfortunately, the private sector remains the screw up and the US government remains the entity bailing out the private sector. And for so long as that is the case, Lincoln money will be expensive (ie interest rates will be low) and Medici money will be cheap (Gold price cheap). Notice that the only time when interest rates rose recently was during the Trump administration where his incompetence punctured confidence in Lincoln money (Treasuries) in favor of Medici money (Gold). That is why we saw Gold go up from $1200 to $2000 under Trump and interest rates rise so high in 2018. Now that confidence is back in the US government under Biden, predictably Gold is down and Treasuries are up.

Public Sector Central Bank Digital Currency

We arrive at the present and the American dual system of money is influencing the debate around CBDC. Should the CBDC be a digital coin issued by the Fed as public money advocates want or should it be digital cash issued by private sector entities like banks or stablecoin issuers like Circle (USDC) and Tether (USDT)? This isn’t a simple question to answer. Let’s look at the benefits and drawbacks of each scenario.

Quick note here: CBDC won’t replace physical cash or any of the current things that the Fed issues. Instead it will complement them. Cash still will be there. CBDC will be just another technology through which the US dollar gets distributed.

In the first scenario, the Fed issues a CBDC itself directly to the American public. What that means is that there is some kind of a phone app or a web page where every American can open an account directly at the Fed. Americans can go to that app and make transfers back and forth to their bank accounts if they wish or they can just hold their money at the Fed account. And if Americans don’t have bank accounts, maybe the Fed might even have to run bank branches for customer support. There is about 8 million unbanked Americans. This design would allow the Fed to target future stimulus in a way that it can’t today. Today the Fed has to give stimulus money to banks which make the credit decisions and often times stimulus never reaches the intended recipients simply because they don’t have bank accounts or the banks hoard the money for whatever reason. QE has resulted in a lot of wealth inequality over the last 15 years and the reason for that is that the banks are distributing the Fed stimulus, not the Fed itself. At the end of the day, banks are private sector entities and if customers don’t churn out profit for them, they don’t serve them. There is a discrepancy here. The Fed wants to help everybody in the economy even if they are not productive whereas banks are by statute prohibited from serving clients who produce losses (banks must make profit and make positive return on investment). Many people are unbanked because they are unprofitable for banks to serve. A Fed issued CBDC theoretically can reach these people and thus the Fed can be more successful in stimulating the economy. However, I don’t think the Fed wants to be in the business of serving US retail. The Fed then becomes like an Apple or JP Morgan. It has to run servers and a big computer infrastructure that serves the vast American public. It has to secure that infrastructure. It becomes a technology provider. It has to hire top technologists to do that and computer guys are hard to find. It also has to keep up with the latest technology which changes faster than laws can be changed. It also becomes a central point of failure and a magnet for subversive efforts both from foreign states and random anarchists. It is a question if the Fed can do this, whether it wants to do this and whether this falls within the parameters of its mandate to provide full employment and stable prices.

The answer is that is not the Fed’s job. The Fed’s job is to provide monetary stimulus not provide banking services to the unbanked population of the US. What I think will happen here is the US will create a new Public Bank whose job will be to serve the unbanked population in the US. A public bank can carry unprofitable customers. The Post Office branches can double as Public Bank branches. The Fed then can issue CBDC to that US Public Bank and let the bank deal with the American public. Every American can open an account there in addition to their existing private sector bank accounts. If people want to get stimulus directly from the Fed, they have to open those public bank accounts. I imagine such a scenario will be opposed by the existing banks like JPM and Bank of America because it is direct competition. However, if there is a public bank, the Fed won’t have to require banks to adhere to the Fed rate for savings accounts. So to attract capital banks can start offering higher interest rates on savings. A US Public Bank will have 2 mandates – distribute targeted Fed stimulus and serve the unbanked. This retains private sector banking (JPM, Bank of America, etc) as the main credit decision maker in the economy. So I think having a public bank is actually going to be a much better outcome for the private sector banking industry. BTW, Germany has a set of public banks today so having something like this is not unprecedented in the Western world. Bank of Canada and Commonwealth Bank in Australia were also public (government) banks in the past.

There is another potential solution that some will consider where the existing private sector banks will take on the job of managing CBDC accounts on behalf of the Fed and assist the Fed in providing both stimulus and services for the unbanked population. Presumably banks already have the expertise to serve retail. That they do, but again will banks want to serve people that don’t make profit for them? I doubt it. We are also looking at multiple implementations of the same functionality in different organizations and as we saw with the PPT loans that was not an ideal solution at all. Stimulus reached different groups at different times, some organization struggled to find the additional resources to implement the new federal requirements and there were questions about corruption and so forth. A bank implementation of CBDC would face the same concerns. So I think the private sector bank solution will be looked at and ultimately discarded in favor of a public bank solution.

Private Sector US Dollar Stablecoins

Now we get to the second scenario – privately issued stablecoins. We already have Circle’s USDC and Tether’s USDT. Private sector entities can keep up with the latest trends and innovate. They can support as many blockchains as underlying technology as they wish. Currently Circle intends to offer USDC over something like 10 chains in addition to the current ones – Ethereum, Algorand and Solana. There is also more privacy in using a private sector entity where the government can’t overreach and censor individuals directly or at minimum government overreach can be checked by the private sector. As much as people think the US government and private sector are one and the same, they aren’t. Private sector censored Trump while he was President – something the US government never would have happened while Trump was the executive (or even if he wasn’t the executive). So there are privacy and distributed censorship benefits to privately issued stablecoins over a Fed coin (CBDC).

The Fed can serve as a backstop to private sector stablecoin issuers and should require that stablecoin issuers register with it. A stablecoin issuer shoudn’t be all that different from a bank from a regulatory standpoint. One area which the Fed has to regulate is what assets can back the stablecoins that are issued. Tether and Circle need to be regulated by the Fed and they need to have transparency about their asset holdings. For example Circle hasn’t revealed its assets even though it is assumed that its USDC is overcollaterized. But nobody knows by how much. There is no such public report made available yet. USDT (Tether) issued a report about its asset holdings and it turns out most of it is backed by commercial paper. USDT is not as overcollaterized as some thought. Only 0.37% (or leverage ratio of 289 to 1). For example, Fannie Mae and Freddie Mac had overcollaterization of 1.5% (leverage ratio of 60 to 1) and became insolvent with that during the Financial Crisis in 2008. So Tether is not as secure as some may think. Tether is similar to a money market fund but a bit more risky. Yet that is not exactly the same as a Fed issued US dollar particularly if the market is under stress like it was in 2008 where a number of money market funds “broke the buck”. So these are definitely issues that the Fed needs to regulate for private stablecoin issuers. At the end of the day, the US dollar is liability of the US government and other entities can’t simply conjure up US dollars out of thin air. The Fed needs to be intimately involved in US dollar creation wherever in the world it happens and whichever way it happens. For US Dollar stablecoins to have credibility especially among the retail public, strong regulation by the Fed is exactly what is needed here. Not in terms of how stablecoin issuers technically implement the stablecoin, but what mix of assets is acceptable to be backing a USD stablecoin.

The benefits of the private sector stablecoin solution is decentralization (many issuers) and reduction of single point of failure risk, the ability to experiment with different asset backing strategies (financial innovation), outsourcing of technological upgrades (technology, blockchain innovation) and consumer privacy (stablecoins are more like cash as opposed bank accounts that carry identity). The drawbacks are that Fed won’t be able to target stimulus or guarantee that the unbanked population will be served.

Here is one big benefit of US dollar stablecoins that I hear rarely discussed: they can dramatically expand the reach of the US dollar abroad. People abroad can only use their local banks and therefore only hold money in their local currency. However with USDC, anybody anywhere can create a USDC wallet on any computing device. They can do it on exchanges or on self-custody mobile apps or computer programs. Now people in a country like Venezuela can have US dollar deposits. As you can imagine only the rich in Venezuela have dollar bank accounts. The rest are unbanked because they are not profitable customers for the local banks. A US dollar stablecoin can change all of that. At the end of the day people abroad don’t want the volatile Bitcoin as a day to day medium of exchange. They want the stability and liquidity of the US dollar if it was only accessible. USDC and USDT make the US dollar more accessible to world-wide audience at all income levels more than ever before.

BTW, this low cost accessibility of CBDC is why China is pushing ahead quickly with its Digital Yuan project. They want to target the unbanked population of Africa, Latin America and the Muslim countries in the Middle East. They want to capture that market first. If you are an unbanked person in Africa and you are given an app where you can store Chinese Yuan which is basically pegged to the US dollar, you will do for it in a heartbeat. That person won’t care about all the other macro considerations that makes professional investors pick a US dollar over the Chinese Yuan. All unbanked care about is stable money on their phone. Digital Yuan is stable enough. But then through this side door, the Chinese Yuan becomes a global reserve currency. If the US wants to combat the Digital Yuan effectively it needs to articulate and push a digital US dollar strategy as soon as possible. There can’t be any delays here. This is a space race of the 2020s – the digital currency race. And the US actually has the heads up. USD stable coins are more than $100 billion asset class now. The Fed needs to get to work and give them US government legitimacy and from there they will spread like weed abroad through the private sector. The US government also needs to make sure it funds a private sector effort targeting the unbanked in Africa, Latin America and the Middle East.

Ultimately what I think happens here is that the US government will do the following:

1. Regulate private sector US dollar stablecoins and pass laws to legitimize them and set rules of the road. This potentially could be an issue for USDT and BUSD – USD stablecoins issued by foreign entities. This could be a boon for Circle’s USDC.
2. Establish US Public Bank to distribute Fed stimulus and serve unbanked US population
3. The US government will choose one official private stablecoin like Circle’s USDC to be used for US Public Bank accounts. Then when the Fed prints digital dollars for economic stimulus, it will be creating USDC and transferring them to the US Public Bank to target to individual accounts.
4. Allow banks to issue stablecoins (in addition to standalone stablecoin issuers). In that respect, Circle may be purchased by a bank like JP Morgan in the future.
5. Provide funding for international adoption of US dollar stablecoins in unbanked populations in Africa, Latin America and Middle East

At the end of this, the US dollar will be bigger than it has ever been and its reach in the global economy bigger than ever. Potentially this expansion of US dollar use globally could be on the scale of that accomplished after World War 2. A company like Circle could become enormous in its global reach. In its attempt to take out the US dollar, the only thing Bitcoin will accomplish is make it bigger. The President of El Salvador is pushing Bitcoin wallets on smartphones as a way to serve the unbanked population of his country. Within 6 months what will actually happen with El Salvador’s unbanked population is they will be using and transacting with USDC on their phones.

The Fed currently has an initiative called FedNow underway that is researching the digital currency space and is implementing some form of a solution. This project is supposed to be out in 2 years. I think it needs to move faster. The Fed’s Fedwire Funds Service processes $4 trillion in payments every day. The private-sector ACH (Automated Clearing House) settles $2 trillion in payments every day. That gives you an idea how big the USD stablecoin market can get. It is currently $100 billion. Getting to $6 trillion is a 60x from here. There will be massive amounts of innovation happening over the next 2 years with the Digital Dollar.

Quantity Theory of Disaggregated Credit

Originally sent to VIXCONTANGO subscribers on August 12th, 2021

In 1517, almost exactly 500 years ago, Copernicus invents the Quantity Theory of Money. In its modern form that theory can be reduced to the following famous equation: M * V = P * Q, or

Money Supply * Velocity of Money (transaction frequency) = General Price Level * Real Quantity of Goods

Keep this in mind as we will need it later. Fast forward to 1992 and Professor Richard Werner (pictured above) proposed a new theory of money creation called the “Quantity Theory of Disaggregated Credit” or more simply “Quantity Theory of Credit” which builds upon Schumpeter’s credit theory of money (that money is credit, not a metal). In 2014, he published the first empirical evidence that each bank creates credit when it issues a new loan. He is a well-known academic in both the East and West with public and private sector experience. In 1995, while he was living and working in Japan, he proposed a new monetary policy called “Quantitative Easing” to deal with banking crises which was published in the Nikkei magazine (in Japanese!) and later adopted by the Bank of Japan. Richard Werner is the Father of Quantitative Easing. QE in the US is often associated with Ben Bernanke but it was Werner who created the academic theory that powers this monetary policy. The Bank of Japan ran QE a decade before the US. Werner’s 2001 book “Princes of the Yen” was number one general bestseller in Japan. He also has the honor of being designated as a “Global Leader of Tomorrow” by the World Economic Forum in Davos.

Today I want to cover Werner’s theory because it is critical to understand what is going on in markets and finance today. He gave a great speech at the SORA Economic Forum (the guys behind Polkaswap) which you can watch here. I am basically reprinting what he said in that speech.

There is no “economic growth”. We know this from physics – the laws of thermodynamics. You can’t create energy, you can only transform it. Economic growth is a statistical illusion created in national income accounting by adding up “value add” transactions connected to goods and services but not subtracting the costs such as depletion of natural resources. This “economic growth” concept was created by large banks a century ago in order to find out how much interest they could charge governments when lending to them. This explains why nominal ten-year yields of government bonds (long term interest rates) follow nominal GDP growth and are usually of similar size. If the banks charged more than economic growth (i > g), a “debt trap” would follow. A debt trap is bad because it would cripple the economy and the banks as well because if the debtor defaults the creditor is in trouble. A parasite like the banks needs the host alive so really not a good idea for them to charge usury rates in the long run. The maximum the big banks can charge in interest is the economic growth rate. The banks can also charge BELOW the economic growth rate as it is currently happening. Nominal US GDP growth right now is around 10% while TNX (10-year Treasury Yields) are stuck at 1.5%. That condition is actually very good for the economy if not as profit maximizing for the banks as they would like. Even though banks are printing record earnings numbers as we speak.

Ultimately, “economic growth” is a monetary concept since it measures only monetary transactions taking place in markets and paid for with money. Financial transactions are not part of GDP since GDP tries to measure “value add” transactions. Financial transactions are simply purchases or sales of assets between counter-parties which is just ownership transfer. Ownership transfer is not a “value add” activity – it is a zero sum game. By contrast, activity that produces new goods and services like entrepreneurship adds new value and everybody is better off. Economic growth means that those value add transactions that are part of GDP have increased this year compared to last year.

How do you increase economic growth? If we use Copernicus’ equation M*V = P*Q, to have economic growth that means that you need to have a positive change in M*V and that change should equal the change in P*Q. In other words, Δ (P*Q) = Δ (M*V). Increase in the value of transactions can only come if there is an increase in the money used for these transactions. In other words, for economic growth to be possible, the money supply must grow. To get more Q you need more M if you assume P and V are constant. There is no economic growth without money supply growth. That is a concept that Gold bugs have never been able to understand.

In Neoclassical Economics, or what we call Econ 101 class taught to everybody everywhere, there is the concept of equilibrium between supply and demand that determines prices. That equilibrium makes a breathtaking number of assumptions:

1. Market participants have perfect information
2. Markets are complete
3. There is perfect competition between players
4. Price adjustments are instantaneous
5. There is zero transaction costs
6. There are no time constraints for price setting
7. All agents are rational and seek to maximize profits
8. Nobody is influenced in any way by the actions of others

Except that those assumptions are really bad and don’t actually happen in the real world. People don’t have perfect information, not everybody is in the market all the time, perfect competition is rare, transaction costs are very heavy (see the Island of Manhattan built by transactions costs), there are time constraints all the time, market agents aren’t rational – there is a lot of price manipulation and you have to be a fool to think that there isn’t herding behavior – people absolutely are influenced by societal trends. In Alice in Wonderland, the Queen said that she believed six impossible things before breakfast. In modern day economics, you have to believe 8 impossible things all the time! If probability of all these assumptions are true are 60%, the combined probability is 60% to the power of 8 or barely 1%. And reality is that the individual probability of any of those actually happening is less than 10%.

In other words, perfects markets don’t exist. Textbook economics is a fairy tale. Demand does not equal supply. Markets are rationed. Rationing in one market affects other markets. Information, time and money are all rationed – there is a limit to them and distribution isn’t perfect. Different market players have different levels of information, time and money or simply put different “market power”. In rationed markets, market power is the primary driver behind market prices. Market power is used and abused. Rationed markets are determined by quantities, not prices. The outcome is determined by whichever quantity is smaller – demand or supply (the “short-size principle”). Thus, government intervention in markets is a “distortion” and “undesirable” only in the theoretical world of Econ 101 general equilibrium economics (which is what libertarians believe so strongly). Since markets are rationed and skewed, government intervention can actually improve market outcomes by checking market power abuse.

There were 3 main theories of banking:

1. Financial Intermediation Theory
2. Fractional Reserve Theory
3. Credit Creation Theory

“Financial Intermediation Theory” says that banks are intermediaries in the private sector and they gather deposits from savers and then lend them out to productive enterprises (or debtors). That theory forms the basis of what we call “private money” and what I called “Medici money” in prior writings. And this is the theory of banks and money that most people are familiar with and accept easily. In this theory, banks don’t create money supply neither individually nor collectively. Money comes from client deposits (already exists).

In “Fractional Reserve Theory”, there is a Central Bank and all banks put a reserve aside with the central bank. This reserve is used to clear interbank payments and allows banks to make payments to each other. New loans in the economy are extended out of new reserves. New reserves can get created by the central bank. This is the basis for “public money” or what I also called “Lincoln money” in prior writings. In this theory, banks create money collectively but not individually. In other words, a committee of private sector and government bankers like the Fed jointly creates new money when they increase the reserves or loosen the reserve requirements. This fractional banking theory has much resistance in the public because it is a little bit more complicated and centralizes the power of money creation to the mysterious Central Bank. And in addition, money can be lent out that doesn’t exist and people simply don’t want to believe in magic. Whether the public likes this theory or not, you can in fact lend more than you have in deposit since depositors rarely pull out their deposits over time and particularly those at the Central Bank. Banks can leverage those deposits as much as 8x according to international banking regulations (Basel III). The only reason Central Bankers get away with this “atrocity” is because this is a key way to produce economic growth that wouldn’t exist otherwise. If banks could only lend what they had on deposit, the economies would be much smaller.

The 3^rd theory is called “Credit Creation Theory” of banking and says that banks aren’t just intermediaries – they are the center of the economy and money gets created only when they lend. Thus banks create money ex nihilo (out of nothing) both individually and collectively. Werner did empirical tests of all 3 theories and found out that Financial Intermediary and Fractional Reserve theories are wrong and not consistent with evidence and that only the Credit Creation Theory is correct and consistent with real-world evidence. Or in other words, banks are the center of the economic universe and they create money out of thin air when they make lending decisions. Any theories and economic models that don’t reflect this reality about banks (that they create money individually and collectively) can’t be used to describe our economy.

There is a BIG discrepancy in how neoclassical economists (and therefore the public) view banks and the banks’ actual status in the real economy. Economists think that banks are deposit taking firms that lend money. In the real world banks don’t take deposits and don’t lend money. Get a load of that! Banks actually “borrow” money from their clients. In law, client “deposits” are loans to the bank. When I put my money in the bank, the money is not on “deposit” (held in custody by the bank). It is owned and controlled by the bank, not the depositor. That is because the “depositor” lends money to the bank and becomes a “general creditor” to the bank. The bank records a “credit” on behalf of the customer in its records of its debts. When it comes to “lending”, banks don’t lend money either. They purchase “securities” – the loan contract is a “promissory note” (or a “security”) that the bank acquires. The bank does not payout the money referred to in the loan contract. Instead, the banks records a “credit” on behalf of the customer in its records of its own debts to the public.

This is how money gets created: when the bank lends, it in fact “purchases” a loan contract from the borrower and records this as an asset. The bank now owes the borrower and has a liability. The bank records this in the 2-sided accounting ledger as a fictitious customer deposit to balance the assets and liabilities. The bank pretends the borrower has deposited the money. And voila, we have a new money in the system. The money appears out of thin air since obviously it wasn’t transferred from anybody else. It appears because a loan was made!

This dynamic confers a new status on banks – they are special! Banks create the money supply. Unlike non-bank financial institutions, banks create money via credit creation. Bank credit and deposits are created simultaneously. Credit creation is a unique measure of money as it is injected into the economy and that measure can be disaggregated by the use the new money is put to. Banks decide who gets newly created money and for what purpose. Banks reshape the economic landscape through their loan decisions. Now we know why central banks conduct their “true” monetary policy by guiding bank credit. When new money is created by the central banks, it can either land in non-GDP transactions (which is Asset Markets like stocks/real estate) or in GDP transactions (Real Economy). The Real Economy is further subdivided into Consumption (consumer purchases) and Investment (productive purposes such as productivity enhancement, technology innovation, etc). Roughly, the formula looks like this

Δ CR = AM + I + C

Δ CR = new credit/new money

AM = Asset markets like stocks, bonds and real estate

I = Investment into products and services (supply side)

C = Consumer consumption (demand side)

Where the money lands in the economy is further guided by the legislative branch or Congress in what is called Fiscal Policy. Fiscal policy can redirect the money to Investment or to Consumption (consumers) via tax cuts, subsidies and other forms of stimulus. If Congress does NOT direct new money creation into the Real Economy, then all the money goes into Asset Markets like stocks and bonds and inflates their prices. Before the COVID pandemic in 2020, most of the new money creation in the economy via QE ended up exclusively in the asset markets because Republicans (in the Presidency, House or Senate) don’t believe in “picking winners and losers” in the economy and thus refrained from directing the flow of new credit coming from QE to Investment or Consumption. There is a particular reason GOP doesn’t like directing new credit to Consumption – inflation. Money that goes to consumer spending but not to investment results in more dollars chasing the same amount of goods and thus results in consumer price inflation which is unsustainable and not perceived to be good for society. On the other hand, if you direct money to Investment, you get more goods for a fixed amount of consumption and then you get deflation which GOP views as positive and contributing to real wealth (buying more stuff for the same amount of money). This is what has been going on pre 2020 and if you remember many libertarian Gold bugs argued in 2008 that QE will result in consumer price inflation and were proven to be dead wrong over the last decade. Inflation went nowhere for a decade. Why? Because new credit wasn’t directed to consumption. The only directing of credit were tax cuts which directs money to Investment which puts a lid on prices. So the Gold bugs were simply dead wrong. I mean you can’t possibly be any more wrong than that! Absent fiscal policy directing money specifically to Consumption, you simply can’t get consumer price increases at all. It just can’t happen.

During the COVID pandemic we saw a different paradigm emerge – some of the money went to the Consumer (pandemic UI, broad stimulus checks, etc) and some went into Investment (Pfizer vaccine production, military spending, etc). As a result we see CPI readings that are higher. But those higher CPI readings are going to be transitory because we are not printing $2000 checks for each family every few months. The new fiscal policy by the Biden administration is not THAT expansive. There was certainly an output gap to be filled last year and earlier this year. However, the Biden administration is not going abandon Consumption entirely – the child tax credit is a move in that direction to firm up consumption and thus inflationary readings. If there was any criticism of monetary policy in the 2010s is that it didn’t achieve the 2% inflation target that it set for itself. Why? Because all money went into Asset Markets and Investment. That in turn pushed interest rates lower which then gave the government a lower capacity to stimulate the economy without additional money printing in the case of a recessionary shock. The Fed does want inflation to be 2% and interest rates to 2% so that it can stimulate the economy with the least amount of money printing. By that standard, the 2010s were a debacle. Which is not surprising because that is the first time US politicians and government administrators were learning how the Quantity Theory of Disaggregated Credit works. But from what we have seen so far from the Biden administration, they are much better practitioners than the GOP policy makers that preceded them and that is encouraging.

What is one side effect that can go egregiously wrong under this model? Obviously, lack of Fiscal Policy to direct money to Investment and Consumption can result in all the new credit creation/new money going to the Asset Markets. When you have sustained broad bank credit growth exceeding nominal GDP consistently for a long time, you end up with a banking crisis. Too much of the money in the economy is trapped in the banking sector. That is what led to the banking crisis in Japan in 1990 and in the US in 2008 – mismanagement of bank credit creation. Now the question is why do bank crises keep happening if Central Bankers know all of this? The answer is “Revealed Preference”. Central bankers actually do want this to keep happening. Warner calls this “Central Bank Risk” or giving way too much power to central planners (like the Central Bankers) and not ensuring meaningful accountability. You could see this complete lack of accountability and dangerous hubris in 2019 when for absolutely no economic reason, Powell lowered interest rates from 2.75% to 0.5% and launched QE of $80 billion per month in September of 2019. That was done for nakedly political purposes to ensure that the economy is juiced up above its normal capacity ahead of the 2020 election and ensure that Republicans retain majority in the Senate and Trump gets reelected. We really just witnessed one of the worst Central Bank mismanagement in the history of the US. And Jay Powell was a chief actor in those decisions.

Warner calls this regulatory preference to generate crises “Regulatory Moral Hazard”. Bureaucrats create crises and then help defuse the crises and as a result they get rewarded with bigger regulatory powers by Congress. In effect, central bankers get rewarded for each crisis they create. As result, over the past 50 years Central Bankers have become more powerful than ever before. During that time period the amplitude and frequency of business cycles has increased. They actually are not business cycles anymore but credit creation boom/bust cycles. These are now recurring boom/bust cycles artificially created by banking crises of the central bankers own invention.

Over the past 20 years, Central Banks have used monetary and regulatory intervention to reduce the profitability of ordinary and small banks driving them out of business. Over 5000 small banks disappeared in the US and Europe for a total of 10,000 during this time. As a result credit creation has increasingly been centralized in a few big banks. Now via a central bank digital currency (CBDC), Central Banks want to enter into a competition with their private sector counterparts (JP Morgan, Bank of America, etc) which they regulate and start to control the credit creation process directly. A recent speech by Fed government Chris Waller addressed some of these issues brilliantly and you should read it. Such a move means that banks will be driven out of business entirely and will disappear.

The next banking crisis will finish the banks off and push all the credit creation into the hands of the Central Bank (the Fed). Werner doesn’t like that because this is what led to the decline of the Soviet Union. This new West banking model looks a lot like Soviet-style central monetary authority. Warner credits the demise of the Soviet Union and the ascent of China on the centralized and decentralized nature of their banking systems and resulting centralization/decentralization of credit creation. After the fall of the Soviet Union in 1990, China established thousands of regional banks and delegated credit creation to them. Warner credits the resurgence in the Chinese economy with this decentralized credit creation process and mourns the centralization happening in the West at present. He thinks that economic growth will go to zero if we adopt a centralized central bank model of money creation.

That is why central bankers prefer the “degrowth” narrative and claim that we need “zero growth” for environmental reasons. This is not true in reality because economic growth isn’t harmful to the environment since if you remember the start of this article – economic growth is simply a statistical illusion and entirely a monetary phenomenon. What is harmful to the environment are harmful activities and those need to be regulated directly instead of regulating the banks in an attempt to achieve that same result. Green economic activity instead can be a boom sector and can result in high economic growth – if banks are allowed to create money for this activity. Werner bemoans that Central Banks have propagated the abolition of cash in order to be able to enforce negative interest rates (withdrawals from your bank account) and have proposed universal basic income (UBI) to deal with large-scale unemployment by implementing a central bank digital currency (CBDC).

Ultimately, Werner tacks in the other direction entirely and favors a high level of decentralization of the banking system and of credit creation. He points out that countries with large amounts of banks also have healthier and recession-proof economies. He points out that Germany has the highest number of “industry champions” – companies that are in the top 3 of market share in their industry. Not coincidentally, Germany also has the highest number of banks by a factor of 3 or 4 over peers like United Kingdom, Spain, Italy or France. The propensity to lend to small companies is in small banks. Big banks don’t lend to small businesses. The fact that small banks lend to small businesses in a weaker economy tends to smooth out the boom/bust cycles. Werner points out that Germany’s highly decentralized banking system has resulted in smoother boom/bust cycles over the past 20 years. Germany has 70% of money creation generated by 1,500 community banks.

Werner proposes the following reforms to the banking system:

• Ban bank credit transactions that don’t contribute to GDP (asset transactions)
• Create a network of many small community banks which lend for productive purposes and return all gains back to the community creating real choice and options in banking.

Competition in banking is only ensured if large commercial banks are forced to compete against such community banks. This is partially what is happening with crypto right now where you have decentralized lending protocols like AAVE and KAVA put credit decisions in the hands of the public. Ultimately, you have to look at crypto industry as an industry whose goal is to decentralize credit and money supply creation back into the hands of the public and act to counterbalance the ongoing centralization of credit creation activity in the establishment (big banks and central banks).