Originally sent to VIXCONTANGO subscribers on February 6th, 2022
There has been a question I have been grappling with for the past couple of months with regards to stablecoins and I am sure that same question has been vexing the Fed as well: Are stablecoins going to kill off fractional reserve banking? Fed researchers issued a paper last week called “Stablecoins: Growth Potential and Impact on Banking” that discusses this problem and I found this paper very helpful in formulating my thinking on the subject. Note that the solution I propose here is very different from what the paper recommends and what the Fed currently thinks, but I think the approach I outline ultimately will win in the end.
Currently, there are 2 major stablecoins – USDC (USD Coin) issued by Circle and USDT issued by Tether. USDT has $78 billion in AUM while USDC has $50 billion. They are both big and quite widely used in the crypto ecosystem – USDT is primarily used a trade settlement asset on digital only exchanges like Binance while USDC is used as collateral in DeFi apps like Aave and Compound. However, the two coins have very different implementations behind the scenes. USDC essentially takes US dollars, puts them in a bank account and then issues 1 USDC for each $1 in the bank. In contrast, USDT takes your $1 and with it purchases securities (ie loans and notes) with short duration such as Treasuries and commercial paper. USDT is very similar to a money market fund while USDC is very similar to your savings account at a bank. Because USDT is backed by bonds, crypto traders prefer it as a settlement asset – if the crypto market tanks, traders would buy short term bonds as a hedge and that is what USDT is. Thus when you have crypto market stress, the paper finds that USDT actually rises in value. It acts as a VIX of sorts and the reason is because traders buy bonds when risk is off (it’s like buying AGG when SPY sells off). The Fed paper calls the USDC approach “two tiered intermediation” while the USDT approach “security holdings”. The Fed paper finds that those two designs aren’t really all that different from the current banking system. Putting money in USDC is the equivalent to parking money in a commercial bank while putting money in USDT is the equivalent of buying commercial paper and Treasuries. So the answer to the question whether current stablecoins like USDC or USDT will kill off fractional reserve banking is a resounding NO. But this is not all.
The paper also introduces a 3rd theoretical stablecoin design called the “narrow bank” in which the stablecoin is backed by central bank reserves. This is very interesting and very powerful concept. There is no such narrow bank stablecoin at the moment, but Circle’s boss Jeremy Allaire is pushing very hard for regulators to turn USDC into a narrow bank stablecoin – ie for USDC to be backed by central bank reserves.
Generally speaking, the Fed is very leery of “narrow banks”. It doesn’t like them. In 2018 there was bank called “The Narrow Bank” (TNB) created by a former New York Fed Research Director James McAndrews which applied to become the first narrow bank in the US but was summarily rejected by the Fed. The purpose of The Narrow Bank was to serve non-bank financial institutions and provide them with direct access to the Fed’s central bank reserves. There is such a bank in Norway called “Safe Deposit Bank of Norway” used by high net worth individuals and institutions such as pension funds and sovereign wealth funds. Institutions want their money to be safe during market turmoil and there is nothing safer than central bank reserves in the modern banking system. Institutions know better than regular people that banks are fractional reserve institutions and lend out their deposits at minimum 8-1 ratio and therefore are risky – subject to a bank run. So if institutions put their money there, they know they aren’t guaranteed to get them back and to top it all off currently they are getting a bad rate of interest of 0%. Note that big balances at banks also aren’t FDIC insured. While retail deposits are insured, institutional deposits aren’t. So there is a whole lot of risk and no yield and institutions don’t like that setup one bit. For the non-bank financial institutions, James McAndrews was their man at trying to create this unique financial product in the USA, but it didn’t happen. Why?
Because the Fed doesn’t want to kill off fractional reserve banking. I discussed in my “Stablecoins vs CBDC” article how fractional reserve banking was Medici’s main invention and how it produced more economic growth than otherwise and the Fed isn’t about kill that banking invention/golden goose. If you have a Narrow Bank in existence, the Fed envisions that in times of economic trouble people will run to the narrow bank because central bank reserves are the ultimate safety and thus abandon commercial banks for good. All the deposits will become central bank reserves and banks will go caput. When that happens, banks obviously won’t lend and the economy will collapse. Fractional reserve banking disappears. Unlike China, in the US the Fed doesn’t believe that the central bank should become a centralized lender – that amounts to a communist takeover and central planning. There is pretty wide agreement that lending decisions need to be decentralized in order to avoid the fate of the Soviet Union. In fact, if there is one thing that people agree on unanimously in the US is that there are too few banks in the US in the aftermath of the Financial Crisis and that the big banks have grown too big and too centralized and need to be broken up. For that reason, the Fed is not going to approve a narrow bank that will compete directly with existing commercial banks (don’t forget the Fed partially represents the banks). For the same exact reason, the Fed is really leery of turning USDC into a narrow bank stablecoin and so far has resisted Jeremy Allaire’s overtures.
However, I think the Fed researchers and the Fed are thinking about this all wrong. There is critical omission here: there is already a narrow bank in existence currently and its name is CASH. Bank notes (or cash) are direct liability of the central bank – in other words they are themselves central bank reserves. So if an individual wants the ultimate safety, he can put a ton of cash in his basement. In fact, in Europe many wealth advisors have contemplated storing mountains of euro bills in bank safes as opposed to holding them as commercial bank deposits.
Still there is a critical difference between cash and central bank reserves. Cash has a permanent interest rate of 0%. Reserves on the other hand are a yield products – the Fed pays the IEOR rate on central bank reserves. Paying a positive rate on reserves is really a policy decision and different central banks have different approaches. In Japan the rate on central bank reserves is set to zero regardless of what the rate in the interbank market is (which in Europe and Japan has been mostly negative over the past decade). There is really no reason for the Fed to be paying positive IEOR rate because there is no solvency or liquidity risk for central bank reserves. They are the safest asset in the banking system. Many liberals in the US staunchly object to a positive IEOR rate and for good reason. BTW, the IEOR rate was renamed to IORB rate (interest rate on reserve balances) in 2021 and there is a new series for it at the FRED. IEOR series has been discontinued.
If the Fed simply creates a new special rate only for narrow bank reserves and sets it to zero, then a narrow bank stablecoin solution all of sudden becomes not only feasible but also desirable. Why? Because the Fed goes back in time to the pre-Financial Crisis financial system while simultaneously preserving the stability innovations introduced in its aftermath.
Before the Financial Crisis, the US had a normal financial system in which people who wanted a stable currency could put their money in cash. If they wanted to take risk, they put the money in a commercial bank deposit and would get 4-5%. They were compensated for the risk they were taking with the fractional reserve banking system and simultaneously they were not compensated for being in a safe central bank reserve instrument like cash. Everybody was happy – if people felt the economy and the banking system was in trouble, they could store cash under the mattress like Tony Soprano. If they thought the economy was doing well, they could go and take risk and put their money in a bank account and get paid 4-5%. However, our constantly virtue signaling government was not happy that drug dealers like Pablo Escobar had billions in cash and they wanted to put an end to cash and its use in money laundering and drug trafficking activity. From about 1985 on, the US government stopped printing cash. As a result, people were forced to put money in commercial banks. Commercial bank deposits vs cash ratio kept increasing from a historically normal, fairly stable 1-8 ratio to 1-10 to 1-15 and culminated at 1-20 ratio right ahead of the Financial Crisis in 2007. In other words, by refusing to print cash, the Fed massively leveraged the financial system over a period of 2 decades and the system ultimately collapsed from the accumulated leverage. Then Bernanke was forced to print cash in 2008 like a maniac but instead of printing cash, he printed central bank reserves and put them in the US banks. Obviously, the US government didn’t want to print cash that would end up in the hands of the likes of Pablo Escobar and so it printed reserves which can be very tightly controlled.
The problem with reserves though was that banks no longer wanted to lend. Bernanke himself killed the fractional reserve banking system. BTW the IEOR rate was 10 bps higher than the Fed Rate. Banks would rather keep the money at the Fed and get the IEOR rate instead of take risk and lend it in the economy. So the Fed’s worries about issuing a narrow bank stablecoin stem directly from Bernanke’s mistakes. But the Bernanke mistake wasn’t so much that he issued reserves and reduced leverage in the system, but that the IEOR rate was basically the same or higher than the Fed rate. You can’t have the commercial bank rate (Fed rate) be the same reserve rate (IEOR). IEOR has to be lower than the Fed rate in order to encourage people to take risk in the commercial banking system. It is just a fact that central bank reserves are of lower risk than commercial bank deposits and that needs to be reflected with a differential in those rates. You can’t have the difference between these two rates being 10 basis points. The spread between these rates needs to be 200 to 400 bps (2% to 4%).
If you implement USDC as a narrow bank stablecoin and set the narrow bank reserve rate to 0%, the Fed will accomplish everything that it wants to accomplish. USDC becomes the digital equivalent to cash. Institutions can go to USDC for safety and just hold it on the blockchain when they need to. But if they want to make money on their USDC and get positive interest, they need to lend it out in the economy (for example give it to Celsius or a commercial bank like Chase). The Fed can get away from the policy of Fed rate suppression that it has had over the past decade and banks can again offer 4% interest rates. If the Fed wants to stimulate the economy, it can issue new reserves in the form of USDC and have it directly distributed to retail. If retail can’t spend it and wants to save it, it puts it in a bank and the bank puts it to work. By having a differential rate between narrow bank rate and the Fed rate, the Fed will greatly incentivize an increase in commercial bank deposits. You end up with a dramatically bigger commercial banking system which is simultaneously safer than the pre-2008 system.
Censorship of any narrow bank stablecoin (like potentially USDC) has to be significantly more decentralized than a central bank digital currency. Censorship of CBDC is essentially a bureaucrat in the government. We know these bureaucrat positions go to ideologues so that is a tremendously dangerous setup and undesirable. Instead, censorship of the stablecoin has to reside with the stablecoin issuer (for example Circle) and the entities that custody your stablecoin such as banks or crypto exchanges (Coinbase). This is more similar to how the current banking system works. The Fed doesn’t censor cash or bank accounts. Banks do that. The only new addition to the censorship structure here is the narrow bank stablecoin issuer (Circle) because people can use self-custody wallets and then the only way to censor is through the stablecoin issuer. Basically the US government has to ask Circle to censor USDC while the Fed really is not involved at all because censorship decisions are inherently political and the Fed needs to stay out of that. I think this is a much more familiar and better setup. It is intuitive and people will accept it very quickly.
I completely disagree with the Fed paper conclusion that a narrow bank stablecoin will have a negative effect on commercial bank deposits. I think the exact opposite – it will increase them dramatically because it offers consumers a choice. They can pick the safety of central bank reserves for 0% yield or they can decide when to put those safe reserves to work in the economy for positive yield. On the other hand, a stablecoin like USDC which is backed by commercial bank deposits or USDT backed by securities is simply a return to the Pre-2008 financial system that led to the financial crisis. There is no cash equivalent instrument in that system and in times of trouble institutions will abandon USDC for non-sovereign safe havens like Bitcoin and Gold. The reason why Gold rose ahead of the Financial Crisis and after the Financial Crisis is because people were looking for a safe haven and there wasn’t enough cash to go around. So they were forced into Gold. If a narrow bank stablecoin is available, many people will choose that first over Gold or Bitcoin depending on their individual situation. That is why I call the narrow bank stablecoin a “Bitcoin killer”. If it was available, institutions would seek safety in central bank reserves via a narrow bank stablecoin first before they turn to non-sovereign scarce assets like Bitcoin or Gold. If the Fed wants to kill Bitcoin and put it on a downside trajectory like it did Gold in the 80s, it needs to have a narrow bank stablecoin (digital cash) in its arsenal. Commercial bank stablecoins (current USDC) or security holding stablecoins (USDT) are not going to be perceived as good safe havens in times of economic distress just like banks weren’t in 2008. It wasn’t until the Fed deleveraged the banking system in 2011 that Gold’s rise stopped. With a narrow bank stablecoin the Fed can keep the system as deleveraged as pre-Pablo Escobar.
A banking system with 0% narrow bank stablecoins and positive Fed rates is naturally self-governing. If the economy goes into recession and the deposits go from commercial bank to stablecoin, the overall rate in the economy goes down. Let’s say 10% of the money is in stablecoins earning 0% and 90% is in the commercial banking system earning 4%. The aggregate rate is 3.6%. If depositors move to 20% stablecoin/80% commercial because of recession, and the rates are unchanged the aggregate rate is now 3.2% without the Fed cutting rates. This type of system would make Fed rates far more stable and predictable and the Fed can really only reduce rates in a really big recession. By keeping commercial bank rates at 4%, institutions will be much more incentivized to keep their money in the banking system and take risk. The current system where you lower rates in the commercial bank system to 0% is simply not an acceptable proposition – investors don’t get paid for the risk that the fractional banking system poses.
If the Fed doesn’t approve of the narrow bank stablecoin design, it will face stiff competition from Europe and China. Putin and Jinping just signed a 30-year gas deal between Russia and China that will be settled in Euros worth about $120 billion. Euro stablecoins aren’t a big deal yet, but will be in the future. Europe can certainly try a narrow bank stablecoin or an equivalent CBDC type design. China already has its CBDC and I don’t know if you have noticed but China’s rates are nearly 4%. That is because its CBDC can act like safe haven for Chinese citizens and that allows the PBOC to keep rates on commercial deposits high. The Chinese know that America’s cashless financial system failed and that is why they told Hank Paulson “there is nothing you can teach us”. America’s financial system has been in decline for the past decade and the only way out is to reintroduce cash back into the system in the form of a narrow bank stablecoin. The Fed needs to allow the economy to risk manage itself. Removing cash impaired the economy natural risk management adjustments. Digital cash/narrow bank stablecoin is the solution going forward.
An introduction of narrow bank stablecoin here would enable the Fed to raise Fed rates to 4% and thus allow it to battle inflation with better credibility. Right now markets aren’t convinced the Fed can raise rates to 2.5% because it would trigger a bunch of defaults in the high yield market. But if there was a narrow bank stablecoin option for institutions, they can diversify away from Treasuries and high yield debt today, build out their portfolio with safe central bank reserve 0% yielding instrument and call it a day. Federal debt just passed $30 trillion. That means that there is about $3 trillion (10%) potential demand for a narrow bank stablecoin. The Fed can convert big portion of its central bank reserves to narrow bank stablecoins and call it a day. USDC and Circle in my view are the clear cut leaders that would profit from this type of transition. Allaire understands this whole situation and has been pushing for Circle to adopt a narrow bank design. And I think we are not far from the moment when he is going to get that charter. Watch for USDC market cap to explode in the coming year. Circle currently offers 4% yield on USDC because USDC is basically a commercial bank deposit at the moment. When it switches to a narrow bank stablecoin USDC will lose the yield but gain the world.
A transition of USDC to a narrow bank stablecoin is also key to my short Bitcoin thesis at the moment. The moment the Fed opens central bank reserves to the public via USDC, much of the safety bid in Bitcoin will disappear and Bitcoin will collapse rather dramatically. Don’t forget the Fed will be simultaneously making its reserve scarcer via QT. I don’t know how long it will take for this transition to happen but once there is consensus at the Fed to go down the narrow bank route for official USD stablecoins, these guys will move very quickly. And USDC already there, ready to capitalize.
Stablecoins: Growth Potential and Impact on Banking