Stablecoins are a battleground for the future of money

The House Financial Services Committee marked up the long-awaited stablecoin bill and moved it toward a potential floor vote on July 27. This was a milestone, but — despite over a year of negotiations across the aisle — the bill did not have bipartisan support. Chairman McHenry bitterly complained:  

“Unfortunately, there was a third party in this negotiation that did not share our same sense of urgency — the White House…It was the White House’s unwillingness to compromise that has once again brought negotiations to a halt.”

Partisan politics may have played a role in the White House’s objection to the stablecoin bill, but what we are really witnessing is a battle for the future of money and who can issue money.

During the economic turmoil of the Great Depression, many leading macroeconomists, including Irving Fisher and other luminaries, called for a full-reserve banking monetary system, later known as the Chicago Plan. Congress ignored these calls and chose to keep fractional-reserve banking, which is still the system we have today.

During my tenure as a Fed staffer, the Chicago Plan was never mentioned to me. I was trained to take for granted that fractional-reserve banking was the only monetary system possible. Under this model, you deposit your money with a bank, and the bank must hold a portion of your deposits, but can lend out the rest. The bank can also hold cash reserves at the central bank (i.e., the Federal Reserve), which determines reserve requirements (e.g., capital requirements). Thus, banks create “commercial bank money” whenever they make loans. Only just over 1% of money in circulation today is physical currency. Most of the rest is commercial bank money.

But these Chicago Plan economists argued that this unsecured bank credit circulating in the economy as a “money substitute” was economically unstable. They argued for full-reserve banking where banks must maintain 100% each customer’s demand deposits in cash available for immediate withdrawal. Full-reserve banks cannot lend demand deposits and can only lend time deposits.

I can see why Congress found the Chicago Plan too radical. Who would make loans if not the banks? (When she was the head of the IMF, Christine Lagarde made a similar comment when asked about an IMF Working Paper on the Chicago Plan.) However, when Silicon Valley Bank and Signature Bank were closed, the real sea change that occurred was not that the US government saved regional banks because of their size and activities, but that it saved them because of the public’s changing expectations of deposits.  

We as depositors now expect to have immediate access to our deposits. When SVB failed, we depositors did not view our deposits as contractual claims the way banks viewed our deposits as liabilities. We viewed our deposits simply as money — instantly available.

But for a nerve-wracking weekend, we suddenly realized that our money at SVB and Signature was not money but really liabilities of failing banks. Even payroll processors that used SVB were caught off guard as their small business clients transferred millions of dollars to them to pay their employees.

After decades of a successful deposit insurance scheme, we now expect our deposits to be cash, available for immediate withdrawal, and we as US taxpayers bankroll our expectation that deposits are money.

When one boils it down, the current stablecoin bill debate is over who can issue the money of the future — banks or non-banks — and therefore what type of digital money can even be issued.

All in all, banks can be stablecoin issuers. They have been issuing commercial bank money for decades and can continue to do so as issuers of digital dollars on blockchain. The Regulated Liabilities Network project incubated at the New York Fed is an example of the largest banks studying how to tokenize bank deposit liabilities.

But full-reserve banks, including money transmitters, can also issue digital dollars. Money transmitters are simply transferring funds. If I send money via a money transmitter, the money transmitter can tokenize my money and send it across the blockchain to make payment. In the meantime, the money transmitter must maintain 100% cash reserves. Such stablecoins would not be digital representations of deposit liabilities, but simply digital representations of funds.

I am not arguing that the US can have only fractional reserve banking or only full reserve banking. But our system should allow for both models to co-exist. The nature of money is quickly evolving, and we should not let old paradigms prevent respecting the new societal expectation that the money we leave with a financial institution is fully ours to use when and how we want to.

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Don’t Blame Crypto for Your Banking Problems

Before I began working in the crypto sector, I was a banking regulator. I am struck by this string of bank crises and how some believe crypto is to blame. The evidence, by contrast, points to a more fundamental culpability besides crypto.

Ultimately, much of what we are seeing with these crises is an artifact of a structural change in the system. At some level, uninsured deposits will always bear a run risk; and as uninsured deposits increase across the system, the system in turn will face a greater run risk. Add a rising interest rate environment to this, and you pour gasoline on the fire. 

And looking towards Silicon Valley, or, more narrowly, crypto, as the root of the problem is looking in the wrong place.

The narrative conflating SVB with crypto woes is dangerously misleading. Unlike Silvergate, SVB was not a crypto-focused bank, it was a technology and healthcare-focused bank. Why is SVB failing on the heels of Silvergate’s wind down? Did Silvergate’s collapse cause SVB’s failure? Or was it simply correlation, though perhaps with some shared underlying causes?

Concentration risk brought down crypto-friendly banks Silvergate and Signature

At the first crypto startup where I worked, we struggled to find banking partners even though we were funded by well-known VCs (and indeed, by the co-founder of Microsoft). At that time, which was four years ago, there were only three or four crypto-friendly banks out of the over 4,000 banks in the US — and SVB was not one of them. 

Instead of distributing exposure risk to the crypto sector across the US banking system, the risk was concentrated in these few banks because other banks were not willing to bank crypto companies. This concentration risk was not unknown. I wrote about it in my research paper back in 2021. Due to the lack of regulatory certainty and passive supervisory encouragement to de-risk (aka, to not bank crypto), most banks did not want to incur the additional scrutiny. Fast forward to last year, and we still see the same environment of regulatory uncertainty along with the same three or four crypto-friendly banks. This huge concentration risk was not created by industry; regulators had a heavy hand.

Fast forward again to today, none of these crypto-friendly banks are available anymore to bank crypto. Two of these crypto-friendly banks have failed, and the other one or two banks have de-risked. While we have seen deposits from crypto now going toward large and regional US banks, it’s not clear if this will be short-term support or long-term commitment. And if crypto firm deposits go offshore or to shadow banking, this will pose a worrying vision for the digital future of the US.

Deposits shot up across the banking system

Bank deposits shot up across the entire US banking system during the pandemic — not just banks heavily engaged with crypto companies

According to a Fed research paper published last year, deposits at US domestic commercial banks expanded dramatically when the Covid-19 pandemic began. Total deposits rose by more than 35 percent between the end of 2019 and the fourth quarter of 2021 to around $18 trillion. 

It had been a considerable time since the US witnessed such a dramatic increase in deposits. Intuition might suggest that greater savings, i.e. the consumer acting prudentially in a crisis, is maybe a good thing. As with most things, the answer is: It depends.

The FDIC was created by FDR in 1933 to address the most severe banking crisis in US history by insuring bank deposits. I was working on the Hill when Congress raised the FDIC coverage from $100,000 to $250,000 per depositor and per insured bank, during the 2008 global financial crisis. It helped to stem the tide of bank runs by retail depositors, but even then I wondered how it would possibly mitigate the risk of bank runs by corporate depositors. 

Companies must meet payroll, receive payments and make payments. Businesses generally keep a cash buffer of three to six months’ worth of operating expenses, which can easily exceed $250,000 — even for startup companies. These large corporate deposit accounts can go down quickly. Bank runs are no longer caused just by retail depositors, but by regular companies, VCs and startups. Silicon Valley Bank (SVB) experienced a $42 billion bank run in less than 24 hours.

According to Business Insider, its survey of 15 US banks found over $1 trillion of uninsured deposits. Signature Bank had 90% uninsured deposits, SVB had 88%, and even Citigroup, a global systemically-important bank, has 85%.

These numbers reveal a general and increasing financial stability risk in the US financial system. Yet in its most recent Financial Stability Report from 2022, the Fed did not call out this structural vulnerability.  

I’m also seeing a narrative in the media that if SVB had been subject to full capital and liquidity rules, there would not have been a bank run. Whether SVB should have been subject to these rules is a separate question, but it’s unclear to me whether any bank — no matter how well capitalized and well-managed — can withstand a $42 billion outflow in a single day.

In the end, bank deposits are simply contract claims the depositor has with the bank. The Fed, along with the Treasury and the FDIC, took the unprecedented step of insuring ALL deposits at SVB and Signature Bank. Many of us in both the tech and crypto sector breathed a sigh of relief and gratitude for the government’s action, but we will not know how this unusual move will impact moral hazard in the financial system in the long run. Former FDIC head Sheila Bair recently commented that the uninsured depositors, the companies and high net worth individuals should be the ones exerting market discipline by more closely examining their banks of choice. But how can they do that when material information about the bank, including supervisory exam findings, is confidential?  

Poor management of interest rate risk tanked SVB

Banks generally fail due to credit risk from borrowing short and lending long. But SVB failed due to interest rate risk, which is a more unusual phenomenon. Supervisory bank exams by regulators cover several risk “stripes,” including interest rate risk (IRR). As described above, SVB (like other banks in a low interest rate environment) purchased longer-dated Treasury securities in search of higher net interest margins (NIMs). What SVB did not foresee was the accelerated rate with which its tech company customers would begin to use up their store of deposits that they had raised during fatter years.

SVB simply forgot the fundamentals of IRR management. For almost a decade — from 2008 to 2017 — the US experienced not only low interest rates, but near-zero interest rates. SVB is definitely not the only bank to have grown used to the low interest rate environment. Banks across the US financial system are sitting on $620 billion in unrealized losses (assets that have decreased in price but have not been sold).

But even if SVB and other US banks may have forgotten how to manage IRR, the Fed and state supervisors (note: SVB’s main regulators were the San Francisco Fed and California’s DFPI) should not have forgotten. IRR supervisory reviews should have flagged this weakness in the safety and soundness of SVB, especially because disclosures show that risk clearly became a skyrocketing concern for the SVB board.

US policymakers and industry should leverage lessons learned to address the structural vulnerabilities that have cracked through. The unprecedented move to protect all deposits at SVB and Signature will have consequences on the US banking industry to be discussed another day, and it’s certainly time for a refresher of fundamentals in bank risk management for both the US banking industry and regulators.

But most importantly, regulators should encourage US banks to bank all sectors in order to reduce exposure risk — from crypto to tech to housing and beyond.

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