Friday, September 23, 2016

The French shareholder revolution


I recently stumbled on a new and innovative capital structure that, as far as I can tell, only exists in France.

Since 2011, French beauty giant L'Oréal has been rewarding long-term investors with a loyalty bonus. It goes like this: if you buy L'Oréal shares, register them before the end of 2016, and hold them till 2019, you'll start to enjoy a 10% dividend bonus come January 1, 2019. So if L'Oréal declares a dividend of €1.00 in 2019, anyone who has held since 2016 gets €1.10. Not bad, eh?

Think of this as an obligatory transfer payment from short-term L'Oréal shareholders to long-term ones. Put differently, if you want to speculate in L'Oréal shares, expect to pay investors a fee, or tax, for that luxury. Unlike most taxes, this one hasn't been instituted by the government. Rather, it's the corporation that is decreeing this particular redistribution of income.

How big is the tax? Let's imagine an investment of $10,000 in the shares of a company that consistently appreciates 5% each year and increases its dividend by 5%. The dividend yield is 2% and all dividends are re-invested.

Fig 1: Comparative return from investing $10,000 in a firm that offers a loyalty bonus program

Assuming no loyalty dividend, the initial stake will be worth $79,851 upon retirement thirty years later. However, if the shares are registered in the 10% loyalty program for the entire period then the stake grows to $84,851. See figure above. The patient investor who takes the second option is 6.3% richer thanks to the premium. Tens of thousands of impatient speculators over that thirty year period will have effectively provided the patient investor with this boost to their wealth, most of these speculators probably not even aware of the subsidy they are providing. That's the magic of compound loyalty dividends! Note: By playing with the assumptions, say by making dividends grow at a faster rate (7%) than the share price (3%), the final wealth differential can be as high as 11.8%.  

The loyalty dividend structure, otherwise known as prime de fidélité in French, goes back to 1993 when Groupe SEB, a French appliance manufacturer, adopted it. That same year it was copied by industrial gas giant Air Liquide, Siparex, and De Dietrich (which went private in the early 2000s). Despite ensuing controversy in the French legislature over the fairness of elevating one class of shareholder above the rest, the ability to provide prime de fidélité was enshrined in French law in 1994, with several limits.

These limits include: 1) Shareholders must hold for at least two years; 2) The bonus cannot exceed 10% i.e. if the regular dividend is €1.00, nothing over €1.10 can be paid, and; 3) If a given shareholder owns, say, 10% of the company, they can only earn a bonus on the first 0.5% of that, the other 9.5% qualifying for the regular dividend.

After the first wave of adoption, the prime de fidélité structure was largely ignored by French firms, the exception being concrete giant Lafarge which began paying a loyalty dividend in 1999. But post credit-crisis, the idea has found a second wind. L'Oreal votde to institute a prime de fidélité in 2009; Credit Agricole, Energie de France, and Sodexo did so in 2011; and GDF Suez and Albioma in 2014. These are not small companies. Five of them—Lafarge, GDF, EDF, Credit Agricole, and Lafarge—are in the CAC 40, France's bellwether equity index.

I'm a fan of the prime de fidélité structure. If firms want to encourage an investing mentality among their shareholder base, setting up an an incentive mechanism like a loyalty bonus scheme seems a good way to go about it. Shareholders who are incentivized to think in terms of the long game will be more likely to elect a board of directors with that same mindset, the board in turn exerting pressure on management to adopt long-term goals. Even better would be a version of this program that allows investors to begin enjoying loyalty dividends from the moment they buy shares, say by giving new shareholders the option to lock-up their shares for a fixed two year term in return for a reward.

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Addendum: All of this ties into a favorite topic of mine. The world is missing a key financial product that I like to call the equity deposit. Indexed ETFs and mutual funds allow for immediate or end of day redemption, but this sort of uber-liquidity simply isn't required by the large population of passive equity investors who expect to hold till retirement.

To buy these indexed equity deposits, investors would be required to lock-in their investment for, say, ten years, with redemption only possible upon maturity. With captive funds in hand, the manager of the equity deposit scheme would be able to move a large percentage of the fund's assets out of unregistered shares and into registered loyalty programs. Mutual funds and ETFs, which offer instant or end of day redemption, need to stay relatively liquid in order to meet potential redemption requests. Putting shares into registered share programs like L'Oréal's would introduce liquidity risk, so mutual funds and ETFs would probably only be able to make limited usage of loyalty programs.

Equity deposits would thus be able to lever the magic of compound loyalty dividends to provide those with long-term goals a higher return than an equivalent index mutual fund or ETF. After all, if your plan is to buy once in your thirties and sell once in your sixties, why waste money paying for all the liquidity services that come in between?

Thursday, September 15, 2016

Is the Fed breaking the law by paying too much interest?


George Selgin had an interesting post describing how the Fed appears to be breaking the law by paying too much interest to reserve-holders. This is an idea that's cropped up on the blogosphere before, here is David Glasner, for instance.

I agree with George that the the letter of the law is being broken. That's unfortunate. As Section 19(b)(12)(A) of the Federal Reserve Act stipulates, the Fed can only pay interest "at a rate or rates not to exceed the general level of short-term interest rates." With three month treasury bills currently around 0.33% and the fed funds rate at 0.4%, the current interest rate on reserves (IOR) of 0.5% exceeds the legal maximum.

Unlike George, I don't think the Fed deserves criticism over this. If the letter of the law is being broken, the spirit of the law surely isn't.

If there is a spirit residing in the law governing IOR, it's the ghost of Milton Friedman. Since the Fed's inception in 1913, IOR had been effectively set at 0%, far below the general level of short term interest rates. This has acted as a tax on bankers. They have been forced to hold an asset—reserves—that provides a below-market return. Friedman's big idea was to remove this distortionary tax by bringing IOR up to the same level as other short term interest rates. Banks would now be earning the same rate as everyone else. The Fed would only get the authority to set a positive rate on reserves in 2008, long after most modern central banks like the Bank of Canada had implemented Friedman's idea.

Friedman wanted to remove the tax, but he didn't want to introduce a subsidy in its place. To prevent central bank subsidization of banks, the Federal Reserve Act is explicit that IOR should not exceed other short-term interest rates.

In practice, how might the Fed set IOR in a way that subsidizes banks? This is more complicated than it seems. If the Fed sets IOR at 1%, arbitrage dictates that all other short term rates will converge to that same level. After all, why would a financial institution buy a safe short term fixed income product for anything less than 1% if the central bank is fixing the yield of a competing product, reserves, at 1%?

Short-term yields won't converge exactly to IOR. Some will trade a hair above IOR, others a bit below. This is because each short-term fixed income product has its own set of peculiarities and these get built into their yield. For instance, buying federal funds is riskier than parking money at the Fed; in the latter transaction the Fed is your counterparty while in the former it's a bank, So the fed funds rate should trade a bit above IOR. But we wouldn't say that a higher fed funds rate is a sign of a below-market return on reserves, or that this spread represents an implicit tax on reserve owners. The fed funds rate exceeds IOR only because that is how the market has chosen to appraise the risk of owning fed funds.

Conversely, because a treasury bill is ofttimes less risky then parking money at the Fed, its yield should regularly dip below IOR. When it does, no one would say that the Fed is providing an unfair subsidy to reserve holders by paying IOR in excess of the treasury bill rate. The lower treasury bill rate is simply the free market's way of accounting for the superior risk profile of treasury bills relative to reserves.

Nowadays, with IOR at 0.5% and treasury bills yielding 0.33%, the Fed is clearly contradicting the wording of the Federal Reserve Act. IOR has been set at a rate that "exceeds the general level of short-term interest rates." But this by no means implies that the Fed is breaking the spirit of the law. The spirit of the law only tells the Fed not to pay subsidies to banks. As I explained above, the yield differential may simply reflect the market's assessment of the unique risks of various short-term fixed income products, not  a policy of paying subsidies.

To get the ghost of Milton Friedman rolling in his grave, here is how to structure IOR so that it offers a subsidy to banks. The Fed would have to set up a tiered reserve system where a bank's first tier of reserves earns a higher rate than the next tier. To begin with, assume that Fed officials deem that a 0.5% fed funds rate is consistent with a 2% inflation target. The Fed offers to pays interest of 100% on required reserves (I'm exaggerating to make my point) while offering just 0.5% on excess reserves. Banks will hold required reserves up to the maximum and reap an incredibly 100% yearly return. All reserves above that ceiling will either be parked at the Fed to earn 0.5% or lent out in the fed funds market.

Thanks to arbitrage, the 0.5% rate on excess reserves ripples through to other short term rates. Because a bank can always leave excess reserves at the Fed and earn an easy 0.5%, a borrower will have to bid up the fed funds rate and t-bill rates to at least 0.5% in order to coax the marginal lender away from the Fed.

And that's how the Fed would subsidize banks. The "general level" of rates as implied by the rate on fed funds and treasury bills hovers at 0.5% while banks are earning a stunning 100% on a portion of their reserve holdings. It's highway robbery! Milton Friedman would be furious; the distortionary tax he so disliked has been replaced with a distortionary subsidy.

By the way, if you really want to know what tiering and central bank subsidies to banks look like, this is the exact same mechanism the Bank of Japan and Swiss National Bank have introduced to help banks deal with negative interest rates. See here and here.  

So the bit of legalese that says that IOR should not exceed the "general level of short-term interest rates" is really just a poorly chosen set of words meant to describe a very specific idea, namely, a prohibition against setting a tiered reserve policy where the first tier, required reserves, earns more than the second, excess reserves, the ensuing subsidy flowing through to banks.

At the end of the day, what accounts for the current divergence between IOR and the other short term rates? Because the Fed has not set up a tiered reserve policy, there is simply no way that the divergence reflects a subsidization of banks. There is only one remaining explanation. Peculiar developments in the microstructure of the fed funds and t-bills markets have led traders to discount these rates relative to IOR.

So you can rest easy, Milton.

The peculiarities bedeviling the fed funds market are explained by Stephen Williamson here. There are several large entities, the GSEs, that can keep reserves at the Fed but are legally prevented from earning IOR. Anxious to get a better return, they invest in the fed funds market market, but only a limited number of banks have the balance sheet capacity to accept these funds. This oligopoly is able to extract a pound of flesh from the GSEs by lowballing the return they offer, the result being that the fed funds rate lies below IOR.

As for treasury bills, they are unique because, unlike reserves held at the Fed, they are accepted as collateral by a whole assortment of financial intermediaries. Put differently, treasury bills are a better money than reserves. Because the government is loath to issue too many of them, the supply of treasury bills has been kept artificially scarce so that they trade at a premium, a liquidity premium.

George ends his post by appealing to his readers to sue the Fed. I don't think think a lawsuit will bring much justice. If there are to be any legal battles to be fought, better to petition Congress to adjust the wording of the Federal Reserve Act so that it better fits the spirit of the law. We don't want the law to misidentify a situation involving IOR in excess of the "general level of interest rates" as necessarily implying subsidization when microstructure is actually at fault. While Milton Friedman had a lot of reasons to criticize the Fed, this probably wouldn't be one of them.

Tuesday, September 6, 2016

What finance can learn from automakers


Arnold Kling is appalled by Lynn Stout, who accuses Wall Street of providing too much liquidity:
Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”
Kling disagrees, saying that liquidity is a good thing:
I have said that as individuals and nonfinancial firms we wish to hold liquid, riskless assets and issue risky, illiquid liabilities. Financial firms do the opposite. I am quite sure that this produces real benefits.
I'm going to walk the line between Kling and Stout in an effort to show how they're both right; liquidity is an awesome product that Wall Street just happens to be providing too much of. And I'm going to use the market for cars as my foil.

Given a choice between buying a car that has an old-fashioned manual transmission or a modern automatic, the easier option beckons. That's probably why automatics have become so popular with consumers since being introduced back in the 1940s. But the advent of the automatic transmission hasn't stopped automakers from selling vehicles with manual transmissions and consumers from buying them. If you're willing to put up with the constant pumping of the clutch in rush hour traffic, the smaller sticker price of a manual is quite attractive, as are its lower maintenance costs. By selling cars with either transmission, car companies satisfy the preferences of both sets of consumers.

This same strategy of product splitting (for lack of a better term) should also be used for liquidity, but it isn't.

When Wall Street improves the range of liquidity services that are built-in to bonds and shares, it does so for every instrument in existence. This sort of broad improvement in liquidity is what Kling is celebrating in his post. Now there should be no doubt that liquidity is a product that offers very real benefits, as Kling points out. But improving the liquidity of every instrument is like a car manufacturer adding only automatic transmissions to every car it produces. If you think that neither the ease of an automatic transmission nor the improved liquidity services embedded in a stock are justified by their higher price—tough luck: you can't exercise an opt out clause. You've simply got to eat the cost of these features.

While car manufacturers have chosen to appeal to both sets of customers by continuing to sell manual transmissions, Wall Street doesn't provide an equivalent liquidity-lite option to go with its regular fare of increasingly-liquid instruments. If you're a buy-and-hold investor like me, then you've probably purchased a few ETFs that you're going to unthinkingly hold for a x decades until retirement. Folks like us—slow investors—simply don't put much value on the ability to sell our ETFs at lightning speeds between now and then. So in a sense Stout is right to accuse bank executives of profiting from the overproduction of liquidity. Slow investors like me would be quite content with a good ol' manual transmission, but because Wall Street is only hawking fancy automatics, we're paying up for a product—liquidity—that we simply don't need.

And that's why I agree with both Kling and Stout. Kling is surely right that the huge quantity of liquidity created by Wall Street over the last 40 years has been a boon for many investors, but Stout is right that these liquidity services exceed the needs of a certain set of investors. Automatics are great, but unfortunately they're all that the finance industry builds—some of us just want manuals.

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If you're interested, here's a solution.

The way to satisfy both sets of investors, those who crave liquidity and those who don't, is for Wall Street to start engaging in the same product splitting that car manufacturers do. For every existing stock or ETF, offer both automatics & manuals: an expensive liquid option as well as an illiquid but cheaper version. As an example, consider that banks already offer manuals & automatics in their deposit businesses. Depositors can choose to hold easily transferable demand deposits or forgo liquidity by investing in higher-yielding (i.e. cheaper) term deposits.

Here are ways to implement a manual & automatic program in the world of equities:

1. Publicly-traded companies should start slow share programs.

By implementing a slow share program, companies provide those investor who are willing to forego liquidity for at least two years with bonus stock dividends. The shares of these investors are locked up; they cannot be sold. Short term investors, those who prefer to hold for less than two years—and therefore refuse to lock up their shares—won't qualify for the bonus. Stock dividends provided by a slow share program improve the returns of long-term investors by diluting the ownership position of short-term investors. To complete our car analogy, locked-in slow shares are Wall Street's cheap but inconvenient manual transmission; regular unlocked shares are the expensive but handy automatic.

I go into some of the reasons that firms may have for rewarding long term investors here.

2. Financial services firms should provide equity deposits.

When an investor buys an ETF or an index mutual fund, it's as if they've deposited the underlying shares at a bank and have received a receipt in return. The receipt for the world's most popular ETF, the SPDR S&P 500, is incredibly liquid; as long as it's not the weekend or late at night, anyone can cash out in just a moment. An index mutual fund receipt is a little less liquid; it can only be redeemed at the end of each trading day.

If ETFs and index mutual funds are the expensive automatics of the finance world, here's how to create a cheap manual. The idea behind an equity deposit is to push the redemption period out even longer. A three-month equity deposit could only be cashed in after three months have expired, a five-year deposit after five years have passed, and likewise for a twenty-year deposit.

Because the manager of an equity deposit scheme has a set of investors who have committed to being illiquid for a fixed term, he/she can lock up more shares in slow share programs than the manager of an ETF or index mutual fund, who always requires a certain degree of flexibility to meet the liquidity needs of investors. Greater participation in slow share programs means that the returns that flow to an equity deposit holder will always be higher than those that flow to ETF or index mutual fund owner, or, put differently, that those willing to forgo liquidity can buy a dollar's worth of corporate earnings for less than those who are not willing to forgo it.

While slow share schemes are just science fiction, stock lending provides a real life way for equity deposit managers to reduce costs. ETFs and index funds earn significant amounts from lending out stock, see for instance here. Because they have a committed deposit base, equity deposit managers would be able to commit to lending out stock for long periods of time, say for a fixed 365-day term. Because their base of depositors can cash out at any moment, ETF and index fund managers can only rollover a series of 1-day stock loans for 365 days. This flexibility allows equity deposit managers to harvest the stock lending term premium. Put differently, you can make a lot more money by committing to lend once for a full year than to lend 365 times for one day.

I've gone into more detail on equity deposits, the potential manual transmission of the finance world, here and here.

Friday, September 2, 2016

Kocherlakota on cash


Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:


I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.



P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.

Monday, August 22, 2016

End of a stablecoin



Bitcoin has had another white knuckle year, rising from a low of $350 in January to a high of $780 in June. As I've said many times before, if crytpocurrency is going to make a genuine dent in the world monetary order, it'll only happen when its price isn't so volatile. And one of the best ways to smooth things out is by creating a stablecoin, specifically by choosing to peg a cryptocurrency to a popular existing medium of exchange like the U.S. dollar.

Stablecoin isn't just theoretical, a number of these tokens exist. They fail too. It's worth investigating the recent collapse of one the fledgling stablecoins, NuBits, to look for clues about the dangers and pitfalls of maintaining a stablecoin peg.

Back in September 2014 a developer going by the pseudonym JordanLee set out on a brave attempt at pegging a cryptocurrency, NuBits, to the U.S. dollar. The $1 peg lasted for around twenty months before falling in late May to 95 cents and outright failing on June 8. See the chart below.

Source: Coinmarketcap

My understanding is that at its peak, NuBits was registering a healthy $3-4 million in trading volumes every day. While it never grew to be a genuine medium of exchange--you couldn't buy a coffee with it--the tokens were a popular way to hedge against bitcoin volatility. Had the peg held, who knows what might have happened?

In late May, a single large seller of NuBits emerged, offloading around 10% of the entire NuBits supply in a day or two (you can see the volume spike in the chart above). To keep the price of NuBits at $1, the NuBits team that was tasked with maintaining the peg had to use up a large quantity of its reserves. In the course of events the team decided to widen the peg to $0.95-$1.01 in order to slow the reserve bleed. However, the next round of selling broke the peg for good and the now-floating NuBits price quickly plummeted below 50 cents.

Did NuBits fail because it was well-thought out but poorly implemented? Or was it unsound from the get-go? I lean towards the latter.

To understand how the NuBits peg works, we need to back up and investigate the architecture of NuBits a bit more. NuBits are digital tokens issued by the overlying "Nu network," which is sort of like a digital corporation with no physical hub and no real legal structure. In addition to NuBits, the Nu network also issues shares which give shareholders the right to earn profits from the network and participate in governance. These shares are called NuShares, and as I'll show later on these NuShares are a key part of maintaining the NuBits peg.

Protecting the peg when there is a large increase in demand for NuBits is easy; just create more NuBits. Protecting it when there is an excess supply of NuBits is trickier. In this respect, NuBits is no different from any currency issuer maintaining a peg, say like the People's Bank of China which must have enough resources to keep the yuan anchored in place when a run into dollars begins.

A small quantity of Bitcoin reserves is just one of the Nu network's bulwarks. Once used up, the peg's next line of defence is referred to as parking. Think of this as paying an interest rate on term deposits. When NuBits sellers are pressuring the peg, the Nu network relieves that pressure by offering, say, 10% interest to anyone who is willing to park, or freeze, their NuBits for a period of time. Instead of selling on the open market, the idea is that people will decide to stay put.

Unfortunately, I think that parking may have actually contributed to a failure of the peg. The problem is that the Nu network's parking rates are paid with new NuBits rather than existing NuBits and thus they increase the supply. If a peg is being threatened by an excess supply of money, it makes little sense to relieve said pressure by creating even more NuBits. Instead, the Nu network could have avoided parking-related supply bloat by paying interest using existing NuBits. And it should have earned these NuBits out of the regular course of its operations, say by charging a small user fee, or cutting down on costs. Whatever the case, it means that the Nu network needs to be profitable.

In addition to parking, the Nu network has another mechanism for maintaining the peg. It can issue new NuShares (by engaging in a stock split) and use these to buy back NuBits. The actual route taken seems to have been more lengthy, specifically selling new NuShares for bitcoin, and then using bitcoin to buy back enough NuBits so the $1 peg holds.

But using NuShares to 'back' the NuBits side of the network seems to me like a ticking time bomb. Consider the following dynamic: the moment the peg is challenged by NuBits sellers, speculators will push down the price of NuShares in anticipation of potentially dilutive issue of new NuShares. Which means that the Nu network will have to issue even more NuShares to protect the peg, which only makes the peg that much more costly to maintain and therefore more vulnerable. This leads to more speculation against the peg, and yet another round of NuShares panic as speculators unload in anticipation of dilution. It's a vicious circle that ends in a price of zero for NuShares, and for NuBits too.

There's also an inherent conflict of interest. If maintaining the peg means that shareholders must bear a collapse in the price of their NuShares, at some point is it worth it for them to maintain the peg? Perhaps it's better to pull a Richard Nixon and close the conversion window. Scan the NuBits discussion boards and there seems to have been a bit of this self-serving thinking during the breaking of the peg episode.

Better to use a stable asset like gold or dollars in a vault to back a NuBits-style scheme than volatile share tokens. Of course, this isn't as elegant a solution, since it requires a lifeline to a real world safety deposit box. Nevertheless, it would have helped keep the peg in place.

In sum, NuShares is a good attempt, but it didn't quite succeed. That it lasted so long is a testament to the value of the community that emerged around it. As a tight-knit group it was probably able to self-support the peg at least for a while, insulated from its own inherent short comings by its own momentum. That being said, the Nu network is still around, and according to some rumours, trying to re-peg themselves at $1. I wish them luck!



Related links:

A Report on Peg Abandonment and How to Proceed From Here [link]
The Search for a Stable Cryptocurrency [link]
NuBits - The price stable currency... until it’s NOT!! [link] [update]
My Interpretation of Jordan Lee’s Liquidity Engine Model & Why its First Attempt at Pegging Failed [link]
Theoretical Fedcoin, Meet Operational NuBits [link]
Hayek-Style Cybercurrency [link]
Some Thoughts on Cryptocurrencies and the Block Chain [link]
Robert Sams: Bitcoin, Volatility and the Search for a Stable Cryptocurrency [link]

Wednesday, August 10, 2016

Central banks deposits for you and me


The Bank of England recently announced that it will end a 300-year tradition of allowing employees to keep chequing accounts at the Bank. You can see an example of a cheque above, which is marked with the sort code 10-00-00. Traditionally, folks like you and me have only been able to get a piece of the central bank's balance sheet by holding banknotes. Central bank deposit accounts, which are far more convenient, have been limited to banks and other financial institutions. But the BoE provides a rare example of regular people, specifically employees, being permitted to directly own fully transferable central bank deposits, at least until recently.

The BoE's termination of this seemingly archaic practice is especially interesting in the context of growing efforts to crack open central bank balance sheets to those who have traditionally been hived off from them. A concrete step in this direction is the Federal Reserve's overnight reverse repurchase facility, which allows money market mutual funds to hold overnight balances at the Fed. More ambitious (but less concrete) is the Bank of England's Ben Broadbent, who describes the idea of a central bank adding more counterparties-
"perhaps a wide range of non-bank financial companies, say.  It might mean something more dramatic:  in the limiting case, everyone – including individuals – would be able to hold such balances."   
Echoing Broadbent, BoE Deputy Governor Minouche Shafik has spoken of the need to rethink "about to whom we give access to the advantages of central bank money with its unique qualities of finality of settlement." The idea here is to allow non-banks involved in fintech direct access to the Bank's real time gross settlement system, as Mark Carney goes on to illustrate here.

Turning to the blogosphere, John Cochrane has recently written about having all money backed by the government in order to end bank runs. And in the same vein, here is David Andolfatto's idea of allowing TreasuryDirect balances to be tradeable, thus providing individuals and firms with a safe place to keep cash other than the banking or shadow banking system.

This democratization of central banking sounds like a novel idea. Nosing deeper into the Bank of England's history, however, we learn that it was not just employees who could hold Bank of England deposits; most people could. Some of them were quite famous. An interesting anecdote from the 1700s has Sarah, Duchess of Marlborough, asking her bankers at the Bank of England to provide her with a freebie, namely some pens because she 'could get none that were good.' [1]

Moving forward a century, we learn that upon opening for business in 1855 the Bank of England's Western branch tended to attract small businessmen and private individuals "of modest means" as clients, including the accounts of the University of London, a Regent Street hatter, and a Sackville Street clothier—all on its first day of operations. Later that year the household of Queen Victoria left its private bank in order to do business with the Western branch. By all accounts, the Bank of England seems to have had excellent service:
"Staff were expected to recognize customers on sight and have a good, clear hand for writing up passbooks. Two porters were always on duty at the main entrance, clad in the pink livery of the Bank of England with silk top hats, and even the cashiers wore top hats when serving at the counter." [2]
The Bank of England kept up a retail presence well into the 1900s. But as public service came to be regarded as the Bank's main role, the aggressiveness of its commercial and retail businesses was reduced and it transitioned into a purely bankers' bank. The Western branch would be sold in 1930 to the Royal Bank of Scotland. [3]

By 1963 the Bank of England's services to the public were limited to a small number of accounts for existing customers. Presumably as they died, these accounts were closed. The most recent example of the Bank of England allowing non-banks to set up accounts comes from 2003, when Bank officials decided to provide Huntingdon Live Sciences, a drug company facing threats from animal rights activists, with a BoE account because commercial banks refused to offer their services.

So while it may seem that the Bank of England's Broadbent and Shafik are introducing a modern approach to central banking, the practice of allowing private individuals and non-financial businesses to directly hold central bank balance sheet space (in a non-cash form) is actually an old one. What lessons can we take from this historical example?

Many people believe that an open central bank balance sheet has the potential to render our traditional banking system extinct. Banks are special. They provide the world's most popular exhange media—deposits—as an offshoot of their primary business, lending. But as Robert Sams points out, if individuals are allowed to own safe central bank deposits directly there may no  longer be a reason for them to hold risky bank accounts. Demand for bank deposits falling to zero, banks will have to fund their loans to the public with regular bonds or equity, even as payments are re-routed through the books of the central bank. Fractional reserve banking as we know it is dead.

Depending on who you ask, the replacement of fractional reserve banking with so-called narrow banking, or 100% reserve banking, can be either good or bad. I'll leave that discussion for another day. Whatever the case, Bank of England history illustrates that private bank deposits can coexist with an open central bank balance sheet. Given the choice between keeping accounts with the safe Western branch or a risky private bank, individuals did not collectively flock to the former.

No doubt this was partly due to the two things, the Bank of England's policy of charging for servicing unprofitable accounts and of not paying interest on deposits. Its competitors, on the other hand, did pay interest. In essence, private banks had to retain customers by offering better services.

Which brings us back to the Bank of England's recent decision to close employee accounts. Given the Bank's stated intention of opening up its balance sheet, wouldn't it have been an opportune time to open up its retail banking business to all of England rather than shutting it down? The Bank maintains that it had been having trouble competing with services like online banking being offered by private banks. But as history shows, since a central bank offers something private banks can't —safety—it needn't be as competitive in the services it provides. Alternatively, it could be that the Bank will be following a different strategy of opening itself up, say through a distributed ledger or something like PositiveMoney's Digital Cash Accounts. Whatever the case, don't be fooled by the technological terminology; if the Bank were to open itself up, this would be more of a returning to the fold than a bold new future.



[1] Bank of England: first report, session 1969-70 (link)
[2] Western Branch of The Royal Bank of Scotland - The Story of a Bank and its Building (pdf)
[3] Branches of the Bank of England, 1963 (pdf)

Sunday, July 31, 2016

Monetary policy as a system of connected lakes (a post for John Hussman)


I always like reading fund manager John Hussman because he writes very well, but I feel like he's dug himself into a bit of an intellectual rut—a situation that happens to all of us. For a number of years now Hussman has been accusing the Federal Reserve of setting off a massive bubble in equity markets. But if you ask me, his claim really doesn't square with the observation that we haven't seen a shred of consumer price inflation over that same time frame. Let's explore more.

Hussman recently penned an admirable description of the hot potato effect, the process that is set off by an easing in central bank policy:
Initially, central banks focus on purchasing the highest-tier government securities (such as Treasury bonds in the case of the U.S. Federal Reserve). Central banks buy these interest-bearing securities, and pay for them by creating “base money” - currency and bank reserves. That base money takes the place of interest-bearing securities in the hands of the public, and someone then has to hold that amount of zero-interest money at every moment in time until it is actually retired by the central bank. 
Now, having traded their high-quality, interest-bearing securities to the central bank in return for zero-interest cash, a portion of those investors will simply hold the cash in the form of currency or bank deposits, but some investors will feel uncomfortable earning nothing on those holdings, and will try to pass the hot potatoes onto someone else. To do so, these investors now have to buy some other security that is lower on the ladder of credit quality, and more speculative. The sellers of those securities then get the zero-interest cash. Some of those sellers, unwilling to reach for yield in even more speculative securities, hold the cash, but some climb out to a further speculative limb. Ultimately, the process stops when yields on speculative securities have fallen low enough that investors are indifferent between holding zero-interest cash and holding low-yielding but more speculative securities. At that point, all of the new base money is passively held by somebody.
For those who didn't bother reading the above quotes, here's a quick summary. Start out with a market where everyone is happy with their holdings of cash and securities. New base money is suddenly introduced by the Fed. In an effort to rid themselves of the excess cash, people drive the prices of securities to a high enough level (or their yields low enough) that everyone is once again content with their portfolio of cash and securities. In other words, we get asset price inflation.

A nice way to think of this is to imagine a system of lakes connected by channels, the water level representing prices. When water is poured into one lake the system is disturbed. Water quickly flows out of the first lake through the various channels into the other lakes, the water level of each body of water rising until they are equal. The agitated water becomes stagnant again. Likewise, when the Fed creates and spends new money it quickly courses through the various asset market until the price of each security has risen to a point that all new money is willingly held.

Hussman uses the hot potato effect a lot in his writing. And while I like his description of the effect, it always seems incomplete. He's missed how a Fed-induced asset price inflation might be conveyed to consumer goods markets.

Securities are really just promises of future consumption. By buying Google shares now, we delay consuming stuff now and push it off to some future date. So when Hussman says that easy monetary policy is driving up securities prices, we can think of this as the price of future consumption rising relative to present consumption.

Prior to the monetary expansion, investors will have already chosen whatever balance between present and future consumption feels right to them. Assuming these preferences stay the same throughout, the Fed-induced rise in future consumption prices (ie. Hussman's asset price inflation) means that people are now getting more future consumption than they had originally bargained for. Using our lake metaphor,  the water level of the future consumption lake has risen above the present consumption lake.

Uncomfortable holding too much future consumption, people will begin to rebalance into present consumption—after all, it offers a better bang for the dollar. Consumer price inflation is stoked as everyone buy goods and services. This inflationary process stops only when yields on present consumption have fallen low enough that people are once again indifferent between future consumption and present consumption. Or, returning to our lake metaphor, water has to flow out of the future consumption lake into the present consumption lake until water levels are equal and the surface is once again calm.

Over the years, Hussman has made use of the hot potato effect to say that the stock market is in a massive bubble thanks to Fed easy monetary policy. But I don't buy this claim. If the Fed really was causing such an enormous disturbance in securities markets, we'd have seen some sort of spillover into consumer prices as investors rebalance out of future consumption into present consumption. However, inflation in the U.S. has been well below 2% for several years now.

If the Fed is to be accused of causing an asset bubble, Hussman needs a theory to explain why people have not been arbitraging the markets for future and present consumption. Why haven't we seen a roaring CPI? This seems like a tall order. From what I've read of his work, Hussman traces easy money to as early as 2009. So his theory needs to explain why Fed monetary policy could inflate asset markets for seven years without affecting goods markets.

One way to patch up the story would be to resort to the good ol' Shadowstats trick, or the idea that there is consumer price inflation, we just don't see it in official statistics. But that's a weak argument, and thankfully I don't see Hussman using it. Alternatively, maybe something is inhibiting the rebalancing process. Returning to the lake metaphor, if a network of locks are being used to connect the lakes, then the water level of one lake can rise far above the others insofar as movement between them is inhibited by a locking mechanism. Like the picture at top. Thus we might be able to get asset price inflation without consumer price inflation. But what force could possible be strong enough to hold back such a torrent? I'd love to hear. It's possible it's not Hussman who's in a rut, but myself.

Until Hussman gives a decent explanation, I'll stick to the theory that there never was a Fed-induced financial bubble in the first place. Despite what many fund managers might claim, Fed monetary policy really hasn't been very easy, and that's why we haven't seen any froth develop in consumer goods markets. We need a better explanation for rising asset prices than Hussman's irresponsible Fed theory.

Tuesday, July 26, 2016

Helicopter money, Canadian-style


Proponents of helicopter money have been getting a lot of press lately, but I don't really get what all the excitement is about. I live in Canada, and no nation is closer to implementing helicopter money than mine. But if I work through the basic steps involved in implementing Canadian helicopter money drops, I'm underwhelmed. As far as I can tell, deploying loonie-filled CH-147 Chinooks just doesn't do anything that other government tools don't already achieve.

Helicopter money means using the nation's central bank to fund government spending. If a government wants to spend money, it typically auctions bills and bonds to the public and uses the money to fund programs, all the while paying interest on the debt it has issued. Cue the helicopter money advocates: why not have a central bank create money from scratch and gift it to the government for spending? This certainly seems to be a more stimulative approach than regular debt-funded government spending. The added bonus is that the government gets to provide extra services to people without having to pay interest on bonds.

As I said earlier, Canada is the closest nation to implementing helicopter money. This is because the Bank of Canada is permitted to credit the government's account with newly printed money by direct purchases of Federal government bonds at government debt auctions. Canada is unique in this regard; the U.S., Europe, U.K., Japan and most other central banks have set up a fence between the nation's central bank and its executive branch that prevent the latter from financing the former. Central banks can acquire government debt, but they can only do so by buying from the private sector in the second hand market for bonds, i.e. *after* the public has first acquired government debt. This means that central bank can't create new money for the government; they can only create new money for the public, specifically banks.

Ok, so what—the Bank of Canada has no fence. While it can provide new money directly to the government,  this money is free, right? After all, in order to get its hands on the funds the government still has to provide a bond to the Bank of Canada and pay interest on that bond.

But this ignores the fact that the Bank of Canada is owned by the Federal government and therefore pays all its profits to the government in the form of dividends. Thus any interest that the Federal government pays to the Bank is simply returned to the government. So the lack of a fence between the two institutions really does mean that the Bank of Canada can gift the Federal government with free money. The Bank buys new government bonds at government bond auctions, creates fresh money for the government, and re-gifts all interest it receives back to the government.  

Not only does Canada lack a fence between central bank and government, but it has been making extensive use of this feature for the last five years. In 2011, the government announced a measure called the Prudential Liquidity Management Plan (PLMP), the goal of which was to increase Federal government cash reserves by an amount sufficient to cover at least one month of net projected cash flows, or around $35 billion. The Bank of Canada was to directly supply around $20 billion of this amount.

To understand how it went about this, consider that the Bank usually buys around 15% of each government bond auction. It does so in order to maintain the size its existing portfolio of government bonds. After all, bonds are always maturing and need to be 'rolled over' if the funds are to stay invested. By raising the proportion of new Government of Canada bonds that it directly purchases at government securities auctions from 15% to 20%, the Bank of Canada's rate of purchases began to exceed the rate at which bonds matured, thus leading to a steadily growing balance in the Government's account at the Bank of Canada. That's right; cue helicopter money.

The arrow on the following chart illustrates what the 5% increase in participation did to the liability side of the Bank of Canada's balance sheet:


Note how the Federal government's deposits (in red) have grown quite considerably as a result of the PLMP. By the way, if you are interested in more details on the PLMP, I've blogged more fully about it here and here.

Canada hasn't fully gone down the path to helicopter money. To qualify as helicopter money, the funds must not only be created but also be spent. While the Bank of Canada has loaded up the helicopters, the Federal government has not yet allowed any of the $20 billion to be rained down on Canadians. That is understandable since the PLMP was always supposed to be a rainy day fund.

But let's say it did deploy the helicopters. Imagine that next month Justin Trudeau, Canada's new Prime Minister, decides to spend the $20 billion in PLMP funds held at the BoC by mailing a $1000 check to every adult Canadian. Would anything out of the ordinary happen?

The heli drops complete, Canadians will deposit these checks in the banking system, either saving the funds or spending the funds. Whatever the case, the $20 billion that had previously been held in the government's account at the Bank of Canada does not disappear. It flows out of the government's account at the Bank of Canada and into the accounts that private banks maintain with the central bank. In the chart above, the entire red area would be replaced by a large jump in the green area.

The Bank of Canada pays interest to depositors at a rate that is quite close to the rate that the Federal government pays on treasury bills. Interest payments made to banks reduce the Bank of Canada's profits, which means that the dividend flowing to the Federal government is much smaller than if the helicopter drop had not been deployed.

In the end, the government ends up in the same position as it would have if it had funded its mailing of cheques with traditional bond financing. Consider the traditional way of doing things. Trudeau issues $20 billion worth of T-bills to the market at 0.5%, paying interest of around $100 million yearly. Canadians all get nice fat checks. If Trudeau instead routes his efforts through the Bank of Canada, it is the Bank that ends up paying $100 million in interest each year to private banks given a deposit rate of 0.5%. This in turn reduces government revenues by $100 million because interest costs reduce the size of the dividend that the Bank of Canada is able to pay. Either way—traditional financing or helicopter money—we get to the same ending point; Canadians get $20 billion to spend and the Trudeau government faces a cost of $100 million.

So there seems to be no difference between Justin Trudeau providing cheques to Canadian via helicopters or the regular bond-financed route. Why then are so many people quite keen on helicopter money? I'm not sure, but it could be that the advocates already know that helicopter money isn't special. Instead, helicopter money is just a way to get increased government spending without calling it government spending. Add a veneer of central bankishness to anything and it becomes sterile and boring, effectively removing any political charge that new spending brings with it.

Or maybe not, I could be missing some good reasons for why helicopter money is a truly unique tool. Feel free to correct me in the comments section, although please illustrate using Canada as your example; it's always easiest to work off of real world data.

Friday, July 8, 2016

Hyperinflation 2.0?


If you haven't heard, protests are breaking out in Zimbabwe and unpaid civil servants are going on strike. This sort of thing hasn't happened in many years.

It's possible to trace at least some of the motivation for these developments to monetary mischief. Over the last twenty years, no nation has suffered more problems with its money than Zimbabwe has. Everyone remembers the hyperinflation and subsequent dollarization in late 2008. The most recent episode has seen a nation-wide bank run break out as Zimbabweans queue at ATMs to withdraw U.S. dollars, the local currency.

Remember last year's Greek bank run? I'd argue that Zimbabwe's bank run is similar. If you recall, Greek depositors were worried that—in the event of a Greek exit from the Eurozone—their deposits would be redenominated from euros to a Greek version of the euro or even a new drachma. Better to cash out in good euros before getting stuck with something worse. Line-ups grew outside Greek banks until authorities had no choice but to shut the system down.

Like Greece, there is a decent chance that Zimbabwean bank deposits might be made payable in funny money, namely a Zimbabwean version of the U.S. dollar rather than the actual U.S. banknotes. This may explain why Zimbabweans have been desperately queuing up at bank machines—they want to cash out before the worst case scenario happens.

To understand what I mean by 'Zimbabwean version of the U.S. dollar', we need to take a quick tour of the Zimbabwean banking system. A nation's central bank usually runs the plumbing that connects local banks. These banks keep accounts at the central bank—in Zimbabwe's case the Reserve Bank of Zimbabwe (RBZ)—and use balances held in these accounts to clear and settle among each other. These accounts, along with central bank-issued banknotes, constitute a nation's supply of base money, the quantity of which determines its price level. When Zimbabweans spontaneously stopped using the local currency, the Zimbabwean dollar, in late 2008, RBZ accounts (and cash) became worthless. The RBZ-managed plumbing system had imploded.

Zimbabweans still needed to bank, however, so local banks soon began offering U.S. dollar accounts to clients. A new plumbing system was re-erected overseas; instead of maintaining clearing accounts at the now defunct Reserve Bank of Zimbabwe, local banks held U.S dollar accounts at banks in Europe and the U.S., otherwise known as nostro accounts. They used these offshore accounts to settle interbank Zimbabwe payments. [1]

To understand how this offshore plumbing system worked, say Joseph (who lives in the capital Harare) writes a cheque to Robert (who lives in Bulawayo). Joseph's local bank might settle the cheque thousands of miles away by having its New York bank wire funds to the nostro account of Robert's bank, which might be based in London. Circuitous, right?

As for cash, say Joseph wants to withdraw $100,000 in U.S. banknotes from his Zimbabwe bank account. His bank would request its New York bank to debit its nostro account by $100,000 and then ship the $100,000 in banknotes to Zimbabwe. Joseph now has a suitcase full of Ben Franklins.

This offshore plumbing system worked pretty well. However, it didn't take long for the RBZ to re-insinuate itself into the works by offering local banks U.S. dollar accounts. These accounts allowed the local banks to use the RBZ's re-christened real-time gross settlement system (RTGS) to settle interbank payments rather than using the offshore plumbing system. After having lost its printing press, the RBZ had got back into the monetary printing game. It had created a Zimbabwean version of the U.S. dollar.

My understanding is that as time passed the RBZ forced local banks to "repatriate" their clearing accounts from the overseas system and deposit them at the RBZ. In effect, local banks were told to wire U.S. funds from their foreign-based nostro accounts into an RBZ account held at a European/American bank. In turn, the local bank was credited with an equal quantity of U.S. dollar deposits on the RBZ's own books. Voila, local banks had gone from holding U.S. dollars in relatively safe foreign banks located in places like London to holding the domestic RBZ version of the dollar. I can't imagine that bank managers were terribly fond of this forced switch given the RBZ role in igniting the 21st century's first hyperinflation.

Let's see how this new system works. Now when Joseph wants $100,000 in cash, Joseph's bank—call it the Commonwealth Bank of Zimbabwe—has two choices. Use its foreign nostro account as before. Or it can ask the RBZ to debit the Commonwealth Bank RTGS account and provide the proper number of U.S. banknotes. The RBZ in turn sources the cash by requesting its foreign bank to debit the RBZ account—now plump with confiscated dollars—and send the cash to Zimbabwe by plane. The RBZ's overseas dollar accounts in effect "back" the dollar deposits that the RBZ has issued to local banks.

On paper this sort of system should work fine... as long as the RBZ doesn't abscond with the funds in the foreign bank accounts. Unfortunately, this may be exactly what happened. The RBZ had effectively gone from being bankrupt to having amassed large amounts of U.S. funds overseas. This proved tempting, and according to former finance minister Tendai Biti the regime began dipping into the RBZ's foreign stash to pay for expensive junkets and to finance public sector salaries. The upshot it that there may not be enough U.S. funds in the RBZ's foreign accounts to back its promises to local banks.

This means that now when Zimbabweans go to their banks to get U.S. cash, the banks—which before had no problems meeting these requests via their nostro accounts—are hamstrung. They have U.S. dollar accounts at the RBZ but the RBZ is unable to draw on its depleted overseas accounts to get the requested cash. The lineups that have developed are the public's attempt to squeeze out whatever spare dollars remain in the system, an attempt that is rendered much hard given the withdrawal limits that have been instituted to slow down the run.

Zimbabweans are already starting to see a divergence between the price of an electronic dollar and a paper dollar. Various media reports say the practice of "cash burning" has re-emerged for the first time since the hyperinflation of 2007-08. Anyone who needs to convert deposits into cash, frustrated by long lines at ATMs and withdrawal limits, can instead approach an informal dealer who offers to buy their deposits at a discount of 10-20% of their cash value (see here and here). Think of the 'cash burning' discount as the market value of an RBZ-backed bank deposit. If the regime has indeed wasted all the money in its nostro accounts, this discount will only widen.

The theory that the regime has absconded with the RBZ's overseas funds is consistent with a flurry of official proclamations over the last month or two. If the RBZ is indeed bankrupt, it would make sense for the ruling regime to adopt the same strategy that Greece did last year; implement capital controls to trap as many U.S. dollars in the banking system as possible, thus limiting the damage and buying time for the government to rebuild the balance sheets of both the RBZ and the local banks before reopening for business. This would probably require some sort of loan from China or elsewhere. Under this scenario, Zimbabwean deposit holders could very well have to take a large haircut.

As in Greece, the RBZ has started to ring-fence the system by instituting daily withdrawal limits (of around $100); enough to allow Zimbabweans to get by but not enough to hurt the banking system. To coax people into accepting electronic dollars rather than paper dollars, the central bank has suddenly decreed much lower fees on bank payments and transfers. The government has also invoked the Bank Use Promotion and Suppression of Money Laundering Act, which punishes citizens and business if they refuse to deposit their money in banks. More radically, it has imposed severe import restrictions on a broad variety of goods from furniture to beans to fertilizer, a policy that presumably prevents cash leaking over the border. Together, all these regulations seem designed to help stuff as many U.S. banknotes back into the RBZ as possible.

Alternatively, it's possible the Zimbabwe government cribs from the Argentina play book and sets up a corralito, or coral, followed by a redenomination of dollar accounts into the local unit. Unlike Argentina, which had pesos, Zimbabwe is fully dollarized and doesn't have its own paper currency in which to redenominate deposits. But so-called bond notes (which I wrote about last month), an issue of paper money set to debut this fall in denominations of $2, $5, $10 and $20, may be a step in the Argentinean direction. Rather than meeting conversion requests by providing U.S. dollars, the RBZ will be able to print off any quantity of bond notes it deems necessary. In this way U.S. dollar claims on Zimbabwean banks will cease to be payable in actual dollars but in the RBZ's peculiar brand of U.S. banknotes, probably worth far less than the real thing.

It seems perverse that Zimbabwe could see another hyperinflation while on the very dollar standard that was meant to immunize it from a hyperinflation scenario, but I'm starting to worry this could happen. Consider that Robert John Mangudya, the head of the RBZ, claims that retailers are beginning to put two different price tags on one product, a higher one for electronic payments and a lower one for cash. If the RBZ-issued electronic dollar continues to inflate then electronic dollar sticker price will rise but the U.S. paper dollar price will stay constant. This second set of prices would at least provide some modicum of price stability to the nation.

Not so fast. Mangudya warns that the central bank will prosecute any retailer that sets two prices. If retailers comply and set only one price for their wares, that effectively undervalues U.S. banknotes and overvalues RBZ-issued U.S. electronic dollars. Gresham's law will take hold as shoppers use only bad electronic dollars to pay for things while hoarding their good, and undervalued, paper dollars in their wallets. Unwilling to be the dupes and accumulate overvalued and unwanted electronic dollars, retailers will have no choice but to jack up their prices, essentially adopting the RBZ U.S. e-dollar as the standard unit of account, or unit in which they set prices. With U.S. dollars no longer being used as a medium of exchange and unit of account, price stability in Zimbabwe will cease to exist.

One hopes that rumors that the regime has absconded with the RBZ's funds are false and that the current bank run and potential inflation is just a temporary spate of animal spirits. But in my experience, most sustained bank runs are underpinned by something real.


[1] I get much of this information from here.