Blogroll

A (the?) main move in finance goes like this:

1. You have a risky thing. It will be worth a lot of money in some states of the world and less money in some other states of the world. Perhaps it will be worth $200, or $100, or $50. Perhaps it is trading at $100 now.
2. You divide that risky thing into junior and senior claims. When you find out how much the risky thing is worth, you pay off the senior claims first, and then the junior claims get whatever’s left. Perhaps you issue $50 of senior claims and promise to pay them back $50,[1] and then you issue $50 of junior claims and promise to pay them back whatever’s left. If the thing ends up being worth $200, the senior claims get $50 and the junior claims get $150 and triple their money; if the thing ends up being worth $50, the senior claims get $50 and the junior claims get $0 and lose all their money. The junior claims are extra-risky — more risky than just the original risky thing itself — while the senior claims are, in this hypothetical scenario, completely safe. The senior claimants put in $50 and get back $50 no matter what.

There are variations on this move; principally, you can divide the thing into more than two tranches of claim. (Very safe super-senior claims get paid first, quite safe senior claims get paid next, then somewhat risky mezzanine claims, then quite risky equity claims.) Also you can compose this move: You can divide a bunch of things into junior and senior claims, bundle a set of junior or senior claims together, and then slice that bundle into junior and senior claims.

Most of what happens in finance is some form of this move. And the reason for that is basically that some people want to own safe things, because they have money that they don’t want to lose, and other people want to own risky things, because they have money that they want to turn into more money. If you have something that is moderately risky, someone will buy it, but if you slice it into things that are super safe and things that are super risky, more people might buy them. Financial theory suggests that this is impossible but virtually all of financial practice disagrees.

Some examples. A business is a risky thing; its future cash flows might be high or low. It slices those cash flows into senior claims (debt) and junior claims (equity). Some people (banks, etc.) want to lend the business money in exchange for a safe senior claim on its future cash flows. Other people (venture capitalists, etc.) want to give the business money in exchange for a lottery ticket that it will one day be worth a lot.

A house can go up or down in value; it may end up being worth more or less than you pay for it. But if you get a mortgage, your bank puts up (say) 80% of the money and has a senior claim on your house. If your house loses 19% of its value, and you sell it, you will be sad; your down payment evaporated. But the bank will be fine.

Actually the bank doesn’t care because it has pooled a bunch of those mortgages (senior claims on houses) into a mortgage-backed security, cut that security into tranches (senior claims, mezzanine claims, junior claims) and sold the tranches on to investors. Perhaps some of those investors bought a bunch of mezzanine claims (junior-ish claims on a pool of senior claims on houses) and put them into a collateralized debt obligation, another kind of pool, and then sold tranches of that. Perhaps someone bought some of those tranches and put them into a CDO-squared. If you buy the senior tranche of a CDO-squared you’re getting a senior claim (the CDO-squared tranche) on a pool (the CDO-squared) of junior claims (mezzanine CDO tranches) on a pool (the CDO) of junior claims (mezzanine mortgage-backed security tranches) on a pool (the MBS) of senior claims (mortgages) on houses.[2] Just composing the main move.

Actually the bank itself is a composition of this move. A bank makes a bunch of loans in exchange for senior claims on businesses, houses, etc. Then it pools those loans together on its balance sheet and issues a bunch of different claims on them. The most senior claims, classically, are “bank deposits”; the most junior claims are “equity” or “capital.” Some people want to own a bank; they think that First Bank of X is good at running its business and will grow its assets and improve its margins and its stock will be worth more in the future, so they buy equity (shares of stock) of the bank. Other people, though, just want to keep their money safe; they put their deposits in the First Bank of X because they are confident that a dollar deposited in an account there will always be worth a dollar.

The fundamental reason for this confidence is that bank deposits are senior claims (deposits) on a pool of senior claims (loans) on a diversified set of good assets (businesses, houses). (In modern banking there are other reasons — deposit insurance, etc. — but this is the fundamental reason.) But notice that this is magic: At one end of the process you have risky businesses, at the other end of the process you have perfectly safe dollars. Again, this is due in part to deposit insurance and regulation and lenders of last resort, but it is due mainly to the magic of composing senior claims on senior claims. You use seniority to turn risky things into safe things.

One more example. A share of stock is a junior claim (equity) on a business. A margin loan is a senior claim on a share of stock. You’ve got a share of stock worth $100, your broker lends you $50, you put up the other $50, if the stock doubles you pay off the loan and keep $150, if the stock goes down by 50% you pay off the loan and lose all your money. Either way the broker gets its $50 back. Of course if the stock goes down by 90% the broker loses money. Not every senior claim is completely safe. Just, safer.

Okay now let’s do Bitcoin.

Bitcoin is a risky asset that lives, in some sense, in an alternate financial world. Ownership of Bitcoin is recorded on the Bitcoin blockchain, not in the records of the traditional financial system, and the brokerages and exchanges and processes for trading and owning and financing Bitcoin (and cryptocurrency generally) tend to be separate from the ones for stocks or bonds or mortgages or whatever.

Some people live in that alternate financial world with Bitcoin. Sometimes this is because they do not live in the traditional financial world at all: They are drug dealers or sanctioned autocrats or crypto utopians or dogmatic libertarians or regular people in countries with failed or repressive regimes. But sometimes they live in both worlds: They are hedge funds who trade both stocks and crypto, say. Even for those people, though, it costs time and effort to switch between worlds. Sending your counterparty dollars for her Bitcoins is sort of annoying; her Bitcoins live on the blockchain, in Bitcoin-world, while your dollars live at the bank, in traditional-finance-world. It is convenient to be able to stay in the crypto world.

The people who live in Bitcoin world are people like anyone else. Some of them (quite a lot of them by all accounts) want lots of risk: They are there to gamble; their goal is to increase their money as much as possible. Bitcoin is volatile, but levered Bitcoin is even more volatile, and volatility is what they want.

Others want no risk. They want to put their money into a thing worth a dollar, and be sure that no matter what they’ll get their dollar back. But they don’t want to do that in a bank account or whatever, because they want their dollar to live in crypto world. What they want is a “stablecoin”: A thing that lives on the blockchain, is easily exchangeable for Bitcoin (or other crypto assets) using the tools and exchanges and brokerages and processes of crypto world, but is always worth a dollar.

How do you get that thing? We have talked about stablecoins a lot around here. Here is how I would generally describe their mechanics: Some company (the stablecoin issuer) acts as a bridge between the crypto world and the traditional finance world. The issuer sells you stablecoins on the blockchain in exchange for $1 from your bank account, it puts the $1 in its bank account, and it promises to redeem the stablecoins at $1 (a dollar sent from its bank account to your bank account) if you want. The stablecoin issuer is selling, in effect, “blockchain depositary receipts” on U.S. dollars kept in the traditional financial system.[3] It says: “Moving between the traditional and crypto worlds is difficult and complicated, so let me handle that for you.” (As compensation, it generally gets to keep the interest on the money it keeps in its bank account.)

But there is another way, which is to apply that main move of finance to Bitcoin:

1. You get a bunch of Bitcoins.
2. You slice them into junior and senior claims.
3. You sell the junior claims to people who want levered Bitcoin: People who want margin loans against their Bitcoins, etc., who want to gamble on Bitcoin without putting up too much cash.
4. You sell the senior claims as stablecoins: “Even if Bitcoin drops by 50%,” you say, “these coins will still be worth $1, because they are backed by $2 worth of Bitcoin.”

This alternative has a huge advantage over the traditional, money-in-the-bank, blockchain-depositary-receipt approach to stablecoins: It is, in a sense, self-contained. You have manufactured a money-good $1 crypto claim out of pure crypto, without ever going through the U.S. financial system, banks, etc. There is no nexus between this stablecoin and the traditional financial system; regulators can’t shut down its access to banks because it doesn’t rely on banks.[4] It just takes volatile Bitcoins, does some magic to them, and spits out stablecoins worth a dollar.

It also has a huge disadvantage over the traditional approach, which is that Bitcoin is quite young and very volatile. Today it is trading at about $54,000. A year ago it was at about $11,000. Five years ago it was at about $600. If you very conservatively collateralized your stablecoin 20 to 1 — if you issued just $5 worth of stablecoins for every $100 of Bitcoin securing them — those stablecoins would be safe even if Bitcoin fell to $2,700, but Bitcoin was below $2,700 for much of 2017. Also, no cash flows, no intrinsic value, blah blah blah. If Bitcoin went to zero next year this stablecoin approach would not work at all. The only way it can work is if people trust that Bitcoin won’t go to zero, if they trust it enough that “this senior claim on Bitcoin will always be worth a dollar” is persuasive. I would say that five years ago that claim was not broadly persuasive. I would say that now it is?

So the point is that in theory you could have a Crypto Bank that works like this:

1. People who want stablecoins give it $1 million in cash U.S. dollars.
2. It mints one million of its own stablecoins, promising that they will always be worth $1 each, and gives those coins to the people in step 1.
3. People who want levered Bitcoin exposure give it $1 million in cash U.S. dollars.
4. It buys the $2 million of Bitcoin with the cash and gives those Bitcoins to the people in step 3, levered with a margin loan.

If the Bitcoins lose value, the people in step 3 (the levered Bitcoin speculators) lose money, but if they don’t lose too much money the Crypto Bank is fine (it has a senior claim on the Bitcoins) and so the stablecoins are still worth $1 each.

I don’t mean anything by the loan-to-value ratio here, by the way; possibly the people in step 3 should be putting up, say, $2 million for $3 million worth of Bitcoin in order to appropriately overcollateralize the stablecoins. Or perhaps you need to compose the move: Some margin lender gives 2-to-1 leverage, but it borrows money (issuing a senior claim) from Crypto Bank, which then has a bit more security. Etc.

Anyway! I could quote all day from this Zeke Faux story in Bloomberg Businessweek titled “Anyone Seen Tether’s Billions,” which features a “former child actor who’d missed a penalty shot in The Mighty Ducks,” “the Inspector Gadget co-creator,” “a former plastic surgeon from Italy” who “was once fined for selling counterfeit Microsoft software” and who “goes by Merlinthewizard” on Telegram, and a citation to “a press release announcing a special bonus scene in the 2008 film Young Harlots: In Detention.” But the density of good lines is high enough that rather than quote them here I will just suggest that you read the whole thing. It’s very fun!

We have talked about Tether, a leading stablecoin, before and, uh, I cannot object to Faux’s description of it here:

It was hard to believe that people had sent $69 billion in real U.S. dollars to a company that seemed to be practically quilted out of red flags. But every day, on cryptocurrency exchanges, traders buy and sell Tether coins as if they’re just as good as dollars. Some days, more than $100 billion in Tether changes hands. It seemed the people with the most at stake in the crypto markets trusted Tether, and I wanted to know why.

He goes on a hilarious quest to find where Tether is keeping its $69 billion and, toward the end, gets this partial but very suggestive answer:

After I returned to the U.S., I obtained a document showing a detailed account of Tether Holdings’ reserves. It said they include billions of dollars of short-term loans to large Chinese companies—something money-market funds avoid. And that was before one of the country’s largest property developers, China Evergrande Group, started to collapse. I also learned that Tether had lent billions of dollars more to other crypto companies, with Bitcoin as collateral. One of them is Celsius Network Ltd., a giant quasi-bank for cryptocurrency investors, its founder Alex Mashinsky told me. He said he pays an interest rate of 5% to 6% on $1 billion in loans from Tether. Tether has denied holding any Evergrande debt, but Hoegner, Tether’s lawyer, declined to say whether Tether had other Chinese commercial paper. He said the vast majority of its commercial paper has high grades from credit ratings firms, and that its secured loans are low-risk, because borrowers have to put up Bitcoin that’s worth more than what they borrow. “All Tether tokens are fully backed,” he said.

The standard story of Tether — the story that Tether tells — is the one that I have called the “blockchain depositary receipt.” Tether takes dollars, it puts them into very safe dollar-denominated traditional finance assets (bank accounts, highly rated commercial paper), and it issues stablecoins against them. If you want your dollar back, Tether basically takes it out of the bank and gives it to you in exchange for your stablecoin. Easy peasy.

The standard objection to this story is that nobody can figure out where Tether actually keeps the money:

Elsewhere on the website, there’s a letter from an accounting firm stating that Tether has the reserves to back its coins, along with a pie chart showing that about $30 billion of its dollar holdings are invested in commercial paper—short-term loans to corporations. That would make Tether the seventh-largest holder of such debt, right up there with Charles Schwab and Vanguard Group.

To fact-check this claim, a few colleagues and I canvassed Wall Street traders to see if any had seen Tether buying anything. No one had. “It’s a small market with a lot of people who know each other,” said Deborah Cunningham, chief investment officer of global money markets at Federated Hermes, an asset management company in Pittsburgh. “If there were a new entrant, it would be usually very obvious.”

That sort of thing. In particular, people worry that a lot of the money might be in Chinese commercial paper that is riskier than its ratings would suggest. Why would Tether do this? Well, partly because it is somewhat difficult for a crypto company that has had a few regulatory run-ins to put $69 billion somewhere safe and normal; some traditional counterparties might not want that business. But there is also a reaching-for-yield theory:

Tether’s website had long displayed a pledge: “Every Tether is always backed 1-to-1, by traditional currency held in our reserves.” But, according to [Tether’s former banker in Puerto Rico, John] Betts, [Tether Chief Financial Officer and former plastic surgeon Giancarlo] Devasini wanted to use those reserves to make investments. If the $1 billion in reserves Tether said it had at the time earned returns at, say, 1% a year, that would be $10 million in annual profit. Betts saw this as a conflict of interest for Devasini, since any investment gains would go to Devasini and his partners, but Tether holders would potentially lose everything if the investments went bad. When Betts objected, Devasini accused him of stealing. “Giancarlo wanted a higher rate of return,” Betts said. “I repeatedly implored him to be patient and do the work with auditors.”

Fine, all traditional stuff. And most of the story of Tether is in fact that it invests dollars in traditional dollar assets, and some of those assets are very safe, and maybe some of them are a bit less safe than you’d like and that might worry you, but it’s still hard to tell.

But the part I want to talk about here is … I’ll quote it again:

I also learned that Tether had lent billions of dollars more to other crypto companies, with Bitcoin as collateral. One of them is Celsius Network Ltd., a giant quasi-bank for cryptocurrency investors, its founder Alex Mashinsky told me. … Hoegner, Tether’s lawyer, [said] … that its secured loans are low-risk, because borrowers have to put up Bitcoin that’s worth more than what they borrow.

There! That part! That seems to be only a minority of the Tether story, but it’s the interesting part:

1. Various crypto “quasi-banks” give people levered exposure to Bitcoin and take senior claims on their Bitcoin.
2. Those quasi-banks borrow dollars from Tether, giving Tether a senior claim on the Bitcoins they hold.
3. Tether uses those pools of Bitcoin to back its stablecoins.[5]

Tether transmutes risky Bitcoins into risk-free stablecoins. Or does it, ha ha ha; of course you can object to the notion that anything risk-free can be extracted from Bitcoin (“it could go to zero tomorrow!”). Or you can say “well that's fine in theory, but for safety you need way more collateral than Tether demands,” though I have no idea how much collateral Tether actually demands, because it doesn’t say.

Again, I think if you told that story five years ago people would think you were nuts. “No no no,” they would say, “you can’t manufacture safe dollar assets out of Bitcoin, Bitcoin is too volatile, there is no floor, it could go to zero, this is nonsense.” I think there is a good chance that if you tell that story five years from now it will be unremarkable. “Yes right of course the Bank of Tether issues deposits worth one Tether and uses those deposits to fund margin loans to levered Bitcoin investors, that’s just how banking works,” people will say. It is just a function of how confident people are in Bitcoin’s permanence and its function as a store of value. Right now we are in between; the story is plausible but still weird. It’s not the story that Tether wants to tell, and it’s not the main story of Tether. But it's the interesting part.

This has gone on long enough but I do want to end on a couple of discussion questions:

1. Traditional financial regulators seem very worried about the implications of stablecoins for financial stability. (Faux: “If enough traders asked for their dollars back at once, the company could have to liquidate its assets at a loss, setting off a run on the not-bank. The losses could cascade into the regulated financial system by crashing credit markets.”) If you found out that, instead of being backed by U.S. Treasury bills and highly-rated commercial paper of large multinational companies, Tether is mostly backed by loans collateralized by Bitcoins, how would that make you feel about the threat that Tether does or does not pose to the traditional financial system?
2. Same question except not about the stability of the traditional financial system, but about the stability of the crypto financial system. If Tether’s always-worth-a-dollar value came from the value of senior claims on levered Bitcoin positions, rather than from Treasury bills etc. — if the value of Tether comes in essence from people’s confidence in the value of Bitcoin — could a strong wind blow the whole thing over?