tag:blogger.com,1999:blog-87645418740436941592024-03-18T09:09:08.016+00:00Coppola CommentFinance, economics and musicFrances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.comBlogger754125tag:blogger.com,1999:blog-8764541874043694159.post-34737545231209544932024-02-20T10:36:00.002+00:002024-02-20T10:36:20.857+00:00The tragedy of Gaza<p>Dear friends, I said I wouldn't post any more on this site. But Elon Musk doesn't like me posting Substack links on Twitter. And Substack itself is a mess. The <a href="https://coppolacomment.substack.com/?sort=top">home page</a> looks amateurish, and new posts don't even appear on it until they've amassed enough views to push down previous posts. It's an absurd way of organising a site. </p><p>So I have decided in future to post links to my Substack posts here. Hopefully this will mean you can find them more easily, both on Google and Twitter. Some of my Substack posts have paywalls, but you will have the option to subscribe or opt for a free trial. </p><p>Here's the introduction to my latest Substack post, <b>The Tragedy of Gaza</b>. Click the <a href="https://coppolacomment.substack.com/p/the-tragedy-of-gaza">link</a> to read all of it. It is free to read.</p><p><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhbwliFEZ8BglRFTICu-UIamt59HCKzJxa4JOOJHVeAYzbDCJZjaRMWYwHrrqDtIkokJb8iJnjcM3m8BbGafPqgjnTLaZ85fMaWggMPD5MGso9WxKldy07NVyPrSQlLt-bJO9a3ZZOJntdMBbvqS8SwOu-2b6dkmGTsIbAvFbOMSKVdL-DNzB-b1eIzd28" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="683" data-original-width="1024" height="426" src="https://blogger.googleusercontent.com/img/a/AVvXsEhbwliFEZ8BglRFTICu-UIamt59HCKzJxa4JOOJHVeAYzbDCJZjaRMWYwHrrqDtIkokJb8iJnjcM3m8BbGafPqgjnTLaZ85fMaWggMPD5MGso9WxKldy07NVyPrSQlLt-bJO9a3ZZOJntdMBbvqS8SwOu-2b6dkmGTsIbAvFbOMSKVdL-DNzB-b1eIzd28=w640-h426" width="640" /></a></div><br /><p></p><i><blockquote>The Palestinian economy is enduring a fiscal crisis and the economic outlook is dire.” - IMF, 26th April 2022.</blockquote></i><div>I’m sure everyone realises by now that Gaza’s economy has fallen off a cliff. There is almost no productive activity, so GDP has collapsed and nearly everyone is unemployed. The UN <a href="https://palestine.un.org/en/259432-gaza-economic-recovery-could-take-decades-un-report#:~:text=It%20is%20estimated%20the%20annual,in%20earnest%20and%20without%20delay.">estimates that </a>Gaza’s GDP fell by 24% in 2023. It is of course still falling - rapidly.<br /><br />Massive GDP falls are common in wars: for example, Ukraine’s economy shrank by 30% in 2022, equivalent to the US Great Depression. But what people perhaps don’t realise is how bad things were <b>before</b> the current crisis.</div><div><br /></div><div>In the rest of this post, I examine: </div><div><ul style="text-align: left;"><li>the large growing divergence between the economies of Gaza and the West Bank, using data from the IMF </li><li>the economic cost to both Gaza and the West Bank of Israel's fifteen-year blockade of Gaza and repeated military actions</li><li>how disastrous internal politics in Palestine and malicious meddling by external powers, notably the US, tipped Gaza into long-term decline </li><li>how wars and protests fatally weakened the Gaza economy</li><li>why the October 7th attacks were inevitable </li><li>why Israel's end game is the total destruction of Gaza, and why we are powerless to prevent it. </li></ul><div>Read my full analysis <a href="https://coppolacomment.substack.com/p/the-tragedy-of-gaza">here</a>. </div></div><div><br /></div><div><b>Related reading:</b></div><div><br /></div><div><a href="https://coppolacomment.substack.com/p/the-road-to-armageddon">The road to Armageddon</a></div><div><a href="https://coppolacomment.substack.com/p/tunnel-economy">Tunnel economy</a></div><div><br /></div><i>Image: Theatre mask mosaic, Naples National Archaeological Museum, Public domain, via <a href="https://commons.wikimedia.org/wiki/File:Theatre_mask_mosaic_MAN_Napoli_Inv9994.jpg">Wikimedia Commons</a></i>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-45560248289475184332023-05-10T09:32:00.004+01:002023-05-10T09:32:42.256+01:00Sunset<p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEj8GxM6tv8jQjh0hWl5DgsbF0iLR0rRFroTNabj2yWutRS67P5Eqn_X30eIbUJzfGlDlGZlh194bL4k0tlUrvBpx3z-qUjeaYHGV-iXAz4aeLi_wEjWGc36UZZ3HJFekHZgA9MZJFOFPBFWXZCgHGfIGS_h_VtNo-yuctbDl_-h5rvCU8nJe8GYRYQ8" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1200" data-original-width="1600" height="480" src="https://blogger.googleusercontent.com/img/a/AVvXsEj8GxM6tv8jQjh0hWl5DgsbF0iLR0rRFroTNabj2yWutRS67P5Eqn_X30eIbUJzfGlDlGZlh194bL4k0tlUrvBpx3z-qUjeaYHGV-iXAz4aeLi_wEjWGc36UZZ3HJFekHZgA9MZJFOFPBFWXZCgHGfIGS_h_VtNo-yuctbDl_-h5rvCU8nJe8GYRYQ8=w640-h480" width="640" /></a></div><br />Dear friends, this is my last post on this site. Coppola Comment has moved to Substack. You can find the new site <a href="http://coppolacomment.substack.com">here</a>. <p></p><p>Why the move? Well, Blogger has become increasingly difficult to use. The code generator is buggy and I constantly have to mess around with the HTML to make posts look half decent. I don't have the time for this nonsense. I just need a nice straightforward CMS that doesn't make my life difficult. </p><p>Also, those of you who subscribed by email will know that for some time now you have not been receiving email notifications. This is because Google turned off Feedburner. Google helpfully said I could download the email list and do notifications myself using something like mailchimp, but I don't have the time for this, either. I want a platform that manages my subscribers and notifications for me. </p><p>I did consider moving to Wordpress, but I've never really got on with that (it's why I used Blogger). And I also considered Patreon for the subscriber side. But Substack meets my needs for the moment. In some ways it is more basic than Blogger, which is frustrating. But they have now added tags, which will make it easier to organise my posts, and they are gradually improving the look of the site. </p><p>This site will remain up and you are welcome to browse all the posts here for free. Comments are now moderated on all posts except this one. </p><p>Posts on the new site are also currently free to read, but from Monday next week, 15th May, some posts will be behind a paywall. You will have the option of only reading free posts or paying a small amount per month or per year to gain access to all posts. </p><p>I do hope lots of you will see my work as sufficiently valuable to warrant a paid subscription, but it is of course entirely up to you. Here's the link to subscribe to my new site, whether paid or free. </p><p> <iframe frameborder="0" height="320" scrolling="no" src="https://coppolacomment.substack.com/embed" style="background: white; border: 1px solid #EEE;" width="480"></iframe></p><p>At some point in the next couple of months, Coppola Comment on Substack will move to the CoppolaComment.com domain, and this site will revert to its original blogspot URL. </p><p>Farewell, and I hope to see lots of you on the new site. </p><p><i>Image is of St. Cuthbert's Island, Northumberland, from Holy Island, at the start of the Easter Vigil, Saturday 8th April 2023. The bonfire symbolises the death of the old and the start of new life. </i></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-19177978386850472132023-04-16T11:06:00.008+01:002023-04-19T12:46:31.805+01:00A fractional reserve crisis<p><i><br /></i></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglzZVrHeQLUHRZaM6NdY2l0Gk4wOYcBcNzBhnETPUDUx3TVu5VMx3TLE1R5lNsYBh0bbiz1hnO440PiGdIuuAcxSQ2vfNuLxVEq-K6wtyJP8D4KRTIVpVs6GZKID1dlfsA0COdnxq7_LaPf92IiNCsRbRanyVGPkgwBJiDs2x4j_II6LfOdWoxr8DZ/s1140/Frances%20at%20Ghent%20cropped.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="894" data-original-width="1140" height="502" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglzZVrHeQLUHRZaM6NdY2l0Gk4wOYcBcNzBhnETPUDUx3TVu5VMx3TLE1R5lNsYBh0bbiz1hnO440PiGdIuuAcxSQ2vfNuLxVEq-K6wtyJP8D4KRTIVpVs6GZKID1dlfsA0COdnxq7_LaPf92IiNCsRbRanyVGPkgwBJiDs2x4j_II6LfOdWoxr8DZ/w640-h502/Frances%20at%20Ghent%20cropped.png" width="640" /></a></div><i><p><i><br /></i></p>This is a slightly amended version of a keynote speech I gave on 14th April 2023 at the University of Ghent, for the Workshop on Fintech 2023. </i><p></p>
<p>The crisis that has engulfed crypto in the last year is a crisis of fractional reserve banking. Silvergate Bank and Signature Bank NY were fractional reserve banks. So too were Celsius Network, Voyager, BlockFi, Babel Finance and FTX. And still standing are the crypto fractional reserve banks Coinbase, Gemini, Binance, Nexo, MakerDAO, Tether, Circle, and, I would argue, every one of the DeFi staking pools. All of these are doing some variety of fractional reserve banking. Custodia Bank and Kraken Finance claim to be full-reserve banks – but 100% reserve backing for deposits is both hard to prove and not a guarantee of safety. </p>
<p>What do I mean by “fractional reserve banking”? My definition might surprise you. For me, fractional reserve banking simply means that the composition of a bank’s assets is less liquid than that of its liabilities.</p><p><b>Fractional reserve banking is not dead</b></p>
<p>The well-known fractional reserve banking model taught to economics students proposes that: </p><p></p><ul style="text-align: left;"><li>banks keep 10% of deposits in reserve and lend out the rest (no they don’t)</li><li>for every $10 a bank receives in deposits it can create $90 of new loans (no, this is not how bank lending works)</li><li>every $1 of bank reserves becomes $10 of bank money (no it doesn’t).</li></ul><p></p>
<p>This was never more than a toy model, a wildly over-simplified description of banking that bears little resemblance to what banks actually do. It conflates lending with payments and thus creates a wholly fictional relationship between lending and reserves. And after a decade of QE, the relevance of this model of fractional reserve banking, based as it is on the mistaken notion that banks “multiply up” their reserves by some percentage set by the central bank, is extremely doubtful. </p><p>But though the model may be past its sell-by date, this does not mean the concept of “fractional reserve” is dead. Far from it. The current crisis has once again brought to the fore the fundamental risk of fractional reserve banking – namely that banks, and other financial institutions doing bank-like things, can literally run out of money.</p><p>Classically, a fractionally reserved bank has demand deposits funding a portfolio of long-dated commercial and household loans, much of it secured on real estate. In the <a href="https://www.bu.edu/econ/files/2012/01/DD83jpe.pdf">Diamond-Dybvig model of bank runs</a>, when depositors all pull their deposits at the same time, the bank is assumed to foreclose loans to obtain sufficient money to pay them. But loans are legal contracts: unless there is a clause in the contract permitting instantaneous no-fault termination, they can’t simply be foreclosed without warning. So a bank whose assets consist entirely of illiquid loans is at serious risk of defaulting on its obligations to its depositors. </p><p>In practice, banks keep a certain amount of liquid assets to ensure they can meet a reasonable level of payment requests. The rest is – frankly - a Hail Mary, though for regulated banks, deposit insurance and central bank lender-of-last-resort support mitigate the risk of payment requests exceeding available liquidity. </p><p>The quantity of liquid assets banks maintain to meet normal payment requests used to be determined by the reserve requirement. But in these days of excess reserves, Basel liquidity regulations, and "living wills", few central banks now have reserve requirements. More importantly, central banks now recognise that the primary purpose of reserve requirements and other liquidity regulations is not to control lending, but to ensure that banks have enough liquidity to make payments. </p><div><b>What do we mean by "reserves"?</b></div><p>Reserves are the essential liquidity needed to ensure the smooth operation of the payments system. They help to ensure the independence of outgoing payments from incoming ones. We could call them "float". </p><p>For regulated banks with central bank reserve accounts, reserves are the balances in those reserve accounts – what we call “high-powered money” or “outside money”. For other financial institutions, reserves come in various forms, but they are always about ensuring the institution has the money it needs to make payments in full and on time. So, a British credit union that pre-funds its clearing account at Barclays is holding sterling reserves. A Caribbean bank that pre-funds its US dollar nostro account at Citibank is holding US dollar reserves. And a crypto exchange that keeps U.S. dollars in omnibus accounts at U.S. banks “for the benefit of” its customers is holding dollar reserves.</p><p>Holding some funds “in reserve” in anticipation of payments helps to maintain smooth operation of the payments system. But if financial institutions try to hold reserves in anticipation of payments that may never be made, the system becomes illiquid. We saw this happen in September 2019, when the U.S's large banks <a href="https://www.coppolacomment.com/2019/12/the-blind-federal-reserve.html">hoarded reserves</a> in anticipation of very large payment requests from corporations and the U.S. government. As the banks stopped lending liquidity, the cost of market funding shot up and repo markets froze. The Fed was forced to step in to provide liquidity and thus maintain the flow of funds through the financial system. </p><p>Some payments systems are fully pre-funded. The US correspondent banking system, for example. And here I must give a shout-out to Ripple, which says that locking up dollars in nostro accounts is inefficient. I don’t agree with their solution, but they are absolutely right. Dollar hoarding makes the system sticky and expensive. The only reason we don't notice this is that we've never known anything else. </p><p>However, if foreign banks, small banks and non-banks keep reserves in banks that are themselves fractionally reserved, they cannot credibly claim to be fully reserved. The stablecoin issuer Circle painfully discovered this when Silicon Valley Bank failed. Its supposedly “safe” stablecoin, USDC, fell off its peg when it was revealed that Circle held some of its reserves in SVB.</p><p><b>Fractional reserve, solvency and creditworthiness</b></p>
<p>If a financial institution is “fractionally reserved”, it does not have enough actual money to pay out all its deposits at once. This does not necessarily mean it is insolvent. What it usually means is that there is a liquidity mismatch between its deposits and its assets. If deposits are wholly liquid, and assets wholly illiquid, the institution may be unable to meet its obligations even if it is in balance sheet terms solvent, by which I mean the value of its assets exceeds its liabilities. Silvergate, SBNY and Silicon Valley Bank were all, on paper, solvent, but were nevertheless unable to raise the money they needed to pay depositors.</p>
<p> How can an ostensibly solvent institution become unable to pay its way? It’s all down to creditworthiness. As long as a fractionally reserved financial institution can borrow, it can meet its obligations. But if no-one will lend to it, then it cannot. And in these days of collateralised lending, creditworthiness is all about the quality of your assets.</p>
<p> A bank can’t borrow more than the market value of the securities it is pawning (lending cash against valuable collateral is pawnbroking). And if the assets are risky, the amount it can borrow will be much less. I am constantly amused by crypto people who talk glowingly about “overcollateralization” as if this is something new, innovative and exclusive to crypto. Tradfi has been doing overcollateralization for hundreds of years. But it prefers reciprocals. What crypto people call overcollateralization, tradfi calls a “haircut”. </p>
<p> If a bank’s balance sheet consists mainly of degraded loans and junk securities, it’s going to face large haircuts on collateralised borrowing. This applies whether the institution is borrowing from markets, from other financial institutions, or from central banks. There’s an apocryphal story of a high street bank offering the Bank of England its staff travel loan scheme as collateral against borrowing. “We will accept it,” said the Bank, “but you won’t like the haircut.” But even a staff loan scheme is better collateral than highly volatile cryptocurrencies and stablecoins. In its <a href="https://www.bis.org/bcbs/publ/d545.pdf">guidance on the prudential treatment of crypto-asset exposures for banks,</a> the Bank for International Settlements cheerfully imposed a 100% haircut on cryptocurrency collateral. That is infinite overcollateralisation. (You see why tradfi prefers reciprocals?).</p>
<p> But even if a bank’s balance sheet has substantial quantities of “safe” assets such as government bonds, falling bond prices can reduce its borrowing capacity to the point where it cannot raise enough money to meet its obligations. This is what happened in the Eurozone crisis: the so-called “doom loop” between sovereigns and banks, which meant that whenever a sovereign’s bonds fell in value (usually because of a Moody’s downgrade), its banks ran out of money. And it is also what happened to Silvergate Bank, Silicon Valley Bank, and SBNY, and to other US medium-size banks too. These banks were solvent on paper because they were not marking their securities portfolios to market. But because of the Fed’s interest rate rises, they were taking heavy unrealised losses on those securities. When they had to sell those securities to obtain money, the losses were crystallised. And for both SBNY and SVB the market value of the securities was insufficient to raise enough money to meet their obligations. Having to pledge securities at market value rendered them insolvent. This is why the Fed’s new lending program for banks accepts securities pledged at face value, not market value. It is a “lender of last resort” intervention to ensure that fractionally reserved banks don’t fail because Fed interest rate rises make it impossible for them to meet their obligations.</p><p><b>It's not just banks that are fractionally reserved </b></p>
<p> Taken to its logical conclusion, “fractionally reserved” can be taken to mean any balance sheet structure in which the average duration of liabilities is shorter than the average duration of assets. This is known as “maturity transformation”, and is characteristic of banks. However, it is an extremely broad definition which applies not only to banks, but many other types of financial institution. Money market funds, for example. When Reserve Primary MMMF “broke the buck” after the fall of Lehman Brothers in 2008, it was experiencing a fractional reserve crisis. Its shareholders were selling shares, but its assets were falling in value, eventually rendering it unable to obtain the money needed to pay the shareholders par value. In the last decade we also saw real estate investment funds suspending withdrawals when falling commercial property prices created a large gap between the value of their assets and their liabilities. And the bellwether for the current crisis was, of all things, defined-benefit pension funds.</p>
<p> Defined-benefit pension funds should be the last things on earth to experience a fractional-reserve crisis, except possibly the Danish mortgage market. They have long-dated liabilities matched with long-dated assets. They are about as liquid as the Gobi desert, but their payment obligations are stable and forecastable. Yet last September, they were suddenly faced with demands for large payments for which they were wholly unprepared. They had to sell assets to raise the money to make the payments. The assets they sold were UK 30-year gilts, of which they were almost the only holders. As a result, the 30-year gilts market crashed. As the price fell, the funds were forced to sell even more assets. This created a “death spiral”, a dangerous positive feedback loop that threatened to spill over to other markets too and even to the real economy. The Bank of England stepped in as buyer of last resort, setting a floor under the 30-year gilt price and thus enabling pension funds to raise the cash they needed. Crypto aficionados perhaps should note that setting a floor under a falling asset price can stop it becoming a death spiral. At the macro level, QE prevents economy-wide deflationary death spirals by setting a floor under asset prices. </p>
<p> But why did the pension funds need to raise money? It turned out that they hadn’t been fully matching their liabilities with assets of similar duration. Instead, they had been <a href="https://www.coppolacomment.com/2022/09/what-was-real-reason-for-bank-of.html">relying on interest rate swaps</a> to cover their deficits – in effect, betting on interest rates staying low. They obtained cash collateral to post against these swaps by pledging long-term assets as collateral for short-term borrowing. They knew they were at risk of margin calls if the value of their collateral fell. But it was worth it for the potential returns.</p>
<p> Deliberately taking on asset-liability duration mismatch, and the associated liquidity risk, to earn a return is the essence of fractional reserve banking. Pension funds are not banks, but they were taking bank-like risks. And the disruption their crisis caused threatened to trigger a wider financial crisis. Hence the Bank of England’s intervention – and, eventually, the UK government’s change of fiscal direction. Pension funds were, on this occasion, “shadow banks”. </p><p><b>The return of shadow banking</b></p>
<p> We’ve come to associate the term “shadow bank” with the special purpose vehicles, money market funds, insurance companies and the rest of the alphabet soup that played such a large part in the 2008 financial crisis. Lehman Brothers was a shadow bank – an unregulated financial institution that did bank-like things and took bank-like risks. Its failure caused a world-wide financial and economic crisis. Other giant banks that are now household names were also “shadow banks” at that time; Goldman Sachs, for example. After the crisis, these too-big-to-fail institutions converted themselves into banks and submitted to regulation and supervision so that they could gain access to public safety nets.</p>
<p> But where there are shadows, there is always shadow banking. And few areas of the financial system are as shadowy as crypto. So it should come as no surprise to discover a massive outbreak of shadow banking in the crypto ecosystem. Of the crypto-related companies I listed at the start, only Silvergate and SBNY were regulated banks with central bank reserve accounts. Kraken and Custodia are regulated banks, but as the Federal Reserve has rejected their applications for reserve accounts, they must rely on other U.S. banks for dollar clearing, and they probably have to pre-fund their clearing accounts (which they don’t want to do). The rest of the companies do – or did - bank-like things but are not regulated like banks and do not have access to the public safety nets provided to regulated banks. They are, or were, “shadow banks”.</p>
<p> Things that grow in the shadows go unnoticed until it is too late. Pension regulators failed to spot the risk posed by duration mismatches and illiquidity in defined-benefit pension funds. Bank regulators failed to spot the risk posed by duration mismatches and illiquidity in U.S. mid-tier banks such as Silvergate, Signature Bank NY, and Silicon Valley Bank. And crypto regulators – to the extent that they exist at all – failed to spot the gaping balance sheet holes and catastrophic shortage of liquidity in crypto shadow banks such as Celsius, Voyager, BlockFI and FTX.
In the 2000s, unregulated financial institutions blew up a giant bubble in mortgage-backed securities and derivatives. In the 2020s, unregulated crypto institutions blew up a giant bubble of crypto-related securities and derivatives. It’s the same old jive. </p>
<p> And it’s the <a href="https://www.coppolacomment.com/2022/12/snake-oil-in-stablecoin-world.html">same old snake oil</a>, too. Turns out, if you put “Fully reserved, unlike banks” or “Unbank yourself” on a crypto shadow bank, people rush to lend it money, believing it will deliver high returns without risk - especially if the shadow bank sports an FDIC logo to which it is not, and never will be, entitled. Convincing people their funds are completely safe even though you are lending them out to hedge funds and ponzi schemes and have no insurance is a helluvan earner. And if you are really good, you’ll build yourself an escape hatch so when the scheme blows up, it is only your customers that get burned. </p>
<p> Now, of course, there’s a flurry of regulatory activity “to protect the public”. New rules for pension funds and their advisors; new rules for bank capital and liquidity; and above all, a raft of new rules to bring the crypto industry to heel. The stable doors are not only being shut, but reinforced, and an array of shiny new padlocks is being installed. But the horses have disappeared into the shadows, where they are already building the next generation of shadow banks. </p><p><br /></p><p><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2023/02/proof-of-reserves-is-proof-of-nothing.html">Proof of reserves is proof of nothing</a></p><p><a href="https://www.coppolacomment.com/2013/07/anatomy-of-bank-run.html">Anatomy of a bank run</a></p><p><a href="https://www.coppolacomment.com/2015/04/rediscovering-old-economic-models.html">Rediscovering old economic models</a></p><p><a href="https://www.coindesk.com/consensus-magazine/2022/12/14/after-ftx-explaining-the-difference-between-liquidity-and-insolvency/">After FTX: Explaining the difference between liquidity and solvency</a> - Coindesk</p><p><a href="https://www.coindesk.com/markets/2021/02/08/caveat-depositor-how-safe-is-your-stablecoin/">Caveat Depositor: How safe is your stablecoin?</a> - Coindesk</p><p><i>Photo courtesy of Brian Lucey. </i></p><p><br /></p>
Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com4tag:blogger.com,1999:blog-8764541874043694159.post-65535607335906220132023-03-29T23:28:00.011+01:002023-03-30T08:49:29.454+01:00What really happened to Signature Bank NY?<p> </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKiCbSu6Jy8omeT1ToiyA66XxKA5g_OFnfcxDCfhJ6l583zuuLfomVMeRXey-9bizlkbtUAC_RbSIRn0Pf2EWOnpMj7Wawct7QKkmUUF6xCEa9QIMSHGu6Fx5CwUjM5sTL9oioaMqEOY3novx4f1H12G7aUyNW3IpCb0qCPqcsoPL2aDycOoTaKEdq/s4710/Signature_bank_storefront_(39th_&_Madison)_reporters_swarming.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="3138" data-original-width="4710" height="426" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKiCbSu6Jy8omeT1ToiyA66XxKA5g_OFnfcxDCfhJ6l583zuuLfomVMeRXey-9bizlkbtUAC_RbSIRn0Pf2EWOnpMj7Wawct7QKkmUUF6xCEa9QIMSHGu6Fx5CwUjM5sTL9oioaMqEOY3novx4f1H12G7aUyNW3IpCb0qCPqcsoPL2aDycOoTaKEdq/w640-h426/Signature_bank_storefront_(39th_&_Madison)_reporters_swarming.png" width="640" /></a></div><br /><p></p><p>As the world reeled in shock at the sudden collapse of Silicon Valley Bank (SVB), another bank quietly went under. On Sunday 12th March, the U.S. Treasury, Federal Reserve and FDIC <a href="https://home.treasury.gov/news/press-releases/jy1337">announced that</a> all SVB depositors, whether insured or not, would have access to their funds from Monday. And then they added: </p>
<blockquote>We are also announcing a similar systemic risk exception for Signature Bank, New York, which was closed today by its state chartering authority.</blockquote><p>Signature Bank NY's state chartering authority was the New York State Department of Financial Services (NY DFS). It posted <a href="https://www.dfs.ny.gov/consumers/alerts/SignatureBank">this on its website</a>: </p>
<blockquote>On Sunday, March 12, 2023, the New York State Department of Financial Services (DFS) took possession of Signature Bank in order to protect depositors. All depositors will be made whole. </blockquote><blockquote>
DFS has appointed the Federal Deposit Insurance Corporation (FDIC) as receiver, and the FDIC has transferred all of the deposits and substantially all of the assets of Signature Bank to Signature Bridge Bank, N.A., a full-service bank that will be operated by the FDIC as it markets the institution to potential bidders.</blockquote><p>So the NY DFS closed down Signature Bank NY (SBNY) and handed it over to the FDIC for resolution. </p><p>Unlike California's Department of Financial Protection and Innovation, the NY DFS didn't have to get a court order to close down its bank. It simply exercised its powers under <a href="https://codes.findlaw.com/ny/banking-law/bnk-sect-606/#:~:text=The%20superintendent%20may%2C%20in%20his%20discretion%2C%20and%20upon%20such%20conditions,banking%20organization%20to%20resume%20business">Section 606 of the New York Banking Act</a>. Those powers are extremely wide-ranging: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEj-mP2wqoXb07b7wGfyNknkzu7VQLS3pnZt9FsY_fPtNEZ4S5Od77FjlCBFSZ_q3g_VTjR-sZHSXVcAqdCgvZNIcE5kKY0VzfXhHfMU3p0AFa8z9iNnUnEKv5K-lD24ToXv7pb7KjwQyR1zHWjdEIypEC_793rULxnW1t13mVp25Ols_RD4CLbZQX0H" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1223" data-original-width="1723" height="454" src="https://blogger.googleusercontent.com/img/a/AVvXsEj-mP2wqoXb07b7wGfyNknkzu7VQLS3pnZt9FsY_fPtNEZ4S5Od77FjlCBFSZ_q3g_VTjR-sZHSXVcAqdCgvZNIcE5kKY0VzfXhHfMU3p0AFa8z9iNnUnEKv5K-lD24ToXv7pb7KjwQyR1zHWjdEIypEC_793rULxnW1t13mVp25Ols_RD4CLbZQX0H=w640-h454" width="640" /></a></div><br />We could summarise this as "we can close you down at any time, without notice, if we don't like what you are doing". <p></p><p>The NY DFS gave no explanation for its decision to close SBNY down, nor for putting it into FDIC receivership. It didn't even identify which clauses in the above list it relied upon. Lots of people were puzzled, because on paper, SBNY looked solvent: its 10-K regulatory filing, announced in February 2023, reported that at 31st December 2022, it had $110.36bn of assets and $88.59bn in deposits. True, it had weaknesses: like Silvergate, it provided specialist depository and payment services to crypto exchanges and platforms, and as a result had a high proportion of uninsured and highly runnable deposits. And like Silvergate, it was carrying unrecognised fair value losses on its securities portfolio. But it had a large, and apparently sound, real estate lending portfolio. And its uninsured deposits had grown substantially in the previous week, as many crypto exchanges and platforms had moved their funds to it from Silvergate Bank. So why had the NY DFS closed it down without warning? </p><p>I thought rapid inflows from Silvergate might have overwhelmed SBNY's administration and control systems, rendering it no longer in a safe and sound condition (clause (c)) and unable to safely continue in business (clause (d)). But this might have been temporary, and Section 606 allows for temporary closures, for example to prevent bank runs due to contagion rather than fundamentals. SBNY's books didn't look too bad, so I wondered why the NY DFS had put SBNY straight into receivership. Did it think SBNY was "conducting its business in an unauthorized or unsafe manner" (clause (b))? Did it close down SBNY because of suspected complicity in FTX/Alameda's wire fraud (clause (a))? Or had SBNY suffered impairment to its capital as a result of Silvergate contagion (clause (e))? I didn't know, but I thought there must have been some kind of catastrophic failure to justify such drastic action. </p><p>But crypto people smelled a rat. After Silvergate went into voluntary liquidation, SBNY was the only major provider of banking services to crypto companies. It had already announced its intention to reduce its exposure, but perhaps this wasn't enough for regulators that were increasingly unfriendly to crypto activities. Could the regulators have used the smokescreen created by SVB's failure as an opportunity to close down a bank that was engaged in business they didn't like?</p><p>Then Barney Frank stepped in. Frank was joint author of the Dodd-Frank bank regulations introduced in response to the 2008 banking crisis - and a director of SBNY. Completely ignoring the bank's crypto-related activities, Frank insisted that the bank was sound, <a href="https://www.bloomberg.com/news/articles/2023-03-13/barney-frank-us-banking-reformer-watches-his-own-lender-fail?sref=3roVJZZ4">telling Bloomberg</a>:</p><blockquote>I think that if we’d been allowed to open tomorrow, that we could’ve continued — we have a solid loan book, we’re the biggest lender in New York City under the low-income housing tax credit. I think the bank could’ve been a going concern.”</blockquote>
<p>Following Frank's intervention, the idea that SBNY was a solvent bank unfairly closed down by regulators spread like wildfire. Only a month before, the crypto entrepreneur Nic Carter had <a href="https://www.piratewires.com/p/crypto-choke-point">published an article</a> claiming that the Biden administration was intending to choke off crypto companies' access to the US banking system in the same way that the Obama administration had choked off access for payday lenders. Carter called this plan "Operation Chokepoint 2.0". To many people, the closure of SBNY was evidence that Carter was right. "Operation Chokepoint 2.0" was real, and it was here. </p><p>The law firm Cooper & Kirk, which says it "successfully challenged" President Obama's Operation Choke Point (though the case never reached court), has now <a href="https://www.cooperkirk.com/wp-content/uploads/2023/03/Operation-Choke-Point-2.0.pdf">published a paper</a> purporting to prove the existence of Operation Chokepoint 2.0. This paper, somewhat grandly entitled "The Federal bank regulators come for crypto", lists the manifold ways in which it says regulators are denying crypto people their constitutional rights. These include: failing to charter crypto-friendly banks (Protego); demanding that existing banks exit crypto-related activities; refusing Federal Reserve master accounts to state banks engaged in crypto-related business (Custodia, Kraken); and closing down a solvent bank (SBNY) solely because of its crypto-related activity: </p>
<blockquote>Finally, the federal bank regulators are acting in an arbitrary and capricious fashion
by failing to adequately explain their decisions, by failing to engage in reasoned
decisionmaking, and by failing to treat like cases alike. It is difficult to imagine a
more arbitrary and capricious agency action than simultaneously placing a solvent
bank into receivership solely because it provided financial services to the crypto
industry, while permitting insolvent institutions not tied to the crypto industry to
continue operating. </blockquote><p>Now, it is probably true that the US regulators are clamping down on the crypto industry with the intention of driving much of it out of the US. The fall of FTX crystallised the risks that a largely unregulated crypto system poses to ordinary depositors and to the financial system. In January 2023, the Fed/FDIC/OCC brutally listed these risks in their<a href="https://www.fdic.gov/news/press-releases/2023/pr23002a.pdf"> joint statement on crypto-asset risks to banks</a>:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhiZqU1mE6_CetIsGQP-l-wMZgkI2C5ataIU4NzvMSuDel2GfqGXyjzfnyqfiINBRL6NmeMdeyPwbE2AcmHhC4Qe41myLIWnaS2neuXWVHgeqkV_bcIFCzazFHmwlFm7Qfr31w-o0eWl1s70OoWBPUUSdZVJTpeQPD51gIx-jXjcwbQTw3J3kaapEQQ" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="860" data-original-width="1351" height="408" src="https://blogger.googleusercontent.com/img/a/AVvXsEhiZqU1mE6_CetIsGQP-l-wMZgkI2C5ataIU4NzvMSuDel2GfqGXyjzfnyqfiINBRL6NmeMdeyPwbE2AcmHhC4Qe41myLIWnaS2neuXWVHgeqkV_bcIFCzazFHmwlFm7Qfr31w-o0eWl1s70OoWBPUUSdZVJTpeQPD51gIx-jXjcwbQTw3J3kaapEQQ=w640-h408" width="640" /></a></div><br />Cooper & Kirk, following Carter, claim this statement is evidence of the US regulators' ill-will towards the crypto industry. But in the past year, every one of the risks and abuses that the regulators list has been evident in the crypto world. And as a result, many people have lost money they could ill afford. <div><br /></div><div>It is hard to see that regulatory action intended to protect people from such behaviour is unreasonable. And it is therefore also hard to see why such action should be seen as an unfair and illegal conspiracy against legitimate businesses. In fact it could be argued that the regulatory clampdown is a fine example of shutting the stable door after the horses have absconded with large amounts of people's money. Regulators are tasked with protecting the public, and they have manifestly failed to do so. This is the real scandal, not a fictitious "chokepoint" invented by people desperate to preserve a business model built on avoiding regulation. <p></p><p>In February, the Fed, FDIC and OCC went on to <a href="https://www.fdic.gov/news/financial-institution-letters/2023/fil23008a.pdf">warn banks about liquidity risks</a> arising from crypto-related activities. This statement in particular proved exceptionally prescient: </p><blockquote>When a banking organization’s deposit funding base is concentrated in
crypto-asset-related entities that are highly interconnected or share similar risk profiles, deposit
fluctuations may also be correlated, and liquidity risk therefore may be further heightened.</blockquote>
<p>Less than a month later, highly interconnected depositors all removing their funds at the same time brought down both Silvergate Bank and SVB. </p>
<p>And we now know that despite the inflows earlier in the week, this was also what brought down SBNY. In his <a href="https://www.fdic.gov/news/speeches/2023/spmar2723.html">testimony to the House Financial Services Committee</a>, FDIC chairman Martin J. Gruenberg gave the first comprehensive description of the events that led to the closure of SBNY. It's quite a story. </p><p>Like Silvergate, SBNY's troubles began with the fall of FTX:</p><blockquote>Signature Bank was subject to media scrutiny following the bankruptcy of FTX and Alameda Trading in November 2022, as the bank had deposit relationships with both. Subsequently, in December 2022, Signature Bank announced that it would reduce its exposure to digital asset related deposits. These declines were funded primarily by cash and borrowings collateralized with securities. <br /><br /> In February 2023, Signature Bank was again subject to media attention when a lawsuit was filed alleging it facilitated FTX commingling of accounts.</blockquote>
<p>SBNY then suffered contagion from Silvergate: </p>
<blockquote> Following the March 1, 2023 announcement by Silvergate Bank regarding the delay in filing its year-end 2022 financial statements and comments about its ability to continue as a going concern, Signature Bank once again experienced negative media attention, which raised questions about its liquidity position. This attention continued as Silvergate Bank later announced its self-liquidation.</blockquote><p>And from SVB too: </p>
<blockquote> Subsequently, as word of SVB’s problems began to spread, Signature Bank began to experience contagion effects with deposit outflows that began on March 9 and became acute on Friday, March 10, with the announcement of SVB’s failure. </blockquote>
<p>On Friday 10th March, SBNY suffered a massive bank run, losing 20% of its deposits in a single day. The only reason this didn't make headline news was that SVB's failure swamped the airwaves. </p><p>Losing deposits at that rate is catastrophic for a bank. Like SVB, SBNY quickly ran up an unauthorised overdraft at the Federal Reserve. Banks are not allowed to maintain overdrafts in their reserve accounts overnight, so SBNY had to convert the overdraft to discount window borrowing before close of business on Friday 10th March. It barely made it:</p>
<blockquote>Bank management could not provide accurate data regarding the amount of the deficit, and resolution of the negative balance required a prolonged joint effort among Signature Bank, regulators, and the Federal Home Loan Bank of New York to pledge collateral and obtain the necessary funding from the Federal Reserve’s Discount Window to cover the negative outflows. This was accomplished with minutes to spare before the Federal Reserve’s wire room closed.
</blockquote>
<p>But in these days of instant electronic payments, people can remove their funds from a bank even when the bank is closed for the weekend. So the bank run didn't stop:</p><blockquote>Over the weekend, liquidity risk at the bank rose to a critical level as withdrawal requests mounted, along with uncertainties about meeting those requests, and potentially others in light of the high level of uninsured deposits, raised doubts about the bank’s continued viability.</blockquote>
<p>According to Barney Frank, deposit ouflows had slowed by Sunday, and SBNY management believed they had stabilised the situation. But it seems NY DFS thought otherwise. On Sunday afternoon, it shuttered the bank. </p><p>Would SBNY have been able to continue if it had opened on Monday? It seems unlikely. SBNY was already critically short of eligible collateral, and reopening on Monday would likely have reignited the bank run. A bank that has insufficient eligible collateral to tap the Fed's discount window for funding to meet its obligations is insolvent, not merely illiquid. And I don't mean insolvent in the sense that its assets are worth less than its liabilities, though that was probably also true. I mean that it is unable to meet its obligations as they fall due. That is the textbook <a href="https://uk.practicallaw.thomsonreuters.com/Glossary/UKPracticalLaw/Ib9aa19861c9a11e38578f7ccc38dcbee?transitionType=Default&contextData=%28sc.Default%29">definition of insolvency</a>. </p><p>And this explains why the NY DFS not only closed SBNY down, but handed it over to FDIC for resolution. The catastrophic run it had suffered had rendered it insolvent. </p><p>I checked the references in Cooper & Kirk's paper. Their claim that SBNY was solvent rests entirely on the word of Barney Frank <a href="https://www.cnbc.com/2023/03/13/signature-bank-third-biggest-bank-failure-in-us-history.html">as reported by CNBC</a>. And his belief that the bank was solvent in turn rested entirely on what he was being told by SBNY's management. In fact Cooper & Kirk's theory that regulators deliberately closed down a solvent bank is really nothing but the unsupported opinion of Barney Frank. If this part of their case is so weak, what does it say about the rest?</p><p>Of course, believers in Operation Chokepoint 2.0 will reasonably point out that Gruenberg is the only person who has described the fall of SBNY in such detail. Gruenberg was of course testifying to a House committee, rather than simply giving a personal opinion to a media publication, so his words should carry more weight. But nevertheless it is a valid criticism. Had NY DFS published the rationale for its decision at the time, as California's DFPI did in its <a href="https://dfpi.ca.gov/wp-content/uploads/sites/337/2023/03/DFPI-Orders-Silicon-Valley-Bank-03102023.pdf?emrc=bedc09">court filing</a>, the idea that regulators had closed down a solvent bank would never have gained traction. After all, no-one dares question California DFPI's decision to close down SVB. </p><p>Regulators need to be a lot more transparent about their decisions. And law firms need to remember that the unsupported opinion of one person with a vested interest is not evidence. The public has a right to know the truth. </p><p><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2023/03/silvergate-bank-post-mortem.html">Silvergate Bank - a post mortem</a></p><p><a href="https://www.coppolacomment.com/2013/07/anatomy-of-bank-run.html">Anatomy of a bank run</a></p><p><a href="https://www.coindesk.com/consensus-magazine/2023/03/02/what-now-for-crypto-banking/?utm_medium=social&utm_source=twitter&utm_content=editorial&utm_term=organic&utm_campaign=coindesk_main">What now for crypto banking? </a>- Coindesk</p><p><a href="https://www.federalreserve.gov/newsevents/pressreleases/files/orders20230324a1.pdf">Federal Reserve's order denying Custodia Bank's application for membership</a></p><p><i>Image: Reporters outside Signature Bank New York. By SWinxy - Own work, CC BY-SA 4.0, <a href="https://commons.wikimedia.org/w/index.php?curid=129570493">https://commons.wikimedia.org/w/index.php?curid=129570493</a></i></p><p></p></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-40146748527144485872023-03-16T19:38:00.022+00:002023-04-02T15:41:59.645+01:00The Peston effect<div><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWjXdYysqRG0ybt8yQMTLpysJXQa4gA_UX-hN_jN-6FnJH2OQI5hNxOtZ04SHc-_CygtRGlRVNZb707NieJRItUV--nb_6XWG99b_RgxKjIc47Ekwoj3Mw_nXbET73-lEn5C1zce1KrzRemeMNzjUxzN2hHu2V1cLt4U8389aZ91ZiSv31gkMTDypN/s2048/Northern_Rock_Customers,_September_14,_2007.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1536" data-original-width="2048" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWjXdYysqRG0ybt8yQMTLpysJXQa4gA_UX-hN_jN-6FnJH2OQI5hNxOtZ04SHc-_CygtRGlRVNZb707NieJRItUV--nb_6XWG99b_RgxKjIc47Ekwoj3Mw_nXbET73-lEn5C1zce1KrzRemeMNzjUxzN2hHu2V1cLt4U8389aZ91ZiSv31gkMTDypN/w640-h480/Northern_Rock_Customers,_September_14,_2007.jpg" width="640" /></a></div><div><br /></div><div>The last week or so has seen some of the worst bank communications since 2007, when the Bank of England started a bank run by leaking news of Northern Rock's emergency liquidity request to the journalist Robert Peston. Then as now, awful communications have frightened the horses, triggered stampedes and caused banks to fail.<p>Three banks in particular have shown an extraordinary insensitivity to popular fears: Silicon Valley Bank, Credit Suisse, and Wells Fargo. Two of these have paid a heavy price for their management's inept handling of vital communications. But the third seems to have got away with it - this time. Next time, it might not be so lucky. </p><b>Exhibit 1: Silicon Valley Bank (SVB)</b></div><div><br /></div><div>In the wake of Silvergate Bank's failure, Silicon Valley Bank decided to restructure its balance sheet. </div><div><br /></div><div>SVB's <a href="https://d18rn0p25nwr6d.cloudfront.net/CIK-0000719739/f36fc4d7-9459-41d7-9e3d-2c468971b386.pdf">full-year accounts</a> released in February revealed that it was backing highly volatile uninsured deposits with long-dated government securities that were falling in value and, as a result, becoming increasingly illiquid. To make matters worse, it was flattering its capital position by classing most of these securities as held-to-maturity even though it was obvious that in the event of a bank run it would have to raise cash by selling or pledging them at fair value. SVB was desperately short of liquidity and, on a fair value basis, had negative equity. But management sat on its hands - until Silvergate failed. </div><div><br /></div><div>Silvergate's failure was a massive wakeup call for SVB. Suddenly, the duration mismatch and illiquidity that management had been ignoring became an existential crisis. <a href="https://www.reuters.com/markets/us/silicon-valley-banks-demise-began-with-downgrade-threat-sources-2023-03-11/">Reuters reports</a> that the ratings agency Moody's threat to downgrade the bank's credit rating prodded SVB's management into action. They hastily cobbled together a plan to sell $21bn of long-dated bonds and replace them with short-dated, liquid securities, financed by a $2.25bn capital raise. On 8th March, they announced the plan and sold the bonds at a loss of $1.8bn. </div><div><br /></div><div>SVB's decision to shorten the duration of its US government bond portfolio and raise more capital was eminently sensible, though far too late and nowhere near enough. But the market took it to mean the bank was in deep trouble. The bank had sold the securities before raising the capital, which gave the impression that it was desperately short of cash. And announcing a $1.8bn loss with only $500m of the capital raise needed to finance it guaranteed didn't go down at all well with investors. The share price collapsed. </div><div><br /></div><div>Over the next 24 hours, $42 billion of uninsured deposits fled the bank. By the end of Thursday 9th March, SVB had overdrawn its reserve account at the Fed by nearly $1bn and was completely unable to find the collateral to convert this to authorised borrowing. The California Department of Financial Protectio and Innovation (CA DFPI), SVB's regulator, <a href="https://dfpi.ca.gov/2023/03/10/california-financial-regulator-takes-possession-of-silicon-valley-bank/">decided it was insolvent</a>, obtained <a href="https://dfpi.ca.gov/wp-content/uploads/sites/337/2023/03/DFPI-Orders-Silicon-Valley-Bank-03102023.pdf">a court order to close it down</a> and handed it over to the FDIC for resolution. </div><div><br /></div><div>This is a fine example of what we might term the Peston effect. An announcement intended to reassure markets and prevent a bank run had precisely the opposite effect. And like a genie, once the announcement was out of its bottle it proved impossible to control. News that SVB was in trouble spread far and wide on social media, helped by powerful influencers whose motives for spreading it were perhaps less than entirely honourable. </div><div><br /></div><div>Many have commented on the role of social media in the failure of SVB. And it is certainly true that the power of social media to amplify bad rumours contributed greatly to the extraordinary speed of the bank's collapse. But if the bank's management hadn't sat on its hands until it was forced to act then made an utter horlicks of communicating its plans, there wouldn't have been a bad rumour to spread, and the bank might still be standing today.</div><div><br /></div><div><b>Exhibit 2: Credit Suisse </b></div><div><br /><div>Credit Suisse has a history of terrible communications. In October 2022, a rumour spread on social media that "a Globally Systemically Important Bank" was on the brink of collapse. At that time, Credit Suisse was about to embark on a major restructuring in the hopes of ending a long run of terrible investment decisions and major losses. Analysts, including the armchair variety, put two and two together and decided that the failing G-SIB was Credit Suisse. Bond yields slumped and shares sold off. </div><div><br /></div><div>The bank's Chief Executive, Ulrich Koerner, tried to calm things down. He sent a memo to staff saying that the bank's capital and liquidity were strong. The memo was widely reported in the press - for example, by the newswire Reuters, which <a href="https://www.reuters.com/business/finance/credit-suisse-has-strong-capital-base-liquidity-ceo-memo-2022-09-30/">used the memo's wording as its headline</a>: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEij18XLIP4T7EOvs03q74iGdK2ng4dYNXm4Dges9-2Q2I20iHZ_wEhK6h7Rw58ZI8ZcClsjGOHHQ2WdTPJYBGkk_wRCXTXqqGKH65DXsCt5P_sR6zCeM7DxtFSIo1iRniL8D1bnWbcjUndiVl2k2GbiDrRKZT0os8OykoptFtfpPuySX-Fstv7GnyWa/s1486/Reuters%20Credit%20Suisse%20CEO.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="362" data-original-width="1486" height="156" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEij18XLIP4T7EOvs03q74iGdK2ng4dYNXm4Dges9-2Q2I20iHZ_wEhK6h7Rw58ZI8ZcClsjGOHHQ2WdTPJYBGkk_wRCXTXqqGKH65DXsCt5P_sR6zCeM7DxtFSIo1iRniL8D1bnWbcjUndiVl2k2GbiDrRKZT0os8OykoptFtfpPuySX-Fstv7GnyWa/w640-h156/Reuters%20Credit%20Suisse%20CEO.png" width="640" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div>He really shouldn't have used that phrase. Earlier that year, Do Kwon, owner/manager of the Terra stablecoin, had sent this tweet just before its crash in May 2022: </div><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTL9OwNHev6tGycRs9MFWb9vSZLAzSWNYsDCZV2tZNcFZYm90JS-NUbOVgfm-StkhFOck3EjQAoZbD6dvk_zc15xxyKq8yR5oJa6L5khFk5bbzh2P_86EVF85I0zc_OfCbz3Uzb-3A0ajgEoUJj9z4sl_9rvB46AMAmh_YjkVhfZ93q1msbrlKhhj1/s1146/Do%20Kwon%20tweet.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="446" data-original-width="1146" height="250" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTL9OwNHev6tGycRs9MFWb9vSZLAzSWNYsDCZV2tZNcFZYm90JS-NUbOVgfm-StkhFOck3EjQAoZbD6dvk_zc15xxyKq8yR5oJa6L5khFk5bbzh2P_86EVF85I0zc_OfCbz3Uzb-3A0ajgEoUJj9z4sl_9rvB46AMAmh_YjkVhfZ93q1msbrlKhhj1/w640-h250/Do%20Kwon%20tweet.png" width="640" /></a></div><br /><div>Twitter of course noticed the similarity and joked about Credit Suisse "deploying more capital". </div><div><br /></div><div>But worse, the phrase also resembled another Reuters headline, about the investment bank Bear Stearns: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjsg_YG2o91bKNJnjPNQLSXLLqP7DITPBFzrPUjrr1ITeG8iFQPf6UfJynPS4_PrDd-cchZ_pQ-mveeT0EmKu_NpHeOXe-JiVXcR_WxEcm8g5i0PsBkUpzr4CIN9Ss0gYYZdPpOV8kUfrjtRPUtdSAWrY5SVzFrdYXN96hn5xkXNT9dbY_iZTEX-2YV/s1572/Reuters%20Bear%20Sterns%20CEO.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="394" data-original-width="1572" height="160" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjsg_YG2o91bKNJnjPNQLSXLLqP7DITPBFzrPUjrr1ITeG8iFQPf6UfJynPS4_PrDd-cchZ_pQ-mveeT0EmKu_NpHeOXe-JiVXcR_WxEcm8g5i0PsBkUpzr4CIN9Ss0gYYZdPpOV8kUfrjtRPUtdSAWrY5SVzFrdYXN96hn5xkXNT9dbY_iZTEX-2YV/w640-h160/Reuters%20Bear%20Sterns%20CEO.png" width="640" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div>Three days after the CEO's statement, Bear Stearns collapsed into insolvency. <br /><br />The hapless Koerner's unwitting echoing of phrases from the past spooked the markets. The share sell-off intensified, bond yields fell to record lows, and CDS prices soared. As confidence in the bank slumped, customers pulled their funds. In the fourth quarter of 2022, some $88bn flowed out of the bank. At the end of October, Credit Suisse announced a major restructuring and 9,000 job cuts, financed by a rights issue of about CHF 4billion. </div><div><br /></div><div>You'd think Credit Suisse's management would have learned from the October 2022 communications disaster. But no. Today, after getting an emergency cash injection from the Swiss National Bank, Koerner <a href="https://www.reuters.com/business/finance/credit-suisse-ceo-said-banks-liquidity-basis-is-very-very-strong-2023-03-16/">gave an interview to the press</a>. Guess what he said. Yep, you got it....</div><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgqwexiSS6p_t0RDUpF61SS0l9vs3mpHflVSrMcCSrH9_ngxT7nr1q43DxztebITXfu50cSf4zLA5FTmF71pNtFP3EDearwbT64smTzo1uac0DlZOiTJVkNB_Lf2iFgJZOmdNmnKBzjAWbXfAFboLtR86MhSbpwif9ebHAp8h-wDp9y94ifSAi2139R/s1500/Reuters%20Credit%20Suisse%20CEO%202023.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="362" data-original-width="1500" height="154" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgqwexiSS6p_t0RDUpF61SS0l9vs3mpHflVSrMcCSrH9_ngxT7nr1q43DxztebITXfu50cSf4zLA5FTmF71pNtFP3EDearwbT64smTzo1uac0DlZOiTJVkNB_Lf2iFgJZOmdNmnKBzjAWbXfAFboLtR86MhSbpwif9ebHAp8h-wDp9y94ifSAi2139R/w640-h154/Reuters%20Credit%20Suisse%20CEO%202023.png" width="640" /></a></div><div><br /></div>Wen collapse?<div><br /></div><div><b>Exhibit 3: Wells Fargo</b></div><div><b><br /></b></div><div>If you were running one of the US's largest banks, would you see the worst US banking crisis since 2008 as an ideal time to announce your intention to issue lots more debt? No, me neither. But Wells Fargo's management did. On Tuesday 14th March, as the flames rose round the US's regional banks, it filed for a mixed shelf offering of up to $9.5 bn of assorted types of debt security. </div><div><br /></div><div>Wells Fargo has done shelf offerings before - in <a href="https://www.fool.com/investing/2020/06/09/wells-fargo-files-for-13-billion-mixed-shelf-offer.aspx">2020</a>, for example, and in <a href="https://www.sec.gov/Archives/edgar/data/72971/000007297115000607/wfc-06302015x10q.htm">2015</a>. They aren't emergency borrowing, and they aren't a capital raise. In fact the filing itself doesn't raise any funds at all. It's simply an announcement that the bank intends to issue securities at some time in the (we assume fairly near) future. So why the bank's management decided to file this offering in the middle of a banking crisis is a mystery. Perhaps they thought it was a good time to bury bad news. </div><div><br /></div><div>If this was their intention, they largely succeeded. The shelf offering wasn't even reported in the mainstream press. It was Seeking Alpha, of all places, that broke the news. But the problem with news being broken by fringe media is that it attracts fringe attention. As a result, there was something of a kerfuffle on Twitter from people who mistook the shelf offering for an emergency capital raise and thought it meant Wells Fargo was in trouble. Fortunately it doesn't seem to have come to anything, but given how easily misinformation spreads on social media, this could have ended very badly for Wells Fargo - and blown up a much larger financial crisis than the one currently engulfing the US's regional banks. </div><div><br /></div><div>Careless talk costs money. Do better, bank executives. </div><div><br /></div><div><b>Related reading:</b></div><div><b><br /></b></div><div><a href="https://www.coppolacomment.com/2012/07/the-shoebox-swindle.html">The shoebox swindle</a></div><div><a href="https://www.coppolacomment.com/2023/03/silvergate-bank-post-mortem.html">Silvergate Bank - a post mortem</a></div><div><a href="https://www.coppolacomment.com/2013/07/anatomy-of-bank-run.html">Anatomy of a bank run</a></div><div><a href="https://www.coppolacomment.com/2012/05/liquidity-matters.html">Liquidity matters</a></div><div><br /></div><div><br /></div><div><i>Image: Alex Gunningham from London, Perfidious Albion (UK plc) - Northern Rock Customers, Golders Green., CC BY 2.0, <a href="https://commons.wikimedia.org/w/index.php?curid=2749081">https://commons.wikimedia.org/w/index.php?curid=2749081</a></i></div><div><br /></div></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com3tag:blogger.com,1999:blog-8764541874043694159.post-36971910470004626852023-03-09T17:16:00.008+00:002023-03-09T22:52:40.357+00:00Silvergate Bank - a post mortem<p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEj7vXEeyOo_77tP9yKL6r1MDb3n-JkR2NO1E9mpYh8cpLYKAKoQiop_6jqxLSMfdR2OOE9zrT2OQKCOtyuaSVL7IPyDZg4aGTmIY35PUCGdQZPOlkG2REX0sDcb3NGx9X3IEOaRu0FgfIBu6gX6issi80DJfSEkEpQv_kpkLYVvXSuiKZIqYhjcwsZu" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="168" data-original-width="300" height="358" src="https://blogger.googleusercontent.com/img/a/AVvXsEj7vXEeyOo_77tP9yKL6r1MDb3n-JkR2NO1E9mpYh8cpLYKAKoQiop_6jqxLSMfdR2OOE9zrT2OQKCOtyuaSVL7IPyDZg4aGTmIY35PUCGdQZPOlkG2REX0sDcb3NGx9X3IEOaRu0FgfIBu6gX6issi80DJfSEkEpQv_kpkLYVvXSuiKZIqYhjcwsZu=w640-h358" width="640" /></a></div><br />Silvergate Bank died yesterday. Its parent, Silvergate Capital Corporation, posted <a href="https://ir.silvergate.com/news/news-details/2023/Silvergate-Capital-Corporation-Announces-Intent-to-Wind-Down-Operations-and-Voluntarily-Liquidate-Silvergate-Bank/default.aspx#:~:text=In%20light%20of%20recent%20industry,full%20repayment%20of%20all%20deposits.">an obituary notice</a> <i>(click for larger image):</i><p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEi3Kk0wKGutqkNnESc-ExFLpvAnK9YeZDGRbtSkY32yEQ5T0njOAkIdVP5tMTUkwkDT_UJsFB6QR_kgDQsfXbddIZcjErOZu_tZqIRjmIY6V2SagoFvtxdQ2Q-NgKSPBU0Qr9Yk5mlf7_ler-j0LSDGUvbtyjdib7TLV3UHcccHmVsi3PTLSVEC8HK2" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="693" data-original-width="2522" height="176" src="https://blogger.googleusercontent.com/img/a/AVvXsEi3Kk0wKGutqkNnESc-ExFLpvAnK9YeZDGRbtSkY32yEQ5T0njOAkIdVP5tMTUkwkDT_UJsFB6QR_kgDQsfXbddIZcjErOZu_tZqIRjmIY6V2SagoFvtxdQ2Q-NgKSPBU0Qr9Yk5mlf7_ler-j0LSDGUvbtyjdib7TLV3UHcccHmVsi3PTLSVEC8HK2=w640-h176" width="640" /></a></div><br />Silvergate Bank bled to death after announcing significant delay to its 10-K full-year accounts and warning that it might not be able to continue as a going concern. We will never know whether it could have recovered from the bank run after the failure of FTX. The bank run after the announcement was far, far worse. The exit of its major crypto customers sealed Silvergate's fate. <p></p><p>But the agent of death was a government agency. On 7th March, <a href="https://www.bloomberg.com/news/articles/2023-03-07/silvergate-in-talks-with-fdic-officials-on-ways-to-salvage-bank?sref=3roVJZZ4">Bloomberg reported</a> that Silvergate Bank had been in talks with FDIC about a potential resolution "since last week". Many of us had expected FDIC to go into the bank last Friday with a view to resolving it over the weekend. We now know that FDIC did indeed go into the bank, but a resolution over the weekend wasn't possible. Presumably, this means there was no buyer. </p><p>Why do I say there was no buyer? Because Silvergate Capital Corporation has put its bank into voluntary liquidation. Liquidation means it is a "gone concern". There's no prospect of resurrection and the best that can be hoped for now is extraction of value from the bank's remaining assets. Silvergate says it intends to repay deposits "in full", but it's not yet clear that it will actually be able to do this. We know that the securities portfolio that ostensibly backs the remaining deposits has fallen considerably in value. Whether sales of the bank's other assets will be sufficient to make good all uninsured depositors remains to be seen. </p><p>No doubt FDIC did try to find a buyer. That's how it usually resolves failing banks. And the little that journalists managed to get out of FDIC officials and Silvergate employees suggests that for a while, they had some hope. FDIC probably tried to persuade other banks and financial institutions to take on this deeply distressed bank as a going concern. There was even talk of a crypto industry buyout, though this was never a credible solution for a regulated bank with a Fed master account. But it seems no-one was interested, at least at a price that Silvergate Capital would accept. And hedgies and distressed debt specialists no doubt saw more value in the bank's assets than they did in the business. Vultures prefer their meat to die before they pick its bones clean. </p><p>Incredibly, Bloomberg said crypto investors might help the bank "shore up its liquidity". But <a href="https://www.coindesk.com/consensus-magazine/2022/12/14/after-ftx-explaining-the-difference-between-liquidity-and-insolvency/">liquidity isn't a solution to a solvency problem</a>. Like FTX, Carillion, RBS and all the other companies that have desperately called for more liquidity while going down in flames, Silvergate Bank is insolvent. Deeply so. And has been for some time. </p><p>The death of Silvergate Bank should give other banks pause for thought. Silvergate is far from the only bank that is backing volatile demand deposits with government securities that are falling in value as central banks raise interest rates. Silicon Valley Bank, for example, is currently backing demand deposits with a held-to-maturity securities portfolio that at the end of December 2022 was underwater to the tune of over $15 billion - no, this is not a typo, the figures in this table are in millions <i>(click for larger image)</i>:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgDHecubfpSXW-UeDcxE6h5WKz6Y2C7NYC0XVB5n1QEe-mu7to-UrgchvqOYTa30CsGGgfs_iAm9FagNxzx8e7ZR3Xych-dyylO6o41ZldS9BWOKO84bRFSUlrpYMhW3x6EmPOoX7GFJQghKFyoJeM78dyo0FvO4WHKzChDrLCRICSrzdLr4v_C2B3y" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="728" data-original-width="2484" height="188" src="https://blogger.googleusercontent.com/img/a/AVvXsEgDHecubfpSXW-UeDcxE6h5WKz6Y2C7NYC0XVB5n1QEe-mu7to-UrgchvqOYTa30CsGGgfs_iAm9FagNxzx8e7ZR3Xych-dyylO6o41ZldS9BWOKO84bRFSUlrpYMhW3x6EmPOoX7GFJQghKFyoJeM78dyo0FvO4WHKzChDrLCRICSrzdLr4v_C2B3y=w640-h188" width="640" /></a></div><br />As we saw with Silvergate, fair value losses can be concealed by means of accounting devices such as classing securities as held-to-maturity and carrying them at amortised cost. In 2021, Silicon Valley Bank moved securities with a carry value of $8.8 billion from available-for-sale to held-to-maturity. <p></p><p>Unrealised fair value losses on assets marked as available-for-sale are reported in "other comprehensive income" on the income statement. They don't affect headline profits, but they do affect the bank's capitalisation. If these unrealised losses exceed shareholders' equity, the bank is technically insolvent. In its December 2022 full-year accounts, Silicon Valley Bank reported unrealised losses of $1.911 billion. </p><p>But unrealised fair value losses on assets marked as held-to-maturity are not reported in the income statement. In fact they are not reported anywhere except in the notes to the accounts. So they don't affect the bank's capitalisation. </p><p>This is fine as long as the bank doesn't experience a liquidity crisis. When a bank needs liquidity, it pledges or sells securities on the open market or at other banks (including the Federal Home Loan Bank and the Federal Reserve) for cash. Selling securities crystallises fair value losses, and as we saw with Silvergate, standing ready to sell securities to meet an unknown volume of deposit withdrawal requests forces the bank to mark its held-to-maturity assets as available-for-sale. As a result, the fair value losses on held-to-maturity assets immediately go through the income statement: realised losses are deducted from headline profits, and all losses, realised and unrealised, are deducted from shareholders' equity. </p><p>Silicon Valley Bank's total shareholders' equity is $16.995 billion. So even if it had to move all its held-to-maturity securities to available-for-sale, and take $15bn of accumulated fair value losses through the income statement, it would still be solvent. But this wouldn't leave a great deal of headroom for other losses. So Silicon Valley Bank has now decided to shore up its equity with a <a href="https://www.ft.com/content/f55df9d1-386a-4643-8194-095228741054">$2.25bn stock sale</a>. </p><p>But there's another problem. A bank can't raise more cash than the market value of the securities it is selling, and if it is pledging securities, it will raise less. So if the market value of the securities is less than the value of the deposits they are backing, the bank may be unable to raise the money it needs to honour deposit requests. Silicon Valley Bank is is already suffering significant deposit outflows. It could be in deep trouble if this became a full-scale flood. (Though right now, the tanking share price seems to be a more immediate concern...)</p><p>Silicon Valley Bank is far from the only bank whose solvency and liquidity are both compromised by rising yields on government securities. In fact smaller banks that are currently permitted to opt out from including unrealised losses on available-for-sale securities in regulatory capital calculations are most exposed. </p><p>The lesson from this is that banks should refrain from concealing fair value losses on securities that they might need to sell to obtain liquidity, and regulators should not permit banks that have a high proportion of runnable deposits to mark large parts of their securities portfolios as held-to-maturity in order to avoid taking unrealised fair value losses through P&L. The liquidity risk is far too great. </p><p>Furthermore, when asset prices are falling, all banks should shore up their capital buffers to protect creditors from the risk of losses. If they don't do this, there is an enhanced risk of bank runs as people start to question their solvency. And regulators need to change their practices so they are not fooled by apparently healthy capital ratios arising from zero-weighting of government securities and AOCI opt-outs. Silvergate's Tier 1 capital ratio exceeded 50% at the time of its failure - but it was nevertheless deeply insolvent. </p><p>When both liquidity and solvency are compromised because of falling asset values, inadequate equity buffers and imprudent accounting practices, banks can literally bleed to death. That's what happened to Silvergate. Those who say that Silvergate's failure was a crypto industry problem are entirely missing the point. Yes, it was runs on crypto platforms that brought Silvergate down, but the underlying fragility was of its own making. What happened to Silvergate could happen to a lot more banks if they don't change their ways. </p><p><br /></p><p><b>Related reading:</b><br /><br /><a href="https://www.coppolacomment.com/2023/03/lessons-from-disaster-engulfing.html?sc=1678356196843#c7384126576872228569">Lessons from the disaster engulfing Silvergate Bank</a></p><p><a href="https://www.ft.com/content/c94279a4-4ec2-4a0c-86fb-be8375e12ef2">Silicon Valley Tank(s)</a> - FT Alphaville</p><p><a href="https://twitter.com/RagingVentures/status/1615826088038473733?s=20">Twitter thread on Silicon Valley Bank</a> from @RagingVentures</p><p>Silicon Valley Bank's 10-K report December 2022 can be downloaded <a href="https://ir.svb.com/financials/sec-filings/default.aspx">here</a>. It makes interesting reading, but I recommend the FT's excellent reporting on what is going on at SVB. I've just used it in this piece as a timely example of solvency and liquidity risk in a much larger bank than Silvergate.</p><div><br /></div><p><br /></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com1tag:blogger.com,1999:blog-8764541874043694159.post-21134303050277576432023-03-07T17:44:00.003+00:002023-03-07T17:50:06.989+00:00Lessons from the disaster engulfing Silvergate Capital<p>This is the story of a bank that put all its eggs into an emerging digital basket, believing that providing non-interest-bearing deposit and payment services to crypto exchanges and platforms would be a nice little earner, while completely failing to understand the extraordinary risks involved with such a venture. </p><p>On 1st March, Silvergate Capital Corporation announced that filing of its audited full-year accounts <a href="https://ir.silvergate.com/sec-filings/sec-filings-details/default.aspx?FilingId=16454314">would be significantly delayed</a>, and warned that its financial position had materially changed for the worse since the publication of its provisional results on January 17th, when it reported a full-year loss of nearly $1bn.</p>
<p>The stock price promptly tanked, falling 60% during the day: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEg2MkubwzC6w0sUCl0aqmgMnDuua-UtFlZ49XV6Q6gSJ9fkVfN3DksdosAVU1hpttMtlGbhJ4w_-670kbV7aJcPEkDgQbGr-U1jldmiQZH1xIt10KvJji6PnMSIGSol9RcMRkl6NpHAS8R2PltJ7bPjoTHO3W1i5xFppRSlDBD2VMfoJPEIbwoWf0l2" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="679" data-original-width="1224" height="356" src="https://blogger.googleusercontent.com/img/a/AVvXsEg2MkubwzC6w0sUCl0aqmgMnDuua-UtFlZ49XV6Q6gSJ9fkVfN3DksdosAVU1hpttMtlGbhJ4w_-670kbV7aJcPEkDgQbGr-U1jldmiQZH1xIt10KvJji6PnMSIGSol9RcMRkl6NpHAS8R2PltJ7bPjoTHO3W1i5xFppRSlDBD2VMfoJPEIbwoWf0l2=w640-h356" width="640" /></a></div><br /> Platforms, exchanges and other banks halted or re-routed transactions on Silvergate's SEN payments network, and customers that had other banking relationships removed their deposits. In response, Silvergate halted the SEN network. A banner on its <a href="https://www.silvergate.com/">website</a> now reads:<blockquote>Effective immediately Silvergate Bank has made a risk-based decision to discontinue the Silvergate Exchange Network (SEN). All other deposit-related services remain operational.
</blockquote>
<p>However bad Silvergate's financial position was before the announcement, it is now much, much worse. Some are questioning whether it will survive. "We believe a receivership/liquidation scenario is a distinct possibility," <a href="https://www.reuters.com/technology/crypto-stocks-fall-silvergate-crisis-deepens-2023-03-06/">said analysts at Wedbush Securities</a> (Reuters). </p>
<p>The proximate causes of Silvergate's distress appear to be twofold. Firstly, a demand from the Federal Home Loan Bank of San Francisco to repay its advances "in full", for which Silvergate has had to sell securities. Secondly, losses due to impairment of its securities portfolio. This toxic combination of circumstances threatens Silvergate's solvency: </p>
<blockquote>These additional losses will negatively impact the regulatory capital ratios of the Company and the Company's wholly owned subsidiary, Silvergate Bank (the "Bank"), and could result in the Company and the Bank being less than well-capitalized. In addition, the Company is evaluating the impact that these subsequent events have on its ability to continue as a going concern for the twelve months following the issuance of its financial statements. The Company is currently in the process of reevaluating its businesses and strategies in light of the business and regulatory challenges it currently faces. </blockquote>
<p>And it reveals an underlying fragility that raises serious questions about the business models of banks involved with crypto. </p><p>Silvergate's asset base consists largely of US treasuries, agency MBS and CMOs, and muni bonds, mostly maturing within 12 months. Many of these are zero-rated for capital purposes. Hence the extraordinarily high CET1 and Tier 1 capital ratios it reported in its interim accounts in September 2022:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgX3TcD1WZQyQZkLRqeeSECxmdphESv9WAlLSDbOcP1clGH7MHLqeqV_B61JNuP_w86FQ0Bwa3rsb6CpsJHgK2b5cYSWyW_m2o3gB84lDOqNYgD4MeFFQPnXLQZcotMD_YJGYcrQp5XyJa8vaNh6a91vxYUPWDCx_gmDfKuPaGat87QS9uoUMTg-Spp" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1083" data-original-width="2692" height="258" src="https://blogger.googleusercontent.com/img/a/AVvXsEgX3TcD1WZQyQZkLRqeeSECxmdphESv9WAlLSDbOcP1clGH7MHLqeqV_B61JNuP_w86FQ0Bwa3rsb6CpsJHgK2b5cYSWyW_m2o3gB84lDOqNYgD4MeFFQPnXLQZcotMD_YJGYcrQp5XyJa8vaNh6a91vxYUPWDCx_gmDfKuPaGat87QS9uoUMTg-Spp=w640-h258" width="640" /></a></div><br />But the government securities in Silvergate's asset base are exposed to market risk. In the last year, yields have risen significantly, and prices have correspondingly fallen. So the fair value of Silvergate's assets is considerably lower than it was a year ago. Silvergate's solvency was already threatened long before the bank run that drove it to its knees. Interestingly, this is reflected in its share price:<br /><br /><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjqagFBCBbAYsg8Mc3Mn06QKgjzx-QoprWWc-7HAgLDku0VCYUmWXrNTjXyKy6srW135yM9BRWHp0dVwrl9DdnIYnhTTDVLWRshtyFRLCcwTnObqkq3IyCUAAaiouiecRrhSScngMEzq7i_xI8KbMHYdH3RrsVN7lmT-WajQMhn6O-79IU1u3EfdlDt" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img alt="" data-original-height="683" data-original-width="1222" height="358" src="https://blogger.googleusercontent.com/img/a/AVvXsEjqagFBCBbAYsg8Mc3Mn06QKgjzx-QoprWWc-7HAgLDku0VCYUmWXrNTjXyKy6srW135yM9BRWHp0dVwrl9DdnIYnhTTDVLWRshtyFRLCcwTnObqkq3IyCUAAaiouiecRrhSScngMEzq7i_xI8KbMHYdH3RrsVN7lmT-WajQMhn6O-79IU1u3EfdlDt=w640-h358" width="640" /></a><div><div><br /></div><div>Some prescient traders were shorting it. Though this might not have been solely because of worries about the fair value of its asset portfolio. As we shall see, Silvergate was also hideously exposed to the chaos in the crypto world in 2022.</div><div><div><br /></div></div></div><div><div>Because so much of the asset base is zero-weighted for capital purposes, Silverlake's regulatory capital ratios do not reflect the solvency risk. But the leverage ratio reported in the interim filings should have done. The reason that it didn't is that it was manipulated. </div><div><br /></div><div>In 1Q22, Silvergate moved $1.5bn of securities from available-for-sale to held-to-maturity, and in 2Q22 it moved a further $1.9bn. This enabled it to hold these securities at amortised cost instead of fair value. The asset value gain from this move was considerable. In September 2022, the total unrealized fair value loss on securities held-to-maturity was $1.1bn, none of which featured in the accounts.</div><div>
<p>Since the fair value loss arose mainly from the Federal Reserve's interest rate rises, and the Fed had given no indication that it intended to stop raising interest rates any time soon, arguably Silvergate should have impaired these assets. But Silvergate's management thought the fall in value was only temporary: </p>
<blockquote>....The Company determined that none of its securities required an other-than-temporary impairment charge at September 30, 2022. </blockquote>
<p>And they believed they wouldn't have to sell any of these assets before the maturity date, so would recover the full value: </p><blockquote>Current unrealized losses are expected to be recovered as the securities approach their respective maturity dates. Management believes it will more than likely not be required to sell any of the debt securities in an unrealized loss position before recovery of the amortized cost basis.</blockquote>
<p> But they were wrong. </p><p>In November 2022, the crypto exchange FTX collapsed. Crypto depositors rushed to withdraw their funds from the crypto exchanges and platforms that banked with Silvergate. To meet those withdrawal requests, the crypto exchanges and platforms drew on their Silvergate deposits. Runs on Silvergate's customers became a run on Silvergate. Billions of dollars flowed out of its accounts. By the end of December, its total deposits had fallen by $6bn. </p><p>But Silvergate's assets were largely in the form of investment securities. So it didn't have sufficient liquidity to finance the proxy run. It had to pledge or sell securities to obtain liquidity. </p><p>Initially, Silvergate borrowed heavily from the San Francisco FHLB. The FHLB-SF was Silvergate's main source of short-term funding, though it also had credit lines with three correspondent banks and access to the Fed's discount window. At 30th September, Silvergate had outstanding advances of $700m from FHLB-SF and had pre-positioned sufficient collateral to borrow an additional $1.6bn. But provided it could stump up sufficient collateral, it could borrow up to 35% of its total assets. And it did. In the fourth quarter of 2022, it borrowed an additional $3.6bn. At the end of December, its total borrowing from FHLB-SF stood at $4.3bn, or about 29% of its total assets. </p><p>Funding from the Federal Home Loan Banks is intended to support residential real estate lending. And to that end, it is taxpayer guaranteed. Federal Home Loan Banks are government-supported enterprises overseen by the Federal Home Finance Association (FHFA). </p>
<p>Silvergate's use of FHLB-SF funding to facilitate a proxy run originating from crypto exchanges and platforms raised a lot of eyebrows - including, perhaps, at the FHLB-SF itself. For reasons which are not entirely clear, the FHLB-SF now seems to have either terminated the loans or declined to roll them over. Silvergate has had to pay all the money back. </p>
<p>We don't know exactly why the FHLB-SF pulled the funding. But it can't simply have been done on a whim, as some have suggested. A loan is a legal agreement, so if the loans were terminated, there must have been a breach of the terms and conditions. </p><p>Bank loans to commercial enterprises are typically subject to covenants that set minimum requirements for key performance indicators such as debt/assets, debt/equity or EBITDA. As Silvergate is a bank, covenants might include regulatory captal ratios such as Tier1 capital, leverage ratio or liquidity coverage ratio. </p><p>Breaching one or more covenants means loans become instantly repayable. Lenders are often willing to delay testing covenants if the company is experiencing temporary difficulties such as, in Silvergate's case, a proxy bank run. But it seems the FHLB-SF wasn't willing. It wanted its money back. Was it spooked by the disastrous fall in Silvergate's leverage ratio, from well over 10% to just a whisker above 5%, when the assets previously classified as held-to-maturity were moved to available-for-sale? Or did Silvergate inadvertently break some other rule, such as the Federal Housing Finance Association's tangible capital rule, which has <a href="https://www.americanbanker.com/news/rising-interest-rates-put-community-banks-in-regulatory-bind-with-fhfa-rule#:~:text=The%20FHFA's%20tangible%20capital%20rule,regulator%20agrees%20to%20a%20waiver.">attracted criticism from the American Bankers' Association</a> for causing liquidity problems for smaller banks when interest rates rise? </p>
<p>Even if the FHLB-SF simply declined to roll the loans over, it would have done so because for some reason Silvergate no longer met its lending criteria. This would most likely be due to the considerable deterioration in Silvergate's financial position in the fourth quarter of 2022, but it could also have been that the FHLB-SF's supervisory bodies took a dim view of a government-sponsored home loan bank lending taxpayer-backed funds to finance a crypto-related bank run. </p>
<p>Whatever the reason, the FHLB-SF's action was draconian. Not only did it pull the funding, it did so with effect from the 31st December, with a short stay of execution to enable Silvergate to raise the money. Silvergate sold securities in January and February to repay the loans. These sales will be included in the 2022 full-year accounts. </p><p>But the $3.6bn Silvergate borrowed from the FHLB-SF wasn't enough to cover the massive deposit outflows in the fourth quarter of 2022 anyway. And for some reason, Silvergate didn't want to borrow from the Fed. So even before the FHLB-SF pulled its funding, Silvergate was already selling securities. </p><p>Selling securities at market price crystallized the fair value losses that had accrued over the past year, Even before the FHLB-SF pulled its funding, this resulted in a provisional headline loss of $1.1bn. The loss will be much larger in the restated full-year accounts. </p><p>Because of the securities sales, in December 2022 the bank moved all its held-to-maturity securities back to available-for sale. As a result, Silvergate will now have to impair its entire securities portfolio and take the losses through P&L as "other comprehensive income". This won't affect the headline loss, but it will negatively affect the bank's capitalization, and the impact will be considerable. In my view this change has been forced on it by its auditors. And it is this, even more than the loss of liquidity caused by the withdrawal of the FHLB-SF advances, that threatens Silvergate's future as a going concern. </p><p>The fact that Silvergate's apparently low-risk balance sheet structure has proved so fragile has important implications not only for banks and their regulators, but for crypto exchanges, platforms and stablecoin issuers. </p><p>Silvergate's crypto-related balance sheet structure was that of a money market mutual fund (MMMF). If Silvergate were a MMMF, the fall in the fair value of assets could be reflected in a lower net asset value, and customers trying to withdraw their deposits might not get their entire investment back. But Silvergate is a bank - in fact it is a member of the Federal Reserve system and has a Fed master account which gives it direct access to dollar payment services via Fedwire. Federally-regulated banks are required to honour deposit withdrawal requests at par. So the fall in the fair value of Silvergate's assets was not matched by a corresponding fall in the value of liabilities. </p><p>And this exposes the real problem with Silvergate's business model. Silvergate provides depository and payment services to crypto platforms. In September 2022, 90% of its deposits were non-interest bearing demand deposits from crypto platforms, almost all of which did not qualify for FDIC insurance. As the name implies, demand deposits can be withdrawn at any time without notice. In the classic bank run, it is demand deposits that are withdrawn. The more demand deposits a bank has, the more at risk it is of serious liquidity shortfalls in a bank run. </p><p>So up to 90% of Silvergate's deposits could be withdrawn at any time, at par, without notice. That's almost all of its funding base. And to make matters worse, the deposit withdrawals could take the form of payment requests made by customers of Silvergate's crypto platform customers to those platforms, not to Silvergate itself. Silvergate would have no control over the size or the timing of the withdrawals. It would simply have to make the payments.</p>
<p>Had Silvergate actually been fully reserved - by which I mean holding sufficient central bank reserves to enable all of its deposits to be withdrawn simultaneously - it would have had no problem paying out up to 90% of its deposits at par. But because Silvergate's asset base consisted largely of interest-bearing securities, it didn't have sufficient liquidity to honour such demands.To meet them, it would have to borrow from other banks, from the FHLB, or from the Fed. And if these sources failed, it would have to sell securities. But the market price of the securities could differ from their carry value. So there was a risk that selling them would fail to raise enough liquidity and/or would render the bank insolvent. </p>
<p>I often see crypto people describing as "fully reserved" a balance sheet that consists of deposit liabilities backed by high-quality investment securities of the kind held by Silvergate. But the disaster that has engulfed Silvergate shows that this isn't really full-reserve banking. Silvergate's deposits were backed by US government securities, and its capital ratios looked extremely healthy. But its solvency was threatened by fair value losses, and it had insufficient liquidity to meet deposit withdrawal requests. If the duration of your assets doesn't match that of your liabilities, and you don't have enough liquidity to finance a run on deposits, you aren't fully reserved. </p><p>Silvergate also resorted to some doubtful accounting tactics to conceal its fragility. It is at best unwise to mark securities as "held-to-maturity" and carry them at amortised cost when they are the backing for demand deposits and might therefore have to be sold at any time to obtain liquidity. Auditors didn't have the chance to question this until the year-end reporting cycle. But regulators did. Why didn't they intervene?</p><p>Silvergate could have opted to back its non-interest-bearing deposits fully with central bank reserves. There are still ample reserves in the dollar system, and the Fed is still paying interest on them. It's not clear why Silvergate opted for a business model that left it dangerously exposed to liquidity shortfalls and fair value losses. Crypto exchanges, platforms and stablecoin issuers at least have the excuse that they don't have direct access to central bank liquidity. But Silvergate does - and yet it didn't use it. And no-one except the traders who were shorting it seemed to notice the risks it was running. Regulators seem to have been asleep at the wheel, again. </p><p>Finally, neither banks nor regulators have paid sufficient attention to the serious danger of proxy bank runs originating from crypto platforms and exchanges. A bank swamped with direct deposit withdrawal requests can close its doors. But a bank that is intermediating payment requests from its customers' customers has no such recourse. In 2008 the Fed had to bail out the shadow banking system to prevent proxy runs destroying regulated banks. The same dynamic is now playing out in the banks that are foolishly providing banking services to crypto platforms and exchanges without full reserve backing. Silvergate is not the only one. Regulators need to intervene now, before this cancer spreads throughout the financial system. </p><p><br /></p><p><b>Related reading:</b></p><p><a href="https://www.coindesk.com/consensus-magazine/2023/03/02/what-now-for-crypto-banking/">What now for crypto banking?</a> - Coindesk</p><p><a href="https://www.coppolacomment.com/2013/07/anatomy-of-bank-run.html">Anatomy of a bank run</a></p><p>Silvergate Capital Corporation SEC filings can be downloaded <a href="https://ir.silvergate.com/sec-filings/default.aspx">here</a>. </p></div></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com2tag:blogger.com,1999:blog-8764541874043694159.post-41660455579507864842023-02-28T11:01:00.008+00:002023-03-01T09:19:53.127+00:00WASPI Campaign's legal action is morally wrong<p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjo-FMNit-tcZ4qtM_0J_OOUNHcBYnM73d1ZrjlL4r_IGJnfm58gIZHSFthKYl6kgLBn73ED4eMbKd1l5atrS2kosMdKWYuo8W1i7LEkg5zf1oVKEV0GoDToD6lsB9bBCBbHk23XsHN1T3CQNUVO50KY-LEubLBk4RBGdYRVvQ-zXcjuXXIZ1VNPfdN" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="350" data-original-width="624" height="358" src="https://blogger.googleusercontent.com/img/a/AVvXsEjo-FMNit-tcZ4qtM_0J_OOUNHcBYnM73d1ZrjlL4r_IGJnfm58gIZHSFthKYl6kgLBn73ED4eMbKd1l5atrS2kosMdKWYuo8W1i7LEkg5zf1oVKEV0GoDToD6lsB9bBCBbHk23XsHN1T3CQNUVO50KY-LEubLBk4RBGdYRVvQ-zXcjuXXIZ1VNPfdN=w640-h358" width="640" /></a></div><br /><br />I haven't written a post about WASPI for a very long time. I felt I had said everything I wanted to say, and it had become evident that the WASPI campaign and its offshoots had neither the widespread support nor the legal arguments that they claimed. Labour's proposed £58bn payment to WASPI women contributed to its disastrous defeat at the 2019 General Election. And in 2020, the hardline Back to 60 group's bid to overturn their state pension age rises failed in the Court of Appeal. The Government had no intention of compensating WASPI women for their lost pensions, and there was neither legal nor political means to force it to do so. The campaign seemed, in short, dead in the water. <p></p>
<p>But it seems it isn't, quite. Some years ago, WASPI campaign received legal advice that a challenge to the legislation would almost certainly fail but that there might be a case for maladministration on the part of the DWP. Women would have to make individual maladministration claims and would have to prove that they had suffered material financial loss as a consequence of the DWP's failure to administer the 1995 and 2011 Pensions Acts properly. WASPI's lawyers, Bindmans, provided templates for women to make claims against the DWP. Thousands did so. </p>
<p>The progress of the maladministration claims was necessarily paused during Back to 60's legal action. Part of Back to 60's argument was that the DWP was legally obliged to notify women individually of the rise in their state pension age and had failed to do so. If true, this would be maladministration. There was therefore a clear conflict with the individual maladministration claims put forward by WASPI women. Back to 60's failed legal action thus caused significant delay to WASPI's attempt to obtain compensation for its supporters. </p>
<p>But in June 2021, the Parliamentary and Health Service Ombudsman (PHSO) <a href="https://www.ombudsman.org.uk/sites/default/files/Women%E2%80%99s_State_Pension_age_-_our_findings_on_the_Department_for_Work_and_Pensions_communication_of_changes_Final.pdf">found that there had been maladministration</a> in the DWP's rollout of state pension age rises under the 1995 Pension Act. </p>
<p>The PHSO does not find that the raising of state pension ages for women born in the 1950s was illegal. Indeed, he has no power to do so. That power rests with the courts. The <a href="https://www.judiciary.uk/wp-content/uploads/2020/09/Delve-and-Glynn-v-SSWP-judgment.pdf">Court of Appeal dismissed</a> Back to 60's argument that the Pension Acts 1995 and 2011 unfairly targeted women born between between 6/4/1950 and 5/4/1960 and therefore constituted direct and indirect discrimination on grounds of age, sex and age & sex combined. The Supreme Court refused a further appeal. </p>
<p>The PHSO also has no power to overturn the Court of Appeal's finding that the DWP had no legal obligation to write women individually to notify them of the state pension age rises. However, the PHSO's maladministration finding nevertheless concerns the way the DWP went about notifying women. <br /><br />In 2006, the DWP decided to write to women individually after a survey revealed that a significant number of women, particularly poorer and less well educated women, didn't know their state pension age. But it then delayed writing to them for another 28 months. This delay is the maladministration that the PHSO has found.</p>
<p>The PHSO has now considered what financial redress should be paid to women affected by the maladministration. He has yet to publish his recommendations, but leaked information suggests a figure of about £1,000 per woman. And this is where the WASPI campaign's misinformation starts.</p><p>When considering financial redress for maladministration, the PHSO's stated aim is to "put the person affected back into a position where they would have been, had there not been a negative impact on them." This was also the <a href="https://www.coppolacomment.com/2016/07/the-waspi-campaigns-unreasonable-demand.html">original WASPI claim</a> as stated by Anne Keen, one of WASPI campaign's co-founders, in evidence to the Work and Pensions Select Committee. But there's an enormous difference. Whereas the PHSO is only concerned with compensation for maladministration, the WASPI claim was for compensation for the loss of state pension from 60. In other words, to negate the intended effect of the 1995 and 2011 Pensions Acts. </p><p>The WASPI campaign no longer states this aim explicitly on its site. Until recently, it demanded a "bridging pension". But because many 1950s women are now receiving their state pensions, WASPI campaign has changed its demand. It now wants a lump sum to compensate women for the pension that they did not receive between the age of 60 and their eventual state pension age: </p>
<blockquote>The initial aim of the WASPI Campaign was to achieve fair transitional arrangements for all women affected by the rapid increase to the SPA, with little notice to make alternative arrangements. This translated into a ‘bridging’ pension to provide an income until State Pension Age, not means-tested, and with recompense for losses for those women who have already reached their SPA. There are no specific age groups within the period mentioned above that are favoured above others.<br /><br />The Campaign has been going since 2015 and much has changed in that time. Most women affected have now reached their State Pension age. So, a bridging pension would not be relevant. For them, and in fact for all women a lump sum in compensation for the lack of notice received, commensurate with the degree of loss suffered, would be a more equable solution.</blockquote>
<p>On the face of it, this would appear to be a demand for compensation for the state pension age rises themselves, not redress for maladministration in the DWP's handling of them. The WASPI campaign's "ask" has never really changed. And neither have the expectations of its supporters. Conversations on Twitter and Facebook show that many WASPI women expect the PHSO to give them their lost pensions. </p><p>There are six levels of redress that the PHSO can recommend for maladministration, ranging from a mere apology (Level 1) to compensation payments of £10,000 or more (Level 6). But the PHSO's guidelines say Level 6 compensation is reserved for the most serious cases, cases where there has been loss of life, reduced life expectancy or permanent injury. </p><p>WASPI argues that the 6-year delay to their pension has had such effects on many women. And it therefore told supporters to expect Level 6 compensation. But distressing though it is to read stories of women dying before receiving their state pension or having to live on wholly inadequate disability and sickness benefits, <b>this is the intended consequence of the legislation itself</b>. </p><p>The PHSO <a href="https://www.ombudsman.org.uk/complaints-womens-state-pension-age">is not empowered</a> to recommend an award that would compensate women for the effects of the legislation itself:</p><blockquote>Many complainants have told us they are seeking reinstatement of their State Pension, the State Pension age to revert to 60, and/or compensation for the amount of State Pension they would have received had their State Pension age not changed.<br /><br />A <a href="https://www.judiciary.uk/judgments/r-on-the-application-of-julie-delve-and-karen-glynn-v-the-secretary-of-state-for-work-and-pensions/" rel="noopener" style="box-sizing: border-box; color: #006699; font-weight: 600; text-decoration-line: none; transition: all 0.2s ease 0s;" target="_blank">2019 High Court decision</a> underlined that we are not able to recommend DWP reimburse ‘lost’ pensions. Nor can we recommend that anyone receive their State Pension any earlier than the law allows or gets more State Pension than they are entitled to. To do so would amount to us recommending DWP reverse or try to reverse primary legislation. </blockquote><p>The delay to the pension is not maladministration. The PHSO cannot recommend that women be compensated for it. And although many WASPI women said they had suffered serious losses as a result of maladministration, the PHSO <a href="https://www.ombudsman.org.uk/complaints-womens-state-pension-age.">did not find</a> that the delay in writing to them caused the injustices that they claimed. </p>
<p> The proposed legal action by WASPI would judicially review the PHSO's proposed compensation award with a view to increasing this award significantly. The case rests on a technical disagreement over the way the PHSO calculated the effect of the notification delay on women. WASPI's lawyers argue that the method the PHSO used enabled it to discount losses suffered by some women, whereas had it used a different method, it might have to compensate them for these losses and the amounts could be considerable. But they have to show that it was irrational for the PHSO to use the method he did, and this is a high bar. Judicial reviews of PHSO decisions <a href="https://phsothetruestory.com/judicial-review/">tend not to end well </a>for the claimants.</p><p>But even if the judicial review succeeded, the PHSO would still be unlikely to award the amount of compensation that the WASPI campaign has led its supporters to expect, because he cannot make an award that would negate the intended effect of the legislation. And anyway, the final decision regarding compensation rests with the Government. The Government is under no obligation to pay what the PHSO recommends: indeed it doesn't have to pay anything at all. So this looks like yet another delaying tactic by a failed campaign to avoid having to admit it has lost. <br /><br />It grieves me to see WASPI raising women's hopes yet again, and worse, soliciting money from them that they can ill afford to fund what looks to me like a hopeless case. I really, really don't think WASPI should have any publicity for this futile attempt to secure money it should never have led women to expect. </p>
<p> Furthermore, I fundamentally oppose substantial compensation awards for state pension age rises. A compensation award of the level sought by WASPI would cost £billions. This would have to be funded either by additional government borrowing, by diverting government spending from other areas, or by higher taxes. Additional government borrowing would potentially have inflationary consequences requiring higher interest rates, which would hurt young families with mortgages and young people renting properties from landlords with mortgages. Diverting government spending would potentially mean cuts to benefit payments, affecting some of the poorest people in the land, or front-line services that are already seriously overstretched. And higher taxes would mean taking money from people whose state pension ages are already higher than those of WASPI women, many of whom are significantly less wealthy than people of the WASPI generation and likely to remain so. It's simply not fair to take even more money from younger generations to give to women of the wealthiest generation in history. </p>
<p> There is another reason, too, why I believe compensation for WASPI women is the wrong solution. Part of the reason for the distress some WASPI women are experiencing is the severe cuts to working-age benefits over the last decade or so. There is now a huge difference in income between state pensioners and people below state pension age who are unable to work because of illness, disability, caring responsibilities or unemployment. WASPI women who have to claim benefits to cover the time between their expected state pension at 60 and their actual state pension age are living in poverty, which they would not have been had they received their state pension at 60. But the solution is to reverse the cuts to working-age benefits and reform the harsh means-testing and fitness-to-work regimes to make them more suitable for older people, not to give WASPI women a bridging payment while leaving other groups (such as men of the same age) struggling to survive. If additional money is to be spent, I'd much rather it went into uprating working-age benefits and properly funding health and social care. </p>
<p> Finally, and at the risk of boring long-term readers of this blog, I'd like to quash a few myths about the state pension. WASPI women often say that they have "paid for" their state pensions through NI contributions, and that the government has "robbed" them by raising their state pension age. Some of them claim that the reason why their state pension age was raised was that previous governments diverted the state pension "pot" to other purposes. Unfortunately none of this is true. No-one "pays for" their own state pension. People's NI contributions aren't payments into a pension fund, they are hypothecated taxes that fund a range of welfare benefits -- contributory JSA, ESA, statutory maternity benefit, bereavement benefit, a couple of other small benefits and, of course, the state pension. They also part-fund the NHS. Because of longevity increases, baby boomers retiring, and the triple lock increasing state pensions above inflation, the state pension now takes almost all of the NI contributions that don't go to the NHS. And far from raiding National Insurance, the government in 2014-16 contributed an additional £14.2bn from general taxation to ensure that state pensions and other benefits could continue to be paid when NI contributions fell in the early 2010s. Without the state pension age rises that have affected WASPI women and are now affecting younger people, the state pension would eat up an ever-larger proportion of government spending, to the detriment of the rest of the people of the UK. <br /><br />So while I agree that the state pension rises affecting WASPI women could have been better handled - particularly the 2011 acceleration, which I think was grossly unfair to women born in 1953-54 - I don't think there is any case for reducing or eliminating their impact on the women concerned. That includes me. I am myself one of the women impacted. </p><p>I was born a few days into 1960, so am not a 1950s-born woman. However, I have had exactly the same state pension age rises as women born October 1954 to December 1959, and like them was never personally informed. I am now 63 and have a little less than 3 years to wait for my state pension. But had the 1995 and 2011 rises never happened, I would now have been in receipt of my state pension for over three years. And contrary to the baseless claims made by WASPI women on Twitter and Facebook, I am far from rich. I cannot retire before my state pension age, and when I do reach it, I will be dependent on my state pension. </p><p>I therefore understand why many 1950s-born women believe that they have unfairly suffered a material loss running to tens of thousands of pounds as a result of state pension age rises, and that they are entitled to compensation for this loss. Six years is a very long time to wait for a pension you believed you would receive from the age of 60.</p><p>But I'm afraid they are wrong. It distresses me to say this, but the loss we have suffered is the intended consequence of the 1995 and 2011 Pension Acts. We cannot, and will not, be compensated for this. The WASPI campaign's attempts to keep itself alive by leading women to expect compensation they will never receive are morally wrong. <br /><br /><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2018/11/now-state-pensions-are-equalised-lets.html">Now state pension ages are equalised, let's fix the real problems</a></p><p><a href="https://inews.co.uk/news/waspi-legal-action-more-compensation-state-pension-age-changes-morally-wrong-economist-2174440">WASPI's legal action for more compensation over state pension age changes is morally wrong, says economist</a> - i newspaper</p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com1tag:blogger.com,1999:blog-8764541874043694159.post-81690050341326180162023-02-16T13:09:00.014+00:002023-02-17T07:08:28.477+00:00Proof of reserves is proof of nothing<br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjfp81lRCjdt-l8S6XHdMSUTv5jYm-H54cbHYjlK-lKSjGg4jeYbDTlVTR80gQlAfkKziZgmsBUAhnosG_3ijGBu_zVE9kzrkwc5IgCEWNNcyMXX-0QcJ8NF9FfCGpbpXtZVqdRASL0uLlks4bFgJW4Mn_4i8SCm3mi6awaZ6_-Pgf6O0oJTp11hhSu" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="546" data-original-width="728" height="480" src="https://blogger.googleusercontent.com/img/a/AVvXsEjfp81lRCjdt-l8S6XHdMSUTv5jYm-H54cbHYjlK-lKSjGg4jeYbDTlVTR80gQlAfkKziZgmsBUAhnosG_3ijGBu_zVE9kzrkwc5IgCEWNNcyMXX-0QcJ8NF9FfCGpbpXtZVqdRASL0uLlks4bFgJW4Mn_4i8SCm3mi6awaZ6_-Pgf6O0oJTp11hhSu=w640-h480" width="640" /></a></div><br /><br />Proof of reserves is all the rage on crypto platforms. The idea is that if the platform can prove to its customers' satisfaction that their deposits are fully matched by equivalent assets on the platform, their deposits are safe. And if the mechanism they use to prove this uses crypto technology, that's even better. Crypto tech solutions have surely got to be much more reliable than traditional financial accounts and audits - after all, <a href="https://blockworks.co/news/ftx-joins-coinbase-kraken-with-us-gaap-audit-pass">FTX passed a U.S. GAAP audit</a>. <p>No, they aren't. Proof of reserves as done by exchanges like Binance does not prove that customer deposits are safe. It is smoke and mirrors to fool prospective punters into relinquishing their money, just like claims that exchanges and platforms are "audited" or have "insurance". There are no audits in the crypto world, there is no insurance, and as I shall explain, proof of reserves proves absolutely nothing.</p>
<p>The biggest crypto exchange, Binance, uses a Merkle tree proof of reserves. <a href="https://www.binance.com/en/proof-of-reserves">Here's how it describes it:</a></p>
<blockquote>A Merkle Tree is a cryptographic tool that enables the consolidation of large amounts of data into a single hash. This single hash, called a Merkle Root, acts as a cryptographic seal that “summarizes” all the inputted data. Additionally, Merkle Trees give users the ability to verify specific contents that were included within a particular set of “sealed” data. We use these properties of Merkle Trees during our Proof of Reserves assessments to verify individual user accounts are included within the liabilities report inspected by the auditor.</blockquote>
<p> And here's a handy graphic showing how the hashing works: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhDx5arYnRCbIOqR4FREpx7CIIJa8AolLkVxYUU9-8Q-1Lf2gje3SHIWZ2XLfucMly9uS1qXoJXAayrTecP42TJiYfYZu5utOfkEBMvGHI79us1eyUCjEGI-iTDOK6jki1Gc_axXvBnh4RuM3VUjK-0VrjjcrbKZ_bHuMIW8W6tM0UFPbWhHmzMetsg" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="759" data-original-width="1367" height="356" src="https://blogger.googleusercontent.com/img/a/AVvXsEhDx5arYnRCbIOqR4FREpx7CIIJa8AolLkVxYUU9-8Q-1Lf2gje3SHIWZ2XLfucMly9uS1qXoJXAayrTecP42TJiYfYZu5utOfkEBMvGHI79us1eyUCjEGI-iTDOK6jki1Gc_axXvBnh4RuM3VUjK-0VrjjcrbKZ_bHuMIW8W6tM0UFPbWhHmzMetsg=w640-h356" width="640" /></a></div><br /><br /><p></p><p>Of course, adding up balances doesn't need crypto technology. You can do that on an Excel spreadsheet. So the clever bit here is the hashing. This "seals" the numbers so that they can't be amended. So far, so good. But what does it prove? </p><p>It is supposed to prove that the assets in Binance's own wallets are sufficient to cover the total balance in all customer wallets. For any given asset, if the total in the Binance wallet is equal to or greater than the total in all customer wallets, then this proves those customer deposits are "fully reserved". It doesn't prove any such thing, of course - but we'll come to that shortly. </p><p>Binance also provides a facility for customers to verify whether Binance's proof of reserves includes their individual deposits. This is how it works:</p>
<blockquote> Log in to the Binance Website <br />
-> Click on “Wallet”<br />
-> Click on “Verification”<br />
You will be able to find your Merkle Leaf and Record ID within the page.<br /><br />
Select the verification date you want to check. You will then find confirmation of the verification type, your Record ID (specific to your account and this particular verification), the assets that were covered, and your asset balances at the time of the verification.<br /></blockquote><blockquote>The Record ID/Merkle Leaf enables you to independently verify that your account balance was included by the third-party auditor’s attestation report.</blockquote>
<p>Eh, what's that? A third-party auditor's attestation? Where?</p>
<p> In November 2022, Binance employed the auditor Mazars to conduct a Merkle tree "proof of reserves" for Bitcoin (BTC) and its "wrapped" (derivative) versions BBTC and BTCB running on the BTC, ETH, BSC and BNB blockchains. The asset balance reported by Mazars was a pitiful $582,486 - a tiny proportion of the total asset balance of $69 billion <a href="https://www.binance.com/en/feed/post/53973">Binance had reported only a couple of weeks before</a>. It was also less than the total customer balances for the BTC assets, but Binance fudged that by instructing Mazars to include in its scope assets that customers had borrowed against collateral that was out of scope: </p>
<blockquote> We found that Binance was 97% collateralized without taking into account the Out-Of-Scope Assets pledged by customers as collateral for the In-Scope-Assets lent through the margin and loans service offering resulting in negative balances on the Customer Liability Report. With the inclusion of In-Scope Assets lent to customers through margin and loans which are overcollateralized by Out-Of-Scope Assets, we found that Binance was 101% collateralized.</blockquote>
<p><a href="https://www.ledgerinsights.com/wp-content/uploads/2022/12/Binance_POR_Report_7_December_2022.pdf">Mazar's proof of reserves</a> showed that Binance had sufficient nominal reserves in dollar terms to enable all customers to withdraw their deposits of BTC and its derivatives. But the reserve mix was different from that of the customer balances and included assets of unknown value and liquidity pledged by customers as collateral: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgvUEinap6tCgsxZF4hHCWF9bcSaKYV1K7ngY53GRrQ3E2AYor7ySPA_kEq2zuqcXkta3_7nCQmYO042p6-AbyQlIDE8MZqqJCenA2X2Nb8pbPXpuD-Kud7W_NrNiCX-wExnhVuzKmtRHSFn97QGktWz52L0GbZbni-HKPHV6ZO1wyIfN9RlyNL783i" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="389" data-original-width="1666" height="150" src="https://blogger.googleusercontent.com/img/a/AVvXsEgvUEinap6tCgsxZF4hHCWF9bcSaKYV1K7ngY53GRrQ3E2AYor7ySPA_kEq2zuqcXkta3_7nCQmYO042p6-AbyQlIDE8MZqqJCenA2X2Nb8pbPXpuD-Kud7W_NrNiCX-wExnhVuzKmtRHSFn97QGktWz52L0GbZbni-HKPHV6ZO1wyIfN9RlyNL783i=w640-h150" width="640" /></a></div><div>Clearly, if all customers had tried to withdraw their BTC and derivative balances at the same time, Binance would not have been able to honour those requests. <br /><br />And there is another problem. Proof of reserves is useless without proof of liabilities. For all we know, Binance has used the BTC and derivatives in its wallet as collateral against other borrowing. If it has, then the lenders, not Binance's depositors, have first claim on those assets. Binance's CEO, Changpeng Zhao, insisted on Twitter that Binance has no debt, but he has provided no proof and says proof of liabilities is "hard". Clearly, customer deposits aren't Binance's only liabilities. Until Binance discloses its other liabilities, we simply do not know whether the assets disclosed in Mazars' limited "proof of reserves" are available for distribution to customers, whether to honour withdrawal requests <b>or in the event of insolvency</b>. </div><div><br /></div><div>Without proof of liabilities, we do not know if the company is even solvent. Of course, a proof of liabilities combined with a proof of assets is a balance sheet. Maybe there's some merit in traditional financial accounts after all? <br /></div><div><br /></div><div>Despite the limitations of Mazars' proof of reserves, word spread that it proved customers' BTC holdings on Binance were fully reserved. Worse, it became conflated with Binance's earlier publication of its wallet balances, which Binance had <a href="https://www.binance.com/en/feed/post/53973">misleadingly called "proof of reserves"</a>, In December, no doubt concerned that its work was being misinterpreted to mean that all customer assets on Binance were safe when they plainly were not, Mazars stepped down as auditor. <br /><br />Mazars' proof is no longer available on Binance's website, and Binance has so far been unable to find another reputable auditor willing to undertake a proof of reserves. It is even struggling to find an auditor willing to perform a traditional audit. </div><div><br /></div><div>Characteristically, senior managers at Binance <a href="https://www.bloomberg.com/news/articles/2023-02-08/binance-signals-full-audit-for-crypto-s-biggest-exchange-remains-some-way-off?sref=3roVJZZ4">blame ignorance of crypto among auditors</a> for the company's inability to recruit a replacement for Mazars. But really, the problem is that Binance's marketing heavily depends on the company not disclosing its true financial position. And this in turn relies on crypto people not understanding what "fully reserved" really means. </div><div><br /></div><div>In the banking world, we have now, after many years of confusion, broadly
reached agreement that the term "reserves" specifically means the
liquidity that banks need to settle deposit withdrawals and make payments. This liquidity is narrowly defined as central bank deposits and
physical currency - what is usually known as "base money" or M0, and
we could perhaps also (though, strictly speaking, incorrectly) deem
"cash". "Fully reserved" means the bank holds sufficient M0 to enable all customers to withdraw their deposits simultaneously. It's sometimes called "narrow banking". </div><div><br /></div><div>Anything other than this is "fractionally reserved" because only a fraction of depositors can withdraw their deposits simultaneously. High-quality liquid assets (HQLA) such as US Treasury bills can't be used to settle retail deposit withdrawals, so are not included in the definition of "reserves". So a bank that is holding sufficient HQLA to cover all customer deposits is still fractionally reserved unless the HQLA consists entirely of central bank deposits and physical cash. </div><div><p>Unfortunately this is widely misunderstood, especially in cryptoland. Crypto people complain that traditional banks don't have 100% cash backing for their deposits, then claim stablecoins, exchanges and crypto lenders are "fully reserved" even if their assets consist largely of illiquid loans and securities. But this is actually what the asset base of traditional banks looks like. </p>
<p> Most, if not all, crypto exchanges and platforms are fractionally reserved like traditional banks. They do not hold sufficient cash and tokens to enable all customers to withdraw their deposits simultaneously. This does not necessarily mean they are insolvent - but it does raise the risk of liquidity crises.</p>
<p> Investment firms that offer their customers the right to withdraw their investments on demand have similar liquidity needs to those of banks. These firms have limited access to central bank reserves (though the Fed's overnight reverse repo facility allows some of them to deposit funds at the central bank), and they don't tend to keep much in the way of physical currency. So for them, "reserves" means what banks would call HQLA - cash in bank deposit accounts, and short-term high-quality liquid assets such as treasury bills and commercial paper. Money market mutual funds are supposed to maintain sufficient reserves of this kind to allow 100% of investors to withdraw their money without the net asset value (NAV) falling below par - what is known as "breaking the buck". In 2008, Reserve Primary MMMF triggered a money market meltdown when it "broke the buck" and investors rushed to withdraw their money from money market funds. </p>
<p>In cryptoland, reserves are usually described in two ways: as the "backing" for crypto assets such as stablecoins that are pegged at par to a fiat currency such as the US dollar, or the "backing" for crypto assets held on customers' behalf by a exchange or platform. These are not the same thing.</p>
<p> Stablecoin issuers aren't banks, so don't have access to central bank deposit accounts. But they need fiat cash or HQLA "backing" to maintain their pegs, even if they restrict redemptions (as Tether does, for example). So for them, the MMMF definition of "reserves" is perhaps the closest - though Tether's attestations conflate the reserves needed to "back" its stablecoins with the company's total assets. A fully reserved stablecoin issuer should hold sufficient cash in FDIC-insured bank accounts and short-term highly liquid safe assets such as Treasury bills to enable all stablecoins to be redeemed simultaneously. If its reserves consist of anything else, it is fractionally reserved and at risk of liquidity crisis.</p>
<p>However, neither the MMMF definition nor the banking definition really works for crypto exchanges like Binance, nor for lending platforms like Celsius. Customer deposits on crypto exchanges and lending platforms are a wild mix of cryptocurrencies, stablecoins, derivatives and other tokens. So reserves consisting of 100% fiat cash and T-bills would be exposed to enormous foreign exchange and liquidity risk. </p><p>To be fully reserved, Binance needs to hold <b>the exact same quantity and mix</b> of crypto assets as its customers have deposited. If there is any mismatch, <a href="https://www.cnbc.com/2022/12/13/crypto-exchange-binance-temporarily-halts-usdc-stablecoin-withdrawals.html">even temporarily</a>, it is fractionally reserved. And if the reserve assets are encumbered in any way, it is also fractionally reserved. </p><p>Proving Binance was fully reserved at all times across all assets would be a formidable undertaking. Even Mazars' limited proof of reserves covering BTC and two derivatives on four blockchains failed to prove that Binance was holding the same quantity and mix of assets as its customer balances. A full proof of reserves would need to cover every coin traded on Binance, with its derivatives, on every blockchain supported by Binance. I frankly doubt if any exchange, let alone an external auditor, is capable of proving a reserve position as complex as this. And that's before we even get to proof of liabilities.</p><p>U.S. regulators are on a mission to force crypto companies to protect their customers' assets properly. In March 2022, the SEC published new accounting guidance that aimed to ensure crypto exchanges and platforms maintained full reserves across the entire asset mix. <a href="https://www.sec.gov/oca/staff-accounting-bulletin-121">SAB 121</a> advises crypto exchanges and platforms to record "safeguarding" liabilities and corresponding assets. And it requires any losses due to mismatches between the safeguarding liabilities and assets to be borne by the exchange or platform, not its customers. These safeguarding assets are the exchange or platform's "reserves".</p><p>But the SEC's guidance is at present voluntary and hardly any exchanges even try to comply with it, no doubt because it is really, really difficult and the company's profits are at risk. Instead, exchanges and platforms are rushing to implement crypto-tech "proof of reserves" gimmicks that are proof of nothing at all. There's no such thing as "fully reserved" in cryptoland. Whatever the snake oil sellers told you, your deposits are fully at risk and you can lose<b> all your money</b>. </p><div><br /></div><p><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2022/08/why-coinbases-balance-sheet-has.html">Why Coinbase's balance sheet has massively inflated</a></p><p><a href="https://www.coindesk.com/business/2023/01/10/a-binance-stablecoin-wasnt-always-fully-backed-bloomberg/">A Binance stablecoin wasn't always fully backed</a> - Coindesk<br /><br /><a href="https://www.coindesk.com/consensus-magazine/2022/12/14/after-ftx-explaining-the-difference-between-liquidity-and-insolvency/">After FTX: explaining the difference between liquidity and solvency</a> - Coindesk</p><p><br /></p><p><i>Image from <a href="https://www.wikihow.life/Read-a-Balance-Sheet">Wikihow</a>, with thanks</i>. </p>
<p></p></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com1tag:blogger.com,1999:blog-8764541874043694159.post-83092720118142722742023-02-13T23:10:00.018+00:002023-02-14T08:11:56.826+00:00Binance and its stablecoins<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhD8YtQ1wEBqRUjgL8QQUQByJ5Co1PtOnshp91sakMO8fwy0t6by7_jZry22E_-ZqRn-djwAPiCzQ2KuQMQ2An3xxBXAQKNioqN5msTvQ73gzis-xWEjrQnq4CzbeueKNgHng5fcmtyHPoZbJVsQlNVkG-drHeFzl6wU2xjOXCtgl3ZeanbgVFEdWdw/s2048/Laocoon_and_His_Sons_black.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2048" data-original-width="2034" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhD8YtQ1wEBqRUjgL8QQUQByJ5Co1PtOnshp91sakMO8fwy0t6by7_jZry22E_-ZqRn-djwAPiCzQ2KuQMQ2An3xxBXAQKNioqN5msTvQ73gzis-xWEjrQnq4CzbeueKNgHng5fcmtyHPoZbJVsQlNVkG-drHeFzl6wU2xjOXCtgl3ZeanbgVFEdWdw/w636-h640/Laocoon_and_His_Sons_black.jpg" width="636" /></a></div><br /><p>Yesterday, the SEC <a href="https://www.prnewswire.com/news-releases/paxos-issues-statement-301745616.html">issued a Wells notice to the stablecoin issuer Paxos</a>, warning it that the SEC intended to take legal action against it for issuing an unregistered security. The security in question is the fully-reserved stablecoin BUSD (Binance USD), which Paxos issues expressly for use on the Binance crypto exchange. The Wells notice doesn't apply to Paxos's other fully-reserved stablecoin, USDP, which it issues for use on its own platform. </p>
<p>A few hours later, the New York Department of Financial Services (NY DFS) ordered Paxos to stop minting BUSD. In a <a href="https://www.dfs.ny.gov/consumers/alerts/Paxos_and_Binance">consumer alert </a>published on its website, the NY DFS said there were "several unresolved issues related to Paxos’ oversight of its relationship with Binance in regard to Paxos-issued BUSD." It didn't specify what these issues were, but it went on to clarify that Paxos's BUSD and Binance's coin of the same name are not the same thing, and that it only regulates Paxos's coin, not Binance's:
</p><blockquote>It is important to note that the Department authorized Paxos to issue BUSD on the Ethereum blockchain. The Department has not authorized Binance-Peg BUSD on any blockchain, and Binance-Peg BUSD is not issued by Paxos. There is currently no restriction on the listing or exchange in New York of existing Paxos-issued BUSD by DFS-licensed entities. </blockquote>Now, maybe I am reading too much into this, but to me the NY DFS sounds distinctly irritated that Binance has seen fit to issue an offshore unregulated coin with the same name as an onshore regulated one, and deploy it on multiple blockchains, none of which is the one on which the NY DFS has authorized Paxos to issue its coin. And it has a point. <br /><br />The fact that there are two coins with the same name is bound to confuse customers. I have no doubt that this was intentional. Binance and Paxos (yes, both of them) want customers to use Binance-pegged BUSD through Binance's platform, not Paxos-issued BUSD through some other platform regulated by NYDFS. This would be fine if Binance-pegged BUSD, like Paxos BUSD, were fully reserved and regulated by the NYDFS, as <a href="https://www.binance.com/en/busd">Binance's website</a> implies. But it is not. <p>As Binance explains in a <a href="https://www.binance.com/en/blog/ecosystem/understanding-busd-and-binancepeg-busd-5526464425033159282">blogpost</a>, Binance-pegged BUSD is a "wrapped" version of Paxos BUSD, or what in tradfi parlance we might call a "derivative" or a "securitization". Whereas Paxos BUSD only operates on the Ethereum blockchain, currently these "wrapped" versions run on six blockchains <i>(click for larger image)</i>:</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjCEaBnu5APRyraI3QchNzdVReveAdobcyX5_akjHykG_Rezn7Dy8GW1ikfbzhApTgtH-XwBY6l8ywFNGmgi8j4eFNsLnaGqIoTEbwn43Rb97BBXrdvyj-rUoMOjr7AvlI8CIeXUc95pjRi2-QUZnXo44ONsvbMpYcwoGGBbj5FCdqKFYCMyWV_8u-i/s2526/Binance%20wrapped%20BUSD%20Feb%2013%202023.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1208" data-original-width="2526" height="306" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjCEaBnu5APRyraI3QchNzdVReveAdobcyX5_akjHykG_Rezn7Dy8GW1ikfbzhApTgtH-XwBY6l8ywFNGmgi8j4eFNsLnaGqIoTEbwn43Rb97BBXrdvyj-rUoMOjr7AvlI8CIeXUc95pjRi2-QUZnXo44ONsvbMpYcwoGGBbj5FCdqKFYCMyWV_8u-i/w640-h306/Binance%20wrapped%20BUSD%20Feb%2013%202023.png" width="640" /></a></div><br /><p>By exchanging Paxos BUSD for Binance-pegged BUSD, holders can use their BUSD tokens on multiple blockchains, rather than being restricted to the Ethereum blockchain. It's a bit like putting a coin into a slot machine and getting out a token which you can use on other slot machines that don't take the coin you put into the first machine. We could say it increases the liquidity of the BUSD token - though only in Binance's arcade. </p><p>Another way of looking at it is to regard Paxos BUSD as equivalent to dollars issued by the Federal Reserve (bank reserves and physical currency), and Binance-pegged BUSD as equivalent to dollars issued by commercial banks. Dollars issued by commercial banks are much more liquid than Fed dollars, but since they aren't issued by a U.S. government agency, they need a Federal guarantee to maintain their value. So they are hard-pegged to Fed dollars at par, and the Fed guarantees the peg subject to the commercial banks stumping up sufficient acceptable collateral.* Similarly, Binance-pegged BUSD is more liquid than Paxos BUSD, but it's not regulated by the NY DFS and isn't fully backed by US dollars and USD-denominated safe assets. So Paxos guarantees Binance-pegged BUSD's par peg to Paxos BUSD, subject to Binance providing collateral. </p><p>Paxos is far from a passive participant in this scheme. It is every bit as invested in maintaining an equal relationship between the two coins as Binance. Binance creates demand for its stablecoin, and it earns income from the assets that back the stablecoin. </p><p>The deal between the two companies says that Binance-pegged BUSD is always backed 1:1 by Paxos BUSD:</p>
<blockquote> How can users be sure that the value of Binance-Peg BUSD tokens is equally protected? That’s simple: each Binance-Peg BUSD token that Binance mints correspond to a BUSD token held in reserve by its issuer – Paxos. BUSD (ERC-20) and Binance-Peg BUSD holders can swap their tokens between the blockchains freely. In sum, each Binance-Peg BUSD token represents the value of a native BUSD custodied outside of Binance, meaning that its value is secured by the same robust protection mechanisms that make BUSD one of the most reliable stablecoins on the market. </blockquote>
<p> But between September 2020 and July 2021, <a href="https://www.bloomberg.com/news/articles/2023-01-10/binance-bnb-acknowledges-past-flaws-in-managing-busd-peg-stablecoin-reserves?sref=3roVJZZ4">it wasn't</a>. At times, the gap between Binance-pegged BUSD in circulation and Paxos BUSD reserves was over $1bn. Binance <a href="https://www.binance.com/en/blog/ecosystem/how-we-back-binancepeg-busd-and-explaining-historical-discrepancies-7761334533351669941">insisted that these were merely "timing differences"</a> and that customers were never at risk of not being able to withdraw their funds. But as anyone familiar with <a href="https://thebusinessprofessor.com/en_US/investments-trading-financial-markets/herstatt-risk-defined">Herstatt risk</a> knows, timing differences can become permanent differences. Despite Binance's assurances to the contrary, customer funds <b>were</b> at risk. <br /><br />So the NY DFS's action might have been precipitated by the revelation that Binance-pegged BUSD had not always been fully backed by Paxos BUSD. But if so, why didn't it act a month ago? Why has its action come hot on the heels of the SEC's Wells notice? <br /><br />The obvious explanation is that the SEC's notice alleges that Paxos BUSD is an unregistered security. Unlike Binance-pegged BUSD, Paxos BUSD is regulated by the NY DFS. Once the SEC had deemed it illegal, the NY DFS had no choice but to close it down. It couldn't be seen to be regulating an illegal security. <br /><br />However, the NY DFS was already investigating Paxos BUSD because of its questionable relationship with Binance. So maybe it would have closed it down anyway. Perhaps it just brought its planned action forward. Or perhaps the two agencies coordinated their enforcement actions. It would be nice to think they did. The US's <a href="https://www.coppolacomment.com/2012/08/standard-chartered-and-regulatory.html">regulatory smorgasbord</a> can have some very unfortunate effects, and not just in tradfi. And the optics are frankly terrible. There's been much criticism from the crypto community of the SEC's patchwork approach to regulation, but really the same criticism can be levelled at all the US's regulators. A coordinated approach is sorely needed. </p>
<p>The withdrawal of Paxos BUSD will hit Binance hard. Binance currently autoconverts USD deposits to Binance-pegged BUSD, which as we have discussed, is supposedly backed 1:1 by Paxos USD. Clearly, if the supply of Paxos BUSD will fall over time, so too must the supply of Binance-pegged BUSD, unless Binance moves to an explicitly (rather than accidentally) fractionally-reserved model. Binance will have to choose between persisent liquidity problems because of reserve shortages, or a partially (and eventually wholly) unbacked stablecoin worth considerably less in USD terms than it is today. The collapse in the price of BNB today reflects sharply increased uncertainty about the future of Binance:<br /><br /><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEggLApJf1k6I8aedNKS5OWgYty_OkR8rstgyCz1Zns3pnnmpHweiR8GExFfHwNqdLIxIglTWwXrWMnBeHj-N0B7hPuJ8KPd90aZzCvLoCZRjnGnW8J9lZUvzej5drk-SLKfHVod_i42mk-9CjgI4TBZSNGRxQZZkwgonkq1CvKHq7EKl-P4LFKDjPLc/s1856/BNB%20price%2013th%20February%202023.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1146" data-original-width="1856" height="397" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEggLApJf1k6I8aedNKS5OWgYty_OkR8rstgyCz1Zns3pnnmpHweiR8GExFfHwNqdLIxIglTWwXrWMnBeHj-N0B7hPuJ8KPd90aZzCvLoCZRjnGnW8J9lZUvzej5drk-SLKfHVod_i42mk-9CjgI4TBZSNGRxQZZkwgonkq1CvKHq7EKl-P4LFKDjPLc/w640-h397/BNB%20price%2013th%20February%202023.png" width="640" /></a></div><br /><div class="separator" style="clear: both; text-align: center;"><br /></div><br /><br />If Binance were a public company, its share price would be tanking.<p></p>
<p>Binance will no doubt look for alternative stablecoins to back its home USD stablecoin. Perhaps the most obvious candidate is USDT, though USDC <a href="https://www.nasdaq.com/articles/binance-usds-$16b-market-cap-up-for-grabs-as-paxos-regulatory-action-stirs-up-stablecoin">would also be a candidate</a>. However, we don't yet know why the SEC is targeting BUSD. Why have they picked on the stablecoin that is most closely linked to Binance? If the SEC's purpose in pursuing this legal action is to shut Binance off from sources of USD, then any stablecoin that replaced Paxos BUSD in Binance's ecosystem would surely be next in line for a SEC Wells notice.</p>
<p>But there's another mystery. Why is the SEC alleging that Paxos BUSD is an unregistered security? Binance-pegged BUSD is almost certainly a security, since it is a derivative or securitization of another stablecoin. But it's much less clear why Paxos BUSD should be classed as a security. The Howey test that the SEC uses to determine whether a cryptocurrency is a security has four criteria, all of which must be met for the cryptocurrency to be deemed a security:</p>
<ul style="text-align: left;">
<li>it must involve an investment of money</li>
<li>it must be investment in a common enterprise (ie other people are investing too)</li>
<li>investors must have a reasonable expectation of profits</li>
<li>the profits must come from the efforts of others</li></ul>Paxos BUSD meets three of the four criteria: it involves an investment of money, it is a common enterprise, and any profits (e.g. returns on the backing assets) would come from the efforts of others. But it is hard-pegged to the US dollar at par. All investors can reasonably expect is to get their money back when they redeem the coins. So where does the "reasonable expectation of profits" come from?
<p>There are a few possibilities. Firstly, the fact that BUSD is a listed asset in Binance's Earn program. Customers can lend their BUSD to Binance at a stated rate of interest, and Binance pools their coins and lends them out. Similar Earn programs at other exchanges have already been deemed illegal securities: Coinbase pulled the launch of its Earn program when the SEC issued a Wells notice. </p>
<p>Secondly, the relationship between Paxos and Binance. Paxos earns a return on the assets that back Paxos BUSD, and remits part of this to Binance. Since Binance is Paxos's customer, it could perhaps be argued that Binance has a reasonable expectation of profiting from its investment in Paxos BUSD. <br /><br />Thirdly, it's possible that the SEC regards Paxos BUSD as a note which has characteristics of a security. If this is the case, then the <a href="https://t.co/VijSDKxe8z">Reves test</a>, not the Howey test, is the right one to use. Notes are included in the general list of securities types in the Exchange Acts, but over the years, case law has carved out a number of exceptions, mainly products offered by licensed banks. So the Reves test works differently from the Howey test. Where the Howey test defines four criteria that a product must meet to be classed as a security, the Reves test says that unless you can come up with a good reason why a note should not be classed as a security, it is a security. Clearly, this could catch a much wider range of crypto products than a strictly-applied Howey test. There has already been <a href="https://www.jdsupra.com/legalnews/the-limits-of-applying-reves-v-ernst-5896777/">quite a bit of discussion </a>about whether DeFi products would fail the Reves test. </p>
<p>Fourthly, it's possible that because of the nature of the assets backing Paxos BUSD, the SEC regards it as a money market mutual fund (MMMF) or some other kind of investment fund. Many people have argued that securities-backed stablecoins such as Tether are MMMFs, and it would appear the SEC looks favourably on this approach. In <a href="https://www.sec.gov/news/speech/gensler-sec-speaks-090822#_ftn15">this speech</a>, Gary Gensler, current Chair of the SEC, cites former Chair, Jay Clayton, defining stablecoins backed by commercial paper as MMMFs:</p>
<blockquote> “A stablecoin that promises $1 back to you, in exchange for the coin, and is backed by cash is one item. Such a coin that is backed by commercial paper, whether it’s 30, 60 or 90 days, sure looks like a money market mutual fund to me. So the second element really looks like a security. We have decided that a pooled vehicle of commercial paper that you use for daily liquidity is a money market mutual fund and should be regulated as such.” </blockquote>
<p>The first two of the above possibilities concern the relationship between Binance and Paxos. This would be consistent with the line taken by the NY DFS and might explain why the agencies appear to have coordinated their action. Both of these possibilities could have unfortunate consequences for Paxos and/or Binance, but unless one or both of these companies crashes and burns in the way that FTX did, there should be little impact on the wider crypto ecosystem.</p>
<p>But the third and fourth possibilities have far wider implications. <br /><br />If the SEC successfully argues in court that Paxos BUSD is a money market mutual fund or some other kind of investment fund because of the nature of the backing assets, then the logical next step would be to class all securities-backed stablecoins as MMMFs or other investment funds, consistent with Jay Clayton's definition. </p><p>And if the SEC convinces a court that Paxos BUSD is a note with security-like characteristics, then not only other stablecoins, but things like DeFi staking** could potentially be classed as securities. This would have profound and long-lasting ramifications for the entire crypto ecosystem.</p>
<p>The crypto ecosystem relies on stablecoins as a cheap and plentiful form of dollar liquidity. If all stablecoins were classed as securities, dollar liquidity for onshore crypto exchanges and platforms would dry up as stablecoin issuers either went offshore or out of business. It is very hard to see what would replace it, at least in the short term: U.S. dollars (and other fiat currencies) are not liquid on crypto exchanges, because to move them around requires banks, and non-USD stablecoins have gained little traction thus far. So trading crypto onshore would become much more expensive and considerably riskier. The dollar liquidity drought could also severely impact DeFi, because that relies on stablecoins (or derivatives of stablecoins) as collateral. So the SEC's action could bring down the onshore crypto ecosystem. </p>
<p>Conversely, the offshore industry might get bigger, as enforcement actions by the SEC and others drove crypto platforms and exchanges offshore. Indeed I suspect this is the point. The SEC wants to prevent US citizens interacting with crypto. What the rest of the world does is not its concern.</p>
<p>However, regulators in other countries are likely to follow suit. Those that are reliant on the U.S dollar for trade won't want to find themselves playing host to an industry to which the U.S. has turned a cold shoulder - indeed, it would be dangerous for them to do so. And although Asian and Middle Eastern powerhouses might not be so concerned about the long reach of U.S. regulators, they have their own reasons to impose strict regulation of crypto platforms and exchanges. So liquidity and safe collateral on crypto exchanges and platforms is going to become ever scarcer, not only in the U.S. but globally. The crypto winter is about to get much, much colder. </p><p>There's a possibility that this could bring about an existential crisis in the crypto world similar to the dollar Armageddon about which Bitcoiners like to fantasise. The crypto world has allowed itself to become dependent on crypto equivalents of the US dollar and US Treasuries. Just as the world economy would collapse if the supply of these suddenly dried up, so the crypto economy could collapse if the supply of the crypto equivalents evaporated like the morning mist.</p>
<p>But the links to the real economy are sufficiently strong now to make a sudden collapse of the entire crypto ecosystem a serious threat to real-world financial stability. The SEC won't want to trigger another 2008 or 1929. So although the SEC could simply close down all stablecoins overnight, I don't think it will do so. Rather, I think it will slowly strangle the crypto ecosystem by banning new mints and forcing stablecoin issuers to redeem their coins, just as the Fed is slowly strangling the offshore dollar finance industry by withdrawing reserves from the tradfi system. Quantitative tightening is coming to a stablecoin near you, any time now. </p><p>Whatever the SEC does, it won't mean the end of stablecoins. The worst case is that they will just become another regulated instrument issued by licensed and regulated financial institutions. In a decade's time, you'll have forgotten that the unregulated variety ever existed. That's how the financial system rolls. </p><p><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2022/05/theres-no-such-thing-as-safe-stablecoin.html">There's no such thing as a safe stablecoin</a></p><p><a href="https://www.bloomberg.com/news/articles/2023-02-13/circle-usdc-alerted-new-york-over-binance-peg-busd-issues?srnd=all&sref=3roVJZZ4">Stablecoin issuer Circle warned New York regulator about rival Binance's token</a> - Bloomberg</p><p><i>Image: Laocoon and his Sons being Devoured by Serpents, statue. Via Wikimedia Commons. I'm sure the symbolism won't be lost on readers of this post. </i><br /><br />* Collateral gives banks access to Fed liquidity, thus making it possible for banks to honour customer redemption requests. FDIC insurance protects depositors in the event that the bank becomes insolvent, but doesn't guarantee liquidity for redemption requests. So it's the Fed that guarantees the par peg, not FDIC. I hope this distinction is clear. <br /><br />** A DeFi stake is similar to a certificate of deposit (CD). A 1982 Supreme Court judgment (<i>Marine Bank vs Weaver</i>, 455 U.S. 551) established that CDs issued by licensed banks aren't securities, because the banks are Federally regulated and the products are Federally insured. But the court said that in other contexts, similar products might be classed as securities. </p>
<p></p><p></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-28674696387128584312023-02-08T16:09:00.009+00:002023-02-14T12:13:05.341+00:00The fatal flaws of Celsius Network<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiU15wt4HEavd2XVcqxpLC0mP_r9QOLwIdaO9PfqAVwjZj37_DmkjIxSwjbx0riie4YHCUJjRp61vfOLFv0QPgxOVHDkm0D8PlwF60FNAkTD5J48DyOwN8SnvchYMRoKv6M9qlRIj6RaWsKeIr5EQXnEjhF3Ct3KSppCMqub5qd_MCLTe1zNqdYmbw5/s5369/2021_-_Centre_Stage_PO1_0057_(51654289843).jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="3579" data-original-width="5369" height="426" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiU15wt4HEavd2XVcqxpLC0mP_r9QOLwIdaO9PfqAVwjZj37_DmkjIxSwjbx0riie4YHCUJjRp61vfOLFv0QPgxOVHDkm0D8PlwF60FNAkTD5J48DyOwN8SnvchYMRoKv6M9qlRIj6RaWsKeIr5EQXnEjhF3Ct3KSppCMqub5qd_MCLTe1zNqdYmbw5/w640-h426/2021_-_Centre_Stage_PO1_0057_(51654289843).jpg" width="640" /></a></div><br /><div class="separator" style="clear: both; text-align: center;"><br /></div>Celsius Network was never a real business. It did not have a viable business model. Really, it was a momentum trading scheme that relied on the premise that crypto prices would always rise. And when they didn't, it resorted to fake valuations and market manipulation to escape insolvency. It was fraudulent from the start. <div><br /></div><div>This is the conclusion I've reached after studying <a href="https://cases.stretto.com/public/x191/11749/PLEADINGS/1174901312380000000039.pdf">the U.S. Examiner's final report</a> (yes, I've read all 476 pages of it) and Celsius's audited reports and accounts up to 31st December 2020. There are no more recent audited accounts. It was due to file its 2021 accounts by 31st December 2022, but it did not do so. The accounts are now significantly overdue. I doubt if they will ever be filed. </div><div><br /></div><div>The U.S. Examiner's report reveals deep and long-lasting insolvency, concealed by layer on layer of fraud. Whether Alex Mashinsky, Celsius's founder, owner and CEO, knew that the devices he used to conceal the company's insolvency were fraudulent is uncertain. But I am certain that whoever was advising him knew. Mashinsky's associates are, understandably, portraying him as a loose cannon who made all the operating decisions and wouldn't listen to advice, and no doubt this is to some degree true. But some of the concealment schemes were devised by a financial expert. Mashinsky doesn't have that sort of expertise. This fraud was a team effort. <br /></div><div><br /></div><div><b>Loans for shares</b></div><div><b><br /></b></div><div>One of Celsius's elaborate concealment schemes arose from an attempt to raise market funding to develop its business. In March 2018, Celsius did an Initial Coin Offering (ICO) in which it offered 325 million CEL tokens for sale to the public. Prices ranged from $0.20 in the private pre-sale to $0.30 during the sale period itself, with bonus schemes reducing the effective price in many cases. </div><div><br /></div><div>Had Celsius sold all 325m tokens, it would have raised some $50m. But the ICO flopped. Celsius only managed to sell 203m tokens, and raised only $32m. Nevertheless, it proceeded as if the ICO had been fully subscribed. On 18th April 2018, Celsius minted 700m CEL tokens and distributed 203m of them to purchasers. It retained 325m as "Treasury stock", and placed 50m in a smart contract which would automatically release them if the price of CEL hit certain benchmarks. The remaining unsold tokens should have been burned - but only a few of them were. <br /><br />Mashinsky's company A.M. Ventures (AMV) agreed to purchase any unsold tokens from the ICO at $0.20, up to a maximum of $18m, plus a 30% bonus. So, after the ICO failed, AMV bought 117m tokens for $18m. But it did not complete the purchase. The 117m tokens were left in limbo. They were "owned" by AMV, but "custodied" by Celsius. Obviously, Celsius couldn't burn them. So it segregated them in a separate blockchain wallet. </div><div><br /></div><div>But neither Celsius nor AMV could profit from the tokens. They were stuck in limbo. So between them, the two companies devised an elaborate scheme to transfer them to Celsius's balance sheet. The U.S. Examiner describes it thus:<br /><br /></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: left;">"In January 2020, Celsius and AM Venture attempted to paper over AM
Venture’s failure to close on its purchase agreement by entering into a loan
agreement. Under the loan agreement, AM Venture would borrow $18 million
from Celsius at 6% annual interest. AM Venture would then allow Celsius to
offset AM Venture’s obligation to purchase $18 million worth of CEL To
secure the loan, AM Venture would pledge the 117 million in CEL that AM
Venture had agreed to, but did not purchase, and Mr. Mashinsky would pledge
his stock in Celsius Network Inc." </div></blockquote><div><br /></div><div>Now, on the surface this appears straightforward, if expensive. AMV sold the tokens back to Celsius at a significant premium over what it paid for them, the difference to be paid in instalments, with the premium partially discounted by equity shares in Celsius. <i>(14th February 2023: paragraph amended to correct the direction of the interest payment)</i><br /><br />But AMV hadn't completed its purchase of the CEL tokens. It didn't own them. So it couldn't "pledge" (or sell) them to Celsius. Furthermore, since Mashinsky owned both companies, Celsius's equity pledge was meaningless. So what was really going on?<br /><br />Taking the tokens out of the picture reveals a fraudulent self-financing scheme. In Celsius-speak, "pledge" means full transfer of ownership rights for a period of time. So Celsius actually lent $18m to AMV to purchase its own share capital. Lending to purchase own shares is illegal in most jurisdictions. Moreover, since Mashinsky owned both companies, he was pledging shares he already owned to himself, presumably to give the impression that this was a legitimate market transaction. It was a clever deception devised by someone well-versed in corporate finance and accounting. <br /><br />Celsius's management knew this scheme was fraudulent. One senior manager, Ashley Harrell, commented that AMV couldn't pledge tokens it didn't own. But it didn't last long. A few months later, Celsius and AMV wrote off the loans. And in December 2020, Celsius took the 117m tokens onto its own balance sheet, inflating its value by $628m. I'm pretty sure this was the end goal of the scheme. <br /><br /><b>The amazing balance sheet inflation scheme</b></div><div><br /></div><div>The "loans for shares" scheme was far from the first time Celsius's management had used CEL tokens to inflate its balance sheet. In fact it did so from the moment they were issued. Without them, Celsius would have failed in its first year of trading. </div><div><br />The accounting policies in Celsius's first set of audited accounts, made up to 28th February 2019, reveal that it held the 325m CEL tokens in its Treasury at fair value, with changes in value taken to P&L through "other comprehensive income". Furthermore, although the tokens were minted within the accounting period, it did not record any production costs for them <i>(my emphasis)</i>:<br /><br /></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: left;">"The company considers that treasury cryptocurrencies are an intangible asset with an indefinite useful life as the Company considers that they do not have an expiry date nor have a foreseeable limit to the period of which they will be exchanged with a willing counterparty for cash or goods and services. Treasury cryptocurrencies relate to CEL tokens held by the company and can be issued at the company's discretion. <b>No costs were capitalised in respect of treasury tokens in line with the company's policy on research and development. </b></div></blockquote><p> <span>So although the individual CEL tokens were individually worth very little, 325m of them recorded at fair value and zero cost was a substantial boost to Celsius's balance sheet. We don't know how they determined the fair value of the tokens, but a back-of-the-envelope calculation using </span><a href="https://www.coingecko.com/en/coins/celsius-network-token">Coingecko's CEL price on 28th February 2019</a><span> gives a value of approximately $12.8m, all of which was taken to P&L. It is included in the "Other Comprehensive Income" line in the income statement: </span></p><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8N0tDhf9wnYmg5agBMUJ-B1UbjEIZgeKkpZFgDfPIpk-xVWd2zPBkc4Ck2ui93c1aYYOSpQQlC_N9l82-0spBV21ffkwu_o30xiud5btzMM6UooNxJohMjsTZ1utgdWmWtPVfEcYF5SbtjzI8m0m9cP2bxJx96q3m11naEYePjQ3PINnkrLL3LCE0/s1446/Celsius%20income%20statement%20highlighted.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1298" data-original-width="1446" height="574" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8N0tDhf9wnYmg5agBMUJ-B1UbjEIZgeKkpZFgDfPIpk-xVWd2zPBkc4Ck2ui93c1aYYOSpQQlC_N9l82-0spBV21ffkwu_o30xiud5btzMM6UooNxJohMjsTZ1utgdWmWtPVfEcYF5SbtjzI8m0m9cP2bxJx96q3m11naEYePjQ3PINnkrLL3LCE0/w640-h574/Celsius%20income%20statement%20highlighted.png" width="640" /></a></div><br /><div>Clearly, the fair value of Treasury CEL tokens was significantly more than the amount booked to other comprehensive income. But Celsius was also holding other crypto assets at fair value - and this was the "crypto winter" of 2018-19, during which the prices of crypto assets fell considerably. Bitcoin's price, for example, fell from nearly $20,000 in December 2017 to less than $3,000 by the end of February 2019. So Celsius was taking heavy losses on the fair value of its other crypto assets. Deducting the $12.8m I have estimated as the fair value of Treasury CEL tokens at that time turns a revaluation surplus of $8.7m into a loss of around $4.1m. Adding this to the headline loss for the period of nearly $1.5m gives a total comprehensive loss for the period of approximately $7.2m. <br /><br />On the balance sheet, Celsius recorded intangible assets of $51.67m: </div><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqIULBbFFsObRNjLVSBz1GExrJmzrUoAW8zCrV-jYZlN50y-6KwbjMIe3llkWicP9qvfYKSekdhEGz4l2t-F06ZPL6E3k5XH28PhR2X0RpEouVStA7h8sIh4o4R8e_g4FGaysvlpJLVGMhHiHm3d3c2hj9CTWg2IceeABwvD14N0ofMUdh605Sb3ty/s1616/Celsius%20balance%20sheet%20highlighted.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1482" data-original-width="1616" height="586" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqIULBbFFsObRNjLVSBz1GExrJmzrUoAW8zCrV-jYZlN50y-6KwbjMIe3llkWicP9qvfYKSekdhEGz4l2t-F06ZPL6E3k5XH28PhR2X0RpEouVStA7h8sIh4o4R8e_g4FGaysvlpJLVGMhHiHm3d3c2hj9CTWg2IceeABwvD14N0ofMUdh605Sb3ty/w640-h586/Celsius%20balance%20sheet%20highlighted.png" width="640" /></a></div><br /><div><br /></div><div>But this includes the Treasury CEL tokens. Deducting their estimated value of $12.8m reduces Celsius's intangible assets to $38.87m, and its net assets to <b>negative</b> $7,244, wiping out its entire shareholders' equity.</div><div><br />So Celsius was insolvent in its first year of trading. It should have gone into bankruptcy in the UK. But by recording its own issued tokens at fair value on its balance sheet and taking this into P&L as unrealised gains, it convinced its auditors, Companies House and the general public that it was a going concern. What a racket. </div><div><br /></div><div>To be fair, at the time that these accounts were produced - and indeed still today - there were no generally-accepted accounting standards even for cryptocurrencies such as Bitcoin, let alone for own tokens. So Celsius didn't break any rules by inflating its balance sheet in this way. But concealing insolvency is at best misleading and can be actually fraudulent. And it did not wholly escape the notice of the auditors. <br /><br />The Notes to the Accounts recorded a warning that the company might not be able to continue as a going concern, ostensibly due to the threat of Covid. As these accounts are supposedly made up to 28th February 2019, which was best part of a year before the threat of Covid even emerged, this is not a credible reason for the going concern warning. However, the auditors noted it:</div><div><br /></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: left;">"We draw attention to note 2.2 in the financial statements, which indicates that while the directors consider that the company has adequate resources to continue in operational existence for the foreseeable future, there is uncertainty due to the impact of the COVID-19 virus which cannot yet be fully quantified. As stated in note 2.2, these events or conditions, along with the other matters as set forth in note 2.2, indicate that a material uncertainty exists that may cast significant doube on the Company's ability to continue as a going concern."</div></blockquote><p>And to cover their own backs, they included a disclaimer placing all responsibility for any fraudulent misrepresentation on Celsius's directors: <br /></p><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><p style="text-align: left;">"Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an Auditor's Report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs (UK) will always detect a material misstatement when it exists. Misstatementss can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements". </p></blockquote><p></p><div class="separator" style="clear: both; text-align: left;">This is probably a standard disclaimer, but.... no, I reckon they knew the company was insolvent. </div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;"><b>The cash haemorrage</b></div><p>A year later, Celsius was in even deeper trouble. Its accounts dated 28th February 2020 reveal a company teetering on the edge of bankruptcy. It posted a whopping before-tax loss of nearly $40m, and an operating loss of some $28m, largely because of a toxic combination of falling turnover and rapidly rising cost of sales: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjD7uBDhF-QBIKcv9G-RLvoO6FUubNyr_qVCJWnnyDEAFXn0RUs8L-pigxzOeSdWVxhS51a3SBmEHhrwWi3hId0COVspJ7EKVj-WfGGlUMkaLJgqwqmuficWInD9i-pGn0VLPBLAD9OUD-XvI7TVX8X0WvFE_pfiSXhCZM2JtweFO8em-H2ViWFUJKj/s1418/Celsius%202020%20income%20statement%20highlighted.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1362" data-original-width="1418" height="614" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjD7uBDhF-QBIKcv9G-RLvoO6FUubNyr_qVCJWnnyDEAFXn0RUs8L-pigxzOeSdWVxhS51a3SBmEHhrwWi3hId0COVspJ7EKVj-WfGGlUMkaLJgqwqmuficWInD9i-pGn0VLPBLAD9OUD-XvI7TVX8X0WvFE_pfiSXhCZM2JtweFO8em-H2ViWFUJKj/w640-h614/Celsius%202020%20income%20statement%20highlighted.png" width="640" /></a></div>Once agin, revaluation of intangible assets came to the rescue. A whopping loss magically became total comprehensive income of $28.65m. Partly, this was because of a general rise in crypto prices over the course of the year, which resulted in significant fair value gains on Celsius's crypto asset holdings. But it was also helped by the increase in value of the CEL token during that time. Using the same method as I used above, I calculate that the total value of the Treasury CEL tokens had risen from $12.8m to approximately $47.6m. Deducting the fair value gain of $29.8m on these tokens from Other Comprehensive Income reveals a total comprehensive loss of approximately $1.5m. <p></p><p>Now, I know you're thinking "that's not too bad". True, it's not. But Celsius's actual business was losing money hand over fist. And the cash flow statement shows that it was also bleeding cash. Between March 2019 to February 2020 it suffered a net operating cash outflow of $25.4m and spent nearly $50m buying "short term unlisted instruments". It financed this cash drain with new borrowing totalling nearly $87.6m. The additional borrowing meant it ended the year with a positive cash balance, but at the price of a massive increase in debt. By the year end its short-term borrowing (less than 1 year) totalled over half a billion dollars, and its current ratio - a crucial measure of liquidity - was flashing red at only 0.6. Celsius was dreadfully short of cash and in serious danger of not being able to meet its obligations. </p><p>As in the 2018-19 accounts, the notes to the 2019-20 accounts contain a warning that Celsius might not be able to continue as a going concern. Again, Covid is blamed, and with some justification this time, since the pandemic struck the UK with full force in March 2020, forcing the government to impose a lockdown that remained in place with varying degrees of strictness for the next two years. But my analysis shows that the company would have gone down anyway - unless it found a means of generating cash. </p><p><b>The flywheel</b></p><p>The crypto world doesn't have any endogenous sources of cash. Crypto lenders like Celsius can't create dollars when they lend in the way that banks do, and they can't tap the Fed for liquidity. They can borrow from banks and financial markets if they have acceptable collateral, but crypto assets generally aren't acceptable. So for a cash-strapped lender like Celsius, there are really only two sources of dollar liquidity: investors, and depositors. Celsius went for both. </p><p>In 2020, Celsius changed its year-end to December. So the final set of accounts it produced while headquartered in the UK covers the period from 1st March 2020 to 31st December 2020. And it documents a remarkable transformation in Celsius's fortunes. In ten months, it moved from a fragile small company bleeding cash at an unsustainable rate to a cash-generating behemoth. The "going concern" warning disappeared from its accounts, though the auditors still warned (presciently, as it turned out) about the possibility of fraudulent misstatement. </p><p>But a closer look reveals that the underlying fragilities were still there. In fact they were much, much worse. During the period, Celsius sold some shares, raising $23.26m of unencumbered dollars. But the rest of the money it managed to attract came from short-term creditors, principally new depositors. In ten months, current liabilities rose from $0.5 billion to $4.8 billion, of which $3.9 billion were new deposits. </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEiuZMCBbsRTfCpBfeuSB7WS3E0IGiTOcT1ZjvN0-LHBvstTHp9mf7BGKj6P168oDclH88PnUbgkwtcjg9uG-B6JE0d4yCSqH8dSbasXL5gGZN98WO0Swv9-7ecgt8noiKstX_xnrArqI49_iY3b5ODALZDXLLKMsZTtl8XtH4O045nhhNtKPNspTwZP" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1199" data-original-width="1994" height="384" src="https://blogger.googleusercontent.com/img/a/AVvXsEiuZMCBbsRTfCpBfeuSB7WS3E0IGiTOcT1ZjvN0-LHBvstTHp9mf7BGKj6P168oDclH88PnUbgkwtcjg9uG-B6JE0d4yCSqH8dSbasXL5gGZN98WO0Swv9-7ecgt8noiKstX_xnrArqI49_iY3b5ODALZDXLLKMsZTtl8XtH4O045nhhNtKPNspTwZP=w640-h384" width="640" /></a></div><br />As a result of this influx of new money, Celsius's end of year cash postion improved to $17.8 million, and its total current assets increased to $2.203 billion. But its liquidity had actually deteriorated. Its net current liabilities were $2.6 billion and its current ratio had slipped to 0.39. It had no means of repaying its short-term creditors.<p></p><p>What was it spending the money on? Mainly, buying and selling cryptocurrencies. During the period, it bought $3.1bn and sold $2.15 bn, and at the end of the period it recorded a revaluation gain of $1.51 bn. <a href="https://blogger.googleusercontent.com/img/a/AVvXsEhcnBi5SC_OrQKqVt_-4tZf0STgBeMw0RuXtMwyQF2MnH1aR7bMdTQJ5N6_cUs35d1xk3qUF_Na6wm-RXCnL_M0uGE2nJuVaodmHdPqSbbWjIuxtAIqBW-tdkpMi_GP6Vo_D_nghxSpiHktO7tWqaD-LRCBo4Dd9rPHWFkr49TxjcIKdY4BrRY4Eydb" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img alt="" data-original-height="939" data-original-width="1932" height="312" src="https://blogger.googleusercontent.com/img/a/AVvXsEhcnBi5SC_OrQKqVt_-4tZf0STgBeMw0RuXtMwyQF2MnH1aR7bMdTQJ5N6_cUs35d1xk3qUF_Na6wm-RXCnL_M0uGE2nJuVaodmHdPqSbbWjIuxtAIqBW-tdkpMi_GP6Vo_D_nghxSpiHktO7tWqaD-LRCBo4Dd9rPHWFkr49TxjcIKdY4BrRY4Eydb=w640-h312" width="640" /></a></p><p>Without this gain, Celsius would have once again been in balance sheet insolvency at the end of the period. </p><p></p><p></p><p>We now know that the cryptocurrency Celsius was so actively trading was is own token, CEL. By the end of 2020, the "fair value" of Celsius's Treasury CEL tokens had risen from a few millions to $1.5bn. Once again, Celsius had escaped insolvency by puffing up its balance sheet with its own tokens. </p><p></p><p>But this time, the fair value gain did not arise from Celsius's accounting policies and the absence of generally-accepted accounting standards for crypto assets. The U.S. Examiner explains how from May 2020, Celsius's business strategy changed from simple deposit-taking and lending to actively manipulating the price of CEL:</p><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><p></p><p style="text-align: left;">"In May 2020, Celsius’s strategy became more nuanced. In connection with
discussions of overall strategy for buying CEL, Mr. Mashinsky stated his basic
premise: “Our job is to protect CEL . . . .” In line with this thinking, the new
approach to CEL management had one “main thesis”—that Celsius will “rise and
fall with CEL" "</p></blockquote><p>The Examiner says there were three main components to Celsius's CEL manipulation: </p><p></p><ul style="text-align: left;"><li>Celsius began to regularly buy back more than 50% (and usually
100%) of the weekly CEL rewards from the market... Based on the setting of reward rates, Celsius would calculate how much
CEL was needed to pay customers rewards. Celsius would time its purchases of
the needed CEL throughout the week to either raise the price of CEL or avoid a
price drop. This strategy proved to be successful.</li><li>Celsius began placing “resting orders” of CEL purchases on
exchanges at prices below the then-current market price of CEL; these resting
orders would automatically trigger if CEL dipped to the specified price. For
example, if CEL was trading at $0.10, Celsius would put in an order to
automatically purchase a specified amount of CEL at $0.08. Celsius did this for
the express purpose of token price control... To ensure that Celsius stayed ahead of market
conditions, Mr. Treutler and Mr. Nolan, and later Dean Tappen (Coin
Deployment Specialist) would monitor CEL trading activity seven days a week
and readjust the “resting orders” as needed to protect the price of CEL.</li><li>Celsius started using its over-the-counter (OTC) trading desk to sell
CEL. These sales, which were made at market prices, went “hand in hand with
the weekly CEL purchases for Interest payments. . . .” This strategy was
internally referred to as the “OTC Flywheel” and operated on the theory that:
“[t]he more CEL we sell . . . [t]he more CEL we can repurchase . . . [t]he more
attractive CEL markets look like . . . [t]he more CEL buy orders we received . . .
[t]he more our Treasury is worth. </li></ul><div>This chart shows the correlation between Celsius's buybacks and CEL's price. <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEg0465r86cgRH007o_qmOca9tx-FUJpMKJjAca9cSRT8FNgRdwFx-5Vm13RoGL2HPN2-ByoZC-Ju-VMyX_ZXZee4FaTNY35JjnLE7FPb7j4VqFypg29ZwilTbD9ZYieEmIaCOtCu_McWiV2F80b73_gkbcvrm9rjwdYPKIfpA_Awbmzcx38qdljlDfo" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1048" data-original-width="1410" height="476" src="https://blogger.googleusercontent.com/img/a/AVvXsEg0465r86cgRH007o_qmOca9tx-FUJpMKJjAca9cSRT8FNgRdwFx-5Vm13RoGL2HPN2-ByoZC-Ju-VMyX_ZXZee4FaTNY35JjnLE7FPb7j4VqFypg29ZwilTbD9ZYieEmIaCOtCu_McWiV2F80b73_gkbcvrm9rjwdYPKIfpA_Awbmzcx38qdljlDfo=w640-h476" width="640" /></a></div><br />Clearly, CEL's price was driven to a large extent by Celsius's buybacks. <br /><br />Selling and buying back stocks or securities to give the impression that they are more heavily traded than is actually the case, thereby enticing other market participants to buy them and thus pushing up the price, is known as "<a href="https://financial-dictionary.thefreedictionary.com/painting+the+tape">painting the tape</a>". It is market abuse and is illegal in most jurisdictions, including both the U.K. and the U.S. Celsius had crossed a line. </div><div><br /></div><div>And it had also ensured its own eventual demise. Celsius's "flywheel" was far from cost free. It increased Celsius's leverage and decreased its liquidity - hence the deteriorating current ratio. As CEL's price rose, Celsius would need more and more new funds to pay for the buybacks. It would become increasingly illiquid. Furthermore, since there is a finite number of new investors and depositors, eventually the flywheel would stop spinning. Indeed, once investors and depositors realised Celsius wasn't in a position to pay them the returns it promised - or even return their funds - the flywheel could go into reverse. If it did, the end would come quickly. Even in 2020, Celsius was so highly leveraged and illiquid that insolvency was inevitable once customers started withdrawing their money. </div><div><br /></div><div>There's a disturbing similarity between Celsius's "flywheel" and the <a href="https://www.coppolacomment.com/2014/10/financial-hurricanes.html">unstable leveraging flow system that crashed so disastrously in 2008</a>. Systems like these are only self-perpetuating so long as the conditions that enable them remain. What Celsius needed to keep its flywheel spinning was an ever-increasing supply of new money, coupled with control of sales (so it could keep prices rising in line with inflows of new money). If either of these failed, Celsius would be in serious trouble. As Chuck Prince, ex-CEO of Citigroup, said: "When the music stops, in terms of liquidity, things will be complicated.” For Celsius, this turned out to be an understatement.</div><div><br /></div><div>Heavy marketing of Celsius's deposit schemes to retail customers kept the flywheel spinning for nearly two years. But Celsius never had complete control of sales. From May 2020 until its eventual collapse in July 2022, there was an active seller of CEL tokens - one Alex Mashinsky. Mashinsky is <a href="https://www.ft.com/content/4fa06516-119b-4722-946b-944e38b02f45">estimated to have made $44m from sales of CEL tokens</a>. All of these tokens were subsequently bought back by Celsius. A Celsius senior manager cited by the U.S. Examiner says that Celsius management knowingly used customers' and investors' money to fund buybacks of CEL tokens sold by Mashinsky and other insiders. That is fraud. </div><div><br /></div><div><b>Evading the regulators</b></div><div><b><br /></b></div><div>On 22nd June 2021, the U.K.'s Financial Conduct Authority issued a general warning about over 100 crypto companies operating in the U.K. without a licence, saying they posed a risk to the financial system and consumers, banks and payment companies should not deal with them. Celsius, it seems, was one of them. The following day, Celsius announced that it was terminating its outstanding application for an FCA licence and withdrawing from the United Kingdom. Its new headquarters would be in Delaware, U.S. </div><div><br /></div><div>But in fact, its U.K. entity remained active. Indeed, rather a lot of Celsius's subsequent business was channelled through it. In important respects, such as the location of corporate and customer assets, Celsius remained a U.K. company. It merely transferred to Delaware its retail customer -facing business. We now know that it did so not because of "regulatory uncertainty", as it claimed in its <a href="https://celsiusnetwork.medium.com/celsius-community-update-june-23-2021-a28fca899091">community update</a>, but to avoid being closed down by the FCA. On 11th June 2021, the FCA notified Celsius that its business constituted an unregulated collective investment scheme (UCIS) under the Financial Services and Markets Act 2000, which, since 2013, <a href="https://www.fca.org.uk/news/press-releases/fca-ban-promotion-ucis-and-certain-close-substitutes-ordinary-retail-investors#:~:text=The%20Financial%20Conduct%20Authority%20(FCA,retail%20investors%20in%20the%20UK.">cannot legally be sold to ordinary retail customers</a>.* It ordered Celsius to cease selling to retail customers in the U.K. and withdraw its application for an FCA licence. </div><div><br /></div><div>It is unfortunate that the FCA's action merely encouraged Celsius to relocate in a different country. Had the FCA closed Celsius down at this point, much pain and loss would have been spared. </div><div><br /></div><div>To comply with the FCA's order, Celsius transferred all customer obligations to the U.S. entity and ended deposit-taking in the U.K. But its institutional lending and treasury management, including deployment of CEL tokens, remained in the U.K. entity. To conceal the glaring mismatch between assets and liabilities that this created, the lending-related assets retained in the U.K. entity were recorded as a demand loan from the U.S. entity. This made the U.K. entity the lending agent of the U.S. entity in much the same way as <a href="https://www.coppolacomment.com/2022/11/the-ftx-alameda-nexus.html">Alameda was the lending agent for FTX</a>. The U.S entity trawled for retail deposits and fed them to the U.K. entity, which lent them out for a return.</div><div><br /></div><div>So Celsius's business was split between two countries. The deposit-taking engine that drove the flywheel was in the U.S.; but the lending that generated the returns promised to depositors, along with the CEL token purchases, sales and burns that stabilised the flywheel, were in the U.K. Neither the U.S. nor the U.K. company stood alone as an independent company. </div><div><br /></div><div>But internally, Celsius's management accounting didn't distinguish between them. To Celsius's management, there was only one business, and the fact that it was split between the U.S. and the U.K. was merely an inconvenient device to evade the FCA. <br /><br />The U.S. Examiner's disclosure that the U.S. company was "insolvent from inception" appears shocking, but is really of interest only as evidence of the lengths to which Celsius would go to escape the attention of regulators.</div><div><br />Of much more importance is the long-standing insolvency of the entire Celsius Network and the fraudulent devices Celsius used to conceal it. And so I move on to the fundamental issue underlying all of this. </div><div><br /></div><div><b>Why was Celsius never a viable business?</b></div><div><br /></div><div>Celsius's primary business was deposit-taking and lending. Indeed, to start with, this was its sole business. This is its purpose as stated its 2018/19 report and accounts: </div><div><br /></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px; text-align: left;"><div><span>"Celsius Network Limited ("the Company") was created to create a community centric organization that will always act in the vest interest of its customers and depositors, providing two services:</span></div><div><span>1. The ability to deposit digital assets and earn yield on such assets</span></div><div><span>2. The ability to borrow or take a loan against such assets"</span></div></blockquote><div><div class="separator" style="clear: both; text-align: center;"><br /></div>Deposit-taking and lending is the business of banking. Celsius was an unregistered, unregulated bank - what we know as a "shadow" bank. Shadow banking is usually a profitable business, sometimes exorbitantly so. Admittedly, shadow banks tend to implode disastrously when economic conditions turn against them, and Celsius certainly was no exception. But Celsius seems to have been totally unable to profit from its core business even in the good times. It reported headline losses year after year, and relied on inflating the value of its own tokens to escape the bankruptcy court. Its core business was simply never viable. Why was this?</div><div><br /></div><div>The problem was the return Celsius promised to its depositors. Banking is a margin business: to be profitable, a bank must earn more money from lending than it pays to depositors. "Net interest margin" (NIM) is the difference between the average interest rate on loans and the average interest rate on deposits. The wider that margin, the more profitable the bank. If net interest margin is persistently too low to cover administrative and other expenses, the bank will be loss-making unless it can earn sufficient income from other sources (fees, for example) to cover those expenses. </div><div><br /></div><div>Celsius's NIM was persistently too low to cover its expenses. At times, it was negative. Celsius's marketing model relied on offering depositors higher interest rates than its competitors, but it was unable to generate sufficient income from lending to pay these exorbitant returns. It also did not charge fees. In short, its pricing model was broken from the start. </div><div><br /></div><div>In 2019 through 2021, Celsius concealed its broken pricing model by reporting significant unrealised income from fair value gains on crypto asset holdings. We now know this income was mainly from its own token, and from mid-2021 onwards was fraudulently generated. Anyway, fair value gains cannot conceal headline losses. All three annual reports filed with the U.K.'s Companies House reported substantial headline losses. And although Celsius has not filed a report for 2021, a Board presentation recorded in the U.S. Examiner's Report says it would have turned in a headline loss of $881m. </div><div><br /></div><div>But Celsius's financial position deteriorated rapidly when crypto entered a bear market in early 2022. Despite taking ever-larger risks, it had been unable to improve its lending income sufficiently to pay its depositors. And it was no longer able to mitigate losses on its core business with unrealised gains on its CEL tokens. It didn't have sufficient liquidity to buy back the tokens in the quantities needed to support the price, so CEL's price started to fall - rapidly. This had a disastrous effect on Celsius's solvency. After all, if you mark your Treasury assets to market when their price is rising, you must also do so when it is falling. This chart shows how the carry value of Celsius's Treasury assets collapsed as CEL's price fell:</div><div><br /></div><div><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgaqHBse0a-Ky2uJCIt_8xo3x9aZaJWxoAWR5txQN7PuD671LwweBwZWW5d6FYrOUB_yPjpeQAPtDaASLDCkpL6fvTQUxfzT9pwsq0h9a3dAViMUy2eRtHl8qxCATzAnu1lzA_Z_Tr9LgniRlWAzVs9xIdIFu1Oye1LUxHluru6xdGsqLKVKoxXtlMF" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img alt="" data-original-height="870" data-original-width="1350" height="412" src="https://blogger.googleusercontent.com/img/a/AVvXsEgaqHBse0a-Ky2uJCIt_8xo3x9aZaJWxoAWR5txQN7PuD671LwweBwZWW5d6FYrOUB_yPjpeQAPtDaASLDCkpL6fvTQUxfzT9pwsq0h9a3dAViMUy2eRtHl8qxCATzAnu1lzA_Z_Tr9LgniRlWAzVs9xIdIFu1Oye1LUxHluru6xdGsqLKVKoxXtlMF=w640-h412" width="640" /></a> </div><div>Concerned by Celsius's persistently poor NIM and growing illiquidity, some members of Celsius's senior management pushed for interest rate reductions on deposits, including CEL rewards. But they were overridden by Alex Mashinsky. Right to the end, Celsius continued to pay above-market interest rates on deposits and offer financial incentives to attract new depositors to the platform. </div><div><br /></div><div>Celsius's death knell was sounded by the collapse of TerraLuna in May 2022. This sparked a bank run which fatally destabilised the "flywheel" and rapidly drained what was left of its liquidity. By June, Celsius was so short of money that it was using new deposits to pay the returns it had promised to existing depositors. It had become a Ponzi scheme.<br /><br />The end for Celsius came quickly. On 12th June, it suspended withdrawals. And a month later, on 13th July, it filed for Chapter 11 bankruptcy. </div><div><br /></div><div>Would Celsius have survived if crypto hadn't entered a bear market, and if TerraLuna hadn't crashed? No. It would simply have taken longer to die, and lost even more of its customers' and investors' money. Really, the events of 2022 were a kindness. The tragedy is that because accountants and regulators on both sides of the Atlantic failed to spot the red flags, this company was able to defraud people of their money for four long years. </div><div><br /></div><div><br /></div><div><b>Related reading:</b></div><div><br /></div><div><a href="https://www.coppolacomment.com/2022/07/celsiuss-failure-shows-importantce-of.html">Why Celsius Network's depositors won't get their money back</a></div><div><br /></div><div><a href="https://www.coppolacomment.com/2022/08/celsius-is-heading-for-absolute-zero.html">Celsius is heading for absolute zero</a></div><div><br /></div><div><a href="https://www.coppolacomment.com/2022/11/the-entire-crypto-ecosystem-is-ponzi.html">The entire crypto ecosystem is a ponzi </a></div><div><br /></div><div>Celsius Network's reports and accounts for February 2019, February 2020 and December 2020 can be downloaded from the U.K.'s <a href="https://find-and-update.company-information.service.gov.uk/company/11198050/filing-history">Companies House website</a>. No published accounts exist after this date. </div><div><br /></div><div><br /></div><div>* The U.S. Examiner's report incorrectly records this as an "unregistered collective investment scheme under the Financial Services and Markets Act 2010"</div><div><br /></div><div><br /></div><div><i>Image of Alex Mashinsky, then CEO of Celsius, at Web Summit in 2021. By Web Summit - PO1_0057, CC BY 2.0, <a href="https://commons.wikimedia.org/w/index.php?curid=112287338">https://commons.wikimedia.org/w/index.php?curid=112287338</a><a href="https://en.wikipedia.org/wiki/Alex_Mashinsky"><div class="separator" style="clear: both; text-align: center;"><br /></div><br /></a>. </i></div><div><br /></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-36854363365178377452023-01-23T19:55:00.006+00:002023-01-28T09:43:46.732+00:00Hollow Promises<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhzJKotgADG0pmNaTFjYU5Q0Qggi_oz5FTO0QHT-FN4ciful-mIZC9PTMvrQwpGihnxssQegKUanX4YwutqAUyooYRZlPVBGX3BXixxGteArMOy2LXzW0QDL34P0QG27tpp2U9Hku4xk-tqbqMraN6wDMuunyzwa3h859kWFiSfpjq6gsAsVNlaJkwh/s763/BrokenPromises_JohnFekner.jpg" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="490" data-original-width="763" height="412" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhzJKotgADG0pmNaTFjYU5Q0Qggi_oz5FTO0QHT-FN4ciful-mIZC9PTMvrQwpGihnxssQegKUanX4YwutqAUyooYRZlPVBGX3BXixxGteArMOy2LXzW0QDL34P0QG27tpp2U9Hku4xk-tqbqMraN6wDMuunyzwa3h859kWFiSfpjq6gsAsVNlaJkwh/w640-h412/BrokenPromises_JohnFekner.jpg" width="640" /></a><br /><br />Today, I bring you the sad tale of a crypto lender that promised safety and high returns to its depositors, but whose promises have proved to be as hollow as its name. <br /><br />Donut Inc., a self-proclaimed DeFi" lender, has a "Proof of Reserves" section on its <a href="https://www.donut.app/proof-of-reserves/">website</a>. This is supposed to reassure customers that their deposits are matched one for one by the platform's liquid assets. I am firmly of the opinion that "Proof of Reserves" statements prove nothing without a corresponding statement of liabilities, since deposits aren't the only form of liability, and encumbered assets can't back deposits. But in this case, the "Proof of Reserves" is worse than useless. It is actually fiction. And it conceals a truly dreadful situation for Donut's customers. <br /><br />As of today, this is what the "Proof of Reserves" says: <div><br /></div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEiq8Vb7_-F6ue-pqhBtnPqxDunNU3j8yTcG8K8CqmE0pXx4TgORBkLr6lnD26D1Gd1W8qkylB8Vp-y6KgCAXO2ussGRbKMf7VDR7vbPGDv1KHePNq1SAz4zLyt6f1ssgRXykGZesgzotp9ju6kBUPw8iv35Kl0xddV80w_8o0tpZXu88sMf5EH3834y" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1255" data-original-width="1677" height="478" src="https://blogger.googleusercontent.com/img/a/AVvXsEiq8Vb7_-F6ue-pqhBtnPqxDunNU3j8yTcG8K8CqmE0pXx4TgORBkLr6lnD26D1Gd1W8qkylB8Vp-y6KgCAXO2ussGRbKMf7VDR7vbPGDv1KHePNq1SAz4zLyt6f1ssgRXykGZesgzotp9ju6kBUPw8iv35Kl0xddV80w_8o0tpZXu88sMf5EH3834y=w640-h478" width="640" /></a></div><br />By itself, this doesn't prove anything at all. It's just an unsupported statement of what the company calls "assets under management".* We need to know what these assets are and how they protect customer deposits. </div><div><br /></div><div>Scrolling down the page brings us to this:</div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgdYu15SatEFDzIsogON0W0wYWA-ax_CaNmO_PHtZ6p1hD1JEI9rsphlb1H8QEagRZPqTgq5chXzzSJ6Yv8wvfvlazGAVoNV7NQDEeRB9x4hplG7faoiuNwvJSZZt8ow_CX5hwJ9d6aMll9f3pTIF_8vvQGDLC6GjDFyyC6xDizJF-_t22PGGqGuKDO" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1506" data-original-width="1833" height="526" src="https://blogger.googleusercontent.com/img/a/AVvXsEgdYu15SatEFDzIsogON0W0wYWA-ax_CaNmO_PHtZ6p1hD1JEI9rsphlb1H8QEagRZPqTgq5chXzzSJ6Yv8wvfvlazGAVoNV7NQDEeRB9x4hplG7faoiuNwvJSZZt8ow_CX5hwJ9d6aMll9f3pTIF_8vvQGDLC6GjDFyyC6xDizJF-_t22PGGqGuKDO=w640-h526" width="640" /></a></div><br /><br /></div><div>Really, Donut? You have 100% liquidity, but you've had to suspend withdrawals because your principal lending partner has suspended redemptions?</div><div><br /></div><div>The claim that "every dollar on Donut is matched by at least one corresponding dollar in reserve" is very evidently untrue. There are two types of customer assets on Donut: cash deposits, and loans to Donut's lending partners. </div><br />Cash deposits <a href="https://www.donut.app/terms/">are held by</a> Donut's partner bank Evolve Bank & Trust, and banking services are provided by the Banking-As-a-Service company Synapse FI. FDIC-insured banks like Evolve do not hold one dollar in reserve for every dollar on deposit. They are fractionally reserved, which means they do not hold sufficient actual dollars to enable all depositors to withdraw their funds simultaneously. When an FDIC-insured bank suffers a run, it must borrow cash to settle deposit withdrawals. Recently, runs on the crypto-related bank Silvergate <a href="https://www.americanbanker.com/news/silvergate-bank-loaded-up-on-4-3-billion-in-fhlb-advances">have forced it to borrow</a> large amounts from the Federal Home Loan Bank (FHLB). <div><br /></div><div>But on Donut, dollars don't remain dollars for long anyway. Donut automatically converts them to USDC and lends them out: <div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjYsegzb_7ZKlr7nV9cRKT8FDgskaltEe5dftSv41EC5ZmLjjaPx_-i9UbNpclVCAsWk8X6D6wMyZ2fSl_lw_SyYJIRh9KfbRDBnBou26A164LganVv_u0NRG6WyRe09VpGx6MVzIAIYOlRUtMwYelA0r1nYJkdBdH-Shb6iV8oAnzVMjz0y9vTQT7c" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1319" data-original-width="1898" height="444" src="https://blogger.googleusercontent.com/img/a/AVvXsEjYsegzb_7ZKlr7nV9cRKT8FDgskaltEe5dftSv41EC5ZmLjjaPx_-i9UbNpclVCAsWk8X6D6wMyZ2fSl_lw_SyYJIRh9KfbRDBnBou26A164LganVv_u0NRG6WyRe09VpGx6MVzIAIYOlRUtMwYelA0r1nYJkdBdH-Shb6iV8oAnzVMjz0y9vTQT7c=w640-h444" width="640" /></a></div></div><div><br /></div><div><br /></div><div><div>As funds on Donut are automatically lent out to earn interest, all the bank and its agent really do is provide a funding service. Donut accounts can be funded by manual or scheduled transfers from bank accounts or with credit and debit cards, and it also has a wage deposit facility. All of these funding methods necessarily involve a bank.</div><div><br /></div><div>So for the brief time that dollars exist in Donut accounts, they are held in a fractionally-reserved bank and are therefore not backed 1:1 by actual dollars. And once they have been converted to USDC and lent out, the customer asset is an illiquid loan, not actual dollars.<br /><br />This is why a liquidity problem at a lending partner forces Donut to suspend withdrawals. It does not hold anything like enough actual dollars to settle customer withdrawal requests, and it also does not have much in the way of assets it can pledge for dollars. In fact as we shall see, right now it has almost no liquidity. And that is because of the nature of its lending. </div><div><br /></div><div>Donut says it lends to what it calls "<a href="https://intercom.help/donut-app/en/articles/4965782-what-are-prime-brokers">prime brokers</a>", who in turn lend to high-yielding (and highly risky) ventures. That's how the high yields Donut promises are generated. In fact the yields are rather higher than Donut pays to its depositors. In <a href="https://intercom.help/donut-app/en/articles/4960325-how-does-donut-make-money">an article on its Help Centre</a>, it explains how it makes money: </div><div><br /></div></div></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div><div><div style="text-align: left;">"Donut earns money on the margin between the variable rates we secure with partners and the fixed rates we provide to users"</div></div></div></blockquote><div><div><br />This is the business model of a bank. So Donut is yet another unregulated, unsupervised and uninsured crypto bank that promises safety and high returns to its depositors while making money (or losing it) on opaque and highly risky lending. </div><div><br /></div><div>And it is now in very big trouble. Here's Donut's list of approved borrowers:</div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEh1ApU1ThpSt2sF1KSBGBLFlCmJJCeCL-EFTRutNaO463ZRKEUfzmIJIwjPDLBCextIZIUjnV4Z332ksxkg34R_bbr3IfaApeFBO4lrztkZlnWfR2KAV-yyN9jyyj0RWMDnuD0YO9K2OyIP6IgFZSxmfkWDy-JxJ3XAE51j-xaCNOC_hB_NsY3HzfEw" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="947" data-original-width="2309" height="262" src="https://blogger.googleusercontent.com/img/a/AVvXsEh1ApU1ThpSt2sF1KSBGBLFlCmJJCeCL-EFTRutNaO463ZRKEUfzmIJIwjPDLBCextIZIUjnV4Z332ksxkg34R_bbr3IfaApeFBO4lrztkZlnWfR2KAV-yyN9jyyj0RWMDnuD0YO9K2OyIP6IgFZSxmfkWDy-JxJ3XAE51j-xaCNOC_hB_NsY3HzfEw=w640-h262" width="640" /></a></div><br /><br /></div><div>So it only has three approved borrowers - and the biggest by far is Genesis Global. </div><div><br /></div><div>Genesis Global <a href="https://cointelegraph.com/news/breaking-crypto-lender-genesis-global-halts-withdrawals">suspended withdrawals</a> on 16th November 2022 in the wake of FTX's collapse, citing "exceptional market turmoil". This is the "liquidity issue" Donut mentions on its Proof of Reserves page. <br /><br />But <a href="https://www.coindesk.com/consensus-magazine/2022/12/14/after-ftx-explaining-the-difference-between-liquidity-and-insolvency/">as with FTX</a>, Genesis's "liquidity issue" has turned out to be insolvency. On 20th January 2023, Genesis Global <a href="https://www.theguardian.com/business/2023/jan/20/crypto-lender-genesis-files-chapter-11-bankruptcy">filed for Chapter 11 bankruptcy in the United States</a>. The <a href="https://restructuring.ra.kroll.com/genesis/Home-DownloadPDF?id1=MTQzOTc1NQ==&id2=-1">bankruptcy filing</a> (<i>pdf) </i>reveals that it owes creditors over $5 bn. One of those creditors is Donut. In fact Donut is the 10th biggest creditor <i>(click for larger image)</i>:</div><div><br /><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjXSvZg483sNtBtHhAi8E8wVgFzK83LAvOwQUH6C6nnjDMs8wTJSUFL5_WoaZm37NNNJiOi6GbSfJIFdRttl_xGDQ9I08rrS9qRNm0PSDjzIwcluK8FMyAbKZncci7f7CGMAwYAi3toEDDRa0REmXXJ9N_hocJ6i46pLt1yOtPvq3IO1fuVkYl07y04/s2308/Genesis%20creditors%20list%20Donut%20highlighted.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1270" data-original-width="2308" height="352" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjXSvZg483sNtBtHhAi8E8wVgFzK83LAvOwQUH6C6nnjDMs8wTJSUFL5_WoaZm37NNNJiOi6GbSfJIFdRttl_xGDQ9I08rrS9qRNm0PSDjzIwcluK8FMyAbKZncci7f7CGMAwYAi3toEDDRa0REmXXJ9N_hocJ6i46pLt1yOtPvq3IO1fuVkYl07y04/w640-h352/Genesis%20creditors%20list%20Donut%20highlighted.png" width="640" /></a></div><br /><div><br />So Genesis owes Donut $78,037,054. Donut's Proof of Reserves says it has $78,384,987 AUM. Of those AUM, therefore, all but $347,933 consist of loans to Genesis. That is 99.55% of its total AUM. </div><div><br /></div><div>Furthermore, Donut's loans to Genesis are unsecured. There is no collateral that can be liquidated to repay Donut's customers. </div><div><br /></div><div>Now this is odd. Donut's website appears to say that its lending is overcollateralized: </div><div><br /></div></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div><div style="text-align: left;">"Defi lending is highly collateralized, typically over 125%. This makes it more likely that in the event of a borrower default, there may be sufficient collateral to protect your funds"</div></div></blockquote><div><div><br /></div><div><div class="separator" style="clear: both; text-align: left;">So has Donut lied? Technically, no it hasn't. It calls Genesis a prime broker, not a DeFi borrower. It describes Genesis is a "highly collateralized" platform, by which it appears to mean that Genesis's own borrowers post large amounts of collateral (which it now appears isn't true, though that's a separate issue). But it does <b>not</b> say that Genesis was posting collateral against its own borrowing from Donut. Clearly, it wasn't. </div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">However, I would regard Donut's repeated insistence that customer funds were safe because lending was "overcollateralized" as misleading to the point of dishonesty. Donut's actual lending wasn't collateralized, and it didn't have any control whatsover over what Genesis did with the money. It claims to have done <a href="https://intercom.help/donut-app/en/articles/6341502-what-diligence-is-performed-on-partners">due diligence</a> on its borrowers, but clearly whatever it did was nowhere near adequate. </div><br /></div><div>All Donut now has by way of "reserves" is a massive pile of defaulted loans. Its liquidity is zero, not 100%. Its <a href="https://help.donut.app/en/articles/6745747-market-update-genesis-pauses-withdrawals">Markets Update</a> about Genesis's Chapter 11 bankruptcy reveals the extent of the mess it has created for its customers:</div><div><br /></div></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div><div style="text-align: left;">"Your current balance, after withdrawing the full value of your funds from other lending partners, is with Genesis in its entirety, who continues to prevent withdrawals. Donut is not holding any of your funds nor preventing withdrawals."</div></div></blockquote><div><div><br /></div><div>The funds are gone and Genesis is not in position to return them. <br /><br />Nor is Donut in a position to make its customers good. It has hardly any liquidity and no means of obtaining any. So it is rationing the little it has. Build customers can withdraw 14.5% of their balances, but Save customers, who are the majority of Donut's customers (and, it would seem, more exposed to Genesis) can only withdraw 5%. That's a rubbish recovery rate. </div><div><br /></div><div>Donut seems to be banking on the Chapter 11 process enabling it to make good its customers. But unlike Gemini's Earn customers, Donut customers are not listed as direct creditors of Genesis. Rather, Donut itself is the creditor. So Donut, not Genesis, is responsible for making good its customers. And if it can't, then it should file for Chapter 11 bankruptcy itself. </div><div><br /></div><div>But whether or not Donut files for Chapter 11, its customers have probably lost most of their money. Genesis is deeply, deeply insolvent, and there is a massive pile of unsecured creditors - not least, Gemini's Earn depositors - who rank pari passu with Donut. Furthermore, Genesis has proposed a <a href="https://restructuring.ra.kroll.com/genesis/Home-DownloadPDF?id1=MTQzOTEyNA==&id2=-1">restructuring plan</a> <i>(pdf) </i>that could mean coercive bail-in of unsecured creditors. If this went ahead, then Donut's customers could suffer potentially large unrecoverable losses. <br /><br />I don't see any possibility of Donut's customers recovering all, or even much, of their money. Heaven help anyone who was paying their wages into this ghastly scheme, or who had put student loans or other debt on deposit here. Just like Voyager, Celsius and BlockFi, ordinary people will pay the price for Donut's mis-selling, mismanagement and dishonesty.</div><div><br /></div><div>Regulators must now hunt down and kill all crypto platforms that mis-sell risky loan schemes as "safe" and offer high yields to attract naive retail customers. . They are a plague, and they need to be stamped out, before anyone else gets hurt. </div><div><br /></div><div><b>Related reading:</b></div><div><b><br /></b></div><div><a href="https://www.coppolacomment.com/2020/03/too-good-to-be-true.html">Too Good To Be True</a> </div><div><br /></div><div><a href="https://www.themintmagazine.com/from-bank-vaults-to-the-crypt/">From bank vaults to the crypt</a> - The Mint</div><div><br /></div><div><a href="https://www.coppolacomment.com/2022/07/shipwrecked.html">Shipwrecked</a></div><div><br /></div><div>*I've <a href="https://www.coppolacomment.com/2022/07/celsiuss-failure-shows-importantce-of.html">complained before</a> about the misuse of this term by crypto lenders, but in this case I'll let it pass, as the status of Donut deposits is unclear - though there doesn't seem to have been much "management" going on. </div></div><div class="separator" style="clear: both; text-align: center;"><br /></div><i>Image: Broken Promises by John Fekner. User Incantation on en.wikipedia, CC BY-SA 3.0 <http://creativecommons.org/licenses/by-sa/3.0/>, via <a href="https://commons.wikimedia.org/wiki/File:BrokenPromises_JohnFekner.jpg">Wikimedia Commons</a></i><div class="separator" style="clear: both; text-align: center;"><br /></div><br />Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-65820197873998772742022-12-11T14:41:00.010+00:002022-12-12T09:08:27.573+00:00Snake oil sellers in the stablecoin world<p> <br /><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwe3RxlechgYCYHOejS7OcdHCFcue5hPjpPy8vmf-KdLPYlRMCqoe-ZMyNeuIFrqxDwxDzriZOGIahUECHBoFS6kw0C3qMZuvwoO1SQ_7pBDNWNE7nh5WR57SrRvWPmJh49CZAV40oBkR2eL3bwcO2Mec35F7ceCwk6449ETmtn6U9X7QcGtHB7JV1/s1600/Snake_Oil_Tonics.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="1200" data-original-width="1600" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwe3RxlechgYCYHOejS7OcdHCFcue5hPjpPy8vmf-KdLPYlRMCqoe-ZMyNeuIFrqxDwxDzriZOGIahUECHBoFS6kw0C3qMZuvwoO1SQ_7pBDNWNE7nh5WR57SrRvWPmJh49CZAV40oBkR2eL3bwcO2Mec35F7ceCwk6449ETmtn6U9X7QcGtHB7JV1/w640-h480/Snake_Oil_Tonics.jpg" width="640" /></a></p><br /><div class="separator" style="clear: both; text-align: left;"><span style="text-align: left;">It's been evident for some years now that those selling risky crypto products to risk-averse investors like to have federal branding on their snake oil. Tether </span><a href="https://www.forbes.com/sites/francescoppola/2019/03/14/tethers-u-s-dollar-peg-is-no-longer-credible/" style="text-align: left;">claimed to have 100% actual dollar backing</a><span style="text-align: left;"> for its stablecoin. Various exchanges and platforms claimed that customer deposits were FDIC insured. The New York Attorney General showed that Tether didn't have 100% dollar backing or anything like it. And now the FDIC has sent cease & desist orders to </span><a href="https://www.fdic.gov/news/press-releases/2022/ftx-harrison-letter.pdf" style="text-align: left;">FTX</a><span style="text-align: left;">, </span><a href="https://www.dechert.com/knowledge/onpoint/2022/8/fdic-issues-cease-and-desist-letter-to-voyager-digital--llc--fac.html#:~:text=Voyager%20is%20not%20an%20FDIC%2Dinsured%20depository%20institution." style="text-align: left;">Voyager</a><span style="text-align: left;"> and </span><a href="https://content.govdelivery.com/accounts/USFDIC/bulletins/328cfe1" style="text-align: left;">several other crypto companies</a><span style="text-align: left;">, it has become dangerous even to mention FDIC insurance in marketing material. </span></div><p></p><p>But that doesn't meant they've given up on the quest for a credible claim to Federal backing. The new Holy Grail is gaining access to Federal Reserve funding without becoming a licensed bank. Accordingt to analysts at Barclays, Circle, the issuer of the USDC stablecoin widely regarded in crypto markets as a "safe" dollar equivalent, may have found a way: </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjupnu2xHZc_K8dqbidyVZzSRtKo9aelgw8UcX0xIRUPnl9fHJJJoxost3AXCJ3T-KLOlofHptWTD_Q-cbza5OZPJEtcKX1vYaucUSYsH0rFGNjnaBUwBj9MNX8uss3dVpQRxu79BGwp7cgKpDtaFL3Rpt03b-jq5N_jI4BzfuS3AcxaqZH8KIB1IYx" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="610" data-original-width="518" height="640" src="https://blogger.googleusercontent.com/img/a/AVvXsEjupnu2xHZc_K8dqbidyVZzSRtKo9aelgw8UcX0xIRUPnl9fHJJJoxost3AXCJ3T-KLOlofHptWTD_Q-cbza5OZPJEtcKX1vYaucUSYsH0rFGNjnaBUwBj9MNX8uss3dVpQRxu79BGwp7cgKpDtaFL3Rpt03b-jq5N_jI4BzfuS3AcxaqZH8KIB1IYx=w544-h640" width="544" /></a></div><br />This screenshot comes from Zero Hedge, who tweeted it saying "USDC stablecoin could have access to Fed reverse repo soon", thus adding to the confusion by conflating Circle with Blackrock. Circle isn't going to have access to Fed reverse repo, and nor is its stablecoin. And although it is possible that Blackrock might, this would not be the ground-breaking change that Barclays analysts imply. I fear we are watching the brewing of yet another vat of snake oil. <div><br /></div><div>Firstly, let's unpick exactly what Circle is up to. Early in November, Circle, USDC's issuer, announced that it intended to put all the Treasuries in USDC's reserves into a fund managed by Blackrock, the Circle Reserve Fund. This fund<a href="https://www.sec.gov/Archives/edgar/data/844779/000119312522241722/d390733d497k.htm"> is regulated by the SEC</a>. It invests only in short-term government instruments: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhE9ie6hWkz9xsqkEzpjnrGd51-ie1BjWEqbOyQOAI3SLoWOMmE838HgAMknbR6QuiW5D9gh2EeJZmDpbY4PmJltAkup0u6AjK8Gh9QW-GPEfb4-vNiYLLo1yoN1kK4zhgJAmX744YFZcG5PrHwEpgK7_xOczziHQy-Og_3GKLdfGLgz02nlLQvPc7M" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="121" data-original-width="2678" height="28" src="https://blogger.googleusercontent.com/img/a/AVvXsEhE9ie6hWkz9xsqkEzpjnrGd51-ie1BjWEqbOyQOAI3SLoWOMmE838HgAMknbR6QuiW5D9gh2EeJZmDpbY4PmJltAkup0u6AjK8Gh9QW-GPEfb4-vNiYLLo1yoN1kK4zhgJAmX744YFZcG5PrHwEpgK7_xOczziHQy-Og_3GKLdfGLgz02nlLQvPc7M=w640-h28" width="640" /></a></div><br />Circle Internet Financial LLC is its only eligible investor. </div><div><br /></div><div>However, although the fund could accept cash, Circle says it is not putting USDC's cash reserves into the fund. Circle's Chief Financial Officer, Jeremy Fox-Green, <a href="https://www.coindesk.com/business/2022/11/03/circle-begins-putting-reserves-into-new-blackrock-fund/">told Coindesk</a> that it would continue to keep cash reserves in commercial banks because that would make it easier for USDC holders to redeem their holdings 24/7. </div><div><br /></div><div>It is obviously sensible to have the stablecoin's reserves professionally managed at arm's length in (we assume) a bankruptcy-remote vehicle. But Blackrock isn't a bank. It doesn't have cash reserves or central bank liquidity support, and it doesn't have direct access to payment systems. And investment funds can be illiquid things, especially if you are the only shareholder. Normally, shareholders in an MMF would sell or pledge shares on capital markets to obtain cash. But there's literally no market for the Circle Reserve Fund's shares. So obtaining cash from the fund would presumably involve instructing Blackrock to sell or pledge securities. </div><div><br /></div><div>Since Circle allows USDC holders to redeem on demand, therefore, it is also obviously sensible to maintain significant cash reserves in banks. It's much quicker to instruct a bank to pay your customer than it is to instruct your tame investment fund to sell or pledge securities to raise cash to pay your customer. Circle says USDC's cash reserves in partner banks amount to about 20% of its total reserves. So, assuming that USDC is fully reserved, 20% of USDC holders could redeem their coins before Circle had to start drawing on its Blackrock fund. </div><div><br /></div><div>And this is where it all starts to go horribly wrong. Fox-Green said that keeping cash reserves in banks was a temporary measure; Blackrock would apply to the Federal Reserve for access to its Overnight Reverse Repo Facility (ON RRP), and when that access was granted (as it usually is for government-only funds), Circle would move its cash reserves into the fund. According to Fox-Green (as reported by Coindesk), this will "improve the risk profile and oversight and the disclosures around the USDC reserve". </div><div><br /></div><div>Well, it might. But it will do absolutely nothing for the liquidity of the cash reserve - and as USDC can be redeemed on demand, it is liquidity that matters. The ON RRP facility is not remotely equivalent to a demand deposit account in a bank. Any cash Blackrock placed at the Fed would be significantly less liquid than cash in commercial bank demand deposit accounts. </div><div><br /></div><div>The ON RRP facility was originally introduced to strengthen the Fed's monetary policy framework in the era of quantitative easing (QE). Long-term readers of this blog might remember the debates over <a href="https://www.coppolacomment.com/2013/02/floors-and-ceilings.html">"floor" versus "corridor" systems</a> in the years after the 2008 financial crisis, but for those who don't, here's a brief recap. </div><div><br /></div><div>QE vastly increased the quantity of bank reserves in the financial system, far in excess of the quantity of reserves needed to settle payments. Banks are collectively obliged to hold all the reserves the Fed issues. So banks ended up with more reserves than they wanted or needed. The Fed had always relied on a vibrant interbank lending market to control the Fed Funds rate. But as banks had little need to lend to each other, and were too scared to lend unsecured anyway, the interbank market died and bank funding transactions moved to the repo market. </div><div><br /></div><div>To prevent the Fed Funds Rate dropping below zero, the Fed started paying interest on reserves deposited at the Fed in excess of the reserve requirement. The "interest on excess reserves" (IOER) rate set the "floor" for interest rates. When the Fed abolished the reserve requirement in March 2020, the IOER rate simply became the "IOR" rate. It remains the principal policy tool to this day. <br /><br />But the "floor" turned out to be less than solid. The GSEs (Fannie Mae, Freddie Mac, Sallie Mae and Ginnie Mae) didn't have Fed master accounts so couldn't place funds on deposit there. So they lent to banks at a rate somewhat below the IOR rate. For banks, this was a source of cheap funding; for the GSEs it meant they could actually earn something on their cash balances; but for the Fed, it was a nuisance, because it meant it did not have full control of the policy rate. So the Fed introduced an overnight deposit facility for GSEs and other non-bank market participants - the ON RRP. </div><div><br /></div><div>The interest rate on the ON RRP is slightly below the IOR rate, because the Fed doesn't want to discourage GSEs, MMFs and the like from lending to banks. It just wants to control the rate that banks pay them. The combination of IOR and ON RRP creates a solid interest rate floor that keeps the Fed Funds Rate, which bizarrely is still the "official" policy rate even though the Fed can't control it directly any more, within its target range. </div><div><br /></div><div>In 2021, the Fed added another facility, this time for banks. Although banks collectively have lots of reserves, individually they can experience shortages. And changes in the regulatory environment (notably the Fed's Living Wills) have resulted in big banks needing to maintain much higher levels of reserves. In 2019, reserve hoarding by big banks caused <a href="https://www.coppolacomment.com/2019/12/the-blind-federal-reserve.html">major disruption in the repo market</a>, forcing the Fed to inject money into the market. Following this, the Fed realised that if big banks were to be the primary providers of liquidity to markets, they <a href="https://www.coppolacomment.com/2020/02/much-ado-about-nothing.html">had to be able to obtain liquidity from the Fed whenever they needed it</a>. Enter the Standing Repo Facility (SRF). </div><div><br /></div><div>The SRF enables banks to help themselves to new reserves whenever they want, in return for pre-positioned collateral (typically US treasuries). It replaces the "discount window" facility which banks were reluctant to use because using it had come to be interpreted as a signal of distress. </div><div><br /></div><div>So, we now have something akin to a monetary policy pump: US banks borrow money from the Fed at the policy rate and lend to financial market participants at a slightly higher rate. Financial markets are complex things, so I won't spend time now describing how the money circulates. Suffice it to say that it eventually finds its way into GSEs, MMFs, foreign central banks and other non-bank market participants, These deposit any money they don't immediately need, and that US banks don't want to borrow, back at the Fed at slightly below the policy rate. Money in at a deposit rate: money out at a somewhat higher lending rate. That's the business model of a bank. Which is, of course, what the Fed is. </div><div><br /></div><div>That's the wonkish bit. But what does all this have to do with Blackrock?</div><div><br /></div><div>I'm afraid whoever wrote the Barclays note has fundamentally misunderstood the nature of ON RRP. It is an overnight collateralised term deposit, not a demand deposit. So funds are placed in the evening and locked up until the following morning. Neither Blackrock nor the Fed has access to the funds during that time. They can't be paid out to redeem USDC. </div><div><br /></div><div><div><div>Banks have access to payment facilities: when USDC holders ask to redeem their coins, Circle can simply instruct the banks that hold its cash reserves to pay up. But Blackrock can't issue any such instruction to the Fed. ON RRP deposits are not negotiable instruments. They can't be paid away to other people. Nor would the Fed have the means of doing so. Fedwire is a Fed facility, yes, but access to it is via commercial banks. </div><div><br /></div><div></div></div><div>But, I hear you say, surely the Fed could simply move the funds to the master accounts of USDC holders' settlement banks? No, it could not. ON RRP is not the same as a Fed master account. It is not bank reserves. There's simply no facility for the Fed to move funds from an ON RRP deposit directly to a bank's Fed master account. </div></div><div><br /></div><div><div>So how would Blackrock gain access to the funds deposited at the Fed? Well, it must wait for the reverse repo to unwind. As <a href="https://twitter.com/KimDriver11/status/1600944048864657408?s=20&t=2j_roOAWPmPEjCc6R3LgFQ">Kim Driver pointed out on Twitter</a>, during the day the funds would be held in commercial bank deposit accounts. Blackrock could choose to re-deposit them the following evening, or it could instruct its bank to pay them away during the day, just as it can now. </div><div><br /></div><div>Contrary to what the Barclays note says, placing funds on deposit at the Fed through the ON RRP facility would not make USDC a "closer substitute for insured bank deposits". Since ON RRP deposits are not liquid, it would actually make it less like an insured bank deposit, since it would not be possible to redeem it overnight. </div><div><br /></div><div>Would it reduce the run risk? Well, if people thought ON RRP was a cash lending facility like SRF, it might. And the Barclays note suggests that this is exactly what Circle wants people to think: </div><div><br /></div></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div><div style="text-align: left;"><i>Last year, the President's Working Group (PWG) on financial markets recommended limiting stablecoin issuance to depository institutions, which would give them "access to the federal safety net"</i></div></div></blockquote><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><p style="text-align: left;"> <i>Like the PWG's suggestion, USDC access to the RRP through a separately managed money fund would reduce run risk in the stablecoin</i> </p></blockquote><div><div><br /></div><div>ON RRP is not part of the federal safety net. It is not a lending facility. It does not provide emergency liquidity to desperate non-banks facing redemption requests they can't honour. It actually makes non-banks less liquid, not more. The SRF is part of the federal safety net, as is FDIC insurance. But neither of these are available to Blackrock or Circle. </div><div><br /></div><div>Furthermore, Blackrock's fund is not the stablecoin issuer. Circle itself would have no access to the Fed, even to deposit cash. So Barclays' claim that Blackrock's access to ON RRP would make USDC resemble a CBDC is, I'm afraid, bunk. </div><div><br /></div><div>If Circle were faced with an overnight run on USDC, and all its cash reserves were on deposit at the Fed, Blackrock would have no choice but to to sell or pledge securities - potentially including the securities it had borrowed through the ON RRP - on foreign financial markets to obtain dollars. And the Fed would not help. Nothing in this scheme would in any way protect USDC from runs or USDC holders from losses. <br /><br /></div><div>Giving the impression that USDC would have access to Fed liquidity appears to be yet another attempt by a crypto company to shill their coin to the unwary by claiming government backing to which they are not entitled. It's out of the same stable as Voyager's and FTX's claim to have FDIC insurance, and Tether's claim to be 100% backed by "actual dollars". It is, in short, a lie. </div></div><div><br /></div><div><br /></div><div><b>Related reading:</b></div><div><br /></div><div><a href="https://www.coppolacomment.com/2020/03/too-good-to-be-true.html">Too Good to be True</a></div><div><a href="https://www.coppolacomment.com/2013/02/floors-and-ceilings.html">Floors and Ceilings</a></div><div><br /></div><div><br /></div><div><i>Image: By Wesley Fryer from Oklahoma City, Oklahoma, USA - Snake Oil Tonics, CC BY-SA 2.0, <a href="https://commons.wikimedia.org/w/index.php?curid=33792752">Wikimedia Commons</a> </i></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-24161335388152753332022-11-26T19:13:00.001+00:002022-11-26T19:16:28.862+00:00The entire crypto ecosystem is a ponzi<p> </p><div class="separator" style="clear: both; text-align: center;"><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjl4V29IuGyTsrFGs7agQ3EcE4fhSCQ7_BxNU-TU-kqENmVU8FgBQdK4kwkZAxA1u1UKingN33jhI21VXMmvGIao7X7pja4QCL5MQri08hF2l8S3o7szpOA-EF_rm0NPUF3WzcXAVSPLYexfUwhJdEBqr11kU5wHQwLUaOTtTG36iqq9pxzy1etNap3" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="971" data-original-width="1581" height="394" src="https://blogger.googleusercontent.com/img/a/AVvXsEjl4V29IuGyTsrFGs7agQ3EcE4fhSCQ7_BxNU-TU-kqENmVU8FgBQdK4kwkZAxA1u1UKingN33jhI21VXMmvGIao7X7pja4QCL5MQri08hF2l8S3o7szpOA-EF_rm0NPUF3WzcXAVSPLYexfUwhJdEBqr11kU5wHQwLUaOTtTG36iqq9pxzy1etNap3=w640-h394" width="640" /></a></div><br /><br /></div>The crypto ecosystem has grown massively in the last three years. Many of those participating in it have made life-changing amounts of money - on paper, or perhaps more accurately on computer. But the problem with paper gains is that they tend to evaporate like the morning mist when the market turns. The crypto market turned towards the end of 2021 and is now firmly in bear territory. Bitcoin has fallen from above $60,000 in November 2021 to barely $16,000 now. For anyone who bought Bitcoin near the top, that is a mammoth real loss. And even though it is not a real loss for people who bought Bitcoin in the bear market of 2018 and have HODLed for years, it is still a mammoth paper loss. No-one likes to see an unrealised financial gain wiped out by the markets before they can claim it. <div><br /></div><div>Unsurprisingly, crypto people have been selling up in droves. For crypto investors to cash out their extraordinary gains, there must be real money in the system - dollars, euros, yen, pounds. But the crypto system, unlike the traditional finance system, is unable to create real money. It can create tokens that represent dollars, euros, yen etc, but these aren't accepted for real-world transactions such as purchasing condos in the Bahamas. So the crypto system needs inflows of real money. The more it grows, the more real money it must attract. <div><br /></div><div> Much of the real money that has gone into the crypto ecosystem in the last three years has come from institutional investors. But as any bank will tell you, institutional money is not the most stable form of funding. Professional investors are a fickle bunch: they'll withdraw their money in a flash if they see a better profit opportunity, and they run at the first sign of trouble. For stable funding, what you really need is retail deposits. So platforms such as FTX specifically targeted retail customers, offering higher-yielding alternatives to bank accounts, complete with online payment facilities and debit cards, and encouraging retail customers to have their wages paid directly into accounts on the platform:<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhmZDTgSY8wYL3lpojEEwmyuDThRaSgfATmF6t_hKGK5huSVHLk1AS9N0eCHBjK7Ws9WItNR-a7gvL9oJFJB6MbTHvh_i2U7P0nw5Pc-UStfIEyh17YXRiGcLXWMIucymfMc95EP-1ECAWU3iWH6gUxLCp70TpWKNxCtqizsgIZ9C6WiMio17AJDPlf" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="832" data-original-width="1194" height="223" src="https://blogger.googleusercontent.com/img/a/AVvXsEhmZDTgSY8wYL3lpojEEwmyuDThRaSgfATmF6t_hKGK5huSVHLk1AS9N0eCHBjK7Ws9WItNR-a7gvL9oJFJB6MbTHvh_i2U7P0nw5Pc-UStfIEyh17YXRiGcLXWMIucymfMc95EP-1ECAWU3iWH6gUxLCp70TpWKNxCtqizsgIZ9C6WiMio17AJDPlf" width="320" /></a></div><br />The interest rates on these retail-focused crypto deposit accounts were far above those offered by banks. </div><div><br /></div><div><div>But attractive though these slick high-yield bank-like deposit accounts were, they struggled to attract the quantity of new depositors that the system needed. Many retail customers were wary of crypto because of its reputation as a vehicle for illegal activities, and suspicious of high returns from bank-like things that don't have deposit insurance. They worried that they might lose their money. So platforms needed to convince retail depositors that these accounts were as safe or safer than bank accounts. </div><div><br /></div><div>Some relied on advertising and network marketing to persuade people to part with their money. Celsius Network, for example, explicitly marketed itself as <a href="https://www.cbsnews.com/news/celsius-bankruptcy-filing-most-activity-still-paused/">"better than a bank"</a>. It exploited memories of the 2008 financial crisis and the Cyprus depositor bail-in in 2013 to convince potential customers that their money was not safe in banks and they should transfer it to Celsius, which would keep their money completely safe as well as giving them better interest rates than any bank. This was, of course, <a href="https://www.coppolacomment.com/2022/07/celsiuss-failure-shows-importantce-of.html">a lie</a>. Celsius was in reality taking risks with retail deposits that no bank now would be allowed to take. It was pooling and lending out customer deposits to undisclosed and, we now know, highly risky borrowers, and rehypothecating collateral pledged against that borrowing, effectively rendering the loans unsecured. It had neither central bank liquidity support nor deposit insurance. And it was not subject to the capital and liquidity regulations that protect depositors from losses if traditional banks fail. Celsius's business model was far more dangerous for retail depositors than that of the banks from which it was enticing them to move their deposits. But repeated warnings from informed observers about Celsius's business model were dismissed and ignored by many in the crypto community. </div><div><br /></div><div>The party came to an end for Celsius as long ago as April 2021, when cease & desist orders from <a href="https://www.nj.gov/oag/newsreleases21/Celsius-Order-9.17.21.pdf">New Jersey</a> and other states forced it to stop offering interest-bearing accounts to U.S. customers. But it stumbled on for another eighteen months, concealing the growing hole in its balance sheet with sales of its own token, and continuing to recruit retail customers, including from the U.S. The <a href="https://protos.com/wp-content/uploads/2022/11/Celsius-Interim-Investigator-Report.pdf">U.S. Examiner's report</a> reveals that although it stopped paying interest to U.S. customers, it did not segregate their funds, but continued to use them to support liquidity on the platform. As of October 28th, 2022, some $16.9 million worth of their deposits had gone missing. <br /><br />Other platforms found another way of persuading people that it was safe to put their money into crypto. Fiat money in banks has FDICinsurance (or the equivalent in other countries). So crypto platforms such as Voyager entered into relationships with FDIC-insured banks and then marketed fiat deposits on the platform as FDIC insured. This was, strictly speaking, true - but depositors were only covered if the bank failed, not if the platform did. Not that Voyager cared. It cheerfully <a href="https://www.coppolacomment.com/2022/07/the-sinking-of-voyager.html">told its customers that their deposits were insured if either the bank or the platform failed</a>. When the platform failed in June 2022, customers understandably demanded their FDIC insurance payout. But there was no payout. <a href="https://www.coppolacomment.com/2022/07/shipwrecked.html">Voyager had lied</a>. FDIC was not liable for losses arising from failure of the platform.</div><div><br /></div><div>Voyager was not the only or even the first, crypto platform to mis-sell FDIC insurance to retail depositors. It was <a href=" https://www.coindesk.com/markets/2020/05/04/the-stablecoin-surge-is-built-on-smoke-and-mirrors/">a long-running industry-wide scam</a>. In March 2020, I <a href="https://www.coppolacomment.com/2020/03/too-good-to-be-true.html">publicly criticised the crypto lender Cred</a> for claiming its retail deposits were FDIC insured when they clearly were not. Cred failed in November 2020, taking lots of its depositors' money with it. As I had warned, they turned out not to be insured. <br /><br />And it was not just lending platforms that claimed their deposits were FDIC insured. Crypto exchanges, notably Coinbase and Gemini, <a href="https://www.coindesk.com/markets/2020/05/04/the-stablecoin-surge-is-built-on-smoke-and-mirrors/">told their customers</a> that fiat deposits qualified for FDIC "pass-through" insurance. FDIC has to my knowledge never confirmed that fiat deposits on any crypto exchange or platform qualify for either direct or pass-through insurance. But for well over two years, crypto exchanges and platforms got away with marketing themselves as FDIC-insured. It wasn't until the summer of 2022 that FDIC <a href="https://www.fdic.gov/news/financial-institution-letters/2022/fil22035.html">made a serious attempt</a> to end mis-selling of FDIC insurance by crypto companies. </div><div><br /></div><div>Why did it take FDIC so long to act? Partly, I suspect, because crypto wasn't seen as posing a serious risk to the mainstream financial system. And perhaps also because crypto has never been eligible for FDIC insurance, so there was no particular reason for FDIC to take an interest in it. Whatever the reason, FDIC did not act until after Voyager's failure revealed systematic mis-selling of FDIC insurance to retail customers. </div><div><br /></div><div>Just as FDIC was starting to clamp down on mis-selling of FDIC insurance by crypto companies, FTX jumped on the FDIC insurance scam bandwagon. In a series of tweets, Brett Harrison, CEO of FTX, claimed that fiat deposits on FTX would be individual accounts in its partner bank and would therefore qualify for FDIC insurance. <a href="https://twitter.com/ProfJulieHill/status/1549800371262001152?s=20&t=Uz0fzgwhhVZUrG6smS_BfA">Several</a> <a href="https://twitter.com/Frances_Coppola/status/1550073329335271426?s=20&t=mlADK2mw-xz7Mx6RDN3W7Q">people</a> pointed out that this was inconsistent with FTX's terms of service, which said deposits would be held in omnibus accounts. But Harrison insisted that <a href="https://twitter.com/BrettHarrison88/status/1549809822979293184?s=20&t=Uz0fzgwhhVZUrG6smS_BfA">the terms were being updated</a> and FDIC insurance would apply. </div><div><br /></div><div><div>Quite why FTX decided to advertise its deposits as FDIC insured is unclear. But we now know that FTX had a whopping hole in its balance sheet because of Alameda's losses. So perhaps it was desperately trying to trawl in new depositors to keep itself afloat. Not that new deposits were ever going to fill the hole. Pouring more water into a leaky bucket doesn't stop it leaking. </div><div><br /></div></div><div>Anyway, FTX's FDIC scam didn't last long. In August 2022 FDIC hit FTX and four other crypto companies with <a href="https://www.coindesk.com/policy/2022/08/19/fdic-orders-ftx-us-4-other-companies-to-cease-and-desist-misleading-consumers/">cease & desist order</a>s forcing them to stop marketing FDIC insurance immediately. Harrison, who was specifically named in <a href="https://www.fdic.gov/news/press-releases/2022/ftx-harrison-letter.pdf">FTX's cease & desisr order</a>, deleted his tweets, and FTX changed its terms of service to eliminate all references to deposit insurance. </div><div><br /></div><div><div>We don't know to what extent the ending of the FDIC scam contributed to FTX's bankruptcy, but it didn't long survive the cease & desist order. Less than three months later it suffered a catastrophic run on deposits, completely destroying its carefully-crafted illusion of solvency and forcing it to file for Chapter 11 bankruptcy. Its remaining depositors <a href="https://time.com/6236610/ftx-account-holders-money-back/">stand to lose most, perhaps all, of their money.</a> </div></div><div><br /></div><div>FTX is the latest in a very long line of crypto platforms that have gone down taking their depositors' money with them. It will probably not be the last. You'd think, given how much money retail depositors have already lost and are still to lose, that the remaining platforms would refrain from offering obviously unsustainable returns. But no. They are still offering insanely high yields on dollar or dollar-equivalent deposits. Here, for example, is Justin Sun's Tron DAO Reserve promising risk-free returns of 39.66% on USDT, 46.66% on USDC and 46.14% on TUSD: </div><div><br /></div><div><a href="https://blogger.googleusercontent.com/img/a/AVvXsEj6aADcBhqdtO8lh8ocy9wp84AyJVRY_erVApTAXf039MXERDIBmjwpUb9h_nUvvyuAcgdiqt6cjbLkVktNCDTcY-m1RCp9hqjVL8RbysxZNdWBjyajn6440RqGzNMU4IECOxB3JYtqS0f44FIYKVWTDx31Udj8fND7owDvn4oGku6YClIuqdqa_PT4" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img alt="" data-original-height="614" data-original-width="1905" height="206" src="https://blogger.googleusercontent.com/img/a/AVvXsEj6aADcBhqdtO8lh8ocy9wp84AyJVRY_erVApTAXf039MXERDIBmjwpUb9h_nUvvyuAcgdiqt6cjbLkVktNCDTcY-m1RCp9hqjVL8RbysxZNdWBjyajn6440RqGzNMU4IECOxB3JYtqS0f44FIYKVWTDx31Udj8fND7owDvn4oGku6YClIuqdqa_PT4=w640-h206" width="640" /></a><br /><br /><br /></div><div>And here is FTX's nemesis, Binance, offering yields in excess of 65% on stablecoin deposits:</div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjek6pLbJCAR2WNlr2-Kfsbw0otzt-rOYYnxc0vtJHUu0rj-IXhUuh06N3LxUTqlOw9OIY6ntu04DCs8RtqP1h5z2Mf4C1fcgRT6Q2M0S6aYhhcF-jHFnJba-KLIujpOBFuivC7AyfuOvUFQyYpNyeDDi1LnbPEleow1bnGa2lT25KTOcDj03Z6bpA7" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="2048" data-original-width="1238" height="640" src="https://blogger.googleusercontent.com/img/a/AVvXsEjek6pLbJCAR2WNlr2-Kfsbw0otzt-rOYYnxc0vtJHUu0rj-IXhUuh06N3LxUTqlOw9OIY6ntu04DCs8RtqP1h5z2Mf4C1fcgRT6Q2M0S6aYhhcF-jHFnJba-KLIujpOBFuivC7AyfuOvUFQyYpNyeDDi1LnbPEleow1bnGa2lT25KTOcDj03Z6bpA7=w387-h640" width="387" /></a></div><br />These are the crypto ecosystem's main stablecoins, readily obtained from crypto exchanges. All you have to do is deposit some real dollars. Then you trade them for stablecoins, feed the stablecoins into the thirsty maw of Tron DAO Reserve or Binance, sit back and collect your returns, which are of course far better than anything you can get in a conventional bank or fund. And it's all entirely risk free, because these stablecoins are dollars, really - aren't they?</div><div><div><br /></div><div>This is of course far too good to be true. But no doubt some suckers will believe it and hand over their dollar stablecoins. And that is exactly what the platform wants. Dollar liquidity, to preserve the illusion that there are enough dollars in the system for everyone to withdraw not only what they have deposited, but also what they have earned.</div><div><br /></div><div>There's already substantial evidence that the crypto space is infested with frauds, scams and ponzis. But I would go further. The entire crypto ecosystem is ponzi. The whole thing depends on ever more people parting with their savings and wages to pay the lunatic returns promised by the platforms to people who can provide the liquidity they so desperately need. No wonder platforms like FTX chase market share and insist that any problems are just "liquidity crises". The more people they can attract, the more liquidity they have and thus the longer they can survive. </div><div><br /></div><div>And if you think I am making this up, you should listen to <a href="https://www.bloomberg.com/news/articles/2022-11-18/odd-lots-podcast-matt-levine-on-sam-bankman-fried-ftx-and-alameda?sref=3roVJZZ4">Sam Bankman-Fried explaining to the Odd Lots team at Bloomberg</a> how the crypto ecosystem is reality a giant ponzi scheme. He's ostensibly talking about yield farming in "decentralized finance", but the centralized parts of crypto are every bit as dependent on a constant supply of greater fools. </div><div><br /></div><div><div>The crypto system's need to persudade more and more people to part with their savings to maintain the ponzi makes false promises and mis-selling endemic. Nor has a swathe of high-profile failures, culminating in the recent collapse of Sam Bankman-Fried's empire, in any way deterred the survivors. Indeed it makes it even more imperative that they attract new deposits. If they don't, the whole thing will implode. </div><div><br /></div><div>But implode it will, eventually. Because <a href="https://www.theguardian.com/technology/commentisfree/2022/jun/19/the-crypto-crash-all-ponzi-schemes-topple-eventually">ponzis always do</a>. </div><div><br /></div></div><div><br /></div><div><b>Related reading:</b></div></div><div><b><br /></b></div><div><a href="https://www.coindesk.com/layer2/futureofmoney/2022/06/29/why-this-crypto-crash-is-different/">Why this crypto crash is different</a> - Coindesk</div><div><br /></div><div><i>Image: Great Pyramid of Cheops. Nina at the Norwegian bokmål language Wikipedia, CC BY-SA 3.0 <http://creativecommons.org/licenses/by-sa/3.0/>, via Wikimedia Commons</i></div><div><br /></div><div><br /></div><div><br /></div><div><div><div class="separator" style="clear: both; text-align: center;"><br /></div><br /><br /></div><div><br /></div></div></div></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com3tag:blogger.com,1999:blog-8764541874043694159.post-65321860357788548912022-11-10T11:17:00.009+00:002022-12-03T13:42:48.954+00:00The FTX-Alameda nexus<p>How did it all go so wrong, so quickly? Less than a month ago, Sam Bankman-Fried was the golden boy of crypto, with a net worth in the $billions, and his exchange FTX was valued at $32bn. Now, FTX has a gaping hole in its balance sheet, thousands of people have lost their money, and Sam is facing personal bankruptcy and, potentially, fraud charges. </p><p>The short answer is - it didn't. The hole in FTX's balance sheet has existed for a long time. We don't know exactly how long, but the size of the estimates (ranging from $6-$10 billion) suggests several months if not years. Sam has been trading while insolvent. He's not the only crypto oligarch to do so: Celsius's Mashinsky also traded while insolvent for an extended period of time. </p><p>Trading while insolvent is illegal, of course. But in cryptoland scant attention is paid to such niceties. It is (or would like to be) a lawless, self-regulating space in which conventional courts and regulators have no place. And anyway, there are plenty of creative ways of hiding a black hole. Issuing your own token, for example. And using your own hedge fund to pump its value. </p><p>Here's how it works. The young, dynamic, ambitious owner of a crypto hedge fund - let's call him "Joe" - sets up a crypto exchange. To start with, this just enables his hedge fund to trade without having to pay margin or exchange fees. But Joe has larger ambitions. He wants to run the biggest and best exchange in the world. And he wants to make money from it. Lots and lots of money. Trillions of dollars, in fact. </p><p>Now, his hedge fund can make money by taking risky leveraged positions, but it has to raise funds, and that's not cheap. And his exchange can make money by charging fees on transactions, but although that can be a nice slow steady income, it's not going to make him the trillions of dollars he wants. </p><p>But Joe's spotted an opportunity. The exchange has lots of customer assets that aren't earning anything. If he puts those customer assets to work, he can earn far more from his exchange customers. And he's got an obvious vehicle through which to put them to work. The hedge fund. If he transfers customer assets on the exchange to the hedge fund, it can lend or pledge them at risk to earn megabucks. <br /><br />Of course, there's a risk that the hedge fund could lose some or all of the customers' funds. And the exchange promises that customers can have their assets back on demand, which could be a trifle problematic if they are locked up in leveraged positions held by the hedge fund. But this is crypto. There's an easy solution. The exchange can issue its own token to replace the customer assets transferred to the hedge fund. The exchange will report customer balances in terms of the assets they have deposited, but what it will actually hold will be its own token. If customers request to withdraw their balances, the exchange will sell its own tokens to obtain the necessary assets - after all, crypto assets, like dollars, are fungible. </p><p>For this to work, however, the token must reliably hold its value. So the exchange creates more of the tokens than are needed to replace customer balances, and the hedge fund actively buys and sells them on the exchange, thus creating a market in the things and pumping the price. The price rockets, inflating the balance sheets of both the hedge fund and the exchange, and making $billions in unrealised profits for Joe and his investors - of whom there are suddenly a whole lot more, including some exceedingly respectable institutional investors. <br /><br /><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhzHnz0SGl2rQHWHf-s8-RzyhEsk9beq4S39UImtwHQ5LM3mlZTT8ejrY5kFaAozTAlsbuAPzQsT5QONSG752e0qCPa3uSECryYoHGnDlH9BXjEvUENkwR0aryYsVI_r1YFqFZoCvU8wUqHr6sd7iR68b1RlSmgBGvJMLKiuC8E5dodkB28RRSKKIQ7" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1048" data-original-width="1832" height="366" src="https://blogger.googleusercontent.com/img/a/AVvXsEhzHnz0SGl2rQHWHf-s8-RzyhEsk9beq4S39UImtwHQ5LM3mlZTT8ejrY5kFaAozTAlsbuAPzQsT5QONSG752e0qCPa3uSECryYoHGnDlH9BXjEvUENkwR0aryYsVI_r1YFqFZoCvU8wUqHr6sd7iR68b1RlSmgBGvJMLKiuC8E5dodkB28RRSKKIQ7=w640-h366" width="640" /></a></div><br /><p></p><p>It works brilliantly. So, this becomes Joe's business model. Customer assets deposited on the exchange are routinely lent to the hedge fund against collateral consisting of the exchange's tokens. There's a massive and growing mismatch between the asset balances reported to customers on the exchange and the assets the exchange actually holds. But it doesn't matter, because the token is highly liquid and the value of the tokens pledged as collateral comfortably exceeds the value of the missing customer assets. And the exchange can easily honour all withdrawal requests by trading out its own tokens. Indeed, the tokens are doing so well that even when the hedge fund suffers serious losses in a crypto crash, the exchange is able to bail it out. It's completely self-sustaining. That is, until the token's value crashes. </p><p>When the value of the token crashes, a gaping hole opens up in the exchange's balance sheet. On the liabilities side are its customers' assets, whose value has not changed (well, not as much as the value of the token, anyway). But the asset side consists mainly of the devalued token. It's not difficult to see that the further the token's price falls, the bigger the gap between the exchange's assets and liabilities. <br /><br />Furthermore, because the token's price is falling, the exchange has to create more tokens in order to honour customers' withdrawal requests, pushing the price down even more. And the crashing token price frightens customers, who flock to withdraw their deposits, forcing the exchange to create more and more tokens. The run stops when the token price falls so much that the exchange is unable to buy assets and is forced to suspend withdrawals. But by this time the exchange is deeply, deeply insolvent. For a big exchange, the gap between assets and liabilities can easily amount to billions of dollars. </p><p>This is the same "death spiral" as the one that killed off the Luna and UST tokens back in May. There is no way of recovering from it. Injections of funds will merely delay the inevitable. It is a crisis of solvency, not liquidity. </p><p>But it's only the exchange that becomes insolvent because of the death spiral. The hedge fund is ok, isn't it?</p><p>No, the hedge fund is insolvent too, though this may not be immediately obvious. To understand why both companies are insolvent, let's look at how this would play out if there were no connection between them. </p><p>Suppose the exchange were lending funds to a commercial hedge fund - let's call it "Arabian Nights LLC". Again, it lends those funds against collateral, and accepts its own token as collateral - indeed as it prefers its own token, it gives the fund an incentive to pledge it by giving a substantially smaller haircut than on other assets. The funds are therefore only slightly overcollateralised. <br /><br />When the value of the token crashes, the overcollateralisation evaporates and the value of the collateral becomes insufficient to repay the loan. This triggers a margin call - a demand from the exchange that the hedge fund stump up more collateral. If the hedge fund doesn't do so, the entire loan becomes instantly repayable. And if the hedge fund doesn't repay the loan, the exchange can force it into insolvency. This is <a href="https://www.coppolacomment.com/2022/07/where-has-all-money-gone.html">actually what happened to Three Arrows Capital</a>, the hedge fund that failed as a result of the collapse of TerraLuna in May. Its creditors forced it into bankruptcy after it defaulted on margin calls and loan repayments. </p><p>But Joe's exchange did not demand more collateral from the hedge fund to cover the crashing token price. Nor did it demand that the hedge fund repay its loans. Joe knew perfectly well that the hedge fund couldn't do either of these, so instead tried to find a buyer for his deeply insolvent exchange. But who wants to buy a crypto exchange with no assets, a huge pile of liabilities, and years and years of lawsuits?<br /><br />In effect, the exchange bailed out the hedge fund at the price of its own solvency. Or rather, the exchange's customers bailed out the hedge fund. Both companies are insolvent, and the customers are set to lose all their money - because in cryptoland, there's no deposit insurance. <br /></p><p>FTX is an exchange, and Alameda a hedge fund. But together, they were doing shadow banking - unregulated, risky deposit-taking and lending. And because they are owned by the same person, and are closely connected in other ways too, they really should be considered as one organisation. FTX-Alameda, Celsius and Voyager are brothers under the skin, and their fate - and that of their owner-managers - will be the same. </p><p>Let the lawsuits begin. </p><p><br /></p><p><b>Related reading:</b></p><p><a href="https://www.bloomberg.com/opinion/articles/2022-11-09/bankman-fried-s-ftx-had-a-death-spiral-before-binance-deal?sref=3roVJZZ4">FTX Had A Death Spiral</a> - Matt Levine, Bloomberg <i>(paywall)</i></p><p><a href="https://the-blindspot.com/putting-the-terra-stablecoin-debacle-into-tradfi-context/">Putting the Terra stablecoin debacle into "tradfi" context</a> - The Blind Spot</p><p><a href="https://www.coppolacomment.com/2022/07/the-sinking-of-voyager.html">The sinking of Voyager</a> and <a href="https://www.coppolacomment.com/2022/07/shipwrecked.html">Shipwrecked</a></p><p><a href="https://www.coppolacomment.com/2022/07/celsiuss-failure-shows-importantce-of.html">Why Celsius's depositors won't get their money back</a></p><p><a href="https://www.coppolacomment.com/2020/03/too-good-to-be-true.html">Too Good To Be True</a></p><div><br /></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com2tag:blogger.com,1999:blog-8764541874043694159.post-9229169972096045422022-10-18T22:30:00.009+01:002022-10-19T07:52:25.218+01:00When populism fails<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkUbfiwmgK7WdTS85lc4Q9Usa2masFw0dhL_06wYky7SwAoT7R0BoYslR-huaNsh4EUk5_HdBbjyCrcobFYYvq7Yk1bkgsN35zu8Sn1Xuw0eA52OBrAvU7faxdqu1KUut-YgffMSLJwaFsEJMTOdObxnJVxWS87Kx6YTnSFq7U9Urhe-Di7OTkbTPU/s4288/Acto_de_Posesion_del_Gobernador_Arias_Cardenas.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2784" data-original-width="4288" height="416" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhkUbfiwmgK7WdTS85lc4Q9Usa2masFw0dhL_06wYky7SwAoT7R0BoYslR-huaNsh4EUk5_HdBbjyCrcobFYYvq7Yk1bkgsN35zu8Sn1Xuw0eA52OBrAvU7faxdqu1KUut-YgffMSLJwaFsEJMTOdObxnJVxWS87Kx6YTnSFq7U9Urhe-Di7OTkbTPU/w640-h416/Acto_de_Posesion_del_Gobernador_Arias_Cardenas.jpg" width="640" /></a></div><br />At the Battle of Ideas last Saturday, a panel on "populism" spent an hour and a half discussing everything except economics. Sherelle Jacobs of the Telegraph called for the Tory party to replace what she called a "twisted morality of sacrifice and dependency" with the "Judaeo-Christian" values of thrift and personal responsibility. And when a brave audience member asked "shouldn't we be discussing economics?" Tom Slater of Spiked brushed him off and carried on talking about cultural issues. Economics be damned, populism is all about morality and culture. <p></p><p>But important though morality and culture are, it is economics that really matters. Rudiger Dornbusch's work on macroeconomic populism shows that populism eventually fails because the economics don't work. And when it does, the people who suffer most are those the populists intended to help. </p><p>In <a href="https://www.nber.org/system/files/working_papers/w2986/w2986.pdf">this study</a> (pdf), Dornbusch and Sebastian Edwards define macroeconomic populism thus:</p><p></p><blockquote><p>Macroeconomic populism is an approach to economics that emphasizes growth and income distribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies.</p></blockquote><p>Liz Truss's disastrous budget meets this definition. It was explicitly intended to stimulate growth, and she and Kwarteng ignored the risks of inflation and deficit finance, wrongly assuming that external investors and domestic voters would approve of the plans. Furthermore, the package as a whole was aggressively redistributive, cutting taxes predominately for the rich and supporting household incomes right across the income distribution. </p><p>But although macroeconomic populism failed on Truss's watch, she was neither its source nor its principal architect. The principal architect was Boris Johnson. And the source was George Osborne. </p><p>Dornbusch and Sebastian Edwards locate the source of populism in austerity. "The populist paradigm is typically a reaction against a monetarist experience," they say. And they go on to explain how economic stagnation results from austerity: </p><p></p><blockquote><p><b>Initial Conditions</b>. The country has experienced slow growth,
stagnation or outright depression as a result of previous stabilization
attempts. The experience, typically under an IMF program, has reduced
growth and living standards. Serious economic inequality provides
economic and political appeal for a radically different economic program.
The receding stabilization will have improved the budget and the external
balance sufficiently to provide the room for, though perhaps not the
wisdom of, a highly expansionary program.</p><p></p></blockquote><p>This well describes the UK of the early 2010s. The economy was stagnant, growth was slow and living standards were poor. And although the UK was not subject to an IMF programme, other countries in Europe were. George Osborne and David Cameron leveraged fear of becoming "like Greece" to convince a long-suffering population that austerity now was necessary to ensure growth and prosperity returned in the future. </p><p>But by 2015, growth and prosperity had not returned. Rising inequality and poor living standards, particularly outside London and away from big cities, fuelled popular anger. With rebellion against austerity in the air, Osborne engineered something of a housing boom in time for the 2015 election and succeeded in winning an outright majority for the Conservative party. Just over a year later, both Osborne and Cameron were out of office. But the Conservative party wasn't. </p><p>The turn to populism often starts with the election of a left-wing government. But in the case of the U.K., it didn't. It started with the campaign to leave the EU. Brexit is a populist movement, but not a socialist one. Many of its proponents want free markets and a small state, and while others want a bigger role for the state, they see it as fostering enterprise in left-behind regions. "Take back control", cried the Leave campaign. "WE WILL!" shouted back the voters in the 2016 referendum. The following day, Cameron resigned. His replacement, Theresa May, sacked Osborne. </p><p>May continued to make deficit-reducing spending cuts throughout her premiership. In 2018 she promised to end austerity "<a href="https://www.theguardian.com/politics/2018/oct/03/theresa-may-conference-speech-ambasts-labour-as-she-calls-for-tory-unity">when Brexit was done</a>". But within a year she too was out of office, replaced by Boris Johnson, a leading light of the Brexit movement. In December 2019, the Conservative party won a landslide victory on Johnson's promises to "get Brexit done" and "level up" the country. And so it came to pass that the same centre-right political party that had inflicted the austerity of the post-crisis years, rejected it. </p><p>Johnson told voters that austerity was over, and promised large-scale investment in infrastructure and public services. Suddenly, the government deficit and debt, on which attention had previously been lavished to the point of fetishism, was no longer important. The government had sufficient fiscal room to do whatever it wanted. And when the Covid pandemic hit, all constraints on government spending were removed. The UK had pivoted fully from austerity to Dornbusch's "no constraints":</p><blockquote><b>No Constraints:</b> Policy makers explicitly reject the
conservative paradigm. Idle capacity is seen as providing the leeway for
expansion. Existing reserves and the ability to ration foreign exchange
provide room for expansion without the risk of running into external
constraints. The risks of deficit finance emphasized in traditional
thinking are portrayed as exaggerated or altogether unfounded. Expansion
is not inflationary (if there is no devaluation), because spare capacity
and decreasing long run costs contain cost pressures and; there is room to
squeeze profit margins by price controls.</blockquote><p>To be sure, the UK was far from alone in removing all constraints at this time. Governments all over the world were spending without limit, supported by massive QE from their central banks. But Johnson's agenda was far more than just a pragmatic response to a public health crisis. It was a radical populist programme:<br /><b></b></p><blockquote><b>The Policy Prescription.</b> Populist programs emphasize three
elements: reactivation, redistribution of income and restructuring of the
economy. The common thread here is "reactivation with redistribution". The
recommended policy is a redistribution of income, typically by large real
wage increases. </blockquote><p></p><p>Johnson's rejection of his predecessors' austerity was accompanied by an explicit commitment to redistribution and restructuring not only of the UK economy, but of society. The "levelling up" agenda that bought him the votes of the "red wall" aimed to close the wide income and wealth gap between London & the South East and the rest of the UK. </p><p>Johnson's profligacy led to carelessness and corruption, both financial and personal. Eventually, it brought about his downfall. But Truss inherited his mandate, and although her first action on coming into office was to downplay "levelling up" in favour of an equally radical "growing the pie", her plan for tax-light "enterprise zones" across the country was, at least in theory, strongly redistributive. Her mini-budget was every bit as populist as Johnson's programme. But not more so. Had he remained in office, Johnson's populist programme would eventually have unravelled as disastrously as hers - because populist programmes always do. </p><p>Dornbusch and Edwards document four phases in the collapse of macroeconomic populism, which I reproduce verbatim below. Their work is on Latin American countries, so not entirely applicable to the UK. But the lessons nonetheless are valuable. </p><p></p><ul style="text-align: left;"><li><b>Phase I</b>: In the first phase, the policy makers are fully
vindicated in their diagnosis and prescription: growth of output, real
wages and employment are high, and the macroeconomic policies are nothing
short of successful. Controls assure that inflation is not a problem, and
shortages are alleviated by imports. The run-down of inventories and the
availability of imports (financed by reserve decumulation or suspension of
external payments) accommodates the demand expansion with little impact on
inflation.</li><li><b>Phase II</b>: The economy runs into bottlenecks, partly as a
result of a strong expansion in demand for domestic goods, and partly
because of a growing lack of foreign exchange. Whereas inventory
decumulation was an essential feature of the first phase, the low levels
of inventories and inventory building are now a source of problems. Price realignments and devaluation, exchange control, or protection become
necessary. Inflation increases significantly, but wages keep up. The
budget deficit worsens tremendously as a result of pervasive subsidies on
wage goods and foreign exchange.</li><li><b>Phase III</b>: Pervasive shortages, extreme acceleration of
inflation, and an obvious foreign exchange gap lead to capital flight and
demonetization of the economy. The budget deficit deteriorates violently
because of a steep decline in tax collection and increasing subsidy costs.
The government attempts to stabilize by cutting subsidies and by a real
depreciation. Real wages fall massively, and politics become unstable. It
becomes clear that the government has lost.</li><li><b>Phase IV</b>: Orthodox stabilization takes over under a new
government. An IMF program will be enacted; and, when everything is said
and done, the real wage will have declined massively, to a level
significantly lower than when the whole episode began! Moreover, that
decline will be very persistent, because the politics and economics of the
experience will have depressed investment and promoted capital flight. The
extremity of real wage declines is due to a simple fact: capital is mobile
across borders, but labor is not.</li></ul><p></p><p>The extraordinary conditions of the pandemic complicate things somewhat. But looking back, it can be said that the macroeconomic policies of the pandemic were successful, and their enormous expense was not a problem because the central bank was - unusually for the UK - captive at that time. I find it odd that those complaining about the threat of fiscal dominance in the Bank of England's handling of the <a href="https://www.coppolacomment.com/2022/09/what-was-real-reason-for-bank-of.html">gilts meltdown</a> under Truss have failed to notice two whole years of actual fiscal dominance under Johnson. The Bank of England explicitly ensured that Johnson's government could finance exorbitant expenditure on covid-related schemes. I am not saying that this was a mistake: there was a clear need for coordinated government and central bank action to keep people and businesses alive during successive lockdowns. But we should beware of double standards. Johnson's extraordinary profligacy was supported by the Bank of England and accepted by markets. Truss's was not. </p><p>So the pandemic period was Phase 1, when the populist paradigm works brilliantly. And thank goodness for it. Attempting to do austerity at that time would have been disastrous. </p><p>The cracks started to appear as the economy reopened. Supply chain problems caused shortages and price rises. Inflation started to rise. This was Phase 2. </p><p>Political instability and the Ukraine war ushered in Phase 3. Energy prices spiked and inflation shot up. Johnson was ousted by his own MPs, and there was then a protracted leadership campaign, during which the eventual winner, Liz Truss, said some worrying things and made some unwise promises. By the time she took office, gilt yields were already rising and sterling experiencing considerable volatility. But the wheels came off with the "mini-budget" on September 23rd. </p><p>Quite why Truss thought she could introduce a wildly profligate budget when inflation was high and rising, interest rates rising and sterling already under pressure is unclear. Perhaps she genuinely thought she would be able to face down financial markets. After all, her government wasn't socialist, it was a right-wing, true-blue Tory government with an agenda modelled on the successful tax-cutting programmes of Thatcher and Reagan. Surely financial markets would approve?</p><p>But financial markets are amoral. They don't care whether a government favours the rich or the poor. They only care that its economics make sense. Truss's didn't. So they punished her in exactly the same way that they would a socialist government pursuing a massive programme of unfunded welfare increases at a time of rising inflation, binding resource constraints and near-full employment. They sold everything denominated in sterling, including sterling itself. Capital fled from the UK. </p><p>Dornbusch doesn't mention the importance of personalities, but in my view part of Truss's problem is that she isn't Johnson. She is, if you like, the UK's equivalent of Nicolas Maduro, the Venezuealan leader who took over from Hugo Chavez but has never commanded his popularity. Truss has neither Johnson's popular appeal nor his communication skills. Johnson might have been able to blag his way through the return of the bond vigilantes, but Truss, wooden and unempathic, never stood a chance. </p><p>Now, the UK is in phase 4. The Conservatives have appointed a new Chancellor who has already taken a hatchet to Truss's tax-cutting budget and is indicating further cuts to come. And with her entire economic programme now in shreds on the floor, Truss seems unlikely to be able to hold on to office for much longer. It is not at all clear who will replace her, and the prospect of the Conservatives putting in place an unelected technocratic government with no mandate to undertake the fiscal consolidation that is now necessary is profoundly undemocratic. We need a General Election, not a Tory coronation.</p><p>We have come full circle. Austerity is back, bigger than before. And those who will pay are the very people that voted for Johnson and for Brexit because they thought this would make their lives better. Just as Dornbusch and Edwards predicted, there will now be brutal real income falls across the entire income distribution. This chart from the Resolution Foundation is unbelievably stark:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEh01zCf3z3bUX410LSGFCw4KZ90LwajBu1LeaLozAtGYSmljVo4mH-6lxHj3v4eCUK6sryBoz7cNrI6FeyV6ebODUyChhBI0WyvOOHdY6GhB_00LVoXPJffXLBdOnSiWGiwn45zDRGprHZIOTrYs-YpDeOoYvd9cQ1D6aOXh2V3Y-pJ5IEHAB2Vy4-s" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="616" data-original-width="1041" height="378" src="https://blogger.googleusercontent.com/img/a/AVvXsEh01zCf3z3bUX410LSGFCw4KZ90LwajBu1LeaLozAtGYSmljVo4mH-6lxHj3v4eCUK6sryBoz7cNrI6FeyV6ebODUyChhBI0WyvOOHdY6GhB_00LVoXPJffXLBdOnSiWGiwn45zDRGprHZIOTrYs-YpDeOoYvd9cQ1D6aOXh2V3Y-pJ5IEHAB2Vy4-s=w640-h378" width="640" /></a></div><br />Nor are pensioners likely to escape the income squeeze. The Chancellor has already indicated that he may take his hatchet to the sacred triple lock that ensures their state pensions always rise by as much or more than inflation and average earnings. And the returns on their savings are unlikely to keep up with inflation.<p></p><p>Why do populist programmes always end disastrously for those they aim to help? It's not because of lack of commitment, or failure to make the case for them. Populist leaders often believe strongly in their programmes. It is the economic substance of the programmes that is the problem. Populist politicians think the rules of economics don't apply to them. They eventually find out the hard way that they do. <br /><br />Truss's attempt at a Barber-style "dash for growth" was short-lived, but its consequences will be long-lasting. The UK now faces persistently raised interest rates, a persistently weaker currency, and persistently higher government borrowing costs as a direct result of her folly. </p><p>Sadly, as Dornbusch and Edwards warn, the return of austerity, if not tempered by measures to improve growth and what they call "social progress", will sow the seeds of the next crisis. And this is where those who see populism as being about morality and culture perhaps have something important to contribute. For it is morality, not economics, that says the social fabric of society is important and must be maintained. <br /><br />Osborne's economics-driven austerity <a href="https://www.coppolacomment.com/2016/03/the-unaffordable-george.html">shredded social safety nets and rendered essential public services unfit for purpose</a>. It is vital that the new technocratic government does not embark on the same disastrous course. We don't need a "new morality", we need to reinforce our traditional British - indeed, dare I say it, Judaeo-Christian - values of fairness, duty, <a href="https://www.coppolacomment.com/2012/09/the-foolish-samaritan.html">compassion</a> and <a href="https://www.coppolacomment.com/2013/12/generosity.html">generosity</a>. </p><p><br /></p><p><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2016/09/austerity-and-rise-of-populism.html">Austerity and the rise of populism</a></p><p><a href="https://www.coppolacomment.com/2015/01/a-latin-american-tragedy.html">A Latin American tragedy</a></p><p><a href="https://cepr.org/voxeu/columns/social-imprint-sovereign-defaults">The social imprint of sovereign defaults</a>, CEPR </p><p><br /></p><p><i> Image:A<span face="sans-serif" style="background-color: #f8f9fa; color: #202122; font-size: 12.3704px;"> 2012 rally by members of the left-wing populist United Socialist Party of Venezuela in </span><a href="https://en.wikipedia.org/wiki/Maracaibo" style="background: none rgb(248, 249, 250); color: #0645ad; font-family: sans-serif; font-size: 12.3704px; text-decoration-line: none;" title="Maracaibo">Maracaibo</a>. By Wilfredor - Own work, CC0, <a href="https://commons.wikimedia.org/w/index.php?curid=23284996">Wikipedia</a></i></p><p><br /></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-34401090980367318752022-09-30T11:18:00.008+01:002022-10-03T13:09:12.892+01:00What was the real reason for the Bank of England's gilt market intervention?<p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgmYTEQHo3WEZzSWJSO8zycem0e5x6lFxUJbAdgP1QVT5N5juH4Kv9CPL7jMLYNX96WtlwOjMLo0gqbF492QPJ3IDQrVYE9sxzjwJbN0khS8wxszMK0W0EYR0qLUTHsqISgdvoQjJPoGX2_IO-k-_ltldO-MUymAIBA8BLQIWduGIRhmrSYQZXfsagd/s2561/EH1079134_Bank_of_England_06_(cropped).jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1887" data-original-width="2561" height="472" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgmYTEQHo3WEZzSWJSO8zycem0e5x6lFxUJbAdgP1QVT5N5juH4Kv9CPL7jMLYNX96WtlwOjMLo0gqbF492QPJ3IDQrVYE9sxzjwJbN0khS8wxszMK0W0EYR0qLUTHsqISgdvoQjJPoGX2_IO-k-_ltldO-MUymAIBA8BLQIWduGIRhmrSYQZXfsagd/w640-h472/EH1079134_Bank_of_England_06_(cropped).jpg" width="640" /></a></div><br /><div class="separator" style="clear: both; text-align: center;"><span style="text-align: left;"><br /></span></div><div class="separator" style="clear: both; text-align: left;"><span style="text-align: left;">Why did the Bank of England intervene in the gilt market this week? The answer that has been doing the rounds is that it was protecting the solvency of pension funds. But this doesn't make sense to me. The Bank doesn't have any mandate to prevent pension funds going bust. And anyway, the type of pension fund that got into trouble isn't at meaningful risk of insolvency. There was never any risk to people's pensions. </span></div><p></p><p>I don't think the Bank was concerned about pension funds at all. I think it had a totally different type of financial institution in its sights. <br /></p><p>Let's recap the sequence of events from a market perspective. This was, on the face of it, a classic market freeze. Pension funds sold assets, mainly long-dated gilts, to raise cash to meet margin calls on interest rate swaps (of which more shortly). The sudden influx of long gilts on to a market already spooked by an extremely foolish government policy announcement caused their price to crash. I am told that at one point, long gilts couldn't be priced - which means there were literally no buyers. </p><p>The crashing price of long gilts severely damaged the asset side of defined-benefit (DB) pension fund balance sheets. If these were normal companies, this might mean insolvency. But DB pension funds aren't normal companies. They are really the asset management arms of their sponsoring employers. As long as the employer is solvent, a DB pension fund can run with a substantial deficit - and some do, especially in the public sector, though this imposes an obligation on the employer to ensure the pension fund can meet its obligations over the longer term. <br /><br />Anyway, the present value of DB pension fund liabilities falls as gilt yields rise. Since yield is the inverse of price, long gilts falling in price therefore poses no risk to the solvency of DB pension schemes. If anything it improves it. <br /><br />So scary stories about pension fund "insolvency" entirely missed the point. DB pension funds were never at risk of insolvency. They were merely extremely illiquid. If you aren't clear on the difference between illiquidity and insolvency, read <a href="https://www.coppolacomment.com/2012/05/liquidity-matters.html">this</a>. </p><p>DB pension funds try to minimise deficits, because <a href="https://www.ft.com/content/038b30c3-f550-4cc0-93ed-9154021d6ee2">as Toby explains</a>, employers really don't like having to report wild swings in their DB pension obligations in their financial accounts:</p><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><p style="text-align: left;">"So if you, a board member of a company with loads of pension obligations, want to avoid reporting wild swings in your pensions funding status to both markets (in your reports and accounts) or the Pensions Regulator (and maybe have to submit a recovery plan, as well as pay a higher risk-based PPF levy), you want a pension scheme that aligns its assets with the way your liabilities are measured..."</p></blockquote><p>Pension funds therefore aim to match the duration of their liabilities and assets as far as possible. And they use interest rate swaps to smooth out cashflows and perhaps make a bit of money from leverage. This is what "liability driven investment" (LDI) is all about. (I am oversimplifying quite a bit as this isn't a post about the workings of LDI, on which I don't pretend to be an expert.) </p><p>The way interest rate swaps work is key to this post. Pension funds that use derivatives have to post liquid assets (cash or cash equivalents) as collateral. The collateral must be sufficient to cover daily changes in the market price of the swaps (variation margin). Collateral insufficiency triggers a margin call, in response to which the fund must post more liquid collateral. </p><p>Pension funds that are trying to match assets with long-dated liabilities obviously won't hold much in the way of cash and cash equivalents. So when they receive margin calls they have to sell or pledge the most liquid of their assets to obtain cash. For sterling DB pension funds, that means long gilts. As Toby says, they hold lots and lots of them. <br /><br />So when the long gilt market froze, DB pension funds couldn't raise enough cash to meet their margin calls. There was a real risk that they would default on them. This could trigger immediate liquidation of the collateral and unwinding of the swaps. </p><p>When swaps unwind because of missed margin calls, losses due to collateral insufficiency rebound to the counterparties - and the losses can be substantial. Who were these counterparties? <br /><br />Well, they weren't LDI managers such as Blackrock. Those are just intermediaries. Some of them might have failed - or shut their doors, as Blackrock did - but that wouldn't have bothered the Bank of England. And nor would DB pension funds suffering mark-to-market losses on long gilts. That's a problem for their sponsoring corporations and perhaps the pensions regulator, not the Bank of England. </p><p>Yet the Bank of England was clearly worried enough to intervene directly in the long gilt market. It acted as buyer of last resort for long gilts, signalling that it would buy £65bn worth of the things over the next couple of weeks. This injected liquidity into the market, enabling pension funds to raise the cash they needed. It also incidentally set a floor under the long gilt price, limiting the damage to pension fund balance sheets. <br /><br />But the Bank's action wasn't fundamentallly about ensuring the solvency of pension funds. It was intended to head off the threat of a systemic meltdown. </p><p>As mentioned before, pension funds hedge the difference between assets and liabilities with interest rate swaps. They have fixed liabilities and variable assets, so they want to swap fixed for floating rate (again I am simplifying - Toby has a more detailed explanation, op. cit.). So counterparties to these swaps must be institutions that want to swap floating rate for fixed. What type of institutions have floating-rate short-term liabilities but longer-term fixed-rate assets? Why, banks, of course. </p><p>So this is not a story about pension funds, it's about banks. The gilt market freeze was creating a cash collateral shortfall for pension funds, and as a result banks were at risk of serious losses on derivatives. We've seen this movie before and we know it ends with large quantities of blood on the floor. That's what the Bank of England feared. It intervened to stop the bleeding before it became a haemorrhage. </p><p>When you dig deeply enough into a financial crisis, you almost always find it's really about banks. </p><p>UPDATE: <a href="https://twitter.com/thomadcock/status/1575805391425794048?s=20&t=oAxxNOJh840iP5MGhGI7dA">Thom Adcock on Twitter</a> has pointed out that the interest rate swaps were likely to have been centrally cleared. If so, then the Bank of England was supporting clearing houses in much the same way that in the financial crisis the Fed supported AIG to prevent knock-on contagion to banks. A central swap clearer failing because of a gilts market freeze would have been a systemic catastrophe. </p><p><br /></p><p><b>Further reading: </b></p><p><a href="https://www.ft.com/content/f4a728a5-0179-48bd-b292-f48e30f8603c">LDI: the better mousetrap that almost broke the UK</a> - Financial Times</p><p><a href="https://criticalfinance.org/2022/09/29/pension-funds-and-liquidity-spirals/">Pension funds and liquidity spirals</a> - Critical Finance Blog</p><p><br /></p><p><i>Image from <a href="By Katie Chan - Wikimedia Commons, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=31159048">Wikimedia Commons</a></i></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-53394281452532173542022-08-16T18:30:00.012+01:002022-08-16T21:39:59.965+01:00Celsius is heading for absolute zero<div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTS2-TXyre_BcBhvVVnRl9v13EPvk1aZZXXn7uaudmerbvDsleyEJCeigBtFvAsox3XwhLcKSoiN-oIV4AdZ9pdRtXUghwSHEPANXL9LqyNppO1TD2PRl2r9MofPE5CorYF3s9g6i-9081Bk5URMPM8une64XSrLpP0fdORFnhvzRFQo39HD9TeqUO/s3127/ice.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="2089" data-original-width="3127" height="428" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTS2-TXyre_BcBhvVVnRl9v13EPvk1aZZXXn7uaudmerbvDsleyEJCeigBtFvAsox3XwhLcKSoiN-oIV4AdZ9pdRtXUghwSHEPANXL9LqyNppO1TD2PRl2r9MofPE5CorYF3s9g6i-9081Bk5URMPM8une64XSrLpP0fdORFnhvzRFQo39HD9TeqUO/w640-h428/ice.png" width="640" /></a></div><br /><div class="separator" style="clear: both; text-align: left;"><br /></div><span style="text-align: left;"><div class="separator" style="clear: both; text-align: left;"><span style="text-align: left;">Yesterday, the failed crypto lender Celsius </span><a href="https://cases.stretto.com/public/x191/11749/PLEADINGS/1174908152280000000004.pdf" style="text-align: left;">filed </a><span style="text-align: left;">a monthy cash flow forecast and a statement of its assets and liabilities held in the form of cryptocurrency and stablecoins. They showed that the lender is deeply underwater and will run out of money within two months. </span></div></span><span style="text-align: left;"> </span></div></div><div>Today, Celsius <a href="https://cases.stretto.com/public/x191/11749/CORRESPONDENCE/1174908162250000000001.pdf">presented an update</a> regarding its chapter 11 bankruptcy plans. Reading this, you'd think it was a different company. Liquidation isn't on the agenda. No, they are talking about "reorganization" and and seeking debtor-in-possession (DIP) financing: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgW_stiYuSXAHQylu01sQn7tGJG0bjpD02sK8s-MUnzzasE3qB-1hLwoI0rCZ9DjnNOavIXsR43UrxxdlEUyxfCT5zPaKPv8NAfmnkbysWLSzw6zuxLvG30T1X93I9bul7vqVS4L7ccNrX69r6W_qq5YaoG393qPZZbame8cbfczJzmT4hQ64uhF0EU" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="740" data-original-width="1338" height="354" src="https://blogger.googleusercontent.com/img/a/AVvXsEgW_stiYuSXAHQylu01sQn7tGJG0bjpD02sK8s-MUnzzasE3qB-1hLwoI0rCZ9DjnNOavIXsR43UrxxdlEUyxfCT5zPaKPv8NAfmnkbysWLSzw6zuxLvG30T1X93I9bul7vqVS4L7ccNrX69r6W_qq5YaoG393qPZZbame8cbfczJzmT4hQ64uhF0EU=w640-h354" width="640" /></a></div><a href="https://www.investopedia.com/terms/d/debtorinpossessionfinancing.asp#:~:text=Debtor%2Din%2Dpossession%20(DIP)%20financing%20is%20financing%20for,assets%2C%20ahead%20of%20previous%20lenders.">DIP financing </a>is a specialist form of finance for companies in chapter 11 bankruptcy to enable a company to continue operating. It usually takes the form of term loans. DIP loans are secured on the company's remaining assets and are typically senior over all other claims, so must be repaid before claims from existing creditors can be settled. Because DIP finance dilutes existing claims, the bankruptcy court must agree to it. <br /><br />In Celsius's case, the bankruptcy court will be advised by the Creditor Committee and the Ad Hoc Groups of custodial and withheld acccount creditors. These creditor representatives will want to be satisfied that enabling the company to continue operating will give them a better chance of recovery than putting it straight into liquidation. I don't know what they will make of the cash flow forecast and "Coin report" filed yesterday, but the figures in these documents make me extremely sceptical. I am struggling to see why the company isn't going straight into liquidation. </div><div><br /></div><div>First, the cash flow report. This is operational, not accounting, cash flow. In other words, it is the cash Celsius needs to meet its obligations day-to-day. Celsius has helpfully outlined liquidity in red to make it easy to read:</div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEi6bR6hKiWf7aPTb8LQvneuMAWREk2AG8f16Hiax95D3uCJSwx-V7RDR8qReCMMWUGZQmy5SktszCLFAFXAxPXcMFgbAg-bFsAa8GhakphagsmjxCYDyBU8bJqi5cXWKc1gCYwmQZivVGTtNgdr32lngAPv7W_vC1nHQX4m6aKLEMLssZzXbgs6TTVA" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="933" data-original-width="1489" height="402" src="https://blogger.googleusercontent.com/img/a/AVvXsEi6bR6hKiWf7aPTb8LQvneuMAWREk2AG8f16Hiax95D3uCJSwx-V7RDR8qReCMMWUGZQmy5SktszCLFAFXAxPXcMFgbAg-bFsAa8GhakphagsmjxCYDyBU8bJqi5cXWKc1gCYwmQZivVGTtNgdr32lngAPv7W_vC1nHQX4m6aKLEMLssZzXbgs6TTVA=w640-h402" width="640" /></a></div>Celsius is burning through its remaining cash at an extraordinary rate. As we might expect from a company that is unable to trade at the moment, total receipts are some distance adrift of total operating disbursements, so operating cash flow is significantly negative. </div><div><br /></div><div>But it's not operating cash flow that is burning through Celsius's cash. It is unspecified "capital expenditures", which are swallowing cash at a rate of $20-30m <b>per month. </b>What on earth is Celsius purchasing that costs that much, why is it incurring sales taxes, shipping costs and customs duties, and above all - why is it still doing it? Also, why is the cost of "restructuring activities" going to increase by nearly $10m in October? If I were on those creditor committees, I'd want to know where my money is going. </div><div><br /></div><div>If Celsius carries on splashing the cash at this rate, it will run out of money within two months. The forecast for October is for a liquidity shortfall of nearly $34m. Since this means being unable to meet its obligations as they fall due, it is actual bankruptcy, rather than simply balance sheet insolvency. Presumably Celsius is soliciting DIP finance to relieve the liquidity shortfall. But to me, this looks like throwing good money after bad. What, exactly, about Celsius's financials indicates that lending it more money will achieve a better recovery for its existing creditors?</div><div><br /></div><div>The Coin report is no help. It shows that the company's total coin liabilities exceed its total coin assets by over $2.8m at fair value. <br /></div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjRmxbtQDNoJ_QILQ_S_e2tSzSZaRqB-czF9i_rJ2cGIEGrNknz76lu_qBUgcRh2TqcV-NjnQBoKistA1bKpJzs9r6WhTEGQrlMi3hPnxvTnwTkDllUDtuqtNxxM4KdU09tPWTOmASCgoPVDHmv91Msxji01IwCA3qKN_iv8y1kMAN4Z2LoV-xuEwhG" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="821" data-original-width="1383" height="380" src="https://blogger.googleusercontent.com/img/a/AVvXsEjRmxbtQDNoJ_QILQ_S_e2tSzSZaRqB-czF9i_rJ2cGIEGrNknz76lu_qBUgcRh2TqcV-NjnQBoKistA1bKpJzs9r6WhTEGQrlMi3hPnxvTnwTkDllUDtuqtNxxM4KdU09tPWTOmASCgoPVDHmv91Msxji01IwCA3qKN_iv8y1kMAN4Z2LoV-xuEwhG=w640-h380" width="640" /></a></div><br />It has net negative positions in BTC, ETH, USDC and other coins, most likely because of runs on customer deposits, and although its positions in the derivatives wBTC and stETH are positive, both of these are extremely illiquid. And the value of its own coin holdings is presumably inflated by the social-media-driven "Celsius Short Squeeze" that has recently pumped up the price of the CEL token. It seems rather unlikely that CEL will remain at this price, though stranger things have happened in crypto. </div><div><br /></div><div>Celsius claimed in its July presentation that a key factor in its insolvency was the collapse of the market prices of BTC and ETH: <a href="https://blogger.googleusercontent.com/img/a/AVvXsEh-qcp-WN2K8FTrTgGx12oA0K6c85d1ez3WxckO8Pqd0h2MqT82DkM2OxqObWh47q9k3bmumY01QAEU98h5pJBqChZC_D38FXPAZkzKwiB2EZpv8Vj6epCUUlv1WnVXQaq4EZN9eIWRL2QcnVRVbnBaTgNjEyfRutCq7Wnse3UaorGfpt6ZMjOtK-wX" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img alt="" data-original-height="730" data-original-width="1429" height="326" src="https://blogger.googleusercontent.com/img/a/AVvXsEh-qcp-WN2K8FTrTgGx12oA0K6c85d1ez3WxckO8Pqd0h2MqT82DkM2OxqObWh47q9k3bmumY01QAEU98h5pJBqChZC_D38FXPAZkzKwiB2EZpv8Vj6epCUUlv1WnVXQaq4EZN9eIWRL2QcnVRVbnBaTgNjEyfRutCq7Wnse3UaorGfpt6ZMjOtK-wX=w640-h326" width="640" /></a></div><div><br /><br /></div><div>But I'm afraid the Coin report rather gives the lie to this. Celsius's positions in BTC and ETH are <b>net</b> negative at fair value. So a recovery in the market prices of these coins wouldn't restore balance sheet solvency. </div><div><br /></div><div>In his <a href="https://pacer-documents.s3.amazonaws.com/115/312902/126122257414.pdf">Court affidavit</a>, Alex Mashinsky, Celsius's CEO, said the company planned to use mined BTC to close the company's balance sheet deficit. </div><div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEheAzvYAN5_MedBEQJHXr8VzXZeGlPD-xXYowDFRdX0tzoI5pgsCm_Honhlw-OpsBIjs7Sw9e2PaKsL-wHD1hpXU7pkZj6YoUdSa6ePC92vLbH8c1y05yn4I6kNGPdMuMhRGq6JcpOcrqW0Ax6xQ6J3414NwRxJnrvFfm26asDujlyAh5jdFrKFstgx" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="397" data-original-width="1033" height="246" src="https://blogger.googleusercontent.com/img/a/AVvXsEheAzvYAN5_MedBEQJHXr8VzXZeGlPD-xXYowDFRdX0tzoI5pgsCm_Honhlw-OpsBIjs7Sw9e2PaKsL-wHD1hpXU7pkZj6YoUdSa6ePC92vLbH8c1y05yn4I6kNGPdMuMhRGq6JcpOcrqW0Ax6xQ6J3414NwRxJnrvFfm26asDujlyAh5jdFrKFstgx=w640-h246" width="640" /></a></div><br /></div><div>In similar vein, Celsius's July presentation indicated that Celsius's management intended to try to turn round the company rather than liquidating it, and part of the recovery strategy involved mining activities: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEikSLyCKWdkhNZiKs1TNpUAUXWL9T_CZU2rQMvl7yRpUx7rA2w3mro5nJutfUoExq_RJHFZR-ztFth-s2ZOoFttT1guOJFCOe8ke4NSQK27zHE1P8I0WDymfmcqknWrRdc2mDi0g7Ad0COpyKdfztgZyuTtdc0VTLNDcV5EXw6PmDEpxxf2BU7PbWmM" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="603" data-original-width="1385" height="278" src="https://blogger.googleusercontent.com/img/a/AVvXsEikSLyCKWdkhNZiKs1TNpUAUXWL9T_CZU2rQMvl7yRpUx7rA2w3mro5nJutfUoExq_RJHFZR-ztFth-s2ZOoFttT1guOJFCOe8ke4NSQK27zHE1P8I0WDymfmcqknWrRdc2mDi0g7Ad0COpyKdfztgZyuTtdc0VTLNDcV5EXw6PmDEpxxf2BU7PbWmM=w640-h278" width="640" /></a></div><br /><div>But there simply isn't enough mining going on to touch that balance sheet deficit. The Coin report shows a BTC asset balance of $0.384m, all of which is mined BTC, versus a BTC liability of $2.5m. The attached Mining Activity report says Celsius sold about a quarter of its mined BTC prior to the Chapter 11 filing, so the value reported on the Coin report is most of what has been mined so far. And a footnote to the liquidity report says that total receipts include the anticipated proceeds of forthcoming sales of mined BTC for which Celsius is awaiting the permission of the court. </div><div><br /></div><div>The fact is that a turnaround plan that relies on existing mining activity is going nowhere. Mining rigs don't run on fresh air, so Celsius needs to sell part of the BTC it has already mined to keep the rigs running. It can't use it to close the deficit. <br /><br />If Mashinsky's turnaround plan involves massively expanding mining activity, that would explain the capital expenditures that are eating Celsius's cash. But this seems to depend on there being a strong recovery in BTC prices without a commensurate increase in mining costs - which is not how BTC mining works. This is by any standards an extremely high risk, not to say reckless, strategy.</div><div><br /></div><div>High-risk and reckless strategies have brought this company to its knees. It is hard to see what benefit there would be to creditors from throwing what is left of their money into yet another such strategy. </div><div><br /></div><div>I'm not seeing anything in Celsius's published financials that justify trying to keep it going. It is, to coin a phrase, heading for absolute zero. Liquidate it now, before it wastes any more of other people's money.<br /> </div><div><br /></div><div><b>Related reading:</b></div><div><br /></div><div><a href="https://www.coppolacomment.com/2022/07/celsiuss-failure-shows-importantce-of.html">Why Celsius's depositors won't get their money back </a></div></div><div><br /></div><div><br /></div><div><i><span face="-apple-system, BlinkMacSystemFont, "San Francisco", "Helvetica Neue", Helvetica, Ubuntu, Roboto, Noto, "Segoe UI", Arial, sans-serif" style="background-color: whitesmoke; color: #111111; font-size: 13px; white-space: nowrap;">Photo by </span><a href="https://unsplash.com/@epw615?utm_source=unsplash&utm_medium=referral&utm_content=creditCopyText" style="background-color: whitesmoke; box-sizing: border-box; color: #767676; font-family: -apple-system, BlinkMacSystemFont, "San Francisco", "Helvetica Neue", Helvetica, Ubuntu, Roboto, Noto, "Segoe UI", Arial, sans-serif; font-size: 13px; text-decoration-skip-ink: auto; transition: color 0.1s ease-in-out 0s, opacity 0.1s ease-in-out 0s; white-space: nowrap;">erin mckenna</a><span face="-apple-system, BlinkMacSystemFont, "San Francisco", "Helvetica Neue", Helvetica, Ubuntu, Roboto, Noto, "Segoe UI", Arial, sans-serif" style="background-color: whitesmoke; color: #111111; font-size: 13px; white-space: nowrap;"> on </span><a href="https://unsplash.com/s/photos/ice?utm_source=unsplash&utm_medium=referral&utm_content=creditCopyText" style="background-color: whitesmoke; box-sizing: border-box; color: #767676; font-family: -apple-system, BlinkMacSystemFont, "San Francisco", "Helvetica Neue", Helvetica, Ubuntu, Roboto, Noto, "Segoe UI", Arial, sans-serif; font-size: 13px; text-decoration-skip-ink: auto; transition: color 0.1s ease-in-out 0s, opacity 0.1s ease-in-out 0s; white-space: nowrap;">Unsplash</a></i></div><div><br /></div><div> </div><div><br /></div><div><br /></div><div><br /></div><div><br /><br /></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-25643515609422371912022-08-15T16:45:00.006+01:002022-08-15T18:11:07.262+01:00Why Coinbase's balance sheet has massively inflatedCoinbase recently filed its interim financial report. It makes pretty grim reading. A quarterly net loss of over $1bn, net cash drain of £4.6bn in 6 months, fair value losses of over 600k... To be sure, Coinbase is not on its knees yet. It still has $12bn of its own and customers' cash (both are on its balance sheet), and a whopping asset base. In fact its assets have increased - a lot. As have its liabilities. Coinbase's balance sheet is five times bigger than it was in December 2021. <div><div><br /></div><div>Here's Coinbase's balance sheet, as reported in its <a href="https://investor.coinbase.com/financials/sec-filings/default.aspx">10-Q filing</a>. I've outlined the relevant items in red: </div><div><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuASd17HUI0Vyu_isckVr1T0bAMgDc19ewNIOe-g_HaInNzVqT4Jwfko026GRsYZDco70waQxxCG7k0bTVAZ96EVi15ZZoppDErQku8PB9VdjuWEohH-co1B8AU8BKS3yDLsnnvikCZcJDWnv84De82HqOOYnyaysTtKaj5_lMO-ycCo_xuwQO1SYv/s1144/Coinbase%20balance%20sheet%20Aug%2022.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1144" data-original-width="912" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuASd17HUI0Vyu_isckVr1T0bAMgDc19ewNIOe-g_HaInNzVqT4Jwfko026GRsYZDco70waQxxCG7k0bTVAZ96EVi15ZZoppDErQku8PB9VdjuWEohH-co1B8AU8BKS3yDLsnnvikCZcJDWnv84De82HqOOYnyaysTtKaj5_lMO-ycCo_xuwQO1SYv/w510-h640/Coinbase%20balance%20sheet%20Aug%2022.png" width="510" /></a></div><br /><div><br /></div><div>There's a new asset called "customer crypto assets" worth some $88.45 bn, matched by a new liability called "crypto asset liabilities". This asset and its associated liability are by far the biggest items on Coinbase's balance sheet. Footnotes to the balance sheet describe these new items as "safeguarding assets" and "safeguarding liabilities". </div><div><br /></div><div>A note to the financial statements explains that as of June 2022, Coinbase has taken all customer assets on to its own balance sheet. It was already recording customer cash balances on its balance sheet, but now it is also recording customer crypto holdings. The size of the "safeguarding" liability is far too large for it to represent assets in Coinbase's custody service. It must include assets in ordinary wallets. So Coinbase is no longer simply hosting wallets and providing a platform for peer-to-peer transactions. It is taking custodial responsibility for every customer asset on its platform. <br /><br /></div><div><div class="separator" style="clear: both; text-align: left;">But why this sudden change in the accounting treatment of customer crypto assets? Six months ago, they weren't even on its balance sheet.</div><div class="separator" style="clear: both; text-align: left;"><br />The explanation is in the same note <i>(my emphasis)</i>:</div><div class="separator" style="clear: both; text-align: left;"><br /></div></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div><div class="separator" style="clear: both; text-align: left;">"The Company safeguards crypto assets for customers in digital wallets and portions of cryptographic keys necessary to access crypto assets on the Company’s platform. The Company safeguards these assets and/or keys and is obligated to safeguard them from loss, theft, or other misuse. The Company records Customer crypto assets as well as corresponding Customer crypto liabilities, <b>in accordance with recently adopted guidance, SAB 121</b>." </div></div></blockquote><p>So this is at the behest of the SEC. <a href="https://www.sec.gov/oca/staff-accounting-bulletin-121">SAB 121</a> is a Staff Accounting Bulletin issued in March 2022. It's complex, technical and not easy to read. It's also very wide-ranging and has far-reaching implications not only for crypto exchanges like Coinbase, but for any company providing crypto-related services involving public blockchains. Yet it seems to have passed unnoticed by the crypto and financial press. How it slipped under the radar is a mystery. </p><p>SAB 121 (footnote 3) defines "crypto assets" broadly: </p></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px; text-align: left;">"the term “crypto-asset” refers to a digital asset that is issued and/or transferred using distributed ledger or blockchain technology using cryptographic techniques."</blockquote><div><p>That could mean anything on a blockchain. Crowe LLP's <a href="https://www.crowe.com/insights/sab-121-frequently-asked-questions">handy explainer</a> lists four types of crypto asset it thinks will be affected by this change:</p><li>Crypto assets used as a medium of exchange (for example, bitcoin) </li><li>Stablecoins (for example, a digital asset that is backed 1:1 to the U.S. dollar) </li><li>NFTs;</li><li>Utility tokens </li><br /></div><div>This list is not exhaustive. It would be unwise of a crypto company to think that because some asset doesn't strictly fall into any of the categories above, it wouldn't need to be treated in the same way. <br /></div><div><br /></div><div>What defines whether assets fall under the scope of SAB 121 is not the nature of the assets, but the nature of the relationship with the customer. The SEC says platforms providing transaction services to crypto asset holders are responsible for protecting the platform user’s crypto-assets from loss or theft, and to this end, often maintain the keys needed to access the assets. This creates risks unique to crypto asset transaction services: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEj6urEppl55fhVCy-gaKu82XWJcG5D9kK2noV6-xE-pVP37QObUR5Q-lgVqiss4INWsTGUhBaJZkEEdwAfruMsgNtTKq1TZSM3CfqkjzIe7qQ6Eni6DTBlPkZCpm1sh_ABLjPAlAnCaa2uv9hCIwvrvS93XCbKFRySEHWpP-05fbDZr-F2BPmp48Zlu" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="454" data-original-width="1065" height="272" src="https://blogger.googleusercontent.com/img/a/AVvXsEj6urEppl55fhVCy-gaKu82XWJcG5D9kK2noV6-xE-pVP37QObUR5Q-lgVqiss4INWsTGUhBaJZkEEdwAfruMsgNtTKq1TZSM3CfqkjzIe7qQ6Eni6DTBlPkZCpm1sh_ABLjPAlAnCaa2uv9hCIwvrvS93XCbKFRySEHWpP-05fbDZr-F2BPmp48Zlu=w640-h272" width="640" /></a></div><br /></div>Technological risks include such things as hard forks, hacking, multisig failures, "configuration issues" and bugs in the code. The terms of service of crypto exchanges and platforms nearly always contain a clause saying "we are not liable for any of these", but it seems the SEC disagrees. <br /><br />Legal and regulatory risks arise from the fact that crypto is a relatively new field in which the legal and regulatory frameworks are as yet unclear. The legal risks are particularly interesting in the light of <a href="https://www.bloomberg.com/news/articles/2022-05-11/coinbase-gives-256-billion-reminder-about-agonies-of-bankruptcy?sref=3roVJZZ4">Coinbase's admission</a> that customer cash on its balance sheet might not be bankruptcy remote, and the uncertainty over the status of both cash and crypto assets in certain <a href="https://www.coppolacomment.com/2022/07/the-sinking-of-voyager.html">high-profile crypto platform failures</a>. <br /><br />The SEC, it seems, is not satisfied that keeping customer assets off the platform's own balance sheet and those of its agents necessarily means the assets are either bankruptcy remote or protected from fraud, theft, technological failure or other losses beyond the customer's control. So, in the interests of protecting customers from these risks, it has simply decided to make the platforms and their agents liable for everything. The new accounting guidance says that the companies must carry on their own balance sheets a "safeguarding liability" equal to total customer crypto assets at fair value. So if anything happens to those crypto assets, the company, not the customer, will bear the losses.<div><br />Furthermore, to ensure that customers can always be reimbursed for any losses due to hacking, security failures, bugs, fraud and so forth, the companies must also carry a "safeguarding asset" whose fair value is equal to the fair value of the liability. In effect, the SEC is requiring 100% reserving of customer crypto assets. And to discourage crypto platforms and their agents from leveraging up the safeguarding liability by diversifying the safeguarding asset into a riskier mix of assets, thus putting customers at risk of losses, SAB 121 says that if the fair value of the safeguarding asset falls below the fair value of the liability, the company must take the fair value loss through its own P&L. </div><div><br /></div><div>To show how this works, here's Coinbase's breakdown of its customer crypto assets at fair value as at June 2022: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEj3FVPHn4_tLaxkQX-yROclC_k6463qvgjWUlsJT_bHQmCTSsQYmWhGShaahqAT5_0-9hhC0mWgM6FseX_yIjlD3Y3rPLnQoBUaH737c5_-d5gRTFPNl4e04brIem4dj-j0nTxmcxuwXwf_lVwbz1WzP1iRJ1LwUmOEqGd9TrudiHjjUE5sFViAq3yH" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="167" data-original-width="2181" height="50" src="https://blogger.googleusercontent.com/img/a/AVvXsEj3FVPHn4_tLaxkQX-yROclC_k6463qvgjWUlsJT_bHQmCTSsQYmWhGShaahqAT5_0-9hhC0mWgM6FseX_yIjlD3Y3rPLnQoBUaH737c5_-d5gRTFPNl4e04brIem4dj-j0nTxmcxuwXwf_lVwbz1WzP1iRJ1LwUmOEqGd9TrudiHjjUE5sFViAq3yH=w640-h50" width="640" /></a></div><br />This means that its "safeguarding liability" is made up of 47.2% BTC, 21.2% ETH and 31.6% other coins. To be fully insulated from fair value losses, the "safeguarding asset" must be made up of the exact same proportions of BTC, ETH and other coins. But the "safeguarding asset" is Coinbase's own asset, not a customer asset. So, Coinbase could decide to reduce the proportion of low-yielding BTC and increase the proportion of higher-yielding but riskier coins. In a crypto market crash, the market price of riskier coins would be likely to fall more than the market price of BTC, so the fair value of Coinbase's "safeguarding asset" would fall below that of the "safeguarding liability". Coinbase would have to take that fair value loss directly to its own P&L, rather than dumping it on its customers by haircutting their assets. I hope this makes sense. </div><div><br /></div><div>SAB 121 does not only apply to customer assets formally held by the exchange or platform as custodian. It also applies to assets in "hot" wallets to which the exchange or platform holds the key. That, as the crypto exchange Gemini explains (<i>my emphasis</i>), is pretty much all assets on crypto exchanges:</div><div><br /></div><blockquote style="border: none; margin: 0px 0px 0px 40px; padding: 0px;"><div style="text-align: left;">"If you buy cryptocurrency on a crypto exchange, it is immediately stored in your exchange-hosted wallet <b>where, typically, the exchange controls your private key.</b>"</div></blockquote><div><br /> It will also apply to assets on other crypto platforms.</div><div><br /></div><div>The new accounting guidance takes effect from 15th June 2022. Coinbase therefore reported its end of June half-year results under the new guidance. Other exchanges will follow suit when their accounts fall due, and so too should other crypto platforms that host customer assets to which they control the keys. No doubt some will think up all manner of reasons why they shouldn't have to, and others will simply not bother and hope to get away with it, but we should nevertheless expect to see a swathe of massively inflated balance sheets in the next few months. </div><div><br /></div><div>The accounting itself is simple enough. But the implications for exchanges and platforms are far-reaching. No longer can the costs of hacks, security failures, bugs and exploits, rug pulls, scams and frauds be dumped on customers by means of coercive deposit haircuts and token issuance. Exchanges and platforms will have to hold sufficient crypto assets of the right quality to be able to reimburse customers for any and all losses from events like these. And if there is a shortfall, that must be borne by their owners and shareholders, not by their customers. </div><div><br /></div><div>Of course, it should always have been like this. Crypto exchanges and platforms should never have been allowed to put their customers' assets at risk of losses from safeguarding and security failures. And nor should they have been allowed to operate as unlicensed, unregulated shadow banks, leveraging up their customers' assets while pretending those assets were not at risk. It is a tragedy that the SEC has taken so long to introduce this new guidance. And it is even sadder that it is only guidance. It needs to be much stronger, with strict reporting and control requirements, and severe penalties for infringement. Regulators, it's time to show your teeth. </div><div><br /></div><div><b>Related reading:</b></div><div><b><br /></b></div><div><a href="https://www.coppolacomment.com/2022/07/shipwrecked.html">Shipwrecked</a></div><div><a href="https://www.coppolacomment.com/2022/07/celsiuss-failure-shows-importantce-of.html">Why Celsius Network's depositors won't get their money back</a></div><div><br /></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-39671040093964212192022-08-13T00:57:00.022+01:002022-08-13T11:08:48.964+01:00The ones who stay in Omelas<div><div class="separator" style="clear: both; text-align: center;"><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgp3MQZ8q4dY29j8xEGiAU3r5QFmdkGAFojhIy6tNsvQamHrPIqMaU0Dg0K8wVTNk1MJDHaAPF3duDAsu0QkZpY3FHqXO_EBy2FzK9H5oTlwtd47lYiZIyfXKlz3GL6ZL7JWH9bLhXyucIu7FWEX2vbm-Bd5poRU-57_1LMOVhUtXvvg6x4B9eXsVRU" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="187" data-original-width="270" height="444" src="https://blogger.googleusercontent.com/img/a/AVvXsEgp3MQZ8q4dY29j8xEGiAU3r5QFmdkGAFojhIy6tNsvQamHrPIqMaU0Dg0K8wVTNk1MJDHaAPF3duDAsu0QkZpY3FHqXO_EBy2FzK9H5oTlwtd47lYiZIyfXKlz3GL6ZL7JWH9bLhXyucIu7FWEX2vbm-Bd5poRU-57_1LMOVhUtXvvg6x4B9eXsVRU=w640-h444" width="640" /></a></div><br /><br /></div></div>Ursula Le Guin's short story "<a href="https://learning.hccs.edu/faculty/emily.klotz/engl1302-6/readings/the-ones-who-walk-away-from-omelas-ursula-le-guin/view">The Ones Who Walk Away From Omelas</a>" contains a terrible moral conundrum. Many people have agonised over it: to my knowledge, no-one has solved it. Attempts that I have seen all in some way change the framing of the story, whether by <a href="https://www.lightspeedmagazine.com/fiction/the-ones-who-stay-and-fight/">justifying blood sacrifice</a>, insisting that <a href="https://www.tor.com/2021/11/03/the-ones-who-cant-walk-away-another-perspective-on-omelas/">there must be a better way</a>, or <a href="https://mariaallyn.wordpress.com/2016/09/30/alternate-ending-for-the-ones-who-walk-away-from-omelas/">creating a better alternative</a>. But if you change the framing, you have not solved the problem. You have avoided it.<br /><br />As I read through Le Guin's story to the end, I recognised the moral conundrum. It is similar to the one I posed in <a href="https://www.coppolacomment.com/2016/05/pilates-game.html">this piece</a>. In Le Guin's story, as in mine, the facts don't matter. It is what people believe that matters.<br /><br />In Le Guin's story, millions of people believe their happiness and that of everyone they love - indeed, their very existence - depends on a child being condemned to live in darkness, pain and squalor. They accept that the child's suffering is necessary, so they do nothing about it. Indeed, they contribute to it, for fear that, through a moment's inattentive kindness, they might inadvertently bring about the destruction they fear.<br /><br />I might say, "But the happiness of millions cannot depend totally upon the silent suffering of a single individual shut away from society. This is a myth. Why do you, intelligent people, believe this myth?"<br /><br />But they will not answer. They believe, and that is all there is to be said.<br /><br />I might say, "Our happiness and our pain stem from our relationships with each other. If we feel only happiness, and shut away our pain, our relationships are incomplete: we are only half human". <br /><br />Indeed, the moral dilemma in Le Guin's piece is about whether to silence our consciences and numb our compassion for this child in the name of the "greater good", and in so doing, make ourselves less than human; and if we cannot do this to ourselves, then what?<br /><br />In Le Guin's piece, as in mine, the majority chooses to allow the individual to suffer. Her piece is more problematic than mine: in mine, we know Jesus is blameless, but the crowd believes he is guilty and therefore demands his death. But in hers, the crowd knows the child is blameless, and yet demands that it suffers. In mine, too, Jesus is an adult who has voluntarily chosen the path that will lead to the cross. But Le Guin's child did not choose. It was too young to make such a choice. It was chosen, and condemned.<br /><br />It does not matter whether the myth people have been told - that if the child is rescued, or even treated with momentary kindness, the city will be destroyed - is true. It matters only that the majority believes it is true. Or even, that the majority believes the majority believes it is true.<br /><br />While the majority believes the myth, or believes that it believes the myth, the child cannot be rescued, just as the fact that the crowd believed Jesus should die made it impossible for Pilate to rescue him.<br /><br />So "the ones who walk away from Omelas" make the same choice as Pilate. Just as Pilate wanted to rescue Jesus, they want to rescue the child. But because the majority believes the child must suffer, they cannot rescue the child. They must either accept the horror or leave the game. Pilate washed his hands and let Jesus die. The ones who walk away leave the child to suffer. They have not solved the conundrum, they have avoided it.<br /><br />Where do they go? We do not know. In their own way, they too are scapegoats, sharing the suffering and isolation of the child; Le Guin is at pains to emphasise that they leave alone. They seem to know where they are going, yes, but perhaps that is just "anywhere but Omelas". They are single-minded in their determination to leave that terrible place, but once beyond the bounds of the city, they disappear from our sight. Maybe, like <a href="https://www.oxfordlieder.co.uk/song/1542">Schubert's Wanderer</a>, they wander joylessly through the strange land beyond the city, forever seeking happiness but condemned never to find it: "where you are not, there is happiness."<br /><br />After reading Le Guin's story, I asked myself what I would do. You will probably think me callous, but I quickly realised that there was no way I could rescue the child. I might personally believe the myth is nonsense, but I can't fight the wrong beliefs of millions.<br /><br />But I believe - I BELIEVE - with all my being, that condemning others to pain and misery to ensure our own safety and wellbeing is wrong, and that happiness bought with the suffering of others is grotesque. I cannot blind myself to what I see, nor numb myself to what I feel.<br /><br />So once I had seen the child - once I had been forced against my will to become one of its torturers - I could no longer bear to live in the terrible city that imprisons it. Not because of its suffering, but because of mine. <br /><br />And so, perhaps, I would walk away from Omelas.<br /><br />But I am uneasy. I cannot end the child's suffering by walking away. And I cannot end mine, either. In my mind's eye there will always be the image of that tortured child in its dungeon. So whether I stay or I go, I will forever be entangled in a web of pain and guilt. What benefit would there be in relinquishing the hedonistic pleasures of Omelas for the wilderness beyond its gates? I might find deprivation and isolation more soothing to my guilt-filled conscience than a summer party, but it will not relieve the child's suffering. And when there are no parties to distract me, I would have to face the fact that I, coward that I am, walked away. Death might be preferable to living with such guilt. <div><br /></div><div>Perhaps the ones who walk away are not seeking a brighter future, nor even resigning themselves to eternal joyless wandering. Many authors portray death as a beautiful gateway, and the path to death is always travelled alone. Perhaps the ones who walk away choose to die rather than live vicariously through the suffering of an innocent. They walk purposefully towards annihilation. That's courageous, for sure, but what does it achieve? It does not change the child's situation. Suicide is merely another way of avoiding the problem. </div><div><br /></div><div>Besides, to walk away is to reject the child's gift of happiness. To be sure, the child does not choose to give this gift: but nevertheless, it gives it, at great personal cost. Would it not be a worse insult even than unkindness and maltreatment to walk away from the one good thing that stems from the child's incarceration? Perhaps graciously accepting this gift, horrible though it is, is the best that can be done. The tortured child in its filthy dungeon commands us to be happy, because that is all that gives meaning to its suffering. How could I refuse?</div><div><br /></div><div>The child's unspoken demand that everyone except itself be happy binds everyone who stays in Omelas. Their happiness is not fake, it is a necessary response to the child's suffering. They must either be happy or end the child's suffering, and ending the child's suffering will bring destruction. <br /><br />The child is a kind of god, a peculiar object of worship. Just as other religions require sacrifices to placate the angry, destructive gods, so the religion of Omelas requires everyone to placate the suffering child - the destructive child - by being ostentatiously happy. Everyone makes a pilgrimage to see the child at least once in their lives; seeing it in all its pain and squalor is a rite of passage from childhood to adulthood. And once the initial grief and rage at the child's suffering is past, all negative emotions must be packed away. There is no room for sorrow or anger in Omelas, nor for fear or pain. Only the child has permission to feel these emotions, and these are the only emotions it is allowed to feel. It must never know happiness; but for everyone else, happiness is compulsory. Omelas takes psychological splitting to a new dimension. </div><div><div></div><div><br /></div><div>Nonetheless, since everyone has seen the child at least once, they know it is real. They know the extent of its suffering, and they know they can do nothing to relieve it. Though they sublimate their horror at this awful truth by making beautiful things, throwing big parties and being kind to their children, still the brutal contrast between their prosperous lives and the child's misery remains ever-present in their minds.This is not happiness, it is mental torture. <br /><br />It is perhaps not surprising, therefore, that Le Guin advances as justification for Omelans' refusal to relieve the child's torment that they perceive it as "less than human", a disgusting thing, filthy, fearful even of inanimate objects, unable to speak coherently. There is no point in caring about it; the child has been incarcerated so long that releasing it would bring it little benefit. And anyway, why would you destroy the happiness - even the lives - of millions of real humans to rescue a tortured subhuman?*</div></div><div><br /></div><div>But I return to the question I asked earlier. Le Guin insists that these are intelligent people: and yet they believe a myth. Why, intelligent people, do you believe this myth? Why doesn't anyone, ever, test whether it is true? It would be easy enough to do. Yet not one of you dares even speak one kind word to a tormented child. It is as if you are under a spell. <br /><br />Or perhaps a curse. Curses typically involve some kind of taboo: doing this thing will instantly bring destruction. "The curse is come upon me!" cries the Lady of Shalott as she breaks the taboo that forces her to see the world only in a mirror. Dying, she leaves her tower, finds a boat and lets the river carry her to Camelot. The sight of her dead body floating through Camelot brings the Round Table's summer party to an abrupt end.</div><div><br /></div><div>Le Guin frames her conundrum as a curse of the Lady of Shalott variety. If anyone does the forbidden thing, retribution will be instant and total. The summer party will come to an abrupt - and permanent - end. Privately, perhaps, many Omelans doubt that the curse is real; but even those who doubt won't dare do the forbidden thing, because if they are wrong, the consequences will be terrible. </div><div><br />It is of the nature of curses that they bind not only the intended victim, but all participants. In Sleeping Beauty, when the princess does the forbidden thing, thus bringing the curse upon herself, everyone in the palace falls asleep for 100 years. In Beauty and the Beast, the curse that creates the Beast also transforms his servants into household objects. And for Omelas, the curse that says the child must suffer forces everyone else to ignore its suffering at the cost of their own humanity. Not only the child, but all the ones who stay in Omelas, are emotionally stunted. <br /><br />The truth is, there is no escape from Omelas. Everyone - the suffering child, the ones who stay, and the ones who walk away - is bound by the curse. The ones who walk away reject the religion of Omelas, the rites and rituals that substitute for compassion. But they still believe the myth. And so they dare not do the forbidden thing. They dare not show compassion to the child. So although they walk away, in their minds they are still in Omelas. </div><div><br /></div><div>And I - perhaps I too would stay in Omelas. For although the compassion I feel for that poor child drives me to want to hold it, soothe it, comfort it, I must also feel compassion for the millions who might suffer and die if I did that. I don't know if I possess the moral courage to say to the people of Omelas, "Your myth is nonsense and your behaviour is monstrous," and reach out to the child, daring the curse to unleash its destruction. Coward that I am, I fear that that like everyone else, one way or another, I would walk away and leave the child to its suffering. <br /><br />I am ashamed.<br /> <br /><br /></div><div><b>Related reading:</b></div><div><br /></div><div><a href="https://poets.org/poem/lady-shalott">The Lady of Shalott</a> - Alfred Lord Tennyson</div><div><br /></div><div><a href="https://www.onbeyondzarathustra.com/traintoomelas">The ones who take the train to Omelas</a> - John Holbo</div><div><br /></div><div>And for those who didn't get what this epistle is really about:</div><div><br /></div><div><a href="https://ecfr.eu/article/shadow-of-the-bomb-russias-nuclear-threats/">Shadow of the bomb: Russia's nuclear threats</a> - ECFR</div><div><a href="https://www.cfr.org/backgrounder/yemen-crisis">Yemen's tragedy: War, Stalemate and Suffering</a> - CFR</div><div><br /></div><div>* I am very aware that this "othering" is all too often used in our own society to justify outright cruelty towards marginalised people. I'm sure it was not lost on Le Guin, either. </div><div><br /></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-73075922525594019602022-07-28T19:44:00.123+01:002022-07-28T20:49:24.021+01:00Where has all the money gone?<p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhPYCI_EQNAt7gnH-IrlloTCA308Ky6s3SFlQHAauIodN5IpmY78ZbmXzyqJZ3NAkIPb1_Q54_Rw3vT9jRZ5UsNz9wHHwAQAvcfd20Jr0PdjC8rX7a77lwnHeFvyhKcXrDK1QFcHVuYWNSkRQDrhgnpS5-Pyf3MDlOmvLNPOYtQGMUGKASH0h9gR4X4" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1600" data-original-width="2560" height="400" src="https://blogger.googleusercontent.com/img/a/AVvXsEhPYCI_EQNAt7gnH-IrlloTCA308Ky6s3SFlQHAauIodN5IpmY78ZbmXzyqJZ3NAkIPb1_Q54_Rw3vT9jRZ5UsNz9wHHwAQAvcfd20Jr0PdjC8rX7a77lwnHeFvyhKcXrDK1QFcHVuYWNSkRQDrhgnpS5-Pyf3MDlOmvLNPOYtQGMUGKASH0h9gR4X4=w640-h400" width="640" /></a></div><br /><br />The collapse of Terra in May sent shock waves round the crypto world, triggering domino-like collapses of crypto companies. One of those companies was the investment fund Three Arrows Capital. At the time, everyone thought 3AC was a conservatively-managed investment company that was simply the unfortunate victim of an unforeseen event. If anyone was to blame for 3AC's collapse, it was Do Kwon. <p></p><p>How wrong they were. Since 3AC was ordered into liquidation by a British Virgin Islands court, more and more creditors have emerged from the woodwork claiming they are owed money. The liquidators have filed emergency motions to freeze 3AC's assets because there is evidence that funds are being moved out of reach. And 3AC's co-founders, Su Zhu and Kyle Davies, have done a runner, though Bloomberg says they are planning to set up shop in Dubai. </p><p>The liquidators applied to the Singapore High Court to have the BVI liquidation order recognised in Singapore. This would give them access to 3AC's premises and documents and allow them to subpoena key individuals to obtain information. In support of their application, they helpfully provided 1157 pages of evidence. Pity the poor judge having to plough through that!</p><p>I have ploughed through it. It's actually a bundle of documentation. Or, rather, a bundle of bundles. And it paints a revealing picture of the true state of 3AC. This was anything but a conservatively-managed investment company. It was so highly leveraged that it could not absorb the fall in crypto prices since last November. Even before Terra's collapse, it was concealing its true indebtedness from its creditors. And after Luna blew a massive hole in its balance sheet, it robbed Peter to pay Paul, lied to its customers and ghosted the creditors on whose loans it was defaulting. <br /><br />The document bundle contains copies of 3AC's loan agreements, together with copies of the letters and emails that its creditors sent it when it defaulted on their margin calls and repayment demands. There are an awful lot of loan agreements, and many of the loans are for very large sums. </p><p>Bizarrely, among the lenders are the co-founders. Su Zhu claims to have lent the company some $5M, and Kyle Davies's partner Kelly Chen says she lent it about $65m. Su Zhu is a shareholder of both Three Arrows Capital Pte Ltd (Singapore) and Three AC Ltd (BVI), and Kelly Chen is a shareholder of Three AC Ltd (BVI): </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqLdHs3DIra-uRt3mTK1EXSN3RM2da2cV3Vf9_lnqi_oGVi8TRjBlLsWI3VOd88wr343v2YXJMJYZYIZcgJ7_6ivwKNRN8bobr9i_dHTXtQReNM3vRAuRcfdaw9F8zG1XHx_WPGNGlOjZM93JkIcliQqPhdRs5O_nl3eKdUpBu5HrNUw62VNq4UIcu/s1280/3AC%20org%20chart.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="670" data-original-width="1280" height="336" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhqLdHs3DIra-uRt3mTK1EXSN3RM2da2cV3Vf9_lnqi_oGVi8TRjBlLsWI3VOd88wr343v2YXJMJYZYIZcgJ7_6ivwKNRN8bobr9i_dHTXtQReNM3vRAuRcfdaw9F8zG1XHx_WPGNGlOjZM93JkIcliQqPhdRs5O_nl3eKdUpBu5HrNUw62VNq4UIcu/w640-h336/3AC%20org%20chart.png" width="640" /></a></div><p>Loans from shareholders are usually subordinated, but this pair don't seem to think normal financial good practice applies to them. They've listed themselves as senior unsecured creditors and are presumably expecting to claim a share of the remaining assets. </p><p>The most recent accounts are filed with the company's insolvency application. They are made up to December 2020, so are over 18 months old. As they reveal that 3AC's high leverage is of long standing. Here's the balance sheet: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjG4lMZ9gqjVHSh9aDa2VgSeDlEUxB7SeNdB8wTY7ahRjBZqtjRs1IORvqToq9up9SolGEzZntWdliVWV72jncyuB9e4F2tWn_6r3uif-ZLTjyFR3nkNgDiHQVy2MWL_mIIdkXJ_nuCAWOcRtGTs9kiHKaKFBQ6PNfIM1X9fk6Vp7ax-Xm_NBObh9ik" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1287" data-original-width="1794" height="461" src="https://blogger.googleusercontent.com/img/a/AVvXsEjG4lMZ9gqjVHSh9aDa2VgSeDlEUxB7SeNdB8wTY7ahRjBZqtjRs1IORvqToq9up9SolGEzZntWdliVWV72jncyuB9e4F2tWn_6r3uif-ZLTjyFR3nkNgDiHQVy2MWL_mIIdkXJ_nuCAWOcRtGTs9kiHKaKFBQ6PNfIM1X9fk6Vp7ax-Xm_NBObh9ik=w640-h461" width="640" /></a></div><p></p><p>This is by any standards highly leveraged. And the assets are held at fair value, so are exposed to fluctuations in market price. This would probably be ok if the assets were stable and low risk, but the majority are digital assets so are by definition volatile. 3AC was terribly exposed to adverse movements in crypto markets. Its entire balance sheet is a massive unhedged bet that crypto prices will always go up. <br /><br />The cash flow strain is evident too: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEj_RzzXTDX2wufmL0MLJFLlrLjZ7neWzmXHAZ8bkhakAi-zM79TS9hAo3BuBV9yxZ6bz7MbRKw6HhufZq-RC2wOp5HMe0AwWrtGFR0SpCcbt1M5ejuigLMy3lUc-rvlCnSTl4oAnOX2RksKH29Xynw7Lz1K21XMpET658YC83p4ABbmPWT_CkkKHbEi" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1078" data-original-width="1693" height="408" src="https://blogger.googleusercontent.com/img/a/AVvXsEj_RzzXTDX2wufmL0MLJFLlrLjZ7neWzmXHAZ8bkhakAi-zM79TS9hAo3BuBV9yxZ6bz7MbRKw6HhufZq-RC2wOp5HMe0AwWrtGFR0SpCcbt1M5ejuigLMy3lUc-rvlCnSTl4oAnOX2RksKH29Xynw7Lz1K21XMpET658YC83p4ABbmPWT_CkkKHbEi=w640-h408" width="640" /></a></div><br />The overall picture that emerges from this, together with the extraordinary series of loan agreements in the bundles, is of a company that was massively over-leveraged and had for some time been experiencing cash flow strain. It borrowed heavily to ride the wave of crypto appreciation during the pandemic. "The money will never run out" was its philosophy. But when the market turned and crypto prices started to fall, it had to borrow even more to maintain its collateral and meet its obligations. <p></p><p>Hyman Minsky called borrowing to obtain cash to meet existing obligations "Ponzi borrowing", because it depends on there being a constant supply of new lenders. This is ultimately unsustainable, of course, but it can be maintained for quite a while if the lenders don't know what is going on and there are no shocks to the system. And indeed, 3AC managed to conceal the scale of its indebtedness from lenders, customers and markets alike. But as the crypto winter deepened, it found it harder and harder to raise funds. Lenders demanded more collateral than it could afford to provide and better information than it wanted to give. One lender pulled out of a loan deal when 3AC refused to provide a balance sheet. </p><p>Terra's collapse in May 2022 was the last straw. Or perhaps the last thread. When it unravelled, so did 3AC's pile of ponzi loans. As crypto prices crashed, lender after lender demanded more collateral. But massively over-leveraged as it was, 3AC had no means of making these payments and no hope of borrowing the funds. So it defaulted on the margin calls. Rumours spread that it had a "liquidity crisis": but as is so often the case, the liquidity crisis turned out to be deep and long-standing insolvency. 3AC didn't fail because of Terra, it failed because of its insanely risky balance sheet and desperate lack of cash. </p><p>Defaulting on the margin calls made its financial situation infinitely worse. When a borrower fails to meet a margin call, the whole loan instantly becomes repayable. So 3AC was now faced with a massive steaming pile of demands for immediate loan repayment that it could not possibly meet. </p><p>What did it do? Nothing. Rather than admitting that it was insolvent and filing for bankruptcy, the co-founders ghosted their lenders. The bundle reveals that they didn't answer emails and didn't open letters. They ignored Whatsapp chats, text messages and contacts via other apps. And the phone went unanswered. <br /><br />On 24th June, DRB Panama ('Deribit') applied to the High Court of the BVI to place 3AC into liquidation. <a href="https://www.docdroid.net/xKIqrjq/20220709-3ac-bvi-liquidation-recognition-1st-affidavit-of-russell-crumpler-filed-pdf#page=1037">Deribit's filing</a> shows that 3AC had failed to meet margin calls and its collateral balance was far less than that required to repay the loan. As at 20th June, 3AC owed it over $80m. <br /><br />It's evident from Deribit's filing that it had no idea of the true scale of 3AC's indebtedness. It knew about Voyager's loan and "monies owing to cryptocurrency platforms such as BlockFi and 8 Blocks Capital". But there's no mention of the rest of the lenders. In particular, there is no mention of Genesis Global Trading, by far 3AC's biggest creditor. It seems 3AC's game of blind man's buff with its creditors was all too successful. </p><p>Deribit complained that 3AC was ghosting it. And it expressed concern that the company appeared to be selling crypto to pay off other loans, transferring crypto to unknown addresses, and continuing to trade crypto. One transfer it identified, for $31.6m, was to a Cayman Islands company controlled by Su Zhu and Kelly Chen, though the funds were subsequently moved out of that company and Deribit was unable to find where they had gone. </p><p>On 27th June Voyager Digital, which had lent over a quarter of its entire asset base to 3AC, <a href="https://cointelegraph.com/news/voyager-digital-issues-notice-of-default-to-three-arrows-capital">filed a notice of default</a>. As a direct consequence of 3AC's default, Voyager itself filed for Chapter 11 bankruptcy just over a week later. </p><p>Also on 27th June, 3AC applied to the High Court of the BVI to place itself into liquidation, saying that because of cryptocurrency price fluctuations it was in default of its loan obligations and had received notices of default from a number of (unspecified) lenders, and had received a statutory demand for $10m from Bitget Singapore Pte Ltd. which it was unable to meet. But an affidavit filed by Kyle Davies revealed the true scale of its indebtedness. It said the company had 32 lenders, for whom the loan repayments outstanding totalled US$2.622bn, BTC 2,285.283 (worth approx US$ 46m at the time of filing) and ETH 17,231.77 (about $20.5m at the time of filing). Of this, approximately $2.3bn was owed to Genesis Global Trading. There was unpaid interest on these borrowings too. <br /><br />The amount owing was partly offset by liquidated collateral of various kinds, including cash, BTC, ETH and, for Genesis Global Trading, shares in Grayscale Bitcoin and Ethereum Trusts. However, much of the borrowing was unsecured, and for the rest, the collateral was clearly insufficient. So it would appear that at the time that it went into liquidation, 3AC admitted to debts of over $2bn. Its real indebtedness was even higher.</p><p>Regulators come in for a lot of criticism, but where 3AC was concerned, one regulator appears to have been very much on the ball. On 30th June, the formidable Monetary Authority of Singapore (MAS) reprimanded 3AC for providing false information and exceeding its S$250m assets under management threshold. 3AC had transferred its investment management to the British Virgin Islands in 2021, but as far as MAS was concerned it was still under Singapore jurisdiction, because the Singapore-based 3AC and its BVI investment manager shared a director (Su Zhu). <br /><br />The alleged breaches of the regulations had occurred in 2020 and 2021. But at the end of the reprimand, MAS added that "in light of recent developments that call into question the solvency of the fund managed by 3AC", it was investigating whether there had been further breaches of its regulations.<br /><br />The co-founders knew the game was up. MAS was on to them. There was nothing more they could do but flee. And that's exactly what they did. On 1st July, 3AC filed for U.S. Chapter 15 bankruptcy protection. In an affidavit signed that day, the BVI liquidator Russell Crumpler observed that the co-founders appeared to be no longer in Singapore. <br /></p><p>But although they were no longer in Singapore, the co-founders still had control of the funds. And Deribit's concerns proved well-founded. After declaring itself bankrupt, 3AC moved stablecoins and NFTs to unknown wallets via the KuCoin exchange. Blockchains reveal the address to which an asset has been moved, but they don't tell you who owns that address. Exchanges often do know who owns hot wallets, but KuCoin did not know these ones. And the trail can literally go cold if the assets are sent to an offline wallet. These assets may never be recovered. </p><p>To prevent 3AC's remaining assets being squirrelled away, the BVI liquidators appealed to courts in the U.S. and Singapore to freeze them with immediate effect, <a href="https://fingfx.thomsonreuters.com/gfx/legaldocs/myvmnlnldpr/three%20arrows%20motion%20for%20emergency%20hearing.pdf">telling a New York Court that</a> "there is an actual and imminent risk that the Debtor’s assets may be transferred or otherwise disposed of by parties other than the court-appointed Foreign Representatives to the detriment of the Debtor, its creditors, and all other interested parties." 3AC's assets are now frozen in both the U.S. and Singapore.<br /><br />But it may be too late. Over two weeks elapsed between 3AC being ordered into liquidation by a BVI court and its assets being frozen. And 3AC's co-founders have not exactly been cooperative. At the time of the U.S. emergency motion, their whereabouts was unknown, though <a href="https://www.bloomberg.com/news/articles/2022-07-22/three-arrows-founders-en-route-to-dubai-describe-ltcm-moment?sref=3roVJZZ4">Bloomberg now reports</a> that they are planning to relocate to Dubai. <a href="https://www.docdroid.net/xKIqrjq/20220709-3ac-bvi-liquidation-recognition-1st-affidavit-of-russell-crumpler-filed-pdf#page=1135">Emails attached to the Singapore petition</a> show that they ghosted the liquidators, just as they had the lenders. It's not difficult to imagine what they were doing while the liquidators were trying to contact them. </p><p>I suspect that whatever assets 3AC still possesses are long gone. Where they have gone is a matter of conjecture. But there are plenty of countries in the world that will provide a safe haven for stolen assets and people on the run from U.S. authorities. A finer example of shutting the stable door after the horse has bolted is hard to imagine. </p><p>And this, I'm afraid, means that unsecured creditors are unlikely to get much of their money back.There is a massive and widening gap between the amount liquidators can recover and the amount 3AC is known to owe. A <a href="https://amyhcastor.files.wordpress.com/2022/07/37.pdf">recent short affidavit</a> from Russell Crumpler says that so far, $40m has been recovered. But known unsecured claims against 3AC's assets already total $2.8bn and Crumpler says he expects this figure to rise considerably. </p><p>The creditors have now formed a Committee to help the liquidators decide how to apportion the tiny pile of recoverable assets - or, if you prefer, to help them decide who should lose what. The Committee is made up of 3AC's largest creditors: Voyager Digital LLC (which is itself in Chapter 11 insolvency), Digital Currency Group Inc., Coinlist Lend LLC, Blockchain Access UK Ltd, and Matrix Port Technology (Hong Kong) Ltd. </p><p>Creditor committees (or Ad Hoc Groups, as they are often known) are a familiar sight in corporate insolvencies and sovereign defaults (for example, <a href="https://www.reuters.com/article/us-argentina-debt-idUSKCN0W2249">Argentina's holdouts</a>, and <a href="https://www.forbes.com/sites/francescoppola/2016/07/15/an-international-legal-battle-is-brewing-over-perus-land-reform-bonds/?sh=7369932e5509">Peru's Land Bonds holders</a>). They serve a useful purpose, esepcially when there are disputes about the best way of resolving a failed institution and distributing its assets fairly. An Ad Hoc Group of creditors <a href="https://www.financierworldwide.com/the-austrian-heta-saga-successful-investor-appeasement-at-last#.YtplG3bMLD4">successfully challenged</a> the Austrian government's proposals to resolve the bankrupt Hypo-Alpe-Adria Bank (HETA), <a href="https://www.fma.gv.at/en/heta-successfully-concludes-orderly-resolution-86-of-eligible-claims-have-been-satisfied-rather-than-35-under-insolvency/">eventually achieving</a> 86.32% recovery. <br /><br />In this case, a creditor committee is needed to force creditors to cooperate with each other. When a company is being liquidated and its remaining assets distributed to its creditors, claims ranked equal in seniority ("pari passu") must be treated equally. But several creditors, most notably Blockchain Access (now a committee member), publicly complained that 3AC was doing deals with other creditors while refusing even to talk to them, effectively subordinating their own claims. </p><p>The creditor committee can be relied upon to ensure that large creditors are treated equitably. But I'm not so sure it will necessarily act in the best interests of smaller ones. The crypto world has a tendency to decide that established rules and practices in traditional finance, such as creditor ranking and "pari passu", don't apply to them. So it's not difficult to imagine that the large creditors that make up this committee might try to cook up a deal that effectively subordinates smaller ones. It is to be hoped that the liquidators will prevent this from happening.</p><p>It is also to be hoped that liquidators will be able to argue that the assets of the co-founders (and in Kyle Davies's case, those of his partner) should be up for grabs. 3AC's organisation chart shows that the co-founders effectively controlled all the company's assets, including customer assets that were supposedly "under management". And documentation in the Singapore bundle reveals that they bought themselves valuable properties and made a down payment on a yacht. All of these assets arguably belong to their creditors. I also think that since Su Zhu and Kelly Chen are controlling shareholders, the courts might look sympathetically on an argument that their claims as creditors should be subordinated to those of other unsecured creditors. And they, along with Kyle Davies and possibly some of 3AC's senior management, may also face legal action for fraud. </p><p>But if the company's remaining assets and those of its co-founders have gone to safe havens beyond the reach of liquidators, and the co-founders have fled to a country with no extradition treaties, then creditors will receive little or nothing and legal action will be toothless. And since the failure of companies like Voyager and Celsius was at least partly caused by 3AC's collapse, it is their retail customers who will ultimately pay for Su Zhu and Kyle Davies's recklessness and extravagance. <br /><br /><b>Related reading:<br /></b></p><p><a href="https://www.coppolacomment.com/2022/07/the-sinking-of-voyager.html">The sinking of Voyager</a></p><p><a href="https://www.coppolacomment.com/2022/07/shipwrecked.html">Shipwrecked</a></p><p><a href="https://the-blindspot.com/putting-the-terra-stablecoin-debacle-into-tradfi-context/">Putting the Terra stablecoin debacle into Tradfi context</a> - The Blind Spot</p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com2tag:blogger.com,1999:blog-8764541874043694159.post-5648954222359461242022-07-14T13:36:00.015+01:002022-07-16T08:24:09.934+01:00Why Celsius Network's depositors won't get their money back<p><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitBoXl4dQxWrlFgddx9q6WluU75rrw71jK2WQkM_G_l8ix2-crwF84lCSipzn6eTIJB2vwLNncJNPdvtaYGNVSLzaxtwl0dqPbTgoU9r4Wc8FlPK24MpXV3Lnv_novdLJhuLbH8MsNeuz1Xy3NLxywCuJlQHMsJysFwtEjlb0F8-TlmZYulE8s_g4d/s2288/the-small-print-1531191.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1712" data-original-width="2288" height="478" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitBoXl4dQxWrlFgddx9q6WluU75rrw71jK2WQkM_G_l8ix2-crwF84lCSipzn6eTIJB2vwLNncJNPdvtaYGNVSLzaxtwl0dqPbTgoU9r4Wc8FlPK24MpXV3Lnv_novdLJhuLbH8MsNeuz1Xy3NLxywCuJlQHMsJysFwtEjlb0F8-TlmZYulE8s_g4d/w640-h478/the-small-print-1531191.jpg" width="640" /></a></div><p><br /></p><p>The crypto lender Celsius has filed for Chapter 11 bankruptcy. This should come as a surprise to absolutely no-one, though the grief and pain on Twitter and Reddit suggests that quite a few "Celsians" didn't want to believe what was staring them in the face. Celsius suspended withdrawals nearly a month ago. So far, every crypto lender that has suspended withdrawals has turned out to be insolvent. There was no reason to suppose that Celsius would be different. </p><p>Celsius's <a href="https://cases.stretto.com/public/x193/11753/PLEADINGS/1175307062280000000036.pdf">bankruptcy filing</a> says the company has assets of $1 - 10 bn and a similar quantity of liabilities: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEglTb4G1iiHQdNhtMwzd3WO0ZPHHQ1eJMlp__Jn4jaqDiymOZcdkdfLfdKTbB8vLF8sRzMRZjaO2u9fFttBm3K6xIfMMoZQr4mfD_yK67S4uWa60gg5NPINlh1jPVLvgnEm2PtoI2it5K_J2FdVp8Kxx0NIj0ZBj13SUuZlYs3pkzSHQfEkky6VWAaQ" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="392" data-original-width="1526" height="164" src="https://blogger.googleusercontent.com/img/a/AVvXsEglTb4G1iiHQdNhtMwzd3WO0ZPHHQ1eJMlp__Jn4jaqDiymOZcdkdfLfdKTbB8vLF8sRzMRZjaO2u9fFttBm3K6xIfMMoZQr4mfD_yK67S4uWa60gg5NPINlh1jPVLvgnEm2PtoI2it5K_J2FdVp8Kxx0NIj0ZBj13SUuZlYs3pkzSHQfEkky6VWAaQ=w640-h164" width="640" /></a></div><br />This doesn't tell us much about the extent of the company's insolvency. But rumours have been circulating of a $2bn hole in its balance sheet. In May, <a href="https://www.coindesk.com/business/2022/06/16/how-crypto-lender-celsius-overheated/">according to Coindesk</a>, the company said it had $12bn of what Celsius calls "customer assets" and Coindesk calls "assets under management", and $8bn lent out to clients. So "assets under management" seem to have fallen by $2bn. Could this be the missing $2bn?<p></p><p>No, it couldn't. It's the wrong side of the balance sheet. What Celsius calls "customer assets" are its own liabilities. And here I must take issue with the wholly wrong and downright misleading terminology used both by Celsius itself and by journalists, including <a href="https://www.ft.com/content/4fa06516-119b-4722-946b-944e38b02f45">Financial Times journalists</a> who really should know better. </p><p>Celsius is not an asset manager, it's a shadow bank. And deposits in banks aren't even "customer assets", let alone "assets under management". They are unsecured loans to the bank. They are thus liabilities of the bank and fully at risk in bankruptcy. </p><p>Depositors in a bank do not have any legal right to return of their funds. Even if the terms of the account say funds can be withdrawn whenever the customer chooses, the bank can refuse to allow customers to withdraw their funds if it doesn't have the cash to pay them. Closing the doors <a href="https://www.coppolacomment.com/2013/07/anatomy-of-bank-run.html">is the traditional way of stopping a bank run</a>. Celsius, like other crypto lenders that have suffered bank runs since Three Arrows Capital collapsed, closed its doors to stop customers withdrawing their funds. If it hadn't, it would have run out of money. <br /><br />Furthermore, if the bank goes bankrupt depositors are only entitled to a share of the residual assets after all secured and senior claims (such as unpaid taxes and loans from central banks) have been met. This is why licensed banks have deposit insurance. And this is also why, in 2008, government chose to recapitalize banks, including unlicensed shadow banks. If they hadn't, millions of depositors would have lost some or all of their money. </p><p>Celsius's <a href="https://celsius.network/terms-of-use">terms of use</a> make it completely clear that customers who deposit funds in Celsius's interest-bearing accounts are lending their funds to Celsius to do with as it pleases. And it specifically says that in the event of bankruptcy, customers might not get all - or indeed any - of their money back. </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEiZ0zFpj1Nekt9FtaGpPFheb_A0RMDUwMZRkIegJn8mAaZ_As0QnxspA2i1DSX4yaGtp0Fyg9DE_86vxPEiFwVqfqZ9VI9SWD8_WhVMB4zE9u5xY7xwsjA56zGKgYBmD8mfYTwD57qUjj4ERU1j2LUVjzlxE3HOfGK1wk_bxjvzS8sztrn4oZ5Z4yFX" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1309" data-original-width="2057" height="408" src="https://blogger.googleusercontent.com/img/a/AVvXsEiZ0zFpj1Nekt9FtaGpPFheb_A0RMDUwMZRkIegJn8mAaZ_As0QnxspA2i1DSX4yaGtp0Fyg9DE_86vxPEiFwVqfqZ9VI9SWD8_WhVMB4zE9u5xY7xwsjA56zGKgYBmD8mfYTwD57qUjj4ERU1j2LUVjzlxE3HOfGK1wk_bxjvzS8sztrn4oZ5Z4yFX=w640-h408" width="640" /></a></div><br />You'd think that in the crypto Wild West of all places, where "caveat emptor" rules and fools deserve to lose their shirts, people would read the small print, wouldn't you?<p></p><p>Not only are customer deposits fully at risk in bankruptcy, collateral pledged against borrowing from Celsius is too. The above excerpt from Celsius's terms of use says that title to the collateral passes to Celsius. So you haven't pledged collateral to Celsius, you've sold it a bunch of crypto. Celsius is fully entitled to lend out the crypto you have sold to it. If it does, and it is unable to recover it, then you won't be able to repurchase your crypto. Anecdotally, I have heard of several instances of people being unable to recover their crypto even when they have repaid the loan. But again, they should have read the small print. They no more have the right to return of their collateral than depositors do to return of their funds. <br /><br />The only users of the Celsius platform who - in theory - have the right to return of their money are holders of "custody accounts". Celsius introduced these in April 2022 because several U.S. states had hit it with cease & desist orders for marketing unregistered securities. These custody accounts are only available to U.S. residents. All other deposits automatically go into interest-bearing accounts. </p><p>The terms of use reassuringly say that title to funds in custody accounts remains with the customer. But that doesn't mean your funds are safe, nor that you will necessarily be able to withdraw them. Celsius controls the keys for these accounts, and it can suspend withdrawals from these accounts. Furthermore, funds in these accounts are not bankruptcy remote:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEithW_75R8HuS62q-cHACcIf2Ng6lIG_xNy60ULd-oKVEmvRLf0SBbjKZs7szVwVGLtF0tPKcNRxZTBcTO1z4Z8CPkLNgngIgHzgNRiNFxhRBD2z8Nh_jDGX1wowBWgOZG6m4cJANwX8JKIr5rgjSXGmQakhAkDaF12ma8Wb6wervd9IBykUlHdYYVK" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="819" data-original-width="2014" height="260" src="https://blogger.googleusercontent.com/img/a/AVvXsEithW_75R8HuS62q-cHACcIf2Ng6lIG_xNy60ULd-oKVEmvRLf0SBbjKZs7szVwVGLtF0tPKcNRxZTBcTO1z4Z8CPkLNgngIgHzgNRiNFxhRBD2z8Nh_jDGX1wowBWgOZG6m4cJANwX8JKIr5rgjSXGmQakhAkDaF12ma8Wb6wervd9IBykUlHdYYVK=w640-h260" width="640" /></a></div><br />This could be called "Custody In Name Only". Custody accounts are merely a legal device to avoid Celsius having to register its products as securities. Unlike Voyager, Celsius seems to have made no attempt to segregate these funds or give holders of these accounts seniority over other unsecured creditors. And it explicitly says it is not a fiduciary: <p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjeOaPUedddHiiqYW5RmTneto2RUQ3nLvPZ0ul6W_vxfq4o4ticZocWyFbFQOUcV7rwf5ZZ-hQHjkFJk21ZeL8ETSFckUUXCfQlT5uJrighfKyolBkzs0fLGd7t1MVB_VXBngR60KlmTgYjtE0WOZslwuW-ELprFztukKhpYegW25aG49bYohRrdFcI" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="459" data-original-width="2064" height="142" src="https://blogger.googleusercontent.com/img/a/AVvXsEjeOaPUedddHiiqYW5RmTneto2RUQ3nLvPZ0ul6W_vxfq4o4ticZocWyFbFQOUcV7rwf5ZZ-hQHjkFJk21ZeL8ETSFckUUXCfQlT5uJrighfKyolBkzs0fLGd7t1MVB_VXBngR60KlmTgYjtE0WOZslwuW-ELprFztukKhpYegW25aG49bYohRrdFcI=w640-h142" width="640" /></a></div><p></p><p>I wouldn't like to assume that people with funds in these "Custody In Name Only" accounts will get their money back. </p><p>Celsius's insolvency is almost certainly a problem of high indebtedness and falling asset prices. When asset prices fall rapidly, as they have been doing in the crypto world recently, a highly leveraged bank's asset value can quickly fall below the value of its liabilities. The $2bn "hole" is Celsius's negative equity. </p><p>Furthermore, lending in the crypto world relies on overcollateralization. Lenders demand collateral top-ups (margin calls) to maintain collateral ratios, and will foreclose loans and liquidate collateral if collateralization ratios fall too low. In DeFi, this process is often automated. </p><p>This has happened to Celsius. In 2021, Celsius took out a $1bn USDT loan from Tether, which was 130% overcollateralized with BTC. As BTC's price fell, Tether repeatedly demanded that Celsius post more BTC collateral to maintain the 130% overcollateralization ratio. It seems that Celsius didn't manage to do this, since Tether has now <a href="https://tether.to/en/tether-discloses-celsius-loan-liquidation-process/">liquidated the collateral and cancelled the loan</a>. </p><p>Celsius has also paid off loans from DeFi lenders, probably to prevent its collateral being liquidated. And I'm sorry, Celsians, but Celsius almost certainly used your deposits to repay these debts. After all, it's not your money. It belongs to Celsius. You agreed that it did. Why wouldn't it use its own money to repay its debts?</p><p>It will be some time before we know how much, if any, money there will be to distribute to depositors. There are no current accounts for Celsius - the most recent accounts filed <a href="https://find-and-update.company-information.service.gov.uk/company/11198050/filing-history">date from February 2020</a> - and Celsius appears to have removed from its website anything that might indicate its current financial position. It is astonishingly opaque, far more so than any bank, or indeed any publicly traded financial institution. You'd think, wouldn't you, that people in the crypto Wild West would want more transparency from crypto companies, not less?</p><p>Celsius marketed itself as "safer than banks". But in reality, it was the opposite. It didn't have deposit insurance, didn't have any of the capital or liquidity buffers that banks are required to hold, had little or no cash reserves backing its deposits, made highly risky loans, participated in complex and opaque investment schemes, and lent out collateral pledged against borrowing. It behaved like the worst of the shadow banks that brought the financial system to its knees in 2008. Why, I want to know, is the crypto world hell-bent on re-enacting historical financial disasters in a new and even more dangerous form? </p><p>Inevitably, there are calls for tougher regulation of crypto shadow banks like Celsius. To some extent, I agree. At the very least, misleading marketing should be stamped on: no way was Celsius ever a safer alternative to a traditional bank. And crypto lenders should be held to the same standards of disclosure as other financial institutions. It should not be possible for a crypto lender to produce no accounts for over two years and scrub all mention of its current financial position from its website. <br /><br />But there were warning signs all over Celsius. The risk to depositors and borrowers was clear from the terms of use documentation. And many people (<a href="https://twitter.com/Frances_Coppola/status/1379794993209036802?s=20&t=JQXSVTajSHY7mL7BOA4dqw">including me</a>) pointed out the ponzi-like nature of its business model. I am sad for those people who foolishly put their life savings into Celsius and other failed lenders. And if there has been actual fraud, then those responsible should be brought to justice. But people who don't read the small print or take any notice of red flags really shouldn't be surprised if they are swept away in the tide of bankruptcy.</p><p><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2022/07/the-sinking-of-voyager.html">The sinking of Voyager</a><br /><a href="https://www.coppolacomment.com/2022/07/shipwrecked.html">Shipwrecked</a></p><p><br /></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com1tag:blogger.com,1999:blog-8764541874043694159.post-77059415654962065362022-07-14T04:46:00.008+01:002022-07-15T14:43:42.356+01:00Shipwrecked<p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhrVuz250sQCfH37hiDW0Gorepezcl2F-CnBpGV6Tj4yFEFej77olyMJ6gzcBTXvQfG7uDRKJ5nsqq0y_kySOW6OY4CFztMrX1trwlR3fTWxZmRZX5FUiBp-496imxtSvX0ywwGrpaP8woT5G6Gp-e3lkhRKF_CYAi3w1KjFymxiuVJPahD7rOoYw3x" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="400" data-original-width="600" height="426" src="https://blogger.googleusercontent.com/img/a/AVvXsEhrVuz250sQCfH37hiDW0Gorepezcl2F-CnBpGV6Tj4yFEFej77olyMJ6gzcBTXvQfG7uDRKJ5nsqq0y_kySOW6OY4CFztMrX1trwlR3fTWxZmRZX5FUiBp-496imxtSvX0ywwGrpaP8woT5G6Gp-e3lkhRKF_CYAi3w1KjFymxiuVJPahD7rOoYw3x=w640-h426" width="640" /></a></div><br /><br />Two days after I published <a href="https://www.coppolacomment.com/2022/07/the-sinking-of-voyager.html">my last post</a>, the ship went down. Voyager Digital <a href="https://www.prnewswire.com/news-releases/voyager-digital-commences-financial-restructuring-process-to-maximize-value-for-all-stakeholders-301581177.html">filed for Chapter 11 bankruptcy protection</a>. <p></p><p>The <a href="https://cases.stretto.com/public/x193/11753/PLEADINGS/1175307062280000000036.pdf">bankruptcy filing</a> revealed the extent of its indebtedness. Tragically, most of its creditors are customers, some of whom hold claims worth millions of dollars. But its largest creditor is Alameda Research, to whom it owes $75m. This is the maximum that Voyager could draw down from Alameda's credit line in a 30-day period. So it appears that Alameda did not pull its credit line as I thought. Rather, Voyager maxed it out - but still ran out of money. Voyager's desperate shortage of cash is the proximate reason for its bankruptcy. </p><p>But for its customers, the hole in its balance sheet is the bigger problem. Voyager admits that it cannot repay all, or even most, deposits in full. Its press release outlines a resolution plan that distinguishes between two classes of depositor <i>(click image for a larger view)</i>:</p><p><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjV2TckxiSnpTgoBSF0h7AUMsK14u1-G9npMWNSbd3djHjDtAfTZYaKUIxnazzCTDiAhGWrF_VtmkvMVJLgp0Bqc2pKcoJvYq-2zw1LODiBNbLHtBqexZpJEG6hYiOpWzOnnNKgVhIqbZygGMMysSR_BqtEdRnXunb1jyY-BQR62knCFZsOmRW20pf7" style="background-color: white; font-family: Montserrat, Helvetica, Arial, sans-serif; font-size: 16px; margin-left: 1em; margin-right: 1em; text-align: center;"><img alt="" data-original-height="424" data-original-width="1469" height="188" src="https://blogger.googleusercontent.com/img/a/AVvXsEjV2TckxiSnpTgoBSF0h7AUMsK14u1-G9npMWNSbd3djHjDtAfTZYaKUIxnazzCTDiAhGWrF_VtmkvMVJLgp0Bqc2pKcoJvYq-2zw1LODiBNbLHtBqexZpJEG6hYiOpWzOnnNKgVhIqbZygGMMysSR_BqtEdRnXunb1jyY-BQR62knCFZsOmRW20pf7=w653-h188" width="653" /></a></p><p>US dollar deposits on Voyager don't earn interest. To earn interest, depositors must exchange their US dollars for one of the cryptocurrencies and stablecoins listed as available for trading. Typically, depositors do this as soon as the dollars have been transferred to the platform. So the vast majority of deposits on Voyager are crypto deposits. These will now be subject to a haircut, the size of which will depend on the outcome of the bankruptcy proceedings of Three Arrows Capital (3AC). And that is a complete can of worms.</p><p>On 29th June, a court in the British Virgin Islands (BVI) <a href="https://news.sky.com/story/crypto-hedge-fund-three-arrows-capital-plunges-into-liquidation-12642402">ordered 3AC into compulsory liquidation</a>. This would have resulted in the winding up of 3AC and distribution of its assets to its creditors, including Voyager. But 3AC responded by <a href="https://www.reuters.com/markets/us/crypto-hedge-fund-three-arrows-files-chapter-15-bankruptcy-2022-07-01/">filing for U.S. Chapter 15 bankruptcy protection</a>, thus preventing its assets in the United States from being seized by the BVI liquidators. <br /><br />Normally, filing for bankruptcy protection means immediate freezing of assets. But in the decentralized crypto world, freezing assets is voluntary. And it seems 3AC's co-founders, Su Zhu and Kyle Davies, don't think they should have to do it. Shortly after filing for bankruptcy, 3AC <a href="https://beincrypto.com/three-arrows-capitals-crypto-assets-are-in-transit-heres-how-the-millions-are-moving/">moved a sizeable part of its remaining stablecoin holdings</a> to a wallet on the KuCoin exchange that, according to the exchange, did not belong to 3AC. And according to <a href="https://twitter.com/MoonOverlord/status/1537036823444217856?s=20&t=-SOemK07luCH5U1tJbzKSQ">a major NFT investor</a>, 3AC had also started to move its NFT collection. There was a real risk that the remaining assets would simply disappear and creditors would end up with nothing. </p><p>Two days ago, annoyed investors <a href="https://www.cnbc.com/2022/07/12/founders-of-bankrupt-crypto-hedge-fund-three-arrows-go-missing.html">obtained a court order</a> to freeze 3AC's assets , saying that the 3AC pair were not cooperating. Liquidators were not being granted access to company documentation, the company's offices in Singapore appeared to be deserted, and Su Zhu and Kyle Davies had disappeared. </p><p>The court order had a remarkable effect. Su Zhu popped up on Twitter complaining that the liquidators were "baiting", and accusing them of negligence: <br /><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhMgEKs5yrd8piZShGfHZmPKNJkbq6c4HtuoN1SBDxow6YiIIZLeoMuatup65JE3PKbNlw29twdUi7roohZTjoOnKsbi0XF9KE0MChLr5v5gQCGtuEr4F_59mUzeA3rCRd76dC-TlHpKf0mpOjPFQBHSAtGBfoXtWhje48i3SJeSfIsEiiDjNUT5CIG" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="1199" data-original-width="1202" height="637" src="https://blogger.googleusercontent.com/img/a/AVvXsEhMgEKs5yrd8piZShGfHZmPKNJkbq6c4HtuoN1SBDxow6YiIIZLeoMuatup65JE3PKbNlw29twdUi7roohZTjoOnKsbi0XF9KE0MChLr5v5gQCGtuEr4F_59mUzeA3rCRd76dC-TlHpKf0mpOjPFQBHSAtGBfoXtWhje48i3SJeSfIsEiiDjNUT5CIG=w640-h637" width="640" /></a></div><br />It does not appear that Su Zhu has any intention of handing over 3ACs assets without a fight - not least because he claims to be a creditor himself. <p></p><p>For Voyager's customers, the 3AC shenanigans are very bad news. If the 3AC loan is not recovered, then they could be facing a haircut of at least 30% and possibly quite a bit more. </p><p>But not all of them will. USD depositors won't be subject to this haircut. Their money (and Voyager <a href="https://www.investvoyager.com/blog/update-on-customer-assets/">is at pains to insist that it is their money</a>) is supposedly safely held in an omnibus account at Metropolitan Commercial Bank. <br /><br />Voyager says it intends to restore access to USD deposits "after a reconciliation and fraud prevention process". I find this rather concerning. If Voyager was keeping proper records of customer deposits and regularly reconciling them with the balance in the bank account, such a process would not be necessary. And what fraud do they think they need to prevent? Could they be planning to blame the bank if there is a discrepancy between their customer records and the balance in the account, and advise customers to sue the bank?</p><p>This brings us back to the question of FDIC insurance. Metropolitan Commercial Bank has FDIC insurance. Voyager does not, but it claims that US deposits are covered by FDIC insurance on an individual customer basis by virtue of being held in an FDIC-insured bank. Voyager insists that US depositors are customers of the bank. This implies that FDIC passthrough insurance applies. And if it does, then the bank is indeed liable. </p><p>Back in 2018, <a href="https://www.reuters.com/article/bc-finreg-fdic-deposit-insurance-idUSKBN1HO21H">FDIC introduced a rule change</a> that forced banks to be able to identify all of their insured depositors, including any that qualify for passthrough insurance, so that FDIC insurance claims could be settled quickly. So if Voyager is correct, then Metropolitan Commercial Bank must know each of Voyager's USD depositors. It cannot argue - as its <a href="https://www.mcbankny.com/fdic-coverage-available-to-voyager-customers/">statement </a>appears to - that customer records are held by Voyager and it has no responsibility for them. </p><p>However, Voyager's claims regarding FDIC coverage for its depositors are decidedly suspect. Voyager's marketing material strongly implied that cash deposits were FDIC-protected in the event of the company's failure: a 2019 blogpost stating this remained up on the company's website and was frequently pointed to in marketing communications. FDIC <a href="https://decrypt.co/104688/fdic-to-investigate-bankrupt-voyager-digitals-insurance-claims">is now investigating</a> whether the company misled customers. </p><p>Whether the bank is liable for any missing funds will depend on whether passthrough insurance applies to Voyager's USD deposits. But Voyager is not a trust company or a licensed broker, and nowhere in its documentation does it say it acts as a fiduciary or agent for its customers. It thus does not appear to meet the requirements for FDIC passthrough insurance. And if it does not, then it is unclear what if any liability the bank has for losses suffered by Voyager's customers. </p><p>It is notable that Voyager's statement only says it will "restore access" to USD deposits. It does not say it will refund them in full. If the bank account has a shortfall, therefore, USD depositors could suffer a haircut. Pursuing recovery of any missing money through the courts could take a long time and ultimately be unsuccessful - especially if the bank is not liable. </p><p>But it is the crypto customers who face the biggest losses. To use banking parlance, they are going to be bailed in. A substantial part of their crypto will be coercively exchanged for new shares in Voyager (which will initially be worthless) and Voyager tokens (<a href="https://www.coingecko.com/en/coins/voyager-token">currently trading at 7 cents</a>). <br /><br />It is easy to say "they should have done their due diligence", but it is nonetheless heartbreaking to read the stories of people who have lost their life savings. Whether they ever recover their losses will depend on the performance of the company once its restructuring is complete and it starts trading again. They will be the new owners of the company and the holders of its native token. Like the Bitfinex depositors who suffered haircuts of 36% in 2016, it will be in their interest to ensure it succeeds. </p><p><br /></p><p><b>Related reading:</b></p><p> <a href="https://www.forbes.com/sites/francescoppola/2016/08/08/the-bitfinex-barber-shop/">The Demon Barber of Bitcoin</a> - Forbes</p><p><a href="https://www.coppolacomment.com/2015/07/the-great-greek-bank-drama-act-ii-heist.html">The Great Greek Bank Drama, Act II; The Heist</a></p><p><a href="https://www.coppolacomment.com/2013/03/a-failure-of-compassion.html">A failure of compassion </a></p><p><br /></p><p><br /></p><p><br /></p><p><br /></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-49896114860467276692022-07-03T13:32:00.005+01:002022-07-03T23:19:24.539+01:00The sinking of Voyager<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgUh25HhRZcyD7w_aFBMUbKPfwd1sChsFoZgsJav7r1HefuiMx4liKEahVosYpfU2e7_cQWVPEL2xcZ4dqjRnJXKGY87Eh_ogaU6Icqi67Z8ONr6ivdDbBQxJ_JasLRpPPTAmfPVqh-ppgM0mJJWnalvRVaMapvrhwAM9of4_pHvuzxACzLM9P8SobO/s1920/landscape-g89cdad3a1_1920.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1080" data-original-width="1920" height="360" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgUh25HhRZcyD7w_aFBMUbKPfwd1sChsFoZgsJav7r1HefuiMx4liKEahVosYpfU2e7_cQWVPEL2xcZ4dqjRnJXKGY87Eh_ogaU6Icqi67Z8ONr6ivdDbBQxJ_JasLRpPPTAmfPVqh-ppgM0mJJWnalvRVaMapvrhwAM9of4_pHvuzxACzLM9P8SobO/w640-h360/landscape-g89cdad3a1_1920.jpg" width="640" /></a></div><br /><span style="text-align: left;">Friday was quite a day. The crypto lender BlockFi </span><a href="https://www.marketwatch.com/story/ftx-signs-deal-to-bail-out-crypto-lender-blockfi-with-option-to-buy-it-for-up-to-240-million-2022-07-01" style="text-align: left;">provisionally agreed a bailout deal with FTX</a><span style="text-align: left;">. The hedge fund Three Arrows Capital (3AC), already in compulsory liquidation in its home territory the British Virgin Islands, </span><a href="https://www.reuters.com/markets/us/crypto-hedge-fund-three-arrows-files-chapter-15-bankruptcy-2022-07-01/" style="text-align: left;">filed for Chapter 15 bankruptcy protection</a><span style="text-align: left;"> in the United States. And the crypto broker Voyager </span><a href="https://www.investvoyager.com/blog/voyager-update-july-1-2022/" style="text-align: left;">suspended trading and withdrawals</a><span style="text-align: left;">. </span><p style="text-align: left;">Voyager's <a href="https://www.newswire.ca/news-releases/voyager-digital-provides-market-update-851734302.html">press release</a> revealed a massive hole in its balance sheet. Some 58% of its loan book consists of loans to 3AC:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhY3Z2KOrBkSH-lYW3zKwTDuZrDGPY7euTOAEHcCW-OBxSO9jPWvOfKodZmPtGAWF0tOoPFCuWbRem6emCnRK-xUehIF1NZHBnifWsip67AU9KSbIAJm7SyRzFzcARd2mnVqwObPTP4HX0qPAjSrBGQQGWDoi4_81VeUatsa3ZtjycXwcBz9AxYqoze" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="541" data-original-width="1381" height="250" src="https://blogger.googleusercontent.com/img/a/AVvXsEhY3Z2KOrBkSH-lYW3zKwTDuZrDGPY7euTOAEHcCW-OBxSO9jPWvOfKodZmPtGAWF0tOoPFCuWbRem6emCnRK-xUehIF1NZHBnifWsip67AU9KSbIAJm7SyRzFzcARd2mnVqwObPTP4HX0qPAjSrBGQQGWDoi4_81VeUatsa3ZtjycXwcBz9AxYqoze=w640-h250" width="640" /></a></div><p>And its loan book is nearly 50% of total assets:</p><p><a href="https://blogger.googleusercontent.com/img/a/AVvXsEiq7FeP6CvLDppjMm1w6nVzS5fvn6xX7hvmfUR3L71uH9wyYMVFJLZimnhz4sFsmm9spU964thN0zzmnp5OxnrrFXxjJLl6KLG8HGvD6yoJxE-yuZyzXNmFGWWra25YEhCSfYc7VY9yS8aAIKfSEs7SQHvS_acGgGuQ0xjnxkbezrEMhDOVxlK3tN53" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img alt="" data-original-height="224" data-original-width="666" height="216" src="https://blogger.googleusercontent.com/img/a/AVvXsEiq7FeP6CvLDppjMm1w6nVzS5fvn6xX7hvmfUR3L71uH9wyYMVFJLZimnhz4sFsmm9spU964thN0zzmnp5OxnrrFXxjJLl6KLG8HGvD6yoJxE-yuZyzXNmFGWWra25YEhCSfYc7VY9yS8aAIKfSEs7SQHvS_acGgGuQ0xjnxkbezrEMhDOVxlK3tN53=w640-h216" width="640" /></a></p><p><br />So approximately 28% of Voyager's assets are in default. And since 3AC now has creditor protection, Voyager must wait for bankruptcy courts to decide how much, if anything, can be recovered. That will take months. </p><p>But the balance sheet hole doesn't explain why Voyager has suspended US dollar withdrawals. Despite its apparently healthy "cash held for customers" balance, it seems to be dreadfully short of cash. There is something else going on here. </p><p>As always when something doesn't quite add up, I take a look at the books. In May, only a few days after Terra's collapse, Voyager released its quarterly financial update, dated 31st March. The income statement makes grim reading: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEiA4SKH8L7B5qp-de1EgokVbvySZCyDypZIjCbG-kkae5V7yBv6K6v_pWvnZ-HT0BSbiDOg280Oqrz-gF8dWGMoeJQ5J9jJ0cHTIi5myZBPEm4otA_FNaEA1wR1S1KudrwBYAAupMcLioGrn4fJMzN_CcKNJK20088HgKBgwrKqrMDxOaJ90m78OO0e" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="948" data-original-width="1134" height="535" src="https://blogger.googleusercontent.com/img/a/AVvXsEiA4SKH8L7B5qp-de1EgokVbvySZCyDypZIjCbG-kkae5V7yBv6K6v_pWvnZ-HT0BSbiDOg280Oqrz-gF8dWGMoeJQ5J9jJ0cHTIi5myZBPEm4otA_FNaEA1wR1S1KudrwBYAAupMcLioGrn4fJMzN_CcKNJK20088HgKBgwrKqrMDxOaJ90m78OO0e=w640-h535" width="640" /></a></div>Voyager is making whopping losses. Like all crypto companies this year, it has taken a mammoth hit on the fair value of its crypto assets. But it's the operating loss that concerns me. In the nine months ended March 31, 2022, it spent over $82m on marketing and sales and a further $182m on customer rewards, far above what it was earning from staking and loan fees. This turned what might have been a decent if uninspiring operating profit into a $68m loss. Such exorbitant expenditure on building a customer base reminds me of <a href="https://www.forbes.com/sites/francescoppola/2019/08/15/weworks-ipo-the-triumph-of-hype-over-fundamentals/?sh=4a3b1d082f75">WeWork during Adam Neumann's tenure as CEO</a> - and we all know <a href="https://www.theguardian.com/business/2019/dec/20/why-wework-went-wrong">how that ended</a>, don't we?<p></p><p>More worrying still is Voyager's cash flow. Voyager is haemorrhaging cash (remember these figures are in thousands):</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjG2RgMyZkPxxnfH-D4zJ85PUFVOEXNzhs_N5NjGoAmHLJy-8VRyot6lhVqe0wV1obHLuHAa9aBmu4VXbu5SfPNiNpsoZdwixTGqtQVaeOAtfIdlFxlXg6BpuWuJaEhNUzg28eEH0T2dBc9orbh09MuWSdUfBKdAVMSBIj_QKaxHvbHLGU9ecXFypsR" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="416" data-original-width="1074" height="248" src="https://blogger.googleusercontent.com/img/a/AVvXsEjG2RgMyZkPxxnfH-D4zJ85PUFVOEXNzhs_N5NjGoAmHLJy-8VRyot6lhVqe0wV1obHLuHAa9aBmu4VXbu5SfPNiNpsoZdwixTGqtQVaeOAtfIdlFxlXg6BpuWuJaEhNUzg28eEH0T2dBc9orbh09MuWSdUfBKdAVMSBIj_QKaxHvbHLGU9ecXFypsR=w640-h248" width="640" /></a></div><br />It has burned through nearly $200m in nine months. During this time, Voyager did a $75m private placement shares issue to raise some cash. But it wasn't anywhere near enough. At the end of the period its total cash and cash equivalents, including cash held for customers, was down by nearly $145m. <p></p><p>So Voyager has no cash and deeply negative income. And its available assets are now considerably less than its liabilities. It is almost certainly insolvent, though it has not yet filed for bankruptcy. </p><p>But Voyager wasn't insolvent when these accounts were produced. Its current assets were easily enough to cover its current liabilities, its net assets were positive, and its ratio of equity to assets (unweighted) was a thin but comfortable 4.2%. </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhHrWJj6peLdxo_oQTUgg7ub2xlbdsnFaSflo4m0GxWzm10-_jFV1IRNcKiE9xipXN_cemL6TZUW2kJi7hwX7ifTqh7HXvyc_YqJJj7yCB6SeiOq3b0t7HhRPE8Yz9MAu2sSd2owStfIPdnzud0a4n5H_nkUC_9TYW3GuC422qGxi2HzLSVKqR1k-Gw" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="799" data-original-width="1129" height="452" src="https://blogger.googleusercontent.com/img/a/AVvXsEhHrWJj6peLdxo_oQTUgg7ub2xlbdsnFaSflo4m0GxWzm10-_jFV1IRNcKiE9xipXN_cemL6TZUW2kJi7hwX7ifTqh7HXvyc_YqJJj7yCB6SeiOq3b0t7HhRPE8Yz9MAu2sSd2owStfIPdnzud0a4n5H_nkUC_9TYW3GuC422qGxi2HzLSVKqR1k-Gw=w640-h452" width="640" /></a></div><br />Voyager's liquidity was strained, but as long as it could borrow against its assets, it would be able to meet its obligations as they fell due. <p></p><p>The collapse of 3AC created a golden opportunity for Voyager to borrow the money it desperately needed. The crypto billionaire Sam Bankman-Fried, CEO of FTX and founder of the asset manager Alameda, was bailing out distressed crypto lenders like BlockFi. Voyager's management decided they wanted a piece of that - after all, Alameda was already a Voyager shareholder. So, saying it wanted to "safeguard customer assets in light of current market volatility", Voyager arranged new revolving credit facilities of $200m USD/USDC and 15,000 BTC with Alameda. Simultaneously, Voyager Digital issued a notice of default against 3AC. </p><p>Presumably Alameda looked at Voyager's books and decided that the company was basically sound. And presumaly they also thought Voyager had a good chance of getting its money back from 3AC. So their decision to provide Voyager with additional liquidity wasn't unreasonable. Shoring up liquidity when the market is turbulent can prevent basically sound companies from failing. </p><p>But 3AC's BVI compulsory liquidation and US Chapter 15 bankruptcy was a game changer. Suddenly, Voyager no longer had a strong balance sheet. It had a steaming pile of extremely distressed and probably unrecoverable loans. And shoring up liquidity for a company whose assets are evaporating is a mug's game, as Carillion's lenders discovered to their cost. Did Alameda pull its credit lines? </p><p>If it did, that would explain why Voyager suspended all withdrawals including US dollars. It does not have sufficient ready cash to pay its customers, and it can't borrow any more. </p><p>But Voyager has told its customers that their US dollar balances are safely held in an omnibus account at its FDIC-insured partner bank. Furthermore, its customer service agreement says that because all movements in and out of the account are controlled by the bank, the customers are therefore customers of the bank:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhh3PC9160_dykkHY4uYpV8_iOR2_w4t3WwC-MZVYdFNCWMbUgZbYpqjDMmXcfKuqOP37lFNfWf5StRZ1LXcB8SmqZbisziHoISXjNuRigv0WUiGaJjCu23aLH6tGSZg3bzPUufoq6hRh7m00vPVCiqICW70FRi2Dge073vS6LXbVPN7BFN7ctuw3gN" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="687" data-original-width="1121" height="392" src="https://blogger.googleusercontent.com/img/a/AVvXsEhh3PC9160_dykkHY4uYpV8_iOR2_w4t3WwC-MZVYdFNCWMbUgZbYpqjDMmXcfKuqOP37lFNfWf5StRZ1LXcB8SmqZbisziHoISXjNuRigv0WUiGaJjCu23aLH6tGSZg3bzPUufoq6hRh7m00vPVCiqICW70FRi2Dge073vS6LXbVPN7BFN7ctuw3gN=w640-h392" width="640" /></a></div><br />Now, this is odd. If movements in and out of the account are controlled entirely by the bank on behalf of Voyager's customers, then Voyager should not be able to suspend US dollar withdrawals. But it has. Clearly, therefore, Voyager is controlling access to the money, despite its statement that it does not provide "any services pertaining to the movement of, and holding of, USD". <p></p><p>And there is a second mystery. If all US dollars belonging to its customers are in the omnibus account as it claims, why has Voyager suspended US dollar withdrawals? It clearly had to suspend conversion of crypto balances into US dollars, because it now has no means of obtaining those dollars. But there seems no reason to suspend withdrawal of existing US dollar balances - unless there isn't enough cash in the omnibus account to reimburse all US dollar depositors. </p><p>This brings us back to Voyager's enormous cash burn over the last nine months. "Cash held for customers" is supposed to be segregated, but as it's on Voyager's own balance sheet this is merely an accounting fiction. There's nothing to stop Voyager borrowing its customers' dollars. So, what if Voyager has used the omnibus account as a source of dollar liquidity? What if it has drained that account to defray its exorbitant operating expenses, and now can't put the money back? Indeed, what if all along it has funded that account on a just-in-time basis, borrowing US dollars when needed to meet withdrawal requests, and now it can't fund it any more because its credit lines have been pulled? This would explain why it has had to suspend US dollar withdrawals. It can't pay out money it doesn't have and can't get. </p><p>The omnibus account at Metropolitan Commercial Bank comes with FDIC insurance of up to $250,000. This protects the money in that account from loss in the event of the bank's failure. It does <b>not</b> protect Voyager's customers from losses in the event of Voyager's failure. This is clearly stated in Voyager's own customer service agreement (cited above):</p><p></p><blockquote>FDIC insurance does not protect against the failure of Voyager or any Custodian (as defined below) or malfeasance by any Voyager or Custodian employee. </blockquote><p></p><p>However, Voyager's <a href="https://invest-voyager.medium.com/usd-held-with-voyager-is-now-fdic-insured-5165343aa554">marketing material</a> incorrectly states that FDIC insurance protects customers from the company's failure:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhNS1qQl1A0lmQJlL2aDk9mqB3n-o5ENkavTnPhDVYfSaWknyi2TizAhNgo0XdhRhgTuIdJHYSl-Voc5p6yJxFv1gFIwoP2AGSkJHzL7uCQJ4rEl0N3j24XY29KhjUX8tK1dbAUoc9_GrariTgBBDUB_65NgrUe8GgNyK-w12jLmACqhaZQbZTI13X8" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="245" data-original-width="1077" height="146" src="https://blogger.googleusercontent.com/img/a/AVvXsEhNS1qQl1A0lmQJlL2aDk9mqB3n-o5ENkavTnPhDVYfSaWknyi2TizAhNgo0XdhRhgTuIdJHYSl-Voc5p6yJxFv1gFIwoP2AGSkJHzL7uCQJ4rEl0N3j24XY29KhjUX8tK1dbAUoc9_GrariTgBBDUB_65NgrUe8GgNyK-w12jLmACqhaZQbZTI13X8=w640-h146" width="640" /></a></div>It is hardly surprising that Voyager's customers, deprived of their US dollars, are asking "When FDIC?"<p></p><p>An enterprising Voyager customer rang FDIC to ask how they could claim on the insurance. The answer was clear and comprehensive: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEi7G9-VPEuVbXHawzSfR07BOPyiVK-cQr6PdaSoiPbKcl18Ao_6RQC7_BvPe5aVT__A15unFVqLUUvkERGElepoL48mQ-xEGz21tlifiZ2DKQ4jXEi5OUmhkjLMY_pklnZvxo4adsZfOYZsSR1EW6GbF5HOu6BOk5f_I-eiyf64b79fy-yGnBGG6BgQ" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="273" data-original-width="867" height="202" src="https://blogger.googleusercontent.com/img/a/AVvXsEi7G9-VPEuVbXHawzSfR07BOPyiVK-cQr6PdaSoiPbKcl18Ao_6RQC7_BvPe5aVT__A15unFVqLUUvkERGElepoL48mQ-xEGz21tlifiZ2DKQ4jXEi5OUmhkjLMY_pklnZvxo4adsZfOYZsSR1EW6GbF5HOu6BOk5f_I-eiyf64b79fy-yGnBGG6BgQ=w640-h202" width="640" /></a></div>(<i>source: <a href="https://www.reddit.com/r/Invest_Voyager/comments/vp8kdq/preparing_for_the_inevitable_fdic_claims/">reddit</a>)</i><br /><br /><p></p><p>Metropolitan Commercial Bank has also put out a <a href="https://www.mcbankny.com/fdic-coverage-available-to-voyager-customers/">statement</a> confirming that FDIC insurance would only be triggered in the event of its own insolvency, not Voyager's: </p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgiEXpflU4pk8wlYSPMZ5rIGPmdz_e4oGitfERffDqfsIknpRzjGf6zXhJDcn6EA75bzw7bLTAii9GiW6wrHkHQ0ALXC0LyfJlQNePJEd-5fyKK9c0wfwuOdk23wfUmKe9RFTKlVv_s69vmpKlNXHTA-zycI3vhnfm14UQqu3SekmPJHHEkB1Ztdb3O" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="256" data-original-width="1424" height="116" src="https://blogger.googleusercontent.com/img/a/AVvXsEgiEXpflU4pk8wlYSPMZ5rIGPmdz_e4oGitfERffDqfsIknpRzjGf6zXhJDcn6EA75bzw7bLTAii9GiW6wrHkHQ0ALXC0LyfJlQNePJEd-5fyKK9c0wfwuOdk23wfUmKe9RFTKlVv_s69vmpKlNXHTA-zycI3vhnfm14UQqu3SekmPJHHEkB1Ztdb3O=w640-h116" width="640" /></a></div><br />Oh, and in case you were wondering, SIPC protection doesn't apply either - not surprisingly, since Voyager's products are not registered as securities. Again, this is clearly stated in Voyager's own customer service agreement: <p></p><blockquote><p>Voyager is not a member of the Financial Industry Regulatory Authority, Inc. ("FINRA") or the Securities Investor Protection Corporation ("SIPC"), and therefore Cash is not SIPC-protected.</p></blockquote><p>There will no doubt be calls for retail depositors in risky enterprises like Voyager to have some form of insurance protection. But to my mind, the biggest problem here is mis-selling. Voyager deliberately marketed its accounts as safe products for retail customers, using FDIC insurance as the "hook" to trawl them in. It did so knowing that FDIC insurance would not protect those customers in the event of Voyager's insolvency. <br /><br />Furthermore, for FDIC insurance limits to apply to individual Voyager customers as if they were customers of the insured bank, as Voyager's customer service agreement implies, Voyager would have to be acting as agent or fiduciary for its customers in the placing of US deposits with its banking partner, and those deposits would have to be properly segregated as client funds. But nowhere in Voyager's legal agreements does it say that it acts as agent or fiduciary for its US dollar customers. It shows the funds on its own balance sheet, so they clearly aren't segregated. And it controls access to the funds. So it is hard to see why passthrough insurance limits would apply. And if they don't, then in the event of Metropolitan Commercial Bank failing, FDIC insurance would be limited to $250,000 in total, not $250,000 per customer, and would go to Voyager, not its customers. So customers would lose some or all of their money if the bank failed. Voyager's marketing was seriously misleading. </p><p>Voyager also gave the impression that its investments were safe when they were anything but. The loan book is extremely concentrated: almost all the lending is to only 7 counterparties, of which the largest by far is 3AC. <br /><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhcMq9VBxyu6cc6fYs1WXL6i9nul1aB1GqbwhW9seVZt6g0uBy6uE4X4gOJuBwC4uW3312BNFhMhi9huVWA9BIA9t6VxQ5k1thj0t3XGdE5MBiDO3Fladb728kjoDKT7b5jxDgGo9L461_lUywwaJLKzAkFcHqudifFG78qpAeu73El36ivyqRGkvz2" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="471" data-original-width="839" height="360" src="https://blogger.googleusercontent.com/img/a/AVvXsEhcMq9VBxyu6cc6fYs1WXL6i9nul1aB1GqbwhW9seVZt6g0uBy6uE4X4gOJuBwC4uW3312BNFhMhi9huVWA9BIA9t6VxQ5k1thj0t3XGdE5MBiDO3Fladb728kjoDKT7b5jxDgGo9L461_lUywwaJLKzAkFcHqudifFG78qpAeu73El36ivyqRGkvz2=w640-h360" width="640" /></a></div><br />And the loans are seriously undercollateralized. In the <a href="https://seekingalpha.com/article/4512111-voyager-digital-ltd-vygvf-ceo-steve-ehrlich-on-q3-2022-results-earnings-call-transcript">earnings call on 16th May</a>, Voyager's CEO, Steve Ehrlich, admitted that there isn't much collateral, but insisted that high levels of effectively unsecured lending were absolutely fine: <p></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgdN0yj-6gmlMDPNzSwinpqxLrddE4P4SSH1HbEIlj6x92zN_NmvCfB1af5-KZs976_NekZaekPPnLqxw6Tjk2gFS4icSOaHWhN7W6Qi2dX3cRAy9DYZvFt4NASG02STn6KBOFPBLblfGH1N5LqQf_m43EVdKQnP0yqSlMpw7JnAa8-LHw6nf1a_0gv" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="371" data-original-width="949" height="250" src="https://blogger.googleusercontent.com/img/a/AVvXsEgdN0yj-6gmlMDPNzSwinpqxLrddE4P4SSH1HbEIlj6x92zN_NmvCfB1af5-KZs976_NekZaekPPnLqxw6Tjk2gFS4icSOaHWhN7W6Qi2dX3cRAy9DYZvFt4NASG02STn6KBOFPBLblfGH1N5LqQf_m43EVdKQnP0yqSlMpw7JnAa8-LHw6nf1a_0gv=w640-h250" width="640" /></a></div>But his largest borrower, 3AC, was already heading for bankruptcy because of its exposure to Luna/UST. Clearly, he didn't know his borrowers nearly as well as he needed to. <p></p><p>I have no problem with a hedge fund lending only to seven counterparties, if it is lending its own funds or those of professional investors who understand the risks they are taking. But Voyager marketed high-risk investments to retail depositors with promises of safety and (non-existent) insurance. To my mind, this isn't just bad, it is criminal. But crypto is an unregulated, borderless space. Even if Voyager has lied to its customers and embezzled their funds, it is unclear what if any power national authorities have to hold it to account. And even though there will undoubtedly be a forest of lawsuits, the money is gone. </p><p>Sorry, Voyagers. You are going down with this ship, and no lifeboat will save you. <br /><br /></p><p><b>Related reading:</b></p><p><a href="https://www.coppolacomment.com/2012/05/liquidity-matters.html">Liquidity Matters</a></p><p><i>Image by <a href="https://pixabay.com/users/8385-8385/?utm_source=link-attribution&utm_medium=referral&utm_campaign=image&utm_content=1328858">Reimund Bertrams</a> from <a href="https://pixabay.com/?utm_source=link-attribution&utm_medium=referral&utm_campaign=image&utm_content=1328858">Pixabay</a></i></p>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0tag:blogger.com,1999:blog-8764541874043694159.post-86358536705865802452022-05-31T01:10:00.010+01:002022-05-31T11:36:50.371+01:00There's no such thing as a safe stablecoin<p> Stablecoins aren't stable. So-called algorithmic stablecoins crash and burn when people behave in ways the algorithm didn't expect. And reserved stablecoins fall off their pegs - in either direction. A stablecoin that does not stay on its peg is unstable. Not one of the stablecoins currently in circulation lives up to its name. </p><p>Don't believe me? Well, here's the evidence. Exhibit 1, USDT since the end of April:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEifnb6qwuppILR602IS1Tget_rmXnnd4Wo6aDWxdJK2gubtg8JNm9PirekA6szQu1FxAwZtnvS6tFoLRr1WQN8fnShuWgEnmUOJ5eOyib93WiUOMUb3Keu-dFJsWgQdhmOyh-JngH_NQEgw8Je6_TAkjwn9gJRgO_uWqw9l7-M8M99X3TMBZkmPTthg" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="934" data-original-width="1446" height="414" src="https://blogger.googleusercontent.com/img/a/AVvXsEifnb6qwuppILR602IS1Tget_rmXnnd4Wo6aDWxdJK2gubtg8JNm9PirekA6szQu1FxAwZtnvS6tFoLRr1WQN8fnShuWgEnmUOJ5eOyib93WiUOMUb3Keu-dFJsWgQdhmOyh-JngH_NQEgw8Je6_TAkjwn9gJRgO_uWqw9l7-M8M99X3TMBZkmPTthg=w640-h414" width="640" /></a></div><br /><br /><p></p><p>Exhibit 2, USDC over the same time period:</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgd8FdH2KoHjFaqnGqEhILV-cruLmTVDCwDLdxKJKhutRKxtELMKQimKgaIRrkae3MIm5BbBILW-_b5H3gUOOEHkwVHpEIRFg6vPQ5UiyiNIY_ru_pF1Lb6tv6zVWVPRKJeD1VubZOsm6Z9TjE5RyTmGgxuA0U_90tT3x-GjjBdr06mI9YYGvFScR3d" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="942" data-original-width="1443" height="418" src="https://blogger.googleusercontent.com/img/a/AVvXsEgd8FdH2KoHjFaqnGqEhILV-cruLmTVDCwDLdxKJKhutRKxtELMKQimKgaIRrkae3MIm5BbBILW-_b5H3gUOOEHkwVHpEIRFg6vPQ5UiyiNIY_ru_pF1Lb6tv6zVWVPRKJeD1VubZOsm6Z9TjE5RyTmGgxuA0U_90tT3x-GjjBdr06mI9YYGvFScR3d=w640-h418" width="640" /></a></div><br /><i>(charts from Coinmarketcap)</i><div><i><br /></i><div>Both coins de-pegged on 12th May. Neither has returned to par. Stable, they are not. <p></p><p>And no, USDC is not "more stable" than USDT. A stablecoin that can't hold its peg when everyone is piling into it is no more stable than one that can't hold its peg when everyone is selling it. Indeed, since stablecoins can be created without limit, there is arguably much less excuse for a stablecoin de-pegging on the upside. Stablecoin issuers can run out of reserves, but they can't run out of their own tokens. </p><p>So USDC and USDT are equally unstable, just in opposite directions. Why is this?</p><p>The reason for the discrepancy appears to be market perception that USDC is "safe", while USDT is risky. On 12th May, crypto markets melted down as the UST algorithmic stablecoin crashed, triggering a flight to what in the crypto world passes for "safety".<br /><br />For genuine crypto diehards, "safety" is BTC, which although highly volatile does seem to generate value over the longer term. But for the thousands of speculators, investors and amateur traders who are dabbling in crypto in the hope of finding some yield in an era of low interest rates, "safety" is fiat currency. Specifically, U.S. dollar-denominated "safe assets". </p><p>Like traditional financial markets, crypto markets use safe assets as media of exchange, collateral, and a safe haven in times of distress. The world's premier safe assets are USD-denominated assets such as dollar bills, FDIC-insured bank deposits, and U.S. treasury bills. But these aren't terribly liquid on crypto markets and can be in very short supply. So the crypto world has created its own versions of them that can be produced in potentially unlimited quantities to meet the crypto market's need for safety and liquidity. USD-pegged stablecoins are crypto versions of USD-denominated safe assets. </p><p>But not all stablecoins are perceived as completely safe. There's very definitely a hierarchy of stablecoins. "Fully reserved" stablecoins such as USDC are premium products, since they are seen as safe stores of value as well as highly liquid media of exchange. Fractionally reserved stablecoins like USDT are convenient as media of exchange but are distrusted as stores of value. And algorithmic stablecoins mostly seem to be used as a risky lending product generating very high returns. </p><p>Such a difference in risk perception should be reflected in price differentials. And to some extent, it is. In DeFi borrowing, there's typically a larger haircut on USDT collateral than there is on USDC. But because of the USD par peg, the coins themselves don't have a price difference - until there is a market panic. Then the pegs fail, the safe asset (USDC) trades at a premium and the risky asset (USDT) trades at a discount. When both de-pegged on 12th May, we briefly saw their real prices until the automated wash trading that both issuers employ brought them back close to their pegs. But despite the bots' best efforts, USDC is still trading at a slight premium and USDT at a small discount, reflecting continuing market uncertainty. </p><p>The crypto market has convinced itself that USDC is as good as a U.S. dollar. The fact that USDC tends to trade above its peg merely reflects the fact that USDC is more liquid than USD on crypto markets and thus has greater utility. To all intents and purposes, a USDC token is a dollar. </p><p>But it's not. USDC is the safest asset available on crypto markets, but it's not a safe asset. There is no such thing as a safe stablecoin. </p><p>A <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4083679">new research paper</a> by Ben Charoenwong, Robert M. Kirby and Jonathan Reiter says that the only type of stablecoin that can guarantee to hold its USD peg under all conditions - and therefore be a credible safe asset - is one that is fully backed by hard dollars in the manner of a currency board. Algorithmic stablecoins like UST cannot be guaranteed to hold their pegs under all conditions. For fractionally-reserved stablecoins, overcollateralization (holding a portfolio mix of safe and risky assets whose total market value exceeds that of the stablecoins in issuance) offers some protection, but bleeds value over time. In some state of the world, therefore, even overcollateralized stablecoins can lose their reserve backing and fall off their pegs (or be forced off them). </p><p>It's worth examining how the authors draw this conclusion. Firstly, they use a mathematical theorem (<a href="https://en.wikipedia.org/wiki/Rice%27s_theorem">Rice's theorem</a>) to show that the smart contracts underpinning stablecoins cannot possibly compute for all present and future states of the world, and that failures are therefore inevitable. </p><p>This might seem obvious, but unfortuately many people in the crypto world appear oblivious to the limitations of code - or have too much invested in it, both personally and financially, to believe that it can fail or that any failures would personally affect them. </p><p>The authors' use of Rice's theorem is unfortunately open to challenge. They arbitrarily set a limit on the number of blocks within which a stablecoin must regain its peg, on the reasonable grounds that if there is no limit then everything is a stablecoin. But imposing such an arbitrary limit renders Rice's theorem inapplicable, since it can't be assumed that every Turing machine will have the same limit. </p><p>Nonetheless, their general point still stands: even if Turing completeness does not apply, a program still cannot compute for all states of the world, since code is written by humans and no human has perfect foresight. Code can be proved to do what it is designed to do, but it can't be proved either to do or not do what no-one ever thought it should do. When I was a programmer, we used to call a program that failed because it encountered an unforeseen situation an "OSINTOT" - "Oh Sh*t I Never Thought Of That". The crypto world is full of OSINTOTs. </p><p>The authors then consider what they call "hybrid backing", where a USD-pegged stablecoin is backed by a mix of risky assets whose market value exceeds the total value of stablecoins issued (overcollateralization). If the market value falls to par, then the assets are automatically exchanged for USD in what the authors call a "stop-loss" strategy. Executing the stop-loss temporarily creates a currency board, though the USD can be exchanged for risky assets again once the market recovers. However, in a repeated sequence of stop-losses, the portfolio's value is progressively eroded to the point where the USD realised on executing a stop-loss becomes insufficent to back issued stablecoins. When this happens, the par peg fails. Overcollateralization with risky assets therefore cannot guarantee the peg.</p><p>USDT is a stablecoin with "hybrid backing". The <a href="https://assets.ctfassets.net/vyse88cgwfbl/1np5dpcwuHrWJ4AgUgI3Vn/e0dac722de3cea07766e05c52773748b/Tether_Assurance_Consolidated_Reserves_Report_2022-03-31__3_.pdf">attestation it released in May 2022</a>, which was a snapshot taken on 31st March, revealed the following mix of assets: </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEg0SZmxHgnew-Tv49eK44cjTIKojnkZDJ9F10FQdURvt999K7EekxAeY0IcCFJqZcNTrIuOqiefUzVVY30VNQgol0rS2TiH2IW-ffCV0vUqru3HAQYM_mmBysGS_euwHAywn9pT78Pm0LCR28R3Dl1_NbON3cXi0ljft_K5_zqH-emauXKPnEf3k2pn" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="723" data-original-width="846" height="547" src="https://blogger.googleusercontent.com/img/a/AVvXsEg0SZmxHgnew-Tv49eK44cjTIKojnkZDJ9F10FQdURvt999K7EekxAeY0IcCFJqZcNTrIuOqiefUzVVY30VNQgol0rS2TiH2IW-ffCV0vUqru3HAQYM_mmBysGS_euwHAywn9pT78Pm0LCR28R3Dl1_NbON3cXi0ljft_K5_zqH-emauXKPnEf3k2pn=w640-h547" width="640" /></a></div>The proportion of conventional safe assets, notably U.S. Treasury Bills, is quite a bit higher than in previous attestations. But there is still substantial credit and market risk in this portfolio. It is not by any stretch of the imagination a currency board. </div><div><br /></div><div>Furthermore, it is barely overcollateralized. The total number of stablecoins in issuance at the time of the report was US$82,188,190,813. So the value of total assets exceeds the par value of issued stablecoins by less than 0.3%. Were the market value of this portfolio to drop even slightly, issued stablecoins would be worth less than par. Since Tether's portfolio includes digital assets, almost all of which have dropped substantially in value since this snapshot was taken, it is distinctly possible that USDT is now underwater. This would explain why it de-pegged at the time of the crypto sell-off, and why it has not returned to par despite Tether's wash trading bots. It is not currently known whether Tether has executed a stop-loss. <p></p><p>However, USDC is different. Although USDC's <a href="https://www.centre.io/hubfs/PDF/2022%20Circle%20Examination%20Report%20April%202022.pdf?hsLang=en">most recent attestation</a> does not reveal the composition of its assets, a <a href="https://www.circle.com/blog/how-to-be-stable-usdc-transparency-and-trust">blog post</a> by its Chief Financial Officer, Jeremy Fox-Green, said that USDC reserves are "held entirely in cash and short-dated U.S. government obligations, consisting of U.S. Treasuries with maturities of 3 months or less." He went on to state that as of 12.00 noon EST on 13th May 2022, the reserves consisted of $11.6 bn cash and $39 bn U.S. T-bills, a total of $50.6 bn in safe liquid assets backing 50.6 bn USDT stablecoins. Admittedly, he provided no evidence to support this statement. But if it is correct, then USDC meets the definition of a currency board. Provided the reserve does not "leak", USDC is not at risk of peg failure. This would explain why it tends to trade slightly above par. It is indeed a version of the U.S. dollar that is sufficiently liquid to trade on crypto markets. </p><p>But maintaining 100% liquid USD reserves necessarily means limiting stablecoin issuance. Circle can only issue the number of stablecoins for which it is able to obtain reserves. It is not a bank, so it can't obtain dollars from the Fed. It must buy or borrow reserves on the open market. This explains why it de-pegged during the May market panic. It could not obtain reserves fast enough to issue the quantity of USDC that investors were demanding, so the price rose sharply. </p><p>So we have a paradox. A fully-reserved stablecoin that relies totally on financial markets to obtain the reserves it needs to maintain its peg can't guarantee to maintain its peg. </p><p>How can we resolve this paradox? Well, the obvious solution is for the stablecoin issuer <a href="https://www.bloomberg.com/news/articles/2022-04-13/circle-bank-charter-application-coming-in-near-future?sref=3roVJZZ4">to become a bank</a>. That would give it access to unlimited dollar reserves. But it would need to maintain sufficient high-quality collateral to obtain them - and guess what the prime collateral accepted by central banks is? Why, short-dated government debt, of course, which the stablecoin issuer would have to obtain from markets (unless it became a broker-dealer). If a stablecoin issuer couldn't obtain sufficient T-bills to maintain 100% reserves in a market panic, how would it obtain sufficient T-bills to borrow those reserves from the Fed? I'm not sure <a href="https://newmoneyreview.com/index.php/2022/05/19/stablecoins-give-regulators-a-headache/#:~:text=According%20to%20IMF%20economist%20Manmohan,form%20of%20central%20bank%20reserves.">those who argue that stablecoin issuers should become 100% reserve banks</a> have quite thought this through. If a stablecoin issuer with a Fed master account must obtain collateral from markets in order to borrow the reserves it needs to hold its peg, then it cannot guarantee its peg. </p><p>So becoming a bank would not resolve the paradox. And this, I'm afraid, is where the self-referential nature of private sector stablecoins fundamentally fails. Even if they maintain 100% hard dollar reserves, USD-pegged stablecoins cannot guarantee their own pegs.* And for that reason, they cannot be safe assets. </p><p>In conventional licensed banks, the central bank guarantees the par peg between bank deposits and bank reserves/physical cash, provided that the bank is solvent: if the bank is insolvent, then the peg is often still guaranteed by deposit insurance schemes, though this may only be for relatively small amounts. No doubt some will argue that central banks should similarly guarantee the par peg for 100% reserved stablecoins. But if a stablecoin requires a central bank to guarantee its peg, and <a href="https://uk.investing.com/news/cryptocurrency-news/vitalik-buterin-calls-for-bank-deposit-insurancelike-protection-for-small-crypto-investors-2649388">insurance to protect its depositors from losses</a>, in what way is it materially different from a bank deposit account? </p><p>Furthermore, even without a Fed guarantee for the par peg, maintaining 100% reserves in cash and short-term government obligations renders trustlessness and decentralization impossible. As Charoenwong, Kirby and Reiter observe (my emphasis),<br /></p><blockquote> ..if we require stability with respect to an off-chain balance
– for example USD – then we need to hold that asset in the treasury.<b> If that asset
is not natively on-chain then this process must require a trusted off-chain connection.</b></blockquote><p></p><p>So we need T-bills and cash on the blockchain, eh? Hello, CBDCs and tokenised government debt. </p><p>And this is indeed where the authors end up: </p><p></p><blockquote>Any truly reliable stablecoin will look like a wrapper around central bank currency or government debt instruments regardless of whether such assets are tokenized on a blockchain, held book-entry in a database or recorded using any other technology.</blockquote>So a 100% reserved USD-pegged stablecoin is in reality a wrapped Fed dollar. It is not difficult to foresee that if the Fed produced a CBDC, it would quickly be locked up as reserves by private sector stablecoin issuers, especially if it paid interest. And so would tokenised T-bills. <div><br /></div><div>A private sector stablecoin backed by 100% CBDC and/or tokenised T-bill reserves would have the virtue of being completely safe. It would be in no danger of a peg-busting run, and provided the central bank responded quickly to demand for additional coins (and did not require collateral that could only be obtained on conventional financial markets), the peg would be robust under buy pressure too. And unlike USDC, it would not be exposed to losses in the event of conventional bank insolvency (USDC's <a href="https://www.sec.gov/Archives/edgar/data/1876042/000110465921101498/tm2123712-1_s4.htm#tCCBS">SEC filings</a> say that it holds deposit balances at U.S. banks in excess of the FDIC insurance limit). But it would be neither decentralized or trustless. </div><div><br /></div><div>There could be merit in creating a genuinely safe asset for use in crypto markets. The history of finance is littered with disasters caused by the failure of private sector "safe assets". Ten years ago, reflecting on the failure of residential mortgage-backed securities in the Great Financial Crisis, Professor Gary Gorton <a href="https://www.ft.com/content/b4711b48-a82a-38fb-8550-7f566e8f914e">said that </a>only the public sector can create a genuinely safe asset. Since then, the Eurozone crisis has taught us that not all public sectors can create genuinely safe assets. There's a small elite club of nations that can create safe assets, of which the largest by far is the United States. Perhaps, in time, the title of "safe asset issuer for the world" may pass to another sovereign, as it has in the past. But that time isn't upon us yet. </div><div><br /></div><div><div>But if the U.S. did issue tokenised dollars and T-bills, why would anyone use 100% reserved USD-pegged stablecoins? Indeed, why would anyone even issue them? What would be the point of locking up all those Fed dollars and T-bills just to issue a private sector equivalent? Countries with currency boards have domestic populations for whom the local currency is an important symbol of identity and sovereignty even though it is externally hard-pegged. But there's no such symbolic importance for stablecoins. The only reason for using them is that fiat currencies themselves are illiquid in crypto markets. But if fiat currencies became liquid, it's hard to see why anyone would use private sector stablecoins unless they were paid to do so - and that would mean the end of 100% reserve stablecoins, since the only way of generating profits would be to diversify into riskier assets. This is how fractional reserve banking systems develop. </div></div><div><br /></div><div>The crypto world has correctly identified the U.S. as its primary source of safety, and despite all its fine words about "trustlessness" and "decentralization", it clings to the U.S.'s institutions like a limpet. Even the incongruously named DeFi ("decentralized finance") is built on stablecoins that rely partially or completely on government obligations. Decentralized, trustless products ultimately depend for their stability on centralized, trusted institutions. </div><div><br /></div><div>Charoenwong, Kirby & Reiter end their paper with a quote from Bagehot: </div><div><br /></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEhTND9K7LlJfHlNf_1AXEe3711494u8kttYN4_0q27yBgwArERHG-RRVgud8Mky3qCnbkhNApuimF-bBGlTwXFVAridPtX3iK_TQia-ys1E3bORoYXQE515BeeTUTYuidg9rf37N58SjmHZeAaAcfYp9RFoepmZVjman7sU-89qZx1jThqTPQar39oX" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="234" data-original-width="818" height="184" src="https://blogger.googleusercontent.com/img/a/AVvXsEhTND9K7LlJfHlNf_1AXEe3711494u8kttYN4_0q27yBgwArERHG-RRVgud8Mky3qCnbkhNApuimF-bBGlTwXFVAridPtX3iK_TQia-ys1E3bORoYXQE515BeeTUTYuidg9rf37N58SjmHZeAaAcfYp9RFoepmZVjman7sU-89qZx1jThqTPQar39oX=w640-h184" width="640" /></a></div><div><br /></div>Financial stability is always and everywhere ensured by trust, not by clever technology. </div><div><br /></div><div><b>Related reading:</b></div><div><br /></div><div><a href="https://www.coppolacomment.com/2013/01/when-governments-become-banks.html">When governments become banks </a></div><div><a href="https://the-blindspot.com/putting-the-terra-stablecoin-debacle-into-tradfi-context/">Putting the Terra stablecoin debacle into "tradfi" context</a> - The Blind Spot</div><div><a href="https://www.forbes.com/sites/francescoppola/2016/03/31/in-technology-we-trust-maybe/?sh=11868c327b84">Bitcoin: In Technology We Trust (Maybe)</a> - Forbes</div><div><a href="https://www.coppolacomment.com/2011/09/on-risk-and-safety.html">On risk and safety </a></div><div><a href="https://www.theedgesingapore.com/views/cryptocurrency/decentralised-stablecoins-are-impossible">Decentralised stablecoins are impossible</a> - Ben Charoenwong and Jonathan Reiter <i>(paywalled)</i></div><div><br /></div><div><br /></div><div><br /></div><div><br /></div></div></div>Frances Coppolahttp://www.blogger.com/profile/09399390283774592713noreply@blogger.com0