Snake oil sellers in the stablecoin world


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 claimed to have 100% actual dollar backing 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 FTX, Voyager and several other crypto companies, it has become dangerous even to mention FDIC insurance in marketing material. 

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: 

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. 

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 is regulated by the SEC. It invests only in short-term government instruments: 

Circle Internet Financial LLC is its only eligible investor. 

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, told Coindesk 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. 

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. 

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. 

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". 

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. 

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 "floor" versus "corridor" systems in the years after the 2008 financial crisis, but for those who don't, here's a brief recap. 

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. 

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.

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. 

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. 

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 major disruption in the repo market, 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 had to be able to obtain liquidity from the Fed whenever they needed it. Enter the Standing Repo Facility (SRF). 

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. 

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. 

That's the wonkish bit. But what does all this have to do with Blackrock?

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. 

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. 

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.  

So how would Blackrock gain access to the funds deposited at the Fed?  Well, it must wait for the reverse repo to unwind. As Kim Driver pointed out on Twitter, 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. 

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. 

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: 

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"

 Like the PWG's suggestion, USDC access to the RRP through a separately managed money fund would reduce run risk in the stablecoin 

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. 

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. 

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. 

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. 

Related reading:

Image: By Wesley Fryer from Oklahoma City, Oklahoma, USA - Snake Oil Tonics, CC BY-SA 2.0, Wikimedia Commons 


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