Thread by @fernandoulrich

Fractional Reserves, Maturity Mismatching, Liquidity.

A long needed and essential thread on #Bitcoin and Banking (and the fragility of USD Tether). 👇

1/24 What prompted me to finally write this was a tweet by @TuurDemeester on Tether Limited's recently updated explanation of its reserves breakdown.

https://twitter.com/TuurDemeester/status/1106333858633576450

2/24 So first things first. Jesus Huerta de Soto (my teacher during my master's degree in Madrid, btw) is certainly right in distinguishing between a "irregular deposit" (deposit of fungible things) and a "loan".

3/24 However, what we now call "bank deposits" are loans, not "irregular deposits" in a kind of bailment contract. Deposits are promises to pay on demand in specie (cash, that is "paper-currency", this is the main meaning for cash, I'll get back to it below).

4/24 Yes, I grant that there is confusion and/or omission on the part of banks nowadays, since most people think money deposited in a bank is theirs and that banks actually hold the physical pieces of paper at all times. Contracts SHOULD be clear on this crucial fact, I agree.

5/24 Despite this lack of clarity, though, courts in many jurisdictions have acknowledged depositors are in fact creditors to banks. Besides, if deposits weren't loans, banks wouldn't have to book these as liabilities on its balance sheets.

6/24 If it's mere bailment (no transfer of ownership), there's no need to record it as a liability. Thus, in case of bailment (in modern banking this is a "safe deposit box", there goes the word "deposit" again to complicate things),

7/24 there's not even a discussion of 100% reserves: anything less than the whole amount at all times constitutes breach of contract, perhaps outright crime. When a bailee goes bankrupt (due to business reasons),

8/24 customers simply ask for restitution of goods under custody. It's not a "payment", it's simply restitution, giving back whatever was handed in for bailment. Unless bailee committed fraud, goods under custody were always safe, fully stored (100%).

9/24 Modern bank deposits are no bailment contracts. They are loans, IOUs, obligations, promises to pay the depositor in specie. But when is the obligation due? Whenever the customer asks for repayment (that's why it's called demand or sight deposits).

10/24 What if a bank doesn't have the funds to redeem in specie? Loans should have clear clauses for breaches of contract (again, current bank contracts should be much clearer on this), like asking for additional days and paying a penalty for late fulfillment.

11/24 What if all depositors show up at the same time to ask for repayment? Well, a bank might need more time to repay everyone. But remember, the contract is always between bank and customer, and not between bank and a collective of customers.

12/24 "I promise to pay you on demand" is not "I promise to pay you and everybody else on demand at the same time". But won't this lead to illiquidity and bring about bank runs? It sure can, but that is neither fraud nor crime. So what is this then?

13/24 Maturity mismatching (or transformation). Banks receive deposits (effectively borrow from depositors) and lend them in full or in part. And depending on the use of borrowed funds, they may put themselves under an illiquid situation.

14/24 There's a liability maturing at any time (bank deposits, zero maturity) and possibly a loan maturing in months or years. How will it be able to repay depositors? Either by constantly asking its creditors to roll over outstanding debt (depositors refraining from withdrawal)

15/24 or by selling assets in the market for more liquid assets (like cash) to repay depositors. The higher the degree of maturity mismatching, the more illiquid a bank becomes and more susceptible to bankruptcy.

16/24 (side note: bankruptcy comes from the italian "banca rotta", or "broken bench", when a bank or money changer failed, his table or bench would be actually broken apart, 16th century).

17/24 That means modern banks borrow short to lend long. Using demand deposits to fund 30-year mortgages is beyond risky. Why do this persist in developed regions like the US and Europe? Because of lender of last resort (LOLR)

18/24 and also limited liability laws (in Brazil for instance, banks are much more capitalized and less illiquid than its american or european counterparts, because local laws will put a banker's personal wealth on the line to cover for losses. Skin in the game squared.)

19/24 The more skin in the game present in a banking system, the less systemic illiquid it will be. LOLR = skin from others in the game.

20/24 So, given that bank deposits are loans, does it make sense to use the term "fractional reserve"? If a bank starts with only its own capital (no deposits received), and grants a new loan to a customer by issuing a fresh demand deposit, what is being "fractionally reserved"?

21/24 Liabilities are always "100% reserved" by assets (balance sheet 101, unless insolvent). The key issue is evaluating the quality of these assets (reserves), or the level maturity mismatching.

22/24 I'll leave the discussion of economic cycles and inflation caused (or not) by "fractional reserve banking" (FRB) for another day, but the short take is: FRB doesn't per se cause economic cycles and isn't inflationary. Blame it mostly on modern central banking.

23/24 When economists say "banks create money out of thin air" this is not entirely true. Banks create in fact "liabilities" out of thin air that do circulate as if they were money. Bank liabilities are thus highly liquid, but it's not money proper, it's not cash.

24/24 Having clarified (I hope) a lot of confusions related to "fractional reserve", let me turn now to USD Tether. As a first step, one must understand what its contract says. This may be a bit long but is ESSENTIAL READING. {continues below}.

1/22 Terms of Service, Clause 3: "Tether issues and redeems Tether Tokens". "Tether Tokens are backed by Tether’s Reserves" (which reserves? Read further below.). "only money will be accepted upon issuance" (I suppose either cash or bank wire, most likely only bank wire).

2/22 "In order to cause Tether Tokens to be issued or redeemed directly by Tether, you must be a verified customer of Tether. The right to have Tether Tokens redeemed or issued is a contractual right personal to you."

3/22 So you must be a customer and this promise of redemption is made to you on a standalone basis (not collectively).
"Tether reserves the right to delay the redemption or withdrawal of Tether Tokens if such delay is necessitated by the illiquidity or unavailability or loss of

4/22 any Reserves held by Tether to back the Tether Tokens, and Tether reserves the right to redeem Tether Tokens by in-kind redemptions of securities and other assets held in the Reserves."

5/22 Before we delve into the "Tether's Reserves", note the following: the above contract clause is pretty much how a standard bank deposit contract should read. Quite remarkable that Tether is much more transparent than banks in this regard.

6/22 Let's walk through the whole process of issuance and redemption of Tether Tokens. After signing-up, compliance (AML/KYC), approval, etc., customer 1) initiates a wire transfer to Tether's bank; 2) Tether issues and transfers new token to customer wallet;

7/22 3) Tether uses received funds (with 90% likelihood) to buy US T-bills; 4) after a given period, customer asks for redemption, sends tokens back to Tether, which sells T-Bills on the market to raise funds and wire the money back to the customer.

8/22 Things to note: no actual cash has been used (physical paper). Even if Tether simply maintains received funds as demand deposits at its bank, it's not cash, but bank promises to pay in specie whenever requested.

9/22 "100% cash reserves" in this context almost never mean setting aside piles of actual cash in a vault. Never. Remember this for any and every stablecoin out there.

10/22 This brings us to Tether reserves. Clause 1.1.32 states: "'Reserves' means traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities."

11/22 Anyone who is familiar with the investment world knows that "cash and cash equivalents" means any highly liquid instrument, usually US Treasury Bills up to three months of maturity.

12/22 Austrians, take note, this is "cash" for the majority of banks, asset managers, hedge funds, and the like. Virtually no one keeps "cash" as idle balances on demand deposits. T-Bills = cash.

13/22 For Tether, money received from customers for issued tokens is called "float", that is, money it can use to purchase whatever assets it may please (according to clause 1.1.32) and earn a positive spread. That's pretty much a stablecoin's business model.

14/22 Now, the very serious and important part, something that I've been vocal about (at least in portuguese): Tether may be issuing tokens on credit, that is, creating liquidity that can affect bitcoin (and altcoins) prices. How?

15/22 Like this: Bitfinex (an affiliated party) calls Tether and says "hey, I need $50 million worth of Tether Tokens, but I can't pay you right now, alright?" and Tether replies, "Sure, not a problem, here you go."

16/22 If you looked at Tether's balance sheet, it would read as follows: Assets - Receivables from Bitfinex $50 MM; Liabilities - Tokens in Circulation (Issued) $50 MM.

17/22 You might think, "No way they would do this!?" Well, I certainly hope so, but it's perfectly in accordance to its terms of service, as reserves mean also "receivables from loans made by Tether to third parties, which may include affiliated entities."

18/22 Tether never said it would maintain an "irregular deposit" (as meant by @TuurDemeester ), it was never a bailment contract.

19/22 Wrapping up: first we need understand what the contracts say. Second, if it's not clear, what is the jurisprudence? What is the actual business practice? Nothing nowadays (besides popular ignorance) proves a "bank deposit" is a bailment transaction instead of a loan.

20/22 We're creditors, banks are debtors. We give them credit by refraining from withdrawing our funds.

21/22 "Fractional reserve" is thus a misnomer. Liabilities are always fully reserved by assets. "Which assets" is everyone's job to investigate to assess a bank's liquidity position (how likely can it fulfill its promises?).

22/22 Finally, if you look at Tether, the contract is crystal clear. There are remaining and troubling questions though:
Is Tether financing Bitfinex by creating liquidity through issuance of tokens to be paid at a later date? If yes, how much? I worry. And you should too. {fin}

Appendix: I should have written “Money and Banking” thread. But since Bitcoin is money... it’s ok.