There is a chance that the US will begin to regulate stablecoins sometime in 2022. Certainly, stablecoins have been a subject of focus by a series of US regulatory bodies as well as the Presidential Working Group on Financial Markets. In this post, I discuss what the works of two very fine twentieth century economists, Frank Hahn and Hyman Minsky, have taught us how to think about money and financial fragility when it comes to regulating stablecoins.
I begin with some background on the crypto space. According to Carolyn Wilkins, who serves as an external member of the Financial Policy Committee, Bank of England, the current value of global financial system is approximately $250 trillion, with the share of the crypto space being about $2.6 trillion or 1%. Of that $2.6 trillion, $2.4 trillion stems from the value of Bitcoin.
Although 1% might not seem like a lot at the moment, the value of the crypto space five years ago was $16 billion. It is easy to dismiss the associated growth as nothing more than a speculative bubble in Bitcoin. However, the financial system is in the midst of making serious structural changes to integrate crypto technology into its operations. In addition, financial regulators are at work putting proposals in place for regulating the crypto sector.
Many people trace the cryptocurrency revolution back to Satoshi Nakamoto’s paper “Bitcoin: A Peer-to-Peer Electronic Cash System,” published on October 31, 2008. However, decades before, when I was a student at the London School of Economics, scholars were at work developing the microeconomic foundations of transaction technologies and cash systems. These scholars included Frank Hahn, my Ph.D. supervisor at the time, and visiting scholars Joe Ostroy and Ross Starr.
In supervising me, Hahn stressed two themes that he suggested I work on in my own research: transaction costs and information. I followed his advice, and as it happens, both of the themes he emphasized are central to the crypto revolution that is now underway.
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Hahn became known for what came to be called “the Hahn problem”, which is often described by the following question: Why is that people are willing to hold legal fiduciary money that has no intrinsic value? By the same token, and please excuse the pun, the same question arises in respect to Bitcoin and other cryptocurrencies.
Hahn addressed this question in an important book entitled “Money and Inflation,” issues which loom large today. In his book, Hahn emphasized the importance of understanding the role of money in transaction technologies. Although the book was published in 1981, more than 25 years before Satoshi Nakamoto’s seminal paper, Hahn’s framework captures the essential features that Nakamoto developed. In this regard, section 2 of Nakamoto’s paper is entitled “Transactions.”
Hyman Minsky, the twentieth century economist associated with the term “Minsky moment” reviewed Hahn’s book. While impressed with Hahn’s technical skill, Minsky was quite critical of Hahn’s overall approach for being too theoretical. Minsky wrote: “Nowhere in Hahn’s volume do the words ‘bank’ or ‘banker’ appear.”
In his writings, Minsky studied the determinants of financial instability, and in this regard analyzed the role that banks and bankers play. In particular, Minsky discussed the role of psychological bias in financial decisions, emphasizing the impact of euphoria. Euphoria, he suggested, underlies speculative bubbles, which grow and burst. A “Minsky moment” occurs when the financial system shifts from being fragile but stable to being unstable. Minsky had a lot to say about how to regulate financial markets in order to address issues involving fragility and instability.
If you were to ask me who is right, Hahn or Minsky, I would say both. Collectively, we need intellectual frameworks to analyze both the impacts of transaction technologies and psychological bias associated with banks and financial stability. To use the analogy of blind men touching different parts of an elephant and describing what they feel, consider this: Hahn and Minsky are analogous to blind men, and the elephant they are touching is analogous to the financial system. Both economists had valuable insights to offer about money in general, and crypto-money in particular.
Minsky’s work was deeply influenced by the events of the 1920 and 1930s. During the 1920s, great innovations in consumer products occurred, largely because of electricity, and the associated euphoria gave rise to a stock market bubble. This bubble burst on October 29, 1929, and was followed by the Great Depression of the 1930s. The major foundations for financial market regulation in the US were established in the 1930s.
The transaction technology known as blockchain, which underlies cryptocurrencies like Bitcoin, uses large amounts of electricity to make financial ledgers secure. Just as electricity powered the innovations of the 1920s, electricity powers new blockchain financial innovations.
Just as the stock market experienced a bubble during the 1920s, the price of Bitcoin experienced a bubble during 2021. In this regard, it is worth reflecting on its price trajectory during 2021. At the beginning of the year, the price of Bitcoin was $28,990 and rose by about 62% over the subsequent twelve months. This trajectory featured great volatility with a peak of $63,588 on April 13, a drop to $29,790 on July 20, and a rise to $67,583 on November 8. Early in 2021, there was speculation among Bitcoin enthusiasts that its price would reach $100,000 by year end. In a previous post, I discussed why this was unlikely. Still, a 62% increase is substantial.
The transaction cost framework developed by Hahn has competition at its core. In Hahn’s framework, competition takes place among financial organizations to carry out financial transactions. Exactly this kind of competition is taking place today. For example, providers of Bitcoin-based blockchain services compete with providers of Ethereum-based blockchain services.
Notably, both Bitcoin and Ethereum currently require very large amounts of electricity to process transactions. However, there are plans to modify the Ethereum blockchain technology in order to reduce electricity demand. Should this plan be implemented—it was to have taken place already and has been postponed until June 2022—the competitive implications will be of great interest.
Transaction technology competition is global. Bitcoin and Ethereum are part of the decentralized finance sector known as DeFi, which compete with financial service firms that are a part of a system connected to a central bank (CeFi).
The price of Bitcoin has been far too volatile for Bitcoin to serve as an effective medium of exchange. However, other cryptocurrencies known as “stablecoins” have emerged that in theory are more suitable to serve in this capacity. One such stablecoin is “Tether,” which is backed by dollars, and whose dollar value is stable.
The case of Tether illustrates why we need to pay attention to the warning messages Minksy delivered about excessive leverage, shadow banks, financial innovation involving speculative finance, asset pricing bubbles, and weak regulation. Of course, all of these issues surfaced in connection with the global financial crisis. Notably, the crisis erupted thirteen years after Minsky died, which is testament to the lasting power of his ideas.
What readers want to remember about Tether is that it was initially structured to be 100% backed by US dollars. This means that in theory, if all the holders of Tether decide to redeem their stablecoins for dollars, there will be enough dollars available to meet the demand. The equivalent of bank run is not something holders of Tether need worry about. However, in recent months, serious questions have been raised about the extent to which Tether is indeed backed by dollars, and therefore whether holders of Tether need worry about the analogue of a bank run. By analogy, think about what happens when a money market fund “breaks the buck.”
As I mentioned earlier, Frank Hahn emphasized two themes to me about money: transaction costs and information. In the case of Tether, it is difficult for holders of Tether to get information about the assets backing Tether.
For Tether to be a true stablecoin, the firm which issues Tether would have to operate much like a bank. This is because purchasing Tether is akin to depositing money in a bank. Holders of Tether would treat the value of their holdings as principal which is tied to the dollar.
Banks generate returns for their shareholders by taking money from depositors and placing the proceeds in investments whose expected return is higher than what they promise to pay to depositors. In effect, the shareholders of banks insure depositors in case the banks’ investments go sour; or at least they do so as long as their equity remains positive.
Commercial banks typically choose investments with relatively low risk, which limits the probability that the bank will fail. In contrast, investment companies such as hedge funds typically choose investments featuring higher risks than the risks chosen by commercial banks. Of course, unlike banks which effectively borrow from their depositors, hedge funds make no promises about protecting the principal associated with their investors’ money.
When a financial firm promotes itself to depositors as a commercial bank, but behaves like a hedge fund, its behavior amounts to committing fraud. Holders of Tether have reason to be concerned that Tether Holdings Ltd., the provider of Tether, has shifted from behaving like a bank to behaving like a hedge fund, but not disclosing exactly what it has been doing. If so, then holders of Tether might not have the protection they believe they have. And if full protection of the associated principal depends on asset price appreciation instead of cash flows, then the collateral qualifies as what Minsky calls “speculative finance.”
Hahn was a neoclassical economist. Neoclassical models are based on the assumption that everyone is rational. One of the great insights of information economics is that information asymmetries can make investors lose so much trust that some markets collapse.
Minsky was a behavioral economist. Behavioral models recognize that because of psychological phenomena such as euphoria, some people can behave irrationally, placing their trust in unwarranted ventures. In consequence, some markets which should collapse because of information asymmetries, instead persist for too long. This is what happens with Ponzi schemes, and also what Minsky called “Ponzi finance.”
In Ponzi finance, a financial security must depend on price appreciation for fulfilling obligations relating to both interest payments and repayment of principal. Think about underfunded pension plans, and what happens to the ability of those plans to fulfill their obligations when the assets they hold fail to appreciate in value.
The absence of perfect rationality provides one reason why it is important to regulate financial markets. In respect to regulation, the essential features of crypto-assets share many features as traditional assets. From a Minsky perspective, crypto-assets can feature excessive leverage, be issued by shadow banks, offer opportunities for financial innovation and speculative finance, be subject to pricing bubbles, and be the subject of weak (or no) regulation.
Blockchain offers great promise in respect to the creation of more efficient transaction technologies. That is one side of the coin. The other side of the coin is the need for sensible regulation of these markets.
DeFi is part of the shadow banking sector, which Minsky called “fringe finance.” Minksy emphasized the importance of asking who are the lenders of last resort for shadow banks, and also asking how imprudent risk taking by shadow banks would generate systemic risks that spill over into mainstream banking. Fast forwarding a bit, the question can be reframed slightly by asking how imprudent risk taking in DeFi will spill over into CeFi.
There is a tendency to ignore Minsky’s messages during good times, and then pay the price during “Minsky moments.” Now is a good time to place Minsky’s messages at the forefront of discussions aimed at regulating stablecoins.