How are we consumers to know whether the dollars that financial institutions provide us aren't fraudulent dollars? On what basis can we assume that the funds we hold at PayPal, for instance, or in Cash App, are "good money"?It's an age-old problem. If you were alive in 1889 and someone offered to pay you with a note from Banque d'Hochelaga (see below), a privately-owned Montreal-based bank, how could you know the issuer wasn't a fraud and that it had enough assets on hand to always redeem notes with gold and/or silver?1889 note, Source: Bank of CanadaThe question of fabricating trust in dollars also applies to today's rapidly growing stablecoin sector. Stablecoins are dollars issued on public blockchains like Ethereum or Tron. Tether has an astonishing billion in U.S. dollar
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How are we consumers to know whether the dollars that financial institutions provide us aren't fraudulent dollars? On what basis can we assume that the funds we hold at PayPal, for instance, or in Cash App, are "good money"?
It's an age-old problem. If you were alive in 1889 and someone offered to pay you with a $10 note from Banque d'Hochelaga (see below), a privately-owned Montreal-based bank, how could you know the issuer wasn't a fraud and that it had enough assets on hand to always redeem notes with gold and/or silver?
|1889 $10 note, Source: Bank of Canada|
The question of fabricating trust in dollars also applies to today's rapidly growing stablecoin sector. Stablecoins are dollars issued on public blockchains like Ethereum or Tron. Tether has an astonishing $24 billion in U.S. dollar stablecoins in circulation, up from just $1 billion three years ago. Competitor USDC has issued about $5 billion in stablecoins, up from $0.5 billion at the beginning of 2020. On what basis can a potential user trust these stablecoin dollars? How do we know that the $500 in Tethers or USDC that someone wants to send us won't melt to $0 a few days from now?
Consumers use simple rules of thumb to differentiate between good dollars and bad ones. We'll call them:
- everyone's using it
- Warren Buffett owns some
- JP Morgan trusts them
- show us the money
- big brother is watching
The first rule of thumb is the everyone's using it approach. If all your friends and family are using Tethers or PayPal or Banque d’Hochelaga notes, then it's probably safe for you to do so too.
There is plenty of wisdom in everyone's using it. If there are thousands of Tether users, then it's likely that at least a few of the more diligent ones have already dug deeper to ascertain the issuer isn't fraudulent, and so we can all piggy-back off of their work. This saves us the hassle of doing our own audit.
Everyone's using it is by no means a fail-proof method of determining the validity of a dollar. If no single user has done sufficient due diligence, then everyone is operating blindly. That's how Bernie Madoff managed to keep things going for so long.
The second rule that consumers use to validate dollars is the Warren Buffett owns some approach. Similar to everyone's using it, the Warren Buffett owns some approach piggy-backs off the work of others. But rather than relying on other users, it free-rides off of the expertise of sophisticated investors.
To see how this works, let's head back to 1880s Canada. In addition to having a set of noteholders, the Banque d’Hochelaga also had bondholders and shareholders. These investors, often prominent members of the community, would have had plenty to lose if Banque D’Hochelaga failed—not just money, but community standing. And so prior to investing in the bank they would have carefully scanned its financial statements, investigated its managers and directors, and verified the quality of its biggest customers. If these well-known and sophisticated stock & bond investors thought it was safe to buy Banque d’Hochelaga securities, then noteholders—without having to do any sophisticated analysis of their own—could assume that it was safe to hold its banknotes too.
Likewise, in modern times should Warren Buffet decide to invest in Tether or PayPal securities, then users of these platforms could be assured that the firm's financials have been thoroughly vetted, and thus by transitivity Tether stablecoins and/or PayPal balances should also be safe.
But Warren Buffett owns some isn't fool-proof. Even Warren Buffett can be tricked. Alternatively, shareholders may have been in on the scam from the start.
A third way for outsiders to gauge the quality of a dollar is the JP Morgan trusts them approach. Like the previous two methods, this one piggy-backs off of other people's due diligence, but in this case it relies on banks & other dollar issuers. In theory, no one should be a better judge of the quality of a dollar issuer than a competing dollar issuer.
In 19th century Canada, for instance, banking giants the Bank of Montreal, Royal Bank, and Dominion Bank all allowed their customers to bring Banque d’Hochelaga notes in for deposit. These bigger banks would have then redeposited said notes the very next day at the Banque d’Hochelaga for conversion into gold/silver. Until the banknotes had been converted, however, the Bank of Montreal, Royal Bank, and Dominion Bank were effectively creditors, or lenders, to the Banque D’Hochelaga. That's a dangerous position to be in. So prior to adopting a policy of accepting deposits of Banque D'Hochelaga notes, these big banks would have audited the smaller bank's books.
Thus a 19th century consumer could trust that Banque D’Hochelaga notes were solid. Competing banking behemoths had already vetted the bank.
The JP Morgan trusts them route to trust formation doesn't quite work with stablecoins or PayPal balances. The issuer of USDC, the Centre consortium, doesn't accept Tether deposits, or vice versa. Nor do PayPal and Cash App interchange deposits with each other. And so unlike Canada's 19th century banks, none of these dollar-issuing platforms operate in an environment in which they are constantly auditing each other's credit worthiness.
Other banks do enter into the picture, but it is in a different, less effective, way. PayPal, Tether and USDC have reserves that they use to secure their dollars. They deposit these reserves at an underlying bank. That bank doesn't act as a creditor to the platform (it acts as the debtor), and so it needn't worry about its customers' credit risk. But it does have to worry about a customer being fraudulent, since this could damage the bank's reputation. Thus we can take some comfort from the fact that Wells Fargo, PayPal's bank, is keeping an eye on PayPal, and that Tether's bank, Deltec, is watching Tether. But this is weak medicine compared to the assurances that Banque d'Hochelaga noteholders enjoyed.
JP Morgan trusts them is a pretty good rule of thumb, but it isn't fool proof. Even bankers can be fooled. Or maybe the bank and its shareholders are themselves in on the scam.
Luckily, a dollar user has yet another way of forging trust in various types of dollars, one that doesn't piggy-back off of others. Let's call it the show us the money approach. Just take a look at the firm's financial statements. The Banque d'Hochelega made it easy for the public to get this information, going so far as to flaunt its capital on its banknotes. See below, where it advertises having $1 million in capital.
|1898 $10 note. Source: Bank of Canada|
It also bragged about its financial strength on its bank passbooks, those little books that account holders had to bring to the bank when they made deposits or withdrawals:
Finally, the Banque D'Hochelaga even took out full page advertisements in newspapers and other publications showcasing its capital and reserves. Below is an ad from a 1910 tourist guide published for visitors to the 21st International Eucharistic Congress, hosted in Montreal:
Show us the money also works in the 21st century. Don't trust PayPal's reserves? Scan its audited balance sheet. PayPal is a publicly-traded company, and so it is obliged to post quarterly audited financial statements. As for USDC, each month it voluntarily attests to how many reserves it holds. Grant Thornton, an accountancy, verifies its numbers.
In many cases, however, the public can't rely on show us the money. Tether, for instance, doesn't publish audited financial statements or attestations.
Which leads us to our final rule of thumb. Consumers can build trust in dollars via the big brother is watching approach, i.e. government regulation. Banque d'Hochelaga operated at a moment in history when government regulation of banks was very light. This lack of regulation worked fine. The Canadian public trusted private banknotes and only rarely did they suffer from bank failures.
But today, regulation is far more pervasive. PayPal and USDC are regulated in the U.S. on a state-by-state level as money transmitters. Each state has different money transmitter legislation, but in general all states require transmitters to limit their investments to a range of permissible securities, to post a surety bond or letter of credit with the regulator as security, and/or to maintain minimum net worth requirements. Transmitters must also provide their state banking regulator with yearly audited financial statements and submit to examinations.
These rules are by no means homogeneous. Dan Awrey, Lev Menand, and James McAndrews have published an interesting comment that gets into some of the nuances of state-by-state money transmitter regulation. The map below, for instance, shows how net worth requirements differ across states.
Even though the U.S. lacks standardized rules, a base level of regulation exists, and so owners of USDC stablecoins and PayPal balances can muster an additional layer of confidence in the safety of their dollars.
But big brother is watching doesn't always apply.
Tether, for instance, doesn't serve U.S. customers, presumably to avoid having to secure state money transmission licenses. Thus it needn't submit itself to state-by-state permissible investment lists, net worth requirements, security deposits, audits, examinations, etc. One might assume that Tether is regulated elsewhere and thus must abide by a different set of strict rules. But that's not necessarily true. Many nations do not have regulatory frameworks for money transmitters. (Canada, my home country, doesn't). Since Tether is likely domiciled in one of these light touch jurisdictions, Tether users cannot rely on big brother is watching to build trust in Tether's dollars.
Indeed, Tether has admitted that a large chunk of its reserves are in the form of a multi-year loan to an affiliate, Bitfinex. The Bitfinex loan would probably not be a permissible asset under most U.S. state money transmitter laws. Put differently, I doubt either USDC or PayPal—which are obliged to follow state law—could have done what Tether did.
I can see why Tether might prefer to avoid US money transmitter licensing requirements. Tether's reserves include receivables from loans to third parties, but if you look through state MSB law (i.e. Florida https://t.co/z8kjGkIoBZ) this sort of investment is not permitted. pic.twitter.com/3mcTq1VO7C— John Paul Koning (@jp_koning) January 21, 2021
Having worked through the rules of thumb that the public uses to establish trust in various types of dollars, let me end with the Tether situation in particular.
Social media is filled with Tether critics. Some of their criticism is weak, and Tether's many supporters on social media are quick to point this out. But the counter-criticisms that Tether's supporters provide are just as shoddy. Apart from their reliance on everyone's using it and a pale version of JP Morgan trusts them, supporters can't give much good evidence for why Tether should be trusted.
And that's because Tether hasn't provided much solid footing for its protectors to stand on. By contrast, there are very few rumours in social media about the solidity of PayPal or USDC. That's because both of these platforms have gone to great lengths to remove all the raw tinder that might cause innuendo to spark and spread in the first place.
If Tether wants to stop public criticism, it need only need copy what its competitors have done and provide something other than everyone's using it as the basis for fabricating trust. It can pick and choose from any of the following: provide the public with audited financial statements or verified attestations; bank at a higher profile bank than Deltec; secure a well-known and highly respected investor; go public; or get licensed as a money transmitter in a few U.S. states. Any of these would help asphyxiate the rumours.
It could be that Tether doesn't have solid enough finances to do any of the things I've listed. Or maybe it does, but it doesn't actually care about rumours. After all, even after years of criticism, Tether continues to grow and dominate the stablecoin sector. The community of stablecoin users seem quite content to rely on everyone's using it. For now, at least.