One day, not long after the financial crisis in 2008-09, I ran into the newsroom at The Wall Street Journal, where I worked at the time. “You guys!!” I said. “I just read the most amazing paper about shadow banking that explains everything.”
I was referring to the work of Yale researcher–and former AIG consultant–Gary Gorton (see full list of his work here). I think I had just read his famous paper “The Panic of 2007,” which then became his book Slapped by the Invisible Hand. In a nutshell, Gorton explained that the panic was sparked not by a retail run on the banks, but by an institutional run on other banks in the “securitized” or “shadow” banking system that had allowed firms like Lehman to be 30x leveraged.
(As a side note, this did not sink in with regulators who went on to write the Dodd-Frank Law without any central focus on shoring up money-market mutual funds or the repo market, prompting Gorton to write again in 2010 about the reforms that were still needed.)
In any case, Gorton contributed tremendously to the understanding of how specifically the panic happened and then turned into a larger financial crisis. So you can imagine my surprise to see his name pop up again this past weekend, as the coauthor of a paper on…wait for it…stablecoins.
Gorton and Fed economist Jeffery Zhang released a paper on Saturday called “Taming Wildcat Stablecoins,” referring to the digital “dollar coins” that have become central to the cryptocurrency system. They are often used to park cash and earn yields, or to transfer funds from one crypto to another, but there has been huge concern this year about the most popular of them, called Tether, since it was revealed that it is not 1:1 backed by actual U.S. dollars. Even its new, “sounder” rival, USDC, backed by Coinbase and Circle, has raised questions since its latest attestation report says its funds are held in FDIC bank accounts and “in approved investments on behalf of the USDC holders.” And Bitcoin bears argue its price will further collapse if stablecoin activity dries up over soundness concerns.
This all sounds familiar to Gorton and Zhang, who list five options for stablecoins going forward (see chart here), but note the only way for them to truly become trustworthy would be to have them issued “from within the insured-bank regulatory perimeter,” be backed “one-for-one by Treasuries or central bank reserves,” or be replaced “with a central bank digital currency.” Hence the Fed’s interest in creating one–which may ultimately be borne out of necessity to stabilize the crypto financial system.
In other words, write Gorton and Zhang, stablecoins have become economically similar to bank deposits pre-FDIC insurance, or to money-market mutual funds which sparked panic in ’08-09 when they “broke the buck.” But if the Fed does step in with a central bank digital currency, it then facilitates the leverage building up in the crypto space! And few think it really wants to do this.
Even crypto proponents like Avanti’s Caitlin Long are concerned about the leverage in the system. In a recent podcast and at the Bitcoin Miami conference last month, she noted that the “financialization” of crypto has caused it to build up “circulation credit” (in the words of von Mises) not unlike fractional reserve banking, making it vulnerable to runs.
And this is all doubly ironic because Bitcoin is supposed to be a “hard money” replacement to the dollar. As one observer tweeted: “Many Bitcoin maxis promote sound money but spent roughly the last 2 yrs building ways to lever crypto 2-100x.”
Regulators are already starting to crack down. New Jersey issued a Cease and Desist order against BlockFi, which is based in the state, just yesterday so they can no longer sell “unregistered securities in the form of interest-earning cryptocurrency accounts.” They also warned other DeFi platforms, saying they “present a heightened risk of loss to investors” but are not protected by FDIC, like the traditional banks, or the SIPC, as with brokerage accounts.
We’ll be speaking about all of this with the CEO of Celsius today–a platform that promises up to 17% yields on your crypto. It took decades for the old “wildcat” banking system to become fully regulated and centralized. It’s hard to imagine the same won’t take place–but at an accelerated pace–for the crypto space.
See you at 1 p.m!