Kaminska: It all makes sense...

It all makes sense when you realise there are TWO US dollar currencies

Izabella Kaminska | Sep 29 19:54

Most people know that China’s currency is classified according to trading conditions. There is, for example, CNY, which refers to onshore yuan. There’s CNH, which refers to Hong Kong (offshore) yuan. And then there’s NDF, the non-deliverable forward market.

What differentiates these currencies are the terms and conditions that apply to those particular market zones, and how easy or not it is to transfer currency in and out. As implied yields of the respective markets show (chart via BNP Paribas), the rates of return for all of these markets varies significantly — because they are, to some extent, entirely different currencies:

http://imgur.com/QE0PA8H.png

If you’re confused how and why the same currency can be valued differently at the same time in different places, a good explainer (albeit unwitting) comes by way of Jeffrey Robinson’s new book on Bitcoin, reviewed here.

Read the chapter dedicated to Bitcoin legislation, with regard to New York’s attempt to slap serious conditionality on the way Bitcoin money transmitters operate their businesses. As Robinson notes, the Bitcoin community has lashed out at the state’s attempt to enforce regulations that, among other things, include minimum capital requirements and rules on the nature and quality of the assets that such operators must hold. These rules, the Bitcoin community says, are much more onerous than those imposed on existing financial services (they’re not, but that’s another story).

However, as Robinson also recounts, another objection goes as follows (our emphasis):

If the Bitcoin Foundation has its way, there would not be a special bitcoin license, and bitcoin businesses would simply be integrated into the existing financial services rules so they could just do their thing, without consequences.

I particularly like the Bitcoin Fountain type who decided that the regulations will create “government-tainted” bitcoins. That bitcoins in New York will trade at a discount to “non-tainted” bitcoins in the rest of the world. As a result, an arbitrage situation will develop wherein traders will buy the tainted coins and sell them in non-regulated jurisdictions for the untainted prices.

Now, Robinson argues that in order for that to be the case you would need to identify a tainted bitcoin once it leaves New York, which he suspects would be hard to do. He adds that even if an arbitrage situation was created — and he says he couldn’t find many people on Wall Street who would even entertain such silliness — the arbitrage wouldn’t last for long because demand for cheaper bitcoin would drive up their price to that of the so called non-tainted coin.

Sadly none of that changes the Bitcoiner’s main point which, it pains us to say, is pretty concrete. In fact, it’s probably the most insightful thing we’ve ever heard from the lips of the Bitcoin community. Nor is it surprising, we should add, that Wall Street execs dismiss such a point as silly. They are either genuinely in the dark about the role of regulatory arbitrage in currency value, and/or prefer to keep the knowledge private and confidential for asymmetric benefit.

We bring all this up because, as it happens, the entanglement of currency conditionality within dollar markets — i.e. the inability to differentiate dollars tainted by government regulations from those which are not — may have played a much greater role in the 2008 global financial crisis than we appreciated.

Take the latest work of Stephen Cecchetti, professor of international economics at the Brandeis International Business School, previously economic adviser and head of the monetary and economic department at the BIS and Kermit Schoenholtz, professor at New York University’s Stern School of Business.

As they note this Monday regarding ongoing findings about money flows during the financial crisis (our emphasis):

With time we learned that banks in Europe and elsewhere outside the United States had been borrowing a large volume of dollars in short-term money markets and investing in U.S. mortgage-backed securities. As the mortgages started to default and the securities lost value, the non-U.S. banks had trouble rolling over their short-term debt. Researchers eventually estimated the dollar shortfall to be well over $1 trillion! That significant parts of the global financial system are running on dollars is no surprise. We discussed some of the basics – the fact that the dollar accounts for 80% of trade finance and 87% of foreign currency market transactions – in an earlier post on the reserve currencies. But there is more, much more. The fact of the matter is that there is a parallel dollar-based financial system – call it the “Global Dollar system” – that operates outside the United States.

As we have explained before, that parallel dollar market is actually the same old eurodollar market that has been befuddling academics such as Milton Friedman for decades.

But it’s nice to know that BIS types see it as an untainted parallel currency market as well.

More from Cecchetti and Schoenholtz about the size of that totally unregulated parallel market:

Using data from the BIS, we can estimate the size of this Global Dollar system. Starting with U.S. dollar liabilities of banks outside the United States, we quickly get around $13 trillion. (If you have a dollar-denominated account in a bank in London, Zurich or Hong Kong, it would be included in this sum.) Now, not all countries report to the BIS, so this subtotal is incomplete. China and Russia are missing, for example. In addition, Ecuador, El Salvador and Panama are dollarized, so their banks are issuing dollar liabilities.

Tallying these non-reporting sources may add another $1 trillion. Next come a few trillion dollars more from dollar-denominated securities that are issued outside the United States (mostly in London).

All of this leads us to conclude that there is a second dollar-based financial system in which firms – mostly financial institutions – have issued dollar liabilities of more than $15 trillion. This volume of Global Dollars exceeds the total liabilities of banks operating within the United States.

Back in Nixon days, this wasn’t so much of an issue. In fact, Nixon famously quipped, “the dollar is our currency, but your problem.”

Nowadays, due to the systemic treatment of all these dollars as one and the same thing — a mistake, we should emphasise China is not making — the problem is everyone’s.

As the authors note:

Such contagion puts the entire financial system at risk, making it everyone’s problem. By lending to a solvent but (temporarily) illiquid bank, a central bank can limit a liquidity crisis. Indeed, it was the frequent banking panics of the late 19th and early 20th century that led to the creation of the Federal Reserve System as the U.S. lender of last resort, the role already played by the European central banks of the day.

Hence, of course, why the single most important Federal Reserve extraordinary action was not QE but the FX swaps it introduced:

Yet, today’s two dollar-based financial systems differ in one absolutely critical respect: Banks operating or based in the United States have access to the Federal Reserve’s discount window, so when they suddenly need dollars they can easily get them, provided that they are solvent. Other solvent banks have no such access. Had the Federal Reserve merely accepted that dichotomy, the crisis of 2007-2009 would have gotten much deeper much faster as leading European banks dumped assets or defaulted!

Instead, in December 2007, the Fed introduced one of its most successful crisis mitigation tools, offering to lend U.S. dollars to foreign central banks that they could in turn lend to their banks. Recognizing that fire sales and defaults of these foreign banks posed a systemic threat back home, the Fed eventually provided 14 other central banks with large (in some cases, unlimited) dollar swap lines to meet the surge in funding dollar needs.

This was, in other words, the equivalent of the Federal Reserve guaranteeing Bitcoin. The biggest challenge for the Fed nowadays is getting the rest of the world that uses its dollars to comply with the domestic rules and regulations it sets.

Either way, the logic is simple: It’s the soundness of the regulations and rules attached to the currency system that make or break the currency. Not the currency itself. Thus, if you allow bad practices to stealth penetrate through your regulatory walls, systemic and unexpected crises will follow.