How Stablecoins Will Transform Banking | Charles Calomiris

24:35Demetri Kofinas:The premise being that the more information a bank has about the state of your business by having access to the flow of capital in and out of your accounts, the better it can determine the risk of lending to you and the prospects of generating a return. That's definitely part of it. But there's another part, which is you might want bankers to have to fund themselves with this very withdrawable kind of debt because it keeps them disciplined in an environment where they don't have, where people don't know what they're doing with the money. We saw how that worked out with SVB. Well, if you were in the old days when we really didn't have deposit insurance, that worked very well.

25:16But in the current environment with the federal home loan bank system and deposit insurance, the problem is the discipline comes suddenly and very late. And so it doesn't work. So it's really more the protection was the problem, not the discipline, if the discipline were there all along. But anyway, so the point is that these arguments are probably true historically. I think there's a lot of evidence for them. But in today's world, we have so many ways of learning about things with big data. So there's this company called Oak North that came to the US and basically created this platform that combines thousands of different data sources to tell bankers about each of their customers, each of their small business clients.

26:02And this web service for them had been developed in the UK as part of a bank lender that never had a default. And the reason they never had a default was because they could see problems that were going on the horizon for their clients because they could see so much information about their clients before their clients even knew that they had a problem. So the point is, once you get an information technology that's able to see things about individual small firms using rich big data sets, then this whole kind of asymmetric information argument, that's the formal term for it, for why you need to combine deposits and loans sort of goes out the window.

26:44So as much as I'd like to say that I think it's still highly relevant, given that I kind of invented the argument, or at least part of the argument, the truth is, I think that we're beyond that. And so socially, there is no reason in my mind to combine payments with lending. So lenders can just fund their loans with market kinds of debts that they raise wholesale funding that they raise in the market. Yes, that means that the bank lender's costs will go up for lending. But let me remind you, there are lots of lenders out there who already fund themselves, non-banks that are funding their lending entirely from wholesale funds.

27:24So the bankers will experience some loss as a result of this. But I don't think that this is a loss to the market or to society in general. I think that we're better off by moving to a situation where lending and payments are separate. Is this going to be another headwind, an additional drag on local banks versus the large

27:47Demetri Kofinas:national banks? Absolutely. Well, for all banks, the big ones and the small ones, as they lose deposits, it's going to be a headwind. It's going to be a problem for them. There will be, I think, a lot of churning, a lot of disturbance in the banking environment. But I think that's good. Frankly, as somebody who in the 1980s and 1990s had been writing research showing that allowing bank consolidation and allowing banks to expand their powers was a positive thing, I've changed my views on that, partly because of changes in technology. but also partly because of what we've seen from a kind of corruption of our political process from the concentration of power in these largest US banks.

28:37So I think we'll all be much better off if we move away from having all of this lending and all of this deposit clearing happening through the current kind of system. We'll have a much more competitive arrangement. The large banks won't be politically as dominant, and that's a good thing for our democracy. And also, if you look at what the banking system evolved into, if you go back even 50 years, banks were not doing that much real estate lending. And now banks have basically become real estate banks. We call them commercial banks, but as Alex Pollack likes to say, it should be called real estate banks.

29:18Demetri Kofinas:Does that change in the constitution of bank loans reflect the larger economic transformation of the American economy during the period from one that was capital heavy, where the banking system played a bigger role in capitalizing the needs of heavy industry to a capital light economy where services have taken up a larger share of economic output? I mean, to some extent, yes. But I think the bigger point is that non-bank funding of loans became very important so that loans became through markets, whether it's a bond market or securitization markets or non-bank finance companies and other kinds of lenders.

29:58They took a lot of the business away from the banks because they out-competed them. And what was left to the banks was local real estate kinds of transactions. And so the banking system just became, I think, something like if you put aside the largest banks, three quarters of bank lending is just real estate. And for the biggest banks, it's more than half. And this was considered completely wrong. So if 100 years ago, if you brought a banker back from the dead, who was around 100 years ago, he'd have a heart attack and die again. If you told him that the bank's balance sheet loans were mainly real estate, because real estate's not a good fit for commercial banks that rely on short-term funding from deposits, because you don't want to have that kind of extreme transformation of liquidity.

30:45so that there was something in the US that we called the real bills doctrine, roughly just said, well, the kind of lending banks should do should be short term, self-liquidating, kind of mainly commercial, to some extent industrial too. I'm not advocating that, but I'm just saying it would be a shock to bankers from 100 years ago to see what's happened. And I think a lot of it is just real estate was what was left over after all of the financial innovation took the industrial and commercial lending largely away from some of these local banks, especially so that they just became real estate lenders.

31:20And that leads to a lot of concentration of risk. Remember, the real estate cycle and the business cycle are very aligned. And so when you have banks that are just focusing on commercial real estate, that means that their risk in terms of systemic risk relating to the business cycle. And when you get a bad shock that puts real estate loans into trouble, they're very hard to liquidate because the whole market becomes very illiquid for selling those mortgages. And so you really like you, we experienced this in the 1980s. And I think that we also experienced it in 2008. So you just don't really want to have your banking system using the payment system to fund real estate.

32:09It's like it's just from the standpoint of the history of thinking about banking, it would be considered just incredibly bad. But we've kind of backed like the frog in the boiling water. We kind of backed our way into this. Deposit insurance meant that the market wouldn't prevent it. If there weren't for deposit insurance, as I've shown in a paper published in the Journal of Financial Intermediation, worldwide deposit insurance has allowed this to happen. Because if it weren't for the protection of bank deposits from deposit insurance, depositors wouldn't want to be in banks that primarily did real estate lending.

32:44But depositors are willing to do it since they're insured. And so the government has kind of taken our banking system through a combination of not allowing financial innovations to remove power from the banking system, as I said, so that what's left to it is real estate. And then they say, well, that's OK. We'll fund that with deposits because we'll ensure the deposits. So we've kind of backed our way into a system that people, you know, from prior to this era would have regarded as very unwise. So I'm really happy at the thought that we will undermine the system and actually get rid of a lot of the existing sort of structure.

33:24I think it's a good thing for our democracy to get rid of the power of the big banks. That's a good thing for the financial system to create more competition, more diversification, less of this concentration of real estate risk in the banking system.

33:36Demetri Kofinas:You know, not to take us into a conversation about unrealized or unrecognized risks and capital misallocation, but is that a good analogy, the analogy of deposit insurance, is that a good analogy to use for describing the dangerous effects that preventive Fed and government policies writ large have had on sort of acting as sort of insurance providers and increasing the systemic levels of risk in the financial markets? Absolutely. You know, it wasn't, and it's not just the Fed, but the Fed is one of the examples. Deposit insurance is part of it. And the federal home loan banks are another part of it because they also are like the Fed.

34:17They're like another version of the Fed that competes with the Fed to provide subsidies to the banking system. And, you know, with SVB, just before it failed, when its bonds were falling in value, they experienced an outflow of deposits, the beginning of market discipline. In the old days, prior to this protective environment that we're talking about now, in the old days, what would have happened is that they would have seen this outflow of deposits. They would have acted in a way to manage their risk, to prevent the outflow, and then they would have stabilized themselves and they wouldn't have gone bust.

34:55Demetri Kofinas:And they would have taken proprietary losses as opposed to socializing them. Yes. Because, by the way, they were not very insolvent. They were borderline insolvent, and they weren't insolvent at that early point. This was like six months before the crisis. They experienced a big deposit outflow. But what happened? They said, oh, we got a big deposit outflow. Let's go to the Federal Home Loan Bank and borrow that money. So what they did was they replaced, when the uninsured deposits first flowed out of them, they replaced that money with Federal Home Loan Bank, insured lending, basically, right?

35:30guaranteed lending from the Federal Home Loan Bank, giving them long-term money at tax, you might say, at taxpayer's expense. And then that insulated them from having to do anything to correct the problem. So we see it in the SVB crisis very clearly, the way protection operated to undermine incentives to manage risk. But we've seen this worldwide. This is probably the most important phenomenon of the past 50 years in terms of creating systemic risk. the protection of banks. And it's allowed the banking system to do things that don't make sense, like concentrate on real estate lending and create the systemic economy-wide vulnerability of the banking system to the real estate side.

36:15It's not something that we, prior to the 1980s, we just didn't allow that. And people now take it for granted, but it's a completely changed banking system from what it used to be. And that's not something that's worth preserving. So when people worry about, oh, what's going to happen to our banking system? I say, well, here's something for you to dream about. Make payments from a checking account-like entity where you earn much higher interest. Make them at the speed of light. Make them with attaching other messages that facilitate your communication with someone that you're transacting with.

36:55Do it in a way that can't be hacked, unlike the Fedwire system. The New York Fed wrote a paper a few years ago called A Premortem on the Hacking, sort of recognizing that sooner or later there was going to be a major hack of Fedwire. Do all of that and then know at the same time that you're getting rid of the non-competitive power of these largest nationwide banks, and that you're also creating a more diversified a financial system that's not going to be as prone to these kinds of housing-related banking crises. So what part of this is bad? And the answer is the incumbents are trying to scare everybody into thinking that getting rid of the current banking system would be such a horrible thing, and that they want to portray all of crypto as risky, risky, risky.

37:48Just go listen to Maxine Waters talk about crypto. Why? Because they don't want to disturb the cozy relationship that they currently have. And the politicians are very much in bed with the incumbent big banks in preserving that system. So I just hope your listeners will at least open their minds to the possibility that it could be great to disrupt this current incumbent equilibrium.

38:16Demetri Kofinas:So let's flesh out some of those social benefits and some of the potential disruptions a bit more, because you've specifically said that stable coins may represent the most important financial technology for creating social benefit since the Bank of Amsterdam first offered merchants a centralized location for clearing bills 400 years ago, and that this marks a potential change in both, not just the global medium of exchange, but in importantly, the unit of account. What exactly did the Vistle Bank do to improve upon the prevailing unit of account? And why do you believe that stable coins are a much bigger potential improvement when it comes to both medium of exchange and unit of account?

39:00Okay, great question. So first, I just want to define terms, medium of exchange means what you use to make your payments. Unit of account is what you denominate your payments in. So initially, let's say for the next decade and maybe longer, when I think about the revolution of stablecoins, it's really they're going to replace checking accounts. But you'll still be denominated in dollars, which is the thing the Fed has a monopoly over creating, the dollar. So we'll still be using stablecoin accounts to transact in dollar-denominated payments. But what's so cool about stablecoins is because this distributed ledger retains all of the transactions on it, you can, if you can find a way to aggregate that information, You can actually create the basis for a new unit of account.

39:59That means for a new way of denominating your transactions. So what I want to explain is that we actually do care what we denominate our transactions. And the reason is because we want to denominate them in something that has a closer relationship to our consumption bundle. It means that we don't worry about inflation and inflation risk causing us to our wages to not be able to pay our rent. Right. If we're denominating our wages in the thing that we consume or something that's very close to the bundle, like if the Dimitri bundle, let's call the Dimitri bundle your consumption bundle, what you actually consume.

40:41And suppose that we took a weighted average of all the things you consume, weighted by how much of them you physically consume. OK, we call it the Dimitri. It's what you consume per month. And we just say that's our unit of account. That bundle is one Dimitri. You would love that because that means you'd be paid in that unit of account. And you know that you're never going to have a problem in converting what you're paid into what you consume because what you're paid is denominated in your consumption bundle. So this is something people aren't used to thinking about. It's the economics of the unit of account.

41:18which just says, oh, we really want to have a unit of account that's very close in its value to our consumption bundle. So the dollar isn't that. The dollar doesn't vary hugely, but it wasn't designed to be particularly close to your consumption bundle or to the average consumption bundle. But you could say, well, it may be the best thing on the menu currently. And I think that's true. It's the most stable thing on the menu currently. But if you go back to Jevons in the 19th century, who was writing about optimal unit of accounts, he was already envisioning that the best way to create a unit of account is the consumption bundle itself.

41:57Now, you asked about the Wiesel Bank. So the Wiesel Bank, what they did was they started off just as a clearinghouse for merchant bills of exchange, denominated in coins, denominated in physical money. The problem is physical money was not ideal because it could be clipping it, you forge it. And so they created their own abstract paper unit of account to actually stabilize the value. And that was a big innovation of the Wiesel Bank to create a synthetic unit of account of, I guess it was called a Gilder, that was the in-banko called Gilder, which was based on their own sort of abstract concept rather than a particular coin.

42:39So the point I was making is that was a great innovation because it stabilized value. But now what we can do with blockchain, now we're thinking more than a decade in the future. So the first transformation we need is to create the network of a medium of exchange of blockchain stablecoin transactions for consumer goods, not just for crypto. Once we've done that, though, people will say, oh, wait a minute. we've got in the blockchain all of the actual consumption transactions. So suppose that we were all interested in creating a new unit of account, different from the dollar, that's going to be closer in its definition to our own consumption bundles.

43:23We could use the record of transactions in the blockchain to design a nearly perfect unit of account. And it could even be a unit of account that changes over time. It could even be a unit of account that differs according to locations, even within the US, depending on what consumption bubbles would be. So this is very futuristic stuff. But the point I'm making in the paper is that the real promise of this is going to be initially to create a new medium of exchange that's much better for consumers and part of a reconstruction of our financial system, which is much more stable. But then in the future, what's going to happen is we're going to have this kind of like near ideal monetary system, which is going to be based on units of account, not just medium of exchange, but units of account that are much closer to consumption bundles.

44:16And the reason we can do that is because blockchain creates a permanent record of all the transactions that occur within it. So you can devise a bundle that is a Dimitri. And so the Dimitri is you would want to be paid in Dimitri's. Now, I don't want to pay you in Dimitri's because I don't have the same consumption bundle. But we'll find a way to compromise and create a consumption bundle that sort of tracks the typical person, or maybe we'll have multiple units of account that people can choose from. Now, there are going to be some new problems that come up here, like how do banks transact and clear in these units of account that might be geographically specific or different?

45:01And the answer is that they're going to have to, and this is where it gets really fun, we're going to have to have tokenized, which means blockchain transactable IOUs, kind of, that are for particular consumption goods.

45:17Demetri Kofinas:Because they have to maintain adequate reserves to back up the consumption bundle. Exactly. So for the banks to transact, they have to have reserves. They have to have a certain number. Suppose we all adopt the Dimitri based on your consumption bundle. Then we're going to have to, the banks are going to have to have reserves of Dimitri's. Well, what does that mean? It means that ultimately the things you consume will have to be tokenized and be holdable as financial reserves by banks. So just let me give you a simple example because this sounds very abstract. Suppose that you're just a Ruth's Chris steak eater.

45:55That's your entire consumption bundle. You're a hobo, but you don't have rent. You don't need anything else. All you eat is Ruth's Chris steak. Okay. So, and then our, that means our whole consumption bundle is just going to be the Dimitri, which is Ruth's Chris steak. So what does that mean? It means Ruth's Chris, which, you know, they create these little cards that you can get to be able to use there. Well, those things get tokenized and get held at the bank so that the bank starts transacting in, well, of course, it's got to be a lot more than just Ruth's Chris State, but it can be that we, I know this sounds very futuristic, but it's actually technologically, this is a problem that we already have the ability to solve.

46:40It's not requiring a new technology. It's just getting us the political decisions that are going to facilitate this, and the network creation that facilitates it, and then it can all be done. So I think we're decades away because those aren't trivial problems to solve, but they're not conceptual problems.

47:00Demetri Kofinas:So this was the part of your paper that I found most interesting because I started conducting my own thought experiments, one of which was whether, and again, there's a lot to discuss here about whether or not the US government would even be okay with losing the seniorage privilege or the reserve rents that come from dollar hegemony. But just on that point around reserve rents, I was thinking, so what happens if a company, let's say Amazon, begins to actually accrue some of those reserve rents for itself? Would that actually have perverse impacts? One, would it cause new natural monopolies to form as a result of the fact that now the currency associated with the service or product becomes an increasingly important part of the use case, and whether that would actually pervert the underlying incentives of the industry.

47:45Demetri Kofinas:That's just one example. But look, I'm going to move us to the second hour, Charles. I want to talk more about how this consumption bundling would work in practice. Sure. Importantly, how it would impact monetary policy, because you go into some interesting lines of thinking in the paper around that. And I definitely want to, in our second hour, address your question, because I think it's an excellent question. Yeah. And to that point, senorize rights, dollar reserve rents, the benefits that accrue from having the reserve currency of the world. And also, I'm curious, this is not something that you talked...

48:15Demetri Kofinas:I don't think you spoke about it in the paper. I feel like we've talked about it in other circumstances, but what does this mean if stable coins become largely adopted? And the conversation we've had so far has been really about the use of stable coins domestically, talking about chartering. But it seems like this would actually be something, at least to the extent that before we get into a conversation about consumption bundling and that kind of innovation, just in terms of stable coins being extensions of the US dollar, this seems like it would further entrench the network effects of the dollar worldwide.

48:45Demetri Kofinas:So that's something else I want to talk with you about the second hour, Charles. For anyone new to the program, Hidden Forces is listener supportive. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second hour of today's conversation with Charles, head over to hiddenforces.io slash subscribe and sign up to one of our three content tiers. All subscribers gain access to our premium feed, which you can use to listen to the rest of today's conversation on your mobile device using your favorite podcast app, just like you're listening to this episode right now.

49:20Demetri Kofinas:Charles, stick around and we're going to move the rest of our conversation onto the premium feed. Looking forward to it. If you want to listen in on the rest of today's conversation, head over to hiddenforces.io slash subscribe and join our premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, you can also do that through our subscriber page. Today's episode was produced by me and edited by Stylianos Nicolaou. For more episodes, you can check out our website at hiddenforces.io. You can follow me on Twitter at Kofinas, and you can email me at info at hiddenforces.io.

50:01Demetri Kofinas:As always, thanks for listening. We'll see you next time.