The Breakdown - A Primer on the Eurodollar and Shadowbanking System [Long Reads Sunday]

Episode Date: June 28, 2020

The latest Long Read is "Crypto Dollars and the Evolution of Eurodollar Banking" by Avi Felman and Max Bronstein.  This piece covers: The Dollar Milkshake Theory Why the demand for the US dollar remains so high  Why demand for dollars is increasing rather than decreasing  What "eurodollars" are What the shadow banking system is How eurodollars and shadow banking contribute to USD demand How stablecoins and cryptodollarization could create demand for crypto 

What's going on, guys? It is Sunday, June 28th. And today I'm doing another edition of the breakdowns Long Read Sunday, where I look at and read a piece from someone else. So today I'm going to be reading the excellent crypto dollars and the evolution of euro dollar banking by Max Bronstine and Avi Feldman. It was written in April, but is honestly one of the best primers on this incredibly important topic that I've come across, so I hope you enjoy it. Overview. While Bitcoin is rapidly assimilating into the global monetary picture, the dollar is unequivocally the world's currency, given its dominance in world trade and the scale of the global demand that exists for dollar-denominated debt. Furthermore, there is a massive supply demand imbalance in the dollar

market today, particularly exacerbated by foreign entities who need dollar liquidity to service their debts and to trade with other countries. Crypto-dollars, namely stable coins and synthetic dollars created through derivative contracts, are uniquely positioned to help service the world's dollar demand, and will likely see immense growth in market capitalization and as the world looks for easier and more programmable ways of storing, transacting, and financing in dollars. For a technology lauded by enthusiasts as a way to escape the dollar, cryptocurrency might actually do more in the near term to sanction the dollar rather than to weaken it. In this paper, we explain why.

The Dollar's Ascent One of the more interesting and before the recent collapse, non-consensus macroeconomic theories pertaining to today's monetary system is the dollar milkshake theory. Popularized by Brent Johnson of Santiago Capital, the theory states that since the dollar, dollar is far in a way the strongest and most demanded world currency, the flood of liquidity that was created by central banks starting in 2008, will inevitably be sucked up by the U.S. dollar and the U.S. economy. The core of the argument is that a global marketplace renders the source of liquidity irrelevant. In the end, liquidity will always make its way to its most productive use, to the place where that liquidity generates the highest return. In this way, the dollar in the U.S.

economy are acting like a large milkshake straw through which the world's liquidity is currently being sucked up and reallocated. To accept this theory, first, one must believe that the dollar is indeed the world's most dominant currency. To convince yourself of dollar superiority, let's examine the most important demand inputs. First, while the Fed Fund's rate in the U.S. is at record lows, the central banks of most other developed economies have pegged rates much lower, with countries like Japan and Switzerland currently flashing negative yielding interest rates. Higher relative yields translate into more demand for U.S. debt, which in turn increases future demand for the dollar as those debt needs to be serviced,

which in turn increases future demand for the dollar as those debts need to be serviced. This trend was particularly exacerbated over the last decade because of how crowded most yield earning strategies became. To contextualize just how desperate investors are today, as of March 2020, there was 11.6 trillion in negative yielding debt globally. Second, the U.S. has a much stronger economy than almost all global peers. The U.S. has been home to most of the wealth generated from the recent secular growth period fueled by software and computer innovation, a fact you can confirm by looking at the deviation

between the S&P 500 and all other global indices over the last 30 years. Strong returns create demand for the dollar as those assets are primarily traded against the dollar. It's hard to invest in the newest AI startups posting 250x revenue multiples with R&B or the Canadian dollar. Similarly, dollars are the only currency that can be transacted for U.S. treasuries, which are at times one of the most in-demand risk-off assets in the world. Third, much of the world trade is denominated in dollars. Companies and countries abroad will often invoice in dollars, even when dealing with non-U.S.

because they find it valuable to transact with the stability of U.S.D. According to Gita Gopinath, the dollar accounts for 4.7 times its share in world imports and 3.1 times its share in world exports. Lastly, and most importantly, the world's debt is by and large denominated in U.S. dollars. With nearly $60 trillion in dollar-denominated debt globally, there is immense demand to service dollar debt. When it comes to borrowers outside of the United States, the dollar debt burden of foreign entities reached $12.07 trillion in Q3 2019,

according to the bank for international settlements. While rates were just recently moved to near 0%, an annual interest rate of 1.5% generates over $1 trillion in annual U.S. dollar demand, since by borrowing USD, the borrower is effectively short dollars, meaning they will have to buy back the principle and pay down interest with USD. Since the dollar is so disproportionately used as the world's primary form of debt, any deflationary pressure in the system can quickly cascade. This is exactly what we're seeing now.

Dollar debt is now four times larger than euro debt and 24 times, larger than yen debt, which gives foreign currencies little breathing room when they begin to depreciate relative to the dollar. Alongside ubiquitous use of the dollar to purchase oil within the petro dollar system, the need to hold USD to service debt is one of the largest drivers of dollar demand. According to the IMF, global central banks hold around 6.75 trillion in dollar claims, over half of all their currency reserves. Assuming the trajectory, US dollar debt grows, central banks will need to buy even more USD to pad their reserves. Over time, all of this culminates in a global short-squeeze on the dollar. If this theory is to play out as described, it would be one of the most destabilizing

forces in monetary history. The dollar's strength would cripple capital markets and cause foreign currencies to collapse, which in turn would lead to debt defaults and subsequent money printing. The only way for politicians to dig themselves out of a mess that calamitous would be to restructure global order, similar to the introduction of the Bretton Wood system in the Plaza Accords. In the former, the world's most powerful governments attempted to stabilize the international monetary system by pegging foreign currencies to the dollar and the dollar to gold. In the latter, G5 countries came together to devalue the dollar in an effort to stabilize foreign trade and make U.S. exports more enticing. If history is any indication, a global monetary restructuring

will likely come with both currency and institutional debasement. Now, we don't have a crystal ball for the future of the global order, so the rest of this discussion will focus on the world's immediate demand for U.S. dollars, how that demand is serviced, and how those services might change over time. This demand spans the entire spectrum of economic actors, from workers in developing countries to the world's largest central banks. Everyone wants and needs dollars. And getting access to the dollar isn't always easy. It usually involves obstacles imposed by either the U.S. government or foreign governments enforcing capital controls. With greater debt deflation abroad and geopolitical tensions, there's a sizable amount of pent-up demand for more seamless dollar distribution sources.

Enter crypto dollars. As we'll discuss, it's very likely that growth for cryptocurrencies in the short term is fueled by economic actors using them as rails to access the dollar, rather than demand for the dominant underlying assets, Bitcoin and Ether. Euro-Dollars and the shadow banking system. To understand the importance of cryptocurrencies as a conduit to access and move around dollars, it's important to first lay out how dollars move throughout the world today. More specifically, how dollars move around outside the U.S. financial system. There are many pieces of infrastructure that encompass offshore USD banking,

but this piece will focus on two elements, the shadow banking system and euro dollars. The shadow banking system involves what its name implies, the facilitation of banking services, primarily the creation of credit, outside the realm of a regulated financial system. Despite the ominous name, shadow banking isn't all that sinister. The shadow refers more to the general lack of insight and transparency than to illusions of illegality. Like traditional banks, entities in the shadow banking system issue credit to counterparties who want liquidity, with the main difference being that they lend against securities rather than commercial deposits. Using securities as collateral dramatically expands the total

available collateral as the market sizes of corporate debt and federal government debt far exceed the total size of commercial bank deposits. In fact, the ratio of corporate debt and federal debt relative to total commercial bank deposits is 2.26 to 1. Since shadow banks aren't lending against commercial deposits, they're not beholden to the Fed's liquidity and capital requirements, giving them the leeway to use more leverage than a traditional bank. Coupled with the fact that the collateral base against which they can lend is also larger, the shadow banking system has become a massive source of dollar funding in the world. The growth of the shadow banking sector took off in the early 2000s and reached a climax in 2007, with an estimated 60 trillion in assets.

Since then, it's been estimated that the system is shrunken size, but the innate lack of visibility into the market makes it hard to size with precision. At the end of the range, the financial stability board has estimated a market size of nearly $100 trillion in 2016. Given the size and liquidity of the shadow banking system, it serves as a good barometer for how much demand there is for the U.S. dollar. The primary use of the shadow banking system is to access dollar liquidity, and the sustained growth of the system shows that the dollar demand is steadily increasing. According to the Financial Stability Board, the shadow banking systems OFIs was the fastest growing in terms of financial assets held.

Recent rumblings in the repo market show both how strong the imbalance is between supply and demand for the dollar, as well as the importance of the shadow banking system within the global economy. For context, repo markets are a massive source of dollar funding where financial institutions can collateralize securities, more specifically high-quality liquid assets to get short-term loans. The repo market is crucial to capital markets because it provides a cheaper and more efficient way for financial institutions to get access to dollar liquidity relative to borrowing from commercial banks. In theory, greater liquidity acts as lubricant, enabling market participants to more efficiently engage in price discovery, settle transactions quicker, and collateralized derivative exposure.

In the fall of 2019, the Federal Reserve had to directly intervene in the repo market, as the collateral repo rate shot up to something around 8% APR. Typically, banks act as lenders in repo transactions, but due to a multitude of factors, banks had no cash to supply. For one, banks had deployed a lot of their idle cash to purchase government bonds over the previous two years. The Fed unwinding their balance in 2017, the Trump tax cuts in 2018, and an escalating trade war in 2019, flooded the market with treasuries that banks were forced to purchase. Coupled with the strict reserve requirements enacted post-great financial crisis, banks were so depleted that they couldn't take advantage of an interest rate over 5x what they're earning in the market.

Since then, the Fed has continued to try and ease the world's dollar crunch by offering up liquidity to repo markets on the order of $500 billion a day. On to concept number two, Euro dollars. Euro-dollar are dollar-like liabilities that are issued by entities outside of the United States, which includes, you guessed it, shadow banks. Eurodollars can also mean dollars held by U.S. regulated entities located in located in... in foreign countries. For example, when Banco Santander Credit Suisse or the Bank of Cairo issue dollar loans or store dollar deposits, they are considered to be dealing in Euro dollars. Eurodollars play the critical role of allowing non-US entities to bank in the dollar without having to deal directly with the Fed or commercial banks. Given the size of Eurodollar

deposits, it's quite easy to see how much foreign entities actually want the dollar. According to BIS, there were $4.5 trillion in offshore dollar deposits by the start of Q4 2016, nearly 33, of all M2 money stock at the time. The euro dollar market is actually so big that the Fed recently began closely monitoring offshore interest rates, with the understanding that foreign funding has a material effect on the Fed funds rate. This similarity in funding costs has only increased demand for euro dollars, as foreign entities can lend at the same rate as the Fed does. They don't have to be regulated by the U.S. government. The system has gotten so large in liquid that derivatives on euro dollar lending rates have become the de facto way for global investors to speculate on

and hedge changes in the Fed funds rate. The rampant demand for dollar exposure has catapulted Eurodollar derivatives to be the largest products traded on the CME by volume and total open interest. Dollarization and weaponization. The strength of the dollar is a delicate dance for the United States. A strong dollar can cause consternation for internal U.S. industries that export services and goods to other countries. Some countries, such as China, intentionally depreciate their currency in order to increase the attractiveness of exports and jumpstart industries. In fact, China is a large holder of U.S. debt and a huge source of dollar demand for the sole reason that they wish to keep their currency low against the dollar to increase exports.

From this angle, it may seem the U.S. would not want a strong dollar to compete in the global marketplace. Viewed through a different lens, a strong dollar allows the U.S. to issue debt more cheaply than other countries, since it is the only currency accepted in exchange for treasury bills, one of the world's most in-demand assets. The other side of the issue is political in nature. A strong dollar gives the U.S. a great deal of leverage. Without access to dollar financing, people and governments lose the ability to freely trade with the rest of the world, and are forced to incur high transaction costs trying to convert assets between weaker currencies.

Throughout history, the U.S. government has harnessed this economic power to punish foreign enemies, sanctions and tariffs being the most common tools. But more recently, Trump has escalated economic warfare to never-before-seen levels, with sanctions being imposed on Russia, Iran, North Korea, and Venezuela, alongside thousands of other economic actors. The U.S. has also become imposing sanctions through the swift payment system, a linchpin of global trade today. The exorbitant privileges endowed by the dollar has pushed many global powers to attempt de-dollarization.

It's not that the United States could use the dollar as a weapon, it's that they actively use the dollar as a weapon, and as geopolitical tensions rise and the dollar strengthens, the leverage of the United States wields even more. foreign governments, on the other hand, have separate reasons to pay attention closely to the dollar. Citizens of countries with failing currencies do all they can to exchange their local currency into the dollar, a phenomenon referred to as dollarization. This can sometimes come from the government in a top-down fashion, as has happened in Panama and El Salvador, where the dollar becomes legal tender,

or through more grassroots movements like in Cambodia and Costa Rica, where citizens elect to exchange dollars for a majority of goods and services. The latter is more contentious, because citizens fleeing their local currency destabilizes the government's ability to control economic activity and dampens the currency's network effect. Similarly, dollarization completely destabilizes the monetary discretion of the local state that is being dollarized. Governments have every motivation to stop this from happening, and they do so through a variety of capital controls. While foreign governments have tried to create alternative payment systems or find substitutes like swapping their dollar reserves for gold, the relative value of the dollar continues to

grow stronger. Similarly, if we fast forward to a few, in which central bank digital currencies are the norm globally, it's easy to imagine that technology will only act as a stronger distributor of dollars to those who demand it. Dollar 2.0. There's a massive supply demand imbalance in the dollar market today, driven in large part by foreign entities without access to the U.S. financial system. The world increasingly needs dollars to trade and to service massive debt payments, but governments have strong incentives to stymie dollar flows.

There's currently a strong worldwide demand for dollars, but it's difficult for individuals to source them. So where do they go? Now, they can turn to networks like Bitcoin and Ethereum, which enable novel ways to acquire dollar exposure that are natively digital, globally accessible, and relatively more seizure-resistant. Furthermore, financial services and networks built on top of these crypto dollars give them global distribution and make holding them competitive to traditional fiat methods. In a world searching for more free access to capital, crypto dollars are a unique solution that helps service a lot of this pent-up demand. As such, stable coins and crypto-backed synthetic dollars should see massive near-term growth as the world scrambles for dollar exposure.

Broadly speaking, we can group the different types of crypto dollars into three buckets, two of which are fungible stable coins. One, central dollar-backed currencies, two, decentralized collateral-backed currencies, three, derivative-backed synthetic dollars. Stable coins. The most direct way that crypto networks enable dollar exposure is through stable coins. Crypto-powered currencies designed to peg their value to the dollar. The stability of the peg and censorship resistance are, for the most part, inversely correlated. Stable coins backed one-to-one with dollar collateral held in banks are much more stable, but of course, holders are trusting that the government won't unilaterally seize or tamper with

those funds. Tether or USDT is an interesting case study because even though news broke that it was likely backed by 77 cents on the dollar, its market capitalization continues to grow, albeit's exchange reacted with volatility. This is a result of the fact that the dollars backing USDT are held in offshore bank accounts. and that the issuing company operates through a very loose corporate structure. At this point, traders have signaled that they believe the operators of Tether are less likely to comply with federal intervention. On the other side of the court are stable coins like USDC, which operate in a much more federally

compliant way. These stable coins have de minimis volatility, which makes them more suitable for use cases like lending and payroll. The other flavor of stable coins are backed by crypto collateral, usually in excess of one-to-one, and rely on external stakeholders to keep their price stable relative to some price feed. This version is less stable because it's susceptible to large credit shocks, but on the flip side, it could be harder for a centralized party to co-opt or shut down. Tether, which was the first rendition of a stable coin, was created in 2014 so exchanges could decrease their reliance on

traditional banking infrastructure. Back then, moving fiat in and out of the crypto ecosystem was extremely burdensome, as few, if any, banks wanted to take on the risk of serving a regulatory gray sector. Tether didn't take off until the 2017 boom when traders and firms began holding USDT on their balance sheets to take advantage of mispricings between exchanges. Over the course of that year, the total market cap of tether grew from $10 million to $1.4 billion, a 140x multiple. After it was clear that stable coins had reached product market fit, new competitors emerged. Die was next in line and actually took the BitUSD model to market. To issue die, users put up collateral at least 1.5x the value of the stable coin they want to issue. The collateral is escrowed in a smart contract that should be

theoretically impossible to corrupt, meaning dye was more seizure-resistant than a tether-like stablecoin. However, the downside is that the overall collateralization burden makes it intrinsically difficult, if not impossible, to scale. Later in 2018, a flurry of U.S.D-backed stablecoins, including USDC, PACs, G-O-S-DC, came to market, and competed with tether in terms of solvency, trust, and with dye in terms of scalability. At present day, the total market capitalization of all stablecoins stands at roughly 8.2 billion USD, roughly 0.45% of the US dollar monetary base, and 6.5% of Bitcoin's market capitalization. These stable coins were able to gain such traction for a number of reasons. One, their digital nature makes it easy to issue and send them around the world at low cost.

Two, existing exchange infrastructure already had a network effect of users. Three, a new class of financial services was created so that stable coins could be borrowed, lent, and used its derivatives collateral. Setting up a crypto wallet to send and receive stable coins is far easier than setting up a bank account, especially for entities outside the U.S. Similarly, a new breed of blockchain-based financial services has created incentives to convert traditional dollars to crypto dollars for more than just trading, the main incentive unequivocally being dollar yield. Crypto dollars can be lent to money market protocols like compound, lent to margin exchanges like DYDX, and then used in peer-to-peer to payment applications like

Darmah, all while still earning a yield. Stablecoin yields have historically been multiples higher than the Fed funds rate, with USDC rates hovering around 4 to 10% APR for most of 2019. It's also worth noting that crypto dollars themselves are beholden to network effects. As the ecosystem progresses, it's likely that only a handful will grow their monetary bases. Outside of Tether, USDC has become the most dominant stablecoin. Hyper-crypto-dollarization. Using cryptocurrencies to get exposure to the dollar has been the untold story of the space since 2018. Fast forward to today, billions in crypto-dollar loans have been originated, and

billions of crypto dollars are earning an interest that far exceeds the yields available at the world's premier financial institutions. Better yet, crypto dollars are far easier to onboard and transact in compared to traditional financial infrastructure. With such rampant global demand for the dollar, it's very likely that cryptocurrencies actually further entrenched its strength, ushering in a world of hyper-crypto-dollarization. What does this future look like? Which use cases will be crypto-dollarized the most? Cryptodollars will grow the most from use cases that actively pull people into the ecosystem away from the traditional world. This just generally means use cases that are fraught with high costs, both transaction fees and opportunity

cost of holding a different currency, or use cases with a lot of counterparty risk exposure to the government. In more developed economies, yields are positioned to be the strongest driver of demand. While stablecoin lending markets are not completely immune to global monetary policy, continued price appreciation should result in higher stable coin yields as it's still relatively difficult to move fiat dollars into the crypto world. Price increases typically result in a forward-sloping futures curve, which is one of the largest demand drivers for stablecoin loans, as it creates the most liquid arbitrage opportunities. Even with crypto markets selling off more recently, stablecoin yields are multiples above short-term U.S. Treasury bills. Yields become

an even stronger accelerant if crypto markets can actually perform well in the midst of a global de-leveraging, and stable-goin yields return to about 5% APR. Another use case ripe for disruption is remittances, primarily in countries with strict capital controls. Using tether as a proxy for the dollar is already becoming commonplace in China, where purchasing more than $50,000 of a foreign currency is illegal. Many OTC dealers who initially began servicing crypto-to-crypto transactions are largely moving their businesses to support both crypto-to-tether transactions, as well as fiatto-tether transactions. The remittance market as a whole processed roughly $689 billion in 2019, but even more important, it overtook foreign direct investment as the largest source of foreign capital inflow.

On average, roughly 5% of transaction value is captured in fees in FX exchange margin, meaning nearly $30 billion of USD is captured by intermediaries. With enough infrastructure, crypto dollars are more than capable of eating into the margins enjoyed by today's remittance providers. When dollar debts come to roost and global currencies begin devaluing against the dollar, it's very likely that governments will do everything they can in an attempt to keep capital from fleeing their countries. Take, for example, Lebanon, where banks began restricting withdrawals and citizens were forced

to sell bankers' checks at 30% discounts. To skirt around withdrawal controls, citizens began converting whatever cash they had into Bitcoin and Tether. Similarly, the Central Bank of Argentina began imposing strict restrictions on how much U.S.D citizens could purchase just last year, after the Argentine stock market and the peso fell precipitously. Since some crypto dollars are more likely to be seizure resistant than traditional fiat notes, it's likely that they're used by citizens to flee their weakening home currency.

Final thoughts. Counter to prevailing mainstream narratives, the new alternative financial systems, being created on top of crypto rails is increasingly assimilating into, if not starting to eat, parts of the traditional world. The unique aspect is that the assimilation doesn't resemble what everyone previously imagined. Dreams of the world ditching their fiat en masse in exchange for cryptocurrencies have been met with the same stark reality facing the entire global monetary system. Everybody wants dollars. Rather than squander the opportunity for ideological reasons, the crypto industry should rally around this dollar scramble to onboard nor users.

Unironically, it is demand that spurs growth, and that's one area the crypto space has been lacking. What does a strong dollar and increased crypto-dollar usage mean for Bitcoin? From a macro perspective, there's the argument that deflation induced by a strong dollar will be damaging to Bitcoin because of the world perceives it as a risk-on asset. That may be true, but it's important to conceptualize that a strong dollar likely leads to widespread currency debasement, and while the dollar is one refuge, there will likely be increased demand in general for fiat hedges. Even more, servicing this demand will only further prove that financials,

financial alternatives exist for everyone, as Bitcoin has all of the features necessary to be the most democratized store of value asset. There's also a strong argument for inflation in the United States. A strong dollar undermines the Federal Reserve's ability to keep the global monetary system stable, which in turn pushes interest rates lower to combat deflation. As MMT takes hold and the U.S. government prepares to play a more dominant role in labor markets, labor costs could rise at the same time assets are buoyed by extra liquidity in foreign asset inflows. Additionally, passive investing has seemingly distorted the structures that help keep markets and reality closely tied, making asset inflows the primary determinant of demand. If the government can issue debt to make sure

401k deposits continue unabated, there's real potential for higher asset prices. In the case we do see inflation, expect crypto dollars to be used that's a seamless bridge to non-debasable assets like Bitcoin.