The Breakdown - Why Bitcoin and Rehypothecation Don’t Mix

Episode Date: December 20, 2020

On this week’s Long Reads Sunday, NLW starts with the latest essay by Jeffrey Snider, “A Nonsensical Jumble of Misused Words Requires Discussion” and then with Caitlin Long’s followup thread, putting the discussion of rehypothecation in the bitcoin context. 

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com and nexo.io and produced and distributed by CoinDess. What's going on, guys? It is Sunday, December 20th, and that means it's time for Longreed Sunday. Today is the last breakdown episode before I start my end-of-year extravaganza with 14 different guests, 21 minutes each, looking at the year that was in the year to come. And so I wanted to do something special for this LRS, and I came across something I thought was pretty cool earlier in the week.

Caitlin Long shared an article by Jeffrey Snyder, who obviously has been on the show. Both Caitlin and Jeffrey have been on the show. And Jeff is particularly acute at popping intellectual bubbles that just, don't hold up under scrutiny. The cool thing, however, is that Caitlin took Jeffrey's article and then expanded it into the world of Bitcoin and Crypto. So what I'm going to do is I'm going to read Jeffrey's article first, and then we're going to read Caitlin's thread building off of it. So Jeffrey's article was on real clear markets and is called a nonsensical jumble of misused words requires discussion. I know, right? Like you, when I first heard about it, there's been

little else on my mind. The structural implications alone were such that any rational person would devote as much time and energy to figuring out all the nuances. The stakes literally cannot be calculated even today. Scarcely has there been a more serious issue. I'm writing, of course, about regulatory arbitrage in the presence of non-harmonized rehypothecation regimes. Only partly tongue-in-cheek, the satire applies solely to the fact that very few humans on this planet could make much sense of what seems otherwise a nonsensical jumble of misused words. Hardly the topic for any mainstream conversation. It really needs to be. To begin with, ask any person about the 2008 crisis, and 99 out of 100 will tell you it was subprime mortgages, those greedy Wall Street bankers

making stupid loans to American housing bubble buyers in no shape to borrow for even the most reasonably priced property. The 100th will simply say, quote, they crashed the system on purpose. Challenge, this near-centenary might go further to allege that these ill-conceived mortgage loans being so badly packaged and at times illicitly maneuvered, these obviously created huge losses for the banking system, which provoked good-thinking people to remove their money before being drawn into the orgy as it inevitably imploded, like Lehman Brothers. A classic case of currency elasticity in the 19th century mold, an old-fashioned banked panic. There were actually very few cases of this, only isolated instances. These certainly made for good television, especially during an election year in the U.S.,

and they did serve to leave a specific impression about banks being banks and doing what banks have always done. Long lines of depositors desperate to convert their deposit claims into bearer currency, cash, just didn't happen except for rare examples, like Northern Rock in the UK or Indy Mac in the US. Lehman Brothers, by the way, didn't even have depositors. Of those big banks who did, like Citigroup, it is true they experienced huge losses. Tens of billions, but not because of subprime mortgages. These were proprietary write-downs, OTTI, other than temporary and temporary and, impairment charges, as large warehouse securities they were holding, or were stuck becoming beneficial

owners of, grew unstable due to severe disruptions in the marketplaces for them. What had made these massive complex securities markets so unstable? Furthermore, why were these disruptions spread out all over the world? U.S. subprime mortgages should have been contained to a U.S. subprime mortgage problem. Instead, it grew to become a gross global bond in fixed income expurgation. While Lehman Brothers had been at the very center of it, very few today understand what was at the center of Lehman Brothers. More to the point, why that still matters. Just as the untimely unwinding of AIG is mistakenly put down as some issue with some derivatives called credit default swaps, in truth, what brought AIG to the brink was largely the same thing which pushed Lehman Brothers

over it, securities lending practices, not trigger-happy depositors. For one thing, Lehman Brothers Inc. was merely the U.S. dealer of a global dealer network housed under a single parent with that name. Counterpart to the American Lehman was the London-based subsidiary Lehman Brothers International Europe. Both prime brokers serving a big range of financial customers, including other brokers and dealers, as well as hedge funds, the London sub had a huge advantage its American cousin couldn't match. Regulations and regulatory arbitrage. It was purposely made much easier to do monetary business in the offshore network of which London's Lombard Street had been the key node. British authorities long ago decided in order to be a player in the growing international currency regime of the Eurodollar system,

they'd let international banks setting up shop in the city do a whole lot more of what they wanted so long as their customers weren't British persons. This meant, among other things, any of these, quote, London banks and subs could offer clients much better terms, so long as, in most cases, clients went along with the full particulars of this arrangement, including getting back to our beginning premise when amounted to a non-harmonized rehypothecation regime. Clients buying securities through Lehman Brothers may or may not have been aware that the end result was those securities actually being custodied with Lehman Brothers International Europe across the Atlantic. In most cases, they wouldn't have cared anyway. The latter dealer offered much better terms,

funding arrangements, and other perks that cheapen the cost of doing financial business, all a form of leverage. This leverage extended to Lehman, too, because in the world of securities lending and what today is called securities funding transactions, to get the best terms mostly means letting your broker secure them on your behalf. Nobody buys securities. They borrow and claim to own repo. The hedge fund client says it wants to own XYZ U.S. Treasury issue, puts up a minimal upfront investment, enough to cover some over-collateralization requirement, and borrows for the rest of the purchase price. In many instances, the broker is the lender as well as custodian. To make this securities funding transaction as cheap as possible, the client will agree to allow the dealer

to re-fledge or re-hypothicate. For our purposes here, the language is interchangeable, though in a legal and regulatory sense these terms can have different meanings, the very security the client is claiming to own. What that means is the dealer acts as an intermediary rather than lending its own cash for the purposes of the client owning this particular security. Instead, the dealer will re-pledge that security in the repo market or to other dealers in order to borrow the cash ultimately used to purchase and then fund the transaction rolling over to its ultimate end, not just the securities financing transaction, a whole series of them. And this series becomes horizontal as well as vertical. The already replgeed security posted by the

the client's dealer to the next dealer in line, can be re-pledge again depending upon the conditions set forth between the client's dealer and what is now the client's dealer's dealer. As you may already guess, the client's dealer's dealer may also be able to re-pledge the same security to its dealer, specifically the client's dealer's dealer. In many, if not most cases, there needn't be the original client need for this chain of re-pleging either. What I mean is, the first link in the chain doesn't have to originate out of the clients need to borrow directly. If permissible, the client's dealer may re-pledge the client's securities for its own purposes with the client being sufficiently incentivized. Thus, a dealer who

does this kind of business with many financial clients can build up a stash of usable collateral that it doesn't exactly own. These securities belong to other firms and vehicles, but are more than useful for the dealer to fund and carry out its dealer activities as a whole because of these peculiar usage rights. The permissibility of these kinds of doings is and remains much higher in the offshore domain, the non-harmonized part of these re-hypothication regimes. The more a dealer could do re-pleging for themselves, the better terms it would offer its customers, giving Lehman Brothers International Europe a serious leg up on Lehman Brothers, Inc. Net result, Lehman Brothers as a global firm, had acquired a significant pool of collateral

owned by its customers in custody at Lehman Brothers International Europe, which underlay a whole range of dealer activities carried out by Lehman Brothers, Inc., including securities financing transactions in its own proprietary book, as well as creating a margin collateral cushion for a whole host of derivative transactions and potential counterclaims. So what happens when customers start to feel a little uncertain about these arrangements? Quite naturally, they may begin to wonder about what their exposure might be, given how their securities are in London. In fact, this, not subprime mortgages, is what led to Lehman's end. Hedge funds and dealers as Lehman clients scrambled to change these prime brokerage agreements

limiting Lehman Brothers Inc. from being able to transfer assets into Lehman Brothers International Europe, or demanding maybe transferred back, having the effect of stripping Lehman of a huge chunk of what had been available collateral by which to supply its global operations. The rest was typical traditional bank-run stuff. Rumors of Lehman being shaky led to the initial customer collateral run, which then made Lehman shakier leading to more customers running in and changing their brokerage language. Soon enough, bye-bye Lehman. It was a run, but it wasn't one like Walter Bagshot or Benjamin Strong would have recognized. It sure hadn't been something Ben Bernacki or any of his kind considered too important either. The latter group, contemporary central bankers, focused instead on the level of bank

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Not to mention, the APR starts at just 5.9%. Stay on top of your investment game with nexo.io. And remember, it's your crypto, your credit, your choice. Get started at nexo.io. What's truly maddening is that authorities in the official sector have and had all the data, and absolutely no idea what to do with it. They have access to confidential streams. Call reports can pretty much open any book like any bank regulator in the past has been able to examine.

They lack, however, the frame of reference, as to properly interpret this data no one else has access to. And if you think this changed over the decade, now dozen years since the first global financial crisis, I've got some very bad news for you, beginning with, obviously, March 2020. The term regulatory arbitrage in the presence of non-harmonized re-hypothication regimes is contained within a January 2017 piece rung together by the Financial Stability Board, which comes to the somewhat familiar conclusions other intermittent such papers had during the years. This kind of repletting stuff sounds really important. Maybe we should look into it. As I wrote a few weeks back, it's 2020 and the Europeans

have only begun a pilot program to trace some securities financing transactions being executed on a few exchanges. If regulators and central bankers don't appear to be in a hurry, that's because they aren't. They need to be. What happened in March 2020 was merely the latest. I had written about the collateral bottleneck, as I called it for years anticipating the very danger so many times before. In many key ways, it's like what's described above regarding Lehman. Dealers are exposed when a significant chunk of their collateral pool might be at risk, and what's more, they know it. And, unlike central bankers and regulators, they don't sit still waiting around to become the next Lehman, or actually believing, as the public is asked to, some Jay Powell type might be able to bail them out

with inert, useless bank reserves. If there's a potential huge gap in their collateral pool, guess what? They'll scramble and fight tooth and nail to fill it, including, like March 2020, bidding at outrageous premiums for any good, unencumbered collateral they might be able to secure. While on the defensive, though, dealers won't, can't do dealer things. The original problem of monetary incest, the pro-cyclical core of great financial crisis one. Once in danger, the dealer restricts its own activities because it has no other choice. If you don't think you'll have sufficient collateral, yours are others, to carry out

the full range of money-dealing activities, those are made to suffer while you hope everything gets sorted out. Without Lehman to transact in these offshore wholesale ways, it sure did immediately lead to problems with other dealers who then pass them along into more dealers as well as markets, widespread liquidations, fire sales, contagion. What doesn't necessarily matter is if ultimately Lehman Brothers fails, or if it manages to remain angoing concern, but out of necessity curtails its vital capacities anyway.

So far as the system's capacities, there isn't any functional difference. It's greatly diminished by either situation, monetary restriction and pro-cyclicality the result of both. This seems to be the conclusion regulators and especially central bankers have gone out of their way to avoid as it pertains to the March financial crisis. There weren't any Lehman-type failures this time around, so everyone must have done their job really well. Meanwhile, the monetary system and the markets dependent upon them suffered massive dislocations even if there weren't any headline-grabbing deaths or near-deaths. This included, importantly,

the Treasury market itself. There hadn't been too many securities for it, rather too few which restricted dealer capacities to do what dealers are meant to do, including intermediate at selling in the Treasury market triggered in the first place by this global monetary implosion. This is not strictly a U.S. dollar problem either, though in the end the denomination matters very little. The euro-dollar system is a monetary system made up of banks transacting in all major currencies, primarily the U.S. dollar. Any irregularity or imbalance that might develop in a single currency block, therefore negatively affects the whole. See Greek debt crisis 2010 to 2012. Dealer impairment, especially where collateral availability might be concerned, is the monetary

agent. It's certainly not bank reserves, dollars, or euros. In fact, the way in which central banks create those reserves can have and has had negative effects on collateral. In Europe, a recent presentation from November 2020 given by Isabel Schnebel, member of the Executive Board of the ECB, highlighted this non-neutral trade-off. In order to raise the level of bank reserves, any central bank must first purchase a security. The net result is more bank reserves, less available collateral. The system, as usual, doesn't stand idly by while central bankers pat themselves on the back over abundant reserves. The subsequent safe asset shortage can lead to has led to more securities lending activity to work around it. Quote, there are two other factors that have further alleviated

collateral scarcity after December 2016. First, the set of securities available for APP purchases was expanded in January 2017. Second, anecdotal evidence suggests that the use of private securities lending operations has increased. The conference paper by Jank, Monk, and Schneider, 2019, investigates the reuse of collateral in response to scarcity induced by the Eurosystem's large-scale asset purchases. She says these things like their positive developments. When Mishnavel refers to alleviated collateral scarcity, over here in reality, what actually happened was that these workarounds only amplified the potential negative pressures, which would arise in any bottleneck. More reuse and repletting, more securities lending, increasing the self-referreact,

reinforcing destructiveness once the aggregate system collateral pool in any currency denomination comes under a threat. That was March 2020. Lehman Brothers 2 not required. They have the data, they have the numbers, they have the position reports we could only dream of obtaining, and they have no idea what they're looking at. Further, authorities are in no rush to change this. Why would they be when bank reserves are globally, quote, abundant, and no individual banks required official intervention even as global liquidations took hold anyway? In the few studies and examinations, which exist, in using Treasury securities, it's been figured these collateral repletting and rehypification change average multiples of six to eight, meaning that a single U.S. Treasury security might be

reused for book and customer businesses six to eight times. Between 85% and 90% of all treasuries taken on dealer books are reused in some fashion. No wonder these banks might become skittish, and why treasury and similar collateral prices remain the way they are. The value in U.S. Treasuries isn't as an investment. It's the liquidity premium demanded by a fragile global monetary system. These are balance sheet tools whose worth is derived from what central bankers and bank regulators are in no rush to comprehend. Currency elasticity is a time-honored worry. Here's the thing, and it's still the thing all these years later. Just what is the currency which becomes destructively inelastic? Not what you're led to think. Someone might want to check on bill prices

recently. Okay, so obviously that was super dense, but I think it's really important. important. It might be worth reading again. I'll obviously include the link. But now I want to read Caitlin Long's tweet thread that built on that. So she says, great article about how financial market plumbing really works, including the real reason why Lehman failed and why the same problem still mostly exist. Rehypothecation and a shortage of collateral despite the frenzy of new government debt issued. But let me connect three dots about how it relates to crypto. There's a shortage of collateral, including T-bills, etc. The stuff big dealer banks need in order to fund themselves. Facebook Libra slash DM could worsen that shortage a lot, so you can see why central bankers

view it as a threat. The repo market periodically has disruptions caused by collateral shortages and undercapitalization of the big dealer banks. Jeff Snyder looks at March 2020 in this piece, but many other examples exist, e.g. Lehman in 2008. When repo markets seizes up, the problems ripple across financial markets. So, it's a big problem when pools of T-bills and other HQLA become scrolled away outside the banking system, plus outside the reach of the repo market. For crypto now, the issue is Facebook's Libro slash DM, but generally stablecoins issued by non-banks other than Facebook will eventually pose the same problem. These are small now, but they've quadrupled since March and are still growing at that rate. Beware, big stablecoin collateral

silos would pose big problems. Next point. Earlier this year, I noted that it was significant that a GSIB moved the head of its repo desk to run a digital asset desk in London. Jeff Snyder's article should connect the dots about London, regulatory arbitrage in the presence of non-harmonized rehypification regimes. Jeff's article explains it well. London doesn't limit rehypification while US does. Was true at the time of Lehman and is still true. So connecting the dots, there's a collateral shortage in Bitcoin is pristine collateral. and London allows unlimited re-hypification. Hmm. As Gretzky said, you got to skate to where the puck is going to be, not where it is. It seems at least one GSIB is indeed doing that. This isn't just about Bitcoin because stablecoins issued by banks, not non-banks, are coming to repo markets too.

Wyoming figured this out two years ago. And that's one reason why Wyoming set up a special non-lending type of bank charter designed to bridge crypto and traditional markets responsibly. The U.S. needs that. Why? It connects to my last point. Beware. Crypto and leverage don't mix. Jeff Snyder's piece gives background. There's big leverage in repo markets and the length of collateral chains isn't clear. So why can't this mix with crypto? Because there's no lender of last resort in crypto and crypto trades settle in minutes with irreversibility. So different. In my opinion,

there's only one way to mix Bitcoin and leverage in a compatible way that doesn't pose financial stability risk. Set up special purpose ring-fenced non-leverage banks with a collateral chain limited to one, i.e. no re-hypothication. In other words, re-hypothication and Bitcoin don't mix. Rehypothication in Bitcoin and leverage GSIs especially don't mix. Mixing Bitcoin and leverage is high risk, both high-less probability and high-loss severity. As global systematically important banks enter crypto, they will want to use these new assets to alleviate re-relivenging. repo markets collateral shortage. I've been thinking about how to marry crypto and traditional finance systems for years, and I think only Wyoming has legal and regulatory regime to do so in

the right way, and that includes custody. Others will catch up, I'm sure, and that will be good for everyone. There's too much at stake to get this wrong. We've talked a lot on this show about whether Bitcoin and crypto in general can survive co-optation by Wall Street. And I think it's important that there's on top of that very surface-level conversation about regulations and about prioritization of things like censorship resistance. There's also this much more systemic structural question about whether it can survive the financialization that comes with being part of the mainstream financial system. I think that what Caitlin is building on Jeff's argument for is a real concern and something that's worth studying and paying attention to closely. I

hope you enjoyed this Long Read Sunday. I hope you're looking forward to the breakdowns end of your extravaganza, which kicks off tomorrow with a conversation with Rao Powell himself. Thanks for listening, guys, and until tomorrow, be safe and take care of each other. Peace.