Monday, October 5, 2015

How I learned to stop worrying and accept deflation

Why can't we create inflation anymore? Maybe it's because money isn't what it used to be.

Money used to be like a car; the market expected it to depreciate every day. When we buy a new car we accept a falling resale value because a car provides a recurring flow of services over time; each day it gets us from point a to point b and back. And since these conveniences are large, the market prices cars such that they yield a steady string of capital losses.

Money, like cars, used to provide a significant flow of services over time. It was the liquidity instrument par excellence. If a problem popped up, we knew that money was the one item we could rapidly exchange to get whatever goods and services were necessary to cope. Given these characteristics, the market set a price for money such that it lost 2-3% every year. We accepted a sure capital loss because we enjoyed a compensating degree of comfort and relief from having some of the stuff in our wallets.

These flows of services are called a convenience yield. Assets that throw off a convenience yield, like cars and money, typically have negative expected price paths. Let's call them Type 1 assets.

Type 2 assets, things like stocks and bonds, don't boast a convenience yield. Without a convenience flow, people only buy them because they promise a real capital return. One way a Type 2 asset provides a capital return is via a positive expected price path. We only hold Google shares because we expect them to rise by around 5-10% a year. Same with treasury bills. The government issues a bill at, say, $97, and they mature a year later at $100.

Another way for a Type 2 asset to provide a capital return is via periodic payments. A bond or an MBS doesn't rise over time. Rather, it provides its return in the form of regular coupon payments.

Could it be that money has steadily lost its convenience yield? If so, it's shifted from being a Type 1 asset with a negative expected price path towards being a Type 2 asset. That would explain our new deflationary era. In the same way that Type 2 assets like Google and t-bills have to offer a positive expected price path if they are to be held, the purchasing power of money needs to improve over time. And since everything in the world is priced in terms of money, that means that the price level can no longer inflate, it has to deflate.

Where has money's once considerable convenience yield gone? The costs of creating liquidity have been steadily diminishing. Wall Street has been able to make a wide variety of assets like stocks and bonds much more liquid at less cost. So whereas money was once the liquidity instrument par excellence, people now have a multitude of liquid instruments that they can choose from. At the same time, central banks, via quantitative easing, have create massive amounts of central bank liabilities. With a sea of liquid assets, maybe liquidity just isn't a valuable commodity anymore.

Welcome to deflation, folks. Into the vacuum left by money's retreating convenience yield, a promise of capital returns has sprung up.

Reversing deflation?

Even if money has become a Type 2 asset, central bankers can still get the inflation rate back to 3%. To do so, they'd have to change the nature of the capital return that it offers. Like Google shares, money now seems to promise a rising expected price path (i.e. deflation). Central bankers need to switch that out with a bond-style promise of juicier periodic payments. This would involve a central banker ratcheting up the interest rate on money balances, or reserves, to an above-market level. Only with an unusually high interest rate on reserves would people once again accept a declining expected price path for money (i.e. inflation).

For an analogy, imagine that tomorrow the U.S. Treasury were to issue a new 10-year bond with an outlandishly high 10% coupon. With the market-clearing yield on existing 10-year bonds sitting at just 2%, the new bond would start trading at a large premium to its $1000 face value and slowly fall over time. Likewise, money that sports an outlandishly high interest rate would steadily lose purchasing power. 

Ratcheting up rates in order to get us back to a 3% inflation path could be a ghastly experience. Before it can start rolling down the hill again, money's purchasing power would have to rise sharply in value. But money is the unit in which everything else is priced, which means the price level would need to rapidly deflate. If prices are sticky, this could result in a glut of unsold labour and goods; a recession.

Alternatively, might a central bank rekindle inflation by forcing interest rates below their market level? In the short term we'd get a quick one-time dose of inflation. But after the adjustments had been made the price level would only continue its previous deflationary descent. A central banker would have to consistently ratchet down interest rates to generate a perpetual series of one-time inflationary pops in order to keep hitting its 2-3% inflation target. This strategy would run into problems. Go much below -1% and a central bank will hit the lower bound. Unless it wants to risk mass cash storage, it won't be able to go further. Even if a central bank devises ways to get below -1%, it'll have to perpetually ratchet rates down in order to spur the next one-time pop in inflation. Once it hits -20%, or -30%, one wonders whether the market won't simply adopt an alternative currency.

Given that these two options don't seem too comforting, maybe we should just get used to a bit of deflation.

Thursday, September 24, 2015

Andy Haldane and BOEcoin

The 1995 British two pound "Dove" coin

The Bank of England's chief economist Andrew Haldane recently called for central banks to think more imaginatively about how to deal with the technological constraint imposed by the zero lower bound on interest rates. Haldane says that the lower bound isn't a passing problem. Rather, there is a growing probability that when policy makers need three percentage points of headroom to cushion the effects of a typical recession, that headroom just won't be there.

Haldane pans higher inflation targets and further quantitative easing as ways to slacken the bound, preferring to focus on negative interest rates on paper currency, a topic which gets discussed often on this blog. He mentions the classic Silvio Gesell stamp tax (which I discussed here), an all out ban on cash as advocated by Ken Rogoff, and Miles Kimball's crawling peg (see here).

According to Haldane, the problem with Gesell's tax, Rogoff's ban (pdf), and Kimball's peg is that each of these faces a significant 'behavioural constraint.'  The use of paper money is a social convention, both as a unit of account and medium of exchange, and conventions can only be shifted at large cost. Tony Yates joins in, pointing out the difficulties of the Gesell option. Instead, Haldane floats the possibility of replacing paper money with a government-backed cryptocurrency, or what we on the blogosphere have been calling Fedcoin (in this case BOEcoin). Unlike cash, it would be easy to impose a negative interest rate on users of Fedcoin or BOEcoin, thus relaxing the lower bound constraint. Conventions stay intact; people still get to use government-backed currency as a medium of exchange and unit of account.*

While I like the way Haldane delineates the problem and his general approach to solving it, I'm not a fan of his chosen solution. As Robert Sams once pointed out, Fedcoin/BoEcoin could be so good that it ends up outcompeting private bank deposits, thus bringing our traditional banking model to an abrupt end. Frequent commenter JKH calls it Chicago Plan #37, a reference to a depression-era reform (since resuscitated) that would have outlawed fractional reserve banking. If Haldane is uncomfortable with the Gesell/Rogoff/Kimball options for slackening the lower bound because they interfere with convention, he should be plenty worried about BOEcoin.


I do agree, however, with Haldane's point that the apparatus adopted to loosen the constraint should interfere with convention as little as possible. We want the cheapest policies; those that only slightly impede the daily lives of the typical Brit on the street while securing the Bank of England a sufficient amount of slack.

With that in mind, here's what I think is the cheapest way for the Bank of England to slacken the lower bound: just freeze the quantity of £50 bills in circulation. Yep, it's that easy. There are currently 236 million £50 notes in circulation. Don't print any more of them, Victoria Cleland.**

I call this a policy of embargoing the largest value note. How does it work?***

Say that in the next crisis, the Bank of England decides to chop rates from 0.5% to -2.0%. Faced with deeply negative interest rates, the UK runs smack dab into the lower bound as Brits collectively try to flee into banknotes. After all, banknotes offer a safe 0% return, the £50 note being the chosen escape route since those are the cheapest to store and convey.

Flooded with withdrawal requests, banks will quickly run out of £50s. At that point the banks would normally turn to the Bank of England to replenish their stash in order to fill customers' demands. But with the Bank of England having frozen the number of £50s at 236 million and not printing any new ones, bankers will only be able to offer their customers low denomination notes. But this will immediately slow the run for cash since £20s, £10s, and £5s are much more expensive to store, ship and transfer than £50s. Whereas people will surely prefer a sleek high denomination note to a deposit that pays -2%, they will be relatively indifferent when the choice is between a bulky low denomination cash and a deposit that pays -2%. Thus the lower bound has been successfully softened by an embargo on the largest value note.

Once negative interest rates have served their purpose and the crisis has abated, they can be boosted back above 0% and the central bank can unfreeze the quantity of £50s. Everything returns to normal.

A few conventions will change when the largest value note is embargoed.

1. People will no longer be able to convert £50 worth of deposits into a £50 note. Instead they'll have to be satisfied with getting two £20s and a £10. That doesn't seem like an expensive convention to discard. And if folks really want to get their hands on £50s, they'll still be able to buy them in the secondary market, albeit at a small premium.

2. In normal times, £50 notes always trade at par. Because their quantity will be fixed under this scheme, £50s will rise to a varying premium above face value whenever interest rates fall significantly below zero. For instance, at a -2.0% interest rate a £50 note might trade in the market at £51 or £52.

The par value of £50 notes is a cheap convention to overturn. The majority of the British population probably don't deal in £50s anyways. Those who do use £50 notes in their daily life will have to get used to monitoring their market price so that they can transact at correct prices. But the inconveniences faced by  this tiny minority is a small cost for society to pay in order to slacken the lower bound.

3. Importantly, there will be no need to proclaim a unit of account switch upon the enacting of an embargo on £50s; the switch will be seamless.

Because the £50 was never an important part of day-to-day commercial and retail existence, come negative interest rates no retailers will set their prices in terms of a £50 standard. If they do choose to set sticker prices in terms of the £50 note, they will find that if they want to preserve their margins they will have to levy a small surcharge each time someone pays with £20s, £10s, and £5s and bank deposits. Given the prevalence of these payment options, that means surcharging on almost every single transaction. That's terribly inconvenient. Far better for a retailer to set sticker prices in terms of the dominant payments media—£20s, £10s, and £5s and bank deposits—and provide a small discount to the rare customer that wants to pay with £50s.

It's entirely possible that the majority of retailers will not bother offering any discount whatsoever on £50s. This would effectively undervalue the £50 note. Gresham's Law tells us that given this undervaluation, the £50 will disappear from circulation as it gets hoarded under people's mattresses. For the regular British citizen, never seeing £50s in circulation probably won't change much. And anyone who does want a £50 can simply advertise on Craig's list for one, offering a high enough premium to draw it out of someone's hoard.

In closing, a few caveats. The figures I am using in this post are ballpark. It could be that a policy of freezing the supply of £50 notes allows the Bank of England to get to -2%. But maybe it only allows for a level of -1.75%, or maybe it slackens the bound so much as to allow a -2.5% rate.

Haldane mentions that the Bank of England could need 3% of headroom to combat subsequent recessions. But as Tony Yates has pointed out, in 2008 bank officials calculated that a -8% rate was needed. The Bank could get part way there by not only embargoing the £50 but also the next highest value note; the £20. But that probably wouldn't be enough. As ever smaller notes have their quantities frozen, this starts to intrude on the lives of the people on the street, making the policy more costly. If it needs to slacken the lower bound in order to allow for rates of -8%, I think the Bank of England should be planning for a heftier policy like Miles Kimball's crawling peg. After all, when the sort of crisis that requires such deeply negative rates hits, the last thing we should be worried about is disturbing a few conventions. Until another 2008-style crisis hits, embargoing large value notes might be the least intrusive, lowest cost option. 

*Of these policies, I think Miles Kimball's plan is by far the best one.
**Specifically, the Bank would only print new bills to replace ripped/worn out bills. Otherwise the outstanding issue will wear out and become easier to counterfeit. As for Scotland, which issues 100 pound notes, their quantity would have to be fixed as well.
*** I first mentioned the idea of embargoing large notes in relation to the Swiss 1000 CHF note, and later elaborated on it in the Lazy Central Banker's Guide to Escaping Liquidity Traps.

Friday, September 11, 2015

Hike rates when you hear the creak of inflation at the door, not when you see the whites of its eyes

A common argument against the Fed raising interest rates next week is the asymmetry in risks that it faces. If it keeps rates low too long and sets off inflation, no problem: it can quickly hike rates a few times to bring prices back in line. However, if it boosts rates too early and an unintended slowdown sets in, the Fed won't have room to cut a few times in order to fix its mistake. That's because the Fed is at the zero lower bound, the edge of the world in monetary policy terms. To avoid this conundrum, the Fed should hold off as long as possible before raising, at least until it "sees the whites of inflation's eyes."

As Paul Krugman points out, the asymmetry argument is only a recent one. Historically U.S. interest rates have hovered far above zero. If the Fed made a mistake, it didn't have to worry about falling off the edge of the world in order to fix the situation, it could simply ratchet rates down a few times. Rather than waiting till the last minute to see the whites of inflation's eyes before hiking, the FOMC only had to hear the creak of inflation at the door.  

I don't buy the current asymmetry argument. I might have bought it back in 2013, but the data has changed.

Over the last year, Sweden, Switzerland, Denmark, and the ECB have all demonstrated to the world that central banks can safely lower rates into negative territory without setting off the sorts of ill effects that economists have always feared, the main one being a race into 0% yielding cash. The theory here is that if a central bank reduces rates to, say, -0.1%, then paper cash—which pays a superior 0% return—starts to look pretty attractive. An arbitrage process begins whereby central bank deposits are converted into cash until all deposits have disappeared. Thus rates can't be reduced below 0%.

Evidence over the last 12 months shows otherwise. Denmark's Nationalbank has kept its deposit rate at -0.75% since early February. Danes, however, are not scrambling for banknotes, as the chart below shows. After seven months of negative rates, cash and coin outstanding are growing at a rate that lies pretty much at its two decade average.

The Swiss National Bank has maintained a -0.75% overnight rate since January, yet there's been no spike in Swiss paper franc demand, as the next chart shows. In fact, cash outstanding seems to be growing at one of its slowest rates in years.

We'd expect the demand for Swiss cash to be especially sensitive when interest rates fall below zero because the SNB issues the world's largest value banknote; the hefty 1000 sFr. The more valuable the banknote the lower the cost of storing wealth in cash form. These carrying costs are particularly important in determining the profitability of flight into cash at negative interest rates. A central bank can push rates a sliver below 0% without setting off a flight out of deposits into banknotes as long as there are inconveniences in storing cash. The greater these inconveniences, the larger that sliver.

The fact that the SNB has been able to keep rates at -0.75% for seven months now without setting off a stampede into 1000 notes indicates that the burdens of holding Swiss currency are higher than everyone had previously thought. It would seem that investors would rather lose 0.75% each year than bear the costs of storing 1000s. At some negative interest rate, maybe -1.5%, the flight into Swiss notes will start. But it hasn't yet. As for the U.S., its highest value banknote is the lowly $100, so it's fair to assume that the costs of storing U.S. paper money are significantly higher than Swiss money. Which means that if the Swiss can safely cut to -0.75% without setting off cash arbitrage, the Fed should be able to descend to at least -1.0% before panic ensues.

The second greatest fear surrounding sub zero U.S. rates has always concerned money market mutual funds. The worry here is that should the Fed reduce rates too deep, a financial intermediary known as a money market mutual fund (MMMF) will 'break the buck,' causing panic and terror among ordinary investors.

MMMFs are like regular mutual funds except their share price stays fixed at US$1.00. Investors can cash out at that price whenever they want, enjoying low but steady dividend payments until then. MMMFs maintain par conversion by investing in safe, highly liquid short term debt. However, if the Fed were to drive short term rates into negative territory, MMMFs would be forced to invest in assets that promise a negative return. $1000 invested in t-bills, for instance, would be worth only $999 upon maturity. That means that an MMMF simply wouldn't have a sufficient quantity of assets to allow everyone to redeem their shares at US$1.00. The fund will "break the buck," or mark its share value down to something like 99 cents to allow for full redemption. Since MMMFs are supposed to be cash-like—in fact, many of them offer cheque-writing capability—such a development would be disastrous, or so goes the story.

I don't consider breaking the buck to be a terrible outcome, but even if it is, European money market mutual funds—faced with negative interest rates—have already found an ingenious way to avoid it; a Reverse Distribution Mechanism. Rather than reducing redemption below par, MMMFs simply dock the number of shares that each shareholder has in his or her account. For example, as rates slide below zero, instead of 100 units being worth only $0.99 each, a shareholder forfeits one unit and ends up with 99 units worth $1.00 each. The deeper rates fall, the less units each investor owns. The genius of this patch is that the purchasing power of each share stays constant, but the negative interest rate is efficiently passed on to the owner of the MMMF.

So fears of a dash into cash at 0% and a collapse of MMMFs are just bogeymen. If the Fed hikes to 0.5% this month—and this proves to be a mistake—it still has plenty of room to make things right. Given how well Europe has coped over the last twelve months, the Fed can easily cut rates another 1.5% to -1.0%; that's six quarter-point reductions or thirty ten-point cuts. Only when rates falls beyond Swiss or Danish levels, say to -1.0%, will the Fed find itself in truly asymmetrical territory. (If necessary, here are some simple ways to allow for even more negative rates).

To be clear, that doesn't mean I think the Fed should hike rates next week. The fact that the FOMC continues to undershoot its 2% core inflation target would seem to indicate that holding off might be the right thing to do. Rather, I don't think that Fed policy makers need to wait to see the white's of inflation's eyes before they hike, they need only wait to hear the creak of inflation at the door.

Saturday, September 5, 2015

Why big fat Greek bank premiums?

National Bank of Greece depository receipt certificate (source)

If you're like me and you like to: 1) explore anomalies in markets; and 2) mix equity analysis with monetary analysis, then you'll like this post. A sneak peak: by the end, we'll be able to use equity markets to figure out the unofficial exchange rate between a Greek euro and non-Greek euro.

For the last few weeks shares of Greek banks have diverged dramatically from their overlying depository receipts (see chart below). A bit of background first. A depository receipt is much like an exchange-traded fund, except where an ETF holds a bundle of different stocks, a depository receipt represents just one stock. That stock is usually listed on an out-of-the-way market (like Greece), whereas the depository receipt trades on a major exchange like New York. Investors interested in owning a foreign stock can avoid currency conversion costs and foreign settlement problems and instead purchase the New York-listed depository receipt hassle-free.

In general, the parent security and its offspring should trade in line with each other. Recently, however, the US-listed depository receipts of the National Bank of Greece and Alpha Bank have risen to a massive premium relative to their Greek-listed parents. For instance, in mid-August investors could have bought National Bank's New-York listed depository receipt for €0.73. However, the Greek-listed stock was trading for just €0.60. For some reason, investors are paying 30% more for a security that provides the exact same stream of earnings. We've got a gross violation of the law of one price.*

This is especially interesting given that a redemption/creation mechanism for depository receipts links the price of parent and offspring via arbitrage. In the same way that an investor deposits cash at a bank and gets a bank deposit, an investor can buy a National Bank of Greece share listed in Athens and 'deposit' that share at a custodian, receiving in return a newly-created New York-listed depository receipt. If either security can be bought for less than the other, an arbitrage opportunity arises. For instance, in mid-August one might (in theory) have bought Greek-listed National Bank of Greece shares for €0.60, converted them into New York-listed depository receipts, sold the depository receipts for €0.73, wired the proceeds from New York to Greece, and repurchased Greek-listed National Bank of Greece shares for €0.60. Rinse and repeat. (This works the other way, too. In the same way that a bank deposit can be converted into cash, investors can purchase a depository receipt and redeem it for underlying equity.)

The effect is that as investors clamour to harvest arbitrage gains, any premium or discount between a New York-listed depository receipts and its Greek parent equity should quickly fall towards zero. Why hasn't this been the case in Greece of late?

There are several explanations for persistent premia/discounts between depository receipts and their underlying shares. The first is liquidity differences. If the depository receipt is more liquid than the underlying equity, then investors will be willing to pay a bit more for the depository receipt. In the case of National Bank of Greece, the depository receipt tends to attract higher trading volumes than the underlying Athens-listed shares, which probably explains why the receipts have tended to trade at a premium.

Premiums or discounts can also occur when the redemption/creation mechanism is inhibited. Depository receipts for Taipei-listed Taiwan Semi Conductor rose to an incredible 60% premium to the shares in the late 1990s and early 2000s. The reason for this premium can be traced to the fact that Taiwan restricts foreign ownership of local companies. This effectively prevented the closing of the premium via purchases of local shares for conversion into depository receipts. These premia evaporated when Taiwan removed foreign ownership restrictions in 2003. (Here is a good summary).

In a 2006 paper, Saxena found that the New York-traded depository receipts of a handful of Indian stocks, including Infosys, Wipro, State Bank of India, MTNL, ICICI Bank, HDFC Bank and Satyam Computers, habitually traded at substantial premium to the underlying Indian-listed equity. Infosys's premium (which reached 60% in 2002) had existed since its U.S. listing in 1999. However, German, South Korean, and Hong Kong-listed companies with New York-listed depository receipts showed negligible premia.

Why was this? Saxena found that Indian depository receipts suffered from limited two-way fungibility. Depository receipts could be freely converted into Indian-listed shares, but Indian-listed shares could only be converted into depository receipts to the extent that there was available 'head room'. The amount of headroom in turn depended on the extent of past conversion of depository receipts into shares. Since headroom in the above shares had been all used up, when American investors flocked to buy depository receipts, thus driving them to a premium relative to the Indian-listed equity, there was no way for arbitrageurs to close the difference.

In the case of Greece, the imposition of capital controls on June 29 seems to have inhibited the redemption/creation mechanism. The Athens stock exchange was closed the same day (the New York-listed receipts continued to trade), but when it reopened on August 3, capital controls remained in place. Since reopening, a wedge has appeared between the prices of National Bank of Greece's depository receipts and its underlying shares, implying that there has been much more demand for the former than the latter. Typically, arbitrageurs would close this gap, buying the underlying Athens-listed shares and turning them into new deposit receipts. Presumably the Greek authorities have asked that banking intermediaries cease allowing the conversion of Greek shares into receipts, so arbitrage has not been possible.

That ended on August 27, 2015. According to a press release for BNY Mellon, clarification requested from Greek authorities regarding conversions of depository receipts had finally been received and, as a result, deposit receipt books would be re-opened for issuance and cancellation. With the ability to arbitrage receipts and the underlying shares once again available, the National Bank of Greece depository receipt premium collapsed from around 30% to 10% when markets opened on August 28. It has been shrinking ever since and now lies within its historical range.


That explains the anomaly and its disappearance. But that's not the end of the story. Going forward, watching the relative price of National Bank of Greece's depository receipts and its share price may provide valuable insights.

In permitting depository receipt redemption and creation, the Greek government has effectively removed capital controls. Currently, Greeks cannot withdraw more than €420 in cash per week from their bank accounts and are not permitted to transfer more than €500 per month to a foreign account. Businesses must go through tedious application processes to get access to their funds. However, with the depository receipt window open, businesses and individuals can simply spend all their bank deposits on Athens-listed National Bank of Greece, convert the shares into depository receipts, sell them in New York for dollars, and convert the funds back to euros. Voila, capital controls evaded.

This loop hole doesn't seem very fair to me. After all, only the financial elite will be aware of the depository receipt escape, with widows, orphans, and the rest oblivious that capital controls have been effectively lifted. Loosening up the depository receipt window only make sense if it is twinned with similar effort to help the broad public, say a higher ceiling on cash withdrawals.

Depending how tightly Greece's capital controls bind, Athens-listed National Bank of Greece shares might actually lose their traditional discount and rise to a premium relative to New York-listed depository receipts (in euro terms). If depository receipts are the best route to evade capital controls, then those desperate to get their money out of Greece will be willing to pay a 'fee' for that privilege. By purchasing National Bank of Greece shares in Athens for, say 0.65 euro, and converting them into depository receipts that trade for just 0.60 euros, investors effectively lose 0.05 euros. The size of that fee, the premium, will equal the cost of the next best alternative for evading capital controls. If controls are leaky, the premium will be small. If they aren't, it could be quite wide.

A number of studies have found that during the Argentinean corralito, Buenos Aires-listed shares rose to a huge premium relative to their New York-listed depository receipts. Brechner, for instance, finds that the premium reached over 40% in January 2002. This gap represented the amount that Argentinians were willing to pay to use depository receipts as a vehicle for moving their wealth from frozen Argentinean bank deposits into liquid U.S bank deposits. When share conversions were restricted in March 2002, that premium disappeared.

Greece seems on its way to being mended. Capital controls should be loosened soon, and people no longer seem anxious about an imminent drachma conversion. So if a premium on local National Bank of Greece shares were to develop, I doubt it would be large like the sort of premia that prevailed in Argentina. However, if things were to get worse, we might see a large gap develop.

In closing, now that depository receipt conversion has been reopened but capital controls remain in place, the exchange rate between Athens-listed National Bank of Greece shares and New York-listed depository receipts serves as the "black market" rate between Greek euros and non-Greek euros. After Hugo Chavez imposed capital controls in 2003, Venezuelans used the rate between Caracas-traded CA Nacional Telefonos de Venezuela (CAN TV) shares relative to New York-listed depository receipts as a shadow rate for the Venezuelan bolivar, until CANTV was nationalized in 2007. Likewise burdened by capital controls, Zimbabweans used the exchange rate between Old Mutual shares listed on the Zimbabwe Stock Exchange and those listed in London as the implicit Zimbabwe dollar exchange rate. It even had a name: the OMIR, or Old Mutual Implied Rate.

So watch the National Bank of Greece equity-to-depository receipt rate closely. It's conveying information about Greek euros.

* More accurately, the depository receipts were trading for US$0.83. To calculate their euro price, I use the 9:30-10:30 price of New York-listed National Bank of Greece depository receipts and converted them into euros at the prevailing dollar-to-euro exchange rate.

Wednesday, August 26, 2015

Negative skewness, or: bulls walk up stairs, bears jump out of windows

Recent market action is a good reminder of the asymmetry in markets. In general, stock market rises don't look like stock market declines. Stock indexes slowly eke out gains over a period of months, but lose all of those gains just a few days. There are plenty of famous meltdowns in stocks, including 1914, 1929, 1987, and 2008, but almost no famous "melt ups."

Just like the Inuit have multiple words for snow because they are surrounded by the stuff, equity commentators have many words for crashes (panics, selloff, etc). These events are not uncommon. In the same way that many indigenous African languages have no word for snow, we lack a good word to describe one or two day melt-ups in equity markets since these aren't part of our landscape.

There are a number of trader's adages that describe this pattern, including bulls walk up the stairs, bears jump out the window and variations on that theme. In the economic literature, this phenomenon is referred to as negative skewness. If you look at the distribution of daily percent returns for the S&P 500 Index over a long period of time, you'll notice that there are more extreme negative results than extreme positive results, with the majority of results being slightly positive. Whereas a normal distribution, or the bell shaped curve we've all seen in statistics class, is symmetrical with 95% of values dwelling within two standard deviations of the mean, a negatively skewed distribution has a fat left tail where declines extend far beyond what you would expect for a normally distributed data set.

The chart below illustrates this. Out of 22,013 trading days going back to 1928, just 47.8% of days resulted in negative outcomes while 52.2% resulted in positive outcomes. This makes sense given the generally upward trajectory of equity markets over that period. If we sort each day's return into buckets, we start to see asymmetries develop. For instance, there were 10,973 days on which markets moved higher or lower by by 0.5%, just 48.4% of which were lower. The majority of 0.5 to 1% and 1 to 2% changes were to the positive side as well. The distribution changes once we look at the 2% and over bucket. Out of 1485 days with "extreme" returns, the majority (51.9%) of changes were declines of 2% or greater rather than rises of +2% or greater.

Figure: Distribution of daily changes in the S&P 500 index going back to 1928

Financial economists have a number of hypothesis for negative skewness. One theory blames leverage, whereby a drop in a firm's equity price raises its leverage, or the amount of debt it uses to finance itself. This makes an investment in the company more risky and leads to higher volatility of its shares. Conversely, when a stock rises, its leverage decreases, making the shares less risky. For that reason, rises in equities are tame while falls are wild. While an attractive theory, data shows that as stock prices decline, all-equity financed companies experience jumps in volatility of the same magnitude as leveraged companies, indicating that leverage is not a good explanation for a pattern of negative skewness.

Another explanation is the existence of "volatility feedback." When important news arrives, this signals that market volatility has increased. If the news is good, investor jubilation will be partially offset by an increase in wariness over volatility, the final change in share price being smaller than it would otherwise have been. When the news is bad, disappointment will be reinforced by this wariness, amplifying the decline.

Other theories blame short sale constraints for the asymmetry. If bearish investors are restricted from expressing their pessimism, they will be forced to the sidelines and their information will not be fully incorporated into prices. When the bulls start to bail out of equities, the bearish group becomes the marginal buyer, at which point bearish information is finally "discovered" by the market, the result being large price declines.

Putting the reasons aside, behavioral finance types have some interesting things to say about how investors perceive skewness. According to prospect theory, investors are not perfectly rational decision makers. To begin with, returns are not appraised in a symmetrical manner; a 5% loss hurts investors more than a 5% gain feels good. Next, investors overweight unlikely events and underweight average ones. Given these two quirks, investors may prefer positively skewed assets (like government bonds), which have far fewer large declines than normally skewed assets, as this distribution reduces the potential for psychological damage. The possibility of large lottery-like returns, the odds of which investors overweight relative to the true odds of a positive payout, also drive preferences for positive skew assets. Negatively skewed assets like equity ETFs, which expose investors to tortuous drops while not offering much potential for large melt-ups, are to be avoided.

Put differently, positive skew is a feature that investors will pay to own. Negative skew is a "bad" and people need to be compensated for enduring it.

If you buy this theory, then in order to coax investors into holding negatively skewed assets like stocks, sellers need to offer buyers a higher expected return. The presence of this carrot could be one of the reasons why equities tend to outperform bonds over time. For equity owners who are suffering through the current downturn, here's the upshot: negative skew events like the current one, while stressful, may be the price you have to pay in order to harvest the superior returns provided by stocks over the long term.

Wednesday, August 12, 2015

How many bullets does the Bank of Canada have left in its chamber?

It's been a while since I blogged about Canadian monetary policy, but Luke Kawa's recent tweet on the topic of Canada's effective lower bound got me thinking.

Luke is referring here to CIBC chief economist Avery Shenfeld's recent missive on how the Bank of Canada might react if the Canadian economy's losing streak were to continue. According to Shenfeld, the Bank of Canada has one final quarter point cut left in its quiver—from 0.5% to 0.25%. Should the bleeding continue, Governor Stephen Poloz can then turn to forward guidance and only when that has been exhausted will quantitative easing become a possibility.

Really? The Bank of Canada can't go below 0.25%? Has Shenfeld not been following what has been occurring outside Canada's borders over the last twelve months? Sweden's central bank, the Riksbank, has cut its repo rate to -0.35% while the European Central Bank has ratcheted its deposit rate down to -0.2%. The Swiss National Bank is targeting an overnight interest rate of -0.75%, down from 0% the prior year, at the same time that the Danmarks Nationalbank currently maintains a certificate of deposit rate of -0.75%. I've been covering this stuff pretty exhaustively here, here, here, here, and here.

After digging a bit further, I was surprised to find that the sort of interest rate emasculation implied in Shenfeld's piece is endemic here in Canada. David Rosenberg of Gluskin Sheff, for instance, recently said that Poloz has "just one bullet left in the chamber" while the FP's John Schmuel wonders what will happen if the Bank of Canada is forced to use its "last remaining lifeline and cut its rate to zero." The Bank of Canada is also a transgressor in spreading the meme: on its FAQ, the Bank says that the overnight rate's lowest possible level—its effective lower bound—is 0.25%.

One reason the faux 0.25% lower bound continues to circulate in the public discourse is the somewhat lazy reliance commentators have on the Bank of Canada's credit crisis playbook as a model for 2015. In addition to implementing forward guidance during the crisis, the Bank reduced the overnight rate to 0.25% by flooding the system with excess balances. But this playbook has gone stale. As I've already pointed out, a number of European central banks have demonstrated the possibility of going below zero. A Bank of Canada deposit rate cut to as deep as, say, -0.50%, combined with an overnight target of -0.25, effectively buys Poloz three more 25 basis point interest rate cuts, not just one.

Ask folks why Canadian markets can't bear negative interest rates and there's typically a lot of arm-waving and mumbling about money markets. Case in point is Shenfeld on the +0.25% level: "In the Canadian money market structure that’s as low as she gets, and effectively represents the zero lower bound for monetary policy." I'm not aware of a single Canadian fixed income product that can't bear slightly negative interest rates. Would maple syrup commercial paper markets come to a standstill if the Bank of Canada cut rates to -0.25%? Would the market for Gordie Howe bonds collapse? While no doubt a nuisance, the transition to negative rates has been managed by money markets in Denmark, Sweden, Switzerland, and the rest of Europe without major mishap. There's simply no justification for Canadian exceptionalism.

While slightly negative rates won't cause structural problems in money markets, deeply negative rates would certainly be problematic. Send rates low enough and bank runs will begin as people cash in their negative-yielding money market instruments for paper dollars. At some point the banking system would cease to exist. But this doesn't occur at Shenfeld's so-called 0.25% lower bound, nor at -0.75%. Thanks to the carrying costs of bulky banknotes, it probably only starts to be a problem somewhere between -1.0% to -3.0%. The existence of a wide safe zone before hitting those levels gives the Bank of Canada a lot more lifelines than just one.

The last reason for the circulation of a false lower bound in Canadian monetary policy discussion is vested interests. I doubt that Canada's big banks are fond of incurring the frictional costs associated with transitioning to a negative rate world. Better to "wipe out" that possibility from the Overton Window and push something less-threatening like forward guidance.

Let me be clear that I have no specific insight into whether the Bank of Canada should be loosening or not. What is important is that the Bank has flexibility to the downside should it decide that easing be necessary. Breathing space is important because pound-for-pound, actual interest rate cuts are always better than unconventional policies like forward guidance—the promise to keep interest rates too low in the future—or quantitative easing. A move to -0.15% or -0.25%, should it be necessary, represents a continuation of the Bank of Canada's decades' long method of implementing conventional monetary policy via direct interest rate adjustments. It's not fancy, but it has been in place for a long time and everyone pretty much gets it by now. Central bank guidance, on the other hand, is complicated and suffers from the fact that the public can never be sure that a three-year promise initiated by a Conservative-appointed governor will stay in place should an NDP-appointed governor take his place. As for quantitative easing, it doesn't even work in theory, as pointed out by none other than Ben Bernanke. (Or see how New Zealand's cashing up the system had no influence on prices)

Incidentally, if Canada were to suffer a broader shock than the current one and the Bank of Canada found it necessary to go deep into negative territory, say -2%, there are all sorts of ways it can go about doing so without causing stress in money markets. In fact, economist & blogger Miles Kimball recently visited the Bank of Canada to explain how to go about implementing extremely low rates without igniting a run into paper dollars, or what he refers to as massive paper storage. I've written about some "lite" ways to go about doing so as well.

Interestingly, Kimball writes that the Bank of Canada already has an “Effective Lower Bound” working group that is focused on "exploring the possibilities for negative interest rate policy in the next recession." So while the public discourse on Canadian monetary policy seems to have settled on the "one remaining lifeline" view, it appears that internally that is not the case—the Bank of Canada knows that it has much more up its sleeve.

Various charts:

Monday, August 3, 2015

Freshwater macro, China's silver standard, and the yuan peg

1934 Chinese silver dollar with Sun Yat-sen on the obverse side. The ship may be in freshwater.

I have been hitting my head against the wall these last few weeks trying to understand Chinese monetary policy, a project that I've probably made harder than necessary by starting in the distant past, specifically with the nation's experience during the Great Depression. Taking a reading break, I was surprised to see that Paul Krugman's recent post on the topic of freshwater macro had surprising parallels to my own admittedly esoteric readings on Chinese monetary history.

Unlike most nations, China was on a silver standard during the Great Depression. The consensus view, at least up until it was challenged by the freshwater economists that people Krugman's post, had always been that the silver standard protected China from the first stage of the Great Depression, only to betray the nation by imposing on it a terrible internal devaluation as silver prices rose. This would eventually lead China to forsake the silver standard. This consensus view has been championed by the likes of Milton Friedman and Anna Schwartz in their monumental Monetary History of the United States.

This consensus view is a decidedly non-freshwater take on things as it it depends on features like sticky prices and money illusion to generate its conclusions. After all, given the huge rise in the value of silver, as long as Chinese prices and wages—the reciprocal of the silver price—could adjust smoothly downwards, then the internal devaluation forced on China would be relatively painless. If, however, the necessary adjustment was impeded by rigidities then prices would have been locked at artificially high levels, the result being unsold inventories, unemployment, and a recession.

Just to add some more colour, China's internal devaluation was imposed on it by American President Franklin D. Roosevelt in two fell swoops, first by de-linking the U.S. from gold in 1933 and then by buying up mass quantities of silver starting in 1934. The first step ignited an economic rebound in the U.S. and around the world that helped push up all prices including that of silver. As for the second, Roosevelt was fulfilling a campaign promise to those who supported him in the western states where a strong silver lobby resided thanks to the abundance of silver mines. The price of silver, which had fallen from 60 cents in 1928 to below 30 cents in 1932, quickly rose back above its 1928 levels, as illustrated in the chart below. According to one contemporary account, that of Arthur N. Young, an American financial adviser to the Nationalist government, "China passed from moderate prosperity to deep depression."

As I mentioned at the outset, this consensus view was challenged by the freshwater economists, no less than the freshest of them all, Thomas Sargent (who was once referred to as "distilled water"), in a 1988 paper coauthored with Loren Brandt (RePEc link). New data showed that Chinese GDP rose in 1933 and only declined modestly in 1934, this due to a harvest failure, not a monetary disturbance. So much for a brutal internal devaluation.

According to Sargent and Brandt, it appeared that "that there was little or no Phillips curve tradeoff between inflation and output growth in China." In non econo-speak, deflation.not.bad. They put forth several reasons for this, including a short duration of nominal contracts and village level mechanisms for "haggling and adjusting loan payments in the event of a crop failure." In essence, Chinese prices were very quick to adjust to silver's incredible rise.

Four years later, Friedman responded (without Schwartz) to what he referred to as the freshwater economists' "highly imaginative and theoretically attractive interpretation." (Here's the RePEc link). His point was that foreign trade data, which apparently has a firmer statistical basis than the output data on which Sargent and Brandt depended, revealed that imports had fallen on a real basis from 1931 to 1935, and particularly sharply from 1933 to 1935. So we are back to a story in which, it would seem, the rise in silver did place a significant drag on the Chinese economy, although Friedman grudgingly allowed for the fact that perhaps he may have "overestimated" the real effects of the silver deflation.

So this battle of economic titans leads to a watered-down story in which Roosevelt's silver purchases probably had *some* deleterious effects on China. China would go on to leave the silver standard, although what probably provided the final nudge was a bank run that kicked off in the financial centre of Shanghai in 1934. Depositors steadily withdrew the white metal from their accounts in anticipation of some combination of a devaluation of the currency, exchange controls, and an all-out exit from the silver standard, a process outlined in a 1988 paper by Kevin Chang (and referenced by Friedman). This self-fulfilling mechanism, very similar in nature to the recent run on Greece, may have encouraged the authorities to sever the currency's linkage to silver and put it on a managed fiat standard. The Chinese economy went on to perform very well in 1935 and 1936, although that all ended with the Japanese invasion in 1937.


As I mentioned at the outset, these events and the way they were perceived by freshwater and non-freshwater economists seem to me to have some relevance to modern Chinese monetary policy. As in 1934, China is to some extent importing made-in-US monetary policy. The yuan is effectively pegged to the U.S. dollar, so any change in the purchasing power of the dollar leads to a concurrent change in the purchasing power of the yuan.

There's an asterisk to this. In 1934, China was a relatively open economy whereas today China makes use of capital controls. By immobilizing wealth, these controls make cross-border arbitrage more difficult, thus providing Chinese monetary authorities with a certain degree of latitude in establishing a made-in-China monetary policy.  But capital controls have become increasingly porous over the years, especially as the effort to internationalize the yuan—which requires more open capital markets—gains momentum. By maintaining the peg and becoming more open, China's monetary policy is getting ever more like it was in 1934.

As best I can tell, the monetary policy that Fed Chair Janet Yellen is exporting to China is getting tighter. One measure of this, albeit an imperfect one, is the incredible rise of the U.S. dollar over the last year. Given its peg, the yuan has gone along for the ride. Another indication of tightness in the U.S. is Scott Sumner's nominal GDP betting market which shows nominal growth expectations for 2015 falling from around 5% to 3.2%. That's quite a decline. On a longer time scale, consider that the Fed has been consistently missing its core PCE price target of 2% since 2009, or that the employment cost index just printed its lowest monthly increase on record.

If Chinese prices are as flexible as Brandt and Sargent claimed they were in 1934, then the tightening of U.S. dollar, like the rise in silver, is no cause for concern for China. But if Chinese prices are to some extent rigid, then we've got a Friedman & Schwartz explanation whereby the importation of Yellen's tight monetary policy could have very real repercussions for the Chinese economy, and for the rest of the world given China's size.

Interestingly, since 2014 Chinese monetary authorities have been widening the band in which the yuan is allowed to trade against the U.S. dollar. And the peg, which authorities had been gently pushing higher since 2005, has been brought to a standstill. The last time the Chinese allowed the peg to stop crawling higher was in 2008 during the credit crisis, a halt that Scott Sumner once went so far as to say saved the world from a depression.

Chinese GDP [edit: GDP growth] continues to fall to multi-decade lows while the monetary authorities consistently undershoot their stated inflation objectives. In pausing the yuan's appreciation, the Chinese authorities could very well be executing something like a Friedman & Schwartz-style exit from the silver standard in order to save their economy from tight U.S. monetary policy. This time it isn't an insane silver buying program that is at fault, but the Fed's odd reticence to reduce rates to anything below 0.25%. Further tightening from Yellen may only provoke more offsetting from the Chinese... unless, of course, the sort of thinking underlying Wallace and Brandt takes hold and Chinese authorities decide to allow domestic prices to take the full brunt of adjustment.

Friday, July 24, 2015

Know thyself... or carry a wallet

Of all the axioms of utility theory, the completeness axiom is perhaps the most questionable.  
- Robert Aumann, Nobel Prize Winner

One of the reasons you keep a well-stocked wallet in your pocket is because you don't know very much about yourself. Know thyself, as the Greeks say, and you can skimp on the amount of media-of-exchange you keep on hand.

Greater self-awareness leads to a cleaner "mapping out" of an individual's tastes and the preferred timetable for the enjoyment of those tastes. For instance, a moment of self reflection might lead you to conclude that pistachio ice cream at 8:31 PM next Friday is the best possible state of the world. If a complete set of futures markets exists, you can purchase a futures contract that is time stamped to deliver pistachio ice cream at 8:31 PM Friday, guaranteeing ahead of time that your tastes will be satisfied.

The problem is that introspection is difficult. We simply don't have the time, knowledge, or energy to sketch out a full timetable of carefully-delineated tastes and preferences. Even if we are blessed with a full range of futures markets, missing preferences prevent us from making use of these contracts.

Instead of committing ahead of time to satisfying taste A rather than tastes B, C or D at 8:31 PM Friday, an individual may prefer to remain non-committal. They can act on this preference by buying a broad range of option contracts that allow them to satisfy tastes A through D over a fuzzier time period, say Friday evening-ish. At the last minute they'll exercise just one of these many options while allowing the others to expire worthless. This sort of last minute off-the-cuff gauging of preferences allows for direct appeal to the mind's current state. This is surely a far more accurate way to get what one wants than trying to imagine what tastes will be like a week from now and locking that decision in by buying the relevant futures contract.

The problem is that the real world is bedeviled by not only missing preferences but also missing markets. Options on future consumption don't exist. Try buying a range of options exercisable between 6 and 10 PM Friday on twenty different flavours of ice cream.

There's an alternative. People can mimic an option buying strategy by allocating a portion of their portfolio to 'monetary assets,' those assets which are more liquid, stable, and cheaper to store than regular assets. The ability of a monetary asset to act as a good store of value up until the final act of acquiring a consumption good means that its owner needn't worry about lacking sufficient purchasing power to satisfy any of tastes A to D. And the liquidity of these monetary assets means that they needn't worry about being unable to swap for whatever consumption good they feel will satisfy their needs. So by holding a monetary asset, an individual has effectively bought themselves an option to satisfy a whole range of tastes at any point on Friday night. This is hassle-free flexibility.

Options aren't free. In financial markets, for instance, traders must pay a premium to secure an option. Likewise for liquidity. By holding monetary assets, individuals gain more flexibility surrounding the satisfaction of their tastes but give up potential returns. After all, a chequing deposit is more liquid than a term deposit, but a term deposit—which serves no monetary purposes—offers a superior capital gain.

So on the margin, people always measure the cost of becoming a bit more self aware against the drawbacks of holding monetary assets. If there is some low-hanging introspective fruit to be harvested, it may be worthwhile to spend a few minutes in reflection if this allows for a subsequent shift in wealth from liquid low-return assets (like chequing deposits) into illiquid high-return assets (like term deposits). On the other hand, if it is desirable to remain fluid and non-committal about tastes and the timetable for achieving them, cash and liquid securities are a means to buy this flexibility.


Here's the punchline.

Economists often (though not always) specify that individuals have a complete set of preferences. This means that the cast of characters that populate economic models come outfitted with fully specified sets of tastes and timetables for their enjoyment. There is no room for self-doubt, waffling, or vacillation. Nor do the people in these models need to spend any time or energy on introspection. Self-knowledge is free.

This no doubt makes economic models mathematically tractable. In the world outside of these models, however, our desire to hold liquidity is motivated by the fact that we are not fully self aware. Our tastes and timetables for realizing them are frequently left empty, usually because introspection is costly, inaccurate, and slow. Liquid media of exchange are an ideal way to stay flexible and uninformed about future tastes. By choosing to assume perfect self-knowledge, economists rule out at the outset some very important reasons people have for holding liquid media of exchange. With the 2008 credit crisis having illustrated the importance of liquidity factors, this seems like an unfortunate assumption to make.

Friday, July 17, 2015


The whippersnappers who work in the cryptocurrency domain are moving incredibly fast.

As I've been saying for a while, assets like bitcoin (or stocks) are unlikely to become popular as exchange media; they're just too damn volatile relative to incumbent fiat currencies. There's a new game in town though: stablecoin. These tokens are similar to bitcoin, but instead of bobbing wildly they have a fixed exchange rate to some other asset, say the U.S. dollar or gold.

Now this is a promising idea. If a crypto-asset can perfectly mimic a U.S. dollar deposit's purchasing power and risk profile, and do so at less cost than a bank, then the monopoly that banks currently maintain in the realm of electronic payments is in trouble. Rather than owning a Bank of America deposit, consumers may prefer to hold an equivalent stablecoin that performs all the same functions while saving on storage and transaction fees. To compete, banks will either have to bribe customers with higher interest rates on deposits, thus putting a crimp in their earnings, or go extinct.

Let's look at these stablecoin options more closely.

Type A: One foot in the legacy banking sector, one foot out

The unifying principle behind each type of stablecoin is the presence of some sort of backing, or security. Bitcoin, by way of comparison, is not backed. Stablecoin backing is typically achieved in two ways. With type A stablecoin, an organization creates a distributed ledger of tokens while maintaining a 1:1 reserve of dollars at a traditional bank. Owners of the tokens can cash out whenever they want into bank dollars at the stipulated rate, thus ensuring that the peg to the dollar holds. Until then, the tokens can be used as a stable medium of exchange. Examples of this are Tether and Ripple U.S dollar IOUs.

Could stablecoin be a bank killer?

We can think of a bank as enjoying stock and flow benefits from its deposit base. The existence of a stock of deposits provides it with a cost of funding advantage while the flow of those deposits from person to person generates fees.

Type A stablecoin pose no threat to the stock benefits that banks enjoy. After all, each stablecoin is always backed by an equivalent bank deposit held in reserve. If people want more stablecoin, the deposit base will have to grow, and that makes traditional bankers happy.

The flow benefits, however, are where the fireworks start. At the outset, people who receive stablecoin--through lack of familiarity--will probably choose to quickly cash out into good old fashioned deposits. But if stablecoin provides an extra range of services relative to deposits, rather than "kicking" back into the bank deposit layer, more people may choose to keep their liquid capital in the overlying stablecoin layer. Merchants will have more incentives to accept stablecoin, only adding to the snowball effect. Once all transactions are routed through the stablecoin layer, underlying deposits will have become entirely inert. While banks will continue to harvest the same stock benefits that they did before, they'll have effectively yielded up all the flow benefits to the upstarts.

So while Type A stablecoin doesn't kill banks, it certainly knocks them down a few wrungs.

By constructing a new layer on top of the deposit layer, stablecoin pioneers would be cribbing off the same playbook that bankers have been using since the profession emerged. Centuries ago, the first bank deposit layer was built on top of an original base money layer. Base money consisted then of gold and silver coin, but in more recent times it morphed into central bank banknotes and deposits. Because bank deposits inherited the price stability of base money (thanks to the promise to redeem in base money), and were highly convenient, bankers succeeded in driving transactions out of the base coinage layer and into the deposit layer. That's why gold and silver rarely appeared in circulation in the 19th century, being confined mostly to vaults. Perhaps one day stablecoin innovators will succeed in confining bank deposits to the "vault" in favour of mass stablecoin circulation. If this sort of displacement hadn't already been done before, I'd be more skeptical.*

Type B: Both feet out of the banking sector

More ambitious are type B stablecoin, which try to liberate themselves entirely from the traditional banking layer. Rather than using old-fashioned bank deposits as backing, a pre-existing issue of distributed digital tokens is used to secure the stablecoin's value.

As an example, take bitShares, a brand of bitcoin-like unbacked tokens. These tokens are every bit as volatile as bitcoin, up 10% one day and down 10% the next. Here's a chart. So far nothing new here, there are literally hundreds of bitcoin look-alikes.

The unique idea is to turn volatile water into stable wine by requiring that a varying amount of bitShares be used to back a second type of token, bitUSD. A bitUSD is a digital token that promises to provide its owner with a U.S. dollar-equivalent return. As long as each bitUSD is secured by, say, $3 worth of bitShares, the owner of one bitUSD will be able to cash out (into one U.S. dollar worth of bitShares) whenever they want and the peg to the U.S. dollar will hold.**

My understanding is that bitUSD, which debuted last year, is coming close to consistently hitting its peg. If bitUSD were to catch on as an alternative transactions layer, banks would lose not only their flow benefits but also stock benefits. After all, a bitUSD-branded stablecoin is not linked to an underlying deposit. We're talking complete devastation of the banking industry.

The system has some warts, however. If the market price of bitShares starts to fall, the scheme requires that more collateral in the form of bitShares be stumped up by the issuer of a bitUSD. This makes sense, it protects the peg. But what if the value of bitShares falls so much that the total market capitalization of bitShares is insufficient to back the total issue of bitUSD? At that point, bitUSD "breaks the buck." A bitUSD will be only worth something like 60 cents, or 30 cents, or 0 cents. Breaking the buck is what a U.S. money market mutual fund is said to do when it can't guarantee its one-to-one peg with the U.S. dollar.   

I'm skeptical of type B stablecoin for this very reason. Cryptocoin like bitcoin and bitShares are plagued by the zero problem; a price of nothing is just as good as a price of $100. They thus make awful backing assets, and any stablecoin that uses them as security has effectively yoked itself to the mast of the Titanic. A breaking of the buck isn't just probable, it is inevitable. Stability is an illusion. Maybe I'd get a bit more bullish on type B stablecoin if there emerged a brand that used digital backing assets not subject to the zero problem.

Anyways, keep your eye on these developments. Like I say, the young whippersnappers who are working on these projects aren't slowing down.

*In principle, type A stablecoin ideas are very similar to m-Pesa and Paypal. Both of these services construct new banking layers, but keep one leg back in the the existing banking infrastructure by ensuring that each Paypal or m-Pesa deposit is fully backed by deposits held at an underlying brick & mortar bank. See Izabella Kaminska, for instance, on m-Pesa.
 ** For those who like central bank analogies, this is an example of indirect convertibility, whereby a central bank sets market price of its liabilities in terms of, say, a bundle of goods, but only offers redemption in varying amounts of gold. See Woolsey and Yeager.  
*** Another working examples of Type B stablecoin is NuBits. Conceptual versions include Robert Sam's Seignorage Shares, the eDollar, and Vitalik Buterin's Schellingcoin.