Central bank settlement systems are the the tectonic plates of the payment system: they are vitally important to our lives, but we never see them in action. All of a nations' electronic payments are ultimately completed, or settled, on these systems. If they stop working, our financial lives go on pause, or at least regress to older forms of payment.

In this post I want to introduce readers to a crucial feature of these payments tectonic plates: their reliance for domestic settlement on SWIFTNet, a financial messaging network used by banks and other financial institutions to communicate payments information. Think of SWIFTNet as a WhatsApp for banks, but exclusive and very secure. 

This reliance – or over-reliance – is best exemplified by a recent decision by the European Central Bank. The Target2 settlement system has long been the bedrock layer of the European payments universe. All domestic payment ultimately get tied-off on the system. Since it was built in 2007, Target2 has been solely reliant on SWIFTNet for sending and receiving messages. 

When the European Central Bank replaced Target2 with T2 earlier this year, it modified the system to have two access points: it kept SWIFTNet but added a competing messaging network, SIAnet, to the mix. As one commentator triumphantly put it, "SWIFT’s monopoly for access to the T2/T2S system is broken."

SWIFTNet is owned by the Society for Worldwide Interbank Financial Telecommunication, or SWIFT, which is structured as a cooperative society under Belgian law and is owned and governed by its 11,000 or so member financial institutions. Whenever SWIFT gets mentioned in conversations, it tends to be associated with cross-border wire payments, for which its messaging network is dominant. However, for many jurisdictions, including Europe, SWIFT is also integral to making domestic payments. It's this little-known local reliance that I'm going to explore in this post.

The dilemma faced by central banks such as the European Central Bank is that SWIFTNet is an incredibly useful messaging network. It is ubiquitous: most banks already use it for cross-border payments. And so the path of least resistance for many central banks is to outsource a nation's domestic messaging requirements to SWIFT, too. However, this reliance exposes national infrastructure to SWIFTNet-related risks like governance, sanctions, snooping, and system outages.

Financial messaging 101

Before going further, we need to understand why financial messaging is important. For a single electronic payment to be completed, a set of databases owned by a number of financial institutions, usually banks, must engage in an intricate dance of credits and debits. To coordinate this dance, these banks need to communicate, and that's where a messaging network is crucial.

Say, for example, that Google needs to pay Apple $10 million. Google tells its banker at Wells Fargo to make the payment. Wells Fargo first updates its own database by debiting Google's balance by $10 million. The payment now has to hop over to Google, which banks at Chase. For that to happen the payment flow must progress to the core of the U.S's payments system, the database owned by the Federal Reserve, the U.S.'s central bank.

Along with most other U.S. banks, Wells Fargo has an account at the Federal Reserve. It communicates to the central bank that it wants its balance to be debited by $10 million and the account of Chase to be credited by that amount. Once Chase's account at the Federal Reserve is updated, Chase gets a notification that it can finally credit Apple for $10 million. At that point Apple can finally spend the $10 million.

This entire process takes just a second or two. For this "dance of databases" to execute properly, the Federal Reserve, Chase, and Wells Fargo need to be connected to a communications network.

The sort of messaging network to which the central bank is connected, and the stewardship of that network, is thus crucial to the entire functioning of the economy.

Proprietary messaging networks or SWIFTNet? 

The Federal Reserve is somewhat unique among central banks in that it has built its own proprietary messaging network for banks. All of the 9,000 or so financial institutions that use the Federal Reserve settlement system, Fedwire, must connect to the Fed's proprietary messaging network to make Fedwire payments. To make international payments, however, U.S. banks must still communicate via SWIFTNet.  

Let's flesh the story out by trekking north of the border. Whereas the Federal Reserve has no reliance on SWIFTNet, Canada's core piece of settlement infrastructure, Lynx, relies entirely on SWIFTNet for messaging.

For example, if Toronto Dominion Bank needs to make a $10 million to Scotiabank, it enters this order into SWIFTNet, upon which SWIFT forwards the message to Lynx, which updates each banks' accounts by $10 million and sends a confirmation back to SWIFTNet, which tells Scotiabank that the payment has settled.

For payments nerds, this network setup is called a Y-copy topology. The network looks like a "Y" because the originating bank message is relayed from the sending bank via SWIFTNet, the pivot at the center of the Y, down to the settlement system, and then back up via SWIFTNet to the recipient bank. It is illustrated below in the context of the UK's payment system, with the CHAPS settlement system instead of Lynx, but the idea is the same.

A Y-copy network topology for settling central bank payments in the UK [source]

With its upgraded T2 system, Europe doesn't go quite as far the Fed's model, which is to build its own bespoke messaging network. Rather, European banks now have the option of either sending messages to T2 using SWIFTNet, or they can use SIAnet, a competing network owned by Nexi, a publicly-traded corporation. SIAnet, stands for Societa Interbancaria per l'Automazione, originally connected Italian banks but is now pan-European.

The reason for this design switch is that European Central Bank desires "network-agnostic connectivity." This dual access model will make things more complex for the European Central Bank. If a commercial bank originates a SIAnet message, the central bank will have to translate this over to a SWIFT message if the recipient bank uses SWIFTNet. Nevertheless, the European Central Bank believes this dual structure will offer more choice to domestic banks.

The ECB also hints at the enhanced "information security" that this new setup will provide, without providing much detail. The UK's recent efforts to update its core settlement layer sheds some extra insights into what these information security improvements might be. Right now, the UK's core settlement system, CHAPS, can only be accessed by the SWIFTNet network, much like in Canada, so that all domestic UK payments are SWIFT-reliant.

In its roadmap for updating CHAPS, the Bank of England is proposing to allow banks to access the system via either SWIFTNet or a second network, which still doesn't yet exist. The idea is to enable "resilient connectivity" to the core settlement layer, especially in periods of "operational or market disruption." Should SWIFTNet go down there would be no way for financial institutions to communicate with CHAPS, and the entire domestic payments system would grind to a halt. A second network removes the "single point of failure" by allowing banks to re-route messages to CHAPS.

The Bank of England also highlights the benefits of competition, which would reduce the costs of connectivity.

This sounds great, but there are tradeoffs. Using a a single network for both domestic and international payments is valuable to the private sector because it offers standardization and efficiencies in banks' processing. Adding a second option will also complicate things for the Bank of England, since it will have to design and build a system from scratch, much like the Fed did, which could be costly. Either that or it will have to find another private option, like the ECB did with SIAnet. This second network may not be as good as SWIFTNet which, despite worries about resiliency, has been incredibly successful.

When CHAPS went down earlier this year for a few hours, for instance, it wasn't SWIFT's fault, but the Bank of England's fault. The same goes for a 2014 outage. 

Comparing a V-shaped network topology to Y-Copy in an Australian context [source]

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In sum, central banks face a host of complicated decisions in how to bolt on messaging capabilities to their key settlement systems. SWIFTNet is an excellent system. However, too much SWIFT-related risk may be perceived as having negative implications for national security. For large nations with extensive banking industries, building a proprietary domestic messaging alternative seems to be the preferred option. It also seems to be the default choice for rogue states like Russia.

Another alternative is to fallback on using multiple independent networks for access, of which one is SWIFTNet, and thus mitigating exposure to SWIFT-related problems. This is the European and UK approach.

For smaller nations that comply with the global consensus, like Canada, the calculus is different. Building an alternative network is likely to be costly. The risk of sanctions and censorship are negligible while the benefits of using a high-quality ubiquitous network for both domestic and foreign payments messaging are significant. Given these factors, it may be worthwhile to bear SWIFT-related risk.

Chris Blec asks the following question:

Source: Twitter

Source: LII

Only one last criteria is lacking. Chris and the other strangers must participate in a "knowing" way. They must be aware that the property involved is criminally-derived. The most obvious example would be if one of the 10 strangers were to loudly announce just prior to putting their notes in the jar that the notes come from contract killing, and everyone hears this yet still participates. 

At this point, the three triggers have been met. Chris and the other strangers have acted in 1) a knowing way 2) to conceal 3) the actual proceeds of unlawful activity.

The state of "knowing" needn't be established in such an explicit fashion as the criminal announcing it loudly. For instance, even if the criminal says nothing, but Chris and the other participants suspect the possibility that dirty money is entering the jar, but they don't do due diligence, then they could be found guilty of money laundering. To demonstrate that they aren't knowing participants, Chris and the other strangers may have to take proactive measures, say like checking ID.

So Chris is right to say that mixing cash in a jar can be legal, but he incorrectly omits to say that it can also be illegal.

Having fleshed out Chris's premise, what about his conclusion? Can the jar-of-cash thought experiment teach us about the legality of crypto mixing methods such as custodial mixers, Tornado Cash, or CoinJoin? I'll let the readers work that one out on their own.

It's been a full year since FTX International and FTX-US collapsed, and the shocking thing is – there is still no regulated crypto venue in the U.S.! You'd think some lessons would have been learnt.

To best protect the public from the Sam Bankman-Frieds of the world, what the U.S. requires is securities-level oversight of crypto exchanges. Exchanges like Coinbase and Kraken are offering the sorts of investment services to the public that the U.S.'s main securities regulator, the SEC, is ideally positioned to regulate, such as trading, margin, custody, and market making. But one year after FTX's collapse, there doesn't appear to be a single SEC-regulated exchange.

The exchanges blame this on the SEC's lack of clarity. The SEC blames this on exchanges refusing to come in and register. God knows who's telling the truth.

Whatever the case, this intransigence only increases the odds that there'll be another U.S. crypto exchange collapse in the next few years, one that appropriate regulation could have otherwise prevented, or at least sheltered investors from the fallout.

What sort of protections am I talking about? After Canada suffered through the collapse of QuadrigaCX a few years back, and a bunch of Canadians like myself lost money, crypto exchanges were brought under the auspices of our existing securities regulatory framework, with a few nips and tucks to the rules to make them fit. This has led to a lot of changes that make Canadian crypto customers safer. I'm going to share the best example in this blog post.

Kraken is a well-known crypto exchange that serves both American and Canadian customers. However, if you're an American customers who uses Kraken, you possess a very different sort of asset than Canadian customers do.

Let's look at the fine print of the U.S. platform:

Source: Kraken's terms of service for U.S. customers

A key observation I want to make here is how fundamentally different this is from how standard regulated marketplaces function like the NASDAQ or the Toronto Stock Exchange. Traditional marketplaces offer a venue to trade assets, but they don't offer custody. If they tried to introduce this, their regulator would very quickly say no. I'll explain why below.

But first, let's head over to Kraken Canada. Once again, here's the fine-print:

Source: Kraken's terms of service for Canadian customers

Source: Kraken's terms of service for Canadian customers

Who is Anchorage? Anchorage is a federally-charted trust that is overseen by the Office of the Comptroller of the Currency, one of the key U.S. federal banking regulators. So if you hold some coins on Kraken, and you are an American, you own what is essentially a Kraken IOU, and you have to trust Kraken, but if you are a Canadian, you're effectively putting most of your trust in a federally charted financial institution. That's pretty stern stuff. 

Canadian securities regulators require all crypto exchanges operating in Canada to delegate at least 80% of customer crypto to a third-party custodian. (The other 20% can be held in a hot wallet for liquidity purposes.) Kraken doesn't appear to be doing this for its American customers, and that's because there's no U.S. regulator prompting it to do so. On top of requiring this separation, Canadian regulators stipulate that third-party custodians must be qualified. That is, they can't just walk in off the street. The custodian has to meet the regulator's standards, which requires having a Systems and Organization Controls (SOC) designation, and a bunch of other stuff too.

You can probably see by now that if you're a customer of Kraken, it's better to be Canadian than American, for the following reasons:

• Anchorage is a federally-regulated financial institution and subject to strict oversight. Kraken U.S. is for the most part unregulated. No one is peering over its shoulder to check whether it is doing a good job safekeeping your coins.
• Kraken has its fingers in a lot of different businesses, but Anchorage specializes on custody, and so it's probably better at the task.
• Anchorage is independent from Kraken. This separation mitigates the risk of loss, theft, or misuse of assets by Kraken management. This is particularly salient in Kraken's case because it engages in many other business activities, such as trading or market-making, and these pose potential conflicts of interest.

In the future, one hopes that Kraken's U.S. exchange provides the same level of customer protection as Kraken's Canadian platform. But that's only go to happen if and when the SEC dictates a fundamental separation of crypto trading from custody, and whether U.S. crypto exchanges actually listen to the SEC.

The next section is for pedants only, of which I'm embarrassed to be, which is why I'm putting this in very small print:

Kraken owns a U.S. bank. How does this fit into the story? Here are the details: In the U.S., the Kraken crypto exchange is really just the trade name for Payward Ventures. Payward Ventures is in turn a subsidiary of Payward, Inc. Payward, Inc has another subsidiary, Payward Financial, Inc, that owns a state-charted bank -- Kraken Bank. Notably, when you sign up as a customer of the Kraken crypto exchange, you are entering into a relationship with Payward Ventures, not Payward Financial. There is no indication in the exchange's terms of service that Kraken Bank is in any way involved in custody. Which seems... odd? Why wouldn't Kraken use its bank for custody?

When Kraken first applied to do business in Canada earlier this year, it said it wanted to use Kraken Bank as its custodian. Given that Kraken is in fact using Anchorage Bank as we speak, I suspect that Canadian regulators told Kraken: "Hey, guys. Kraken Bank is not sufficiently independent, you're going to have to use a third-party." And I suspect they were right about this.

Meanwhile, what about Canada's most popular exchange, Coinbase? Coinbase's Canadian terms of service doesn't indicate that it is using a qualified custodian. Customer assets are "held by the Coinbase Group for your benefit." Yeah, that's not going to fly with the regulators. I suspect that within a few months you're going to see it using a third-party like Anchorage, or its just going to leave Canada.

Two seemingly separate stories, a crypto and a banking story, have a common thread in anti-money laundering thresholds.

In the first story, the New York Times shows how regular folks are increasingly losing their bank accounts because their bank perceives them to be engaging in risky behaviour. In the second, the U.S. government has proposed an expansive new rule that would require financial institutions to report all customers who use cryptocurrency mixers to the government.

Anti-money laundering thresholds underpin what I'll call the Pragmatic Compromise between the government and citizens, albeit a tenuous one, for reasons I'll explain.

The U.S. government and its various law enforcement agencies have the ability to get full access to bank records for the purposes of fighting crime. They can do so directly, that is, without having to proceed through the standard process of convincing a judge to approve a warrant. This is an incredible amount of power to have. To counterbalance this, a compromise of sorts has been agreed to that limits the government's access to bank records. A number of key financial thresholds have been established, below which transactions are protected from surveillance.

The most well-known method the government has for accessing your personal financial information is the requirement that banks submit currency transaction reports, or CTRs (see below), every time someone withdraws or deposits paper money. Banks don't submit a report for all cash transactions. The threshold for submitting is set at $10,000. So if you withdraw $9,999, your name and address won't be reported to the government. If you withdraw $10,001, it will.

The modern U.S. currency transaction report [source]

The U.S. has a long history of providing direct government access to banking records. The practice began in 1945 when Treasury Secretary Henry Morgenthau Jr, invoking war-time powers, issued an executive order (see below) instructing banks to begin reporting currency deposits and withdrawals made by the public. Known as TCR-1 forms, these reports were to be forwarded every month to the government with information about the cash amounts involved and the identification of the individual making the transaction.

Morgenthau's reporting requirement was motivated by the desire to stamp out black marketeering, writes Paul Camacho, which had emerged as a way to evade war-time rationing programs. But even though the war soon ended and rationing ceased, the practice of cash reporting continued through the 1950s and 1960s, albeit on what must have been legally dubious grounds now that it was peacetime.

Henry Morgenthau's 1945 executive order on currency reporting [source]

Suspicious Activity Report form, introduced in 1995

The first legal challenges to the government's direct access to bank records only came in the mid 1970s. But after hearing these cases (California Bankers Association v. Shultz and United States v. Miller), the Supreme Court allowed the entire data collection apparatus to remain intact. The majority ruled that there was no expectation of privacy in bank records, and that the recordkeeping and reporting requirements imposed by the Bank Secrecy Act do not violate bank customers' constitutional rights.

With the public having no constitutional protections against direct government access to bank records, the lone remaining counterbalance is the various anti-money laundering thresholds.

Which gets us back to the New York Times article (we'll touch on the cryptocurrency further down). The reasons for the growing debanking problem that the Times article highlights is complicated, but I'd suggest that one driver is a steady deterioration of two key reporting thresholds at the heart of the Pragmatic Compromise.

The original $10,000 cash reporting threshold was set back in 1945 by Henry Morgenthau, a level that was ratified in 1972 after the passage of the Bank Secrecy Act. This level has never been adjusted. (Morgenthau also set a second and lower $1,000 threshohold, but this only applied when banknotes in denominations of $50 or higher were involved).

Alas, inflation has been steadily eating into each thresholds' real value. When the Bank Secrecy Act was passed, $10,000 was worth $75,000 in today's dollars. In Morgenthau's time it was equal to $173,000. Either way, when the data collection apparatus was first established and the Pragmatic Compromise reached, most people's day-to-day cash withdrawals would have been sheltered from reported requirements. With the passage of time and inflation, a much wider swathe of civilian cash transactions have lost the protection offered by Morgenthau's $10,000 threshold. That means more snooping. It also means more debanking. Rather than absorbing the growing compliance costs of having "risky" cash-reliant customers, banks are closing accounts.  

As for suspicious activity reports, when they were first legislated in 1994 the government subjected them to a $5,000 threshold, which is equal to around $10,000 today. With inflation having effectively destroyed half of the value of the threshold, more and more regular transactions are falling under suspicion. As the Times points out, suspicious customers don't make for good customers: "Multiple SARs often — though not always — lead to a customer’s eviction."

The Pragmatic Compromise that society came to decades ago is being poorly administered. To restore it, what is needed is a reasonably-sized one-time "catching up" of the various thresholds to account for at least part of the inflation that has occurred over the years, and then periodic adjustments to these levels each year to account for subsequent inflation.

Now let's turn to the crypto story. In addition to the two classic anti-money laundering reporting requirements, CTRs and SARs, the U.S. government is now proposing a third reporting requirement: one for crypto mixing.

Last month, the government announced that it deems mixing of cryptocurrency to be of primary money laundering concern. Any U.S. financial institution that knows, suspects, or has reason to suspect that a customer's incoming or outgoing crypto transaction involves the use of a mixer will have to flag it and send a report to the government. That report must include information like the customer's name, date of birth, address, and tax ID.

The US Treasury's proposed rule for treating crypto mixing as a primary money laundering concern [link]

Notably, there are no thresholds to this proposed reporting requirement. Any customer crypto transfer with even just a whiff of mixing must be reported by financial institutions to the government.

In its proposal (this isn't law, yet) the government grants that there are legitimate reasons for mixing coins. What are they? I think the popular view of crypto is that it is anonymous, but this isn't quite right. Every bitcoin or ether transaction gets recorded on transparent databases. This makes them trackable by anyone. In some respects, crypto may be the least privacy-friendly financial medium ever created. Mixing your coins in a jumble along with other's coins is one of the ways to free oneself from this all-seeing eye, both for criminals who have stolen coins and regular folks who don't want their financial lives displayed for all to see.

Given that there can be good reasons for mixing, and putting this in the context of the decades-old Pragmatic Compromise, precedent would seem to suggest that the government should include a reasonably-sized threshold for reporting crypto mixing. If this was set at, say, $5,000 (and then adjusted yearly for inflation), then a customer could in theory mix $3,000 worth of bitcoins and then deposit them at an exchange, and that exchange would not need to report the transaction and the person who made it. Go above $5,000, and the customer will end up in a government computer.

Without a reasonable threshold, the same phenomenon that the Times documents with respect to bank customers will happen to crypto users. A wave of deplatforming will hit as financial institutions close the accounts of any customer that betrays even a hint of risky activity, much of which might only appear to be mixing when it isn't.

The government has the capacity for changing its initial stance on thresholds. If you go back to the early 1970s when the Bank Secrecy Act's thresholds were set by executive order, the government initially proposed a $5,000 threshold. After the public provided comments and grievances were aired, the final rule compromised and pushed it up to $10,000.

Bank Secrecy Act fact of the day. The Act's reporting threshold for currency transactions was originally set at $5,000. After comments were received from the public, the government's final rule upped this to $10,000, which exists to this day. pic.twitter.com/AAPgxmESmp

— John Paul Koning (@jp_koning) November 14, 2023

What role do changes in the supply of banknotes play in contributing to a central bank's ability to carry out monetary policy? Put differently, to what degree does "printing," or creating new physical currency and issuing it into the economy, contribute to generating a central bank's desired inflation rate of 2-3%?

In a recent blog post at Econlog, Scott Sumner suggests that printing physical cash and "forcing" or "injecting" it into the economy has been an important part of central banks hitting their inflation targets, albeit less so now than in times past. I'm not so sure.

Having imbibed Scott's blog posts for more than a decade, I think I'm 99% on the same page as he is when it comes to thinking about monetary policy. We both agree that a central bank must either reduce the interest rate that it pays on the monetary base, or inject more monetary base into the economy, in order to push up prices. Using either of these two methods, the central bank sets off a hot potato effect in which a long chain of market participants do their best to unload their money balances, a process that only comes to an end when all prices have risen to a new and higher equilibrium such that no one feels any additional urge to spend away their extra money. Scott once described the hot potato effect as the the "sine qua non of monetary economics."

The monetary base is comprised of two central bank financial instruments: physical banknotes (a.k.a. cash) and digital clearing balances, sometimes known as reserves, a type of money used by banks.

Reading through Scott's post, I think the one spot where we may disagree is on the relative role played by the two types of base money in the hot potato process.

For my part, I don't think that cash has ever had much of a primary role to play in setting off a hot potato effect. All of the initial uumph necessary for driving prices towards target has typically been provided by reserves, either via a change in the interest rate on reserves or a change in their quantity. Once that initial uumph has been delivered, a whole host of other money types – physical currency, bank deposits, checks, money market funds, and PayPal balances – help convey the forces initiated by reserves to all corners of the economy.

An example of the hot potato effect in action may help illustrate.

Let's start with a central bank that needs to push inflation up to target. It reduces the interest rates on reserves. The first reaction to lower rates is a flight out of reserves into other assets, say shares.

As a result, share prices quickly rise. Those existing shareholders who realized their gains by selling at the new and higher price now find themselves with a hot potato on their hands; they have too many monetary balances in their possession and not enough non-monetary things.

Some of these ex-shareholders may choose to spend their excess deposits to go on, say, a vacation. As a result, airline ticket prices rise. Others transfer their extra money to their PayPal account in order to send it to friends and family, who may in turn make purchases, pushing up the prices of whatever they buy. Another group of ex-shareholders decides to buy used cars. They withdraw banknotes, their banks in turn asking the Fed to print new banknotes and ship them over. Used car prices rise.

The point is, the initial uumph is delivered by the change in reserves, and this gets conveyed to all prices by a daisy-chain of spenders offloading an array of different types of excess money.

In this story, note that cash isn't being actively "injected" into the economy by central banks, nor by commercial banks. Rather, people are choosing to draw cash out as their preferred method for getting rid of unwanted money, in response to a set of forces initiated by reserves. Reserves are the central bank's lever, cash is reactionary.

Consider too that in a world where cash no longer exists, and has been replaced by digital payments options, monetary policy is still effective. In this world, the response to a reduction in the interest rate on reserves gets conducted to all the economy's nooks and crannies via non-cash types of monies, like fintech balances and bank deposits. (I'd be curious to hear if Scott is of the same opinion about monetary policy in a world without cash.)

Here's an interesting thought experiment. Would it be possible to redesign cash and reserves in such a way that cash takes over the initiatory role in monetary policy from reserves? That is, can we turn cash into the active part of the monetary base, the one that drives changes in monetary policy, and relegate reserves to the passive role?  

One step we could take is to pay interest on cash. This may sound odd, but it's possible to do so by setting up a serial note lottery to pay, say, 3% per year to holders of cash. (I wrote about this idea here and here.) Simultaneously, reserves would be rendered less important by no longer paying interest on them.

Now when a central bank needs to raise consumer prices in order to hit its targets, it reduces the interest rate on cash from 3% to 2%. This ignites the hot potato process as the entire economy suddenly tries to offload its unwanted cash, which at 2% just isn't as lucrative as before.

Another change we could enact would be to modify the mechanism by which central banks inject base money into the economy. As it stands now, central banks inject base money by purchasing assets with new reserves. Since reserves are digital, they are a lot more convenient for making billion dollar asset purchases than physical money. These extra reserves become hot potatoes in the hands of asset sellers, which sets off the process of price adjustments described in previous paragraphs. If central banks were to buy assets with cash rather than reserves, that would put cash in the driver's seat, albeit at the expense of convenience.

It's an interesting thought experiment, but in the end I don't think it's very helpful to get bogged down over which type of base money has more monetary significance. As Scott says, the key point is that the central bank controls the price level via its control over base money in general. They can raise prices by either adding to the supply of base money, or by reducing the demand for base money with a cut in the interest rate paid on reserves. "It's basic supply and demand, nothing more." 

Source: America Loves Crypto

You may have recently come across the America Loves Crypto marketing campaign, sponsored by Coinbase, the U.S.'s largest crypto exchange. In an attempt to promote the voting power of crypto owners, the website makes the claim that 52 million American adults currently hold crypto, which constitutes 20% of the U.S. adult population. If true, that's a massive voting block.

As the source for its 20% statistic, Coinbase cites an online survey of 2,202 adults that it commissioned from Morning Consult last February, which among other questions queried respondents for how much crypto they currently hold.

If you've been following other sources for cryptocurrency adoption data, Coinbase's 20% statistic seems... questionable?

To see why, let's dig into U.S. crypto adoption data. What follows is a quick rundown of what the best surveys have had to say about how many Americans hold crypto. Later on in the article I'll get into who they are, how much they own, and why they hold it.

1) The granddaddy of all U.S. payments surveys is the Federal Reserve's Survey and Diary of Consumer Payment Choice, or SDCPC. The SDCPC is a long-running data collection effort that tries to paint a comprehensive picture of U.S. consumers' payment preferences and behavior. It began to incorporate crypto-related questions back in 2014, although crypto is just a tiny portion of the incredible amount of data collected by the SDCPC.

The Fed's SDCPC is run through the University of Southern California's Understanding America Study panel. In its 2022 iteration the SDCPC polled more than 4,761 participants. Notably, the SDCPC includes both a survey and a 3-day diary portion. Diaries are more labor intensive to administer than surveys, but provide better information since they minimize recall bias.

The SDCPC found that 9.6% of American adults owned cryptocurrency in 2022, up from 9.1% in 2021, and far higher than the 0.6% it polled back in 2015. However, that's far less than Coinbase's 20% number. Only one of these can be right. Which one is it?

The SDCPC's historical findings are in the table below.

U.S. cryptocurrency adoptions rates. Source: Federal Reserve's 2022 Survey & Diary of Consumer Payment Choice

Source: Federal Reserve's 2022 SHED

Source: Weber et al (2023) using Nielsen Homescan Panel data

4) The fourth in our survey of crypto surveys was conducted by the Pew Research Center using its American Trends Panel. In a March 2023 survey of 10,701 panelists, Pew found that 17% of American adults have "ever invested in, traded, or used" a cryptocurrency. This is a very broad category, and would presumably include someone who casually bought $25 worth of bitcoin back in 2015 and sold it three days later, and has never touched it again.

Drilling in further, of the 17% who have ever owned or used crypto, 69% report that they currently hold some, which works out to a 2023 ownership rate of 11-12% among American adults. That's not too far off the two Fed surveys and Weber et al, but significantly different from the Coinbase result.

5) A fifth source of data comes from Canada, which serves as a decent cross-check against U.S. data given that both countries are quite similar in terms of culture and geography. Of the two key Canadian surveys, the first is the Bank of Canada's long-running Bitcoin Omnibus Survey (BTCOS), administered by Ipsos, which amalgamates participants from three different panels.

The 2022 BTCOS polled 1,997 Canadians and found an ownership rate of 10%, down from 13% the year before (see chart below). This constitutes a lower bound to ownership rates since it only includes bitcoin owners. The 2022 BTCOS also finds that 3.5% of Canadians own dogecoin and 4% own ether. However, it's not possible to add these amounts to the 10% bitcoin ownership number since many respondents own multiple types of crypto. 

Source: Bank of Canada 2022 Bitcoin Omnibus Survey

The second Canadian survey of note was carried out by the Ontario Securities Commission in 2022 to explore Canadian attitudes towards crypto assets. Conducted with Ipsos, the survey polled 2,360 Canadians in early 2022. It found that 13% of Canadians currently own any type of cryptocurrency, including crypto ETFs, which are legal in Canada but illegal in the US.

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So there you have it. The two Federal Reserve surveys put crypto ownership at 9.6% and 8-10% respectively in 2022, while Weber et al peg it at 12% using Nielsen Homescan data. Pew has American crypto ownership at 11-12% by early 2023. And in Canada, the Bank of Canada calculates bitcoin ownership to be at 10% by the end of 2022, while the Ontario Securities Commission pegs total crypto ownership at 13% in early 2022, before much of crypto imploded.

Given this range of data, the 20% adoption rate that Coinbase's Morning Consult survey trots out is a glaring outlier and probably deserves to be thrown out. The American crypto owner is a big voting group, but not as big as Coinbase would like to believe.

For what it's worth, I've found a few other odd things with Coinbase's Morning Consult survey that further adds to my skepticism. Morning Consult reports that 8% of respondents currently own a cryptocurrency called USDC, down from 10% the quarter before (see here for more). The survey also says that 5% currently own Tether. USDC and Tether are stablecoins. To anyone who follows crypto closely, the idea that 1 in 10 Americans own any particular stablecoin is absurd. Given that Morning Consult has surely got this wrong, perhaps through a sampling error, that makes you wonder about the quality of their overall work.

However, even if we ignore Coinbase's Morning Consult survey, the 9.6% adoption rate found in the bellwether SDCPC is still breathtakingly high. In just fifteen years, crypto has gone from a strange niche product to something that is being held by tens of millions of Americans.

What additional facts do we know about America's crypto owners?

Size of holdings

Going through the SDCPC data, the majority of Americans who own crypto only have a little bit of the stuff. Out of all U.S. crypto owners surveyed, 45% owned just $0-200 worth of crypto in 2022. This is illustrated in the chart below. The median quantity of crypto held was $312. Given such small amounts, I doubt that these crypto owners qualify as durable crypto adopters, as opposed to folks who've jumped on the bandwagon when they saw a Superbowl ad from Coinbase, bought some dogecoin, and have since stopped paying any attention.

Source: Weber et al (2023) using Nielsen Homescan Panel data

Reasons for ownership

Why do Americans own cryptocurrency? Despite being labelled as "currencies," cryptocurrencies are not generally usually used as a medium for making payments. Price appreciation is the dominant motivation for owning them.

When the SDCPC survey queried participants in 2022 for their "primary reason for owning virtual currency," the most popular answer (at 67%) was investment (see chart below, orange rows). The second most popular reason was "I am interested in new technologies." It was rare for respondents to list any sort of payments-related use case as their primary reason for ownership. As for lack of trust in banks, the government, or the dollar – all of which are common cryptocurrency themes – these are rarely mentioned as a primary reason for ownership.

Interestingly, Americans crypto owners were not always so obsessed with price appreciation. In 2014, the SDCPC found that American crypto currency owners offered a much broader set of motivations for owning crypto, including lack of trust, cross-border payments, and to make purchases of goods and services (see chart above, blue rows).

The dominance of investment as the motivating reason for owning crypto is echoed in Weber et al's analysis of Nielsen Homescan survey data. Respondents were allowed to give multiple reasons for owning cryptocurrency, the most popular reason (see chart below) being to take advantage of "expected increase in value." The desire to use cryptocurrencies for international transfers was almost nonexistent, as was the desire to be "independent of banks."

Crypto owners don't care about making international transfers, private purchases, or being "independent of banks," as the chart shows.

What they want is "increase in value."

This is a fairly reliable data source: 80,000 households participating in the Nielsen Homescan Panel. pic.twitter.com/0oBfATgFoY

— John Paul Koning (@jp_koning) June 22, 2023

The Fed's SHED survey isolates the same pattern as the other two surveys. Of the 10% of Americans who report using cryptocurrency in 2022, most do so as an investment. The SHED also finds that around 2% of all survey participants used crypto to send money to friends of family in 2022. This suggests the transactional motive, while not primary, may be somewhat more prevalent than the previous two surveys suggest.

Source: Federal Reserve's 2022 SHED

Types of cryptocurrency held

What sorts of crypto were popular with Americans? The Nielsen Homescan survey found that of the 11% of survey respondents who are crypto owners, 70% held bitcoin while just over 40% held ether and dogecoin respectively.

Around 11% of American households owned crypto in 2021, according to a Nielsen Homescan survey of 80,000 households.

Of this 11%, 4 out of 10 households held Dogecoin.

So around 6 million US households owned Dogecoin in 2021, which is just nuts. pic.twitter.com/31FjTbfqBE

— John Paul Koning (@jp_koning) July 4, 2023

This distribution is echoed in the Fed's 2022 SDCPC. Almost 65% of all crypto owners surveyed held bitcoin, making it the most popular type of cryptocurrency. Meanwhile, 44.8% held ether and 38% held dogecoin, a coin that was originally created as a joke in 2013. That works out to around 4-5% of all Americans who are in on the joke.

Crypto bros

There's a reason that people throw around the term "crypto bro." Without exception, all of the U.S. surveys find that cryptocurrency owners tend to be young, male, and have a high income. 

The same goes for Canada, where in 2022 there were three male bitcoin owners for every female. The Bank of Canada has also regularly tested bitcoin owners for their degree of financial literacy using the Big Three questions method, and finds that they tend to have lower financial literacy than non-bitcoin owners.

The prototypical Canadian bitcoin owner in 2022 was a young university-educated male, employed at a high-income job, and lacking financial literacy. pic.twitter.com/N3hQX4AWes

— John Paul Koning (@jp_koning) September 28, 2023

Source: Federal Reserve's 2022 SHED

All of this data suggests to me the existence of three American crypto archetypes. 

The most dominant crypto archetype is the young wealthy male crypto dabbler, most likely non-white, who holds a few hundred bucks worth of doge or some other coin in order to gamble on prices going up. Coinbase's America Loves Crypto campaign makes the claim that "the crypto owner is a critical voter," but I suspect this doesn't hold for the dominant dabbler archetype, who probably doesn't have much attachment to their casual $50 bet on doge or litecoin, and thus can't be assembled into a voting block for crypto-related cause.

Another archetype is the much rarer crypto fundamentalist, a young male who has committed most of his savings to crypto. I suspect these are the types I encounter on Twitter, who evangelize and debate crypto to anyone who'll listen. This may be a small group, but they are also the most likely to vote for crypto-related causes.

Lastly, there seems to be a very small group of low-income people who are using crypto for actual transactions, the original use-case that Satoshi Nakamoto intended when he introduced the first cryptocurrency back in 2008.

Last week I explored how Henry VIII resorted to coin debasement as a way to raise revenues to fight his wars. This allowed Henry to annex the city of Boulogne from the French in 1544 albeit at the price of England experiencing one of its greatest inflations ever.

Zoom forward five hundred years and Rishi Sunak, the Prime Minister of the UK, has ignited a controversy by referring to inflation as a tax, and suggesting that the "best tax cut I can deliver for the British people is to halve inflation." His BBC interviewer disputed the claim, saying that inflation isn't a tax, a stance that the BBC upholds on its fact checking page.

Rishi Sunak, "The best taxt cut that I can deliver for the British people is to halve inflation."

Laura Kuenssberg, "Inflation is not a tax"

Rishi Sunak, "Inflation is a tax" pic.twitter.com/6LgMbeaprY

— Farrukh (@implausibleblog) October 1, 2023

If you recall, my previous article showed how Henry VIII's debasement functioned very much like a tax, say a new customs duty on wine or a beard tax. But the 21st century monetary system is very different from that of the middle ages. Is Rishi Sunak right to characterize inflation as a tax?

First, we need to better define our terms.

What do the BBC interviewer and Sunak mean by inflation? In the western world, prices have been rising at a regular pace of 2-3% each year for decades as result of central bank policy, which targets a low and steady inflation rate. Is this the definition they are using? Alternatively, Sunak and his interviewer may be referring to inflation as a *change in the change* in price. Since 2022 or so, that 2-3% rate has leapt to 8-9% all over the western world. Is it this jump that Sunak and his interviewer are talking about?

For the sake of this article, we'll assume that the conversation between Sunak and the BBC refers to the latter, a spike in the rate of inflation.

Secondly, what is meant by the word tax? Sometimes when we say that something is a tax we mean that it causes suffering. That is, inflation is taxing: it makes people's lives harder by increasing the cost of living, with salaries failing to keep up. It creates unfair changes in winners and losers.

Fair enough. But the more precise view I want to broach in this article is that inflation is actually a tax, where we define a tax as a formal charge or levy, set by the political process, that leads to cash flowing from the population to the government.

What does the data show?

Interestingly, a surprise jump in inflation leads to the very same effects as a new tax. All things staying the same, a new tax leads to an increase in government revenues. This improves the government's fiscal balance, or the difference between its revenues and expenses. A recent IMF paper by Daniel Garcia-Macia using data from 1962 to 2019 shows how an inflation shock typically achieves this exact same end result, boosting government revenues and improving its fiscal balance. This effect lasts for a few quarters, even up to two or three years, then recedes.

The IMF's chart below breaks down exactly how this revenue effect tends to work over a quarterly basis using data going back to 1999:

Charts source: IMF

Total tax revenue (the first panel) immediately begins to rise after the inflation shock at about the same rate as inflation.That's because most taxes are set by reference to values or prices, say like the prices of goods and services, or the price of labor, or the value of corporate profits. Since inflation pushes these amounts higher, this gets quickly reflected in tax revenues.

Income taxes and profits taxes (the second panel) rise particularly fast. Inflation is presumably pushing tax payers into higher income tax brackets, and so the government very quickly starts to collect a proportionally-larger amount of income tax.

Meanwhile, the government's total expenditures, the third panel, typically stay flat or only marginally rise in the quarters after the inflation shock hits. Notably, the amount of wages that are paid to government employees and social benefits (panels 4 &8) tend to fall.

The net effect is an improvement in the government's fiscal balance. And so an inflationary shock ends up at the same endpoint as a new tax: higher revenues and a better fiscal balance. That doesn't necessarily mean that inflation is itself a tax. Taxes have a degree of intentionality. They get implemented through a political process that has a certain set of goals in mind. By contrast, the extra revenue that an inflation shock raises is often (though not always) accidental, the result of external forces rather than a political process.

So in sum, while it may not fall under the dictionary definition of a tax, the tax implications of a modern inflation shock resemble that of a new tax.

Everything I've written above applies to an inflation shock, say a rise from a 2-3% to 8-9%. Next I want to show that even constant 2-3% inflation can have the same revenue raising implication as a tax. Here's how.

Governments usually have a monopoly over the issuance of two key financial instruments: banknotes and settlement balances (also known as reserves). We all know what banknotes are, but what are settlement balances? Commercial banks find it useful to keep a stock of settlement balances on hand to make crucial large-value payments to other banks. The central bank, which the government controls, is the monopoly provider of these balances. (Sometimes banks are required by law to keep a a fixed number of settlement balances on hand, often above and beyond their day-to-day needs, a policy referred to as required reserves.)

Historically, interest rate on both types of central bank-issued money have been set at 0%. At the same time, the rates on short-term credit instruments (Treasury bills, commercial paper, bankers acceptances, etc) are determined by the market, typically hovering around 1-4% over the last thirty years. These yields are priced to compensate investors for inflation of 1-4% or so.
 
The interest rate gap this gives rise to allows central banks to earn a steady stream of revenues, borrowing at an artificially cheap rate of 0% from both the banknote-using public and banks, and reinvesting at, say, 3%. Most of the revenues that the central bank collects from this interest margin flows back to the government. Economists usually refer to these revenue stream as seigniorage.

So seigniorage performs the same function as a consumption tax or an income tax: it takes resources from the public and gives it to the state. Likewise, a reduction in seigniorage would be very much like a tax cut.

If politicians wanted to, they could do away entirely with this form of raising government revenues. They have two ways of going about this. One way would be to have the central bank reduce price inflation to zero. By doing so, the interest rate on short-term credit instruments like Treasury bills would also fall to 0%, or thereabouts, since these instruments no longer need to compensate investors for inflation. There would be no longer be a gap between the 0% rate at which central bank fund themselves and the rate at which they reinvest, and thus seigniorage would shrink to zero.

Over the last few decades, governments have taken a second route to removing seigniorage by paying a market-linked yield on settlement balances. Canada, for instance, adopted this policy in 1999, and the Bank of England did so in 2006. By paying a market-based return, central banks no longer extract seigniorage from banks by forcing them to hold 0% assets. 

However, that still leaves banknotes as a significant source of seigniorage. We can calculate how much the UK government roughly earns from banknote seigniorage. With £95 billion in banknotes outstanding in October, and interest rates at 5.1%, the Bank of England's banknote-related seigniorage comes out to around £5 billion per year, much of which flows back to the government. That sounds like a lot, but it's only a small chunk of the £790 billion in taxes the UK government collected last year.

Banknote seigniorage isn't a given. It's a policy choice. If governments wanted to, they could reduce this form of seigniorage by paying interest on banknotes. One way to go about this would be by introducing a banknote serial number lottery. This lottery would offer around £5 billion in cash prizes to holders of winning banknote serial numbers, equating to a 5% interest rate on banknotes. Doing so would be akin to enacting a tax cut on British citizens.

To sum up, the fact that both inflation shocks and steady 2-3% inflation have implications for government revenues suggests that they while inflation may not be a tax, it is certainly tax-like.

I've been writing on this blog for a while now – over ten years. Many of those posts are now forgotten (by myself included), but some were pretty popular at the time, and a few still get a steady stream of readers. Someone recently asked me for a list of my top ranked posts according to traffic volume, in order to (presumably) get a better taste for my writing.

Well, here they are. Enjoy!

1. Starbucks, monetary superpower (2019)

Its gift card program provides Starbucks with incredible amounts of 0% interest funding

2. Bitcoin, 11-years in (2019)

Bitcoin isn't a commodity or a currency, it's a game

3. Bringing back the Somali shilling (2017)

If the Somali government wants to bring back the Somali shilling, it'll have to buy back all the counterfeit shillings

4. One country, two monetary systems (2020)

How the Yemeni rial split into two different rials when the country tore apart

5. There are now two types of PayPal dollars, and one is better than the other (2023)

A spotlight on PayPal's new stablecoin and how it reveals America's monetary fragmentation

6. Ripple, or Bills of Exchange 2.0 (2013)

An analysis of Ripple, back when it was still cool

7. The gold trick (2017)

The fiscal effects of changing the US's official gold price from $42.22

8. Fedcoin (2014)

First thoughts on a Fed-issued blockchain-based dollar

9. What happens when a 96 bitcoin ransom payment ends up on Bitfinex (2020)

Shopkeepers get to keep stolen cash. Does the same apply to stolen bitcoins?

10. Kyle Bass's big nickel bet (2019)

Trying to calculate the storage costs of a huge hoard of 5-cent coins

11. Dictionary money (2017)

A very wonky monetary system in which the unit-of-account and medium-of-exchange are separated

12. Bitcoin is more like ham radio than the early internet (2020)

Searching for a better analogy for bitcoin

13. The siren call of T+0, or real-time settlement (2017)

Instant securities settlement is no panacea

Henry VIII, after Hans Holbein the Younger

Source: Rolnick, Velde and Weber [pdf]

English groat (4 pence) issued 1547-49. Source: The British Museum

The demonetization of testoons is announced. Source: C.E. Challis

A constant series of debasements is exactly what Henry VIII and his son Edward enacted between 1542 and 1551 to keep paying their soldiers. Using data from a paper by John Munro, The Coinages and Monetary Policies of Henry VIII, I've charted out (above) how the penny's silver content changed over that time period. Going into the 1500s, an English penny contained 0.72 grams of pure silver. At the end of the Great Debasement, (the term used for Henry VIII's operations on the coinage) the penny contained just 0.11 grams of silver, constituting an 85% reduction in silver content.

We can further split out how Henry VIII's debasements were distributed between changes in fineness and changes in weight. Going into 1542, the English penny was 92.5% fine. Nine years later its purity stood at just 25% silver, the other 75% being base metal such as copper. As for weight, a penny weighed 0.79 grams in the early 1500s, but only 0.43 grams by 1551. 

These changes are illustrated in the chart below.

Thus it was diminutions in purity, not weight, that drove the biggest chunk of the penny's debasement, although weight did have a role to play.

How successful were these policies in creating a financial gusher for Henry and his son?

The charts below from Rolnick, Velde, and Weber (which I've clipped from  a second paper authored by the trio) show how the combination of mintage policies enacted in the 1540s – debasement, new testoons, and a demonetization of the testoon – led to a large influx of silver and gold to the English mints.

Source: Rolnick et al

According to Challis, the combination of these inducements, along with a big boost in fees, resulted in minting profits of £1.3 million for the two kings from 1542 to 1551. This would have paid for a big chunk of the £3.5 million in military expenditures over that same period, much more than actual taxation, which only yielded £976,000.

Of course, the final result of all this was a significant number of deaths, as well as some of the worst price inflation England had ever seen. According to Munro, the English consumer price level rose by 123% between 1541 and 1555.

So there you have it. If you had a time machine, you now know how to go back to medieval Europe and operate the royal mints in order to fund big ticket items like wars. (Whether you should actually do so is another question.)

Here's my quick first-pass take on Privacy Pools, the heir apparent to privacy tool Tornado Cash. My comments are on the legal side, and less so the technical side, although the two aren't mutually exclusive. 

I've already written a bunch of times about Tornado Cash on this blog. Financial privacy is an important topic. 

The quick story is that after attracting a few billion in criminal funds, the Tornado Cash "stack" was sanctioned by the Office of Foreign Assets Control (or OFAC, the U.S.'s sanctioning authority). Privacy Pools is the Ethereum community's attempt to offer up an olive branch to OFAC. "We know you didn't like the last attempt, but we're going to make some changes. What do you think?"

I'm fascinated with the Privacy Pools idea, which will allow users to pick and choose who they associate with, thus excluding potentially bad actors. With fewer bad actors, OFAC may be less hasty to sanction the tool. 

While in theory that sounds great, here's my worry. Privacy Pools still relies on an old Tornado Cash feature: relayers. (For this observation, I'm indebted to Jon Reiter, who wrote a useful article on Privacy Pools for Blockhead.) It also relies on a new type of third-party: association set providers or ASPs.

Relayers and association set providers are a problem, as I'll show below. And the reason has nothing to do with OFAC or sanctions law, but a set of Federal statutes against racketeering found in Chapter 95 of the U.S. criminal code.

Let's assume that Privacy Pools gets deployed and begins to successfully screen out bad actors. That'll make it an even more tempting target for dirty money seeking redemption, bad actors devoting ever more resources to sneak into the mix. Inevitably, some of them will get through and when they do, the authorities will have to find an actor in the Privacy Pools stack to blame. I suspect they'll target relayers and ASPs.

Let's start with relayers. It's likely that the authorities can show that relayers are engaged in an activity defined under a key section of U.S. racketeering law, § 1960, as "money transmission." To avoid breaking this law, relayers will need to register with the Financial Crimes Enforcement Network, or FinCEN, the U.S. government's money laundering watchdog. Registration will obligate relayers to set up an iron-clad customer identification program, which involves collecting and verifying user ID cards, as well as filing Suspicious Activity Reports (SARs) with FinCEN, thus undoing much of Privacy Pools' stated benefits.

Let's back up a sec. Who are relayers?

Doing stuff on the Ethereum blockchain requires paying a small processing fee, and these fees are visible to everyone. When a privacy seeker withdraws from Privacy Pools or Tornado Cash, this fee payment effectively reveals who the user is. To solve this problem, both systems rely on a group of third-party individuals or entities – relayers – to pay this fee on behalf of users, thus restoring privacy, an effort they are remunerated for. But this sounds to me like "transferring funds on behalf of the public," which is Chapter 95's definition of money transmission, which leads me to suspect that relayers can be drawn into said law's licensing and registration requirements.*

Now, I'm just a maritime lawyer, so if I suspect that relayers are money transmitters, who really cares, right? But it's not just me who is making this claim. In its recent indictment of individuals involved in the Tornado Cash stack, the Department of Justice named relayers as engaging in money transmission.

I can sympathize with the argument that the DoJ is overreaching by charging Tornado Cash frontend owners & token holders with money laundering (and failure to register as a money transmitter), but I think the DoJ nailed it 100% when it accused relayers of those same crimes. pic.twitter.com/uzJI9AC7g9

— John Paul Koning (@jp_koning) August 29, 2023

Let's move on to ASPs. With Privacy Pools, users can build unique association sets that allow them to dissociate from potential bad actors. In a recent paper, the Privacy Pools designers suggest that in practice, professional intermediaries – association set providers – will emerge to set up and curate these sets. Users will in turn subscribe to whatever ASP-provided sets meet their needs.

It's inevitable that ASPs will make mistakes and let bad actors into their sets, resulting in illicit money being laundered through Privacy Pools. In response, the authorities may try to follow the same script they used for relayers and accuse a faulty ASP of being an unlicensed money transmitter. But that may not stick; unlike a relayer, an ASP doesn't actually transfer any money. The Department of Justice has more up its sleeve than that, though. They can charge faulty ASPs with breaking other laws in Chapter 95, specifically the money laundering statutes §1956 and 1957.

To avoid a potential money laundering indictment, the intermediaries that curate association sets will have to make a good faith effort to exclude bad actors. Simple blacklists derived from chain tracing tools provided by companies like Chainalysis probably won't cut it. ASPs will have to undertake the same level of customer due diligence as banks and other financial institution. That means painstakingly collecting ID, doing background checks, and more. As before, that may unravel some of the purported anonymity of the Privacy Pools system.

The fact that relayers and ASPs may face FinCEN registration requirements and/or other anti-money laundering obligations isn't necessarily a death knell for projects like Privacy Pools, but it may pose some challenges.

1) Relayers and ASPs may try to sidestep U.S. law by operating outside the U.S. and, if possible, set up their operations to exclude Americans. That means cutting off a big chunk of the world from using the tool. With fewer users, the ability of Privacy Pools to obfuscate the tracks of all its non-U.S. users will be limited.

2) Some relayers and ASPs may choose to accept American customers in a compliant way. They'll verify their users, submit reports to FinCEN, and more. But at that point an American will probably be roughly indifferent between getting privacy from Privacy Pools or Coinbase, a centralized exchange that already complies with the requirements. Any U.S. user who becomes a customer of Coinbase can deposit ether and withdraw it to a new address, thus removing the outside world's ability to track the transaction, albeit at the expense of disclosing their personal information to Coinbase. Privacy Pools would afford this same level of privacy. It would offer U.S. users privacy from the broader community, but not from the employees of a relayer or ASP.**

If Privacy Pools is only providing Coinbase-levels of privacy to Americans, what's the point?

3) Lastly, perhaps the developers can figure out now – before Privacy Pools is even deployed – how to do away with relayers while still preserving privacy, thus entirely bypassing Federal racketeering law's definition of money transmission. Or maybe they can figure out how to design the relaying system such that it falls out of the definition. 

Whether that's even possible is a technical issue that goes waaay beyond my abilities.

* Why can't other elements of the Privacy Pools stack, including the core smart contracts and the people who develop them, be pulled into being defined as money transmitters? My assumption in this post is that if the smart contracts are: 1) non-upgradeable, that is, they are set in stone from the moment they are published, 2) the developer no longer has any association with the "stack" after publishing the contracts; 3) the system is not governed by a DAO; 4) there is no stream of profits thrown off by the system; and 4) there is no token (as was the case with Tornado Cash's TORN), then it is probably less likely that the smart contracts and/or their designers would fall under the definition of a money transmitter. But I could be wrong.

** Mind you, Coinbase and a fully-compliant Privacy Pools wouldn't be perfect substitutes. Whereas Coinbase takes ownership of one's ether, thus subjecting privacy seekers to the risk of Coinbase going bankrupt, Privacy Pools is just a smart contract, and not subject to that same risk. For a sub-group of privacy seekers who worry about Coinbase going bust, FinCEN-compliant relayers and ASPs may be strictly superior to Coinbase.  

We can get an answer by canvassing the range of entities currently offering interest-paying dollar accounts to U.S. retail customers. It pretty much boils down to two sorts of institutions:

• Banks
• SEC-regulated providers like money market funds.

There seem to be a few exceptions. Fintechs like PayPal and Wise are neither of the above, and yet they offer interest-yielding accounts to retail customers. But if you dig under the hood, they do so through a partnership with a bank, in Wise's case JP Morgan and in PayPal's case Synchrony Bank. (Back in the 2000s, PayPal used a money market mutual fund to pay interest). So we're back to banks and SEC-regulated entities.

And then you have Coinbase.

Coinbase will pay 5% APY to anyone who holds USD Coins (USDC), a dollar stablecoin, on its platform. (Coinbase co-created USDC with Circle, and shares in the revenues generated by the assets backing USD Coin.) The rate that Coinbase pays to its customers who hold USDC-denominated balances has steadily tracked the general rise in broader interest rates over the last year or so, rising from 0.15% to 1.5% in October 2022, then to 4% this June, 4.6% in August, and now 5%.

Coinbase isn't a bank, nor is it an SEC-approved money market mutual fund. And unlike Wise and PayPal, Coinbase's interest payments aren't powered under the hood by a bank.

So how does Coinbase pull this off?

In short, Coinbase seems to have seized on a third-path to paying interest. It cleverly describes the ability to receive interest as a "loyalty program", which puts it in the same bucket as Starbucks Rewards or Delta's air miles program. The program itself is dubbed USDC Rewards, and in its FAQ, customers are consistently described as "earning rewards" rather than "earning interest."

This strategy of describing what otherwise appears to be interest as rewards extends to Coinbase's financial accounting. The operating expenses that Coinbase incurs making payments on USDC balances held on its platform is categorized under sales and marketing, not interest expense. 

Oddly, this key datapoint isn't disclosed in Coinbase's financial statements. Instead, we get this information from a conference call with analysts last year, in which the company's CFO described its reasoning for treating USDC payouts as rewards:

Source: Coinbase Q4 2022 conference call

The flow of "rewards" that Coinbase is currently paying out is quite substantial. Combing through its recent financials, Coinbase discloses in its shareholder letter that it had $1.8 billion of USDC on its platform at the end of Q2. Of that, $300 million is Coinbase's corporate holdings, as disclosed on its balance sheet. So that means customers have $1.5 billion worth of USDC-denominated balances on Coinbase's platform.

At a rewards rate of 5%, that works out to $75 million in annual marketing expenses. (Mind you, not everyone gets 5%. We know that MakerDAO, a decentralized bank, is only earning 3.5% on the $500 million worth of USDC it stashes at Coinbase). In any case, the point here is that the amounts being rewarded are not immaterial.

Interestingly, Coinbase does not pay rewards on regular dollar balances held on its platform. It only provides a reward on USDC-denominated balances. This gives rise to a yield differential that seems to have inspired a degree of migration among Coinbase's customer base from regular dollar balances to USDC balances. 

For instance, at the end of Q1 2023, Coinbase held $5.4 billion in U.S. dollar balances, or what it calls customer custodial accounts or fiat balances. (See below). By Q2 2023 this had shrunk to $3.8 billion. Meanwhile, USDC-on-platform rose from $0.9 billion (see below) to $1.5 billion.

Source: Coinbase Q1 letter

Here's an interesting bit in which Coinbase goes into some detail why it believes USDC Rewards isn't a security: https://t.co/ZzXxvNkBsv I think it bears out the idea that once a firm starts offering a return, it risks straying into other regulatory frameworks. pic.twitter.com/DMC7l3Et33

— John Paul Koning (@jp_koning) August 4, 2022

The 2022 sanctioning of privacy tool Tornado Cash by the Office of Foreign Assets Control (or OFAC, the U.S.'s sanctioning authority) has inspired a new privacy idea: Privacy Pools. 

An olive branch to OFAC, Privacy Pools will let users choose who they associate with, the idea being that proactive filtering will quickly expose bad actors who try to use the tool, and so OFAC may be less hasty to apply sanctions to Privacy Pools smart contracts. I think it's a neat idea. We'll see where it goes.

Zooko Wilcox, the creator of the original anonymous cryptocurrency, Zcash, doesn't like the notion of bending a knee to OFAC. In an interesting conversation with Vitalik Buterin, one of the creators of Privacy Pools, Wilcox argues that the Privacy Pools regulatory dance is "unnecessary" because OFAC simply doesn't have the authority to sanction a protocol to death. And he puts forward Zcash as an example of a privacy technology that coexists peacefully with OFAC. Which is a fair point. Zcash has been around for seven years now, and OFAC hasn't shut it down.

This piqued Vitalik's interest, who later on in the podcast goes on to ask Zooko why Zcash hasn't been OFAC'ed, given that it does exactly what Tornado Cash does: provide privacy.

I don't think it's a great idea for folks like Vitalik who are designing tools like Tornado Cash and Privacy Pools to take lessons from Zcash's experience with OFAC. And that's because Zcash is a very different beast than Tornado Cash/Privacy Pools. The two just don't land in the same regulatory bucket.

If you've been watching OFAC's dealings with crypto over the years, you'll notice that Zcash falls in the same OFAC bucket as other base layers like Bitcoin, Ethereum, Monero, Ripple, and more. When OFAC catches a sanctioned actor who controls an address on one of these base chains, it updates its list of sanctioned entities with the relevant address. This is how things have worked since 2018, when the first two bitcoin addresses were added to OFAC's list. But OFAC has always left the functionality of the chain itself unhindered, nor does it impinge on the ability of the chain developers to do their job by sanctioning them.

In fact, I've found a handful of Zcash addresses designated by OFAC, including one associated with the disinformation campaigns set up by recently-deceased Russian mercenary leader/oligarch Yevgeniy Prigozhin:

Source: OFAC

With the arrival of Tornado Cash/Privacy Pools, we've entered into completely new territory of smart contract-based tools built on programmable chains. How OFAC deals with these tools is going to be much more complex and tricky than how it deals with base chain addresses controlled by sanctioned entities. The Tornado Cash sanctions represent OFAC's first attempt, perhaps a clumsy one. Privacy Pools is a riposte from developers that, after being eyeballed by OFAC, might end up at a different equilibrium.

Zcash's regulatory experience just doesn't translate over to the sorts of things Vitalik is working on. It's in smart contact-space where the current evolution of OFAC's prodding of crypto is occurring, but Zcash doesn't have smart contract-based tools.

So from the perspective of a Zcasher like Zooko, it's just not necessary for him to play games with OFAC. The last five years of OFAC behavior suggests that OFAC can't and/or won't sanction Zcash-the-protocol to death, nor Bitcoin-the-protocl or Ethereum-the-protocl. 

But the fact remains that the sanctioning of Tornado Cash (which has already survived one court challenge) suggests that OFAC does seem to have the authority to enact such a ban at the emerging smart contract level. That may not be concerning to Zooko now, but one day it might be possible to build all sorts of automated tools on top of Zcash. And at that point Zcash developers may have to play the same "unnecessary" olive branch game with OFAC that Ethereum smart contract developers like Vitalik are engaged in now.

PayPal now offers its customers two types of U.S. dollars. In addition to having the option of opening a traditional PayPal account to maintain a balance of dollars, PayPal customers can now hold something new called PayPal USD, a crypto version of a dollar. Whereas PayPal USD uses a crypto database, Ethereum, to host U.S. dollar balances (which in industry-speak is sometimes known as a stablecoin), the first sort of dollar relies on a conventional database.

There are currently around $45 million worth of PayPal USD in circulation, as the chart below illustrates:

Source: CoinMarketCap

Source: PayPal 2022 annual report

It would be illegal for PayPal to back its new crypto-based dollars with the assets listed above, yet for some reason it is fine if it backs its traditional dollars with them.

Customer's ranking relative to other creditors

The second drawback of PayPal's regular dollars is that the assets underlying them don't really "belong" to customers in any strong sense of the word. They belong to PayPal.

To understand what this means, let's say that PayPal goes bankrupt. You, a long time PayPal customer, hold $1000 worth of PayPal dollars. You might think that you are guaranteed to be made whole because there exists a corresponding set of underlying customer assets that has been specially earmarked for you and other PayPal customers. But that's not the case. Customers are what is referred to in finance as an unsecured creditor of PayPal, which means you'd be relegated to having to fight with PayPal's other creditors (banks, bond holders, etc) to get a piece of the pie, and that's only after PayPal's secured creditors – those highest in the pecking order – get first dibs. That could potentially mean getting maybe $600 or $700 instead of your original $1000.

The reason for this, as explained here by Dan Awrey, is the fairly lax state-by-state regulatory frameworks under which PayPal's regular dollars are issued, which "often do not require that permissible investments be held in trust for the benefit of customers—thus potentially forcing customers to compete with an [money services business]’s other unsecured creditors in the event that it is forced into bankruptcy."

By contrast, the regulator of PayPal's crypto-based dollars, the NYDFS, specifies that the reserves backing any crypto-based dollar "shall be held at these depository institutions and custodians for the benefit of the holders of the stablecoin, with appropriate titling of accounts." To translate, the assets underlying your $1000 in PayPal USD cryptodollars are not PayPal's assets. Nor are they Paxos's. They are yours. No need to squabble with competing vultures for what's left.

But oddly, PayPal is under no legal obligation to extend these very sensible protections to all of its regular PayPal dollars.  

Degree of transparency

The last big difference between the two types of PayPal dollars is that the crypto version offers far more transparency to customers. If you want to get current information about the assets underlying your crypto PayPal dollars, all you need to do is open up one of PayPal USD's soon-to-be published attestation reports. Published monthly, these reports must include market values of the assets backing PayPal USD's, both in total and broken down by asset class. These values must be recorded on two separate days each month, or 24 times per year. Furthermore, these attestation reports must be prepared by an independent auditor.

By contrast, the only way to get vetted financial information about the assets backing traditional PayPal dollars is to read its audited financial statements, which come out just once a year. For the rest of the twelve months, customers are left in the dark.

So where am I going with all of this?

This illustrates the absurdity of some of the rules we've created surrounding monetary instruments. The fact that one type of PayPal dollar has robust protections while the other is only haphazardly protected, and only because the first is managed with a crypto database and not a traditional database, seems incredibly arbitrary to me. 

Financial regulations exist, in part, to protect retail customers against shoddy financial providers. Shouldn't all PayPal customers, no matter what database technology they select, get to benefit from the same standard protections? What's the logic behind stipulating that one type of PayPal customer is to have the benefit of monthly attestation reports, for instance, while limiting the other type of customer to a black void of information? 

The problem here isn't just one of having a few bad standards. Doesn't having multiple standards add to people's confusion about how they are protected?

Just to make things even more absurd, there's actually a third type of PayPal dollar. It comes in the form of balances held in a PayPal Savings accounts. 

Now you can save for rainy days and getaways with 0.85% APY*. No fees. No minimum balance. So hit the auto-save and achieve those savings #goals. https://t.co/orHIhRlKX2 pic.twitter.com/lxivOjqMoT

— PayPal (@PayPal) June 9, 2022

Unlike the two types of PayPal dollar described above, the third type is insured by the government up to $250,000. PayPal Savings dollars also pay interest, whereas the first two don't, or are prohibited from doing so. PayPal offers this product in conjunction with a bank, Synchrony Bank, which means this third type of PayPal dollar conforms to an entirely different set or rules than the other two: Federal banking law.

But this only reinforces what a Frankenstein of a monetary system we've created. Why are only PayPal Savings dollars protected by deposit insurance, whereas the other two types of PayPal dollars aren't? How does this cacophony of features (or lack of features) help retail customers who, amidst all their other duties in life, simply don't have time to peruse the fine print of each different dollar emitted into the economy?

There's a good article by Leo Schwartz on stablecoin issuer Circle, which provides some clarity into last March's big depegging of the USDC stablecoin, and Circle's subsequent bailout by the government.

I wrote about the whole thing here, but the short version is that a handful of banks collapsed earlier this year, one of which was Silicon Valley Bank (SVB). Circle kept $3.3 billion at SVB, almost all of which was uninsured, which amounted to 8% of the assets keeping USDC stablecoins pegged to $1. When news of SVB's collapse hit on Friday, March 10, a weekend run began on Circle, the price of USDC collapsing to below 90 cents.

Luckily for Circle, it would get a bailout. That weekend, the FDIC announced that the $250,000 limit on government deposit insurance would be waived for SVB. Circle's $3.3 billion was saved. As SVB's biggest depositor, Circle was the single largest beneficiary of the bailout.

According to the article, Circle has "no remorse" over its decision to hold $3.3B at SVB. It was "as diversified as possible" and blames banking for its woes, which is "extremely difficult" for crypto firms.

I just don't buy this argument.

Circle's stablecoin competitor, Paxos, didn't have single-bank exposure. As the screenshot below shows, $185.5 million worth of deposits held to back Paxos's USDP stablecoin were spread over thousands of banks using deposit placement networks like IntraFi, and were thus insured by the government. For the remainder, Paxos obtained $72 million worth private insurance. Only $10.9 million in deposits were effectively unprotected, a small 1.3% sliver of USDP's total assets.

Source: Paxos

Rather than keeping 8% of its assets lodged at a second tier bank without insurance, why didn't Circle follow Paxos's risk reduction strategy?

There are 4,333 FDIC-insured banks and 4,760 NCUA-insured credit unions. The ability to invest $250,000 in each one offers theoretical headroom for around $2.3 billion worth of government insurance. The actual ceiling is much lower, since many banks and credit unions don't participate in deposit placement networks. But that's where private insurance comes in. How much private insurance could Circle have managed to secure? Paxos once again provides a hint. Last year it obtained a hefty $1.5 billion in private insurance for deposits backing BUSD, its largest stablecoin product. 

Combine these two options, and Circle could have easily avoided hyper-exposure to SVB. But it didn't go down that route.

In the article, Circle derides concerns over its deposit holdings as bordering on "risk reduction to absurdity," but the real absurdity here seems to be that Circle didn't engage in the same risk reduction as one of its competitors. Instead of angrily blaming others for what happened to it last March, Circle should probably accept some of the blame itself, and then very humbly thank American taxpayers for the bailout.

Over the last few years I've written a bunch of posts about Tornado Cash, an Ethereum-based mixing service, because I find it to be a fascinating tool. With the recent indictment of two people involved in the Tornado Cash stack for money laundering, here's another post to add to the list.

Let's get this clear from the outset. Somewhere in the Tornado Cash stack, someone is committing the crime of money laundering. That's been the case since at least mid-2020 or so, the moment that crooks started to send their criminally-derived ether proceeds to Tornado Cash for cleansing.

I'm going to repeat that. One of the parties (or groups of parties) woven together via the Tornado Cash apparatus has been knowingly acting as a financial counterparty to criminals, helping to "conduct" transactions that obfuscate dirty ether.

The question always was: who in the stack is guilty of money laundering? Is it the developers who are  laundering money? Miners? TORN token holders? Relayers? Licit users who engage with the smart contracts? And if so, are all licit users guilty, or just some users? Are the operators of the popular user interface the guilty parties?

A recent indictment from the U.S. Department of Justice claims to have figured out who the money launderers are.
 
Before getting to the indictment, let's tally up all the actors involved in the Tornado Cash stack. To begin with there are the users and developers. The central element of the Tornado Cash stack is a set of smart contracts, or pools, where users – both crooks and non-crooks – can send their easily-traced ether to be mixed, getting it back anonymized and untraceable. These core smart contracts were originally coded by three developers in 2019. In mid-2020, the developers removed the core contracts' upgradability, in effect "throwing away the keys" and ending their influence over them.

The next key set of actors are the relayers. Doing stuff on the Ethereum blockchain requires paying a fee to validators. The visibility of these fee payments effectively unwinds Tornado Cash's anonymity and reveals who Tornado Cash's users are. A group of third-party individuals, the relayers, are recruited to handle fees on behalf of users, thus restoring privacy.

The Tornado Cash stack also includes a popular user interface that acts as an overlay over the smart contracts, making them easier to interact with. Control over the user interface is delegated to individuals who own TORN tokens. TORN allows its owners to vote on how the front-end functions, in addition to earning profits from it. TORN holders have no influence over the core smart contracts.

Of these many actors, the DoJ has singled out Roman Storm and Roman Semenov, along with "others known and unknown," as the putative money launderers. (The government also accuses the two of failing to register as a money transmitter, but I'll set that aside.)

Storm and Semenov were the original developers of the core smart contracts, but that doesn't seem to be the nub of the DoJ's money laundering case. Rather, it is the accused's ongoing control over the user interface, exercised through their ownership of a large block of TORN tokens, that seems to have implicated them. Despite knowing that the Tornado Cash stack had become popular with criminals, the owners/operators of the user interface did nothing to screen bad actors from accessing said interface. On the contrary, they made efforts to both improve the interface and increase the profits they made from it.

The government's illustrates this by explaining the involvement of Storm and Semenov in managing the list of relayers that appear on the user interface, as well as crafting the system for rewarding and levying fees on these relayers.The indictment cites a vote made by TORN holders in early 2022 that led to an update of the user interface's mechanism for listing relayers. The change allowed anyone to appear on the list, as long as they could stake a certain quantity of TORN tokens. The DoJ alleges that this decision improved anonymity by lengthening the user interface's list of relayers.  

The indictment further alleges that Storm and Semenov, through their ownership of TORN, profited financially from the user interface's new method of listing relayers. To get on the user interface list, a relayer had to buy TORN, which pushed up TORN's price. In addition, whenever a relayer that appeared on the user interface's list was selected, a portion of that relayer's staked TORN was "slashed," or reduced, forcing relayers to top up with additional TORN purchases in order to continue to qualify for the list. This added more upward pressure on TORN's price to the benefit of holders like Storm and Semenov.
 
In the government's view, the totality of these actions constitute money laundering, specifically a violation of  18 USC § 1956. The DoJ believes that the two defendants "conducted" transactions, a key element of money laundering, via their ongoing control over the user interface, along with other TORN owners. The indictment also shows that a large portion of Tornado Cash transactions were in fact criminal proceeds, including those made by the Lazarus Group. (I mean, we all knew that already.) Lastly, they show that the accused were aware that the funds coursing through the Tornado Cash stack were dirty, a mental state of knowing being a key plank in charging someone for money laundering.

It seems to me like the DoJ has a solid case, although we can debate whether operating the Tornado Cash user interface and its relayer list is tantamount to "conducting" transactions. The legal definition of conducts is a broad one, including "participating in initiating, or concluding a transaction." While the user interface, and thus those who operated it, never directly initiate transfers of ether to the underlying Tornado smart contracts, it doesn't seem a stretch to describe them as participating in the initiation of those transfers. We'll have to see what the judge says.

One weakness of the indictment is that the government never explicitly shows crooks such as Lazarus depositing funds into Tornado Cash via the user interface. If Lazarus primarily deposited directly to the smart contracts, then it'll probably be tough to pin Semenov and Storm with money laundering.

Counterintuitively, the indictment seems like a win, if only a lukewarm one, for fans of decentralized finance, or DeFi.

Proponents of DeFi have long worried that developers of autonomous smart contracts might be held liable in court for crimes. In this case, however, the same actors who happen to be the developers of Tornado's core smart contracts also built a complex and centralized business structure around those same contracts, and it is this tertiary apparatus that is serving as the basis for a money laundering charge, not the original coding of the core smart contracts.

It's a useful thought experiment to imagine how things might have played out if Storm and Semenov had acted differently. Let's imagine that the two coders hadn't created a profitable apparatus around the original smart contracts. Once the core smart contracts were up and running, they ceased to associate in any way with the Tornado Cash stack. Secondly, imagine there was no user interface. To deposit or withdraw funds, users had to interact directly with the smart contracts. Lastly, let's assume that TORN tokens had never been issued, so there was nothing to govern (or govern with), and thus no basis for the government to use "operating control" as a lever for a money laundering prosecution.

Given a very slimmed-down Tornado Cash stack, who does the DoJ now accuse of money laundering? Because they have to accuse someone. Crooks depositing dirty ether are still ending up with laundered ether, so there is by definition a "someone" in the stack who is providing laundering services to them.

In our story, Storm and Semenov aren't the money launderers, and the thrust of the DoJ's indictment confirms this. The two developers created software with presumably noble intentions: to provide regular folks with privacy from the panopticon that is Ethereum. Then they walked away, leaving the tool indelibly etched on the blockchain. It was only then that people started to interact with the tool, some of them to carry out illegal activity. It's this latter group who constitutes the guilty party.

Relayers are excellent candidates for a money laundering charge, a point I made last year. Because they process withdrawals on behalf of users, it would likely be a cinch to pin them for "conducting" transactions. Showing that relayers do this despite knowing that criminals may be their counterparties shouldn't be difficult for prosecutors to establish. And indeed, the DoJ's actual indictment is going in the right direction when it says that Storm and Semenov, along with "others involved in the Tornado Cash service, including the relayers," were engaged in the business of transferring funds, and goes on to accuse these "others," presumably relayers, of engaging in money laundering.

The second logical target for a money laundering charge is the licit users of Tornado Cash, in particular the large and savvy ones who used the tool regularly. A person who is aware that criminals are depositing dirty money into Tornado Cash smart contracts, yet decides to deposit their own funds into those same smart contracts, knowing that their effort will help these criminals conclude transactions that disguise the source of their funds, ticks all the boxes for a money laundering charge.

A licit user of Tornado Cash accused of money laundering might try to wiggle out of the charge by saying: "Sure, I knew crooks were using Tornado, and I know my efforts helped them. But I was only using it for legal reasons. I wanted to get privacy for myself." But that's not a very good defence against a money laundering charge, for the same reason that someone who tries to make a profit from obfuscating criminal funds can't evade a money laundering charge by saying they were only motivated by profit, and profits are legal. The desire to improve one's position, whether that be to get privacy or profits, isn't an excuse to launder money for crooks.

To sum up, the task of any prosecutor trying to bring money laundering charges against the Tornado Cash stack is to find the actual third-parties who misuse the platform for laundering. In a slimmed-down Tornado, that means chasing down relayers and savvy licit users. In the DoJ's actual indictment, it's also trying to show that owners/operators of user interfaces qualify, and while it's not a bad theory, we'll have to wait for the court date to see if it gets confirmed.

Scam call centre on CCTV, via BBC.

Here's a question for you. Should banks be required to reimburse customers who have been scammed?

I was recently reading a CBC article about a 63-year old Toronto man who responded to a phone call from a scammer claiming to be a Bank of Montreal employee, warning him that fraudsters had accessed his bank account. He was soon cajoled into paying out $16,000 to the scammer. Not only did the Bank of Montreal not reimburse the victim the full amount. It continued to charge him interest on the stolen funds.

Which isn't surprising. As the law currently stands, Canadian banks don't have to reimburse their customers who fall prey to authorized push payment (APP) fraud, a range of scams that includes calls from impersonated bank employees, RCMP scams, and fake Revenue Canada refunds.

So why not flip the whole system on its head? Why not require the Bank of Montreal to fully reimburse victims of these sorts of scams? The idea isn't without precedent. In 2024, UK will require that most victims of APP fraud be reimbursed within five business days by their bank.

There are some good arguments in favor of this policy. 

As it currently stands, individuals and their families, friends, and support systems are the main lines of defence for detecting scams. But there are big gaps in these lines of defence. Everyone has vulnerabilities, which scammers skillfully exploit to induce panic. Once in a panic, the victim's ability to think clearly is short-circuited, opening them up to being exploited by the scammer. A victim's second line of defence is to seek a second opinion from a sibling or spouse, but these third-parties may not always be available to help out the scam target.

Banks, by contrast, don't panic. Like scammers, they are cold rational machines. In addition, bank computers never turn off, which means they are available 24/7 to detect fraud. They also have a vast amount of knowledge about their clients' financial lives. Combine this data with technology like AI, and banks are in prime position to intervene in the crucial panic stage of the scam process, thus scuttling the scam.

Banks already do plenty of fraud detection. But imagine how much more vigilant they will be if their profits are at stake because they must reimburse scams.

None of this would be free, though.

Making Canadian banks liable for scams will inevitably mean higher fees and more banking frictions for everyone else. After all, reimbursing victims adds a new cost item to bank operating expenses. To recoup these costs, banks will hike fees on a range of banking products. Bankers will also want to reduce costs by catching scams in progress, which means extra checks when any irregular payment occurs, thus slowing down everyone's economic lives.

While no one likes extra bank fees and delays, think of these burdens as an alternative to the implicit costs that families, friends, communities, and civil society are already absorbing due to APP fraud. For instance, to prevent his elderly parents from being scammed, Jack tries to vet all of his parents' bank transactions. If banks are obliged to reimburse victims, Jack no longer needs to burden himself by monitoring his parents transactions; the bank will now take on that responsibility. The cost of this bank-provided anti-scam insurance comes in the form of Jack, and everyone else, paying higher fees and dealing with the odd delayed transaction.

This isn't a net loss, but a swap of one burden for another. Which is the better option for Jack and his parents? Is it more cost effective for him to monitor his parents transactions, or to pay his bank to do the job?

This gets into the problem of moral hazard. If banks insure customers against scams, then folks like Jack and his parents will become less vigilant, which means the public will be more susceptible to scam calls. However, as long as the additional vigilance brought to bear by banks more than compensates for the lost vigilance of individuals and communities, and does so at lower cost, the policy probably makes sense.

Beware, though. The policy could backfire it it unintentionally unbanks the vulnerable.

Victims of scams are vulnerable. They may be elderly, lonely, have low income, are weighed down by debt, or are working multiple energy-sapping jobs. Requiring Canadian banks to reimburse scams will make it more costly for them to service these groups. In response, banks may close the accounts of those they deem most likely to be tricked by scams. And so one of the unfortunate side effects of trying to protect the vulnerable from scams may be to actually burden them with a worse problem, no bank account.

There may be a fix for to this. Legislators may need to add a companion rule prohibiting banks from discriminating against customers on the basis of "scammability." However, keep in mind that this new rule will go on to have its own round of unintended consequences, which one hopes doesn't necessite a third rule, and a fourth one, and a...

Let's not forget the scammers, by the way, who won't sit idly by. 

Scam call centres will incorporate the new policy as a way to make their attacks even more effective. Imagine a panicked customer who is on the verge of transferring funds to the scammer. She suddenly blurts out loud: "Wait, is this a scam?" The scammer, reading off his script, pounces. "This is not a scam, ma'am, and even if it was, you live in the Canada. Your bank will cover it." The victim's worries allayed, the money is transferred, whereas without a policy of reimbursement the alarm bells in the victim's head might have been sufficient to get her to call a level-headed friend or family member for advice, likely putting an end to the scam.

In response to these tactics, banks will have to roll out their own information campaigns. Thus begins a cat and mouse game, whereby scammers adapt to banks and banks adapt to scammers, who in turn adapt to banks. But this is a cat and mouse game that has always existed, albeit with a different cast of characters, that is, scammers being pitted against individuals and communities. By changing the status quo and pitting scammers against a group that is more well-equipped for the game, bankers, we may all come out ahead.

I recently noticed that the Bank of Jamaica, Jamaica's central bank, has implemented two new marketing strategies to drive adoption of its new central bank digital currency, Jam-Dex. Jam-Dex is one of only four operational central bank digital currencies (CBDCs) in the world, having been introduced to Jamaicans in July 2022.

As they increasingly forsake cash, regular folks are making dozens of digital payments every month. What they don't realize is how this growing reliance on digital payments increasingly yokes their commercial lives to the fate of a single piece of infrastructure: their central bank's large-value settlement system. When that system experiences a glitch, everyone's financial life gets put on hold.

In the United Kingdom's case, it is the Bank of England's RTGS settlement system that lies at the core of the economy. RTGS's centrality is highlighted by the fact that all the arrows in the chart below converge on it: every payment in the UK, big or small (except for cash), ultimately gets finalized using RTGS.

Alas, RTGS failed this Monday for six hours. No reasons were given, although I can't help wonder if it is was due to a software glitch stemming from Bank of England staff having been recently upgraded RTGS to the ISO 20022 payments language, rather than something like a cyberattack.

RTGS's centrality illustrated. Source: Bank of England

To reduce these costs, central bank large value payments systems are typically built with multiple layers of redundancy. In RTGS's case, the hardware is hosted at two different sites, so that if the primary site goes down, the other one can quickly kick in. Presumably whatever knocked RTGS down last Monday was fierce  enough to incapacitate both sites.

A third layer of redundancy comes in the form of the Bank of England's Market Infrastructure Resiliency Service, or MIRS. With RTGS's two sites incapacitated, the Bank can "fail over" to MIRS, payments recommencing. MIRS uses different software, programming, and hardware, as well as being  hosted in a geographical remote location with a separate group of staff. This is achieved by an outsourcing arrangement with SWIFT, the same folks who run the global SWIFT messaging system.

There's no indication that the Bank of England failed over to MIRS earlier this week, staff preferring to focus on fixing RTGS instead. Alas, this choice subjected the UK economy to a long settlement delay. Why no fail-over to MIRS? Why choose such a long period of settlement deprivation?

A reading of the inquiry into the 2014 failure gives some clues into what may have happened two days ago. When RTGS failed on Monday, October 20, 2014, the Bank of England likewise chose not to fail over to MIRS. Why? The inquiry pointed to the fact that it would haven taken 2-2.5 hours to get MIRS up and running. Given this length of time, it made sense to try to fix RTGS instead, an inherently-preferable system because of features like the ability to save on liquidity, which the back-up system MIRS lacked.

Management was also reticent to switch on MIRS because they weren't sure if, after having activated it on Monday, they could turn it off on Tuesday night and manually return to a now-repaired RTGS without making a mistake. Bank officials only felt comfortable doing this manual switch back to RTGS on a weekend, because it afforded them much more time than a weeknight.

And thus trepidation about switching on the back up system led to it never being activated in 2014, which forced 9 hours of settlement deprivation on the UK economy.

Among its suggestions, the 2014 inquiry called for an upgrade to the MIRS back up option in order to make it a less anxiety-inducing option to turn to. The passage is worth reading in full:

Work should be undertaken to remove or reduce the barriers to invocation of MIRS so that
the Bank can "switch and fix" in parallel and in confidence. This should focus on testing the process to fail-back to RTGS intraweek (which is the primary barrier to invocation). If it is not possible to reduce this barrier, consideration should be given to enhancing the resilience and functionality within MIRS. In addition the Bank may wish to consider other back-up options for RTGS.

When I describe bitcoin as a type of ponzi or pyramid, idealistic bitcoiners usually view this as an attack on the nobility of the bitcoin project. But they shouldn't. Bitcoin's ponzi nature is one of its greatest strength.

Imagine that you are trying to bootstrap an unorthodox and potentially illegal asset, one that you are marketing (or mis-marketing) to the world as a new monetary system. The standard way to get your asset to have a positive price is to have some funds in a vault somewhere and then link that new asset to whatever is held in the vault. Examples include failures like e-Gold and Liberty Reserve. Neal Stephenson's gold-backed currency in Cryptonomicon is another that followed this script.

It is this underlying intrinsic anchor that imbues the overlying novel asset that you are trying to kickstart with its original positive price.

The problem with this approach is that if the asset is illegal-ish, then to shut it down the authorities need only locate the underlying source of value and confiscate it. With the backing gone, it's game over.

Instead of relying on the tangible world of vaults and backing, bitcoin's creators got their asset to have a positive value by taking a non-tangible route through people's mindscapes. The original two dozen or so adopters began to play a self-referential mind game which went a bit like this: "If I think Joe will buy bitcoin at a higher price in the future because he thinks Susan will buy at an even higher price, for the reason that she thinks that I will buy even higher up, then I'll buy some bitcoin now."

This circular process, a ponzi game, worked. Very early on, bitcoin was imbued with a positive value. The mind game has since grown from a few dozen players to hundreds to thousands to millions, but the self-referential logic of a ponzi continues to be the basis for bitcoin's price.

It's easy to confiscate gold or shut down a bank account. These things are tangible and have actual physical locations with addresses. But it's tough to shut down a million imaginations participating in a collective illusion. First, there's a million of them. And second, imagination isn't something that authorities can fine or confiscate. People's dreams and delusions, their mental gymnastics and schemes, are all locked safely in their skulls.

And so the authorities very quickly gave up and let the bitcoin ponzi game play out, which probably wouldn't have been the case if bitcoin's creators had gone the non-ponzi route and tried to establish an anchor to real world assets.
 
In sum, bitcoin is resilient because its source of value is ponzi logic playing out in millions of people's heads. Bitcoin idealists may bristle at the idea of being associated with a ponzi, but they should embrace it as a strength.

Critics of anti-money laundering (AML) often point to the fact that just a tiny fraction of 1% of criminal proceeds are seized every year, their point being that AML is not working. Either update our approach to AML, they say, or just throw in the towel and legalize money laundering. (Here's a good example of this genre of critique).

But the critics' focus on the money-that-gets-caught misses out on one of the key channels through which AML works; by making crime more expensive. It isn't just the caught cash, but the costly detours that criminals are forced into along the way, or what I call the AML tax, that are signs of AML performing adequately.

I was reminded of this when I recently read Cash and Carry: the high cost of currency smuggling
in the drug trade, a fascinating paper about drug trafficking and high denomination banknotes. According to the paper, drug traffickers operating between Holland and Colombia typically contract with third-party broker specialists to move their funds back to Colombia. In six different situations from 2003 to 2011, coordinators of these Dutch brokerage operations were arrested. Everything from sketchy financial notes to detailed Excel spreadsheets were seized, allowing the authors of the paper to crunch the costs of running these businesses. 

Put differently, we get to see a juicy insiders' view on how much criminal resources must be sacrificed to successfully evade AML measures.

The authors report that the typical cash shipment to Colombia measured €300,000. The massive 500 euro note was the most popular medium for packaging shipments. The brokers relied on coordinators residing in Holland to supervise individual couriers traveling home to their families to carry these €300,000 packages. Couriers carried these funds in specially built parts of their suitcase.

The cost of moving these €300,000 packages to Colombia adds up very quickly. First, the coordinator had to absorb a 3% fee to convert the trafficker's original low denomination euro banknotes to the very compact 500 euro note. To that, add a 2-3% fee to pay the individual courier and 0.5% on airline tickets, as well as additional administrative costs like modifying luggage and bringing couriers to and from the airport.

A table of costs for the six apprehended coordinators is inserted below:

Data from six criminal investigations by the Dutch police showing the costs of smuggling cash [source]