Welcome to another issue of Net Interest, my newsletter on financial sector themes. Every Friday I go deep on a topic of interest in the sector and highlight a few other trending themes below. If you enjoy Net Interest, please spread the word! It really makes a difference when you recommend this newsletter to others.

The Politics of Money

Look up the city of Bristol on Wikipedia, and after a paragraph on its geography (South West England), a paragraph on its history (royal charter received in 1155) and a paragraph on its maritime status (port of departure for first European landing on mainland North America), you get to a paragraph on its economy. And at the top of that paragraph, you get this:

The city has the largest circulating community currency in the UK; the Bristol pound, which is pegged to the Pound sterling.

The Bristol pound was devised around a table in a pub in 2009 as a ‘convertible local currency’ for the city and its surrounding area. It was established to encourage people to spend their money with local businesses. Around 900 businesses accepted it, including local tax collectors, which enhanced its allure. Transactions could be undertaken using paper notes or electronically.

Even before Covid though, the initiative ran aground. Earlier this year, the currency had B£435,000 in circulation, yet its running costs made it unsustainable. Over the summer, the scheme was wound down; notes in circulation will remain legal tender until September 2021 and Bristol pounds held digitally will be converted to Pound sterling.

The Bristol pound is just one example of a type of money. The Bank for International Settlements came up with the idea of a ‘flower’ to illustrate the different types. Money can be categorised by four properties:

• Whether or not it exists as a physical (or digital) object. The opposite is that it exists as an account, for example with a bank.

• Whether or not it has the creditworthiness of a central bank. Paper banknotes have this property, but bank deposits don’t, which is why they need deposit insurance.

• Whether or not it exists in electronic form. Most forms of money have an electronic or digital form these days; gold coins would be an exception.

• Whether or not it is universally accepted. This is where the Bristol pound falls short—try and spend it down the road in Bath and they will look at you like you’re trying to spend Monopoly money.

The Bristol pound languishes at the edge of the flower. These days, most of the activity around money innovation is closer to the centre. In the past few weeks, central bankers around the world have come forward to discuss their plans for central bank digital currencies, and that’s the subject of this piece.

Central Bank Digital Currencies

So what is a central bank digital currency? It’s electronic, it exists as a digital object, and it’s backed by a central bank. So it’s like cash, except it’s electronic; and it’s like Bitcoin, except it’s central bank backed.

If it sounds a bit abstract that’s because it is. Central bank digital currencies aren’t yet in wide circulation. But in China, they’ve started testing them. Earlier this month 50,000 residents in the city of Shenzhen were each given RMB200 in digital currency in a kind of helicopter money lottery. Two million people applied to take part and the successful few were credited the money in an app-based digital wallet, with scope to spend it in over 3,000 local retail outlets. This follows pilot schemes in what now amounts to four cities across the country.

Since the outbreak of Covid, other central banks have started to examine central bank digital currencies more thoroughly. There are two reasons. First, cash usage is shrinking. In the UK, ATM cash withdrawals over the past few months are down by more than 25% versus last year. In Sweden, according to a recent survey, only 9% of people used cash to pay for their last purchase. Digital currencies provide an alternative to cash for those people who rely on it. Central banks are conscious of some of the benefits of cash – such as not having to have a bank account to spend it – and are keen to develop alternatives.

Second, central bank digital currencies can be used as a way to get government stimulus funds directly into the hands of people who need them. Various schemes have been deployed around the world to distribute government funds during the pandemic, but in many cases they have been slow and inefficient (and subject to fraud).

Hence the renewed urgency. In the past few weeks, the European Central Bank has come out with a report on a digital euro; the International Monetary Fund hosted a panel discussing digital currencies, attended by the Chairman of the Federal Reserve; the Bank for International Settlements published a report alongside seven central banks laying out key requirements for a digital currency; and an international conference on the theme was held in Shanghai. This chart shows how sentiment has changed:

Facebook’s Libra project may have something to do with it, too. Like all institutions, central banks are driven by a desire for self-preservation. Libra represents a threat. Although it doesn’t seek to replace central bank money in the way Bitcoin does – it would be backed by a basket of existing currencies – by proposing a global currency, it could make local currencies less relevant. In turn, it could lead to a drain on commercial bank deposits and reduce central bank visibility on transaction data. Mark Carney, then Governor of the Bank of England, raised the alarm in a speech at Jackson Hole last summer and since then, central banks have been galvanised into innovating their own version of a digital currency.

Unfortunately, competition with Facebook isn’t a strategy they can credibly pursue, and so central banks are in the process of justifying what problem they are trying to solve with digital currency. This is not straightforward, since there are a range of objectives, which policymakers may prioritise differently:

• Financial inclusion. Money has a built-in network effect—one of the reasons for the Bristol pound’s lack of traction. As less people use cash, those with no alternative become marginalised. At the same time, digital money may provide those currently unbanked with greater access to the (authorised) financial system.

• Cost of cash. Handling cash has a cost. In Canada that cost is 0.5% of GDP, so it’s likely to be higher elsewhere. Installing digital currency infrastructure may carry a high fixed cost up front, but its operational costs are lower.

• Financial stability. The European Central Bank in particular has expressed concern over the risk of private payment systems crashing, for example through a cyber attack, and promotes the idea of a back-up system.

• Monetary policy formulation. The ability to reach directly into consumers’ pockets enhances the range of options available to steer monetary policy. Interest rates on digital currency can be as negative as policyholders want (they can’t be negative on cash). Transfers can be directed towards specific consumers or used to incentivise purchases from specific merchants or industries.

• Financial monitoring. A (centralised) digital currency provides whoever operates it with real-time data on spending patterns, making the entire economy much more legible. This is one advantage central banks don’t want to give up to Facebook.

How policymakers prioritise these objectives has a large bearing on the design of their digital currency. They also need to weigh up various drawbacks like the impact on the commercial bank sector and privacy concerns. Which makes it fundamentally a political decision rather than an economic or technological one. Many central bankers are still working through this political process. The European Central Bank is moving tentatively, saying that it will start investigating in mid-2021. Meanwhile, Chairman Powell of the Federal Reserve has talked about an extensive public consultation.

China’s DC/EP

One country that is moving much more quickly is China. Having already been looking at the issue for several years, its pilot scheme represents a shift beyond the political and into the technological phase of digital currency design. Its focus is squarely financial monitoring—and not just for the purpose of aggregating economic activity but for surveying individual financial behaviour.

China’s digital currency is known as DC/EP (Digital Currency / Electronic Payment). Some of its features are:

• It mimics cash in that each DC/EP has its own serial number and even denomination, but can only be used via a digital wallet on a mobile phone.

• It works via a two-tier operating system—the central bank of China issues the currency to commercial banks and other intermediaries like Alipay and WeChat Pay, who then distribute it to the public.

• Unlike Alipay or WeChat Pay, it is interoperable, which means that it can be used across platforms just like cash and not just within the closed-wall ecosystems that those two systems incorporate.

• It can be used without a bank account, although transaction limits apply which are lifted as more personal data becomes associated with the account.

• To be universally accepted it needs to be able to work offline; this is one of the technological features that the pilot is exploring.

Critically, transactions conducted via DC/EP are recorded and managed in a centralised ledger by the central bank and include the whole life cycle of the DC/EP—from issuance, through circulation to redemption. This allows the central bank full line of sight into the transaction information while keeping it hidden from the commercial bank or payment provider interacting with the customer. Chinese officials have called this structure an ‘anonymous front-end, real name back-end’.

As members of the Australian Strategic Policy Institute recently wrote, “It has the potential to create the world’s largest centralised repository of financial transactions data and, while it may address some financial governance challenges, such as money laundering, it would also create unprecedented opportunities for surveillance.”

Initially, the launch of a Chinese digital currency is an entirely domestic experiment. But as it gets exported via the digital wallets of Chinese tourists, students and businesspeople, and if foreigners are mandated to use it to access Chinese markets, it may have wide-ranging global consequences. This becomes especially relevant now that Alipay is retrenching from its overseas ambitions. Having invested substantially outside China, Ant Group recently shifted its strategy to concentrate resources at home, paving the way for DC/EP to take share in the cross-border market.

As it expands abroad, DC/EP may be used as a mechanism to disintermediate existing global financial infrastructure like SWIFT. The SWIFT system (which stands for Society for Worldwide Interbank Financial Telecommunications) was established in 1973 to simplify and accelerate settlements between banks. People use SWIFT to transfer money to each other across any currency—last year it facilitated the transfer of $77 trillion. Although it is owned by its members and not any particular nation state, the US is able to use SWIFT to police international sanctions. DC/EP may be a way to circumvent that.

Longer term, there is little doubt China has its sights on the Dollar’s reserve status. It will take longer to overcome, especially with controls still in place around the Renminbi. Nevertheless, China’s DC/EP trials bear watching. As Niall Ferguson points out, financial innovation is linked to financial power and financial power is linked to overall power:

History teaches us that power is inseparable from financial power. The country that leads in financial innovation leads in every way: from Renaissance Italy, through imperial Spain, the Dutch Republic, the British Empire, and the United States since the 1930s. Only lose that financial leadership — just ask poor Mr. Pound, once worth $4.86 — and you lose your place as global hegemon.

The Bristol pound and China’s DC/EP are far removed in scale, reach and technology, but they are both motivated by politics.

Thanks to James Aitken for his insights on this topic.

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Monetising Exhaust Fumes

Root wasn’t the only insurance-themed IPO of the week. MediaAlpha is an online customer acquisition channel serving the insurance industry. It operates a platform linking sellers and buyers of insurance leads.

Suppose a customer lands at an insurance company’s website looking for an auto policy. They fill in all the details required—name, address, age, type of car and so on. Perhaps they get a quote and choose not to take it; perhaps they don’t get a quote at all because the insurer doesn’t like their risk profile. Either way, the customer logs off without converting. The insurer, meanwhile, is left with a fresh pile of data – a lead – which it can sell on to others. MediaAlpha facilitates that sale. It works with 30 insurance companies on the supply side (alongside other parties such as price comparison websites) and multiple insurance companies on the demand side. Each lead is worth around $9 and MediaAlpha takes a cut of around 12%.

The company is similar to EverQuote, which itself IPO’d in 2018. The difference is that EverQuote sources its leads via websites rather than from sellers. It drives traffic to its websites using chum – a delightful word I learned via a (bearish) write-up on the company here. Curiously, EverQuote seems to generate around $12 per lead, which is odd because of their lower quality. It keeps around 24% of that after advertising expenses.

Insurance is a big business—in the US, insurance companies write over $2 trillion of premium a year. To capture it, they spend $144 billion on customer acquisition, of which ~$4 billion is online digital distribution spend. Around that a whole new industry has emerged to help them maximise the ROI on that spend. And so MediaAlpha, founded in 2011, is able to IPO at a $2 billion market cap. As anyone who’s seen Glengarry Glen Ross knows, leads can be gold.

Remutualisation

History moves in cycles and so does business strategy. Jim Barksdale famously observed that there are two ways companies can make money: bundling and unbundling. The notion extends to corporate strategy, where companies consolidate and deconsolidate. In asset management Morgan Stanley is going in at the same time as Wells Fargo is coming out.

And it also extends to mutualisation.

Credit card processing used to be an enterprise collectively managed by issuing banks, until they spun it out as Visa Inc. in 2008. But in July, European banks announced that they are getting the band back together. Sixteen of them are joining forces to launch a new European Payments Initiative. (The initiative was originally slated to be called PEPSI, as discussed in More Net Interest at the time, but for some reason that name was dropped in favour of EPI).

The same thing is happening in the exchange space. A popular Net Interest theme is the shifting power struggle between brokers and exchanges. Just as their bank customers used to own the payment processors, brokers used to own exchanges, until they spun them out in the 1990’s. Recently they too got the band back together to form a new, member-owned exchange called MEMX. Owned by 18 investor-customers including Citi, Bank of America, JPMorgan and Goldman Sachs, MEMX began trading on a trial basis in September; this week it went live on all stocks. History dictates that it will either fail or be spun out. But for now, the signs are looking good.

Hide Not Slide @HideNotSlide

Of all the new stock exchanges launched the last few months, MEMX has far and away been the most successful. Volume as of 10/23: MEMX: 16 million shares (.2% share) MIAX: 500K shares (.006% share) LTSE: 71K shares (.0009% share)

October 26th 2020

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Bank Lending

The European Central Bank released its quarterly survey of bank loan officers this week. It showed a tightening of loans to businesses in the third quarter, expected to continue into the fourth quarter. More concerning from an economic perspective is that there was a significant decline in loan demand compared with the prior quarter, and that loan demand was weaker than banks had anticipated.

Banks do expect a slight pick up in loan demand in the fourth quarter, but if the demand just isn’t there what are they meant to do? The survey shows that the rejection rate of loans remains lower than in the pre-Covid period. Yet regulators are keen to get them lending. The Bank of England is supposedly negotiating with banks to allow them to restart paying dividends as long as capital ratios remain robust and net lending rises. You can lead a horse to water, but you can’t make him drink.