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Uncovering uncovered interest parity: exchange rates, yield curves and business cycles

Published by Anonymous (not verified) on Mon, 13/07/2020 - 6:00pm in

Simon Lloyd and Emile Marin

The textbook uncovered interest parity (UIP) condition states that the expected change in the exchange rate between two countries over time should be equal to the interest rate differential at that horizon. While UIP appears to hold at longer horizons (around 5-10 years), it is regularly rejected at shorter ones (0-4 years). In a recent paper, we argue that interest rates at other maturities — captured in the slope of the yield curve — reflect information about the pricing of ‘business cycle risks’, which can help explain departures from UIP. A country with a relatively steep yield curve slope will tend to experience a depreciation in excess of the UIP benchmark, at business cycle frequencies especially.

Uncovered interest parity

Underpinned by a number of assumptions (including risk neutrality and rational expectations), UIP predicts that the currencies of countries with relatively high interest rates today should depreciate over time, and vice versa for low interest rate economies. This adjustment acts to equalise returns on domestic and foreign assets measured in a common currency.

However, an overwhelming share of empirical evidence rejects the UIP condition, typically using short-horizon interest rates and exchange rate moves of around 4 years or less, giving rise to the UIP puzzle (a.k.a the Fama puzzle). At these tenors, the currencies of high-yield countries tend to excessively appreciate (or insufficiently depreciate), complicating the forecasting of exchange rates. On the other hand, a body of evidence has failed to reject the hypothesis at longer horizons, out to around 10 years.

A role for the yield curve?

The failure of UIP at short-horizons is especially puzzling in light of its long-horizon success. But the stark textbook prediction — that the expected k-period exchange rate change should be proportional to the differential between k-period yields — is the result of strong assumptions, including that of risk neutrality. In reality, investors can buy a range of assets in a variety of currencies and across a spectrum of maturities. When investors are risk averse (ie concerned about uncertainty in the future), interest rate differentials and exchange rates will reflect investors’ perceptions of risks, as well as expected returns. From a cross-country perspective, exchange rate risk premia, which arise to compensate investors for risk, should therefore be predictable by information contained in the entire yield curve. In other words: k-period exchange rate changes are likely to be related to a range of interest differentials, not only the k-period tenor, along the yield curve that influence risk-averse investors’ portfolio choice.

In a recent Working Paper, we test whether information in the entire yield curve, over and above interest rate differentials, can improve our understanding of exchange rate dynamics. We extend an otherwise standard regression test for UIP — a regression of k-period exchange rate changes (e_{t+k} - e_t) on k-period interest rate differentials (i_{t,k}-i_{t,k}^*) — by adding the relative slope and curvature of yield curves as explanatory variables:

\underbrace{e_{t+k} - e_t = \alpha_k + \beta_{1,k}\left( i_{t,k} - i_{t,k}^* \right)}_{\text{Standard UIP Regression}} + \underbrace{\beta_{2,k} S_t^R + \beta_{3,k} C_t^R}_{\text{Additional Terms}} +  u_{t,t+k}

where e_t is the exchange rate of the domestic economy versus the foreign economy, defined as the home price of one unit of foreign currency such that an increase in e_t corresponds to a domestic depreciation. S_t^R represents the difference between countries’ yield curve slopes (defined as the difference between 10-year and 6-month yields) and C_t^R measures differences in how curved countries’ yield curves are (measured as a combination of short, medium and long-term rates).

We estimate both the standard UIP and augmented regressions using data on six major currencies (Australia dollar, Canadian dollar, Swiss franc, euro, Japanese yen and Great British pound) vs US dollar, from 1980:01 to 2017:12, at a range of horizons k, from 6 months to 10 years.

Consistent with the existing empirical evidence, the UIP coefficient \beta _1,_k estimates from the standard UIP regressions (Figure 1) demonstrate the rejection of UIP at short horizons and the failure to reject it at longer horizons. At 6 to 36-month horizons, the estimate is negative, indicating that high short-term interest rate currencies tend to appreciate, instead of depreciate as UIP predicts. In contrast, longer-horizon estimates are positive and close to 1 — ie the k-period exchange rate change is proportional to the k-maturity interest rate differential. At these horizons, in line with UIP, high interest rate currencies tend to depreciate proportionally to interest rate differentials.

Figure 1: Coefficient depicting relationship between interest rate differentials and exchange rate changes at different horizons from standard UIP regression

Notes: UIP coefficient estimates from standard UIP regression measuring relationship between exchange rate changes and interest rate differentials at different horizons, from 6 months to 10 years. Red bars denote error bands.

Mirroring the UIP puzzle, interest rate differentials only explain a small proportion of exchange rate variation at short-to-medium horizons (Figure 2). This has contributed to the idea that exchange rates do not mirror macroeconomic fundamentals, a phenomenon dubbed the ‘exchange rate disconnect’. But augmenting the UIP regression with measures of the relative yield curve slope and curvature helps to increase the fit for exchange rates. The improvement is particularly pronounced at 3 to 5-year horizons, where interest rate differentials alone capture less than 3pct of variation in yields. The addition of relative slope and curvature almost treble the share of explained variation.

Figure 2: Proportion of exchange rate variation explained by interest rate differentials, and the relative yield curve slope and curvature

Notes: Fraction of exchange rate variation explained by a UIP condition (red) and the yield curve-augmented specification (black) at different horizons, from 6 months to 10 years.

Focusing on the contribution of the yield curve, Figure 3 plots how a 1pp increase in a country’s yield curve slope relative to the US affects exchange rates, in pct. The estimates reveal a tent-shaped relationship between exchange rates and the relative slope across horizons. At short horizons (6-months and 1-year) and longer-horizons (6 to 10-years), estimates suggest no relationship between the two. But at medium horizons (1.5 to 5.5-years), the relative slope and exchange rates tend to be positively related, with the relationship strongest at the 3.5-year horizon.

Figure 3: Coefficient depicting relationship between relative yield curve slope and exchange rate changes at different horizons

Notes: Relative slope coefficient estimates from yield curve-augmented specification (black) at different horizons, from 6 months to 10 years.

Exchange rates and the business cycle

The fact the positive relationship between exchange rates and the relative yield curve slopes is strongest at business cycle frequencies suggests that yield curve slopes reflects information about countries’ relative future economic prospects which are relevant for exchange rates. This is unsurprising when considering that the yield curve is often cited as a good predictor of future GDP growth.

To understand why a steep yield curve slope is associated with a subsequent exchange rate depreciation, consider two things. First, an exchange rate depreciation increases a domestic investors’ return on foreign assets when evaluated in domestic currency terms. Second, a steep yield curve today indicates that future economic prospects and returns are expected to be strong. Knowing better times lie ahead in the distant future, a risk-averse investor will value nearer-term returns relatively highly — wanting to reallocate returns from the distant future to nearer-term. When this desire is stronger for an investor in one country relative to another — reflected by a relatively steep yield curve — their valuation of nearer-term returns will be comparatively high. Reflecting the data, a transitory exchange rate depreciation is required in the nearer-term (relative to UIP) for currencies with a relatively steep yield curve, in order to reallocate returns in response to ‘business cycle risk’.

Yield curve inversions and the return of UIP

Although this relationship between yield curve slopes and exchange rates persists over time, we also show that yield curve inversions are associated with a change in exchange rate dynamics, consistent with evidence that the yield curve is a harbinger of downturns.

Figure 4 presents estimates of UIP coefficients \beta _1,_k over two different periods: periods in which yield curves are upward sloping — as they are on average — and periods in which they are inverted. Consistent with the UIP puzzle, the coefficient estimates are below 1 at short horizons. High interest rate currencies appreciate relative to the UIP. But during inversions, the coefficient reverses significantly in sign at short horizons (6 to 18-months). At these frequencies, high-yield currencies depreciate excessively relative to UIP when yield curves are inverted.

Figure 4: Relationship between interest rate differentials and exchange rate changes at different horizons when yield curves are upward sloping (black) and inverted (red)

Notes: UIP coefficient estimates at different horizons (from 6 months to 10 years) from UIP condition when domestic yield curves slope upwards (black) and when they invert (red). Grey shaded area and red bars denote error bands.

These novel results are difficult to reconcile in standard models, but in our working paper we interpret them through the lens of a literature studying ‘rare events’. Consider again the role of yield curve inversions as a harbinger of downturns. In such a ‘rare event’, investors’ return valuations can evolve in a non-linear fashion. With a domestic yield curve inversion signalling an increase in the likelihood of a domestic downturn, domestic risk-averse investors will value returns disproportionately highly relative to foreign investors. By the same reasoning as before, the exchange rate will depreciate in the near-term to reallocate returns.

These findings speak to a growing literature on the ‘New Fama Puzzle’, which highlight changes in exchange rate dynamics following the global financial crisis. In particular, our results suggest that these ‘flips’ in UIP coefficients are a more pervasive feature of exchange rate dynamics, arising around economic downturns more generally, rather than the global financial crisis specifically.

Conclusion

Overall, our results suggest that information in the entire yield curve, over and above spot interest rate differentials, can help to explain exchange rates. A country with a relatively steep yield curve slope will tend to experience a depreciation in excess of the UIP benchmark at business cycles frequencies. We argue that these dynamics arise because the yield curve slope captures information about risk-averse investors’ expectations of future economic prospects, which exchange rates respond to. Although the relationship between the relative yield curve slope and exchange rates is persistent, we also demonstrate that yield curve inversions signal changes in exchange rate dynamics, adding further nuance to the UIP puzzle.

Simon Lloyd works in the Bank’s Global Analysis Division and Emile Marin works at the University of Cambridge.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

White Paper: Modern Monetary Theory (MMT)

Published by Anonymous (not verified) on Sun, 05/07/2020 - 3:39am in

Warren Mosler email hidden; JavaScript is required
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Published online 4th July 2020

 

Full Document

 

Introduction

 

The purpose of this white paper is to publicly present the fundamentals of MMT.

What is MMT?

MMT began largely a description of Federal Reserve Bank monetary operations, which are best thought of as debits and credits to accounts as kept by banks, businesses, and individuals.

Warren Mosler independently originated what has been popularized as MMT in 1992.  And while subsequent research has revealed writings of authors who had similar thoughts on some of MMT’s monetary understandings and insights, including Abba Lerner, George Knapp, Mitchell Innes, Adam Smith, and former NY Fed chief Beardsley Ruml, MMT is unique in its analysis of monetary economies, and therefore best considered as its own school of thought.

 

 

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The post White Paper: Modern Monetary Theory (MMT) appeared first on The Gower Initiative for Modern Money Studies.

Britain was not "nearly bust" in March

Published by Anonymous (not verified) on Wed, 24/06/2020 - 2:49am in

"Britain nearly went bust in March, says Bank of England", reads a headline in the Guardian. In similar vein, the Telegraph's Business section reports "UK finances were close to collapse, says Governor":Eh, what? The Governor of the Bank of England says the UK nearly turned into Venezuela? Well, that's what the Telegraph seems to think: 

The Bank of England was forced to save the Government from potential financial collapse as markets seized up at the height of the coronavirus crisis, Governor Andrew Bailey has said. In his most explicit comments yet on the country's precarious position in mid-March, Mr Bailey said 'serious disorder' broke out after panicking investors sold UK government bonds in a desperate hunt for cash. It left Britain at risk of failing to auction off the gilts needed to fund crucial spending - and Threadneedle Street had to pump £200bn into markets to restore a semblance of order.

Reading this, you would think that the UK government's emergency gilt issues had triggered a sterling market meltdown, wouldn't you? If this is indeed what happened, then the Bank of England has strayed far beyond its mandate and compromised its independence. Why on earth the Governor would voluntarily admit this surely requires some explanation. After all, if it is true, it could cost him his job. The source for the Telegraph's extraordinary claim is this 51-minute podcast from Sky News, in which Sky's economics editor Ed Conway and former Chancellor Sajid Javid grill the Governor on his handling of monetary policy during the coronavirus crisis. The particular part of the interview that has raised eyebrows is in this clip, which I have transcribed here:

Bailey: We basically had a pretty near meltdown of some of the core financial markets….I got to Wednesday afternoon, and the markets team came down here, and you know it’s not good when they turn up en masse, and you know it’s not good when they say “we’ve got to talk”, and it wasn’t good. We were in a state of borderline disorderly, I mean it was disorderly in the sense that when you looked at the volatility in what was core markets, I mean core exchange rates, core government bond markets, we were seeing things that were pretty unprecedented certainly in recent times, and we were facing serious disorder.

Conway: How scary was that? What would have happened if the Bank hadn’t stepped in?

Bailey: “Oh I think the prospects would have been very bad. We would have had a situation in which in the worst element the Government would have struggled to fund itself in the short run”. 

So no, the market meltdown was not triggered by high government spending. The market meltdown was because of investors panicking about Covid. It did, however, threaten to cause a government debt crisis.

Or - did it? Government struggling to fund itself "in the short run" simply means that it might have needed to pay out money before it could raise it. Normally it would cover short-term cash needs by issuing Treasury bills, which are short-dated, highly liquid bonds with very low interest rates. But when markets are malfunctioning, it can't do this. And high-interest gilts or pandemic bonds would take time to issue. So it could potentially find itself short of ready cash for urgent spending. However, as I have explained before, not being able to raise immediate funds for an urgent purchase is not insolvency, it is illiquidity. Relieving temporary illiquidity is what central banks do, and have done since the time of Bagehot. Historically they have done so not only for banks, but also for governments. And in the UK, the Bank of England still bears this responsibliity. The Ways and Means overdraft (which was extended in April) is the living evidence of the Bank of England's role as liquidity provider of last resort for the UK Government. But it is simply a working capital overdraft, such as any solvent business would have. Using this overdraft in no way implies that the Government is "insolvent", "bust", "bankrupt" or any of the other inflammatory headlines that journalists like to use. And nor does it mean the Bank of England is financing government deficit spending on anything other than a very short-term basis. It simply smooths out cash flow. Conway's assertion that the Government was "within a whisker of insolvency" is total nonsense, as is the Guardian's claim that "Britain nearly went bust in March". The Government was not shut out of markets long-term, as an insolvent sovereign would be. It had short-term cash flow problems solely because markets were malfunctioning.  Indeed, in another part of the interview Bailey said exactly this (my emphasis):

Conway: At the time you were nervous about government not being able to finance itself. 

Bailey: Yes, because of market instability.

Bailey went on to explain that the reason why the Bank intervened was not because the Government was having funding difficulties, but because market instability was driving up interest rates across the entire economy, and indeed across the whole world:

How would this have played out if we hadn’t taken the action that we and other central banks took? I think you would have seen a risk premium enter into interest rates, I think markets would have priced in a risk premium, and it could have been quite substantial given the degree of instability we were seeing. That would have raised the effective borrowing cost throughout the economy. In terms of the Bank of England's objectives, that would have made it harder for us to achieve our objectives, both in terms of inflation and in terms of economic stability.

The market meltdown was weakening central banks' hold on interest rates. They had to act, not to protect government finances but to prevent monetary conditions from tightening sharply, potentially triggering a dangerous debt deflationary spiral. The first responsibility of central banks in this crisis has been to prevent an exogenous shock to the real economy from triggering a financial crisis that would amplify the shock and significantly deepen the inevitable recession. That's what the exceptional interventions by central banks, including the Bank of England, since March have been all about. 
Bailey observed that although the UK Government was the largest borrower in the sterling market, it was far from the only one. Big corporations were borrowing enormous amounts, both in the market and from banks. Interest rates were rising on their bonds as well as government bonds. So the fact that the Government was the largest borrower was "actually largely irrelevant to that argument about a risk premium and an increase in the effective rate of interest."Bailey said that the £200bn of QE announced by the Bank of England the day after his crisis meeting with the markets team was to provide emergency liquidity to the whole market.  By injecting very large amounts of liquidity into the market, the Bank of England aimed to slake investors' thirst for cash and stop the fire sales that were driving up interest rates. And it succeeded. As a by-product of this action, the UK Government regained access to short-term market funding. But Bailey insists that ensuring the Government could fund itself was not the primary target. Regaining control of interest rates was. 
The market meltdown in March also affected banks. It's a measure of how far we have come since 2008 that Conway & Co made nothing of the fact that the Bank of England had to provide emergency liquidity support to banks. Keeping banks afloat when markets are melting down is all in a day's work for a central bank, these days. Nothing to look at at all. But if a central bank provides emergency liquidity support to a government struggling to raise short-term cash when markets are melting down, that means the government is bust, the central bank is captive and the country is Venezuela? How utterly absurd. 
I found the interviewers' constant focus on government financing a serious distraction from what was an important story about the Bank's vital responsibility for ensuring the smooth operation of financial markets. When financial markets melt down as they did in 2008, the whole world suffers. Central banks saw the same thing happening again in March 2020, and acted to stop it. And their action was extremely effective. It seemed to me that this was the story Bailey really wanted to tell, but the interviewers were intent on pushing him towards the issue of monetary financing and the Bank's independence. Sajid Javid, in particular, seemed to want Bailey to paint the Chancellor's handling of the crisis as irresponsible and profligate. Which genius at Sky News thought it was a good idea for the Chancellor who was forced out of his job without ever producing a Budget to discuss the performance of his successor with the Governor of the Bank of England?
Finally, it is extremely unfortunate that none of the media reports highlighted Bailey's strong endorsement of the Government's exceptional measures to support people through this crisis:

It's entirely necessary that the state has to step in at this point. In a shock of this nature, you can't leave it to individual citizens to find their way through it, "well, good luck" sort of thing. The state has to assert its role at this point, which it did. It wasn't easy, but it did it. 

Fiscal policy is pre-eminent. The Bank of England's job is to ensure the smooth functioning of markets and keep the economy as stable as possible so that the Government can support people through this crisis. And that is what it is doing - successfully. This, not "Britain nearly went bust", is what should be on the front page of every newspaper. 
Related reading:
Pandemic economics and the role of central banksThe End of Britain?

There’s more to house prices than interest rates

Published by Anonymous (not verified) on Wed, 03/06/2020 - 6:00pm in

Lisa Panigrahi and Danny Walker

The average house in the UK is worth ten times what it was in 1980. Consumer prices are only three times higher. So house prices have more than trebled in real terms in just over a generation. In the 100 years leading up to 1980 they only doubled. Recent commentary on this blog and elsewhere argues that this unprecedented rise in house prices can be explained by one factor: lower interest rates. But this simple explanation might be too simple. In this blog post – which analyses the data available before Covid-19 hit the UK – we show that the interest rates story doesn’t seem to fit all of the facts. Other factors such as credit conditions or supply constraints could be important too.

Chart 1: Real house prices in the UK

Interest rates have fallen substantially in the UK over the past few decades. The rate on 10 year government bonds – the ‘risk free’ benchmark – is under 1% today, compared to 5% in 2000 and 12% in 1980. In real terms, the 10 year rate is around 7 percentage points lower than it was in 1980. Rates have fallen in many advanced countries, not just the UK. In fact, as Chart 2 shows, the fall in UK rates since 1980 is slightly less than the average across a sample of advanced economies.

Chart 2: Nominal long-term rates in advanced economies

In a standard asset pricing framework, a fall in risk free rates mechanically translates into a rise in asset prices. Discount rates are made up of a risk free rate plus a risk premium. This framework would predict large rises in the prices of many assets in response to the fall in risk free rates in recent decades. Given the fall in UK risk free rates from 1980 to today, a fictional asset that pays out a constant 9% of its price in cash every year and with a constant risk premium of 4%, would have quadrupled in price all else equal.

An influential academic paper from the 1980s showed that housing can be modelled like any other asset. The ‘user cost’ of owning a house should be equal to the rent. If prices were too high, there would be an incentive to rent, which would lead to a fall in prices. A recent post on this blog based on a paper by Miles and Monro (2020) found that the fall in rates over the past four decades, combined with the increase in incomes, might explain all of the rise in UK house prices since then.

But there are a number of facts that this framework doesn’t seem to explain.

The timing of the fall in rates and the rise in house prices doesn’t line up. Chart 3 plots the path of both variables for the UK. There are two periods that stand out. In the decade from 1990 to 2000, UK house prices rose by just 30% while rates more than halved, falling from 11% to 5%. Then from 2000 to the start of the financial crisis in 2008, house prices doubled while rates barely budged. Since the crisis rates have fallen to just above zero and house prices have risen by a further 20%. They have remained flat in real terms on average.

Chart 3: Nominal UK average house prices and nominal long-term rates

UK house prices have risen by more than in almost any comparable country. As Chart 4 makes clear, only three advanced economies – Australia, Norway and Spain – have seen a bigger rise in prices than the UK since 1980. At the other end of the spectrum, house prices in Japan are barely above their 1980 level. All of these economies have seen a similar fall in interest rates to the UK. If UK house prices had grown at the same rate as in the average advanced economy, they would be at half the level they are at now.

Chart 4: Nominal average house prices in advanced economies

The framework doesn’t account for house price growth in other countries. We have calculated what a user cost model would predict for house price growth in the UK and other countries since 1980. The model we use is the same as the one used this previous post and explained in some detail in this working paper, with a different data source. We input actual data on average rents and interest rates for each economy and hold all other factors constant over time. As Chart 5 shows, this model works relatively well for the UK, predicting only slightly higher price growth than we observe in the data. However, for countries like Germany, Italy and the US, the model predicts house prices of more than double the actual level in the latest data.

Chart 5: Predicted house prices in advanced economies vs actual prices

Other UK asset prices have risen by the same amount as in other countries. Given the growth in UK house prices, you might expect other UK asset prices to have risen a lot too. The most accessible risky asset class for households, apart from housing, is equities. Chart 6 compares UK equity prices to other advanced economies. Since 1980 equity prices have risen by almost exactly the same amount in the UK as in the average advanced economy.

Chart 6: Nominal equity prices in advanced economies

There has been large variation in house price growth across regions of the UK. Chart 7 shows how house prices have evolved at the local authority level in the UK over the period for which the statistical authorities produce data. London has seen the highest growth in house prices of any region. The City of London, Newham and Waltham Forest have all seen prices quintuple since 2000. In Blackpool, Burnley and the Isles of Scilly prices have risen by less than half as much over the same period. On a regional basis, house prices in the North East have grown the slowest. A previous post noted that rates alone would not explain this regional variation.

Chart 7: Nominal house prices in UK local authorities

The framework doesn’t account for differences in house price growth across UK regions. We again use a user cost model to predict regional house price growth, taking into account how rents have varied across regions and over time. We look at price growth since 2005, which is the period for which the statistical authorities produce data. And we hold all other factors constant, apart from the fall in rates, which applies to all regions. Chart 8 shows that though this model performs fairly well for the West Midlands and the North West, it under-predicts house price growth in London, the East and South East, and over-predicts it for the other regions. This may be because for regions like London, expectations of rental growth have risen over this period, or because houses in these regions are increasingly seen as safer assets than those in other regions.

Chart 8: Predicted house price growth in UK regions vs actual growth

So what might the framework be missing?

All economic models involve abstractions and simplifications – if they didn’t they would be useless. But given the importance of housing to economic growth and people’s wellbeing, and that changes in house prices could impact financial stability, we need a model that captures the key drivers.

There could be a role for changes in credit conditions. The framework assumes that people are not credit constrained, meaning they can exploit arbitrage opportunities by buying up rental properties. If there are frictions in practice, this could mean that credit conditions matter for house prices. Mortgage debt expanded rapidly as house prices rose in the UK before the crisis, so this could be an important channel for the UK.

The framework does not include an explicit role for supply elasticity. In practice, evidence suggests that housing supply responds very differently to prices in different countries and regions. The Barker review of UK housing supply pointed to low elasticity of supply in the UK. Where supply elasticity is low, as is the case in the UK, the same change in rates will have a larger impact on prices and rents. More work is likely required to document UK supply elasticities in detail and to explore what different elasticities have meant for growth in prices and rents over time and across places.

It’s hard to measure how expectations and risk premia vary over time and place but this could be important. Within the framework, an increase in rental growth expectations or a fall in risk premium would imply an increase in price. There is some evidence to suggest that returns on housing have been similar to other risky assets and relatively constant over the long term.

Other relevant factors might include maintenance costs and taxes. Maintenance costs have risen in line with inflation in the UK. UK property taxes are small and have been relatively flat – but there is evidence that higher taxes would likely reduce house prices. All of these are subject to considerable uncertainty.

Regardless of the consequences of Covid-19 on house prices, the long-term drivers discussed here will remain crucial parts of policy questions in coming years. Future research might be needed to better quantify some of these factors and to build them into a richer modelling framework that considers interactions between interest rates, credit conditions, rents and house prices.

Lisa Panigrahi and Danny Walker work in the Bank’s Macro-Financial Risks Division.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

Too Good To Be True

Published by Anonymous (not verified) on Fri, 06/03/2020 - 9:58am in

"USD-backed stablecoin is 10x better than your savings account," runs the headline on an unsolicited press release in my inbox yesterday. And it goes on to explain:

The average interest rate for savings accounts in the US currently stands at 0.09%, with some German banks even charging negative interest rates.

Universal Protocol, a coalition of leading blockchain organizations, including Uphold, Cred, Blockchain at Berkeley, and Bittrex Global, has recently introduced interest rates of 10% p.a. for its USD-backed stablecoin UPUSD. 

Ok, so they are issuing an altcoin at high interest rates. Why are they comparing this with FDIC-insured savings accounts?

The UPUSD is a fully-transparent digital asset that is collateralized 1-to-1 with US dollars and held at US-domiciled, FDIC-insured banks. 

FDIC-insured banks don't hold digital assets. They hold US dollars. So this should read "collateralized 1-to-1 with US dollars held at US-domiciled, FDIC-insured banks." Perhaps the redundant "and" is a typo?

But even when corrected, this statement is so misleading it amounts to mis-selling. It implies that anyone who invests in this altcoin benefits from FDIC insurance. This is not the first time I have seen this claim made about cryptocurrency investments. It wasn't true last time, and it isn't now.

FDIC insurance protects the customers of regulated US banks from losses if the bank fails. Currently, the insurance only covers US dollar holdings of up to $250,000 per depositor, institution and ownership category. Universal Protocol presumably has corporate accounts, which are an ownership category: these would thus be covered up to a maximum of $250,000 per bank (not per account).

Universal Protocol's website says its "mission" is to bring 100 million new users into cryptocurrency.  Assuming that the minimum a user can hold is one UPUSD, this would mean Universal Protocol holding $100m US dollars in FDIC-insured bank accounts. The US has more than 5,000 FDIC-insured banks and savings institutions, so it would in theory be possible for all of this money to be distributed across US banks. However, managing hundreds of banking relationships would be an enormous overhead. I suspect that if it comes anywhere near succeeding in its mission, Universal Protocol will find that ensuring FDIC backing for all of its USD reserves isn't something it really wants to do.

However, currently the reserves backing UPUSD are far below the FDIC limit. This is from the UPUSD page on Universal Protocol's website:

The stablecoin is underpinned by reserve management developed by Uphold, the world’s most transparent digital money platform, which has handled nearly $4 billion in transactions and publishes its assets and liabilities in real-time.

Uphold publishes its reserve holdings on its website. Tier 5 is described as "a series of tokens and stable coins issued by Universal Protocol as part of a new universal transparent reserve standard which features innovative safeguards like recoverability and inheritability." The three coins listed here are UPUSD, UPBTC and UPEUR. At the time of writing, UPUSD in issue are valued at $60,686.56. If these coins are fully backed by USD as Universal Protocol claims, then this is the amount of USD reserves currently held in banks. So they have some way to go before their claim that the reserves are fully FDIC-insured starts to look shaky.

But there is a much bigger problem with Universal Protocol's implied claim that UPUSD investments would be FDIC-insured. Uphold's description of UPUSD says this:

U.S. dollars are held at banks located in the United States with the intention of being eligible for FDIC “pass-through” deposit insurance, subject to applicable limitations.

Pass-through insurance applies when a bank has a fiduciary duty towards a third party, for example if it is acting as custodian for third party funds. It does not apply to investments. If pass-through insurance were to apply to customer UPUSD holdings, therefore, the USD reserves backing them would have to be held in some kind of custody account on behalf of UPUSD holders. The crypto exchange Gemini, for example, explicitly states that it is a fiduciary and custodian for USD deposits, and on that basis advises customers that it intends their deposits to be eligible for pass-through insurance. Here's how Gemini describes its management of USD deposits:

Your fiat currency deposits are: (i) held across our Customer Omnibus Accounts in the exact proportion that all Gemini Customer fiat currency deposits are held across our Customer Omnibus Accounts; (ii) not treated as our general assets; (iii) fully owned by you; and (iv) recorded and maintained in good faith on our Exchange Ledger and reflected in a sub-account (i.e., the Fiat Account of your Gemini Account) so that your interests in our Customer Omnibus Accounts are readily ascertainable. Our records permit the determination of the balance of U.S. dollars for a particular Gemini Customer as a percentage of total commingled U.S. dollars held FBO all Gemini Customers in all Customer Omnibus Accounts in a manner consistent with 12 C.F.R. § 330.5(a)(2).

Uphold's equivalent paragraph appears to be this:

We maintain at all times a fiat currency deposit balance for the benefit of users that hold Universal Stablecoins that is equal to or greater than the amount of Universal Stablecoins issued and in circulation. You can view the balance of U.S. dollars, Euro or other fiat currency on Uphold pegged to the respective Universal Stablecoin and the amount of Universal Stablecoins held on the Uphold Platform on our Transparency Page.

Gemini specifically says that fiat currency placed on deposit belongs to the customer. But Uphold makes no such statement. Nor does it describe itself anywhere as a fiduciary or custodian. The Transparency Page discloses Universal Protocol's total stablecoin issuance and associated reserve balance, not individual customer reserve balances. And throughout their documentation, both Uphold and Universal Protocol repeatedly refer to the US dollars held in banks as "our reserves". That's not a custodian relationship.

The fact is that buying UPUSD isn't remotely similar to placing dollars on deposit with a custodian intermediary. It is investing in publicly-traded digital assets for profit. FDIC pass-through insurance does not apply to other USD-backed publicly-traded investments such as mutual funds. It therefore seems unlikely that UPUSD purchases will be eligible for FDIC insurance. Unless FDIC says otherwise, those buying UPUSD should assume that they are uninsured.

And it gets worse. Not only are these investments probably uninsured, they are also high risk, complex and opaque. And the returns on them aren't anything like as good as Universal Protocol claims.

Simply buying UPUSD doesn't earn you any interest. To earn a return, you have to lend it out using the Uphold Earn app, also known as Cred Earn. And the interest rate you get depends on the type of asset you lend. Cred Earn says that Uphold members can earn up to 10% interest when they loan certain digital assets to CRED. Currently, the digital assets that can be loaned are BTC, XRP, ETH, Euro, USD and Gold. The interest rate you get depends on the type of asset you lend out. To get 10%, you have to lend BTC. Thus, to earn 10% interest you have to exchange a stablecoin backed 100% by USD reserves for a highly volatile cryptocurrency. I could find no evidence in Cred's marketing material that 10% could be earned in any other way. So Universal Protocol's claim that its USD-backed stablecoin enjoys interest rates of 10% isn't really true.

There is good reason for the promised returns to prove elusive. Browsing Cred's website finds this:

Cred offers sub-10% APR on loans, not 25% like banks and credit card companies.

Clearly, it isn't going to pay anything like 10% on most deposits. Everything except BTC earns 3-5%. If the average loan rate is 8-10%, that is a respectable margin. But is an interest rate of 3% really sufficient to compensate investors for the loss of FDIC insurance, when online banks are offering between 1.5% and 2% on FDIC-insured accounts?

And then there is the nature of the lending on which these somewhat underwhelming returns depend.
When you lend your UPUSD, or BTC, or whatever, you aren't lending it to Uphold or Cred. You are lending it to third party borrowers. This was CredEarn's answer to the question "What do you do with my crypto assets?"

Cred offers crypto lending on a collateralized and guaranteed basis. Your crypto assets are used to lend. Cred acts as an intermediary between borrowers and lenders.

Cred says that borrowers borrow under its own credit line against cryptocurrency collateral. But the funds it lends out aren't its own. Unlike a bank, it physically transfers funds you have chosen to lend out into its lending pool:

Loan assets are swept from customer accounts on the 1st and 15th of every month. For example, if you pledge assets in the week of Jan 28th, funds will be removed from your Uphold wallet on February 1st and you will start earning interest that day (February 1st). If you pledge on February 5th, the assets will be swept from your account on the next funding date - February 15th - and you will start earning on Feb 15th.

And unlike a peer-to-peer lender, you won't know who borrows your funds or what they use them for. All you are told is this:

Your pledged assets are used to lend to and transact with a variety of customers, including retail borrowers and money managers with well-established track records.Cred does not lend to short-sellers.

Cryptocurrency lending is not like bank lending. People don't borrow cryptocurrencies to buy cars or houses, or even to fund business ventures. No, they borrow cryptocurrencies to trade them for other cryptocurrencies, often at very high leverage. Cred partners with crypto exchanges such as Bitbuy and Bittrex Global, which don't offer margin lending facilities to traders. It's not difficult to work out where your funds are going.

Furthermore, the message on the Earn screen saying what Cred does with your pledged assets also appears on the Borrow screen. So it seems that Cred lends out the crypto assets that borrowers pledge as collateral. And you thought your funds were safe?

The press release I received misleadingly presents UPUSD as a high-interest substitute for FDIC-insured US dollar bank accounts. Nowhere does it say that UPUSD might not be covered by FDIC insurance. Indeed, by saying UPUSD is fully backed by USD reserves in FDIC-insured banks, it gives the impression that this investment is as safe as an insured savings account. It also fails to disclose the fact that the advertised interest rate can only be earned by taking on considerable market and credit risk, and that investors' funds may be used for speculative purposes. It is hard not to conclude that the press release is intended to mislead naive retail investors into moving their funds from insured savings accounts to highly risky uninsured investments.

Before writing this piece, I informed Dan Schatt, chairman of Universal Protocol and (surprise, surprise) president of Cred, of my intention to warn the public that his product is in no way equivalent to an insured bank savings account, that investments would probably not be FDIC insured, and that investors would only earn the advertised rate of interest if they allowed their funds to be lent to margin traders at high leverage. I invited him to explain to me why I should not do this. I received no response. So here is my warning.

High returns always mean high risk. If someone promises high returns with no risk, they are selling snake oil. Don't be fooled. 

Trudeau’s proposed speculation tax

Published by Anonymous (not verified) on Thu, 26/09/2019 - 11:45am in

I’ve written a blog post about the Trudeau Liberals’ recently-proposed speculation tax on residential real estate owned by non-resident, non-Canadians.

The full blog post can be accessed here.