The Marshall Islands SOV Deconstructed

In 2018, the Republic of Marshall Islands (RMI) parliament passed the Sovereign Currency Act 2018 (the SOV Act), which established the digital currency Sovereign (SOV) as second legal tender in addition to the US dollar based. As legal tender, the SOV would be able to be used for any purchases as well as all payments of debt and tax obligations. Pursuant to this law, the SOV would be issued by the Ministry of Finance and would be non-redeemable. It was to be introduced via an initial coin offering (ICO), which the appointed organizer – SFB Technologies was tasked to perform. The law also requires transparency over the identity of the SOV users. The SOV would be issued on the Algorand blockchain.

One main purpose of the SOV is to generate revenue for the government. Additional motivations expand financial inclusion and improve RMI’s access to the global digital financial system.

After the initial issuance through an ICO, the number of SOV units would grow by 4 percent per year coded into the blockchain independently of the demand for the currency. Half of the revenue from the initial issuance (24 million SOVs) would be allocated to SFB Technologies and the other half to the RMI government. SFB technologies is tasked with developing and implementing the SOV and would bear all the necessary costs to issue the SOV and perform the ICO.

SFB technologies was planning on organizing a pre-sale of rights to future SOV units, with an eye to “test the markets and technology” and to gather additional information that could inform the government’s decision whether to proceed with the launch of the SOV. The pre-sale as currently conceived is independent of the RMI government and is designed as a private sale.

At a first glance, this arrangement sounds great, but a closer look reveals that it sounds too good to be true. Let us deconstruct the statements above to figure out where the SOV’s fatal flaws lie.

First, introducing the SOV would imply that the RMI would move to a dual currency system. In the absence of a monetary policy framework and a central bank this would impose significant risks to macroeconomic, monetary, and financial stability. The fixed annual growth rate of 4 percent irrespective of the demand for the currency would lead to large fluctuations in the value of the SOV against other currencies, including the U.S. dollar, the primary legal tender. These fluctuations, in turn, could create incentives for households, firms, and visitors to hoard the more stable/appreciating legal tender, while discharging debts and other obligations, including tax obligations, in the depreciating legal tender. This could have serious adverse consequences for the RMI’s public finances. Also, given that the RMI does not have a central bank, the country would effectively outsource its monetary policy to a private sector party creating a strong dependency.

Second, SFB technologies is foreign start-up with limited financial sector experience. The company’s intention was to seek financial support from potential investors to finalize the design of the SOV highlighting the immaturity of their technical concept. Also, SFB technologies’ dual role of issuer and private investor may create the appearance of a conflict of interest.

Third, based on the SOV’s issuance through an ICO as a way of raising revenue can be considered a securities offering. As there is no securities regulation governing either the pre-sale or the actual issuance, the RMI exposes itself to a regulatory vacuum unable to thwart or respond to potential fraud and manipulation.

Fourth, the identity of SOV users is expected to be verified through licensed international exchanges. However, licensing exchanges that will list the SOV is a mammoth task that may exceed this small country’s existing regulatory capacities. Moreover, although the exchanges are responsible for identity verification and establishing white and black lists for financial integrity purposes, the RMI government would still have to manage those lists as well as monitor and enforce compliance. Given the weakness of the country’s anti-money laundering (AML) and counter-terrorism financing (CFT) regime and capacity constraints within the regulatory and supervisory agencies, it remains questionable whether financial integrity risks can be mitigated adequately. The Digital Economic Zone for the exchange of virtual assets would only exacerbate the financial integrity issues.

Fifth, the stated goal behind the SOV is to raise revenue for the government to offset the fallout from revenue from the reduction of the U.S. Compact grants after 2023. However, there is no indication how much revenue the SOV issuance would generate. For revenue to be sizeable, there would need to be strong demand for SOV by foreigners. This seems difficult given the strong competition from existing crypto assets. In addition, through the SOV issuance, the small economy’s revenues would be subject to global crypto market price volatility.

Finally, the country’s frequent power and network outages could hamper the issuance and wide-spread use of the SOV, obstructing the goal to achieve financial inclusion and impeding the country’s access to the global digital financial system. More importantly, the SOV issuance could jeopardize the country’s last U.S. corresponding banking relationship with First Hawaiian Bank exacerbating the RMI’s access to global financial networks.

It is easy to get blinded by the promise of enormous revenue from a state-backed crypto-asset like the SOV especially considering impending revenue fallouts. But issuing, managing and sustainably maintaining a crypto-asset designated as legal tender is a complex endeavor and requires important prerequisites such as an adequate legal and regulatory framework, sufficient capacity to supervise and regulate the SOV as well as the security of the underlying system and a viable digital infrastructure. Rather than embarking on a project of this magnitude and complexity, the Marshallese could consider other options such as rationalizing public spending which is the highest in the Pacific region to unlock extra revenue, lean on regulated stablecoin or e-money providers to expand access to finance, work with development partners such as the World Bank or the Asian Development Bank to expand the country’s core infrastructure and request technical assistance to enhance the country’s legal and regulatory regime.

The government is now considering to repeal the SOV Act and a bill on establishing a Digital Economic Zone was submitted to the Parliament recently.

Central Bank Digital Currency (CBDC) Privacy and Transparency: Not So Black and White

In designing central bank digital currency (CBDC), central banks face a trade-off between satisfying legitimate user preferences for privacy and mitigating financial integrity risk. Physical cash protects privacy because it is anonymous, but it also facilitates criminal financial transactions such as money laundering, financing of terrorism, corruption, and tax evasion.

A CBDC that gives authorities access to user identity and their transaction data would provide obvious financial integrity oversight benefits. However, such fully transparent CBDC might raise concerns around digital surveillance with CBDC potentially being instrumentalized against users, especially in jurisdictions where trust in public institutions is low. Also, such CBDC might disadvantage those without access to identification, which could impair financial inclusion efforts.

On the other hand, a fully opaque CBDC that hides users and their transactions from authorities, could introduce significant financial integrity risks, notably due to the ease and speed with which transactions can be performed and their potential global reach. Privacy preferences are not driven only by the desire to conduct illicit transactions but also to mitigate spamming and identity theft, and of being stalked or robbed (Kahn and others, 2005).

But there are many dimensions of anonymity and privacy with different CBDC design implications.

Dimensions of CBDC Anonymity and Privacy

Brookings (2020) and R3 (2021) specify two dimensions of privacy – anonymity and transaction privacy. Anonymity means that it is impossible to link transactions or activity to the sender or recipient. Under the EU General Data Protection Regulation (GDPR) identity data is considered personal data, i.e., any piece of information that relates to an identifiable person. This can range from pseudonymous keys or metadata (e.g., location data or online identifier) to personally identifiable information, like government ID numbers. A transaction is private if related metadata (e.g., whether it occurred, its amount, between who and when, whether the two parties have transacted before) is not revealed.

Then there is the question of who and how identity and transaction data is shared with. Bech and Garratt (2017) specify two types of financial anonymity – counterparty and third-party anonymity. Counterparty anonymity means that a payor need not reveal their identity to the recipient. Third-party anonymity means that the payor’s identity is invisible to all other parties, including the operator of the payment system.

Digital Currency Design Considerations

The Financial Action Task Force (FATF) has issued standards that countries should implement to prevent money laundering and terrorist financing that will impact CBDC design considerations. In most instances, to comply with FATF standards, some information on CBDC users and transactions would need to be collected and, on a when-necessary basis, made available to competent authorities. However, some form of proportionality could be applied to reduce data requirements on low value transactions to foster adoption and usability, provide a more ubiquitous access to CBDC, and assuage data privacy concerns. For example:

Brookings (2020) suggests that the central bank could delegate account and identity management to one or more payment service providers (PSPs) who verify and record specific identity information, while the central bank sees only pseudonymous public keys. In this business model, individuals are at least pseudonymous with respect to the central bank and the transactions it processes if the PSPs adequately protect this identity information. However, the PSP can disclose the identity associated with a suspicious account to address regulatory compliance and anti-money laundering. See the table below for three examples of this type of business model in action.
The European Central Bank tested out “anonymity vouchers” in a proof of concept (ECB, 2019). These non-transferrable vouchers allow users to anonymously transfer a limited amount of CBDC over a defined period whereby a user’s identity and transaction history cannot be seen by the central bank or counterparties other than those chosen by the user. Hence, anonymous CBDC transfers can be enforced without recording the amount of CBDC that a user has spent, thereby protecting users’ privacy.
China’s eCNY design includes “controllable anonymity” in its design. Although the central bank will be privy to the identity of its users and their transaction data, users will have the ability to control what information they expose to counterparties (Qian, 2018). It aims to keep the degree of anonymity within a controllable range by requiring the disclosure of transaction data only to the central bank (Fan, 2020).
A stored value CBDC hardware solution that takes the form of a card or a mobile wallet app on which prepaid values are stored locally opens the possibility of almost complete anonymity. Such a wallet could conceivably be as anonymous and private as physical cash, although the central bank may require identification to enforce a one wallet per person policy or holding and/or transaction size limits to mitigate financial integrity risk. A couple of vendors (BitMint and WhisperCash) offer this CBDC platform option.

	Holding/Transaction Limit Structures	Data Access
Central Bank of the Bahamas Sand Dollar	Physical/email address, phone number and photo for low-limit access (B$500 holding and B$1,500/month transaction). Plus, government-issued photo ID for higher limits (B$8,000 holding and B$10,000/month).	Transaction transparency to enable CB to monitor suspicious transactions and stop accounts. Pseudonyms ensure user anonymity. CB maintains ledger and server is encrypted.
Eastern Caribbean Central Bank DCash	Physical/email address, phone number, photo and birth date/place for low limit access (EC$1,000 to EC$2,700/month transaction depending on risk profile). Plus, full name and bank account for higher limits (EC$3,000 to EC$20,000/day).	CB can see anonymized transaction data and outstanding CBDC in each digital wallet. Registered financial institutions can fully observe the identity of payers and payees and the purpose of transactions.
Central Bank of Uruguay e-Peso	Physical/email address, SIM card and national ID for low limit access (UYU30,000 wallet maximum). No higher limits except for businesses (UYU200,000).	User data is segregated across different databases. Transaction data per (anonymous) digital wallet can be decrypted to reveal the user’s identity under very restrictive conditions – e.g., a competent authority prosecuting someone that has probable cause to access the transaction data.
People’s Bank of China eCNY	SIM card for low limit access (¥10,000 holding, ¥2,000/transaction and ¥5,000/day). Plus, full name, address, phone number and bank account for higher limits (¥500,000 holding, ¥50,000/transaction and ¥100,000/day).	Controllable anonymity: The PBOC will be privy to the identity of its users as they are required to provide their real identities when they first sign up. However, users will have the ability to control what information they expose to counterparties

Digital currency privacy tradeoffs have sparked intense debate with seemingly irreconcilable differences of opinion. On the one hand, authorities do not want to allow anonymous CBDC because of potential financial integrity risks. Others don’t believe it’s possible to design a fully anonymous currency that’s resistant to double spending attacks. On the other hand, law-abiding users consider privacy an intrinsic non-negotiable right and nobody should have full oversight over their transactions. However, the choice between user anonymity and transparency doesn’t need to be black and white. For example, the recent digital euro public consultation found that, although potential users place a high value on transaction privacy, they don’t support full anonymity. Ultimate design choices will depend on the motivation for CBDC issuance, country specific circumstances and user preferences.

This post was co-written by Sonja Davidovic and the Kiffmeister

Why All the Fuss About Tether?

Bitfinex and Tether reached a $18.5 million settlement with the New York Attorney General (NYAG) over allegations that they hid the loss of commingled client and corporate funds and misrepresented the truth about the reserves backing Tether’s USDT stablecoin. The two firms also agreed to provide to the NYAG quarterly reports on the composition of Tether reserves over the next two years, starting within ninety days of the February 18, 2021 effective date of the settlement. Without admitting or denying any wrongdoing, Tether committed to publicly share these reports. However, the lawsuit did not cover the rumored role of Tether in a huge BTC pumping scheme.

According to the Financial Stability Board, stablecoins are crypto-assets that aim to maintain a stable value relative to a specified asset, or a pool or basket of assets. U.S. dollar pegged USDT is the biggest stablecoin by market capitalization.

Although USDT’s market capitalization is a small fraction of BTC’s ($35 billion versus $940 billion on February 24, 2020) in terms of trading volume it is by far number one. USDT’s main use case appears to be as a crypto-asset trading on-ramp for residents of countries where there are crypto-asset trading bans and/or capital controls, and as a “reserve currency” for unbanked exchanges.

Is USDT fully backed U.S. dollar assets?

Tether claims that USDT is always 100% backed by currency and cash equivalents, plus “other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.” In an ongoing lawsuit launched in 2019 by the New York Attorney General (NYAG) against Tether parent iFinex, it came to light that Tether had loaned $850 million of USDT’s reserves to its sister company Bitfinex. Since then, Tether has been dogged by suspicions that USTD is not 100% backed by U.S. dollar assets, although Tether claims that the Bitfinex loan has been paid off.

Tether has not helped its cause with its opacity regarding USDT’s reserve holdings. Although not audited, other stablecoin issuers at least publish monthly attestations that they are fully backed. However, attestations remain very vague about what comprises the reserves. The last time Tether published anything like an attestation for USDT was in 2017., but claim full details will be released later in 2021.

What kinds of assets back USDT?

But even if USDT’s are fully backed, questions remain around what they are invested in, although the other stablecoin issuers are not paragons of transparency. The USDC attestation report only tells us the reserves are held in segregated accounts at US federally insured depository institutions and in approved investments. The BUSD and PAX reports are equally vague, telling us that the reserves are held at US depository institutions sometimes in amounts backed by debt instruments expressly guaranteed by the full faith and credit of the US Government. Gemini’s attestations seem more transparent and imply that all of the reserves are invested in US Treasury securities.

The perception that Tether’s investments aren’t exactly top-tier, is not contradicted by the redemption restrictions: “Tether reserves the right to delay the redemption or withdrawal of Tether Tokens if such delay is necessitated by the illiquidity or unavailability or loss of any Reserves held by Tether to back the Tether Tokens, and Tether reserves the right to redeem Tether Tokens by in-kind redemptions of securities and other assets held in the Reserves.” (Crypto traders get around this by buying BTC with USDTs on an exchange that trades the BTC/USDT pair, transferring them to an exchange that trades the BTC/USD pair, and cashing them out.)

Is Tether part of a Bitcoin pumping scheme?

Some claim that USDT issuance is part of a BTC price pumping scheme. For example, a 2019 paper found that Bitcoin purchases with Tether “are timed following market downturns and result in sizable increases in Bitcoin prices. Rather than demand from cash investors, these patterns are most consistent with the supply-based hypothesis of unbacked digital money inflating cryptocurrency prices.” See also David Gerard’s succinct description of the process in this Twitter thread.

But according to Frances Coppola, USDT’s asymmetric mechanics both support and disprove this claim. An opposing theory says that what look like BTC pumps are merely Tether reacting to BTC price volatility by supplying more “lubrication” to markets. The “lubrication” idea stems from Tether’s key role as a “reserve asset” for unbanked crypto platforms. Also, a recent paper used USDT deviations from its fiat currency peg to show that USDT acts as a “safe haven” for crypto-asset investors. They found evidence of significant premiums over parity during the crash in non-stable crypto-assets in early 2018 and during the March 2020 COVID-19 crisis. Discounts were found to derive from liquidity effects and collateral concerns. For example, USTD spiked to as low as around $0.90 in April 2017 when doubts were raging about the sufficiency of Tether’s reserves.

So, if BTC’s price is falling, investors wanting to cash out is likely to increase demand for USDT, which will in turn raise its price. In normal circumstances, arbitrage is probably sufficient to maintain the peg. But when BTC is experiencing high volatility – in either direction – demand for USDT can increase far faster than arbitrageurs can bring it down. To prevent the dollar peg breaking, therefore, Tether must respond to this extra demand by issuing more USDT. And issuing more USDT increases exchange liquidity, making it easier to purchase or sell BTC and therefore feeding the price movement. So wild swings in BTC’s price might not be triggered by USDT issuance, but they… can be fed by it.

Conclusions

If Bitfinex and Tether follow through on their commitment to be more transparent about Tether’s reserves, rumors about USDT being backed by flaky assets may be put to bed, although questions remain around possible Tether BTC pumping. Also, it is a big if! However, the NYAG settlement does reduce a major crypto market black swan risk if, as Bryce Weiner believes, the market plumbing absolutely depends on USDT, making it effectively too big to fail.

What’s the deal with the Grayscale Crypto Investment Trusts?

Most institutional investors participate in crypto-asset markets through investment funds like Grayscale Investment’s closed-end trusts. As publicly traded trusts that report to the U.S. Securities and Exchange Commission, they relieve investors of concerns about storage, custody and security of their holdings. Grayscale is the dominant crypto fund manager with over $37 billion assets under management. This blog explores some of the market dynamics associated with the Grayscale Bitcoin Trust (GBTC).

For example, Grayscale Bitcoin Trust (GBTC) has accumulated more than 3% of total Bitcoin supply, and an even higher proportion of liquid supply. (Glassnode analysis found that only 22% of outstanding Bitcoin are considered liquid, i.e., currently in constant circulation and available for trading.) Grayscale also runs eight other single-asset crypto trusts and recently incorporated twelve more such trusts although they have yet to launch. However in this post we’ll focus on GBTC.

Although accredited investors can buy GBTC directly from Grayscale at NAV, many institutional investors cannot take this route because GBTC shares have a six-month lock up period. (According to SEC Rule 144, restricted securities issued by an SEC reporting company like GBTC are subject to a minimum holding period of 6 months.) Hence, these investors are forced to buy the shares at a premium over the native asset value (NAV) in the secondary market, and these premia can be significant:

Source: https://ycharts.com/companies/GBTC/discount_or_premium_to_nav

Price premia over NAV occasionally appear on exchange-traded funds (ETFs) but they rarely exceed about 3%. When they do, authorized participants step in to arbitrage the gap away by creating or redeeming shares of the ETF.

However, some have pointed to a scheme by which the premium could be arbitraged. It involves buying GBTC directly from Grayscale at NAV and shorting free-trading GBTC. Six months later, the two positions net out leaving a risk-free profit. This glosses over risks like not being able to borrow and fund GBTC for up to six months. JP Morgan analysts have estimated the cost of this premium monetization trade at 10-15% per annum. The GBTC long position could also be hedged with BTC futures contracts. However, the fact that the premium continues to exist, implies that such arbitrage is not consistently taking place.

That same JP Morgan analysis concluded that the introduction of a U.S. Bitcoin ETF would be positive for Bitcoin over the longer term but could be short-term negative. It would erode GBTC’s effective monopoly status and could cause a cascade of GBTC outflows and a collapse of its premium. This could have negative near-term implications for Bitcoin given the flow and signaling important of GBTC. And some think that the chances of the SEC giving the green light to a Bitcoin ETF is looking good.

There are two active Bitcoin ETF filings with the SEC: VanEck Bitcoin Trust (submitted in December) and Valkyrie Bitcoin Funding (January 22). In the past, there have been many unsuccessful attempts, all of which were rejected by the SEC on the grounds that the underlying crypto-assets are too subject to market manipulation and liquidity is insufficient. However, some are heartened that SEC Director of the Division of Investment Management Dalia Blass, who oversaw the rejections, is stepping down, and Gary Gensler, President Biden’s nomination as SEC Chairman, is known as very crypto savvy.

Meanwhile, Grayscale competitors are sprouting up. Osprey Bitcoin Trust launched with a 0.49% management fee (versus GBTC’s 2%). BlockFi and Bitwise have followed suit with similar offerings. However, the business models of Grayscale and all such funds hang on whether the SEC will continue to push back on crypto-asset ETFs.