Gareth Vaughan on a return to commodity-backed money, crypto & the GFC, Canada's solutions to NZ-style housing problems, a Covid tax for banks, plus Elon Musk and securities laws

This Top 5 comes from interest.co.nz's Gareth Vaughan.

As always, we welcome your additions in the comments below or via email to david.chaston@interest.co.nz. And if you're interested in contributing the occasional Top 5 yourself, contact gareth.vaughan@interest.co.nz.

See all previous Top 5s here.

1) Bretton Woods III; a return to commodity-backed money.

The latest episode of Bloomberg's Odd Lots podcast is a cracker for anyone interested in the big pressure points and changes occurring in the global financial system. Hosts Joe Weisenthal and Tracy Alloway talk to Zoltan Pozsar, Credit Suisse's Global Head of Short-Term Interest Rate Strategy, about the world entering what he calls Bretton Woods III.

Bretton Woods was the post-World War II collective international currency exchange regime where other currencies were pegged to the US dollar, which was itself pegged to the price of gold. US President Richard Nixon brought the curtain down on this in 1971 by ending the greenback's convertibility into gold. 

Pozsar describes Bretton Woods II as the shift from a gold backed dollar to a dollar governed by the idea that price stability was guaranteed allowing countries such as China, after it joined the World Trade Organisation, to accumulate dollar reserves in US Treasury securities. He suggests this system "blew up in 2008" with the Global Financial Crisis.

Now, with the Russian invasion of Ukraine and western sanctions imposed on Russia, he sees the world entering Bretton Woods III. He also sees challenges to the US dollar's role as global reserve currency.

We are again going to go back to commodity backed money where gold once again is going to play a big role. And not just gold but I think all forms of commodities because this crisis is about commodities. This is about the largest commodity exporter, this is about metals and grains and energy. And so in a way you're back to where you started from after the Second World War. But it's going to be a little bit more different...it's not just gold it's commodities more broadly. And it's not one currency that's dominant, there is going to be, as a reflection of a multi-polar world, a multitude of currencies. Rubles if you want to get Russian oil, RMB [ renminbi] if you want to get stuff out of China, you have the dollar if you trade with the US. And so it's a fragmented system where commodities play a much bigger role and where price stability is a big issue in certain parts of the world. So this is a very complex mosaic that we need to navigate here. That's what Bretton Woods III is about.

Bretton Woods III is about how do you invoice stuff, how do you get stuff from port A to port B, and once you get paid what do you choose as your optimal reserve? Is it a real asset, is it a nominal asset, that type of stuff.

Pozsar sees shipping, or space on ships, as the commodity equivalent of balance sheet space. And Pozsar argues that central banks "can't do a bloody thing" about commodity shortages.

I do agree that globalisation as we know it is probably over. So what are some of the things that are coming out of that? Resource nationalism is a part of Bretton Woods III, more military spending, Europe for sure and the US... is definitely coming out of this, stockpiling of commodities is definitely coming out of this, rethinking supply chains is definitely coming out of this. Bretton Woods II was about a singular supply chain, Foxconn making everything. And Bretton Woods III, if all that world order is torn up and if we have to duplicate production facilities and supply chains, we need to provide a lot of investment and capital for that.

A fascinating discussion.

2) Is crypto re-creating the 2008 Financial Crisis?

This headline from The Atlantic certainly caught my eye. There's a danger, of course, that people focus too hard on looking for parallels to a previous financial crisis with what's going on in the world today in order to try and predict when, where and how the next crisis happens. The old anecdote about generals preparing for the next war by fighting the last one can come to mind. Nonetheless the crypto world is a fascinating one that's not well understood by many people including me. 

Here Charlie Warzel talks to Hilary J. Allen, a Professor at the American University Washington College of Law, where she teaches corporate law and financial regulation. Earlier this year Allen published DeFi (decentralised finance): Shadow Banking 2.0?

Warzel notes Allen argues that part of the decentralised finance ecosystem looks like it “mirrors and magnifies the fragilities of shadow banking innovations that resulted in the crisis of 2008.” In an article written in questions and answer form, he asks her to walk him through her argument. It's an interesting discussion.

Allen: Sure. As somebody who studied the 2008 crisis in great detail, I’m always looking for parallels. So when I’m looking at the building blocks of the 2008 crisis, I’m thinking of things like mortgage-backed securities and credit default swaps. These financialized tools created additional complexity and rigidity and leverage into the financial system that ultimately led to collapse. And I see similarities with what’s being built in DeFi spaces—what unites them is their opacity and complexity and the way that it is potentially destabilizing.

Warzel: Right. The idea is that these financial innovations were essentially workarounds that allowed banks and stakeholders to skirt limits or some regulatory aspects. Or that they were such an abstraction that they were difficult for even bankers to follow — that the complexity of these instruments obscured exactly what people were buying and if it was garbage or not. In the essay, the three financial innovations you see parallels to are money market mutual funds, credit default swaps, and mortgage-backed securities. Can you go through them at a high level?

Allen: Money market mutual funds were created to be a functional equivalent of deposit accounts but in fact are an abstraction: a special accounting treatment that allows a share in a fund to be consistently valued at one dollar. But a share in an MMF is actually a share in a pool of assets with fluctuating prices, and so its value changes constantly. If the value of an MMF share deviates too far from one dollar, shareholders will find their shares revalued below one dollar. When this happened in 2008 and investors pulled out of MMFs, it was analogous to the traditional bank runs. Basically, the financial crisis was made worse by runs on money market mutual funds.

There are—and I’m far from the only person to note this—striking similarities between MMFs and stablecoins, like Tether, which is pegged to the dollar and supposedly backed by the dollar.  But there are a lot of allegations that Tether is not backed as it claims and is fraudulent. Other stablecoins offer their own complexities. I’m maybe less convinced in those parallels than some. But if something were to shake confidence in stablecoins and holders rushed to exchange them back to fiat currency, there could be a similar kind of run dynamic. And, if stablecoin issuers become interwoven in the real economy, it could introduce risk into the broader system.

Now, with credit default swaps, the parallel is leverage. CDSs created a new, initially unlimited way to create leverage, which is another way of saying they used debt to acquire financial assets. In DeFi, you see similar dynamics, especially that tokens can be created out of thin air. Those tokens could then be used as collateral for loans that can then be used to acquire yet more assets. It’s somewhat striking, the parallel.

Warzel: How about the mortgage-backed-security parallel?

Allen: Here, I focus on the rigidity. The idea is that when you have these financial products, they’re designed to be very hard to alter. That’s great most of the time, but things begin to fall apart if something unexpected happens. This was a real problem in the financial crisis. The obvious parallel here is with DeFi’s smart contracts. The whole selling point is that with smart contracts, you set the parameters up at the outset. Things happen quickly and are automated. There’s no opportunity for human intervention, though I’d argue that is overstated to some degree. I’m concerned about that.

3) Canada's solutions to its New Zealand-esque housing issues.

Canada's housing market often draws parallels to New Zealand's housing affordability woes. In an attempt to tackle affordability issues, the Canadian government's budget this week outlined a raft of measures including a temporary ban on foreign buyers, a crackdown on speculators, a pledge to double the pace of new home construction and a tax-free first home savings account. Much of this sounds familiar to a NZ audience...

Here's CBC with the details on how the Canadian government proposes to ramp up housing construction.

Canada now builds about 200,000 new homes a year — a pace the government says is well short of what's needed. So Ottawa has earmarked about $10 billion across various initiatives to get shovels into the ground.

There's $4 billion over five years for a housing accelerator fund run by the CMHC that hopes to create up to 100,000 new units, and half a billion to expand co-operative housing.

There's also $1.5 billion for new affordable housing units, on top of existing commitments, and almost $3 billion earmarked for repairs. Combined, those two commitments could create 10,000 new units, and fix up more than 17,000 units in need of repair.

There's also a one-time payment of $500 for Canadians "facing housing affordability challenges," although the government doesn't define who that might apply to.

There's also a tax rebate meant to encourage Canadians to renovate their homes, worth up to $7,500, to build a secondary suite for a senior or an adult with a disability.

The hope is to double the pace of home building to 400,000 new homes a year — enough to make a dent in the more than three million new homes that the government says forecasts will be required over the next decade.

4) Canada's Covid tax for banks & insurers.

Last year I floated the idea of a one-off Covid-19 tax on New Zealand banks given how much they've benefited from government support programmes during the pandemic. Well, as detailed in its budget, Canada's government is doing this and a bit more. There's a one-off tax on banks and insurers, and a higher corporate tax rate on the big financial institutions.

As with housing, there are similarities between banking in Canada and NZ. The Canadian banking industry is dominated by five large banks to our four.

Here's CBC again:

The main part of what the government is calling a "Canada Recovery Dividend" consists of a one-time tax of 15 per cent on their profits over $1 billion, for the 2021 tax year. That move is expected to bring in about $4 billion.

A second change will see the government inch up the corporate tax rate for banks and insurers on their profits over $100 million to 16.5 per cent, from 15 per cent previously. That move is expected to bring in $445 million annually to government coffers. Over the five years of the budget forecast, that brings the total of the bank tax changes to more than $6 billion.

5) How Elon Musk made US$156 million by delaying filing a form.

As is often the case Elon Musk was in the headlines this week. This time it was because he emerged as Twitter's biggest shareholder, with a 9.2% stake, and gained a seat on the company's board. But just how the CEO of Tesla and SpaceX built up his stake in the microblogging and social networking service has come under scrutiny. 

The Washington Post reports Musk was 11 days late in publicly declaring he had built up a significant Twitter stake, with this omission potentially earning him US$156 million.

That’s because of a 50-year-old law that requires that investors notify the Securities and Exchange Commission when they surpass a 5 percent stake in a company. Musk reached that benchmark March 14, according to the filings. But he made his public disclosure only Monday.

In between, he continued to buy stock at the price of around $39 per share, bringing his total stake to 9.2 percent. After his disclosure, Twitter’s share price rose roughly 30 percent and is now above $50 per share.

The late filing netted Musk $156 million, said David Kass, a finance professor at University of Maryland’s business school. “I really don’t know what’s going through his mind. Was he ignorant or knowledgeable that he was violating securities law?” he said. Whoever was handling the trades for Musk should have known, Kass said.

So will the Securities and Exchange Commission, or SEC, take any action against the world's richest man? 

It's not the first time Musk has disregarded securities laws. In 2018 he entered into a consent decree with the SEC after allegedly misleading investors when he tweeted that he had gathered enough funding to take the share market listed Tesla private. Musk paid a US$20 million fine and agreed to step down as chairman and vet his tweets with lawyers. However in March he asked the SEC to scrap this agreement.

Musk’s windfall may come with a slap on the wrist in the form of a fine from the SEC but will probably be limited to hundreds of thousands of dollars, according to the legal and security experts.

The SEC could also argue in court that Musk needs to part with the theoretical profit, but that would be a long shot, said Adam Pritchard, a professor of securities law at University of Michigan’s law school.

The SEC “would have to be really angry with him to try that because they would have a good chance of a court rejecting that argument,” he said.

Individual shareholders, Pritchard said, have no right to sue Musk because the public disclosure is a regulatory requirement and not something he legally owes to Twitter’s shareholders.

Questions have also been raised about Musk's tweeting on cryptocurrencies such as bitcoin and dogecoin given his tweets have significantly moved their prices.