- Brazil’s plans for a CBDC
- Amazon’s NFTs? And Perhaps an “Amazon Coin”?
- Already, a crack in quantum resistant cybersecurity
Dear Reader,
One of the more common threads regarding the cause of Silicon Valley Bank’s (SVB) collapse has been a narrative around SVB’s poor management. It’s often used to minimize the impact of the actions of the Federal Reserve over the last twelve months.
This narrative isn’t without merit.
SVB’s management and board of directors certainly could have done things differently. SVB had a massive book of long duration U.S. Treasuries which is what caused the duration risk, and ultimately the liquidity problem for the bank when the large depositor outflows began.
SVB’s executive team also leaned heavily into supporting projects that allowed the bank to virtue signal that it was supporting the “right” kinds of causes (for example – ESG related) which can often be horrible investments.
And it didn’t help SVB’s image one bit when executives and members of the board sold $84 million of stock in SVB over the last two years, millions of which happened in the days leading up to the collapse earlier this month.
I agree, it looks awful.
But it got me thinking, what about all the other regional banks? What kind of shape have they been in? And is this something more systemic, rather than just a one off with SVB?
That led me to a report published by the Federal Reserve Bank of Kansas City on September 8 of last year. What was outlined in that report was pretty incredible.
Relationship Between Unrealized Gains (Losses) and Tangible Equity Capital Ratio
It’s important to note that this data is through June of last year, which was quite early in the Federal Reserve’s record breaking sprint of interest rate hikes.
The report from the Kansas City Fed explicitly states that the increasing interest rate environment has resulted in “growing unrealized loss positions within community banking organization (CBO) AFS portfolios.” AFS stands for available-for-sale securities, the most critical tool a bank has for accessing additional liquidity when needed.
The kicker was the following passage from the Kansas City Fed’s analysis at that time:
“At June 30, 2022, the Tangible Equity Capital Ratio at CBOs fell to 8.7 percent as a result of mounting unrealized losses on AFS securities, which totaled 1.5 percent of average assets. At year-end 2021, only 4 community banks had tangible equity capital ratios below 5 percent; that number increased to 333 at June 30, 2022, indicating less ability to sustain economic shocks.”
Again, this data was from June of last year. The Federal Reserve already knew at that time that their policies were putting these banks under stress, weaking their “ability to sustain economic shocks.” And yet the Federal Reserve decided to keep aggressively hiking interest rates.
And it wasn’t just the longer dated U.S. Treasuries that were a problem for these banks. Just look at what the banking industry was doing with commercial real estate.
In a low interest rate environment, other than longer dated U.S. Treasuries, small banks pursue higher yields with their depositor’s capital in commercial real estate. That dynamic was amplified over the course of the last five years. Small banks became responsible for about 69% of all commercial real estate lending.
The problem, as I’m sure we’ve all figured out, is that when interest rates rise, the value of U.S. Treasury bonds and commercial real estate portfolios declines proportionately. And when interest rates rise artificially fast, banks do not have time to adjust their portfolios.
How big is the problem?
Some great research was published days ago that identified $2.2 trillion of losses, primarily driven by losses in mortgage-backed securities and U.S. Treasuries. That’s not a typo, $2.2 trillion. And not surprisingly, the insured deposit coverage ratio is the lowest for smaller banks.
To answer the question that I posed earlier, this is a systemic crisis.
And it was caused by a combination of the government’s fiscal policy and the Federal Reserve’s monetary policy. And it is very scary.
So scary that U.S. Treasury Secretary Yellen announced on Tuesday that the government is prepared to step in and protect depositors at regional banks if further panic ensues.
This isn’t just a precautionary measure. As we learned above, there is already a $2.2 trillion hole, illiquidity throughout the system, and billions of dollars of capital outflows from smaller banks fleeing to the perceived safety of the large banks.
These depositor outflows worsen the crisis for smaller banks, exacerbating losses and liquidity problems. And they further concentrate power in a small number of “too big to fail” banks.
And raising interest rates further will only make matters worse. As we know, the Federal Reserve deeply understands this. They understood it back in June of last year.
The $25 billion Bank Term Funding Program announced on March 12 is just a drop in the bucket. It’s a tiny fraction of the $2.2 trillion in losses that have already been identified just in the banking system.
We shouldn’t be surprised at all when the next “Program” to save us all and shore up the system has a number measured in trillions, rather than billions.
If there was ever a time to move into hard assets and avoid any interest rate exposure, that time is now.
Another G20 country to roll out a CBDC…
Earlier this month, we highlighted the European Central Bank’s (ECB) plan to roll out a central bank digital currency (CBDC) for the European Union (EU). Then the United Kingdom followed suit.
Now it seems Brazil is getting in on the act. And some of the nuances in Brazil’s CBDC plan are quite interesting…
If we remember, a CBDC is a digital currency designed to mimic national fiat currencies. The difference is, they aren’t held in a bank account. Instead, they are held in a digital wallet that is fully controlled by a central bank.
And this month Brazil launched its own CBDC pilot project. They are calling it the “digital real”.
Like the EU’s CBDC plan, Brazil envisions the digital real focusing on day-to-day retail use. That means it will facilitate regular financial services and commercial transactions for Brazilian citizens.
Of course, Brazil’s government is touting the same benefits. Fast transactions… low costs… low friction… it’s the same array of benefits that most blockchain technology enables, the key difference being that it is centralized.
Brazil plans to move quickly with this. The CBDC pilot is happening now. And they expect to roll it out to the public at some point next year.
So we’re seeing a trend forming here.
At first it was just small island-nations who were rolling out CBDCs. Now its major countries like Brazil, the EU, India, China, and the UK. And as I’ve been predicting, I believe that the U.S. will begin rolling out its CBDC later this year.
But Brazil is the first to present something of an interesting idea as part of their CBDC system. They suggested that the CBDC could make “repo” operations available to consumers.
This is interesting.
Repo operations are where financial institutions can put up some kind of collateral in exchange for a loan. This collateral is typically some kind of security like a stock or bond.
This is a mechanism for ensuring there’s always sufficient liquidity within the financial system. In fact, this is exactly what the Fed and the Treasury are doing right now to save the regional banks.
I’ve never heard anyone suggest a retail version of repo operations, however. But if we think about it, this would be a new way to inject “stimulus” into the economy.
For example, individuals may be able to pledge a portion of their investment portfolio as collateral. Then they could get a substantial cash loan to spend for any purpose they desire.
The key here is that the loan needs to be paid back. If it is, we shouldn’t see material consumer price inflation. That’s because the same currency units spent into the economy are also retired when the borrower makes their loan payments.
However, what happens when borrowers don’t pay back their loans?
In those instances the new currency units aren’t retired and borrowers would lose their collateral. And the country’s central bank would take a loss on the sale of the collateral. That would absolutely be inflationary. And it would likely put the borrower in a worse financial position than they were in before.
Of course, most people don’t think this way. And that’s likely the point.
I can see how a program like this would be politically appealing. Politicians can argue that the CBDC will democratize access to liquidity that only large financial institutions have access to right now. And they can emphasize the benefits while leaving out the potential risks.
A great example is what we’re experiencing right now.
Government fiscal, economic, and monetary policies have caused a crisis and resulted in a large decline in most asset valuations.
But a repo program like this could value the collateral at “par value” (i.e. the price that it was purchased at) in the same way that the U.S. Federal Reserve is valuing long duration Treasury bonds at par value when in fact they might only be worth 60% of that.
Politically, this would be a way of injecting stimulus into a population and “making taxpayers whole” for the crisis that was created.
It’s easy to see how this would be politically attractive, and using a mechanism like this would also drive adoption of a newly established CBDC.
Amazon’s plans for a token have been a long time coming…
It’s finally happening. Amazon is paving the way for its own digital asset right now.
Longtime readers will know this is something I’ve predicted for years now. Here’s what I said during the December 2017 edition of The Near Future Report:
A marketplace that facilitates anonymous transactions… sound familiar? It’s precisely what Jeff Bezos was so passionate about with third-market exchanges in the story above. I also believe that there is something even bigger in the works. I think that Amazon is getting ready to launch its own digital currency. And I can’t think of a better company traded on a U.S. stock exchange that could pull this off.
I‘ll admit I was a little early. But it looks like this prediction might be taking shape.
And Amazon is being clever with its approach.
Rather than launch its own digital asset directly, Amazon is first launching a non-fungible token (NFT) platform. This is important for regulatory reasons, as I’ll explain in a minute.
As a reminder, NFTs are a brand-new class of digital assets. In their simplest format, they are a form of digital art and collectibles.
And with its NFT platform, Amazon will specialize in NFTs that we call “digi-fizzies”. These are digital assets that are tied to real-world products that are delivered to the owner.
In Amazon’s case, these digi-fizzies will focus on fashion items initially. Consumers can buy NFTs that display a fashion item… and then Amazon will ship the corresponding item directly to their door.
The timing of this development with Amazon might be a bit surprising given the bear market that we’ve had in digital assets. But that doesn’t mean development of the technology has slowed down. And I believe Amazon is leveraging this as a gateway to launching Amazon Coin.
That’s because Amazon will likely build this NFT platform on its own centralized, private blockchain. Then Amazon could launch a digital asset to facilitate transactions on that blockchain.
In other words, consumers will buy and sell Amazon-based NFTs using an Amazon Coin. And Amazon will incentivize consumers for doing so.
In order to stay out of regulatory trouble, Amazon’s strategy will almost certainly be to implement a walled garden and structure its token/coin with the look and feel of a loyalty program, not of a cryptocurrency.
If Amazon Coin is limited to Amazon’s NFT marketplace, it won’t be seen as a threat to regulators.
I expect that we’ll see something roll out in the next three to five months. And my guess is that anyone who is an Amazon Prime subscriber in the U.S. will hear about it first.
NIST’s new standards can already be cracked…
We talked a lot about quantum computing in my Prediction Series last December. That discussion always includes the need for upgraded quantum resistant encryption standards.
As a reminder, military-grade encryption is considered the “gold standard” of encryption technology today, and its widely in use. And it has served the world reasonably well. But a sufficiently powerful quantum computer could crack military-grade encryption in a matter of minutes if not seconds.
Fortunately, the National Institute of Standards and Technology (NIST) selected four promising new algorithms last year to address this. The plan was for them to replace our current cybersecurity standards in order to prepare for the world of quantum computing.
In other words, NIST believed these algorithms could power quantum resistant encryption across the internet as well as email and other communication services. That was a huge milestone… or so we thought.
A group of researchers just revealed that they cracked the code to one of these key algorithms. Using deep learning technology and neural networks, forms of artificial intelligence, this group found that they could unmask the algorithm’s security techniques and then reconstitute cypher text and encryption keys.
Put more simply, these researchers just rendered NIST’s quantum resistant cybersecurity obsolete if exposed to a sophisticated cyber-attacker with access and knowledge of related artificial intelligence . This is highly concerning. After all, having access to technology like this would not only be the realm of nation states, but also well-organized cybercriminal organizations.
This will require a lot more work by NIST and those companies that contributed to the quantum resistant standards that were developed. They’ve been tested now, and we are learning of weaknesses.
Compounding the matter, we are seeing incredible progress around quantum computing. We talked about the latest on this front earlier this month. And the pace of development of powerful artificial intelligence is happening at an ever quickening pace.
And that means time is short.
First, we have to identify a new set of quantum-proof encryption standards. Then we have to test them. And if they work, it could take a decade to roll them out across all network and communications infrastructure. That’s a massive undertaking.
So, the world’s governments and corporations are racing against time here… and the security of every database and communications network in the world is at stake.
Regards,
Jeff Brown
Editor, The Bleeding Edgeon