Mikko, the founder of Zhibao: On the impact of US dollar liquidity on the cryptocurrency market

This article was published on Distributed Capital, author: Zhu Chen Mikko, organized by Youfei.

The topic I am sharing today is about dollar liquidity and digital currencies. As we start this discussion, it is necessary to clarify some concepts, which may challenge your fundamental understanding of money creation.

The Essence of Money Creation

First, where do you think the money that banks lend to you comes from? Most people believe that banks, as financial intermediaries, absorb everyone's savings and then lend them to others. In fact, banks do not have the right to do this. When banks lend, they engage in a money creation act: they create a sum of money (deposits) for you, rather than taking someone else's deposits to give to you. So how do banks create these deposits? Here, we will introduce double-entry bookkeeping and T-accounts to break down the process of money creation.

Double-entry bookkeeping is a method of accounting, while the T-account (balance sheet) is the structure of double-entry bookkeeping. In the balance sheet, assets are the allocation of all your monetary resources, such as when you buy real estate or a Bitcoin. Liabilities refer to your debts, such as credit card debt or borrowings. Equity is your real money that does not involve any liabilities. For example, if your parents give you 100 yuan, that is your equity. So the left side of this T-account is assets, and the right side is liabilities plus equity.

Let’s take an example of a bank lending to you. The bank lends you 100 yuan, which you need to repay to the bank. Suppose you apply for a loan from Industrial and Commercial Bank, and after approval, you can withdraw the credit limit from your account at the bank. At this point, you have an additional deposit in the bank. When the bank lends, it actually creates a sum of money, creating a deposit for you.

So, bank assets + loan of 100 yuan, liabilities + 100 yuan deposit.

Your liabilities + 100 yuan loan, because it needs to be repaid in the future, and the asset side increases by 100 yuan in bank deposits.

The most classic example of money creation is that loans create deposits, not deposits create loans.

Flooding the Market Leads to a Booming Digital Currency Market

Last year was a special year. Affected by the pandemic, the Federal Reserve stimulated the economy through monetary policy (commonly known as "flooding the market"). Last year's "flooding" also gave rise to a bull market in the cryptocurrency space. In the previous financial crisis, most of the money created by the Federal Reserve flowed into the hands of some banks and non-bank institutions (including hedge funds, asset management companies, etc.).

The current stimulus is different in nature. While the Federal Reserve is increasing the money supply, the U.S. Treasury is absorbing the increased money supply through bond issuance and then distributing it to the public. Banks and hedge funds find it difficult to buy cryptocurrencies because this action does not comply with regulatory requirements, while the public can buy cryptocurrencies. Last year, whether in the U.S. stock market or the digital currency market, a very interesting characteristic emerged: the market was not entirely dominated by institutional investors, but rather by retail investors. Here, I will use T-accounts to explain how dollars flowed into the hands of the public after the Federal Reserve increased the money supply.

We need to list the T-accounts for the Federal Reserve, banks, the U.S. Treasury, and you. First, before implementing quantitative easing, banks had a large amount of government bonds as part of their asset allocation, and investors also held U.S. Treasury bonds.

The Federal Reserve purchases government bonds from banks and individuals and pays them with deposits. Since individuals cannot open accounts at the Federal Reserve, when the Federal Reserve buys government bonds from individuals or non-bank institutions, it pays the agent banks that sell the bonds, such as JPMorgan Chase. After JPMorgan Chase receives the reserve deposits from the Federal Reserve, it records a deposit in the investor's account.

Thus, the Federal Reserve's asset side + government bonds, liability side + deposits (reserves).

Meanwhile, the asset side of banks and individuals decreases due to the sale of government bonds:

Bank's asset side - government bonds + deposits (reserves);

Individual's asset side - government bonds + deposits.

Next, the U.S. Treasury issues new government bonds. According to U.S. law, primary dealers must subscribe to U.S. Treasury bonds in the primary market. The amount of government bonds issued by the U.S. Treasury must be taken up by primary dealers. Therefore, the banks' reserves (the printed money) become government bonds, which they can hold or sell to clients. As banks increase their holdings of government bonds, their deposits and reserves are depleted. This money flows into the Treasury's deposit account. At this point, the Treasury's accounts are balanced.

U.S. Treasury liabilities + government bonds (purchased by banks and investors);

U.S. Treasury assets + Treasury deposits.

Bank assets - reserves + government bonds.

Then, the U.S. Treasury implements a cash distribution policy, providing subsidies to individuals to stimulate economic recovery.

U.S. Treasury assets - deposits;

Individual assets + deposits.

Regarding the Federal Reserve's QE, you will find that the U.S. financial system is a cycle of money creation, with funds circulating within the financial system, having no relation to the real economy. When you receive the deposit subsidy from the Treasury, you have two choices: the first is to foolishly hold this deposit in the U.S. and enjoy nearly 0% interest, and the second is to allocate it to higher-risk assets (such as digital assets and some tech stocks in the U.S. market). In fact, the Federal Reserve increased the money supply by nearly $4 trillion last year, and if we include the deposits created by the banking system's loans, last year's overall liquidity creation should be the highest in history. Investors faced with last year's entire risk asset market did not need to think hard, as all assets were rising.

The Impact of Dollar Liquidity on Digital Currencies

Next, let’s talk about the recent issues of dollar liquidity. From this hard money data, we can see how much money has increased. The blue line in this chart represents the circulating U.S. dollar cash, which has been rising from 2008 to 2020. According to the Federal Reserve's data, its annual growth rate is $90 billion.

We can see that last year, bank deposit reserves grew to $400 billion, which is a staggering figure. Because during 2013 and 2014, the level of reserves was only around $2 trillion. Currently, the $4 trillion level is equivalent to all financial institutions' deposits doubling. If asset prices do not double, is this reasonable? This is just the money on the Federal Reserve's balance sheet; we have not yet accounted for the situation in commercial banks.

The green line represents the Treasury's deposits, and its logic has been explained earlier. First, the Federal Reserve prints money, and then the printed money flows back to the U.S. Treasury; the U.S. Treasury then spends the money (gives it to individuals), and individuals deposit it in banks, which again becomes deposits. Therefore, the red and green lines sometimes move in the same direction and sometimes in opposite directions. Moving in the same direction indicates that too much money is being printed, while moving in opposite directions indicates that the speed of money printing is slowing down, with money structurally circulating between individuals and banks.

From these two charts, we see that the scale of deposits in U.S. commercial banks is increasing, while the scale of loans is not rising much, only $400 billion. This indicates that money creation is currently directly led by the Federal Reserve, rather than being driven by commercial banks creating deposits through loans. Why is the loan growth of commercial banks insufficient? Because the U.S. economy is relatively sluggish during the pandemic, and credit demand is also weak. In the context of insufficient consumption power and loans, and money creation unintentionally helping the real economy, money can only flow into the stock, futures, and digital currency markets.

The above charts indicate that not only is the Federal Reserve printing money (increasing the money supply), but central banks around the world are also printing money. We can see that the ECB (European Central Bank) and BOJ (Bank of Japan) have strong money printing capabilities. Among them, the ECB has started to print money crazily this year. The size of the BOJ's balance sheet is similar to that of the European Central Bank and the Federal Reserve, while Japan's economic size cannot be compared to theirs. Therefore, the BOJ's money printing scale is also quite exaggerated.

The only relatively restrained is our People's Bank of China (PBOC), whose monetary policy is relatively tight compared to developed economies, mainly because we have controlled the pandemic well and do not need to support recovery through large-scale stimulus. From a certain perspective, increasing the money supply is beneficial for GDP: with more money in circulation, there will naturally be consumption and spending, and various business activities can take place.

Digital Currencies Classified as Alternative Assets

JPMorgan's report on Tether

Have you noticed that mainstream investment banks have now classified Bitcoin and digital assets as a very important category of alternative assets? Recently, JPMorgan's U.S. fixed income team wrote a research report on Tether. Tether recently disclosed its asset composition, and more than half of its assets are commercial paper. Here, we need to discuss why commercial paper accounts for such a large proportion.

The premise for Tether to issue USDT is that it has sufficient reserve assets. Previously, Tether had dollar deposits in major banks, such as JPMorgan Chase. To resolve compliance issues, major banks refused Tether's deposits. As a result, Tether deposited its dollar reserves in another smaller bank. These smaller banks (which usually open accounts at JPMorgan Chase because they do not have the ability to settle at the central bank) then deposited the money in JPMorgan Chase. Since the financial system is nested, Tether's deposits ultimately still fall on the balance sheets of major banks.

Commercial paper is essentially short-term private IOUs. There are two types of institutions that issue such invoices in the U.S. market: one is large enterprises with traditional businesses (like Coca-Cola) and the other is tech companies (like Apple). Thus, Tether uses its dollar deposits to purchase the IOUs of Apple and Coca-Cola.

So, does Tether's liquidity reserve have risks? Yes, there are risks. Of course, you could argue that the IOUs from Coca-Cola and Apple have very low risk, and their bond issuance rates may be lower than some sovereign countries. However, these companies' commercial paper also carries risks. Because these enterprises do not have the ability to print money; they must rely on real earnings to repay. So why does Tether have liquidity risks, yet people are still willing to accept it? Because cryptocurrency traders really do not pay much attention to how much reserve Tether has; cryptocurrency traders never care about risks.

After Tether's asset reserves were disclosed, why did it attract the attention of many investment banks? Because as a CP holder, its scale is already among the top in the U.S. This indicates that the scale of digital currencies is also significant, which is a liquidity entity worth noting. And this system is becoming increasingly large, not including other stablecoins.

A few days ago, Federal Reserve Governor Brainard stated that the U.S. CBDC (Central Bank Digital Currency) must be launched as soon as possible and must lead the global digital currency. Why? Because he found that things the government does not do have already been done by others. If the Federal Reserve does not issue a digital currency, its future market share will all belong to Tether. There is a lesson to be learned here. The People's Bank of China is eager to launch a CBDC because 80-90% of its payment market share comes from WeChat and Alipay. These large tech giants can open reserve accounts directly at the central bank. When users deposit money in Alipay, and Alipay deposits 100% of that money in the People's Bank of China, the users' deposits are almost risk-free. In other words, Alipay can be considered the world's largest stable digital currency: it is digitalized, and together with WeChat Pay, it accounts for 80%-90% of the total payment ratio. The purpose of China launching the CBDC is to regain control of the payment business through the CBDC system.

The Current Monetary Environment is Unfavorable for Digital Currencies

The upcoming macro environment will be unfavorable for the digital currency market. Here is an excerpt from the Federal Reserve's meeting minutes: many participants emphasized that the committee must communicate with the market in advance regarding tapering until the economic situation has been assessed as having made "substantial progress." Tapering refers to reducing asset purchases, meaning that the amount of money printed by the Federal Reserve will decrease in the future. Because too much money was printed last year, it may take 5-10 years to digest the increased money supply. Secondly, at the June meeting, the Federal Reserve may begin to signal a tightening of dollar liquidity.

The U.S. Congressional Budget Office recently released a report titled "Options for Reducing the Deficit." This indicates that the U.S. intends to reduce its fiscal deficit over the next 10 years. The deficit of the U.S. Treasury is too severe. Because the U.S. Treasury needs to distribute money to the public, and the money distributed is supported by the Federal Reserve's monetary expansion through bond issuance, the Treasury has absorbed a large amount of liquidity to cover deficit expenditures. Recently, U.S. Treasury Secretary Yellen has done a lot of things in hopes of reducing the fiscal deficit. She aims to change the global tax system, including raising personal taxes, increasing estate taxes, and raising capital gains taxes. Because she wants to change the Treasury's revenue and expenditure structure to make income greater than expenditure. In the future, everyone may need to pay cryptocurrency taxes to the Treasury's account.

Starting in the second half of this year, a major theme in the U.S. will be gradually tightening monetary policy over the next 10 years. In the past decade, the dollar has hardly been tightened. Although there was a rate hike cycle from 2015 to 2018, its balance sheet size remained large. The U.S. government has not substantively tightened its monetary liquidity. When the Clinton administration suddenly began tightening fiscal policy in 1998-1999, the continuous bull market in U.S. stocks for over a decade led people to form a habitual thinking; but when monetary policy began to tighten, people realized that the government does not only implement loose policies. Currently, the U.S. debt-to-GDP ratio is already very high. The U.S. debt can only be rolled over through taxes or newly issued money. The Federal Reserve has also increased a lot of money, and the increase in money supply will further inflate asset prices, bringing about bubble risks.

Although the macro environment is not very favorable, there is still a lifeline; digital assets are an important part of asset allocation. One of Goldman Sachs' core research report series is called "Top of Mind," which is a research report created by Goldman Sachs using its entire research network and think tank connections. In the report, Goldman Sachs believes that crypto will become an important asset class. The report also shows that if you allocate a certain proportion of Bitcoin in a 60/40 stock-bond asset portfolio, it will enhance your overall returns. Because Bitcoin does not have a strong correlation with other assets. Moreover, Bitcoin has a significantly negative correlation with the dollar. Therefore, the only enemy of digital assets is the dollar, but the dollar is also what has enabled them. So now the dollar index is performing very weakly; under a weak trend, digital assets and risk assets have such gains. If one day the dollar index starts to recover, then risks should be noted.

Finally, the so-called digital currencies cannot be called digital currencies. First, all currencies in the current financial system are digitalized; for example, your deposits are digitalized, and Alipay is also digitalized. So the term "digital" does not add any extra meaning to the concept of currency. Second, cryptocurrencies like Bitcoin are not currencies; they are alternative assets. No one will use Bitcoin as a currency in a mainstream monetary environment, which is something everyone must acknowledge. USDT has a certain currency-like nature, but it cannot be called a currency either. Therefore, when you buy digital assets, do not harbor the fantasy that they will replace the dollar in the future.