The new Governor of the DAB, Abdul Qahir Idrees, is introduced to staff.  [Source][Source]

Last week I made the case that the Afghanistan's currency, the Afghan afghani, might hyperinflate. In this post I'm going to take a different tack. In a chaotic economy, the afghani—or at least some version of the afghani—may be one of the country's more reliable elements. I'm going to look to several exotic currency scenarios including that of the 1990s Iraqi dinar, which split into an unstable Saddam dinar and a stable Swiss dinar, as a possible template for what might happen in Afghanistan.

My blog post from last week was about the assets owned by Da Afghanistan Bank (DAB), Afghanistan's central bank. The Taliban, which just took over control of the country, discovered to its chagrin that most of the DAB's US$9.5 billion in assets are held overseas and controlled by the U.S. and institutions like the IMF. And now those assets have been frozen.

Here is the former central banker, Ajmal Ahmady:

This thread is to clarify the location of DAB (Central Bank of Afghanistan) international reserves

I am writing this because I have been told Taliban are asking DAB staff about location of assets

If this is true - it is clear they urgently need to add an economist on their team

— Ajmal Ahmady (@aahmady) August 18, 2021

With a wedge being driven between the afghani banknotes that are circulating in Afghanistan and the New York-domiciled assets backing those notes, I went on to suggest in my post that the notes—now rudderless—could only fall in value.

What follows is my counter-argument, to myself.

Yes, the Taliban-controlled DAB has been cut off from its New York assets. But Taliban officials are about to learn (if they haven't already) that they have also been severed from the global banknote printing market. This means that the Taliban-controlled DAB can't issue any new banknotes. Cash is the dominant form of money in Afghanistan. With the supply of afghanis now fixed, and the demand for them rising over time along with population growth, Econ 101 tells us that the afghani's purchasing power should strengthen, or at least not fall by very much.

Like many other smaller countries, Afghanistan doesn't print its own notes. The DAB signed a contract in 2020 with the Polish Security Printing Works, Poland's state-owned money printer, to provide it with new cash. The first batch of new Polish-made afghani notes arrived earlier this year, with more due to arrive through 2022. 

The Taliban's takeover makes it unlikely that subsequent batches will be delivered, at least not without U.S. approval. Thus the stock of afghani banknotes is locked with no timetable for unlocking it.

Nor can the Taliban-controlled DAB print up its own series of afghani banknotes. Banknote printing is a complex affair due to anti-counterfeiting features, exotic substrates on which notes are printed, and designer security inks. I doubt the Taliban can acquire high quality presses, materials, or the requisite expertise to operate them.

Might a rogue foreign printer produce notes for the Taliban?

This is where things get interesting. We can look to other countries like Yemen, Libya or Iraq for ideas about what might happen if this happens (more on these countries at bottom).

Say that a shortage of notes pushes the Taliban to try and secure new ones. The Taliban-controlled DAB might contact an ally such as Pakistan to get some new notes printed up in secret. The rogue Pakistani printer will probably do a better printing job than the Taliban would on its own, but it still won't be able to make perfect replicas of the Polish series (or prior series). And the Taliban may not want replicas anyways. It may ask for an entirely new note design to commemorate its coming to power. Once the Taliban has received the Pakistani-printed notes, it will proceed to put these not-quite-replicas into circulation.

Now the ball is in the U.S.'s court.

If the U.S. decides to publicly disapprove of the rogue notes, then people in Afghanistan will refuse to treat old notes and new notes as being fungible, or equal to each other. The old approved notes will be seen as being tied to the billions of assets held in rich New York, the new unapproved being linked to a destitute Taliban. So the unapproved notes will trade at a discount to approved notes. At that point Afghanistan will have two afghanis: a strong Yankee one and a bad Taliban one. (This would be a situation similar to the bad Saddam dinars circulating in 1990s Iraq. More on that later.)

The Taliban may react by trying to restore fungibility. Afghan citizens would be required to treat the two unequal banknotes as equals. That is, local stores and banks would be forced to accept both the new and old notes at par on pain of execution.

But these measures would only partly work. People would adapt by limiting all their official compliant purchases to be made using the weaker unapproved banknotes. They would hoard the good approved ones, perhaps for use on the black market (where they will fetch their true value) or for export to regions of Afghanistan that are not controlled by the Taliban, and where the Taliban's one-for-one afghani rule has no effect. (Much like how stable Swiss dinars circulated in Kurdish-controlled Northern Iraq).

So a strategy of rogue printing could very well mean the emergence of a strong and a weak afghan. (Some of you will recognize this as Gresham's law in operation). That sounds like sci-fi, but as I've been hinting at throughout this post, this sort of strange currency divorce isn't all that new. I wrote about Iraq's experience here. 

The short version is that prior to the 1991 Gulf War, Iraqi dinar notes had been printed by a private printer, De La Rue. De La Rue's printing plates were manufactured in Switzerland. Cut off from De La Rue after the war, Iraq's leader Saddam Hussein had a new series printed up locally. These were known as the Saddam dinar and circulated at a discount to the Swiss dinar.

Iraq isn't the only example of currency separation. I've written about Libya's near split in 2016. More recently, I described the Yemeni rial breaking into two.

Yemen remains home to one of the world's oddest monetary situations. The entire Yemeni monetary system has split on the basis of the age of its banknotes, with pre-2016 notes being worth much more than newer notes.

See chart below. Old rial notes are in blue, new in orange.

1/2 pic.twitter.com/om1cYI9CM0

— John Paul Koning (@jp_koning) August 3, 2021

The possibility of a dramatic rupture of the afghani might be enough to get the Taliban to swear off the rogue printing option altogether. It may seek to work with the U.S. (i.e. submit to certain U.S. demands) in order to get access to both its Polish-printed notes and New York assets.

As for the U.S., it may agree to work with the Taliban-run DAB for humanitarian reasons, subject to certain conditions (i.e. limits on how banknotes can be issued). This compromise between enemies might lead to a surprising amount of stability for the Afghan afghani.

I've now written two blog posts about the Afghan afghani, both of them describing wildly different scenarios. What's evident is that the situation is a volatile one. It could proceed along any of vast number of arcs.

The Afghanistan story is a tragic one and I don't have much to add to it apart from my ability to read central bank financial statements and balance sheets. Here's a quick analysis of the balance sheet of Afghanistan's central bank, da Afghanistan Bank. And following that, I'll provide some thoughts on what this means for Afghanistan. As always, feel free to add your opinions and data in the comments section.

Da Afghanistan Bank issues the Afghan afghani, the currency symbol of which is the Af. 

At year-end 2020 the central bank had 781 billion Afs worth of assets, which comes out to around US$9.5 billion at the current exchange rate of US$1-to-86 Afs. That's a lot of resources. No doubt the incoming Taliban regime is keen to access this $9.5 billion. But it will be tough for the Taliban to do so.

Here is what the assets section of the central bank's audited balance sheet looks like, in Afs:

Source: DAB

(Note: For the rest of this article, I will assume that da Afghanistan Bank's 2020 year-end numbers are similar to those prevailing as it is taken over by the Taliban.)

In what follows I'm going to analyze the four biggest components of da Afghanistan Bank's balance sheet: gold reserves, foreign currency cash reserves, due from banks, and investments.

1. To repeat, da Afghanistan Bank lays claim to 781 billion Afs worth of assets. Of this amount it reports holding 703,000 troy ounces of gold, worth 101.77 billion Afs, or 13% of da Afghanistan Bank's assets. At the current gold price, this comes out to a whopping USD$1.25 billion.

But a quick peek at the notes to the financial statements reveals that da Afghanistan Bank's gold is held on the other side of the world, at the Federal Reserve Bank of New York. With the Taliban taking over the central bank, my guess is that this gold will be frozen by the U.S. government. That is, the incoming Taliban regime won't be able to access a single ounce of the yellow metal.

Afghanistan's central bank, da Afghanistan Bank, holds 703,005 ounces of gold, all deposited at the Federal Reserve Bank of New York. That's worth US$1.25 billion. It's a safe guess that with the Taliban taking over this gold will be frozen.

Source: https://t.co/wtF6QOlRtq pic.twitter.com/xxqImhtCeJ

— John Paul Koning (@jp_koning) August 17, 2021

2. The next big line item on da Afghanistan Bank's balance sheet is foreign currency cash reserves. A glance at the notes to the central bank's financial statements reveals that this refers to actual physical banknotes. This stock of currency seem to be held at the Presidential palace and the central bank's head office as well as its branch offices. Most of it U.S. dollars:

Source: DAB

The central bank presumably holds a big stock of U.S. banknotes because it also offers U.S. dollar accounts to locals, and account holders surely want to withdraw money in physical form to make payments. Afghanistan is mostly a cash economy.

At year-end 2020, da Afghanistan Bank held 34 billion Afs of foreign physical cash, or US$400 million. That's not as big as the gold line item, but it still accounts for another 4% of da Afghanistan Bank assets.

My guess is that this US$400 million in cash was quickly whisked away by the outgoing regime on one of the many planes departing Afghanistan, probably for eventual deposit at the Federal Reserve Bank of New York. So that's another big chunk of central bank assets wrested away from Taliban control.

3. Having dealt with gold and physical cash, the next line item is Due from banks and financial institutions. This amounts to 254.7 billion Afs (US$3.2 billion), or 33% of da Afghanistan Bank's assets. Looking through the notes to financial statements, much of this is comprised of various types of deposit accounts held at foreign banks:

Source: DAB

It is likely that these bank deposits are protected from the incoming Taliban regime, depending on the jurisdiction of the bank. If deposits are held in U.S. banks, I suspect they will have already been frozen. But if they are socked away in a place like Switzerland, perhaps the Taliban will be able to use them? I don't know enough about international politics to be sure. If the U.S. quickly institutes some sort of sanctions regime against da Afghanistan Bank, then even neutral foreign jurisdictions will have to lock down the assets of a Taliban-led central bank.

4. The fourth and last line item is investments, best described as a portfolio of U.S. government securities. These investments comprise the biggest chunk of da Afghanistan Bank's assets, summing up to 369 billion Afs (US$4.2 billion), or 47% of the total.

One more glance at the notes to the financial statements tells us that da Afghanistan Bank's investment portfolio is mostly managed by the Federal Reserve Bank of New York and the World Bank's International Bank for Reconstruction and Development (IBRD). A small chunk is run by the Bank for International Settlements. 

Source: DAB

If the chunk held at the Federal Reserve isn't already frozen, I suspect that it will quickly be rendered unusable. I don't know enough about the politics of the World Bank or the BIS to pass comment, but I'd bet that these institutions will also prevent the Taliban from getting access to the funds.

So let's do the math. Gold + foreign cash + due from banks + investments sums up to 760 billion Afs, or 97% of da Afghanistan Bank's assets. That's US$8.8 billion worth of funds. So effectively all of the central bank's assets is either already frozen or capable of being frozen.  

One thing I worry about is that a Taliban-led Afghanistan will quickly experience hyperinflation.

Here's the logic. Da Afghanistan Bank has issued around 293 billion Afs worth of Afghani-denominated coins and banknotes into circulation, for use by regular Afghans for payments. (That's around US$3.5 billion worth of cash). Banks and other customers hold another 106 billion Afs worth of electronic Afghani accounts at the central bank.

Up till now the Afghani notes and electronic deposits that the central bank has issued have been stabilized by its underlying investments, including the gold and dollars held at the New York Fed. Treasury securities yield income. So do bank deposits. Along with gold, these assets can also be used to repurchase issued Afghani currency, thus supporting the Afghani's value. 

But U.S. officials are justifiably worried about what other things the Taliban might do with those assets. What if the Taliban wants to sell $50 million of the central bank's stock of Treasury bills or gold ounces to buy more weapons? A blanket ban on accessing all of da Afghanistan Bank's funds will prevent the Taliban from using those assets to finance itself.

But with these assets being frozen, they can no longer be effectively put to work as stabilizers. And so the Afghani can only fall. In theory I suppose that the Taliban could find replacement backing, but in practice I doubt it has the resources to do so.

As far as developing nation currencies go, the Afghani has been fairly stable against the dollar for the last decade. Inflation has remained low. Freezing da Afghanistan Bank's assets hurts the Taliban, but it also means ensuring that a painful hyperinflation falls on regular Afghani people. This will be an abrupt departure from what Afghans have become used to, and a lot to bear on top of what they are already enduring.

Critics of stablecoins often describe them as unregulated. But that's not accurate.

Over the last few months I've been familiarizing myself with the various financial regulatory strategies stablecoin issuers have been adopting. I thought I'd share my findings in a blog post. Perhaps journalists, investors, and others will find this information useful. (For those not interested in stablecoins, I apologize. This will mostly be gobbledygook to you.) I'll most definitely make a few mistakes in this post, so readers: do not hesitate to provide feedback in the comments section.

I tweeted out the short version of this post last month:

Amongst US$ stablecoins, I've seen four regulatory strategies:

1) The NYDFS trust company model [Paxos, Gemini, BUSD]
2) Piggyback off of a (Nevada) state-chartered trust [TrueUSD, HUSD]
3) Get dozens of money transmitter licenses [USDC]
4) Stay offshore [Tether]

— John Paul Koning (@jp_koning) July 14, 2021

As you can see I've isolated four regulatory strategies that the major U.S. dollar stablecoin issuers have adopted. In this post I'll provide some details on each strategy.

My guess is that when people criticize stablecoins for being unregulated, they have the fourth strategy in mind: stay offshore. But they are ignoring or unaware of the other three.

A few caveats before starting. I'm only going to deal with U.S. dollar stablecoins in this post. Which means I'm ruling out euro-based stablecoins that operate within the EU's e-money regulatory framework. But there aren't really any big non-U.S. dollar stablecoins, so focusing on U.S. stablecoins covers most of the market.

Second, I won't be talking about Dai, Terra USD, Frax or any of the more exotic decentralized stablecoins. I'm sticking to centralized stablecoins: Tether, USD Coin, Gemini Dollar, HUSD, Binance USD, Paxos Standard, and TrueUSD. By centralized, I mean that the stablecoin's backing assets are compromised of traditional assets like Treasury bills, commercial paper, or deposit accounts held at a bank. Redemption or creation of new stablecoin tokens occurs via underlying bank infrastructure.

Lastly, this post doesn't address so-called "FinCEN regulation." Stablecoins will sometimes market themselves as being regulated by the Financial Crimes Enforcement Network, a department of the US Treasury that oversees America's anti-money laundering regulations. In the tweet below, a Tether executive makes this claim:

Reminder: #Tether is registered and regulated under FinCEN as all the centralised competitors. Strict KYC/AML is applied to all Tether direct users, as the other main issuers are doing. Less regulated is just FUD. Ask yourself who benefits from spreading such misinformation? 🤡 https://t.co/0izlgpJ75r

— Paolo Ardoino (@paoloardoino) December 30, 2020

However, this is mis-marketing. When stablecoins interface with FinCEN, they are best described as being registered with FinCEN, not regulated by FinCEN.

Further more, FinCEN registration doesn't qualify as operating under a financial regulatory framework. A financial regulatory framework sets out the rules an issuer has to follow in order to ensure that the product is safe for consumers. It is at this level that fraudsters are caught and poorly designed stablecoins pre-empted. A financial regulatory framework may also address issues like overall stability of the financial system. For its part, FinCEN has nothing to do with financial regulation. It is a money laundering watch dog.

So let's start.  

1. The New York DFS model

The first stablecoin regulatory model is the New York Department of Financial Services (NYDFS) model. The NYDFS regulates money transmitters, trust companies, and banks that do business in the state of New York.

The NYDFS has created an explicit framework for regulating stablecoin issuers. Two issuers currently conform to this model, Paxos Trust and Gemini Trust. Paxos issues its own Paxos Standard stablecoin. It also manages Binance USD (BUSD) on behalf of Binance, a large offshore cryptocurrency exchange. For its part, Gemini Trust issues the Gemini Dollar stablecoin.

Under the NYDFS model, a would-be stablecoin issuer first secures a limited-purpose trust company charter from the NYDFS. This means that it must comply with the NYDFS rules concerning trusts and submit to ongoing oversight.

Once chartered as a trust, the institution can then seek additional NYDFS approval to issue a "price-stable cryptocurrency – commonly known as 'stablecoin'– pegged to the U. S. dollar." The NYDFS says that its approvals for individual stablecoins are based on "stringent requirements for these products," and follow a "comprehensive and rigourous review." Post approval, the stablecoins are subject to continuing "examination and inspection" by DFS examiners.

2. The Nevada Trust model  

The second regulatory framework I have encountered is the Nevada trust model. There are two stablecoins that have chosen to use Nevada as their regulatory jurisdiction: HUSD and TrueUSD.

Let's deal with each stablecoin separately, because they use slightly different versions of the Nevada trust model.

Huobi Technology Holdings, the company that owns both the HUSD stablecoin and the Huobi cryptocurrency exchange, also owns a trust company, Huobi Trust Company. This trust company has been chartered by the Nevada Department of Business and Industry, or DBI. The Nevada DBI is Nevada's counterpart to New York's DFS.

The second stablecoin operating under the Nevada model is TrueUSD. TrueUSD has adopted a rent-a-charter, or multi-layered regulatory model. The TrueUSD stablecoin itself is owned by Techteryx, a Chinese company. But this isn't the layer at which the financial regulatory framework is applied; that occurs several steps removed.

Tecteryx has hired another company, TrustToken, to manage the stablecoin. TrustToken has in turn hired a third company, Prime Trust, a Nevada DBI chartered trust to manage the stablecoin's finances. Prime Trust acts as the regulated container for TrueUSD.

Prime Trust and Huobi Trust are regularly examined by the Nevada DBI to make sure that they are in compliance with Nevada's rules and regulations surrounding trusts.

What makes the Nevada model different from the New York model is that the NYDFS has explicitly acknowledged that New York trust companies can engage in stablecoin-related business. The NYDFS has a process in place to approve the stablecoins themselves, and provides continual inspections of these stablecoins.

The Nevada DBI has not explicitly acknowledged that trusts may (or may not) engage with stablecoin issuers. Unlike the NYDFS, the DBI has not explicitly familiarized itself with stablecoins, and has not set up additional procedures in place to regulate trusts that are engaged in stablecoin business.

For consumers and investors, it may be preferable to own stablecoins that have received explicit regulatory approval.

You'll notice that both the New York and Nevada models are based on trust companies. A trust company is what is known as a fiduciary. That is, it has a legal obligation to place customers' interests above the company's own interests.

The fiduciary nature of the relationship between stablecoin customer and stablecoin issuer is important. When Gemini Trust, Paxos Trust, Prime Trust, or Huobi Trust take in customer funds, their duty as fiduciaries prevents them (in theory) from investing this money in risky high-yielding investments. Were they to do so, they would be breaking their fiduciary duty to end users, the stablecoin owners, and could lose their charter.

The trust structure also protects customer funds in the case that the parent company, which owns the stablecoin, goes bankrupt. That is, if Binance or Tecteryx were to go bankrupt, BUSD or TrueUSD stablecoin owners needn't worry about fighting with other creditors for a piece of the company's resources. Their funds are protected at the trust company level.

3. The dozens of money transmitter licenses model

The only stablecoin that has adopted the dozens of money transmitter licenses regulatory model is the world's second largest stablecoin, USD Coin, issued by Circle. This is the same model that is used by well-known non-bank payments companies such as Square, PayPal, Skrill, Payoneer, Transferwise, Western Union, and Moneygram.

To operate under this model, an issuer gets a money transmitter license from each and every state that requires firms that engage in the business of money transmittal to be licensed. Montana is one of the states that lets money transmitters operate without a license. A few states such as Wyoming have exceptions for firms involved in crypto.

For its part, Circle has obtained 44 money transmittal licenses.

State licensing boards impose audit requirements on money transmitters and conduct examinations. Each state sets its own unique requirements, too. These include what sorts of investments money transmitters are permitted to make, capital requirements, and the size of the surety bond they are required to post. Some states are lenient, others are strict. (Dan Awrey has a good paper on the state-by-state requirements.) 

Some are very strict, like Texas, and some aren't, like Montana. https://t.co/Aa5PNsqVSn pic.twitter.com/OAX3Jco9QJ

— John Paul Koning (@jp_koning) May 20, 2021

But in general, my understanding is that the requirements placed by states on money transmitters are not as demanding as those that they impose on trust companies and banks. So pound for pound, a dollar issued under the NYDFS or Nevada trust model will have more oversight than a dollar issued under the dozens of money transmitter licenses model.

That's not the only advantage of the trust model relative to the dozens of money transmitter licenses model.

Circle is not regulated as a trust company, and thus it doesn't have a fiduciary obligation to its customers. That is, the funds Circle receives to back its stablecoins can be invested in such a way that may be good for Circle's investors and not necessarily good for Circle's customers. By contrast, issuers operating under either the New York or Nevada trust models are fiduciaries and must prioritize the customer's financial interests. Presumably that means that trusts can't put stablecoin customers' money in unsegregated accounts or risky instruments – but Circle can.

In addition, if Circle were to go bankrupt it's not apparent whether USD Coin holders would have better rights to Circle's remaining resources than other unsecured creditors. At least with the trust company model, stablecoin customers are insulated from the bankruptcy of the parent.

So from a customer's perspective, you are probably better off owning a stablecoin operating under either the NYDFS or Nevada model, rather than the dozens of money transmitter licenses model. Not only do the NYDFS or Nevada model have more oversight (because trusts generally face more oversight than money transmitters), but they are legally obligated as fiduciaries to keep the interests of their customers first and foremost. And the trust model probably provides better protection in the event of bankruptcy.

There is another difference between the NYDFS model and the dozens of money transmitter licenses model. Money transmitter licenses are generic. That is, they are a regulatory umbrella for a variety of very different businesses models, including remittance companies like Western Union, wallets like PayPal or Skrill, and finally stablecoins like USD Coin.

Compare this to the NYDFS model, which explicitly recognizes stablecoins and has created a specific process for authorizing and examining these products. (Nevada has not. The Nevada model is also a generic one). If I owned a bunch of stablecoins, I'd probably prefer if the regulator of these products had acknowledged them.

One last difference worth noting is that USD Coin must get 44 money transmitter licenses to operate across the U.S., but stablecoins operating under the Nevada and New York trust models seem to only need that one charter. Why is that?

A state chartered trust is typically exempt from having to get a money transmitters license in its home state. Depending on the circumstances, they may also be able to do business in other states without having to be independently chartered or licensed as a trust and/or money transmitter in those states. This seems to depend on whether the trust's home state has negotiated a reciprocity agreement with other states. Alas, I don't have a list of these agreements.

In any case, because trust company charters have a degree of portability, a single trust company charter seems capable of doing the work of 44 money transmitter licenses.

4. Stay offshore

The largest of the stablecoins, Tether, has adopted the last regulatory strategy: stay offshore. That is, Tether operates from the Cayman British Virgin Islands where it issues a U.S. dollar stablecoin. Tether's Cayman's-based Bahamas-based bank, Deltec, manages Tether's banking needs. And thus Tether avoids the necessity of setting up a New York or Nevada trust, or acquiring 44 money transmitter licenses.

The drawback of this structure is that that Tether can't operate in the U.S. Tether's terms of service prohibits "U.S. persons" from using the product.

Conclusion

In sum, those are the four regulatory strategies I've seen stablecoins pursue. Whereas stablecoins are often criticized for being unregulated, I think my post suggests the opposite. Yes, Tether can be criticized as such. But the New York and Nevada trust company models stand out for providing a significant amount of safety to stablecoin consumers, the NYDFS's approach particularly so because it has explicitly named and recognized stablecoins as products.

If you have comments or criticisms, do share them in the comments section of this post.

Postscript:

You'll notice that the first three strategies all operate at the state level. That is, the financial regulatory framework under which the major stablecoins are currently operating is governed by state licensing boards, and not at the national level by Federal banking regulators.

Might stablecoins eventually jump from a state-by-state framework to the national one?

One of the major financial banking regulators, the Office of the Comptroller of the Currency (OCC), has suggested that Federal financial institutions can support stablecoin transactions, but only if they involve "hosted wallets." A hosted wallet is a digital account hosted by a third-party financial institution. An unhosted one is controlled by the consumer.

But all of the big stablecoins I've mentioned in my blog post allow oodles of unhosted activity, so I suspect that Federal banks regulated by the OCC can't do business with them. Paxos, for instance, has recently secured a national trust bank charter from the OCC. But it appears that Paxos won't be using this national charter as the regulatory home for either the Paxos Standard and Binance USD stablecoins. Its NYDFS-chartered trust company will continue to be the regulatory anchor for its two stablecoin products.