Structure of the Financial System (Inverted Card House?) - Beginners' Guide
Is the cryptocurrency market a card house that could collapse at any moment? And if so, what’s underneath the card house? A strong foundation? A rickety table? Or worse, another card house… Hello, I’m Crypto Casey and this is the first video in a three-part series where we will investigate whether or not the cryptocurrency market, as well as the entire global financial system, is indeed on the verge of collapse. This is a beginners guide where we will break down step-by-step how the traditional financial system is structured, how the cryptocurrency market is structured, what stablecoins are, their role in the cryptocurrency market, and why stablecoins will both drive massive global adoption of cryptocurrencies, while also potentially threatening mass global adoption of cryptocurrencies. Our goal by the end of this video series is for us to understand the traditional financial system’s relationship with the cryptocurrency market, and if a crypto collapse can happen, how and when it could happen, and what we can do to protect ourselves as investors in the space. Awesome. So let’s get started.
So most people that venture down the rabbit hole into the crazy crypto world are fascinated by the idea of getting very rich, very quickly, with little-to-no effort. After some time, then they become mesmerized by the charts, and want to learn how to read the charts, and use the charts to predict the future, and use margins, options, and leverage to make even more money very quickly with little-to-no effort. And 99.9% of the time, they get rekt, absolutely rekt. And either crypto becomes the bane of their existence and they vow to never touch it again, or they get up and try again only to experience the same fate. Unfortunately since the development of easy, gamified user interfaces in investment applications like Robinhood coupled with the covid lockdowns over the past year, a lot of people’s first exposure to and interaction with self-directed investing practices happened recently and on a massive scale during a time when both the stock and crypto markets pretty much only went up and up and up. Everyone was a winner and everyone became an addict.
Only recently, have a lot of the new crypto investors experienced some seismic, gut-wrenching pullbacks. And what do they do? Usually, they sell. So I wanted to paint this picture of the average “investor” in crypto for you, to better explain why they are in fact the complete opposite of an investor.
What I just described is a crypto tourist at best. They bought in less than a year ago and sold in less than a year. And THAT is not investing at all. It’s not even a bastardized version of investing. It is absolutely speculation, or glorified gambling.
So before we get started, it’s important for us to understand the difference between speculation and investing in cryptocurrency. What is Speculation in Crypto? Speculation in crypto is when someone throws money into a project without doing extensive research with the hopes and prayers of making a profit in a short period of time, which is usually less than 12 months. Now, what we need to be in crypto is not speculators, but rather investors. So, let’s clarify what investing is. What is Investing in Crypto? Investing in crypto is when someone allocates money into a project after conducting extensive research with the intention of making a profit in the long term, which is usually over a year, but since the technology and asset class is still so new and high-risk, serious investors in crypto should realistically be planning to invest for a 2 to 5+ year timeframe, and all the while remaining active in the space.
Investors in crypto are not only investing their money, they are investing their time by learning about how finance & economics work, as well as keeping up with global news affecting the crypto markets, the ever-changing regulatory landscape around crypto, progress of the projects they’re invested in, potential competitors of those projects, activity in the traditional stock market, and a myriad of other things that influence the cryptocurrency industry at large. It’s not easy, and as the saying goes, if it were easy, everyone would do it. So with any self-directed investment activity, work is required to reap a reward. And the more risk you take on, the more work required to potentially realize more gains, because you could also lose your investments.
So another key characteristic of a serious investor in the crypto space is to never invest more than you can afford to lose. Nice. Now that we have clarified the difference between a speculator and an investor, let’s investigate whether or not crypto is a card house that could potentially: collapse in the short or long term for a short or long period of time, collapse in the short or long term forever, or not experience a collapse whatsoever, all from the viewpoint of an investor. Chapter 1: The Structure of the Traditional Financial System In this chapter we will break down 7 concepts to help us better understand the foundation upon which all available investments reside, including crypto. Concept 1: Fractional Reserve Banking Fractional Reserve Banking is just a fancy term that describes the system where banks are required to keep a certain amount, or fraction, of the amount of money people deposit into their bank accounts.
For example, let’s say for every $100 you deposit into your account, per the fractional reserve banking system, the bank only has to keep $10 of the total deposit and is allowed to lend out the rest. This fraction of deposits banks are required to maintain are known as reserves. So the $10 dollar fraction of the $100 dollars you deposit into your bank account, is held as reserves. And the fraction of deposits banks are required to maintain are known as reserve requirements.
Hence the term, fractional reserve banking. The fractional reserve banking system was created as a way to allow for the expansion of the economy. Here’s how: For example, imagine a business deposits $100,000 into their bank account. Assuming a 10% reserve requirement, the bank keeps $10,000 of the deposit to maintain the reserve requirement, and then loans out the other $90,000 to a person.
This person then deposits the $90,000 loan into their bank account and their bank keeps $9,000 of it to maintain the 10% reserve requirement, and then, what happens next? Yes, that bank lends out the other $81,000 to another person or company etcetera. So that single $100,000 deposit by the business at the beginning of this analogy effectively created $271,000 in the financial system. And this process can keep repeating over and over again, creating more money in the economy, all courtesy of the fractional reserve banking system. Interesting, right? A little unsettling? What happens if a large percentage of people or businesses want to withdraw their bank deposits and not enough money is available to cover it? Well, this happened once during the Great Depression and it caused the single largest bank failure in American history. Since then the Federal Deposit Insurance Corporation, or FDIC, was formed to insure deposits in US banks in the event of bank failures. Nice, what a relief right? Our money in our banks is safe and secure in the event of another massive bank failure.
Kind of… there are three caveats to be mindful of when assessing whether your deposits are insured: 1) your banking institution must be a member firm with the FDIC to qualify. Following that, 2) the FDIC only insures deposits made into certain types of accounts which generally include checking, savings, CD’s, money market accounts, IRA’s, revocable and irrevocable trust accounts, and employee benefit plans. The FDIC does not insure mutual funds, annuities, life insurance policies, stocks, or bonds.
So assuming your banking institution is a member firm of the FDIC, and your deposits are in a type of account covered by the FDIC, the final caveat 3) is that only $250,000 per person or depositor is insured. Meaning if you as an individual have, let’s say $300,000 deposited in a checking account with an FDIC member bank, in the event of a bank failure, $50,000 of your money is not insured and could be unrecoverable. So here’s a quick tip if you have more than $250,000 you choose to keep in a banking account: consider opening accounts with several different banking institutions that are FDIC members to spread out the deposits to have more FDIC coverage. Awesome. Now that we know how the fractional reserve banking system works and the fail safes put in place with the FDIC to mitigate some damage if the system collapsed, next let’s talk about other ways all of this money we earn, spend, borrow, lend, withdraw, and deposit with banks is created and how the government manages it. Concept 2: US Treasury Bonds The Federal Reserve is the central bank of the United States and in control of the creation and management of money.
And the Federal Reserve controls the US money supply in two ways: one, by digitally adding and subtracting money to and from major banks, and two: by issuing, buying, and selling US treasury bonds. So let’s break down what a US treasury bond is and its role in the management of money in our economy. First, what is a bond? A “bond” is just a fancy word for a loan. So bonds are loans, or debt instruments. And “US Treasury” bonds refer to debt issued by the US Government.
So the Federal Reserve issues debt in the form of US Treasury bonds, and also engages in buying and selling these US Treasury bonds to control the money supply. Let’s talk about how this is done. Imagine the current state of the economy, where there’s a certain amount of US dollars circulating between banks, hedge funds, and other financial institutions. When the Federal Reserve issues US Treasury Bonds, these entities can use some of their dollars to buy the bonds.
And the dollars they give to the Federal Reserve in exchange for the bonds is then taken out of circulation and locked up with the fed. The Federal Reserve uses the money it receives to pay down debts or to fund improvements to infrastructure or similar. When financial entities buy US Treasury bonds, the amount of money in circulation decreases.
And when financial entities sell US Treasury bonds back to the Federal Reserve, the amount of money in circulation increases. So why would financial entities want to buy US Treasury bonds in the first place? Well, treasury bonds are assets similar to blue chip stocks like Apple that pay their stockholders dividends over time; except by holding treasury bonds, the holder receives set interest payments over time. And instead of these assets being backed by a single corporation like Apple, they are backed by the US Federal Reserve, making them a safer, more pristine asset. In fact, US Treasury Bonds are deemed the safest and most pristine asset by many, especially right now which will be important to stay mindful of throughout this video series. So when financial entities or people feel uncertain about markets and the economy at large, they typically choose to buy and hold treasury bonds because they are less risky than other assets.
Cool. So we know why financial entities want to buy US treasury bonds, because: they are deemed safe, pristine assets that pay guaranteed fixed interest over time, they’re backed by the government, and thinking back to how the fractional reserve banking system works, banks have both requirements and incentives to keep assets on their balance sheets so they can create loans, which are income generators for them. And this brings us to our next concept. Concept 3: The US Treasury Bond Market So it’s important to understand that when new US Treasury Bonds are issued by the Federal Reserve, they go up for auction. This is the primary place where new bonds originate. Financial entities can bid on the bonds and if they acquire bonds, they can choose to keep them or sell them in a secondary market known as the US Treasury Bond market.
The US treasury bond market is where financial entities like banks, hedge funds, and other financial institutions can buy and sell US Treasury Bonds that were already previously issued by the Federal Reserve. Simple enough, right? Cool. Onward to: Concept 4: The Repo Market The work “Repo” stands for “repurchase agreements.” And a repurchase agreement is just a fancy word for a short term collateralized loan. The repo market is where financial entities can sell assets like US treasury bonds for the short term in exchange for cash with a promise to buy back or repurchase the assets at a higher price. The buy back or repurchase term is usually overnight, but can be a week, two weeks, or one month depending on the terms of the repurchase agreement.
So when banks, hedge funds, or financial institutions need cash to meet reserve requirements or for liquidity, they can temporarily swap treasuries they have, for cash from banks in the repo market. And when the term of the loan expires, the entity buys back the treasury at a higher price, similar to an interest payment. The price to repurchase the treasury can be dictated in a few different ways. One, by the amount of money in circulation.
The more money in circulation, the lower the interest rate, and vice versa; the less money available, the higher the interest rate. Two, the supply and demand of money. If there’s more demand for cash than the circulating supply, interest rates can get too high.
And when this happens, the Federal Reserve usually steps in and buys treasuries in exchange for cash to put more cash into the ecosystem, which, in turn, lowers interest rates or the cost of borrowing money. And three, how risky the buying or borrowing entity is. So if the entity entering into the repurchase agreement is not financially stable, or possibly close to insolvency, the repurchase price of the treasuries will be much higher, because they are a much riskier borrower. Which brings us to the next concept - Concept 5: Rehypothecation When there are a lot of risky borrowers in the repo market, the price to repurchase treasuries or essentially borrow money, increases.
And when there is high demand for treasuries in a market with a lot of high-risk borrowers with no collateral, the available supply of treasuries decreases. Banks will flat-out refuse to lend money to high-risk borrowers that don’t have any treasuries or other good collateral to secure a loan. So when the amount of available treasuries is low, and the demand for cash is high among a lot of high-risk borrowers on the brink of insolvency, entities will engage in what’s called rehypothecation. Rehypothecation is just a fancy word that basically describes an entity letting another entity use their treasuries to secure a loan. For example, let’s say a hedge fund needs cash, but doesn’t have any treasuries to secure a loan themselves. The hedge fund can call in a favor from one of their financial institution buddies that has treasuries and essentially borrow it from them to use as collateral for the loan.
When financial institutions let other entities borrow their treasuries, the treasuries are deemed rehypothecated. And as you can imagine, rehypothecated treasuries aren’t exactly a safe form of collateral because, at the end of the day, the banks lending the money don’t know who actually owns the treasury. And they also don’t know how many times that treasury has been rehypothecated, because yes, the same treasury can be hypothecated multiple times allowing multiple entities to essentially re-use that same exact treasury as collateral. Meaning a single treasury can be on multiple entities’ balance sheets simultaneously.
This would be like you and 20 other people sharing the same bank account, and let’s just say the bank account has $100 in it. And you and 20 other people are telling lenders you are trying to borrow money from that you definitely have $100 in your account in case things go awry. Yeah, not ideal. So imagine the difference between a treasury and rehypothecated treasury, as a treasury being hard cash or a debit card transaction, versus a rehypothecated treasury being a credit card transaction.
Would you rather someone pay you with cash or with a credit card? Exactly. So since covid, the Federal Reserve has been adding record amounts of cash into the economy, by merely printing it out of thin air and through buying US treasury bonds, which is further decreasing the available supply of pristine collateral. Which brings us to the next section. Concept 6: The Reverse Repo Market A huge supply of cash and low supply of pristine collateral like US treasuries has caused the “reverse repo market” to explode recently. A reverse repo is just the other side of a repo. For an entity selling a US treasury to someone for the short term, the transaction is a regular repo or repurchase agreement.
For the entity buying a US treasury for the short term, the transaction is a reverse repo, or reverse repurchase agreement. Why is the reverse repo market exploding right now? Well, as we described earlier, it’s because there has been both an increase in demand for collateral versus cash, and a supply shortage of preferred collateral, US treasury bonds, in the repo market. Since the fed has been both printing news dollars into the ecosystem and buying up all the treasury bonds from the repo market in exchange for cash, further increasing the amount of dollars in the ecosystem: banks and financial institutions are bursting at the seams with excess cash. As a result, all these entities with excess cash are now saying to other entities, hey, we will pay you interest to borrow our cash, in exchange for treasury bonds. So instead of the borrower having to pay the lender interest on the cash loan, the lender is literally paying the borrower to take their money.
This is because the cash lender wants to pay the cash borrower interest to borrow their collateral. Strange right? So all the financial institutions would rather pay to borrow US treasury bonds than hold cash. They want the collateral, not the cash. Now, why is it so? Well, they could be making a profit from taking the treasuries to the secondary bond market, but also with so much cash in the ecosystem there is nowhere else for it to go. But Casey, what about other less-risky assets like physical properties, mortgage-backed securities, or corporate bonds.
Well, financial institutions aren’t daft and see the writing on the wall. First of all, look at the housing market. Financial institutions have been buying up physical property like crazy, sending prices for homes to record highs. So yeah, they’re buying property.
Next, mortgage-backed securities? Which are bundles of home loans… in the midst of the longest rent, mortgage, and eviction moratoria the US has ever seen? Financial institutions know what’s going to happen when it supposedly ends at the end of this month, July 2021. Lots and lots of defaults on mortgages. Nobodies going to be able to pay several months of mortgage payments all at once, and even if repayment deals are worked out, there’s still a lot of risk to be mindful of. So mortgage backed securities are far from being pristine collateral right now.
From there, corporate bonds and stocks: yeah, we all know they’ve been artificially propped up from covid stimulus packages. Big zombie corporations that should’ve failed years ago still have a pulse, for now. In addition, the overall traditional stock market is well overdue for a correction.
So yeah, US treasury bonds are where it’s at. In a pick your poison economy, US treasury bonds are the least poisonous right now. But if entities are scrambling to buy up all of the treasuries from the treasury market, what happens to the repo market? Well, it basically has what caused this whole issue in the first place: a shortage of sufficient collateral.
Then what happens is more of the same we discussed earlier: more rehypothecation, where entities start borrowing each others’ collateral in order to stay liquid. And if 5 or 10 or 20 entities are using the same exact treasuries as collateral to stay liquid, what happens if one of them goes insolvent? Yeah, it’s basically a game of musical chairs with, like, 1 chair per 20 people trying to sit in it when the music stops. And that’s just assuming banks with cash would be willing to lend to all of the entities using treasuries that have been lent out to god knows how many others. And what if it’s not just the second bond market where rehyophecated treasury bonds are being circulated? What if the Federal Reserve itself is also redistributing rehypothecated treasury bonds? Check out this interesting idea I came across from one of my favorite sources, George Gammon’s YouTube channel.
Here’s an excerpt directly from the New York Federal Reserve’s website about Reverse Repurchase Agreement Operations: 1 - When the Desk conducts RRP, or reverse repurchase agreement, open market operations, it sells securities held in the System Open Market Account (SOMA) to eligible RRP counterparties, with an agreement to buy the assets back on the RRP’s specified maturity date. And here’s the key sentence to soak in: This leaves the SOMA portfolio the same size, as securities sold temporarily under repurchase agreements continue to be shown as assets held by the SOMA in accordance with generally accepted accounting principles, but the transaction shifts some of the liabilities on the Federal Reserve’s balance sheet from deposits held by depository institutions (also known as bank reserves) to reverse repos while the trade is outstanding. These RRP operations may be for overnight maturity or for a specified term. Wait, so did the Fed just admit to allowing a single treasury that they have on their balance sheet to remain on their balance sheet while they sell it to another entity? Or even multiple entities? Have they started implementing a fractional reserve system with US treasury bonds to keep the music playing? Probably, because the Fed knows that if there isn’t enough pristine collateral or US treasury bonds to keep the reverse repo market going, the whole global financial system comes crashing down pretty much. I mean look at this: 2 - This is a graph showing the total amount of money in billions being transacted in overnight reverse repurchase agreements since 2016. Just this past Wednesday on June 30th, it hit over $990 Billion dollars worth of overnight reverse repos.
Meanwhile 3 - On June 24th, the Federal reserve released their latest balance sheet showing $326 Billion dollars worth of US treasury bonds. And if we refer back to the excerpt from their website, this number on their balance sheet remains unchanged regardless of whether or not they sold treasuries in the reverse repo market. Also keeping in mind that these are just reverse repos done with the Fed. The entire reverse repo market where financial entities like banks and hedge funds can transact between each other is over $4 trillion dollars. So is the whole traditional financial system propped up on unlimited, baseless cash and just a few treasuries that have been rehypothecated into oblivion? It’s possible, which brings us to our final concept in this chapter: Concept 7: The US Financial System Card House At the time of this video, the crypto markets are still highly correlated with the traditional markets and on an abstract, conceptual level, still utilizing the traditional global financial system as a foundation. So let’s take a look at the current state of the US financial system in this analogical visual representation of 3 - an inverted or upside down card house.
The bottom and lowest rows represent assets with less perceived risk, and as we move higher up the inverted card house, these assets have more perceived risk. So at the bottom here, we have a few real deal US Treasury Bonds being propped up by Fed Chair Jerome Powell and Treasury Secretary Janet Yellen. Above that, we have a slew of rehypothecated US treasury bonds, all of which we have no idea who actually owns the actual treasury, and no idea how many different balance sheets the treasury exists on simultaneously. Here we also have physical property like houses, apartments, buildings, and other types of real estate. On top of that we have mortgage backed securities representing all of the liens against the real physical property, as well as some commodities like gold, oil, corn, cattle, etcetera.
Above that, we’ve got corporate bonds, blue chip stocks and equities like Apple, Google, Amazon, and similar. As well as stocks, equities, and corporate paper of smaller, more risky corporate entities. And finally, representing the largest quantity of assets harboring the highest risk are options, futures, and derivatives, which in the traditional markets is just legalized gambling, where people pretty much make bets on what the prices of all the other assets in this chart will be in the future. So yes, calling spades, spades here: behold the structure of the current traditional financial system, that also currently serves as the foundation of the entire cryptocurrency market. Fun fun.
Awesome. Congratulations for making it through chapter one in this video series. Yes, it was long, tedious, and boring, but now we will better understand and appreciate how this relates to the crypto market and what we can do to protect our investments. This is the first video in a three-part video series, so make sure to check them all out to get the full scoop. If you enjoyed the video make sure to like this video and subscribe to my channel for more crypto content. So what do you guys think about the current structure of the traditional financial system? Was the video explanation clear or do you have other questions? How about that inverted card house analogy? Clever or concerning? Let me know in the comments below.
Be safe out there.