Monday, October 11, 2021

Offshore Banking: The Basics

A lot of the discussion around stablecoins, and the crypto-banking nexus in general, touches on offshore banking.  Some of this discussion is, um, confused by degrees between innocuously at fatally.  This is an attempt to sketch how the system works and highlight those components that are most relevant.

Basics

Let's start by assuming a working international banking system.  This means banks like Citibank and HSBC exist and offer accounts in both a range of countries and currencies.  Note specifically to Americans: it is common in much of the world for your bank to provide accounts denominated in several currencies both for personal and business use.  This is not a niche product -- especially where cross-border (possibly small) business is concerned.

There is also some regulatory framework for finance specifically and business in general  We can approximate that framework as: don't commit fraud, don't call yourself a bank when you aren't licensed as one and you cannot access the payment system directly without a license.  Obviously that's not exhaustive and there are 200+ banking regimes around the world so it'll have to do.

We also need to assume the existence of "offshore financial centers."  These are regimes where we can establish legal entites, enter into long term contracts under a reasonable legal system, hire corporate services firms for admin and not have to worry about taxes.  This isn't about avoiding taxes -- it's about allowing funds to flow freely through legitimate structures without always worrying about tax.

Going Offshore

Now let's say we want to set up an offshore financial institution.  We incorporate a legal entity in an offshore financial center, call it "XYZ Financial Services."  XYZ has a local company ID number and officers who can sign contracts.  It can go and get a local bank account to rent an office, pay salaries, pay legal fees etc.  This is our "operating" company: it will employ people, pay the electric bill, and generally operate as a business does.

So what does XYZ after moving in to swanky new offices and buying computers?  It sets up "XYZ Capital" as a subsidiary, with it's own ID number.  Capital is going to hold the client assets and maintain links with the financial system.  The operating company now contacts banks around the world to set up accounts for XYZ Capital.  There is probably a contract between them laying out the terms of the relationship.

The operating company then maintains two "spreadsheets."  The first one tracks all of Capital's bank account balances.  And the second one tracks all the money owed to clients.  This second spreadsheet is what we mean by a "client account."  There are no physically segregated piles of cash and securities: an account is simply internal recordkeeping.

If a client demands real hard separation that amounts to setting up a clone of "XYZ Capital" with all it's accounts for that client alone.  The recordkeeping is then identical with perhaps a third spreadsheet tracking which clone is owned by which client(s).

Onboarding Clients

At this point we are ready to take in client money.  Clients are instructed to transfer funds into any of Capital's many bank accounts in whatever currencies are available.  The operating business then records those incoming transfers and credits on both the internal and external spreadsheets.

Note that there is 0 money or credit creation going on here.  We assumed the existence of a global financial system.  The client money now sits in our accounts within that system.  Transfers, withdrawals, investments etc all run out of our accounts.

Our first client is likely the management company itself.  The business model is to charge clients fees in exchange for services.  How do we do that?  Mechanically a fee is simply a notation in the internal books of a transfer from a client account to the management account.  Nothing moves in the outside world -- we just assign a slightly larger ownership share in the external bank accounts to the management company.

Every so often the operating business will request a withdrawal to it's own accounts -- to pay salaries or whatever -- and the external account balances will drop a little.

Commingling Funds Much?

Isn't this scheme commingling client funds?  This behaviour is not what that term means.  Note that all of the operating expenses of the business are paid out of accounts in the name of the management company and those are totally separate from the thing that holds client money.  We a commingling of corporate and client funds when the rent and salaries are paid out of the same bank account used for client transfers.

But how can this be?  All our money sits in one common set of accounts!  No.  The basement of your local bank does not contain individual piles of cash corresponding to each customer.  The bank likely has one (or a handful) of clearing accounts which hold the balances and everything else is an internal record.

Bad Practices

So now it's pretty obvious how this can go wrong.  We can only instruct transfers in the real world for amounts sitting in our external bank accounts.  But we can create any internal records we want!  We can just credit one client, internally, an arbitrary amount of money and let them pay other people.

And in fact as long as they are making payments only within XYZ Capital there are no limits.  However we have a serious problem once withdrawals begin.  If we start with 100 in real client assets and inject 50 of made-up money we can still process 100 in outbound payments.  But the 101st dollar cannot leave out little walled garden

There is nothing stopping the management company from entering into the following deal with a client: we will credit you $100 now and you promise to pay us $101 in 30 days.  And we can roll this 101/102 and 102/103 forever.  Well not forever -- only until someone tries to withdraw and we are out of money in our external accounts.

This is not, in an of itself, a problem.  If the promise for $101 is real -- if it's some kind of tradeable debt security with a market price near 101 -- we can top up our external balances by selling it in the outside world in exchange for an incoming funds transfer.  This is precisely why there is an interbank market for loans and bonds and the like.

But if it's not real, or it's worth dramatically less than $101 in the market, then we have a problem.

Solvency

Our little offshore business dies the day someone asks for an outbound transfer that we cannot service.  It is perfectly reasonable that we need to sell something to service an outbound transfer.  But if we simply cannot raise the funds we are insolvent.

It is therefore in our interest, if we want to do bad things, to keep as much of the action within our little walled garden as possible and keep out prying eyes.

In practice this is how regular banks work too -- except the banking regulator is (supposed to be) constantly checking the spreadsheets for chicanery.  And the deal with a banking license is that the contracts and ownership relationship between the XYZ Capital and XYZ Financial Services get torn up when the regulator says so.

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