Someone is wrong on the internet about the SWIFT network

There's a chart that has been circulating for a while now on social media that shows payments traffic on SWIFT, a key global financial messaging network. Below is a version from the Economist, but I've seen other versions too.

Source: The Economist

When banks make cross-border payments between each other, say euros to dollars, they need to use a communications network to coordinate the debiting and crediting of accounts, and SWIFT is the dominant network for doing so. Think of it as WhatsApp for banks.

Here's the problem. The main conclusion that pundits are taking away from the chart is the wrong one. Most of them seem to think that the chart illustrates an erosion in the euro's global popularity (i.e. de-euroization) and a simultaneous move towards the dollar for global trade. The Economist, which entitles its chart "Dollarisation," is also guilty.

Today I'm going to show you why that's the wrong conclusion; there is no SWIFT-related de-euroization. The reason for going through this effort isn't just because it's fun to dunk on wrong folks. It can also teach us some interesting things about the massive bits of unsung payments infrastructure that underlie our global economy, including not only SWIFT but also Europe's T2 and the U.S.'s Fedwire, two of the world's busiest financial utilities.

Let's dig in. The problem with trying to analyze charts of SWIFT messages across various currency jurisdictions is the data isn't necessarily comparable. As I said at the outset, commercial banks around the world use SWIFT to coordinate cross-border payments with other banks, and that is what people are hoping to measure with the SWIFT chart at top. But muddying the waters is the fact that in the EU, banks also use SWIFT for domestic payments. Here's how:

The most important bit of payments infrastructure in both the U.S. and EU are their respective central bank's large-value payments (or settlement) systems. When commercial banks make crucial domestic payments with each other, typically on behalf of their customers, these payments are settled in real-time using each commercial banks' respective account at their central bank, in the U.S.'s case the Federal Reserve, and in Europe's case the European Central bank, or ECB. The ECB's mechanism for settling payments is known as T2 (and previous to that, Target2.) The Fed uses Fedwire.

To coordinate this "dance of databases," the central bank and participating commercial banks need to communicate clearly and rapidly with each other, and that's where financial messaging networks come in. Fedwire doesn't use SWIFT for this. It comes fitted-out with its own proprietary messaging network for member banks. But the ECB has chosen a different setup. Up until 2023 the ECB had outsourced all messaging to SWIFT, a bank-owned cooperative based in Belgium.

Now you may be able to see why comparing the amount of euro payments made using SWIFT messages to dollar payments made using SWIFT is an apples to oranges comparison. Both data sets include cross-border payments, but the EU dataset also includes a large amount of domestic payments. The U.S. dataset doesn't.

This means that the variations in the amount of euro payments messages that get captured in the chart at top may not reflect dramatic geopolitical shifts like "de-euroization, but may be linked to more banal things like changes in local EU payments habits. And indeed, I'm going to show why domestic and not international factors explain the 2023 drop in the euro share of SWIFT messages. 

In 2023, the ECB replaced its Target2 settlement system with a new system called T2. Two key upgrades were introduced with T2 that ultimately affected SWIFT message flows. 

The first of the upgrades was a new language for constructing messages, with the ISO 20022 messaging standard replacing the legacy MT messaging format. (I wrote about ISO 20022 in an article entitled The Standard About to Revolutionize Payments.) 

This change in payments lingo has had a big effect on the sum of SWIFT data displayed in the chart at top. Both the ECB and SWIFT provide explanations for this, but here is my shorter summary. Prior to the 2023 changeover, a type of euro payment known as a liquidity transfer was regularly captured in the SWIFT chart. A liquidity transfer occurs when a European commercial bank, which often has several accounts at the ECB, must rebalance between its accounts when one of them is running low. These within-bank liquidity transfer messages aren't terribly interesting and have nothing to do with global payments, but were included in the SWIFT dataset nonetheless up until 2023, thus fudging the results. 

With the arrival of ISO 20022, messages related to euro liquidity transfers are now conveyed using a new type of message. Thus the big decline in the euro's share of SWIFT messages in 2023 — liquidity transfers have effectively dropped out of the chart. This is a good thing, though, since the omission of these relatively unimportant within-bank transfers means we're getting a cleaner and more accurate signal.

The second upgrade introduced in 2023 was the opportunity for European commercial banks to choose among multiple messaging networks for accessing T2. Under T2's predecessor, Target2, banks only had one access choice: the SWIFT network. With T2, European banks can also use SIAnet, owned by the Nexi Group. (I wrote about this upgrade here, in which I described T2's switch from an older Y-copy topology to a network agnostic V-shaped topology.)

In that older post, I suggested that adding additional access points was a healthy step for Europe, since it meant more resilience should one network suffer an outage. And in fact, Europe is already reaping the benefits. When SWIFT failed for several hours on July 18, 2024, the ECB issued the following alert:

"T2 is operating normally. However, due to an ongoing SWIFT issue, some incoming messages do not reach T2 immediately. Similarly, some T2 outgoing messages might not reach the receiver immediately... There is no impact on traffic sent or received via NEXI. Participants may continue sending new instructions and queries to CLM/RTGS/CRDM. Updated information will be provided at the latest by 16:30."

Whereas an outage of SWIFT in 2021 or 2022 would have seriously slowed down Europe's financial activity, the addition of Nexi's SIAnet to the mix in 2023 limited the damage caused by the 2024 SWIFT outage. By contrast, the UK's central bank, the Bank of England, remains entirely reliant on SWIFT for messaging, and so the 2024 outage caused more disruption for Brits than Europeans, according to the Financial Times.

Unfortunately, I can't find any data on how many European banks have actually chosen to shift their T2 messaging needs over to Nexi. But I'd imagine that it isn't negligible, given that Nexi's SIANet is already being used by banks to access other key bits of Europe's payments architecture including STEP2, a pan-European automated clearinghouse. And so some non-negligible portion of the drop in the euro's share of SWIFT messages in the top chart is due to a shift away from SWIFT.

If the SWIFT chart at top doesn't mean what people think it means, what is the euro's status as a global trading currency? A 2024 article from the ECB clears this up. In short, the euro's international role hasn't eroded over the last few years. The de-euroization memes are all wrong.

The irony of all of this is that rather than reflecting a decline in Europe's status, the SWIFT chart illustrates the opposite. A bunch of healthy advances are driving the euro's share of SWIFT payments down, including a more accurate classification of financial messaging data thanks to a better messaging language, combined with a much needed de-SWIFTication of European messaging flows. It's not as juicy as euro critics make it out to be.

Inflation as a tax

Last week I explored how Henry VIII resorted to coin debasement as a way to raise revenues in order to fight his wars. This provided Henry with the financial firepower to annex the city of Boulogne from the French in 1544, albeit at the price of England experiencing one of its greatest inflations ever.

Zoom forward five hundred years and Rishi Sunak, the Prime Minister of the UK, has ignited a controversy by referring to inflation as a tax, and further suggesting that the "best tax cut I can deliver for the British people is to halve inflation." His BBC interviewer disputed the claim, saying that inflation isn't a tax, a stance that the BBC upholds on its fact checking page.

Rishi Sunak, "The best taxt cut that I can deliver for the British people is to halve inflation."

Laura Kuenssberg, "Inflation is not a tax"

Rishi Sunak, "Inflation is a tax" pic.twitter.com/6LgMbeaprY

— Farrukh (@implausibleblog) October 1, 2023

If you recall, my previous article showed how Henry VIII's debasement functioned very much like a tax, say a new customs duty on wine or a beard tax. It did so by incentivizing people to flock to English mints to have their precious metals turned into coinage, Henry extracting a small fee on each coin. But the 21st century monetary system is very different from that of the middle ages. Is Rishi Sunak right to characterize inflation as a tax?

First, we need to better define our terms.

What do the BBC interviewer and Sunak mean by inflation? In the western world, prices have been rising at a regular pace of 2-3% each year for decades as result of central bank policy, which targets a low and steady inflation rate. Is this the definition they are using? Alternatively, Sunak and his interviewer may be referring to inflation as a *change in the change* in price. Since 2022 or so, that 2-3% rate has leapt to 8-9% all over the western world. Is it this jump that Sunak and his interviewer are talking about?

For the sake of this article, we'll assume that the conversation between Sunak and the BBC refers to the latter, a spike in the rate of inflation.

Secondly, what is meant by the word tax? Sometimes when we say that something is a tax we mean that it causes suffering. That is, inflation is taxing: it makes people's lives harder by increasing the cost of living, with salaries failing to keep up. It creates unfair changes in winners and losers.

Fair enough. But the more precise view I want to broach in this article is that inflation is actually a tax, where we define a tax as a formal charge or levy, set by the political process, that leads to cash flowing from the population to the government.

What does the data show?

Interestingly, a surprise jump in inflation leads to the very same effects as a new tax. All things staying the same, a new tax leads to an increase in government revenues. This improves the government's fiscal balance, or the difference between its revenues and expenses. A recent IMF paper by Daniel Garcia-Macia using data from 1962 to 2019 shows how an inflation shock typically achieves this exact same end result, boosting government revenues and improving its fiscal balance. This effect lasts for a few quarters, even up to two or three years, then recedes.

The IMF's chart below breaks down exactly how an inflation shock tends to improve government finances using quarterly data going back to 1999:

Charts source: IMF

Total tax revenue (the first panel) immediately begins to rise after the inflation shock at about the same rate as inflation.That's because most taxes are set by reference to values or prices, say like the prices of goods and services, or the price of labor, or the value of corporate profits. Since inflation pushes these amounts higher, this gets quickly reflected in tax revenues.

Income taxes and profits taxes (the second panel) rise particularly fast. Inflation is presumably pushing tax payers into higher income tax brackets, a process known as "bracket crreep," and so the government very quickly starts to collect a proportionally-larger amount of income tax.

Meanwhile, the government's total expenditures, the third panel, typically stay flat or only marginally rises in the quarters after the inflation shock hits. Notably, the amount of wages that are paid to government employees and social benefits (panels 4 & 8) tend to fall.

The net effect is an improvement in the government's fiscal balance. More specifically, for a 1% increase in inflation, the government's overall balance tends to improve by about 0.5% of GDP. And so an inflationary shock ends up at the same endpoint as a new tax: higher revenues and a better budget. That doesn't necessarily mean that inflation is itself a tax. Taxes have a degree of intentionality. They get implemented through a political process that has a certain set of goals in mind. By contrast, the extra revenue that an inflation shock raises is often (though not always) accidental, the result of external forces rather than political decision making.

So while it may not fall under the dictionary definition of a tax, the tax implications of a modern inflation shock resemble that of a new tax.

Everything I've written above applies to an inflation shock, say a rise from a 2-3% to 8-9%. Next I want to show that even constant 2-3% inflation can have the same revenue implication as a tax. Here's how.

Banknotes and seigniorage

Governments usually have a monopoly over the issuance of two key financial instruments: banknotes and settlement balances (also known as reserves). We all know what banknotes are, but what are settlement balances? Commercial banks find it useful to keep a stock of settlement balances on hand to make crucial large-value payments to other banks. The central bank, which the government controls, is the monopoly provider of these balances. (Sometimes banks are required by law to keep a a fixed number of settlement balances on hand, often above and beyond their day-to-day needs, a policy referred to as required reserves.)

Historically, interest rate on both types of central bank-issued money have been set at 0%. At the same time, the rates on short-term credit instruments (Treasury bills, commercial paper, bankers acceptances, etc) are determined by the market, typically hovering at a positive rate ranging between 0.25% to 5% over the last thirty years. These yields are priced to compensate investors for inflation.
 
The interest rate gap this gives rise to allows central banks to earn a steady stream of revenues, borrowing at an artificially cheap rate of 0% from both the banknote-using public and banks, and reinvesting at, say, 3%. Most of the revenues that the central bank collects from this interest margin flows back to the government. Economists usually refer to these revenue stream as seigniorage.

So seigniorage performs the same function as a consumption tax or an income tax: it takes resources from the public and gives it to the state. Likewise, a reduction in seigniorage would be very much like a tax cut.

If politicians wanted to, they could do away entirely with this form of raising government revenues. They have two ways of going about this. One way would be to have the central bank reduce price inflation to zero. By doing so, the interest rate on short-term credit instruments like Treasury bills would also fall to 0%, or thereabouts, since these instruments no longer need to compensate investors for inflation. And so the gap between the 0% rate at which central bank fund themselves and the rate at which they reinvest would cease to exist, seigniorage effectively shrinking to zero.

Over the last few decades, governments have taken a second route to removing seigniorage: they have begun to pay a market-linked yield on settlement balances. Canada, for instance, adopted this policy in 1999, and the Bank of England did so in 2006. By paying a market-based return, central banks no longer extract seigniorage from banks by forcing them to hold 0% assets. 

However, that still leaves banknotes as a significant source of seigniorage. We can calculate how much the UK government roughly earns from banknote seigniorage. With £95 billion in banknotes outstanding in October, and interest rates at 5.1%, the Bank of England's banknote-related seigniorage comes out to around £5 billion per year, much of which flows back to the government. That sounds like a lot, but it's only a small chunk of the £790 billion in taxes the UK government collected last year.

Banknote seigniorage isn't set in stone. It's a policy choice. If governments wanted to, they could reduce this form of seigniorage by paying interest on banknotes. One way to go about this would be to introduce a banknote serial number lottery. This lottery would offer around £5 billion in cash prizes to holders of winning banknote serial numbers, equating to a 5% interest rate on banknotes. Doing so would be akin to enacting a tax cut on British citizens.

To sum up, the fact that both an inflation shock and steady 2-3% inflation have implications for government revenues suggests that while inflation may not quite qualify as a tax, it is certainly tax-like.

UK's core payments settlement system fails... again. Some thoughts

As they increasingly forsake cash, regular folks are making dozens of digital payments every month. What they don't realize is how this growing reliance on digital payments increasingly yokes their commercial lives to the fate of a single piece of infrastructure: their central bank's large-value settlement system. When that system experiences a glitch, everyone's financial life gets put on hold.

In the United Kingdom's case, it is the Bank of England's RTGS settlement system that lies at the core of the economy. RTGS's centrality is highlighted by the fact that all the arrows in the chart below converge on it: every payment in the UK, big or small (except for cash), ultimately gets finalized using RTGS.

Alas, RTGS failed this Monday for six hours. No reasons were given, although I can't help wonder if it is was due to a software glitch stemming from Bank of England staff having been recently upgraded RTGS to the ISO 20022 payments language, rather than something like a cyberattack.

RTGS's centrality illustrated. Source: Bank of England

This isn't RTGS's first long failure. Back in 2014, a poorly-managed software update caused RTGS to shut down for 9 hours, leading to a revealing independent review.

The failure of the nation's key piece of payments infrastructure, even for just a few hours, is not a good thing. During those hours of unavailability, costly delays are imposed on day-to-day commerce as well as financial markets. Even when a buggy system is up and running, the uncertainty of another potential long failure acts as a pervasive cost on commercial society. 

To reduce these costs, central bank large value payments systems are typically built with multiple layers of redundancy. In RTGS's case, the hardware is hosted at two different sites, so that if the primary site goes down, the other one can quickly kick in. Presumably whatever knocked RTGS down last Monday was fierce  enough to incapacitate both sites.

A third layer of redundancy comes in the form of the Bank of England's Market Infrastructure Resiliency Service, or MIRS. With RTGS's two sites incapacitated, the Bank can "fail over" to MIRS, payments recommencing. MIRS uses different software, programming, and hardware, as well as being  hosted in a geographical remote location with a separate group of staff. This is achieved by an outsourcing arrangement with SWIFT, the same folks who run the global SWIFT messaging system.

There's no indication that the Bank of England failed over to MIRS earlier this week, staff preferring to focus on fixing RTGS instead. Alas, this choice subjected the UK economy to a long settlement delay. Why no fail-over to MIRS? Why choose such a long period of settlement deprivation?

A reading of the inquiry into the 2014 failure gives some clues into what may have happened two days ago. When RTGS failed on Monday, October 20, 2014, the Bank of England likewise chose not to fail over to MIRS. Why? The inquiry pointed to the fact that it would haven taken 2-2.5 hours to get MIRS up and running. Given this length of time, it made sense to try to fix RTGS instead, an inherently-preferable system because of features like the ability to save on liquidity, which the back-up system MIRS lacked.

Management was also reticent to switch on MIRS because they weren't sure if, after having activated it on Monday, they could turn it off on Tuesday night and manually return to a now-repaired RTGS without making a mistake. Bank officials only felt comfortable doing this manual switch back to RTGS on a weekend, because it afforded them much more time than a weeknight.

And thus trepidation about switching on the back up system led to it never being activated in 2014, which forced 9 hours of settlement deprivation on the UK economy.

Among its suggestions, the 2014 inquiry called for an upgrade to the MIRS back up option in order to make it a less anxiety-inducing option to turn to. The passage is worth reading in full:

Work should be undertaken to remove or reduce the barriers to invocation of MIRS so that
the Bank can "switch and fix" in parallel and in confidence. This should focus on testing the process to fail-back to RTGS intraweek (which is the primary barrier to invocation). If it is not possible to reduce this barrier, consideration should be given to enhancing the resilience and functionality within MIRS. In addition the Bank may wish to consider other back-up options for RTGS.

These were all good ideas. They would have reduced the hassle of resorting to the backup option by either improving the switching experience, or by upgrading MIRS's features so that being stuck on it for a few days posed less of a nuissance.

Which brings us back to 2023. If there is an inquiry into Monday's RTGS outage, investigators will need to explore why a multi-hour delay was once again imposed on UK citizens. Was it because, once again, the costs of using the back up system were deemed too high relative to the benefits? If so, were the costs deemed too high because none of the improvements suggested back in 2014 were adopted?

Failure to learn from the past would be unfortunate. These issues are especially salient because the Bank of England will introduce the next version of RTGS in 2024. Given that the updated RTGS will be built with more modern technology, it will (hopefully) fail less often than the older version. But it will still fail. What will the updated back up scheme look like? Will RTGS quickly switch over to tertiary site, or will the economy be forced to endure multi-hour settlement failure as a fix is pursued?

These are not just questions for the UK, but for every nation, since we all have large value payments systems on which commercial society is entirely dependent. It seems to me that if you have designed and built a back up system, that back up system should be, ya know, used. Those who operate them, usually central banks, should not be afraid to switch over. In the UK's case, that means that the decision to turn on MIRS (or whatever back up system the updated RTGS will use after 2024) should always be an easy decision for the Bank of England to make, not a gut-wrenching one.

Back to 1875

The last time I wrote about settlement speed was back in 2017. In that article I published a chart of the history of U.S. securities settlement speed, which I only recently had the chance to update. 

Well, here it is:

You'll sometimes catch technologists making the claim that settlement speed is a function of societal advancement. That is, in the old backward days of yore, settlement used to proceed at horse-and-carriage like pace, but as technology improves we gain the capacity to quicken settlement up to hours, then minutes, seconds and finally zero.

But as the chart illustrates, the technological explanation of settlement speed isn't right. We're about to return to t+1 (or next-day settlement) in 2024, the same pace we had back in 1875. Settlement speed isn't dictated by technological advancement, folks, it's the end result of a conscious choice that takes other factors into consideration, such as efficiency.

I was going to write an article explaining this more clearly, but I was reminded of a post I wrote for AIER back in 2021, and hadn't yet re-published here, which already makes this point more than adequately. So without further ado, read on:

In Finance, Slow is Good

In an age of instant communications, a stock trade takes a leisurely two days to settle. That is, if you buy some shares of Tesla on Monday, your brokerage won’t receive the shares (or pay the cash) until Wednesday. In industry speak, this is called T+2.

This seems an achingly long time to settle a transaction. Indeed, last month, the CEO of Robinhood, a discount brokerage, went so far as to suggest that there is no reason why “the greatest financial system the world has ever seen cannot settle trades in real time.”

In fact, there is a very good reason to eschew real-time settlement. Going slowly is a way to capture one of the world’s great natural financial forces: netting. Go too fast and you lose out on it.

To understand the magic of netting, let’s consider a world without it. Imagine a world with real-time settlement, where if I buy Tesla on Monday at 10:49 it settles at 10:49.

Say that I buy $100 worth of Tesla shares from you. We each use a different brokerage. With settlement proceeding in real time, the moment after the trade is made your brokerage will transfer the Tesla shares to my brokerage. My brokerage will simultaneously wire your brokerage the $100.

That’s two transactions between the brokerages.

Now let’s say that thirty minutes later, Jill decides to buy $100 worth of Tesla from Tom. Tom and I are clients of the same broker, while you and Jill are clients of the second broker. As before, the brokerages will have to settle up immediately. Tom’s brokerage will have to transfer the Tesla shares to Jill’s brokerage, and Jill’s brokerage will have to wire Tom’s brokerage the $100.

The two brokers now have to do four transfers between each other.

But if settlement is slowed by just a little bit, then the participants to this trade get to enjoy the magic of netting.

Let’s repeat all those transactions, but wait an hour before settling up accounts. When the hour is up, the brokers have two trades to settle up. But instead of processing both separately, they can just cancel them out. In this example, the inter-brokerage flows perfectly counterbalance each other. Our $100 Tesla trade is offset by that of Jill and Tom. And so the two brokerages needn’t do any transactions with each other. The first brokerage simply balances Jack’s and my account while the second brokerage balances Jill’s and your account.

And that’s why netting is so powerful. By making everyone wait just a little, it cuts down on the amount of work the system must do, in this case reducing brokerage-to-brokerage transfers from four to zero.

The netting afforded by T+2 settlement is so efficient that it allows the National Securities Clearing Corporation, which processes all trades involving U.S. equities, to reduce average daily equity volume of around $1.7 trillion by about 98%, leaving just a tiny $38 billion to be settled.

Faster is often better. But, in finance, a bit of tardiness can be a good thing. That’s why we should be wary of Robinhood’s call for real-time settlement. It would put an end to netting.

In fact, we already have financial systems that have gone real time only to double back and reintroduce slowness. It’s an interesting story, one worth recounting if only to show why real-time stock settlement is no panacea.

In the 1990s, central banks around the world began to roll out a new type of large-value payment system: real-time gross settlement systems (RTGSs). People like you and I use banks to make payments. But banks in turn must make payments amongst each other––very large payments––and for that they use their national central bank’s large-value payments system. This bit of central bank infrastructure is one of the most important, unsung pieces of any nation’s plumbing.

For decades, large-value payment systems operated on a deferred net settlement basis. Settlement was slow by design. Throughout the day, banks initiated payments to each other using the central bank platform. When 5:00PM finally rolled around, all reciprocating debits and credits were netted off and then settled between banks. Deferring settlement to the end of the day allowed for the number of bank-to-bank payments to shrink to a tiny fraction of total business transacted. It was incredibly efficient, albeit slow.

With the arrival of RTGSs in the ’90s, large-value payments were settled instantly, rather than at the end of the day. When Wells Fargo pays Citibank $100 million at 9:52AM, this involves an immediate transfer of $100 million in settlement balances at the Federal Reserve.

The ability to make a real-time payment is valuable. Sometimes you really need to wire funds to someone by 2:31PM, not 2:45PM.

However, real-time settlement at the central bank meant doing without the benefits of netting. So RTGSs had to process a lot more transactions than the deferred net settlement systems that they replaced. To keep up with this payments firehose, banks had to maintain a much larger hoard of central bank money on hand.

In an effort to reduce this hoard, banks adopted a strategy of waiting for an incoming payment to arrive before making an outgoing payment. Unfortunately, with all banks adopting this strategy, the result has been that payments often get pushed towards the end of the day. Many payments experts worry that this pattern isn’t healthy, since it increases the banking system’s vulnerability to operational problems.

The solution that emerged in the mid-2000s was the introduction of a new piece of central bank architecture: liquidity savings mechanisms (LSM). Central banks still allowed banks to settle payments in real time via the RTGS, but they also provided the option of submitting payments to an LSM, or central bank queue. A payment might wait in the LSM for 1 minute, 10 minutes, or 1 hour, until offsetting payments from another bank arrived to cancel it out.

By slowing down settlement, LSMs reintroduced the wonders of netting. And as a result, banks no longer had to keep such a big hoard of central bank money on hand. The Bank of England, UK’s central bank, estimates that after installing its LSM in 2013, the amount of liquidity that UK commercial banks required to make payments fell by 20%. So the same amount of business was being conducted over the Bank of England’s large-value payments system, but much less work was being expended to conduct that business.

LSMs have made the financial system safer by encouraging banks to make payments earlier in the day. After all, the quicker that a bank submits a payment to the LSM, the more time it will have to be matched. This is a neat little paradox. Queues, notorious for causing delay, actually speed things up.

Having taken a detour through central bank large-value payments systems, let’s return to the original debate over two-day stock settlement. Sure, stock markets could follow Robinhood’s advice and introduce real-time settlement. But before long, we’d all start to miss the magic of netting. Just as central banks reintroduced delays by building LSMs, stock markets would likely take steps to bring back slow.

If anything, what the central bank RTGS/LSM two-step teaches us is that we need a good balance between fast and slow. Sure, real-time settlement is a nice feature. But let’s also have delayed settlement. If brokerages have a choice to use some combination of two-day and real-time settlement, we may arrive at a socially optimal stock settlement rate.

Death of a Northern Irish banknote

I was disappointed to see that First Trust Bank, a commercial bank based in Northern Ireland, will stop issuing its own brand of banknotes. Under different names, First Trust has been in the business of providing paper money for almost two hundred years, starting with the Provincial Bank of Ireland back in 1825.

Source: First Trust

99.9% of the world's population uses government-issued banknotes. A small sliver of us—those who live in Northern Island, Scotland, Hong Kong, and Macau—get to use privately-issued banknotes. Prior to First Trust's announcement, I count twelve private issuers scattered across the globe:

Northern Ireland: Bank of Ireland, Danske Bank (formerly Northern Bank), First Trust Bank, and Ulster Bank
Scotland: Bank of Scotland, Clydesdale Bank and The Royal Bank of Scotland
Hong Kong: HSBC, Standard Chartered, Bank of China (Hong Kong)
Macau: Banco Nacional Ultramarino, Bank of China (Macau)

Now there are just eleven.

To our modern sensibilities, privately-issued banknotes seem just strange. But before central banks emerged on the scene, privately-issued banknotes were the norm. Larry White and George Selgin have chronicled how the Scots were particularly adept at this task. Scotland's banking system, which was much more free than the British one, had relatively few bank failures in the 1700 and 1800s compared to the British one, which tried to put limits on banks' ability to issue notes.

In the 1800s this Scottish "free banking" system was imported into my country, Canada, by Scottish immigrants. People might assume that private banknotes were risky instruments, and that's why we needed governments to do the task. But as the chart below shows, between 1868 and 1910 Canadians experienced almost no losses on banknotes.

Canada had no central bank (until 1935) or deposit insurance (until 1967).

But look how safe it was to own banknotes issued by private Canadian banks in the 1800s & early 1900s. No losses! Private banks can do a good job handling the note issue.
Source: https://t.co/tUpAahouyg pic.twitter.com/jdHlpZUlHO

— JP Koning (@jp_koning) February 13, 2019

Only a minute trace of our private banknote heritage remains. In addition to the four jurisdictions that have been allowed to maintain the tradition, a few central banks are still publicly-traded—a vestige of their old status as private issuers. In the case of banks in Northern Ireland and Scotland, their ability to issue notes has been grandfathered. Only the seven existing licenses are allowed and no new entrants are permitted. Once First Trust gives up its banknote franchise, it can never get it back.

First Trust says that its exit from the banknote game is a commercial decision. Let's take a quick look at the profitability (or not) of issuing banknotes. First Trust ATMs and branches can either dispense government-issued Bank of England banknotes or its own brand. If First Trust dispenses its own brand, then it must incur an extra set of costs including printing & design, note destruction, and policing against counterfeits. If it stocks its ATMs with Bank of England notes, it avoids these costs.

But there is a benefit to issuing its own brand of notes. For each note it issues, First Trust "earns the spread". Unlike its other forms of debt, First Trust needn't pay any interest to its banknote holders. But like its other forms of debt, it can earn income on the set of associated assets it holds to "back" those liabilities. If this income outweighs production costs, then it makes sense for First Trust to issue its own notes.

How much does First Trust make on its note issue? For each paper pound that Northern Irish and Scottish banks issue, they are obliged to lodge 1) 60 pence at the Bank of England in the form of banknotes and 2) 40 pence in the form of deposits. Given that Scottish and Irish banks have issued around £7.6 billion in private notes, this means they have collectively invested in some £4.6 billion worth of Bank of England banknotes. Since regular notes like £50 are bulky, the Bank of England issues massive 'Titans' and 'Giants' to cut down on storage costs.

£100 million "Titan" note.

Scottish & Northern Irish private banks have issued £7.6 billion in banknotes. They must back 60% of this—or £4.6b—with Bank of England notes. Better to use Titans than £50 notes... it takes just 46 Titans to store £4.6b compared to 92 million £50s. pic.twitter.com/UuZ4PUBMoh

— JP Koning (@jp_koning) February 17, 2019

For issuers like First Trust, the £4.6 billion worth of Titans and Giants is dead money—they don't earn any interest on it. But the other £3 billion or so in backing assets held in the form of deposits earns interest. The gap between an issuer's 0% funding costs and interest income paid by the Bank of England is what generates a profit for their banknote franchise.

On Twitter, John Turner points out that it was once very profitable for Northern Irish and Scottish banks to issue notes, but new regulations in 2009 changed this:

"Prior to legislation passed in 2009, issuing notes was extremely lucrative for banks because they only had to hold backing assets (essentially reserves at the Bank of England) at the weekend, leaving those funds free to generate income during the trading week.  Some estimates suggest that this generated £70m per year for Northern Irish banks alone.  Since the passage of the Banking Act (2009), banks are required to hold backing assets against their note issue at all times." (source)

Another reason seigniorage has shrunk is a decade of low interest rates. Northern Irish and Scottish banks currently earn just 0.75% on the deposits held at the Bank of England, but in the 2000s they would have been earning as much as 5.75%.

All four Northern Irish issuers (and the Scottish ones too) will have suffered from both the 2009 legislative change and generally low rates, but First Trust particularly so—its banknote issue is far smaller than that of Bank of Ireland and Ulster. Looking at its 2017 Annual Report, First Trust issued just £333 million of the £2.6 billion worth of Northern Irish banknotes in circulation. Which means it earned just £990,000 in seigniorage last year (£333 million x 40% x 0.75%). It's hard to imagine that this is enough to compensate it for its printing and other costs.

By comparison, the Bank of Ireland has issued around £1.2 billion in banknotes with Ulster Bank accounting for another £800 million. Both of these competitors can spread their fixed costs around far more efficiently than First Trust can.

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First Trust's announcement puts me in a bit of a conundrum. I think the financial privacy provided by cash is important. And so is the robustness that it engenders. Banknotes are a decentralized payment instrument that can't break down in the face of disasters. Cash systems are also open: no one can be censored from using them.

At the same time, I see no reason why commercial banks shouldn't be allowed to issue banknotes. But what happens when the private provision of cash breaks down? In countries like Northern Ireland with privately issued cash, we are seeing low interest rate go hand-in-hand with banks eliminating cash. And this in turn means less financial privacy, openness, and robustness.

In short, when interest rates fall to zero, private banks will try to preserve their spreads by pushing the interest rate that they pay on their short-term liabilities (like savings and chequing accounts) into negative territory, say by implementing higher account maintenance fees. But they can't do this with cash. A banknote's rate is fixed at 0%. Rather than absorbing losses from banknotes, private issuers will simply cancel their note issue, much like First Trust has done, forcing everyone into account-based products.

If the UK's low rates persist for another few years (and fall even further) then the remaining private issuers in Northern Ireland and Scotland—Clydesdale Bank, Bank of Scotland, Ulster, Danske, etc—would also be forced to stop printing notes. Both countries would become cash-free zones. And since cash is the best way to transact anonymously, Scotts and Northern Irish would have little to no financial privacy. All transactions would proceed through easily-censored account-based payments systems that break when the power goes down. 

Luckily for the Scots and Northern Irish, they have a backup. The Bank of England can fill any void left by commercial banks with its own notes. Unlike commercial issuers like First Trust, the Bank of England isn't driven by profits. Even as its banknote profits shrinks to nothing, the central bank can keep on supplying currency—and thus financial privacy, openness, and robustness—to the people. Perhaps there is a role after all for public issuers of paper money to play.

Did Brexit break the banknote?

Nations never experience year-over-year declines in cash in circulation. Sweden (which I wrote about here, here, and here) is one of the rare exceptions. India is another, but this was due to its notorious botched demonetization attempt (which I wrote about here, here, here, and here). But now the UK seems to be joining this small group of outliers.

Why does a nation's cash in circulation generally grow consistently from one year to the next? While economies do experience the odd recession, in general they are always improving. Improving economies coincide with more demand to make transactions, and for this the public needs to have greater amounts of cash on hand. There is a counter-cyclical element to cash holdings. When recessions occur, people often turn to unofficial sectors of the economy to make a living, and this often requires cash. The last explanation for the steady growth in cash outstanding is inflation. Let's assume an inflation rate of 10%. Someone who generally hold $10 worth of purchasing power in their wallet in 2018 will have to hold $11 in 2019 if they want their situation to stay the same. To meet that demand, the central bank has to print more banknotes.

All of this is why the UK's recent flirtation with decashification is so strange. Below is a chart showing the year-to-year change in British paper currency in circulation:

For eight months now, since February 2018, the stock of Bank of England banknotes has been registering below the previous year's count, a phenomenon that Britain has never seen (at least not since the start of the data series I found).

One potential explanation for the recent bout of decashification is increased debit and credit card usage. I am not entirely convinced by this argument. People's transactional habits are notoriously slow to change. When the inevitable card-induced decline in cash does occur, it won't suddenly occur in the space of eight or nine months, but will take place over an extended multi-year period. As in the UK, card usage in Canada is ubiquitous, yet we haven't seen the same sort of effect on the stock of cash. Something unique seems to be occurring in the UK.

The UK has been switching to polymer notes recently, the new £10 being introduced in 2017 and the £5 in 2016. Old paper versions can no longer be spent. The £20 is slated for a switch in 2020. Perhaps this is creating havoc with people's money holding patterns? I suppose it's possible, but here in Canada we went through the whole polymerization process without a hiccup. (See chart here). So I don't see why the UK would experience any sort of discontinuities during its own changeover.

The answer can only have something to do with Brexit. One possibility is that Brexit has reduced immigrant inflows and encouraged outflows, and immigrants are large users of cash. Ipso facto, cash-in-circulation has declined. The problem with this explanation is you'd need really large changes in migrations flows to see that sort of pattern in cash demand, and I am skeptical we're seeing that sort of upheaval.

Another Brexit-based explanation is that Brexit has broken the banknote. British banknotes have suffered a massive credibility shock. All those paper pounds hoarded away under Brits' mattresses, or in criminal vaults, or in foreign pockets, are just not as trustworthy as they were before. So they are being quickly spent or exchanged for other paper, say euros. Eventually these unwanted notes are resurfacing back in the UK where the Bank of England is forced to suck them back up and destroy them.This paints a particularly dour picture. It says that the Bank of England's seigniorage revenues have been permanently damaged, the short-fall having to be made up by the British taxpayer. It makes one worry about potential long-term damages to the Bank's ability to effect an independent monetary policy.

Having had some time to think about this, I think I've got a better story. The changes are indeed Brexit-induced. But the big decline we've seen over the last year isn't a sign of distrust in paper pounds. Rather, it's a reversion to trend. More specifically, the decline in cash-in-circulation so far this year is actually the unwinding of an unusual surge in cash-in-circulation that began in early 2016. Check out the chart below:

Beginning in 2016, as the political competition in the leadup to the Brexit vote intensified, banknotes-in-circulation suddenly started to rise relative to long-term trend line growth (black line). This was the fastest rate at which banknotes in circulation had increased since the 2008 credit crisis. The Bank of England's blog, Bank Underground, commented on the surge in banknote demand back in 2016.

The sudden demand to hold more cash continued through the June 23, 2016 vote into early 2017. I suspect that this was a symptom of an underlying uncertainty shock spreading through the UK economy. Brits were growing increasingly worried about the effects of Brexit. Perhaps they wanted to hold fewer deposits, or have less exposure to assets like stocks and real estate. Cash is a coping mechanism. In uncertain times it one of the few assets that offers the combination of short-term price certainty and the ability to be mobilized in an instant.

This chart from the Bank of England shows that the demand for the the £50 note (pink line) was particularly marked in 2016:

Source: Bank of England

But by mid to late-2017, Brexit-related uncertainty began to subside, and cash began to be redeposited into the banking system. UK cash usage has now returned to the long-term trendline growth rate. Going forward, I'd expect the year-to-year change in cash outstanding to return to its habitual 5%-ish per year. That is, absent more Brexit-induced panics.

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For much of this post, I am indebted to this great round of conversation on Twitter:

That's odd. For most of 2018, there has been no year-over-year growth in the quantity of UK banknotes in circulation. Going back to 1998, this sort of sustained lull in cash demand has never happened. What's going on? Less crime? pic.twitter.com/PXv53oB4E7

— JP Koning (@jp_koning) July 18, 2018

Critiquing the Carney critique of central bank digital currency

Over on the message board we've been discussing the implications of central bank-issued digital currency, otherwise known as CBDC. One view is that a central bank digital currency would lead to increased financial instability, Bank of England governor Mark Carney being a vocal proponent of this idea. There are a lot of criticisms that can be leveled against central bank digital currency, but the Carney critique is the one that worries me the least. Let's see why. 

First off, let's establish what we mean by digital currency. Imagine that a central bank has discovered a technology that allows it to create an exact digital replica of the banknote. Like banknotes, these digital tokens are anonymous and untraceable. To make use of them, people don't have to register for an account. Rather, the tokens are held independently on one's device, sort of like how paper money is held in one's wallet without requiring any sort of registration with the issuing central bank. This combination of features makes it impossible for the central bank to censor or prevent people from using digital currency, in the same way that the central bank can't stop people from trading paper money among themselves.

Unlike banknotes, which can only be passed face-to-face, digital currency can be transferred instantaneously over the internet. There are no storage and handling costs. $10 million dollars worth of $20 bills takes up a lot of space and is awkward to carry around, but in the digital world that same nominal amount has neither volume nor weight. Lastly, digital currency is cheap to create, requiring only a few keyboard strokes. Cash requires large printing machines, ink, and paper.

Having established what a digital currency is, let's introduce it into the economy. The central bank announces a demonetization of all banknotes and coins, offering $1 of digital currency for each $1 worth of cash. Anyone who want to withdraw money from their bank account will now get digital currency, not banknotes. No one visits ATMs or the bank teller anymore to make a deposit or withdrawal: with an internet-connected device, deposits and withdrawals can be made from bed, the toilet, or while commuting on the bus.

Carney's contention is that the introduction of a digital currency could hurt the banking system:

"...a general purpose CBDC could mean a much greater role for central banks in the financial system. Central banks may find themselves disintermediating commercial banks in normal times and running the risk of destabilising flights to quality in times of stress."

First, let's deal with Carney's normal times critique. The idea here is that by introducing a digital version of the banknote, a significant proportion of existing depositors—those with chequing and savings accounts—will desert their bank because they want to hold sleek and shiny central bank digital currency instead. (Presumably they didn't desert their banks when banknotes were around because cash was bulky and couldn't be transferred instantaneously over a communications network.) By causing a mass draining of deposits—i.e. disintermediating commercial banks—a new digital currency would impair the ability of banks to make loans, and this would affect the economy in a negative way. 

To show why I don't think the Carney critique holds, we need to investigate one of the important differences between cash/digital currency and bank deposits. When people open bank accounts, what interests them is not just the idea of making payments with those accounts but also maintaining a relationship with the bank in order to benefit from a smorgasbord of other financial services. People with bank accounts are like subscribers to a magazine, they want an ongoing connection.

Those who use cash, on the other hand, would rather just buy the magazine once rather than subscribe to it, or—for another analogy—prefer using disposable plastic plates to maintaining a set of their own plates. Cash is a one-time use commodity; once you spend it, any relationship to its issuer is severed. This lack of an ongoing connection provides value to some people. Consider the process of budgeting. By sticking some cash in an envelope dedicated to groceries, another for rent, presents, entertainment, clothing, you can closely monitor your spending over the course of a month. Once the cash is used up, spending stops. With a bank, however, a connection remains even after someone's balance has fallen to zero, spending potentially continuing via overdrafts and credit cards. People who may not trust themselves to stay within their means may therefore prefer the one-time use nature of cash.

The 'envelope budgeting system' is probably the best example of people using cash as a way to self-monitor spending. https://t.co/mXB8FppRxQ pic.twitter.com/TfAolun98L

— JP Koning (@jp_koning) December 21, 2017

So when digital currency replaces cash, I don't anticipate a mass migration from bank accounts to digital currency. Depositors who have already chosen a subscription-based banking solution over a one-time payments solution won't change their minds when the next generation one-time use product is introduced. Which isn't to say that there won't be some sort of migration out of bank deposits and into a new digital currency. Consider upstanding members of society who have always wanted to make anonymous digital payments but haven't had the chance to do so because the only anonymous option theretofore available to them—cash—was a physical medium, and so instead they have opted for the inferior option of non-anonymous digital payments services of a bank. This group of anonymity seekers will make the switch. 

But the migration of legitimate anonymity seekers out of bank deposits into digital currency will be counterbalanced by a reverse migration out of cash into bank deposits. Let's think for a moment about who uses cash. Illicit users like criminals and tax evaders are big users, and when cash is demonetized they will all shift into digital currency in order to preserve their anonymity. Likewise, licit users of cash who want to keep using a one-time use payments option will opt for digital currency. The undocumented and those who are too poor to qualify bank accounts will also make the migration into censorship resistant digital cash.

That leaves one major group of cash users unaccounted for: those who use cash not because they like any specific feature that it provides but out of pure force of habit. With cash being cancelled, habitual users will have no choice but to switch into some other payments option. And since deposits are the time-tested option, it is likely that many will move their funds into the banking sector. If this wave of inbound habitual users is greater than the wave of outbound anonymity seekers, then the introduction of a digital currency may actually be lead to an increase in bank intermediation rather than Carney's disintermediation!

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So if a digital currency won't affect the banking system during regular times, what about Carney's times of stress criticism? The general criticism here is that during a crisis, households and businesses will desperately shift their deposits into the ultimate risk-free asset: central bank money. Presumably when deposits were only redeemable in banknotes (as is currently the case) and one had to trudge to an ATM to get them, this afforded people time for sober contemplation, thus rendering runs less damaging. But if small depositors can withdraw money from their accounts while in their pajamas, this makes banks more susceptible to sudden shifts in sentiment, goes the Carney critique.     

I don't buy it. Small depositors won't exit banks during a crisis because their money is insured up to $250,000 (in the US). But even in jurisdictions without deposit insurance, I still don't think that shifts into digital currency in times of stress would exceed shifts into banknotes. A bank will quickly run out of banknotes during a panic as it meets client redemption requests, and will have to make arrangements with the central bank to get more cash. Thanks to the logistics of shipping cash, refilling the ATMs and tellers will take time. In the meantime a highly visible lineup will grow in front of the bank, exacerbating the original panic. Now imagine a world with digital currency. In the event of a panic, customer redemption requests will be instantaneously granted by the bank facing the run. But that same speed also works in favor of the bank, since a request to the central bank for a top-up of digital currency could be filled in just a few seconds. Since all depositors gets what they want when they want, no lineups are created. And so the viral nature of the panic is reduced.

But what about large depositors like corporations and the rich who maintain deposits well in excess of deposit insurance ceilings? During a crisis, won't these sophisticated actors be more likely to pull uninsured funds from a bank, which have a small possibility of failure, and put them into risk-free central bank digital currency?

I disagree. In a traditional economy where banknotes circulate, CFOs and the rich don't generally flee into paper money during a crisis, but into short-term t-bills. Paper money and t-bills are government-issued and thus have the same risk profile, t-bills having the advantage of paying positive interest whereas banknotes are barren. The rush out of deposits into t-bills is a digital one, since it only requires a few clicks of the button to effect. Likewise, in an economy where digital currency circulates, CFOs are unlikely to convert deposits into barren digital currency during stress, but will shift into t-bills. The upshot is that banks are not more susceptible to large deposit shifts thanks to the introduction of digital currency—they always were susceptible to digital bank runs thanks to the presence of short-term government debt.

The ability to mitigate shifts out of the banking system during times of stress may be even more potent in a world with digital currency than one without. During a crisis a central bank will generally reduce its main policy interest rate in order to stimulate the economy, short-term market interest rates falling in sympathy. Now, consider an economy with banknotes. Even as short-term rates fall, the interest rate on banknotes stays constant at 0%, the effect being that the relative return on banknotes steadily improves. This only encourages further shifts out of the banking system into cash.

Digital currency updates the cash model by introducing a wonderful new invention: the ability to adjust the interest rate on cash. Now when the central bank reduces its policy rate to offset the weakening economy, it can simultaneously reduce the rate on digital currency. This has the effect of maintaining a constant relative return on currency throughout the crisis. So unlike a banknotes-only world in which the relative return on notes steadily improves as the crisis deepens, thus encouraging disintermediation of the banking sector, a digital currency-only world guards against the sort of return differential that might engender disintermediation.

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So the Carney critique, which frets over mass adoption of digital currency, doesn't amount to much, in my view. A better critique of digital currency is the exact opposite: instead of mass adoption, it is very possible that no one (apart from criminals and tax evaders) uses the stuff.

Let's see why digital currency could fail on takeoff. One potential migration pattern I mentioned above involves upstanding members of society who desire anonymous online payments adopting digital currency. But what if there just aren't that many people who care about online privacy? Countries like Sweden, where banknote usage is plummeting, give credence to this concern while surveys of cash users in the eurozone show that anonymity is not terribly important to them:

Europeans prefer cash not because of its anonymity or immediate settlement, but because it provides a "clear overview of expenses". pic.twitter.com/JUjSB6aDZ6

— JP Koning (@jp_koning) December 17, 2017

Another large base of potential digital currency users includes all those who value cash for both its throw-away nature and lack of censorship. But what if these people choose to adopt pre-paid debit or credit cards instead, both of which are open systems that do not obligate users to maintain an ongoing relationship with the issuer?

If neither of these blocks of licit users adopts digital currency, that leaves only criminals and tax evaders keen to use a new central bank digital currency. For a central banker who is advocating the stuff, that's not a very firm political leg to stand on. In sum, Carney has got it all wrong. A central bank digital currency is less likely to have a massively disruptive effect than it is to arrive stillborn.

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PS: Thanks to Antti, Oliver and the rest on the discussion board for helping me think about this more concretely.

The ubiquitous Spanish dollar—a photo essay

"The head of a fool on the neck of an ass."

That's how Londoners described the strange silver coin pictured above, which first appeared in Britain in 1797. Due to worries that Napoleon was about to invade the British Isles, a run had developed on the Bank of England. In response, Parliament allowed the Bank to refuse to redeem its notes with gold coins, but this had only resulted in an inconvenient shortage of coins.

To remedy the shortage, the Bank of England decided to open its vault and put its hoard of silver coins into circulation. Complicating matters was the fact that these coins were not native shillings or pennies, but Spanish dollars, otherwise known as eight real pieces. As such, they had to be re-purposed into local currency. The Bank of England accomplished this task by stamping the head of King George III—the fool—on the neck of Charles IV of Spain—the ass—who occupied the obverse side of that era's version of the Spanish dollar. The Bank then declared that all stamped Spanish dollars were to be worth four shillings and nine pence. People flocked to the Bank of England's window to get their hands on the new coins.  

That the Spanish dollar temporarily became part of England's circulating media of exchange was due to its ubiquity—in its heyday the Spanish dollar, like today's U.S. dollar, was everywhere. After discovering huge amounts of silver in the new world, the Spaniards had set up a mint in Mexico City in 1536 to produce large quantities of silver coins. Mints in Potosi (Bolivia), Lima (Peru), and elsewhere soon followed. It is estimated that some four-fifths of the world's silver produced between 1493 and 1850 came from Spanish America, almost all of it in the form of Spanish dollars! 

Although their design changed over the centuries, by the 1700s the Spanish dollar—easily identified by the two "pillars of Hercules" on the reverse side of the coin—had become known and accepted all over the world. As the map above shows, the two pillars refer to the Rock of Gibraltar in Spain and its counterpart on the Moroccan side of the narrow strait separating Africa from Europe.

In addition to England, the Spanish dollar shows up in the Caribbean islands where it made up a major part of the local coinage. To provide small change, locals cut dollars up into pieces. Below, an 1806 dollar used in Guadeloupe has had its centre carved out of it and stamped with the letter "G". Earmarking of coins was done to prevent exportation and restrict usage within borders. In this way, local currencies were literally piggybacked into existence off of the ubiquitous Spanish dollar.

Source: The Spanish Dollar as Adapted for Currency in Our West Indian Colonies

In the next image, a Trinidadian version of the dollar has been carved up like a pizza. The half piece has been countermarked with a "6", the third with a "4", and the sixth with a "2". These numbers refer to the number of bits or bitts the piece was worth, the bit being a local accounting unit. By marking the letters "TR" on each dollar to indicate Trinidad, the Spanish dollar has been forked to create a second currency.

Spanish dollar marked with TR for Trinidad

All possible methods of cutting up Spanish dollars were used. Here's a 1797 dollar from Saint Lucia that has been cut up lengthwise, like a loaf of bread, with "SLucie" being countermarked on each section.

Saint Lucia Spanish dollar

The Spanish dollar also made a notable appearance on the opposite side of the globe. In 1813, the colony of Australia minted its first currency, the so-called holey dollar. To deal with a shortage of coins, the governor of New South Wales imported thousands of Spanish dollars. A convicted forger was contracted to cut the centre from each one, countermarking each of the resulting pieces with the name of the colony and its nominal value in shillings and pence. As in the case of the Caribbean Islands, this mutilation of the dollar was an attempt to render them useless outside of the colony. The outer ring was rated at five shillings and the centre—the dump—at fifteen pence, or one shilling and three pence. 

Australians solved a coin shortage in 1812 by overstamping Spanish reals—then cutting a second coin from the middle. https://t.co/HcM8FwCtyz pic.twitter.com/JYpzvmcihI

— JP Koning (@jp_koning) August 24, 2017

The Spanish dollar, which would become the Mexican dollar after Mexico won its independence from Spain, was also popular in China. Merchants and professional money exchangers, or shroffs, would test a coin to verify its silver content. According to James Gullberg, they went about this by balancing the coin on their finger and tapping it. If it rang, it was legitimate. The theory goes that once the coin had passed their purity test, a shroff would stamp that coin with his own peculiar chopmark—a Chinese character, an emblem, symbol, or a pseudo character. (I discussed this practice in more depth here). The more chops a Spanish dollar had, the better its quality—even after it had been chopped beyond recognition.

1807 Spanish dollar with chopmarks

Pictured above is a chopped Spanish dollar from 1807. According to Gullberg, Chinese merchants preferred the Carolus IIII dollar, which was issued between 1772-1810. They referred to it as four work, the IIII resembling the Chinese character for going to work. The influence of the Spanish/Mexican dollar continued even into the 19th century: the banknote below, issued in 1912 by the Sino-Belgian Bank, is redeemable in Mexican dollars.

International finance, 1912 edition. A Chinese banknote denominated in Mexican dollars issued by a Belgian bank. pic.twitter.com/wraMOcIepD

— JP Koning (@jp_koning) August 30, 2016

Moving back west, the Spanish/Mexican dollar had a key role to play in the North American economy up to the mid-1800s. In both Canada and the U.S., the unit of account function of money was separated from the medium of exchange function. Early colonists kept prices in pounds, shillings, and pence unit of account, but Spanish dollars and their subdivisions were used to transact business. Because of the long distance from England, there simply weren't enough shillings and pennies to make do.

Even though a local U.S. dollar coin—which was modeled off of the Spanish dollar—had been minted as early as 1794, the Spanish version remained by far the most popular form of coinage in the U.S. The presence of the Spanish dollar was even enshrined in American law, the coins having been declared legal tender in 1793. Many people have even speculated that the famous dollar sign, $, has been bastardized from the symbol for peso.

Source: Evolution of the Dollar Mark (1912)

To illustrate the ubiquity of the Spanish dollar in the U.S., below I've included a 6¼ cent note issued in 1816 by Easton and Wilkesbarre Turnpike Company, which built and operated private toll roads. This odd denomination only makes sense if you consider it in the same context as the Spanish dollar. Unlike U.S. dollars, which were divisible by 100 into cents, the Spanish dollar was divisible into 8 reals. A one-real coin, a fairly common unit around that time, would have been worth 12½ cents, and a ½ real coin worth 6¼ cents. So while the turnpike company's decision to issue a 6¼ cent note might seem odd to us today, it was probably meant as a convenience to its users, who would have been more familiar with Spanish coins than any other type of coin.

A 6¼¢ note (1816). Odd denomination, but logical given that the Spanish half-real was still a popular coin in the US. (8R = $1, so ½R = 6¼¢) pic.twitter.com/7oDAVCTfFc

— JP Koning (@jp_koning) September 18, 2017

As for Canada, below is an 1819 $5 bill from the Bank of Upper Canada. To help customers who couldn't read, the bank conveniently printed an image of five Spanish dollars at the bottom of the note.

This 1819 banknote has five Spanish dollars illustrated along its bottom

For a number of reasons, the Mexican dollar was eventually killed off . The U.S. had originally been on a bimetallic standard, but in 1834 the authorities changed the silver-to-gold ratio to 16:1 from 15:1, in the process slightly overvaluing gold. The discover of the yellow metal in California only further pressured the price of gold down relative to silver, exacerbating the legally-imposed undervaluation of silver. As a result, silver coins began to disappear. After all, anyone who had a stash of silver coins would have found it more profitable to melt them down and export them overseas where they traded at their true economic value. The U.S. had effectively flipped onto a gold standard. To compound matters, Spanish dollars lost legal tender status in 1856, which would have further crimped their demand.

As for Asia, several competing coins were created, including the Japanese yen, a near-replica of the Mexican dollar. The U.S. began to produce special trade dollars that were to be used solely in Asian trade (I wrote about the trade dollar here). Further reducing the demand for Mexican silver was the decision by many nations to follow the major western nations and officially adopt gold standards, including Japan in 1897 and the Philippines in 1904.

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Even though it was eventually eclipsed, there are still modern day echoes of the old Spanish dollar. The pejorative term two bit is still used in the U.S. as a synonym for cheap or insignificant, as in two-bit thief. One bit was ⅛ of a dollar, or 12.5¢, and two-bits 25¢, so a two-bit thief is a 25¢ thief. Amazingly, the practice of pricing in sixteenths continued on the New York Stock Exchange up till 2001. The Toronto Stock Exchange decimalized in 1996.

Up here in Canada, Quebecers use the word piasse for dollar. I had always assumed that they meant piece, but I recently discovered that the wording actually goes back centuries to piastre, the French word for the Spanish peso. Even more interesting is the vernacular usage of trente-sous (or 30 sous) to mean 25-cents, which I only understood after reading this from Frédéric Farid.
 

After the '87 market crash, a business man begs for 25¢ (Source)

The story goes like this. In the 18th and 19th Centuries, an English halfpenny was referred to in the colony of Lower Canada (i.e. Quebec) as a sou. The pound-shilling-pence unit of account (£/s/d) was still in use at the time but Spanish dollars were the most common coin in circulation in both Upper and Lower Canada. Dollars were officially rated by the British authorities at $4 for each £1. A quarter Spanish dollar (a two-real coin or 25 cent piece) would therefore be worth £0.0625.

Since an English pound contained 240 pence, that meant a quarter Spanish dollar was worth 15 English pennies, or 30 half-pennies. And given that Quebecers referred to half-pennies as sous, that gave rise to the ongoing practice of referring to 25 cents as 30 sous. When they use this term today, Quebecers are just referring to the archaic exchange rate between Spanish dollars and pence.

Source: La Maison nationale des Patriotes

This odd system of conversion really hits home when you work through the above scrip note emitted by Distillerie St-Denis, printed in 1837.  It is denominated in three different units. Trente-sous appears twice in French and once as XXX, while in the English paragraph near the bottom the £/s/d equivalent of one shilling and three pence, or fifteen English pennies, appears. Finally, a two-real coin, or quarter dollar—the pillars of Hercules side showing—has been emblazoned smack in the centre.

To end things off, you can also see a ghost of the old Spanish dollar in Venezuela's 12½ centimos coin. This coin is an eight of a bolivar—reckoning in terms of eights and sixteenths is a hallmark of the days of the old pillar coin.

Venezuela's strange 12.5 cent coin. It's a descendant of the famous Spanish dollar, divisible into eighth bits. pic.twitter.com/rVWmVkcdQO

— JP Koning (@jp_koning) May 20, 2016

Given Venezuela's ongoing hyperinflation, the likely destiny of the 12½ centimos coin is to be nothing more than another two-bit dead coin.

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Sources:
George Selgin, Good Money
A. Piatt Andrew, The End of the Mexican Dollar (link)
J.B. Caldecott. The Spanish Dollar as Adapted for Currency in Our West Indian Colonies (link)