Stablecoins are non-fungible, bank deposits are fungible

On Twitter/X, I recently suggested that the network effects of the stablecoin market are massive. Tether, which has four times more wallets than all other stablecoins, is locked-in as the stablecoin lingua franca, just like English has been locked-in as the global language of business. 

In case you've missed the trend, stablecoins are fiat money (primarily U.S. dollars) that are issued on a new type of database called a blockchain. The total value of stablecoins in circulation has grown from $0 to over $200 billion in a decade, with Tether dominating at $138 billion.

When I said at the outset that the stablecoin market is governed by network effects, what I meant is that a positive feedback loop exists whereby the value that a network (i.e. languages or stablecoins) provides to users increases as more users join the network. Once a given stablecoin has entered into this virtuous loop, other issuers cannot join in, and will have troubles competing. It's a winner take all market that Tether and its stablecoin USDt (and perhaps smaller competitor USDC, issued by Circle) have already won.

Larry White, a monetary economist who I've mentioned a few times on my blog, asked me why I think network effects are present in the stablecoin market. We don’t see network effects with other U.S. dollar payment media like checkable deposits, Larry points out (and I agree), so it's not clear why we should see this with stablecoins.

Here's my logic.

Stablecoins aren't fungible, bank deposits are

The key is that while U.S. dollar stablecoins—Tether's USDt, Circle's USDC, PayPal USD, etc—are pegged to the dollar, and thus seem to be alike, they are not actually completely alike. That is, they are not fungible with each other. 

Fungibility is one of my favorite words, and I write about it quite often on this blog. It means that members of a population are interchangeable, or perfectly replaceable with each other. All grams of pure raw gold are interchangeable. Not all grams of pizza are alike—pizza is non-fungible.

U.S. dollar bank deposits (say Well Fargo dollars and Chase dollars) are fungible with each other. Rather than being independent, they are fused together as homogeneous and singular U.S. dollars. A Chase dollar is just as good as a Wells Fargo dollar for the purposes of making payments.

That's not the case with stablecoins, which are like pizza. Or better yet, in the same way that Chinese yuan and UAE dirham are pegged to the dollar but remain independent currencies, each U.S. dollar stablecoin is pegged to the dollar but functions as its own distinct non-fungible currency. For the purposes of making payments, one stablecoin is not as good as another one, just like how dirham balances aren't perfect replacements for yuan.

The reason behind this difference is that U.S. banks cooperate with each other by accepting competitor's money at par on behalf of their customers. For instance, I can take a Wells Fargo check to my Chase branch and Chase will accept it 1:1 even though it represents a competing bank's dollar. Or I can send an ACH payment directly from Wells Fargo to Chase, and Chase will accept that Wells Fargo dollar at par and convert it into a Chase dollar for me. 

The effect of this reciprocal acceptance is that all U.S. banking dollars are tightly knit together, or interchangeable. A fungible standard has been created.

I can't perform these same actions with stablecoins. I can't send 100 USDC to Tether to be converted into 100 USDt, nor send 100 USDt to Circle, which issues USDC, to be converted into 100 USDC. Stablecoins issuers are loners. They've chosen to avoid banding together to weave a unified U.S dollar stablecoin standard.

This lack of standardization explains some weird things in the stablecoin market, like why there are so many markets to trade USDt for USDC (see below). Notice that the clearing price in these stablecoin-to-stablecoin markets is never an even $1, but always some inconvenient price like 0.991 or 1.018.

Some of the multiple markets for trading USDt for USDC, all at varying prices Source: Coingecko

 

There is no equivalent trading market for Chase-to-Wells Fargo balances or TD-to-Bank of America dollars. These banks' dollars are perfectly compatible and don't require such markets.

The advantages of a single dollar standard

Harmonization is useful. Anyone can walk into a McDonald's and purchase a Big Mac for $5.69 with whatever brand of bank dollar they want. Money held at small banks is just as useful as money at massive ones: the Bank of Little Rock may only have five branches, but its dollars are accepted at McDonald's all across the world, on par with those of Chase, America's largest bank.

McDonald doesn't accept stablecoins, but if it did, it would have to offer multiple prices for a Big Mac: i.e. 5.73 USDt and 5.68 USDC. Each stablecoin serving as its own particular unit of account is inconvenient, both for McDonald's and its customers. PayPal USD probably wouldn't even be accepted at McDonald's: it's too small.

The lack of standardized stablecoin market becomes even more awkward in asset markets. If you want to buy $1 million bitcoins on, say, Binance, there's a whole array of different U.S. dollar stablecoin markets available, including bitcoin-to-USDt, bitcoin-to-USDC, and bitcoin-to-FDUSD. (FDUSD refers to First Digital USD, a medium sized stablecoin.)

The table above shows the prices of bitcoin and ether on Binance, the world's largest crypto exchanges. Notice that liquidity in both Binance's bitcoin and ether trading market is compartmentalized into different stablecoins rather than being fused into a single homogeneous US dollar-to-bitcoin market. Source: Coingecko

You can forget about easily buying bitcoins with PayPal USD stablecoins. No crypto exchange offers that trading pair; PayPal USD is too small to be worth the hassle.

This has the effect of fragmenting the liquidity of the stablecoin market into different buckets. Instead of stablecoins-in-general having a certain level of marketability, each individual stablecoin has its own distinct liquidity profile in asset markets.

In contrast, the liquidity that a Wells Fargo dollar, a Bank of Little Rock, or a Chase dollar provides to their owner in the context of asset markets has been unified into a collective whole. If you want to buy shares of Blackrock's iShares Bitcoin ETF, there isn't a separate market for Wells Fargo-to-bitcoin or Chase-to-bitcoin. As for Bank of Little Rock dollars, they are just as fit for bitcoin purchases as its much largest competitors.

A winner-takes-all market

Now we can understand why network effects dominate the stablecoin market.

If you want to start using stablecoins to trade crypto or buy stuff, you will always be arm-twisted by market logic into choosing the largest most liquid stablecoin. And your decision to go with the largest one makes that stablecoin a little more liquid, thus solidifying its pole position.

Selecting a smaller stablecoin like PayPal USD makes little sense. McDonald's will never accept it, and there are many crypto assets that you won't be able to buy with it. Even when certain PayPal USD trading pairs are available, the bid-ask spreads will be wide, imposing much larger costs on you than if you simply went with a larger stablecoin. Thus network effects, working in reverse, repel uptake of PayPal USD.

The unsafe stablecoin is the largest

Tether remains the largest stablecoin, despite being one of the most unsafe stablecoins. (USDC does not get top marks for safety, either.) Network effects explain this.

Stablecoin rating agency Bluechip awards Tether a D rating, noting that it is "less transparent and has inferior reserves... USDT is not a safe stablecoin". Under normal conditions (i.e. those not characterized by network effects) the safest stablecoins would have long-since displaced Tether from its leading spot. But in stablecoin markets, the safest stablecoins—Gemini USD, PayPal USD, and USDP, all rated A or A- by Bluechip—remain insignificant players. The virtuous circle in which Tether is locked dominates all other factors.

These are the best-ranked fiat stablecoins according to Bluechip. But they are also tiny, with market capitalization below $1 billion. There appears to be no point trying to be a safe stablecoin, since the network effects arising from liquidity completely dominate any safety concerns that users might have.

Eyeing Tether's profits, new competitors are entering the stablecoin market. But this is a game they probably shouldn't bother playing. PayPal arrived last year with PayPal USD, but to date it remains mostly irrelevant, despite huge growth in the overall stablecoin market over the same period. Ripple and Revolut are also slated to bring out their own products. They're also destined to mediocrity, because they're too late to make the jump into the virtuous loop that Tether and (to a lesser extent) Circle occupy. 

(There is one caveat. Should one of the two leaders eventually be shutdown for money laundering offenses or sanctions evasion, one of these also-rans could be vaulted into their spot.)

Might the stablecoin sector eventually migrate over to the unified fungible standard that characterizes banking deposits? 

No, that's probably not going to happen. For a fusion to occur, Tether and runner-up Circle, which issues USDC, would have to start accepting their competitors' stablecoins at par. But they won't go down this path, since that would kill off the network effect that gives them their unrivaled dominance over the rest of the pack. No, it's in the interests of the leaders for chaotic non-fungibility to continue. 

Alas, this lack of standardization may limit the stablecoin sector's broader potential to serve as a cohesive global payment alternative to the better-organized banking standard. Sometimes a bit of cooperation trumps competition.

Transferwise, why so fast?

This post explores some of the technological advancements that have allowed remittances to be completed in seconds rather than days.

If you follow me on Twitter, you'll often see me retweeting folks who have just made really fast remittances using Transferwise, a company that specializes in cross-border payments. Like this one:

Australia to Thailand, less than a minute.

Remittance providers can achieve speeds like this by stitching together domestic 24x7 real-time payment systems, in this case Thailand's PromptPay and/or Australia's New Payments Platform. https://t.co/6UCdcVMFyO

— John Paul Koning (@jp_koning) February 17, 2020

No, I'm not a paid shill for Transferwise. I'm providing a public service. By shining a light on these quick remittances, I'm hoping to counteract two bad ideas. The first one, which goes back at least to 2011 or, is the idea that traditional fiat-based platforms can't do fast remittances. So we need either bitcoin or some sort of blockchain, say Ripple, to bring competence to the remittance space.

This idea was best captured in this meme from a few years back:

The second and related idea is that since banks or fintechs can't do fast remittances, we need some sort of government fix, specifically a central bank digital currency (CBDC), to expedite them. In a recent white paper, for instance, IBM and the Official Monetary and Financial Institutions Forum describe remittances as "cumbersome, expensive and slow," and suggest that CBDCs may ameliorate this problem. The Monetary Authority of Singapore justifies its experiments with CBDC by using the same two adjectives, "slow" and "cumbersome" for remittances.

But as the above Australia to Thailand remittance shows, it is possible to do instant cross-border payments without blockchain or CBDC. Which means that if central bankers want to justify building their own digital currency they'll have to come up with better supporting facts than private sector incapacity to facilitate fast remittances. And if bitcoin is going to take over the world, it'll have to compete on factors other than remittance speed.  

So without further ado, let's get to the main question: how does Transferwise get money from X to Y in ten seconds? After all, it isn't entirely wrong to poke fun at traditional remittance companies. Historically, it has taken a few days to move funds electronically from a bank account in one country to a bank account in another.

To figure out why remittances can go so quickly, we've go to unwind the technology of a money transfer.

The ABCs of a remittance

We can think of any national payment system as a stack of interconnected databases. For a payment to make its way from your account to mine, information has typically had to cascade down the stack of databases to the bottom-most layer and then flow back up. The speed of a payment is a function of both by how quickly each individual database in the stack can be updated, and the speed at which information gets relayed to the next layer in the stack.

Impressive. A 15-second Germany-to-India remittance.

No blockchain required, just good ol' centralized databases being rapidly updated on top of real-time central bank payment systems. https://t.co/NlLeiDk9jr

— John Paul Koning (@jp_koning) January 9, 2020

Say that Jill, who lives in the US, wants to transmit $100 to Tom in Singapore via Transferwise.

Jill sits at the top of the U.S. payments stack. She has an account at the First Bank of Boaz or, put differently, she occupies a spot in First Bank of Boaz's database. Transferwise also sits at the top of the US payments stack. It has a business account at Bank of America. In other words, Transferwise is represented by an entry in Bank of America's database.

Before Transferwise can pay Tom in Singapore, it has to wait for Jill's $100 to make its way through the US payments stack and land in its Bank of America account. But the $100 can't simply hop laterally from First Bank of Boaz's database to Bank of America's database. The payment information first has to plunge down to the next lower level of the payments stack.

The whole process begins with Jill asking the First Bank of Boaz to make the $100 payment. First Bank of Boaz adjusts its database by reducing Jill's balance by $100. This information gets relayed down to the next database in the stack.

First Bank of Boaz is a small bank. It has an account at the much larger Chase Bank. So it informs Chase about the $100 that it wants to send to Transferwise on behalf of its customer Jill. It is now Chase's turn to adjust its database. It reduces First Bank of Boaz's balance by $100.

Transferwise doesn't have the $100 yet, however. The payment information still has to be relayed to the bottom-most layer. Chase and Bank of America both have accounts at the Federal Reserve, America's central bank. Chase informs the Fed about the $100 transfer, upon which the Fed updates its database. It reduces Chase's spot in its database by $100 and adds $100 to Bank of America's entry. The banks have now 'settled' their payment. The most important payments layer, the bottom-most one, shows the switch has been made.

Information starts to flow back up the stack. The Fed notifies Bank of America about the $100 credit to its entry in the Fed's database. Upon which Bank of America updates its own database. It increases Transferwise's entry in its database by $100.

Phew. Transferwise finally owns the $100.

Now it can do the Singapore leg of the transaction.

The same down-and-up-the-stack progression that occurred in the US now plays out in Singapore. Transferwise tells its Singapore bank to transfer SG$140 to Tom at his bank. As before, the payment can't just hop from one bank database to another bank database. The information first cascades down to the bottom-most database, the one maintaind by the Monetary Authority of Singapore. Only after MAS updates its database will the information flow back up the stack to Tom's bank. At which point Tom's bank updates its database.

The remittance is now complete. Tom has an extra SG$140 and is free to spend the funds or withdraw cash.

OMG!!!! @TransferWise You are awesome!!!! 5 seconds to send money from Spain to México. The last time it was like 1 day.

— Javier Camacho 🇲🇽🇪🇺🇪🇸 (@fjccorp) February 11, 2020

In the old days of two or three day remittances, one of the biggest clogs in the system was the glacial speeds at which information flowed onto the base layer and the rate at which the base layer, usually operated by a central bank, was updated.

Rather than sending Jill's payment instructions individually to the central bank database, banks would typically batch her instructions together with millions of other instructions and send them to the central bank just before closing time. The next day the central bank would process these big batches, check for errors, and cancel offsetting payments. Only then would the central bank update its database by adding money to creditor banks (like Bank of America) and removing it from debtor banks (like Chase).

The updated information could now flow up to higher database levels. But by then the original payment instruction was already a day or two old. Remitters like Transferwise were left waiting for days to receive the originating customer's transfer.

The mirror image of this would occur on the other side of the ocean. If it took Transferwise a day or two to receive money in the U.S., it also took a day or two for Transferwise's Singapore dollar payment to land in the Tom's account. This combination of two sluggish central bank databases is why remittances used to flow like molasses.

Even worse, the central bank database was closed on the weekend. So anything that was sent to the central bank by Friday night would have to wait till Monday morning to be processed.

Not anymore.

The dawn of real-time retail payments systems

Much (though not all) of the speed improvements are due to new ways of operating the central bank's bottom-most database.

Instead of Jill's payment instructions being batched together with many other payments and sent to the central bank at the end of the day, banks will now send Jill's instructions individually and in real-time to the central bank. The central bank updates its database a moment later. Now instructions can flow up to Transferwise's account in the seconds that follow. Which means that Transferwise can quickly start working on the foreign leg of the transaction. As long as the foreign central bank's base layer is also capable of operating in real-time, then the whole cascade of database updates can occur in just a few seconds.*

Like this one:

11 seconds to get money from UK to Hong Kong.

Courtesy of the the Hong Kong Monetary Authority newly-built instant retail payments system: https://t.co/WbRhzkXgK8 Transferwise serves as a bridge between the HKMA's new rails and UK's existing instant retail system. https://t.co/1ga0oscZvA

— John Paul Koning (@jp_koning) May 3, 2019

These new core layers work at night and on the weekends too.Which means remittance providers like Transferwise can no now pay out 24x7.

Known as real-time retail payment systems, these newly-revamped layers have sped central banking up. They include UK Faster Payments in 2008, India’s IMPS in 2010, Sweden’s BiR in 2012, Singapore’s FAST in 2014, and Australia’s NPP in 2018.** Brazil's PIX is the newest one.

All of these developments may give the impression that Transferwise is just a passive beneficiary of improvements elsewhere in the payments stack. But Transferwise has had to design its own internal mechanisms for ensuring that it can harness these improvements. Automation and AI no doubt have a big roll to play. But I don't work at Transferwise, so I can't shed much light on this. I'm sure it has used some neat tricks.

So we don't really need CBDC or blockchain to get faster. If we want policies that can speed up remittances even more, the best thing is for central banks to continue the process of setting up real-time retail payment systems, until the whole world is blanketed. Then stand aside and let innovators like Transferwise complete the task of linking these disparate systems up.

But if there was one adjustment that could be made to go even faster, it would be this: let remittance companies like Transferwise hold accounts directly at the central bank.

Most jurisdiction only allow their central bank to interact with banks. But this forces Transferwise and other specialized payments companies to seek out banking intermediaries in order to access the central bank's database. And this extra layer may slow them down. By interfacing directly with the central bank's core layer, Transferwise may be able to optimize the interconnection in order to squeeze a few extra seconds out of each remittance.

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*There are variations on this theme. UK's Faster Payments scheme uses batching but is still able to process payments in real-time. (I explained how here). US's same-day ACH also speeds up the domestic payments system, but also uses batching. By submitting batches before certain cutoff times during the day, the Fed promises to update its database that same day rather than waiting till the next day. 

**By the way, there are other tricks to make the whole series of database updates go quite fast that don't involve speeding up the bottom-most layer. MasterCard and Visa both run real-time communications networks over which debit card-enabled accounts can communicate. And these networks can be used to skip the previously-described trek to the bottom-most (and slowest) layer and back.

For instance, using the Visa Network the First Bank of Boaz tells Bank of America that Jill wants to move $100 to Transferwise's account. Bank of America quickly credits Transferwise the $100 while First Bank of Boaz debits Jill $100. Transferwise can now do the Singapore leg of the remittance. First Bank of Boaz and Bank of America will settle up with each other the next day on the Federal Reserve's database.

XRP and bitcoin as bridge currencies

Eshima Ohashi Bridge, Japan

The value of all outstanding XRPs recently surpassed that of bitcoin, hitting $300 billion or so last month. XRPs are a cryptocurrency issued by Ripple, a company that is trying to shake up the business of cross border payments. Ripple has a number of strategies for doing this, but the one that has caught people's imagination—especially as the price of XRPs rocket higher—is to have banks and other financial institutions use XRP as a 'bridging asset' for moving value across borders. The idea of using a cryptocurrency as a bridge isn't a new idea. Bitcoin remittance companies have been trying to do this for several years now, without very much success.

So what do I mean by using a cryptocurrency like bitcoin or XRP as a bridge asset? Does it make any sense? To answer these questions, let's dissect a hypothetical cross border payment.

Straddling two universes

As users of banks and other financial institutions, we rarely think about what is going on underneath the hood of a money transfer. If I send money from my account to yours, the language of this transaction implies that money is flowing from my bank account to bank account. But moving funds from one bank to another bank is physically impossible. If my account is at Bank A, and yours is at Bank B, I cannot send value directly from my account to your account. Our two accounts may as well exist in entirely separate universes.

The only way I can make a bank-to-bank payment to you is indirectly, by turning to a third-party who straddles both universes. Say my hair dresser has accounts at both my bank and your bank, and for a small fee she'll do the transaction for us. I tell my bank (Bank A) to credit my hairdresser's account at Bank A by $10, and my hair dresser in turn tells her bank (Bank B) to debit her account and credit you account at Bank B by $10. The payment is done. I have $10 less, you have $10 more, and my hair dresser is flat, her $10 having been erased from Bank B's ledger with a new $10 deposit appearing in her account at Bank A.

The same principle is at work in cross border payments, except the person who is doing the straddling between the two bank—my hair dresser—will need to have a domestic bank account, say in Canada, and an international account, say Philippines. And instead of crediting you $10, she will have her Filipino bank send you the peso equivalent of $10, which is around ₱400 at the current 40:1 exchange rate. But apart from that, the concept is the same.

In principle, a cross border payment like this could go very fast. Assuming that it only takes the Canadian bank a few moments to transfer $10 from my account to my hair dresser's account, then she can quickly start the Philippines leg of the transaction. And if the Filipino bank is just as fast, you'll have the ₱400 just a few moments after she clicks the send button. This whole chain needn't take more than twenty minutes of fiddling with bank websites.

The benefits of queues

But there are factors militating against speed. Say that I need to send you money several times a day. It would be a hassle for my hair dresser to log in to her Philippines bank account and process each payment as it arrives in her Canadian account—she has to cut hair, after all. Instead, she chooses to wait till the end of the day when several of my payment requests have accumulated, upon which she batches the payments into one large payment and clicks the send button.

There is a trade-off here between speed and cost. Putting transaction requests into a queue slows down each of my payments to you, but it imposes less costs on my hair dresser. Slow speeds aren't necessarily a bug. If we all want to save some money, sluggishness may be the best solution for all of us.

Pre-funding: expensive but speeds things up

Imagine that over the course of a few weeks I make so many payments to you that my  hairdresser's Filipino account runs out of funds. When this happens she will no longer be able to make outgoing payouts to your Philippines bank account. To keep the system up and running, she will have to replenish her account with pesos. One of her options would be to withdraw cash from her Canadian account, fly it to Philippines in a suitcase, trade it at the airport for peso banknotes, and deposit these into her Filipino account. This would be slow, expensive, dangerous, and potentially illegal, but it's a theoretical option.

A more realistic option would be to sell her Canadian dollar deposits to a foreign exchange dealer and get Filipino peso deposits in return. This dealer, who will have accounts in both Philippines and Canada, will execute this trade for a commission. My hairdresser will have to ask her Canadian bank to credit the dealer's dollar account while the dealer asks his Filipino bank to credit my hair dresser's peso account. There will be some lag as the dealer processes the transaction, say because he—like my  hairdresser—uses a queue to batch payments together so as to save on fees. But once my hair dresser's Filipino account has been topped up, I can once again make payments to you.

Instead of allowing her Filipino account to periodically run down to zero, my hairdresser may try to maintain a permanently-funded peso account. After all, if she doesn't prefund the account, then you and I will have to cope with constant delays as she waits for the foreign exchange dealer to refill her account. Prefunding her Philippines account isn't without  cost, however. Instead of being able to invest the money in bonds or upgrading her salon, my hair dresser must tie her capital up in a low-yielding bank account as she awaits my payments requests.

Thus, as in the case of queuing on the Canadian side, prefunding on the Philippines side involves a trade-off between cost and efficiency. Reducing the amount of pesos held in anticipation of incoming payment request will allow my hairdresser to reduce costs, but it will simultaneously slow down payments from you to me since the odds of having to wait for a refill increase.

To sum up, for cross border payments to occur someone must straddle the divide between isolated banks. This straddler uses techniques like queuing and prefunding in order to make cross border payments proceed as fast as possible without costing too much.

Cryptocurrency as a bridge

So where do XRP and bitcoin come in? The two of us want little more than a flow of recurring peso payments to arrive in your Filipino bank account as fast and cheaply as possible, but what goes on underneath the hood doesn't concern us. If she can increase payment speeds without having to pay a higher cost (or, alternatively, if she can reduce costs without sacrificing speed), it may make sense for my hairdresser to incorporate an asset like XRP or bitcoin in the payments process.

Say at the end of Monday my hair dresser has amassed four $10 payments in her queue, or $40. She logs into her Filipino bank account, and sends you one ₱1600 payment. She wants to rebuild her Filipino account balance in preparation for the rest of the week's incoming payments. Normally she would do so by asking her foreign exchange dealer to swap her some Filipino deposits for her Canadian dollar deposits.

Instead, she decides to pre-fund by turning to the market for cryptocurrencies. One option is to take the $40 I've transferred her and buy $40 worth of XRPs from her foreign exchange dealer, then sell these XRPs to another dealer for ₱1600 in deposits. Alternatively, she may turn to an organized exchange to complete the refunding. She sends the $40 to a Canadian cryptocurrency exchange, buys some bitcoin or XRP, quickly sends these coins to a Filipino cryptocurrency exchange, and then sells them for pesos. At which point she will transfer the pesos to her bank. Voila, her Filipino bank account has been reloaded using cryptocurrency as a bridge.

Comparing fees and speed

Let's compare these two routes. By exchanging dollars directly for pesos via a foreign exchange dealer, only one transaction had to be completed, and thus one set of hassles and fees incurred. By going through the cryptocurrency market, my hairdresser must make two transactions—a purchase of XRP or bitcoin on the Canadian crypto exchange (or from a dealer) using Canadian dollars, and a sale of XRP/bitcoin on the Filipino crypto exchange (or to a dealer) for pesos. If the sum of these two sets of hassles and fees is less than the traditional single set of hassles and fees, then going the cypto route may make some sense for her. But I confess that I think it is highly unlikely that two sets of fees beat one.

It could very well be quicker for my hair dresser to reload her Filipino account via XRP/bitcoin than the traditional route. For instance, the dealer who is buying her Canadian dollars and selling her pesos may delay the peso leg of the transaction for twenty-four hours. But this sluggishness isn't inherent to a fiat-to-fiat transfer. If she asks nicely, there is no reason the dealer can't expedite the transaction so that the pesos appear in her account within the hour. By queuing her request with many others over a twenty-four hour period the dealer reduces his overall costs, these benefits flowing back to my hair dresser in the form of reduced fees. Likewise, my hair dresser could choose to queue her XRP/bitcoin payment into a big chunk along with other people's cryptocurrency payments. This would slow things down, but reduce fees.

US dollars a bridge currency

Not all traditional cross border payments involve one transaction. Canada-Philippines is a relatively popular payments route, but rarely used payments corridors, say like Canada to Uzbekistan, will incorporate a third fiat currency—probably U.S. dollars—as a bridge currency. For this payment to proceed, my hairdresser will need both a Canadian dollar account and a U.S. dollar account. She will have to find a counterpart who straddles the U.S. and Uzbek banking systems by maintaining a U.S. dollar account and an Uzbekistani Som account. Once she transfers her counterpart some U.S. dollars, then he can execute the Uzbek leg of the payment.

Even on exotic corridors I have troubles seeing how XRP/bitcoin can compete as a bridge. The dollar is the world's most entrenched currency. The CADUSD market will always be deeper than the XRP-to-CAD or bitcoin-to-CAD market, and same on the Uzbek Som side. This depth means that transaction costs on U.S. dollar trades will be lower than on crypto trades. For this calculus to change, bitcoin or XRP will somehow have to displace the U.S. dollar as the world's most liquid medium of exchange. But this is unlikely to happen due to the incredible volatility of cryptocurrencies.

Crypto-volatility

Which leads into the next defect of crytocurrencies as bridge assets. XRP and bitcoin are inherently volatile assets, so using crypto as a bridge means the risk of encountering a plunge in value.  In the case of XRPs, my hairdresser will have to hold them for at least a few moments (or even minutes), but that could be enough time to cause some damage. As for bitcoin, which is slower, she will have to carry them for an hour or two before they can be sold in Philippines. That's an eternity in cryptoland. To top it off, crypto exchanges are notoriously risky, outages and thefts being a regular occurrence. These are pretty big risks for my hair dresser to take, so using crypto markets will only make sense if they provide her enough compensating efficiencies.

Where might these come from? Traditional cross border payments have typically offered very little in the way of transparency. If my hair dresser's payment is stuck, it'll be hard for her to get information on its status. To cope with this informational gap, she may choose to constantly over-fund her peso account, which hurts her pocket book. One advantage of something like Ripple is that all XRPs are recorded on the public Ripple ledger, and thus my hair dresser should have a better idea about what stage her payment has progressed. And this may give her the confidence to reduce the amount by which she pre-funds her peso account, the freed up capital being invested in her salon.

That's a nice feature, but I don't quite see how increased transparency can possibly make up for 1) the inherent risks of holding cryptocurrencies, even if just for a few moments, and 2) the aforementioned transactions costs involved in running the bridge. Furthermore, the transparency advantage is being eroded as traditional payments systems respond to the competitive threat posed by players like Ripple. SWIFT, the communications network that is relied on to facilitate traditional cross border payments, has recently incorporated a tracking number to all payments, thus allowing users to get a real-time end-to-end view on the status of their payments.

So for now, I don't think there is much merit to using crypto as currency bridge in cross border payments. That doesn't mean XRP must crash because it has no use case. Dogecoin—a parody cryptocurrency that recently rose above $1 billion in value—demonstrates that coins don't need a fundamental use case to justify their price. But I've been wrong many times about cryptoland, so let's see what happens.

Money in an economy without banks

by Alex Schaefer

 
Most of the world's money is currently in the form of deposits created by banks. After the 2008 credit crisis, which instilled a strong suspicion of banks among the public, it became fashionable to ask what money would look like in an economy without these organizations. Burn them to the ground or shutter them, what would take their place? One vision is to pursue pure centralization: have the state monopolize all money creation, say by providing universally-available accounts at the nation's central bank. Positive Money is an example of this. Another alternative, by way of Satoshi Nakamoto, is to pursue radical decentralization: replace bank IOUs with digital commodity money in the form of bitcoin and other private cryptocoins.

I'm going to provide a few historical examples that sketch out a third option for replacing banks; bills of exchange. A system underpinned by bills of exchange is capable of converting illiquid personal IOUs into money using a distributed method of credit verification, as opposed to a centralized method patched through a banking organization. Unlike bitcoin, however, these are IOUs, not mere bits of digital ledger-space. While few people these days are familiar with the bill of exchange, in its hey day this instrument was responsible for executing a large chunk of the Western world's transactions. 

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The first story is of cheques, an instrument that while not precisely a bill of exchange gets pretty close. Last week in my homage to the cheque I brought up the Irish bank strike of 1970, described by Antoin Murphy (from whom I steal the title of this blog post). When the nation's banks shuttered their windows for half the year, Irish citizens re-purposed uncleared cheques as personal IOUs, these cheques circulating as a cash substitute. The system was decentralized in that banking institutions no longer served as creators of the medium for making payments; instead, everyone became their own unique money issuer. As Tim Harford recently wrote, pubs and corner shops were able to vouch for the creditworthiness (or not) of each cheque.

Irish cheque money only circulated for six months. After the banks reopened in November 1970, mounds of cheques were cleared & settled and the system returned to normal. Luckily, we have historical examples that lasted much longer than this.

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Let's go back in time to Antwerp in the late 1400s. The institution of banking had been present in Europe for a few centuries, but according to Meir Kohn (who I get much of this material from) it began to go into decline at the end of the 15th century as waves of bank failures broke out across the continent, due in part to coin shortages. In Antwerp, the authorities went so far as to ban the practice of banking in 1489. In lieu of bank deposits, coins could of course be used to make payments, but this would have been a step backward since deposit banking had emerged, in part, to solve the problems related to coins, specifically the fact that they are expensive to store, awkward to transport, and heterogeneous, some coins containing more precious metals than others.

Similar to the Irish five hundred years later, Antwerp's financiers adapted to the death of bank money by innovating a decentralized alternative. Where the Irish chose cheques as their payments instrument, Antwerp settled on a related paper-based order called the bill of exchange. A bill of exchange was a popular way to remit money in medieval times. Say you were a citizen of Florence and you needed to get 20 gold coins to a relative in Venice. Rather than incur the cost and danger of transporting the coins yourself, you might try and strike a deal with a merchant who had offices—and gold—in both cities. By paying the merchant some gold in Florence, your home city, he would issue you a bill of exchange. This bill ordered his colleague in Venice to pay out 20 gold coins to whoever happened to be the bill bearer. You'd then send the bill to your relative in Venice, and he'd bring it into the office and collect the money. The merchant would earn a commission on the deal. No actual gold would travel between the two cities, just a secure and light paper instrument. It was a fantastic technology for saving on the costs of shipping and handling heavy coins.

While bills of exchange started out as remittance instruments, they were later used by merchants as a form of credit. A merchant might want to sell some wool to a manufacturer who in turn required three months to convert the wool into cloth and sell it. To finance the purchase of wool, the manufacturer could always turn to a banker. Absent a banker, the merchant himself might provide the manufacturer with a loan by drawing up a bill of exchange. On its face this bill contained written instructions ordering the manufacturer to pay x coins three months hence to the bearer of the bill. The merchant would keep it in his desk, and when the requisite amount of time had passed he would bring the bill to the manufacturer and collect on his debt, earning interest in the meantime.

The common denominator of a bill of exchange, whether used as a remittance or as credit, is that a private citizen has issued their own personal IOU, to be redeemed for cash after some time has passed. Then Antwerp happened.

In its original form, a bill of exchange could only be used by a small group of people, the initial drawer of the bill, the payor, and the payee. Antwerp's financiers took the bill of exchange and converted it into a fully transferable instrument, or money. They pried open the closed circuit so that if merchant A owned a bill of exchange that was to be paid out in coin by merchant B next month, merchant A could in the meantime transfer this IOU to merchant C as payment, and merchant C could transfer it to merchant D, and D to E etc. These transfers, or assignments, could occur without asking the original debtor, merchant B, for permission. This would have dramatically increased the liquidity of bills of exchange, allowing them to fill the vacuum left in Antwerp by the banning of bank deposits,

To further protect anyone who received a bill of exchange in payment, Kohn tells us that these instruments were granted currency status by Antwerp's merchants. As I wrote here, this meant that even if the bill of exchange had been stolen from merchant B and paid to merchant C (who had innocently accepted it), merchant B could not sue merchant C to get the bill back. This legal upgrade would have further promoted the liquidity of bills of exchange, since merchants needn't bother setting up burdensome verification processes to ensure that bills of exchange presented to them were not stolen. In the eyes of merchant law, all bills of exchange were considered "clean."

There was still one last barrier to creating a truly decentralized medium of exchange; how to overcome stranger danger. Say that you and I are acquaintances and I owe you $20. I tell you I'm going to settle my debt by giving you an IOU issued by another party. Banks are a great way to solve the stranger problem, since everyone will agree to settle debts using the IOUs of a well-known and trusted intermediary like a bank. But say instead I offer you a $20 bill of exchange that I've received from a friend. If you know that person you'll probably accept the deal, but in an economy like Antwerp's with thousands and thousands of actors, you might not know the name of the debtor written on the bill. And without enough knowledge to accept the credit, you'd have probably refused it.

According to Kohn, the final innovation developed in Antwerp solved the stranger problem—the ability to endorse a bill of exchange. I simply signed my name to the back of $20 bill of exchange, or endorsed it, and handed it to you. By signing it, I was agreeing to accept the debt as my own. So if the original debtor failed to pay you for the bill when it came due, you could flip the bill over and pursue the first name on the list of endorsees—me—for payment. And since you knew and trusted me, it was now possible for you to evaluate the credibility of a $20 bill of exchange that had originally been issued by a stranger. Bills could in turn be re-endorsed on by others, a long chain of transactions being made before the bill finally expired. Indeed, Henry Dunning Macleod once remarked that bills might sometimes have "150 indorsements on them before they became due."

From Antwerp, the practice of using negotiable bill of exchange would spread to the rest of Europe, in particular Britain. Below is an example of a bill of exchange from 1815 that ordered Pickford's, an English canal company, to pay £72  11s 1d to Richard Vann. You can see first hand how the stranger problem is solved. The bill has multiple endorsements on its reverse side (pictured below), including that of Richard Vann, William Alcock, T S Marriott, William Whittles, Jones & Mann, Thomas Whalley & Sons, James Mitchell and Richard Williams. To see the front side of the bill, click through to the original link:

Source

Not only did this chain of cosigning individuals solve the stranger problem. It also created an incredibly safe instrument. Bills of exchange were effectively secured not only by the original person whose name was inscribed on the front, Vann, but by all the others who had cosigned the back; Alcock, Marriott, Whittles, etc. The odds of everyone on the list failing would have been quite low. It was an ingenious system.

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Another interesting anecdote on bills of exchange comes from the county of Lancashire in north west England in the 1800s. By then, banknotes had long since been invented and were a popular payments medium in England. Typically issued by small private "country banks," banknotes were a centralized payments technology insofar as their value depended on the good credit of one issuer, the bank. Inhabitants of Lancashire were particularly suspicious of these instruments which explains why there were almost no note-issuing banks in the county. T.S. Ashton speculates that this wariness was due to the 1788 failure of Blackburn-based Livesay, Hargreaves and Co, a banknote issuer: "generations after, when proposals were made for local notes, men's minds turned back to the events of 1788."

In the absence of a system of banks providing transferable deposits or notes, bill of exchange circulated in Lancashire, even dominated, so much so that they were often "covered with endorsements" and become famous for their dirty appearance. Indeed as late as the 1820s, Ashton tells us that some "nine-tenths of the business of Manchester was done in bills, and only one-tenth in gold or Bank of England paper." Bills were used even in small denominations, say to pay piece workers. This is surprising because bills of exchange had typically been used by merchants and wholesalers, and therefore tended to be issued in large denominations.

Alas, according to Ashton the Lancashire bill of exchange was done in by the increase in stamp duties, which effectively made it more cost-effective to use bank-issued forms of payment that didn't require a stamp.

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Just a few random thoughts in closing.

While Ireland, Lancashire, and Antwerp all provide a sketch of an alternative, distributed form of converting personal IOUs into money, do we really need a replacement for banks? While the U.S. banking system certainly had its difficulties in 2008, Canadian banks skated smoothly through the crisis. Maybe banks only need a face lift.

Even if we need to burn the suckers down, a paper-based backup like bills of exchange or cheque just won't cut it—we need digital money. But is it possible to digitally replicate the features of a bill of exchange? And even if an online bills of exchange system could be built, we live in an age where money transmitting is a highly regulated industry—how legal would it be for individuals to take over the role of money creator, transmitter, and verifier? (I once thought that Ripple was the answer to digitally replicating bills of exchange. But they decided to serve banks instead. Maybe Trustlines fits the *ahem* bill?)   

Stablecoin

The whippersnappers who work in the cryptocurrency domain are moving incredibly fast.

As I've been saying for a while, assets like bitcoin (or stocks) are unlikely to become popular as exchange media; they're just too damn volatile relative to incumbent fiat currencies. There's a new game in town though: stablecoin. These tokens are similar to bitcoin, but instead of bobbing wildly they have a fixed exchange rate to some other asset, say the U.S. dollar or gold.

Now this is a promising idea. If a crypto-asset can perfectly mimic a U.S. dollar deposit's purchasing power and risk profile, and do so at less cost than a bank, then the monopoly that banks currently maintain in the realm of electronic payments is in trouble. Rather than owning a Bank of America deposit, consumers may prefer to hold an equivalent stablecoin that performs all the same functions while saving on storage and transaction fees. To compete, banks will either have to bribe customers with higher interest rates on deposits, thus putting a crimp in their earnings, or go extinct.

Let's look at these stablecoin options more closely.

Type A: One foot in the legacy banking sector, one foot out

The unifying principle behind each type of stablecoin is the presence of some sort of backing, or security. Bitcoin, by way of comparison, is not backed. Stablecoin backing is typically achieved in two ways. With type A stablecoin, an organization creates a distributed ledger of tokens while maintaining a 1:1 reserve of dollars at a traditional bank. Owners of the tokens can cash out whenever they want into bank dollars at the stipulated rate, thus ensuring that the peg to the dollar holds. Until then, the tokens can be used as a stable medium of exchange. Examples of this are Tether and Ripple U.S dollar IOUs.

Could stablecoin be a bank killer?

We can think of a bank as enjoying stock and flow benefits from its deposit base. The existence of a stock of deposits provides it with a cost of funding advantage while the flow of those deposits from person to person generates fees.

Type A stablecoin pose no threat to the stock benefits that banks enjoy. After all, each stablecoin is always backed by an equivalent bank deposit held in reserve. If people want more stablecoin, the deposit base will have to grow, and that makes traditional bankers happy.

The flow benefits, however, are where the fireworks start. At the outset, people who receive stablecoin--through lack of familiarity--will probably choose to quickly cash out into good old fashioned deposits. But if stablecoin provides an extra range of services relative to deposits, rather than "kicking" back into the bank deposit layer, more people may choose to keep their liquid capital in the overlying stablecoin layer. Merchants will have more incentives to accept stablecoin, only adding to the snowball effect. Once all transactions are routed through the stablecoin layer, underlying deposits will have become entirely inert. While banks will continue to harvest the same stock benefits that they did before, they'll have effectively yielded up all the flow benefits to the upstarts.

So while Type A stablecoin doesn't kill banks, it certainly knocks them down a few wrungs.

By constructing a new layer on top of the deposit layer, stablecoin pioneers would be cribbing off the same playbook that bankers have been using since the profession emerged. Centuries ago, the first bank deposit layer was built on top of an original base money layer. Base money consisted then of gold and silver coin, but in more recent times it morphed into central bank banknotes and deposits. Because bank deposits inherited the price stability of base money (thanks to the promise to redeem in base money), and were highly convenient, bankers succeeded in driving transactions out of the base coinage layer and into the deposit layer. That's why gold and silver rarely appeared in circulation in the 19th century, being confined mostly to vaults. Perhaps one day stablecoin innovators will succeed in confining bank deposits to the "vault" in favour of mass stablecoin circulation. If this sort of displacement hadn't already been done before, I'd be more skeptical.*

Type B: Both feet out of the banking sector

More ambitious are type B stablecoin, which try to liberate themselves entirely from the traditional banking layer. Rather than using old-fashioned bank deposits as backing, a pre-existing issue of distributed digital tokens is used to secure the stablecoin's value.

As an example, take bitShares, a brand of bitcoin-like unbacked tokens. These tokens are every bit as volatile as bitcoin, up 10% one day and down 10% the next. Here's a chart. So far nothing new here, there are literally hundreds of bitcoin look-alikes.

The unique idea is to turn volatile water into stable wine by requiring that a varying amount of bitShares be used to back a second type of token, bitUSD. A bitUSD is a digital token that promises to provide its owner with a U.S. dollar-equivalent return. As long as each bitUSD is secured by, say, $3 worth of bitShares, the owner of one bitUSD will be able to cash out (into one U.S. dollar worth of bitShares) whenever they want and the peg to the U.S. dollar will hold.**

My understanding is that bitUSD, which debuted last year, is coming close to consistently hitting its peg. If bitUSD were to catch on as an alternative transactions layer, banks would lose not only their flow benefits but also stock benefits. After all, a bitUSD-branded stablecoin is not linked to an underlying deposit. We're talking complete devastation of the banking industry.

The system has some warts, however. If the market price of bitShares starts to fall, the scheme requires that more collateral in the form of bitShares be stumped up by the issuer of a bitUSD. This makes sense, it protects the peg. But what if the value of bitShares falls so much that the total market capitalization of bitShares is insufficient to back the total issue of bitUSD? At that point, bitUSD "breaks the buck." A bitUSD will be only worth something like 60 cents, or 30 cents, or 0 cents. Breaking the buck is what a U.S. money market mutual fund is said to do when it can't guarantee its one-to-one peg with the U.S. dollar.   

I'm skeptical of type B stablecoin for this very reason. Cryptocoin like bitcoin and bitShares are plagued by the zero problem; a price of nothing is just as good as a price of $100. They thus make awful backing assets, and any stablecoin that uses them as security has effectively yoked itself to the mast of the Titanic. A breaking of the buck isn't just probable, it is inevitable. Stability is an illusion. Maybe I'd get a bit more bullish on type B stablecoin if there emerged a brand that used digital backing assets not subject to the zero problem.

Anyways, keep your eye on these developments. Like I say, the young whippersnappers who are working on these projects aren't slowing down.

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*In principle, type A stablecoin ideas are very similar to m-Pesa and Paypal. Both of these services construct new banking layers, but keep one leg back in the the existing banking infrastructure by ensuring that each Paypal or m-Pesa deposit is fully backed by deposits held at an underlying brick & mortar bank. See Izabella Kaminska, for instance, on m-Pesa.
 ** For those who like central bank analogies, this is an example of indirect convertibility, whereby a central bank sets market price of its liabilities in terms of, say, a bundle of goods, but only offers redemption in varying amounts of gold. See Woolsey and Yeager.  
*** Another working examples of Type B stablecoin is NuBits. Conceptual versions include Robert Sam's Seignorage Shares, the eDollar, and Vitalik Buterin's Schellingcoin.

Fedcoin

Recent posts by Adrian Hope Baille and Sina Motamedi have got me thinking again about the idea of the Federal Reserve (or any other central bank for that matter) adopting bitcoin technology. Here's an older post of mine on the idea, although this post will take a different tack.

The bitcoin ethos enshrines the idea of a world free from the totalitarian control of central banks. So in exploring the idea of Fed-run bitcoin-style ledger, I realize that I run the risk of being cast as Darth Vader (or even *yikes* the Emperor) by bitcoin true believers. So be it. While I do empathize with the bitcoin ideal—I support freedom in banking—I rank the importance of bitcoin-as-product above bitcoin-as-philosophy. And at the moment, bitcoin is not a great product. While bitcoin has many useful features, these are all overshadowed by the fact that its price is too damn volatile for it to be be taken seriously as an exchange medium. This volatility arises because bitcoin lacks a fundamental value, or anchor, a point that I've written about many times in the past. However, there is one way to fix the crypto volatility problem...

Enter Fedcoin

Setting up the apparatus would be very simple. The Fed would create a new blockchain called Fedcoin. Or it might create a Ripple style ledger by the same name. It doesn't matter which. There would be an important difference between Fedcoin and more traditional cryptoledgers. One user—the Fed—would get special authority to create and destroy ledger entries, or Fedcoin. (Sina Motamedi gives a more technical explanation for how this would work in the case of a blockchain-style ledger)

The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types—paper money and electronic reserves—and Fedcoin at a rate of 1:1. The outcome of this rule would be that Fedcoin could only be created at the same time that an equivalent reserve or paper note was destroyed and, vice versa, Fedcoin could only be destroyed upon the creation of a new paper note or reserve entry.

So unlike bitcoin, the price of Fedcoin would be anchored. Should Fedcoin trade at a discount to dollar notes and reserves, people would convert Fedcoin into these alternatives until the arbitrage opportunity disappears, and vice versa if Fedcoin should trade at a premium.

As for the supply of Fedcoin, it would effectively be left free to vary endogenously, much like how the Fed currently let's the market determine the supply of Fed paper money. This flexibility stands in contrast to the fixed supply of bitcoin and other cryptocoins. The mechanism would work something like this. Should the public demand Fedcoin, they would have to bring paper dollars to the Fed to be converted into an equivalent number of new Fedcoin ledger entries, the notes officially removed from circulation and shredded. As for banks, if they wanted to accumulate an inventory of Fedcoin, they would exchange reserves for Fedcoin at a rate of 1:1, those reserves being deleted from Fed computers and the coins added to the Fedcoin ledger.

Symmetrically, unwanted Fedcoin would reflux to the central bank in return for either newly-created cash (in the case of the public) or reserves (in the case of banks), upon which the Fed would erase those coins from the ledger. The upshot is that the Fed would have no control over the quantity of Fedcoin—it would only passively create new coin according to the demands of the public.

Apart from that, Fedcoin would be similar in nature to most other cryptoledgers. All Fedcoin transactions would be announced to a distributed network of listening nodes for processing and verification. In other words, these nodes, and not the Fed, would be responsible for maintaining the integrity of the Fedcoin ledger.

Why implement Fedcoin?

The main reasons that the Fed would implement Fedcoin would be to provide the public with an innovative and cheap payments option, and to provide the taxpayer with tax savings.

The public would enjoy all the benefits of bitcoin including fast transaction speeds, cheap transaction costs, and the ability to transact almost anywhere and with almost anyone as long as all parties to a transaction had a smartphone and the right software. At the same time Fedcoin's stability would immediately differentiate it from bitcoin. No longer would users have to fear losing 50% of their purchasing power prior to making a transaction.

Fedcoin's distributed architecture would be both complementary and in many ways superior to Fedwire, a centralized system which currently provides for the transferal of Fed electronic reserves among banks. I won't bother getting into the specifics: see this old post.

By introducing Fedcoin, the Fed would also lower its costs. While I haven't done the calculations, I have little doubt that running a distributed cryptoledger is far cheaper than maintaining billions of paper notes in circulation. Paper currency involves all sorts of outlays including designing and printing notes, collecting, processing and storing them, as well as constantly defending the note issue against counterfeiters. A distributed ledger does all this at a fraction of the cost. As Fedcoin begins to displace cash, and I think that this would steadily happen over time due to its superiority over paper, the Fed's costs would fall and its profits rise to the benefit of the taxpayer.

Fedcoin would have no impact on monetary policy

Fed officials might balk at giving the idea a shot if they feared that adopting a Fed cryptoledger would impede the smooth functioning of Fed monetary policy. They needn't worry.

The Fed currently exercises control over the price level by varying the quantity of reserves and/or the interest paid on reserves. The existence of cash doesn't get in the way of this process, nor has it ever gotten in the way. Bringing in a third liability type, Fedcoin, the quantity of which is designed to fluctuate in the same way as cash, would likewise have no impact on monetary policy. The Fed would continue to lever the return on reserves in order to get a bite on prices while allowing the market to independently choose the quantity of Fedcoin and cash it wished to hold.

Well, almost none: Interest on Fedcoin and the zero lower bound

Ok, I sort of lied in the last paragraph. While it happens only rarely, there are times when cash does get in the way of monetary policy, and so would Fedcoin if it were implemented. If the Fed needs to reduce rates on reserves to negative levels in order to hit its price and employment targets, the existence of cash impedes the smooth slide below zero. With reserves yielding -2% and paper notes yielding 0%, reserves would quickly be converted en masse into cash until only the latter remains. At that point the Fed would have lost its ability to alter rates—cash doesn't pay interest nor can it be penalized—and would no longer be capable of exercising monetary policy. This is called the zero-lower bound, and it terrifies central bankers.

Fedcoin has the potential to alleviate the zero lower bound problem. Here's how.

As Fedcoin adoption grows among the public, cash would steadily be withdrawn. And while it might not shrink to nothing—the public might still choose to use some cash—at least the Fed would have a good case for entirely canceling larger denominations like the $100 and $50.

Consider also that it would be possible for interest to be paid on each Fedcoin  (unlike bitcoin and cash), the rate to be determined by the Fed. And just as Fedcoin could earn positive interest, the Fed could also impose a negative rate penalty on Fedcoin. This would effectively solve the Fed's zero lower bound problem. After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store $5s and $10s available.

So by implementing something like Fedcoin, the Fed could safely implement a negative interest rate monetary policy.

(Lastly, monetary policy nerds will notice that the displacement of non-interest yielding cash with interest-yielding Fedcoin is a tidy way to arrive at Milton Friedman's optimum quantity of money, or the Friedman rule.)

The big losers: banks

Fedcoin has the potential to tear down the private banking system. Interest yielding Fedcoin would be able to do everything a bank deposit could do and more, and all this at a fraction of the cost. As the public shifted out of private bank deposits and into Fedcoin, banks would have to sell off their loan portfolios, the entire banking industry shrinking into irrelevance.

One way to prevent this from happening would be for the Fed to make an explicit announcement that any bank could be free to create its own competing copy of Fedcoin, say WellsFargoCoin. Like the Fed, Wells Fargo would promise to offer two-way convertibility between its deposits/cash/Fedcoin and WellsFargoCoin at a rate of 1:1 to ensure that the price of its new ledger entries were well-anchored. The bank could then implement features to compete with Fedcoin such as higher interest rates or complimentary financial services. Even as Wells Fargo's deposit base steadily shrunk due to technological obsolescence, its base of WellsFargoCoin liabilities would rise in a compensatory manner.

The resulting lattice network of competing private bank crypto ledgers built on top of the Fedcoin ledger would work in a similar fashion to the current banking system. Wells Fargo would make loans in WellsFargoCoin and take deposits of FedCoin as well as competing bankcoins, say CitiCoin or BankofAmericaCoin. Intra-bank cryptocoin payments would be cleared on the books of the Federal Reserve with reserves transfers over the Fedwire funds system, although Fedcoin might eventually take the place of Fedwire. A change in the value of Fedcoin or reserves due to a shift in monetary policy would be transmitted immediately into a change in the value of all private bankcoins by virtue of  the convertibility of the latter into the former.

Nor would it be necessary to start with Fedcoin and then introduce bankcoins. Why not begin with the latter and skip Fedcoin altogether? Why aren't private banks at this very moment switching out deposits and replacing them with cryptoledgers?

KYC: Know your customer

'Know your customer' regulations would make implementation difficult, but not impossible.

With bitcoin, the location of a coin (its address) is public but the identity of the owner is not. However, laws require banks to gather information on their customers to protect against money laundering. As these laws are unlikely to change with the advent of new technology, banks would probably require anyone wanting to use bank cryptoledgers to have an account with a regulated bank. This would not be too onerous given that most Americans already have bank accounts.  However, it compromises anonymity, one of the key ideals of bitcoin, since each coin would be traceable by the authorities to a real person.

Perhaps there is still a way to preserve some degree of anonymity. Historically the Fed has always been spared from KYC rules since it has never had to document who uses cash. By grandfathering KYC exemption to Fedcoin, any user who wanted to preserve their anonymity could use Fedcoin rather than any of the multiple bankcoin ledgers, just like today they prefer to use anonymous Fed cash rather than bank accounts to transact.

In summary

So that's a rough sketch of Fedcoin—a decentralized, flexible, and well-backed payments system that grants one user, the Fed, a set of special privileges and responsibilities. Feel free to modify the idea in the comments section.

And just so we are keeping tabs, these are the institutions that Fedcoin could eventually make obsolete: bank deposits, banks (unless the latter are allowed to innovate their own bankcoins), the credit card networks Visa and Mastercard, bank notes, Fedwire, and even bitcoin itself, which would be unable to compete with a stable-value copy of itself.

Bitcoin true believers may not like this post, but perhaps they can take something constructive from it. Fedcoin is one of the potential competitors in the distant horizon. Now is the time for the rebels to figure out how to create a stable-price version of bitcoin, before Darth Vader does it himself. Otherwise they may someday find themselves closing down their bitcoin startups in order to write code for the Empire.

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Note: My apologies to readers for my having succumbed to the constant temptation to adorn all blog posts with Star Wars references.

Chopmarks and other distributed verification methods

A 1795 Spanish dollar, minted in Mexico, with several chopmarks

One of the most interesting things about bitcoin, ripple, and other cryptocurrencies is how they are maintained by a dispersed user base rather than some central issuing authority. These users (miners in the case of bitcoin, nodes for ripple) ensure that each "coin" is a legitimate member of the total population of cryptocoins comprising that particular ledger. They are what stand between good coin and bad coin.

I've run into two historical cases of a dispersed method of policing of the quality of exchange media: the endorsement of bills of exchange and the chopmarking of silver coins. It may be worthwhile to explore these two cases.

The Watchdog role

The watchdog or verification function is an important one, especially in anonymous trade where the unlikelihood of a repeat meeting between buyer and seller increases the incentives to be dishonest and pass off lousy coin. Not-so-liquid goods, say sofas, are insulated from the bad coin problem. Due to physical characteristics that impede their liquidity, sofas tend to be sold from fixed locations, or shops. Because a merchant is shackled to his shop and thus unable to preserve his anonymity, any attempt to pass off bad sofas will hurt his business reputation. In the end, only good sofas get stocked by the merchant.

Unfortunately for him, the merchant faces the danger that his much more mobile customers may try and sell him bad coin. The merchant can always threaten them with an embargo should they fob off a fake, but his customers will simply avoid his penalty by shopping at a competing merchant the next time they want a sofa.

In the case of paper money and coinage, the merchant is somewhat protected from the bad coin problem by difficult-to-counterfeit designs printed on the bill or engraved on a coin's face by the issuing authority. In the case of bank money, he is protected by the owners of the credit card networks who approve the legitimacy of a card prior to consummation of trade. These are centralized watchdog systems. What is interesting is that a number of decentralized, or dispersed systems have evolved in times past to offer further protection, including the use of chopmarks:

Chopmarking

In the 16th C, Spanish silver dollars, or pieces of eight, began to appear in China. These coins were minted in Spanish-controlled Mexico, shipped by Spanish vessels to the Philippines where they were exchanged for Chinese goods like porcelain and spices, and finally brought to China by Chinese and other foreign merchants.

Minted on the reverse side with a Christian cross and the obverse side with a Spanish coat of arms, and covered over with Latin characters, the patterning of the Spanish dollar would have meant little to the typical Chinese consumer or merchant. In fact, any pattern would have done just as well since silver was traditionally not accepted at its face value in China, but by its weight (this contrasts to the west, where Spanish dollars were typically accepted at face value). This may have been partly due to the fact that silver ingots, or sycee, had circulated in China long before the piece of eight ever made an appearance, with each city having its own particular standard. Because these sycee circulated according to weight, prior to consummating a trade, merchants would use a set of scales, or dotchin, to determine the value of each ingot.

While anyone with a set of scales could easily ascertain the weight of a particular coin, the difficult part would have been determining the purity of that coin. Counterfeit Spanish dollars were not uncommon, after all, but not everyone would have had the skills to detect them. This is where chopmarking came in handy. Merchants and professional money exchangers, or shroffs, would assay a coin to verify its silver content. 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.

Numismaticist Bruce Smith describes the reason for chopping thusly:

I think the chop was only a guarantee that it was acceptable silver. It didn't really matter if the coin was genuine or not. As long as it had the right weight and right fineness as far as they could tell. I mean they were only looking at it by eye and by sound. If it looked like the silver was good and it sounded good [the ‘ring’] and the weight was acceptable then it was okay.

According to Frank Rose, a numismatist who published an early text on chop marks, certain merchants chopmarked every legitimate coin that came into their possession and would readily take back any coin bearing one of their earlier marks. So by chopmarking a coin, a merchant would have been taking on a liability of his own, almost as if he had issued a redeemable paper note or a deposit.

In any case, foreign coins often became so covered in chop marks during the course of trade that their initial design became unrecognizable, as the coin below shows.

1807 Spanish dollar with chopmarks

The genius of this system is that a naive Chinese consumer could safely accept a coin knowing that as long as it was chopped it had successfully passed the smell test of professional appraisers--and the more chops the better. Chopping, like bitcoin mining, transformed a virgin coin into the native exchange medium, with chopmarks serving as a way for disparate users to verify a coin's membership in the set of good silver pieces.

Endorsing

Another interesting form of dispersed verification was the system of bills of exchange, especially the system that developed in Lancashire, a county in northern England. A bill of exchange was a paper contract between two sides in a transaction. It was created or 'drawn' up by the person who provided goods or services, the 'drawer'. The counterparty who had taken position of goods stood as the 'acceptor' and by signing the bill, promised to render up a certain amount of coins to the drawer, usually three months hence. The drawer kept the bill in his desk until three months had passed upon which he presented it to the acceptor, got his gold, and the two parted ways.

A bill of exchange, 1843 [link]

In the early 1700s, English commercial law began to accept the practice of transferring debts, or negotiability. Rather than the drawer keeping the note in desk, he could transfer it to a third party. The drawer would typically do so in exchange for some good or service, and would go about this by endorsing it, or signing his own signature on the back. By endorsing the bill, the drawer had become a co-signatory.

When the bill was due the third party could call on the original acceptor for payment, even though the original agreement had been between the drawer and the acceptor. Should the third party find the acceptor unable to pay the gold upon maturity, he could make a claim on the endorser for full payment. Alternatively, the third party could in turn endorse the bill on to someone else, who could it turn endorse it to someone else, etc. turning what had been an illiquid bill into a highly liquid and potent medium of exchange.

This is exactly what happened in Lancashire, according to this paper by T.S. Ashton. Not only were bills used by large scale industry, but according to Ashton they were used in small transactions too. While coin was generally reserved for the payment of wages, those a little higher in economic status than hired workers, small-capitalist spinners and small time manufacturers with an apprentice or two, were induced to accept payment in Lancashire bills. According to Henry Thornton, who Ashton quotes, all payments at Liverpool and Manchester - then part of Lancashire - were carried out either in coin or bills of exchange. Henry Dunning Macleod describes bills "which had sometimes 150 indorsements on them before they became due."

The practice of endorsement was hugely advantageous for the general populace, for as Ashton points out:

"Since each successive holder endorsed it, the more it circulated the greater the number of guarantors of its ultimate payment in cash. Even if some of the parties to it should be men of doubtful credit it might still circulate, for it was unlikely that they would go down simultaneously."

So in the same way that multiple chop marks and blockchain confirmations ensure that a coin is a good one, multiple endorsements converted an IOU into a member of the population of verified IOUs, and therefore suitable for broad circulation. In the end, what bitcoin and the other cryptocoins is certainly novel, but we have seen parts of this story before.

Bitcoin's bootstraps

by Paul Conrad

When we talk about bitcoin, one thing we need to ask ourselves is this: can worthless things circulate and be accepted in trade? If so, how? And can this state of affairs continue indefinitely?

An intrinsically useless, unbacked, and costless fiat object might be accepted in trade, but only if it already has a positive price. A history of positive prices will generate sufficient expectations among potential acceptors that they will be able to trade that object on tomorrow. But how might our fiat object earn a positive price to begin with? If we reply that early adopters expected it to be widely accepted by others in trade, how did these early adopters ever form these expectations if that object didn't already have a positive price? We're dealing with a problem of circularity. There is no way to "break into" a dynamic that might generate a positive value for a fiat object. So logically, worthless things cannot trade in the market at a positive value.

However, fiat objects like dollars and yen do seem to have a positive value. Two types of economists, Austrians and MMTers, recognize the circularity dilemma that emerges when trying to explain the positive price of a useless fiat object. Both solve the circularity problem in different ways.

Austrians say that when early adopters first acquired the fiat object, it was not yet intrinsically useless, unbacked, or costless. Thanks to its original commodity nature, or perhaps its status as a backed financial asset, it already traded at a positive price. Even if that character is lost, the object suddenly becoming a fiat one, it may still be widely accepted in trade on the basis of people's memory of its pre-fiat price. Thus the circle can be broken into, and worthless bits of paper can legitimately have a positive value in trade. This is Ludwig von Mises's famous regression theorem.

MMTers solve the circularity problem by bringing in the tax authority. As long as some agency like the government imposes an obligation on people to pay taxes with these fiat objects, that will be enough to drive their positive value.

I should point out that I don't think we actually face a circularity problem with modern central banknotes since they aren't worthless bits of paper but rather exist as a liability of their issuer. But we do run into the problem with bitcoin. Here we have an unbacked, intrinsically useless, stateless fiat object trading at $950 or so, not to mention a legion of copycat coins trading at various positive prices. [1]

Austrians are all over the board on bitcoin. Because their solution to the circularity problem is to invoke the legacy commodity value of a fiat object, bitcoin poses some theoretical hurdles for them since it is by no means clear whether bitcoin ever had an original commodity value. Bob Murphy for one argues here that bitcoin may have earned its first foothold thanks to non-pecuniary ideological reasons. However, there seems to be no consensus among Austrians on that point. MMTers seem to genuinely dislike bitcoin since their preferred tax obligation story can't bear the load of explaining bitcoin's price. Here is L. Randall Wray who says that bitcoin is a test of the "infinite regress view of money", then gleefully points to its falling price as evidence that the taxed backed theory is the dominant theory (it later rebounded).

Let's move on from MMTers and Austrians. George Selgin recently came up with an interesting way to explain how bitcoin might have earned its all important original positive price:

Records show that a just a few persons took part in most early Bitcoin transfers, and especially in the larger-volume ones. My guess is that they all knew each other, and that those trades were more-or-less fictitious, with large values being traded and then traded back again, with the intent of enhancing the prominence of the positive-value equilibrium by drawing attention away from the much larger set of inactive Bitcoin markets. Bitcoin’s inventors, I’m now almost certain, were making conspicuous leaps onto their own bandwagon, so as to encourage others to do so, whether to express themselves or to profit by doing so. In short, a clever marketing strategy, including a little strategic sleight-of-hand, can substitute for history in putting a positive sign on the expected value of an otherwise useless potential exchange medium.

Here we have neat way to break into the circle. Have a group of insiders trade the fiat object amongst each other in order to generate an artificial history of positive prices, at which point outsiders will be willing to accept it in trade based on the expectation that others will repurchase it from them later.

Making "conspicuous leaps onto one's own bandwagon," as Selgin calls it, is a well worn tactic. In stock markets, the term wash trading refers to the illegal practice whereby an individual or group of schemers trade an illiquid, often worthless, stock back and forth among different accounts. The goal is to give the illusion of activity, thereby attracting innocent traders who would otherwise pass up the stock. A more colourful term for this is "painting the tape", which refers to the old ticker tape of yore.

Another way to paint the tape is to high close a stock. Using this technique, a trader or group of traders will buy a stock in the closing seconds of the day, pushing its price up. Since media outlets tend to focus on a stock's daily closing price, and stock charts depend on the daily close, high closing may be a cost effective strategy for traders to create and benefit from the positive price momentum that news of a high closing price engenders.

Auction markets, say in livestock or art, are sometimes populated with confederates—those who work in conjunction with a seller to provide fictitious bids so as to drive some object's price, say a dubious piece of abstract art, or a lame horse, far higher than it would otherwise be worth. Should the confederate's bid be the only bid, the worst that happens is that the schemers get their own painting or horse back, upon which they can try the same trick over again in the next auction. If their bidding excites someone else to add a bid, then they've succeeded in earning something for nothing.

In any case, all of these techniques can push a worthless object's price above zero, at which point that object may have generated enough of a history of positive prices that it will be valued by enough outsiders that it will join the mass of non-fiat objects in circulation. From nothing, our worthless item it has pulled itself up by its own bootstraps.

Which explains bitcoin's incredible volatility. A bootstrapped object can just as easily let go of its own straps and fall back to zero. Without some real use or backing, there's nothing to catch it on the way to $0. And at $0, there's no guarantee of re-bootstrapping bitcoin back to some positive price. As such, Bitcoin users justifiably expect incredible returns from bitcoin holdings in order to bear the risk of a zero-value equilibrium. Expected hyperdeflation is the carrot that must be proffered up for risky cryptocoins to be held. When those expectations of price appreciation aren't met, a large crash in the current price (relative to its future expected price) is necessary in order to tempt the next crop of speculators to hold it again. Thus bitcoin's pattern of incredible rises, or hyperdeflation, followed by 50% flash crashes, followed by the next round of hyperdeflation.

So if unbacked, useless, and costless objects can be imbued with a positive price via Selgin's painting-the-tape story, why isn't everyone doing it? But they are! Attracted by the potential for large gains, plenty of people are creating alt-coins, as I wrote here and here. In theory, their combined greediness should have the effect of swamping the market with fiat objects, driving their price towards the cost of production. The idea here is similar to the Somali shilling story, in which continual counterfeiting of old fiat shilling notes drove their price down to the cost of production, namely the costs of paper, printing, and shipment.

This hasn't happened yet with bitcoin, which is hovering at around $950. In my old post Milton Friedman and the mania in "copy-paste" cryptocoins, I hypothesized that the seeming inability of competitors to drive bitcoin prices down had something to do with the unassailable benefits that bitcoin enjoys as being the first mover, including superior security and liquidity. Tyler Cowen has some interesting thoughts on this. Bitcoin has a market cap of about $20 billion. As long as Bitcoin's entrenched advantages are so supreme that it would cost $20 billion to create a competitor, then there's no profit in tackling its niche. Cowen, however, thinks that the cost of mimicking bitcoin is far less than this. Rather than being in equilibrium, the cryptocurrency market is currently working itself via a process of "supply-side arbitrage" to a new equilibrium at which bitcoin will be worth far less.

On this same topic, Nick Rowe suggests that a BackedCoin might be one of the competitors capable of carrying of this feat. I agree with Cowen and Rowe —that's why I mostly sold out of bitcoin last year, and why I plan to eventually sell my litecoin. Of course, I'm the dummy who sold BTC back at $100, so my opinions should be taken with a grain of salt.

Where will the competition come from? Robert Sams makes a good argument for why bitcoin knock offs like litecoin, sexcoin, etc., though costless to produce, can't easily compete with bitcoin itself. The mining power that goes into maintaining the integrity of the various blockchains is in scarce supply. Merchants will always congregate to the blockchain with the most security, since that will be the coin that guarantees that the threat of double-spending is the smallest. While clones can be created with a few key strokes, good security can't be bought. Thus bitcoin's price can't be competed down to $0ish by alt-coins.

I think I buy Sams's point. However, he couches his argument within the existing universe of bitcoin and its clones. I'd make the argument that the crypto phenomena through which "supply-side arbitrage" will be carried out could be something entirely different than bitcoin, say Ripple or something we haven't yet seen. Ripple for one isn't constrained by the supply of existing mining power, or hashing, since the Ripple blockchain is maintained via consensus, not by hashing miners. Is this type of security cheaper? I'm no techie, so I won't speculate. But it is something different. And though it may take a while, at some point new and different will also be cheaper.

Another bonus of the Ripple system is that the crypto currency it creates are not bootstrapped assets, they are redeemable IOUs (let's not confuse Ripple IOUs and XRP!). In Rowe's UnbackedCoin vs BackedCoin world, Ripple IOUs are the equivalent of BackedCoin. It is their backing that should protect the exchange value of Ripple IOU from the threat of competition. This very same backing frees them from the hyperdeflation-crash-hyperdeflation patten that bootstrapped coins tend to display, stability being a desirable feature among  those who want to hold an inventory of media of exchange. As long as Ripple IOUs are just as transferable & secure as bitcoin and other alt-coins, this stability will be the edge that pushes them above the crypto competition.

So in sum, worthless assets can be kickstarted into circulation, say by a group of confederates who paint the tape in a way to attract outsiders. The riskiness of these bootstrapped assets requires that they yield incredibly high returns, or constant price appreciation. However, this state of affairs can't last forever since others will be eager to issue their own competing fiat objects, including superior non-volatile competitors. If I'm right, in the future bitcoin will be a smaller part of the cryptocoin world than it it now, whereas stable-value non-bootsrapped crypto assets, like Ripple IOUs, will be a larger part of that world.

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[1] Bitcoin may not be entirely intrinsically worthless. I have floated the idea before that bitcoin has commodity value as a symbol of geek cred.