Revisiting stablecoins

Source: Gravity Glue (2014)

Cryptocurrencies were supposed to destroy the traditional monetary system. Ten years on, where are we?

Bitcoin has been wildly successful, but as a financial game--not as a medium of exchange. It's a fun (and potentially profitable) way to gamble on what Keynes once described as what "average opinion expects the average opinion to be." But no one really uses it to pay for stuff. It's nature as a gambling token makes it too awkward to serve as a true substitute for banknotes and credit cards.

A number of stablecoins have emerged over the last five or six years. (I first wrote about stablecoins four years ago). Like bitcoin, stablecoins exist on a blockchain. But unlike bitcoin, these tokens have a mechanism for ensuring their stability. Stablecoin owners can convert tokens at par into underlying dollar balances maintained in the issuer's account at a regular bank. So stablecoin entrepreneur have basically built a new blockchain layer on top of the existing financial stack. This is interesting, but not very subversive. It's not that different from what PayPal does, or a mobile money operator like M-Pesa.    

Which gets us to MakerDAO. MakerDAO is the name of the decentralized organization that manages the Dai stablecoin. Dai is unique because like bitcoin (and unlike other types of stablecoins), it has no connection whatsoever to the traditional financial system. So Dai has all the rebelliousness of bitcoin. But unlike bitcoin it isn't a gyrating Keynesian beauty contest. Which means that it has a much better chance of becoming a generally-accepted medium of exchange than bitcoin.

This post is for monetary economists and others who would like to know how MakerDAO works, without necessarily getting into the specifics. Since cryptocurrency jargon, like all jargon, is complicated, I'm going to explain it by comparing it to something we can all recognize, a bank.

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The Dai system is in many ways like a regular bank, say Citibank. Citibank create 'stablecoins', specifically deposits, out of unstable assets like personal promises, property claims, flows of future business profits, etc.

The process of creating Citibank deposits begins with a loan. Jim pledges his house that is appraised to be worth $1 million to the bank, and the bank creates $500,000 digital Citibank dollars for Jim. He spends the $500,000 into the economy, which ends up being held by Terry, who is most comfortable investing in safe assets like Citibank deposits. Thus Jim's unstable house has been transformed into Terry's stable deposit.

The creation of Dai tokens works the same way. Jim pledges $1 million in assets to the Dai system, and in return he gets $500,000 Dai. After Jim spends those stablecoins into circulation, they end up with Terry, who wants to hold a stable cryptocurrency.

One difference between Dai and Citibank emerges pretty quick. To get his hands on Citibank dollars, Jim pledges his house as collateral (or some real world instrument, like business inventory or a boat or equity shares). But with Dai, Jim can only pledge assets that exist in blockchain space. Because Dai exists on a particular blockchain--Ethereum--the key pledgeable asset for a Dai loan is Ethereum's native token, ether, a volatile cryptocurrency.

What ensures that Terry's Dai tokens will be worth the same as a Federal Reserve dollar? First, lets revisit why a Citibank dollar is always worth a Federal Reserve dollar.

Citibank maintains a network of ATM machines and tellers that will redeem Terry's deposits at par with paper currency. Since he knows that he can always cash them in 1:1 at a Citibank outlet, Terry needn't ever sell his Citibank dollars at a discount on the open market.

Unlike Citibank, Dai doesn't maintain a network of dollar-filled ATMs. There is simply no way to redeem or cash out of Dai, as there is with other stablecoins. To provide a cash-out mechanism would contradict the whole point of a fully decentralized stablecoin. Dai is trying to recreate a virtual version of the dollar, but entirely within the world of blockchains. It can't rely on out-of-blockchain dollars to secure the system.

So how is the price of Dai kept at $1? 

Let's go back to our Citibank illustration. Imagine that Citibank were to announce that henceforth all its deposits are inconvertible. Its network of ATM machines is to be shut down and cash can no longer be withdrawn at the teller. If Terry can no longer return his Citibank deposits to the bank at par, will their value collapse? Or will the 1:1 exchange rate somehow hold?

The short answer is that the exchange rate will hold... to a degree. Remember that Jim is still obligated to repay $500,000 to Citibank. Even if Terry can no longer directly bring his $500,000 worth of Citibank dollars to Citibank for redemption into Federal Reserve dollars, he can do so indirectly, by offering to sell them to Jim for Federal Reserve dollars, who in turn is obligated to bring deposits to the bank to clear up his loan.

Say that Jim's debt is due and he has decided to take up Terry on his offer. The price that Jim decides to pay Terry for his deposits depends on how many other buyers he must compete with. On any given day, a number of Citibank borrowers will have to purchase Citibank deposits in order to settle their existing debt to Citibank. If they are all anxious to settle their debts, Jim may have to offer Terry as much as $1.05 or $1.06 for his deposits. Again, with ATMs and tellers no longer providing 1:1 convertibility, it is possible for these odd exchange rates between Citibank dollars and Fed dollars to emerge.

Terry isn't the only Citibank depositor. There may be many other depositors who are anxious to sell Citibank deposits that day. If Jim is one of the only buyers, he may be able to convince Terry to accept 93 or 92 cents for each Citibank dollar.

So under inconvertibility, the price of Citibank deposits relative to Federal Reserve dollars depends on the short term demand for deposits and desire to settle debts to Citibank. If there is a large demand to settle debts on Wednesday, and few sellers of Citibank deposits, then the price can spike well above $1. But if everyone wants to sell on Thursday, and no debtors want to settle, it could collapse to well below $1.

The soft Citibank peg I'm describing is exactly how Dai functions. You can actually see below how relaxed Dai's peg is below. Sometimes Dai trades far below $1, sometimes it trades above:

Source: dai.stablecoin.science

This flexibility is not so much a bug, but a feature. It's the same sort of behaviour that Citibank's inconvertible deposits would exhibit.

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Returning to our Citibank analogy, there are limits to how far the price of Citibank deposits can stray from $1. When the price of Citibank deposits falls too low, say to 90 cents, then existing Citibank borrowers will smell a deal. They can buy cheap Citibank deposits, cancel their loans (and thus unencumbering their housing collateral), and then proceed to another bank (say Wells Fargo) in order to re-open the same loan (using the same collateral). The whole process of closing and re-opening the loan will result in a 10% profit. The pace of Citibank debt cancellation will increase as a result, thus shrinking the supply of Citibank deposits and bringing its price back up towards $1.

Conversely, when the price of Citibank deposits gets too high, say $1.10, then borrowers will be eager to mortgage their homes with Citibank (and not another bank). After all, they can mortgage a $1 million home with either Citibank or Wells Fargo and get $500,000 in deposits. But Citibank deposits are worth $1.10 which means that a Citibank borrower gets 10% more bang for buck. A splurge in new Citibank loans will increase the supply of Citibank deposits and drive the premium back down to $1.

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In addition to these automatic forces that push Citibank deposits towards $1, Citibank can use monetary policy, specifically interest rate changes, to keep the exchange rate between their dollars and Federal Reserve dollars close to $1. 

Say that there are is a glut of Citibank depositors who want to get rid of their deposits, and their desire to sell has temporarily pushed Citibank dollars down to 95 cents. By increasing the interest rate on existing loans, Citibank makes it more onerous for those who have Citibank debt to meet their interest payments. These borrowers will start to buy up Citibank deposits in order to cancel their burden. This wave of buying will counterbalance the glut of depositors who want to sell, pushing the price of Citibank dollars back up to $1.

Citibank can also set monetary policy using the rate it pays to depositors. Say that a horde of debtors have lined up to repurchase and cancel their debts to Citibank, pushing the price of Citibank deposits up to $1.05. By lowering the interest rate it pays depositors, Citibank reduces the incentive that people have to hold Citibank deposits. Depositors will flock to sell, thus pushing the purchasing power of Citibank deposits back down to $1.

MakerDAO manipulates a rate called the stability fee to a level that is consistent with $1 Dai. The stability fee is the rate that Dai borrowers must pay. MakerDAO is in the midst of implementing the Dai Savings Rate. This savings rate provides Dai holders with a reward, much like how Citibank depositors are paid interest.

Does Dai monetary policy work? The price of Dai recently fell to a large 3-4% discount to the dollar. In response, MakerDAO jacked up the stability fee. I documented what happened in this series of tweets:

Dai is still trading below $1.

But the stability fee increases do seem to be reducing the supply of Dai, which is down by almost 10 million since April 10: (https://t.co/k13yNtrENe). This should eventually nudge the price back up to $1. Milton Friedman's long & variable lags? pic.twitter.com/k3ycJPHa47

— JP Koning (@jp_koning) May 2, 2019

This effort seems to have successfully brought Dai back to $1.

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Under times of stress, how can these systems continue to ensure that the value of their deposits/tokens stays close to $1?

Each inconvertible Citibank deposit is twinned with a lender who will eventually have to repurchase it. Say that Jim and a few other debtors go bust and can no longer pay back their loan. Now there are a bunch of orphaned deposits. This spells disaster for the peg. There won't be enough debtors to repurchase Citibank deposits from Terry and the remaining depositors. And as a result, the price of Citibank deposits will slide far below $1.

But Citibank has a tool to prevent this. Remember that Jim provided collateral in order to get his loan. When Jim can no longer pay his loan, the bank can seize Jim's collateral--his house, inventory, boat, or whatnot--and sell it to repurchase Citibank deposits. All the orphaned deposits can be withdrawn, driving the exchange rate back up towards $1.    

The same goes for Dai. But rather than seizing debtor's houses, MakerDAO takes control of the cryptocurrency collateral that Dai debtors have provided.

Another feature that helps keep Citibank inconvertible deposits near par is the fact that Citibank can always wind down its operations and go out of business. If so, all debtors must settle their debts, which means buying up Citibank deposits and thus cancelling out what is due to Citibank depositors. Debtors who can't pay their dues will have their collateral seized and sold, the proceeds used to pay remaining depositors US$1 for each Citibank deposit.

As long as Citibank has properly appraised the value of the collateral that has been deposited with it, then it will be able to make everyone whole. The proximity of a wind-down, the mere chance that this event can always occur, should be enough to help push the price of Citibank deposits towards $1.

MakerDao also has an equivalent feature called global settlement. Global settlement occurs when the Dai system is shut down and all Dai holders are paid out an equivalent of US$1, with debtors to the system getting all that remains. The odds of global settlement being invoked should help keep the price of Dai close to $1.

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There is a lot of skepticism surrounding stablecoins. Folks like Preston Byrne, for instance, are convinced like stablecoins are Dai inherently doomed. And some of them have collapsed. (Just read my old post on the demise of Nubits.)

I'm more sanguine. As I've illustrated, Dai isn't that strange of a beast. Apart from the fact that it is inconvertible, a Dai token is very much like a Citibank deposit. Both Citibank and MakerDAO take unstable assets and turn them into stable-priced ones.

These sorts of water-into-wine institutions have been a regular feature of the financial landscape for centuries. Yes, banks have often failed. But they can also be incredibly durable. Here in Canada, the Bank of Montreal has been operating since 1819, some 200 years, without going under. And for those who attribute the Bank of Montreal's longevity to government sponsorship ad support--nope. Canada only got a central bank in 1935 and a deposit insurance scheme in the 1960s.

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Will the new digital upstarts like Dai be able to unseat the incumbents, as many of its fans believe?

Relative to convertible Citibank deposits, inconvertible Citibank deposits really aren't that great of a product. Thanks to Citibank's convertibility mechanism, regular Citibank deposits are fungible not only with Federal Reserve dollars but all other brands of bank deposits including Wells Fargo dollars, Bank of America dollars, JP Morgan Chase deposits, and more. To be fungible means to be perfectly interchangeable.

Harmonization, or interoperability, is pretty useful. People can walk into a store and purchase goods with whatever brand of dollar they want. Neither the buyer nor seller need think twice about which one is being used. But not so with inconvertible Citibank dollars or Dai. Lacking direct 1:1 convertibility into underlying Federal Reserve dollars, the price of these "soft-pegged" versions of the dollar will never be quite the same as other dollars. Any purchase that is made with these exotic dollars would be a bit like walking into a Taco Bell in New York with euro banknotes or Canadian dollars.

I mean, the purchase can still go forward, but there is an extra layer of awkwardness that must be endured. The exchange rate between inconvertible Citibank dollars and Federal Reserve dollars at that instant must be determined, conversion fees must be incurred, and foreign exchange risk absorbed. Likewise with a purchase made with Dai. Sure, Dai tokens are relatively stable. But they aren't fungible with the underlying instrument they are trying to represent--U.S. dollars--and that hobbles their payments functionality.

The same awkwardness occurs when taking out a loan in inconvertible Citibank dollars, say to invest in a business or renovate a house. Businesses and individuals earn income and salary in regular Federal Reserve dollars (and all the other dollars that are interoperable with Fed dollars), but if their loans and interest must be repaid in Citibank dollars, they effectively owe what is a foreign currency.

This undoes one of the most useful features of dollars or yen or pounds, which is that they can be used as general medium for short selling, or put differently, a standard for deferred payment. Standard of deferred payment is "that other function" of money, the one no one thinks about because it is overshadowed by the triumvirate of medium-of-exchange, unit-of-account, and store-of-value.

Briefly, since income is earned in local currency, and income is fairly predictable--especially salaries--a borrower (i.e. a short seller) has a pretty good idea ahead of time how much of their future budget they will be required to pay to cover the bank loan. But when the units borrowed are different from the units that make up most of one's income, all of that pleasurable certainty is lost.

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But what about decentralization? Doesn't this feature give Dai an advantage over other types of dollars?

Unlike inconvertible Citibank deposits, which are issued by a centralized financial institution, Dai tokens are decentralized. What does this mean? The organization that maintains the system--MakerDAO--doesn't exist in a fixed physical location. It resides on the Ethereum blockchain, which is maintained by a crowd of validators that is distributed all across the world. Whereas the authorities can easily exert pressure on Citibank--they know its address--MakerDAO's crowd of decentralized nodes cannot be so easily controlled.

Citibank relies on people in offices to do much of the work of running the bank. MakerDAO uses smart contracts: automated bits of code that cannot be tampered with. Governance of the system occurs over the internet, with MakerDAO shareholders voting on resolutions such as interest rate changes. MakerDAO shareholders needn't reveal their identities, which means the authorities can't exert pressure on them as easily they might on Citibank executives.

Decentralization allows for subversiveness. A regular bank is obligated to meet a long list of regulatory requirements including those on how much capital they must hold, customer identification practices, and more. But since the authorities can't easily get a bead on MakerDAO stakeholders in order to punish it for infractions, the Dai system may be able to avoid all sorts of costly regulations. And these cost savings means that Dai borrowers might be rewarded with lower interest rates than Citibank borrowers, and Dai stablecoin holders with higher interest rates than Citibank depositors.

There are a set of actors who are have been censored from the banking system. For instance, thanks to embargo threats emanating from the U.S. Treasury, Iran has been mostly cut off from accessing U.S. banks. American marijuana companies can't get bank accounts because banks consider them to be too risky to serve. MakerDAO is (in theory) much more resistant to censorship than Citibank. Dai tokens can filter into all sorts of unserved and risky markets because those who run the Dai system needn't worry about being punished by regulators.

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So there is certainly a natural clientele for decentralized dollars. But whether the benefits arising from decentralization--lack of regulation and censorship resistance--are enough to overcome the awkwardness of non-fungibility remains to be seen.

I also wonder how genuine the decentralization of MakerDAO is. I mean, say that Dai became popular for skirting Iranian sanctions. Wouldn't the U.S. Treasury have a number of levers it could pull in order to reverse this? Many of the MakerDAO developers are public figures, as are MakerDAO shareholders. If the U.S. threatened to arrest them for breaking sanctions rules, would they fall into line and write Iran out of the system? If so, Dai is about as subversive as PayPal or Citibank. A centralized and non-fungible stablecoin doesn't seem to offer many benefits.

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

Imaginary worlds with volatile money

On Twitter, Noah Smith asks:

@ClicheGuevara But why don't we use stock shares as our medium of exchange?

— Noah Smith (@Noahpinion) June 13, 2015

He answers his own question on his blog. I pretty much agree. It's interesting to imagine science fiction worlds where people do use volatile instruments like stock as their medium of exchange. Why would people in these worlds be willing to adopt volatile media while people in our world don't?

Liquidity, the world's best insurance policy against uncertainty

First, we need to understand why our world has a preference for stable media of exchange. As Noah points out, people don't know exactly when they are going to need to spend money, or how much. Any individual faces the dizzying fact that any of an infinite number of events could hit them at any point in time. People have many ways to cope with this chaos, one of which is to build up an inventory of assets that can be deployed to help deal with surprises as they occur. Liquid assets—those that can be sold quickly, at low cost, and spent along multiple pathways, will do a better job of this than illiquid assets—those that take time to sell, incur transaction fees, and lack multiple pathways.

A buffer stock of liquidity offers people the same set of services as actual insurance, say a policy issued by GEICO. A home insurance policy immunizes against a range of disasters that might befall someone's residence. So does liquidity, since it can rapidly purchase materials and labour. If home insurance is cheaper than holding an inventory of liquidity (the cost of which, as Noah says, is an inferior expected return), then people will skimp on liquidity. Unfortunately there are only a limited range of future disasters against which people can purchase insurance. Good luck getting GEICO to insure you against a zombie outbreak, for instance. If a zombie scenario is something that you put a non-zero probability on, then staying a little more liquid than you otherwise would may alleviate some of your concerns. Come outbreak, the ability to rapidly dispatch liquid assets in all directions will come in handy.

Back to the question of volatility. If people are trying to build a moat against uncertainty, what use would insurance be if it offered $20,000 in protection on Tuesday, $17,000 on Wednesday, and $23,000 on Thursday? For the same reason that people require a fixed amount of insurance rather than a floating amount when constructing their moats, they will want to invest in stable liquid assets rather than volatile liquid assets. You can't solve for uncertainty with more uncertainty.

Liquidity is a virtuous circle

Liquidity is a virtuous circle; as an asset gets more liquid it becomes more attractive as an insurance policy, which brings in more buyers, which makes it more liquid, which increases its value as insurance, and so on. Once everyone holds the most-liquid asset(s), they have joined what in essence is an economy-wide mutual insurance scheme. At this point it makes little sense for a merchant to accept less-widely held assets as payment. Not only will it be a nuisance to set up the infrastructure, but the merchant runs into the coincidence of wants problem. Because the merchant's employees are already paid in the most-liquid asset, should the merchant accept volatile assets as payment he/she will have to bear the cost of converting them back into the standard unit. To avoid these inconveniences, only widely-held assets will be accepted by the merchant. A payments standard has developed.

Merchants will also try to please customers by setting their sticker prices in terms of the liquid asset. This reduces the calculational burden imposed on customers. At this point the asset has become a unit-of-account, and a pricing standard has developed. Adoption as unit-of-account provides all sorts of extra benefits to owners of the standard unit. As a courtesy, grocers and other retailers will typically keep their prices fixed for a few days, or weeks, which means that anyone who owns the standard unit knows ahead of time approximately how much food they'll be able to purchase. The tendency for prices to be sticky in terms of the unit of account only increases the standard unit's usefulness as a universal insurance policy.

The fact that shares aren't the unit-of-account means that consumers who own them miss out on all the uncertainty-alleviating benefits of sticky retail prices. They have no clue what their purchasing power will be one minute hence, let alone the next day.

Worlds with volatile money

If we lived in a world where we didn't need liquidity to shelter us from uncertainty, then we might be more receptive to using volatile media of exchange.

For instance, I sometimes wonder if the demand for dollar-denominated liquidity is less in Canada than in the U.S. since we Canadians have universal health care. With the nagging concern of how to pay for potentially life saving medical services solved for, we can economize on inventories of stable liquidity and seek out higher returns. Americans, who don't have such a product, probably need to hold larger dollar-denominated hoards in order to alleviate their queasiness about how they'll have to deal with future bodily harm.

Taking this idea to its limits, if an insurer were to introduce an "everything" insurance product (yes, this is science fiction), and it was cheaper than holding the standard liquid unit, then people would no longer need to self-insure against uncertainty by depending on the standard unit, typically central bank money and its banking derivatives. Instead, everyone would migrate their savings over to more volatile instruments like stocks, ETFs, or bitcoin, enjoying what Noah refers to as higher drift, or long-term returns. As long as GEICO is providing a low-cost universal salve against uncertainty, than people will be willing to shoulder all the inconveniences of fluctuating purchasing power insofar as it offers them a bit more drift.

With ownership of low volatility units (dollars, yen, etc) far less ubiquitous than before, and volatile asset (stocks, ETFs, bonds, etc) ownership much more prevalent, it might now make sense for merchants to incur the set-up costs of receiving volatile assets in payment. Furthermore, the fact that their employees will accept these volatile assets as salary, thus solving the coincidence of wants problem, will only accelerate the willingness of merchants to install the requisite infrastructure. After all, merchants can now pay their employees with the same ETF units that they receive from their customer, thus saving both commission expenses and the cost of incurring the difference between the bid and ask price. [1]

Information as a moat against uncertainty

In addition to liquidity and insurance, people can build their moats by acquiring more information. This is something I learnt from David Laidler. (If you want to learn about money via a fascinating detour through the history of monetary thought, you can't go wrong with these three books.) Knowledge allows individuals to better anticipate the future and plan accordingly, thus reducing the need for either liquidity or insurance contracts as hedges. If some cheap technology were to emerge that offered an infinite amount of free information (i.e. the internet?), then maybe people would cease amassing stable liquidity altogether. In this world, people's preferred solution to uncertainty would be to costlessly inform themselves and hold high return/high drift assets like stocks rather than stay uninformed and hold inferior, low return liquid assets.

Of course, we could also argue the opposite; that the internet has solved for one set of risks only to bring in a new set (identity theft, viruses etc), thus perpetuating the necessity of owning both GEICO insurance and liquid assets.

In sum, because our world lacks both infinite information and universal "everything" insurance policies, stable liquidity remain one of the cheapest ways to inoculate against uncertainty. The widespread prevalence of this monetary insurance across all strata of society has encouraged the development of a payments and pricing standards based on these assets. These standards further militate against the emergence volatile assets like bitcoin and shares as widespread media of exchange.


[1] I added this paragraph on June 19.

Labour Shares™: Beating capital at its own game

We all carry a variety of media of exchange in our portfolios, some more liquid than others. Deposits are pretty high on the liquidity scale, stocks and bonds a little less so, and our household's furniture is even less movable. The most sizable medium of exchange in our portfolios also happens to be our least liquid one: labor. Our capacity to use our brains and bodies to work is the primary currency that each of us own, although it isn't a particularly mobile one. Might things be different? Could labor be converted into a more effective medium of exchange that is capable of competing with highly fluid financial assets for preferred liquidity status?

Much of our lives are spent trying to make marginal improvements to the liquidity of our labour. We may choose to learn more skills so that we can participate in multiple markets, the more markets being open to us on any given day the more saleable our labour. Alternatively we may choose to learn one thing very well. While this leaves us with only one market in which to sell our labor, the quality of our work should differentiate itself enough such that the liquidity we enjoy within that one market outweighs the liquidity we choose to forgo by not participating in other labour markets.

Even with these liquidity enhancing strategies, labor remains a relatively hard sell compared to other media of exchange. This is problematic. Insofar as liquid media are the best hedges against an uncertain future—they can be rapidly mobilized to help plug leaks and patch holes—this means that labour, our largest medium of exchange, does a pretty bad job of protecting us from unpredictable events. It takes too much time and effort to sell the damn stuff. Amongst media of exchange, labour is the slow moving Titanic.

Which is why we fashion contractual crutches to convert illiquid labour into a more vendible product. Rather than go out into the marketplace each morning to find a new person who'll buy our labour, we usually make long term deals with buyers that require them to repeatedly purchase our services over a period of time. Having secured a repeated buyer of our services, we've converted a bad hedge against uncertainty into a better one, at least as long as the contract is in effect.

But there are ways to make labor even more liquid. To do so, we need to overcome the physical characteristics of labour that prevent it from being as good of a medium of exchange as, say, gold. Gold is divisible, portable, uniform, and durable. An ounce can be divided into smaller bits without any loss of value, it can be used by successive individuals without depreciating in quality, and it passes easily across time and space. Labor, on the other hand, can't be bottled up and stored, nor can it be passed on from buyer to buyer. Once expended on some task, labour is dissipated and ceases to be a conveyable medium. Labour is like an ice cream cone, it doesn't last very long.

A time-honoured way to encourage the liquidity of something is to securitize it. Take an illiquid mortgage, combine it along with others into a pool and splice that pool up into easily tradeable mortgage-backed securities. Or convert a sole proprietorship into a corporation, create shares that represent ownership, and list those shares on a marketplace, thereby converting illiquid ownership into liquid ownership. Exporting these ideas to the labour front, if people are capable of toiling away for fifty years, then why not create a series of claims on that labour and allow those claims to be sold off? In this science fiction world, these claims might be called 'labour shares'. While physical labour itself cannot be resold, the non-physical representation of that labour—labor shares—can be passed around indefinitely along long monetary chains.

This solves the resaleability problem that has historically impeded the liquidity of labour. After an employer has bought some of our labour shares and put us to work, should they have no further need for us they can trade away our shares to another employer rather than just firing us. Middle men might buy our shares and sell them on to other middle men, with the odd speculator jumping into the fray when they think they can buy low sell high. Financial engineers might combine our shares together with those of other similar workers, creating large pools of labour that can be bought all in one fell swoop by large employers. Our labour, once the Titanic of exchange media, has become a nimble instrument.

In this science fiction world, labour "does" more for its purchaser than in times past. As before it provides anyone who has bought it with a real pecuniary return (a labour share can be converted into work), but now it also provides an extra non-pecuniary return. Specifically, labor shares act as a stock of liquid media of exchange on par with an inventory of cash. A buyer of our labour, say a firm, now finds itself owning a fairly decent uncertainty hedge—should it be blindsided by some unforeseen event, the firm's owners can rest well knowing that the firm's managers can sell off either its cash or its accumulated labour shares, or some combination of the two, in order to help acquire the resources necessary to resolve the crisis.

Since labour now provides potential owners with a greater range of services than before it will command a premium over its previous price, or a liquidity premium. Anyone who provides labour will receive that premium, thereby earning more than they did before.

There are some ugly aspects to this science fiction world. It is certainly dehumanizing, treating humans like any other vendible commodity or asset. A market for labour shares might breed a highly itinerant workforce the members of which, much like Federal Reserve notes, would be constantly recycled from one side of the globe to the other. It also raises moral questions of personal agency. If we no longer want to toil for the employer who owns our labour shares, must we repurchase those shares—and our freedom—back from them?

The positive aspect of a world with liquidity shares is that in rendering itself more liquid, labor earns a greater share of the pie. Why should capital, after all, be rewarded the entire range of liquidity premia that society has to offer? Over the last few decades, financial engineers have made houses, equities, bonds, and all sorts of other assets ever more liquid. As a result the prices of these assets have steadily appreciated, a higher price being the market's reward for any asset that throws off growing quantities of liquidity services. That's great for the 0.01% who's wealth is primarily comprised of these assets; they enjoy ever growing capital gains (see chart below) and a larger slice of society's wealth. However, the majority of the world whose wealth is largely comprised of relatively illiquid labour potential has been left eating dirt.

The wealthiest 0.01% of society now owns 11% of society's wealth, up from just 2% in the 1970s.
Saez and Zucman, March 2014. [pdf]

Speed up the exchangeability of labor, on the other hand, and the reverse happens—labour grabs a larger liquidity premium for itself, thus appreciating in price and henceforth earning a larger share of society's total wealth.

Another advantage to a labour share scheme is that workers reduce their exposure to the discomforts of uncertainty. A worker's labour, represented by the full lifetime stock of liquidity shares in their portfolio, is more marketable than before, which means that they can more easily sell their labour to deal with potential disasters. This renders the future a little less frightening, the reduced contingency planning this entails allowing workers more time to enjoy the present.

Alternatively, rather than speeding up the liquidity of labour, maybe we should be slowing down the liquidity of all other things. That way labour, in the name of keeping up with the Joneses, never has to go down the somewhat ghoulish path of ever-accelerating liquidity. Various policies including a Tobin tax, the slowing down of equity markets in order to weed out HFTs, Glass Steagall style banking restrictions, and trade protectionism are all ways to help clog up the liquidity passageways. Enact these policies and mobile assets like stock and bonds lose their liquidity premia. The 0.01% who previously benefited from capital gains on rising housing, stock, and bond prices now suffer capital losses, and the labouring 90% will enjoy relative wealth gains.

The problem with these policies is that in constricting liquidity, we'd end up losing a major bulwark against felt uncertainty. Fretting and brow furrowing would increase, our lives worse off than before. The retort here is that perhaps liquidity should never have become our most important uncertainty hedge. In times past, self sufficiency, communities, families, and tribes were the institutions that we relied on to cope with a cloudy future. What made one's labour a great hedge against uncertain events, say a flood, was not that it could be rapidly sold off, but rather that together with other members of the community, our toil, sweat, and tears could be mobilized to plug dikes or rebuild houses. Implement policies like a Tobin tax and we may move back towards this world.

That may be true, by we've gone so many centuries down the liquidity path that its probably too late to reverse course. Labour shares, or something like it, might not just be science fiction; they could be the next step in the great liquidity race, especially if labour wants a larger share of resources. Perhaps the best way to cope with the ugliness created by an institution like labour shares, still very much in the imaginative stages, would be to innovate more humane ways to securitize labour. No-trade clauses or limited-movement clauses, for instance, might allow individuals to have some say in determining the destination to which they are dispatched. Unions may have a role to play in designing standards for labour shares that ensure that we don't bargain too much of our humanity away.

There is probably some upper limit to how liquid you can make something. Until that plateau is reached, financial engineers will keep making capital more liquid, and owners of capital will continuously enjoy the resulting price gains. Unless labour decides to liquidate itself, it could be facing many years of deteriorating wealth relative to the top 0.01%.

The cost of manufacturing liquidity premia

I'm going to use a stock market analogy to work out the costs of manufacturing liquidity premia.

In addition to paying dividends and providing price appreciation, stocks provide an amenity flow in the form of expected exchangeability, or liquidity. Like any other consumption good & service, the provision of such an amenity requires an outlay by the supplier. In the same way that a widget producer won't sell widgets below marginal cost, the marginal seller of stock, the issuing firm, won't manufacture new liquidity if the cost of production exceeds the benefits.

Say that a firm can hire an entire investor relations department for next to no cost. The IR team, full of eager promoters, will double the price that the marginal investor is willing to pay for the liquidity services thrown off by the firm's stock. They go about improving the stock's liquidity services by evangelizing the firm's "story", thereby widening the base of investors who deal in the shares. They make it easier for investors to hop in and out of the market.

The firm can now issue new stock at a much higher price thanks to its swollen liquidity premium. It invests the proceeds of new issuance at the risk-free rate of return. The firm has succeeded in getting something for nothing—at no cost to itself it has increased earnings-per-share. By issuing more shares the firm can continue to earn these extra-normal returns, at least until new issuance has satiated investor demand for liquidity and driven the firm's liquidity premium back to its previous level, at which point the strategy will have exhausted itself. New stock issuance will no longer increase per-share earnings.

Of course, investor relations teams can't be hired for nothing. If firms could perpetually increase earnings per share by costlessly boosting their liquidity premium and issuing new shares, then everyone would be doing it. In general, the price of hiring an IR team should be set such that it just offsets the benefits of the increase in a firm's liquidity premium. If the cost is lower, then firms will all try to purchase IR services in order to enjoy extra-normal profits, driving IR costs higher until the window for extra-normal profits has been closed. If the cost is higher, then firms will fire their IR department, the benefits of the liquidity premium manufactured by the IR department not justifying the expense of paying their salaries. In this case, IR costs will retreat until firms once again see some advantage in trying to hire an IR department to generate liquidity premia.

In short, the price that investors pay to enjoy a liquidity premium will be competed down to the IR costs of producing that premium.

Incurring IR costs are not the only way to do encourage liquidity. Relationships with market makers, dealers, and investment banking research departments will also help boost liquidity premia. Illegal practices like wash-trading can do the trick too.

Keep in mind that there are also large network effects at play. Incumbent stocks that have enjoyed high liquidity premia for decades will remain locked into that position, even if the incumbent's CEO were to fire the entire IR department. Liquidity is sticky. It would take incredibly large marketing outlays for a small rookie stock to displace an incumbent like IBM from its superior liquidity position.

If you get the chance, try visiting ten or twenty websites of publicly-traded companies and note how fancy each IR section is. Some will have only bare-bones text (like Berkshire Hathaway), others will have incredibly fancy flash animation and gorgeous pictures (like any junior gold miner).

These websites will give you some sense for each firm's pool of potential projects and respective strategy. Firms with a plenty of high-yielding investment opportunities will see no benefit in allocating funds to boost their liquidity premium. These sorts of firms will generally have ugly IR sections. Firms with fancy IR websites, on the other hand, have presumably measured all potential investment opportunities and decided that the highest yielding one is to hire aggressive IR so as to boost their liquidity premium, subsequently floating new shares. Investors who value liquidity on the margin would do well to gravitate to firms that see value in manufacturing liquidity premia. If you want liquidity, then buy from the people who make the stuff. Those investors who prefer pecuniary returns rather than liquidity returns should always avoid firms with fancy IR pages. After all, why buy liquidity if you don't value it?

The boundary case of firms pursuing higher liquidity premia are penny stock promotes. These firms have no real underlying business. Their only purpose is to create a temporary liquidity premia, the insiders exiting before those premia collapse to zero.

The general principles behind the manufacturing of liquidity premia described above apply not just to stocks, but to bonds, bitcoin, gold, cars, land, banking deposits, and all sorts of other assets. As long as people face uncertainty, they will always want to own liquidity. Those skilled in the manufacturing of  this liquidity—marketers, salespeople, investor relations execs, promoters, bankers, and evangelizers—will always find their talents in high demand.

Beyond bond bubbles: Liquidity-adjusted bond valuation

Real t-bill and bond yields have been falling for decades and are incredibly low right now, even negative (see chart below). With an eye to historical real returns of 2%, folks like Martin Feldstein think that bonds are currently mis-priced and warn that a bond bubble is ready to burst.

Investors need to be careful about comparing real interest rates over different time periods. Today's bond is a sleek electronic entry that trades at lightning speed. Your grandfather's bond was a clunky piece of paper transferred by foot. It's very possible that a modern bond doesn't need to provide investors with the same 2% real coupon that it provided in times past because it provides a compensating return in the form of a higher liquidity yield.

[By now, faithful readers of this blog will know that I'm just repeating the same argument I made about equity yields.]

Here's a way to think about a bond's liquidity yield. Bonds are not merely impassive stores-of-value, they also yield a stream of useful services that investors can "consume" over time. In finance, these consumption streams are referred to as an asset's convenience yield. (HT Mike Sproul)

For instance, the convenience yield of a house is made up of the shelter that the house owner can expect to consume. A Porsche's convenience yield amounts to travel services. What about a bond's convenience yield? I'd argue that a large part of a bond's convenience yield is comprised of the liquidity services that investors can expect to consume over the life time of the bond. Let's call this a monetary convenience yield.

In an uncertain world, it pays to hold a portfolio of goods and financial assets that can be reliably mobilized come some unforeseen event. A fire alarm, a cache of canned beans, and a bible all come to mind. Liquid financial instruments, say cash or marketable bonds, are also useful since they can be sold off quickly in order to procure more appropriate items. This ability to easily liquidate bonds and cash is a meaure of their monetary convenience.

Even if the unforeseen event for which someone has stockpiled canned beans or bonds never materializes, their holder nevertheless will enjoy the convenience of knowing that in all scenarios they will be secure. The stream of uncertainty-shielding services provided by both a bond and a can of beans are "consumed" by their holder as they pass through time.

This monetary convenience yield is an important part of pricing bonds. Prior to purchasing a bond, investors will appraise not only the real return the bond provides (the nominal interest rate minus expected inflation) but will also tally up the stream of future consumption claims that they expect the bond to provide, discounting these claims into the present. The more liquid a bond, the greater the stream of consumption claims it will yield, and the higher its monetary convenience yield. The greater the stream of consumption claims, the smaller the real-return the bond need provide to tempt an investor into buying. (HT once again to Mike Sproul on consumption claims)

Which brings us back to the initial hypothesis. If the liquidity of government debt has increased since the early 1980s, then we need to consider the possibility that bonds are providing an ever larger proportion of their return in the form of a monetary convenience yield, or streams of future consumption claims. If so, the observed fall in real rates isn't a bond bubble. Rather, negative real rates on treasuries may reflect technological advances in market microstructure and improvements in bond market governance that together facilitate the increased moneyness of bonds. Put differently, investors aren't buying bonds at negative real interest rates because they're stupid. It's possible that investors are willing to accept negative real interest rates because they are being sufficiently compensated by improving monetary convenience yields on bonds.

I find this story interesting because we usually think that in the long term, real interest rates are determined primarily by nonmonetary factors, including the expected return to capital investments and the time preferences of consumers. The story here is a bit different. In the long term, real interest rates on bonds are determined (in part) by monetary forces. The higher a bond's monetary convenience yield, the lower its real interest rate. Oddly, bonds may be bought not by consumers who are willing to delay gratification, but by impatient consumers who want to immediately begin consuming a bond's convenience yield (ie. using up future consumption claims). The line between consumption and saving is blurred and fuzzy.

In my previous post on equities, I gave some numbers as evidence for the increased liquidity of stocks. Bonds aren't my shtick, so I won't try to prove my hypothesis. All I'll say is that the rise of repo markets would have contributed dramatically to bond market liquidity since repo increases the ability to use immobilized bonds as transactions media. Give Scott Skyrm a read, for instance.

There is a case of missing markets here. If we could properly prices a bond's monetary convenience yield, then we could get a better understanding of the various components driving bond market prices over time.

Imagine a market that allowed bond investors to auction off their bond's monetary convenience yield while keeping the real interest component. Thus a bond investor could buy a bond in the market, sell (or lease) the entire chain of consumption claims related to a bond's liquidity, invest the proceeds, and be left holding an illiquid bond whose sole function is to pay real interest. By stripping out and pricing whatever portion of a bond's value is related to its monetary nature, investors might now precisely appraise the real price of a bond relative to its real interest payments. Excessively high real prices relative to real interest would indicate overvaluation and a bubble, the opposite would indicate undervaluation and a buying opportunity.

But until we have these sorts of markets, we simply can't say if bond prices are in a bubble. Sure, real rates could be unjustly low because bonds prices have been irrationally bid up. But they could also be justly low if bonds are simply providing alternative returns in the form of monetary convenience. Without a moneyness market, or a convenience yield market, we simply lack the requisite information to be sure.

If your favorite holding period is forever...

[This is a continuation of my post on liquidity adjusted equity valuation.]

If your favorite holding period is forever, then today's stock markets just aren't meant for you.

As I pointed out in my previous post on stocks and liquidity, stocks can do more money-ish and cashlike things than in times past. For most people, the ability of stock (or any other good or asset) to be easily-exchanged is desirable since it ensures that come some unforeseen event, that stock can quickly be swapped for more suitable items. We can think of easily-exchangeable stock as insurance against uncertainty. Investors estimate the stream of 'expected comfort' or 'uncertainty alleviation' that a stock's degree of exchangeability will provide, discount these streams into the present, and arrive at some value for the liquidity return provided by a stock. The more moneylike or liquid a stock, the higher its liquidity return.

A stock's liquidity return makes up but one bit of a stock's total expected return. The other bit is the risk-adjusted real return, or the stream of dividends and price appreciation that a stock provides. When an investor buys a stock, they're getting a 2-in-1 deal. They're buying a real return and a liquidity return. The all-in price paid for a stock is a sum of the prices investors put on the value of these two different return streams.

It's for this reason that modern stocks are not an ideal investment for value investors, the species of investor whose favorite holding period is forever. While most people appreciate the 2-in-1 deal provided by equities, the ability to easily resell a stock is pretty much worthless to a value investor.  In order to enjoy a stock's real return stream (dividends plus price appreciation), a value investor must endure having that stock's liquidity return, which to them isn't worth a dime, forced down their throat.

Here's an analogy. Imagine that you're shopping around for a bare bones car. Unfortunately, the only models available have leather upholstery, oak trim, and a rear seat champagne cooler. Either you pay up for what you see as useless options or you walk away from the lot without a car. This is the same world that Warren Buffet type value investors face every day. Like it or not, they've got to buy stock with all the bells and whistles, even though they put zero value on these extras.

In the real world, a car dealer will let our car buyer strip out the oak trim, the champagne cooler, and the rest of the options they don't need until they arrive at a pared down car package that suits their needs and falls within their budget. Why not do the same in the stock market? Why not allow Buffet-style value investors to strip out the liquidity return of a stock so that they can own a pure real stream of returns?

The way to do this is to establish 'moneyness markets' for equities. In moneyness markets, the liquidity return of a stock is severed from the stock's real return and put up for auction. A value investor would be able to simultaneously buy a stock, sell off the stock's moneyness, or the right to enjoy that stock's liquidity, and be left holding a perpetually non-tradeable chunk of equity.

In doing so our investor has now effectively committed herself to an indefinite holding period. She will continue to earn dividends and enjoy price appreciation (or not), but she has limited her exits to either a cash takeover, the unwinding of the company, or a repurchase and cancellation of shares by company management. Gone is the traditional avenue for exit, the secondary markets.

In constricting her exits, our value investor is no worse off than before since her preferred holding time, moneyness market or not, was always forever. Indeed, moneyness markets have allowed her to improve her position. She has achieved the same final allocation that she would have without such markets, a perpetual long position in a stock, but she has succeeded in reducing the purchase price of her stock by auctioning off an option on which she placed no value whatsoever.

Let's say our value investor has a change of mind. Perhaps the circumstances surrounding a company in her portfolio have worsened and she no longer considers its shares worthy of an eternal holding period. Or maybe her personal situation is less stable and she wants to improve her ability to sell out should some unforeseen event occur. To return to a more liquid state our value investor would have to wade back into the moneyness market and repurchase the option to sell her stock. Put differently, she'd have to pay a fee to recapture her stock's old liquidity return.

How much would she pay to have these restrictions lifted? To restore her ability to freely trade in shares she'd have to pay others an amount sufficient to compensate them for being indefinitely deprived of that very same ability. This is the moneyness market.

This stock market story could be an allegory for all markets. Anyone with an indefinite holding period will usually overpay for things because most active markets are 2-in-1 markets. The asset being sold provides a real return and a liquidity return, whereas so-called "value" buyers typically only want the real return. Moneyness markets in everything would be a way to sell off the liquidity return so as to ensure people achieve the allocation they desire, at the right price.

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Over the next few weeks I hope to sketch out a few related posts dealing with the following rough ideas:

1. When a stock trades at a high multiple to earnings, is this because the stock has an excellent liquidity return or because it is genuinely overvalued relative to its earnings power? Without equity moneyness markets, it's difficult to be sure. With these markets, value investors would be provided with the full range of liquidity price information necessary to decompose real returns from liquidity returns. Liquidity-adjusted earnings metrics would lead to greater accuracy in the pricing of equities, and along with more accurate prices would come a greater degree of precision in capital allocation.

Because they like to buy when everyone is selling, value investors are some of the market's best natural stabilizers. Without moneyness markets, the ability of value investors to efficiently price assets is limited as as their wherewithal to participate. Introduce these markets and value investor's capacity to contribute to market stability expands.

2. While fundamental investors would be sellers of moneyness, I've been a bit circumspect who the buyers would be. Intertwined with this is the question of how to construct an equity moneyness market. Over-the- counter or a central clearing house? Would the terms of a moneyness contract be perpetual or would we see 1, 2, 5, 10, and 30 year moneyness contracts? How well would such a structure port over to housing, fixed income, commodity, and goods markets?

Liquidity premia in the detergent market

There is a recurring story in the media that 150oz Tide detergent bottles are being used as money by criminals. It's a fun story and I can't resist using it to illustrate the idea of liquidity premia.

Assume that two types of detergent bottles are held in individual's inventories. Say that they are entirely similar except one bottle is harder to sell than the other. If some unexpected event were to happen, the liquid (excuse the pun) bottle of detergent can be easily sold so as to mobilize resources to deal with the event. The illiquid one can't. This ability to serve as a superior hedge against the unexpected is a valuable service.

Even if the unexpected doesn't occur, anyone holding the liquid bottle will face less stress and unease over time knowing that they are positioned to deal with any eventuality. A forward-looking individual will anticipate this stream of uncertainty-shielding services provided by the more saleable bottle, discount these streams into the present, and arrive at a value for the bottle's liquidity. This represents a liquidity premium. The more saleable of the two bottles will have a higher liquidity premium than the less saleable one and, as a result, it will earn a higher price in the market.

The source of the difference between the two bottles' liquidities and premia could be due to marketing. Say that one detergent producer has a larger advertising budget than the other and has succeeded in broadening the clientele for its bottles. The difference could also be a result of tradition. The incumbent is well-entrenched whereas the challenger is a foreign product and comes off as a bit odd. Or maybe the CEO of one of the companies has bribed the government to only purchase its brand, thereby rigging the market to make one detergent bottle more liquid than the other.

The differential between each bottle's liquidity premium isn't fixed. Marketing budgets can shrink or expand. Government officials may cease taking bribes or they may accept larger ones from the other side. Traditions fade. Alternatively, the public's perceptions about the world could change. If people become more worried about the future, they'll put more value on the liquid bottle's ability to shield from uncertainty than before. Both its liquidity premium and its price in the market will rise relative to the less saleable bottle. If, on the other hand, people feel less uncertain about the future, the liquid bottle's premium will shrink since its hedging role is less valued.

Can we arbitrage this premium differential? Selling the liquid bottle short and buying an illiquid bottle is a bet that the differential between the two will shrink. But if in the interim people become more worried about the future, or if the more liquid product enjoys an ad budget boost, then the differential will grow and the long-short position will be a loser. There is no risk-free arbitrage between the liquid and illiquid bottles.

While the differential between detergent bottle liquidity premia cannot be arbitraged away, it can be slowly competed away by other detergent products. But it is by no means an inevitability that this will occur. Building up a liquidity network takes time and resources. All sorts of money must be thrown at wrestling away the loyalties and fixed behaviors of the transacting public. The physical infrastructure to underpin the network must also be sufficient to meet demands. If a new company comes out with a bottled detergent product, it doesn't matter how snappy its advertising campaigns is if there is no distribution system to move product from A to B. All of these large fixed costs help to keep existing liquidity premia in place.

Detergent bottle liquidity premia can disappear entirely. If it becomes illegal to pass on bottles, they would lose their liquidity and no longer earn a premium. Substitutes like shampoo bottles would be bought for their liquidity yield. More interestingly, say people become so sure about the future that inventories of potentially saleable goods no longer provide any useful services. With no uncertainty, liquidity is worthless and all liquidity premia fall to 0. Because we do face some level of uncertainty in the real world, we value liquidity and put a premium on more-liquid goods like Tide detergent bottles. Individual premia are probably constantly shifting, but the society-wide aggregate liquidity premium probably stays fairly constant.

Merry Cashmas

Christmas is upon us, and so is the seasonal spike in the demand for cash. This Christmas bump relates to the previous post on liquidity and uncertainty. Christmas isn't just about buying presents – it's also about traveling to distant places to meet up with family and friends. We realize that we can't anticipate all eventualities along the way. To insure ourselves against these uncertainties we carry a bigger wad of cash. This liquid wad provides a very real service by comforting us, even if we never end up having to use it.

It's illuminating to plot the Christmas spike in cash in order to compare it over decades. See below. The data I'm using is the weekly currency component of M1 from the Federal Reserve.

We can eyeball a few trends from the chart. First, we see a consistent seasonal spike in currency in circulation in December and climaxing around New Year's Day. Cash falls heavily in January as people and businesses redeposit it at the bank.

While the Christmas bump was very pronounced in the 1970s and 80s, it appears to have grown more muted over time. In recent Christmases, say 2011, it is difficult to pick out the spike at all, although if you look carefully you'll spot it. It's not just the Christmas bump that has declined, the general rate of increase in cash outstanding over each period has slowed. This is evident in the gradually flattening slope of each line. People don't need cash as much as they used to. Credit cards and direct payments provide good alternative forms of liquidity.

It's also interesting to see a monthly saw-toothed pattern in the data, particularly in the older periods. Around the middle of each month cash outstanding peaks, falling until the beginning of the next month. My guess is that this is some sort of paycheck effect. People deposit paychecks at the beginning of the month, then build up a buffer of cash to pay for that month's necessities and incidentals, this buffer steadily being drawn down over the latter half of the month. This saw-toothed pattern has all but disappeared in the data. Cash just isn't as important as it once was for payments.

It's worthwhile noting that come Christmas the Fed doesn't "blow" this cash out into the economy. Rather, people "suck" it out of the Fed. In anticipation of a spike in the demand for cash by consumers and businesses, private banks decide to hold more cash in their vaults. Banks build this buffer by converting reserves in their bank account held at the Fed into cash, with Brinks trucks moving this paper from Fed to bank. Before the credit crisis of 2008, a general withdrawal of cash would have required the banking system to rebuild their reserves in order to meet statutory minimum reserve requirements. The Fed would have offered to buy treasury bills from the banking system in order to provide those reserves. Nowadays banks hold so many excess reserves that if they convert some of these into cash, they don't need to buy more reserves in order to meet statutory requirements.

Uncertainty and the demand for liquidity

In between my more practical posts, once every week or so I'll do something on the idea of moneyness. Economists have known for a long time that the concepts of uncertainty and money are intimately intertwined. George Costanza knows this too. He holds a bunch of cash to deal with all eventualities... until his wallet blows up. I'll show how we can just as easily replace money with moneyness in this two-step with uncertainty.

Uncertainty is an uncomfortable feeling one endures when thinking about an unforeseeable future. One of the ways to shield oneself from uncertainty is to devote a certain portion of one's portfolio to "money" – dollar bills, bank deposits, and such. Because these money items are liquid, it will be relatively easy for their holder to offload them in the future should some unanticipated eventuality arise. Holding money therefore alleviates discomfort about the future. This is the same sort of service that a fire extinguisher provides. Though someone may never need their extinguisher, it comforts its owner by its mere presence. On the margin, individuals are always comparing the present value of the stream of "security and comfort" that money provides to the consumption goods or durable assets that money can buy.

The link between uncertainty and the demand for money has a long heritage. We can find this idea early on in the Marshallian tradition, for instance. In 1917 Arthur Pigou, a student of Marshall, wrote that any person would be anxious to hold money "to secure him against unexpected demands, due to a sudden need, or to a rise in the price of something that he cannot easily dispense with." On the margin, people could either hold money, spend it on consumption, or exchange it for a capital asset. "These three uses," wrote Pigou, "the production of convenience and security, the production of commodities, and direct consumption, are rival to one another." (The Value of Money, 1917)

In 1921, Fred Lavington explicitly described this very same link between uncertainty and money.

the stock of money held by a business man serves not only to effect his current payments but also as a first line of defence against the uncertain events of the future. (The English Capital Market, 1921)

More explicitly, said Lavington, money provides its owner with a

return of convenience and security. His stock [of money] yields him an income of convenience, for it reduces the cost and trouble of effecting his current payments ; and it yields him an income of security, for it reduces his risks of not being able readily to make payments arising from contingencies which he cannot fully foresee. The investment of resources in the form of a stock of money which facilitates the making of payments is then in no way peculiar; it corresponds to the investment by a merchant in the office furniture which facilitates the dispatch of business, to the investment of the farmer in agricultural implements which facilitate the cultivation of his land, and indeed to investment generally. 

Like Pigou, Lavington emphasized the marginal choice between holding money, spending it on consumption, and investing it.

Resources devoted to consumption supply an income of immediate satisfaction; those held as a stock of currency yield a return of convenience and security; those devoted to investment in the narrower sense of the term yield a return in the form of interest. In so far therefore as his judgment gives effect to his self-interest, the quantity of resources which he holds in the form of money will be such that the unit of resources which is just and only just worth while holding in this form yields him a return of convenience and security equal to the yield of satisfaction derived from the marginal unit spent on consumables, and equal also to the net rate of interest.

The most famous adopter of this idea was Keynes, a friend of Pigou's and, oddly enough, Lavington's teacher.

Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future... The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude. (The General Theory of Unemployment, 1937)

The link between uncertainty and money isn't confined to the Marshallian and Keynesian traditions. Erich Streisler (1973) quotes Carl Menger in Geld:

The amount of money which is used in actual payments constitutes only a part, and indeed a relatively small part, of the cash necessary to a people, and . . . another part is held (in order that the economy may function without friction) in the form of various reserves as a security against uncertain payments, which in many cases in fact are never realized.

William Hutt, an Austrian "fellow traveler", described the prospective yield from money in a 1952 paper called the Yield from Money Held. According to Hutt, the value of money assets was "affected by reason of their being demanded for their 'liquidity,' i.e. for the medium of exchange services that they can perform." These monetary services that money assets provide are prospective – even though money isn't being used, much like a fire engine when there were no fires, it isn't lying idle. "The essence of all these services is availability," wrote Hutt.

Modern Austrian Hans Herman Hoppe provides a very sharp linkage between uncertainty and money holdings.

the investment in money balances must be conceived of as an investment in certainty or an investment in the reduction of subjectively felt uneasiness about uncertainty. ('The Yield from Money Held' Reconsidered, 2009)

Nor is the Auburn side of the Austrian school the only to note linkage. Steve Horwitz, a free-banking Austrian, also gives expression to the link between money and uncertainty:

The connection between Hutt and Menger lies in recognizing that the availability services that money provides flow from it being the most saleable good. To be available to be exchanged for anything at any time requires that the good have the degree of saleability that Menger describes. The nature of Hutt's availability services is that they are a subjective return to holding an item that others also subjectively value a great deal, thus permitting the item to be easily exchangeable. When one chooses to hold wealth in the form of money, one is simply purchasing these availability services. (A Subjectvist Approach to the Demand for Money, 1990)

We also find the link between uncertainty and money among monetarists. In their 1971 paper The Uses of Money, Brunner and Meltzer noted that in a world of perfect certainty, information is available for free. This effectively eliminates the main reasons for the existence of money. However, by relaxing the assumption of certainty, “transactors possess very incomplete information about the location and identity of other transactors, about the quality of the goods offered or demanded, or about the range of prices at which exchanges can be made.” Rather, they must acquire information about these characteristics. Because knowledge acquisition takes time and energy, individuals may alternatively:

search for those sequences of transactions, called transaction chains, that minimize the cost of acquiring information and transacting. The use of assets with peculiar technical properties and low marginal cost of acquiring information reduces these costs. Money is such an asset.

David Laidler, also a monetarist, describes the money as a "buffer against costly consequences of market uncertainty and inflexibility".

If money holding is a cheap and reliable buffer, then agents will find that it pays to remain relatively uninformed about the processes affecting the variability of their net receipts, and will be relativley unwilling to undertake any costly measures that might render them either more predictable or controllable. If, on the other hand, money holding itself is a costly or unreliable source of insulation from such uncertainty, then the expenditure necessary to acquire and utilise extra information is more likely to be made. (Taking Money Seriously, 1990)

It's clear from this wide variety of quotes that many economists have considered money holdings to be uncertainty-alleviating. It's not a big step to replace the concept of "money" with "moneyness". The idea here is that by selling less-liquid items for more-liquid items, individuals can increase their protection from uncertainty. All assets can be ranked on a scale according to their liquidity/moneyness, and as a corollary, by their ability to "lull our disquietude".

On the margin, people are constantly comparing the package of services provided by each asset in an economy, where each package consists of the real services the asset provides, its pecuniary returns (interest, capital gains, or dividends), and finally the extent to which that asset's moneyness shields the holder from uncertainty. This means that in trying to defray their worries about a cloudy future, people seek out the quality of moneyness rather than a specific instrument called money. This quality, or property, is never fully concentrated in one hypothetical asset called "money" but can be found unevenly distributed over the economy's entire range of goods.

To get up to speed, here are two previous posts dealing with the idea of moneyness
1. Why moneyness?
2. What is a non-monetary economy?

How bitcoin illustrates the idea of a liquidity premium

On November 15 @ 5:37 PM, Wordpress.com tweeted that it would be accepting bitcoin as payment. Over the next twenty-four hours, the price of bitcoin steadily rose on Mt. Gox, the major bitcoin exchange. See chart below.

This is a great illustration of the idea of a liquidity premium.

All assets carry a liquidity premium. This premium will be smaller or larger depending on an asset's ability to be easily bought and sold, or its liquidity. The idea of liquidity is straight from Carl Menger, who figured things out back in 1872 (pdf). Keynes also knew this, read Chapter 17 of the General Theory. (This is one of those great examples of Austrians and Keynesians agreeing). Other words for liquidity include saleability and marketability. In short, the more marketable an asset, the larger its liquidity premium, which in turn means a higher price. Illiquid assets have small premiums and lower prices.

In announcing the acceptance of bitcoin, Wordpress has added yet another avenue for the use of bitcoin. And Wordpress is not just any old site. According to Alexa, Wordpress.com is the world's 22nd in terms of traffic. Bitcoin is now more liquid, and as a result, its liquidity premium has increased by about 75 cents.

Why is liquidity worth something? The future is uncertain. Knowing that an asset you own can be readily sold should the need arise provides you with a degree of comfort. Thus liquidity shields you from the displeasure of uncertainty, and since highly liquid assets do more shielding than illiquid ones, you'll have to pay a larger premium for that benefit.

  So with the Wordpress announcement, bitcoin has become a slightly better hedge against uncertainty.  What happens if other large venues start accepting bitcoin? Bitcoin up.