Is the strength of U.S. sanctions due to U.S. dollar hegemony?

I often hear the idea that the U.S. dollar is the means by which the U.S. implements sanctions. And since the U.S. dollar pervades all corners of the globe, the U.S. government's sanctions are uniquely powerful. For instance, Reuters reports that Russian resource giant Rosneft is shifting all its contracts over to euros in order to "shield its transactions from U.S. sanctions."

Another version of this idea was recently floated by David Marcus, the head of the Libra payments project:

"The future in five years, if we don’t have a good answer, is basically China re-wiring” a large part of the world “with a digital renminbi running on their controlled blockchain,” Marcus said. He warned about the prospect of “having a whole part of the world completely blocked from U.S. sanctions and protected from U.S. sanctions and having a new digital reserve currency” with no alternative."

The shared assumption of both the Rosneft and David Marcus quotes is that the U.S dollar is the primary pathway for projecting U.S. sanctions. By going out of their way to adopt a different currency, euros or renminbi, a nation or corporation can sidestep the sanctions threat.

But that's not quite right. Sure, the U.S. dollar is the world's reserve currency. However, the U.S.'s ability to apply strong and effective sanctions has very little to do with the U.S. dollar itself.

To see why, we need to visit how sanctions work. If the U.S. doesn't like a particular company, say Rosneft, and wants to cripple it, it starts with primary sanctions. The government tells U.S. companies to stop dealing with Rosneft on threat of fine.

But the real story begins with secondary sanctions. Here, the U.S. government tells Americans that on top of breaking ties with Rosneft, they must stop doing business with all other foreign entities (European, Canadian, Japanese, etc) that does business with Rosneft.

A foreign company now has a choice. If it is a European refiner, it will have to choose between continuing to buy crude oil from Rosneft or no longer accessing U.S. markets. This means being shut off from U.S. energy exports, doing without Texan oil & gas technology, forgoing U.S. repairs and refinery parts, being exempt from Silicon Valley tech expertise, being excluded from purchasing American assets, and having its existing U.S. subsidiaries threatened. There are also financial repercussions. It will lose access to New York's capital markets and the dollar payments system.

Given a choice between Rosneft or America, which will our refiner choose?

As I wrote a while back at Bullionstar, their are additional costs to being blacklisted by the U.S. government. Blacklisted executives would have to face the possibility of "no longer being able to send their kids to Ivy league schools, travel to Las Vegas for holiday, or seek medical care at Johns Hopkins or the Mayo Clinic." They wouldn't be able to visit the U.S. for business purposes, or explore U.S. job opportunities. I doubt that Russia has enough good job opportunities, universities, vacation spots, and high end hospitals to compensate.

This impressive list of penalties is why the U.S. government's secondary sanctions are so powerful. Almost every foreign company will prefer to give up Rosneft and keep doing business with America.

Now, Rosneft might nudge and wink at its European customers and say "hey, let's just deal in euros. That way we can get around the sanctions. We'll keep doing business together and you won't lose access to the U.S."

But using euros doesn't change the economic calculus facing our refiner. Even if it does business with Rosneft in euros rather than dollars, it is still doing business with Rosneft. And the moment that the U.S. justice department catches a whiff of this (say one of its bankers rats it out), the European company will be blacklisted. And that means losing the entire list of goodies that is associated with access to America. The risk is simply too high.

Fancy payment options like bitcoin or gold don't solve this either. Say that Total, a big European refiner, buys Rosneft oil with bitcoin. Total execs hopes that a bitcoin payment might prevent its bankers from tattling on it to U.S. authorities. But it's very difficult to camouflage the opposite side of that trade--massive movements of crude oil back to Europe. There are just too many bodies involved in that sort of operation. A large law-abiding organization like Total can't take the risk of being discovered. And so, bitcoin or not, it will disconnect Rosneft.

To summarize, what makes American secondary sanctions so effective isn't U.S. dollar hegemony. It is the impressive amount of technology, wealth, goods, services, and experience generated by American companies and individuals. When firms are threatened with losing access to this treasure trove, they will make whatever sacrifices are necessary to keep it.

As for Libra, in an effort to sell his new payments system to American regulators, David Marcus conjured up a world "completely blocked from U.S. sanctions" thanks to a new digital renminbi. But even if firms have the ability to make transactions in digital renminbi, this doesn't change the fact that America's home-grown economic bounty is massive, and foreigners value that bounty above any other, U.S. dollar or not. There are other reasons for regulators to welcome Libra. But bolstering U.S. sanctions isn't one of them.

A free market case for CBDC?

Central bank digital currency, or CBDC, is a form of highly-liquid digital debt that most governments have, till now, held back from issuing. But there is a growing push to change this. Free market economists are generally not big fans of CBDC. They see it as government encroachment on the banking sector.

In this post I'm going to push back on the free market consensus.

(This post was inspired after reading posts by Tyler Cowen and Scott Sumner).

Look, we're always going to have a government. Right? And that government is going to have to raise funds somehow in order to keep the lights on. The question is, how? Should it issue 30-day Treasury bills? Fifty-year bonds? Perpetual debt? Paper currency? Why not issue currency-ish debt instruments in digital form?

Let's start with a parable. Imagine a world in which the government has only ever issued 30-year bonds. But next month it wants to shift some of its borrowing from the 30-year bond range to the 10-year range. Government officials believe that this will reduce the government's interest costs and diversify government sources of funding.

Seems like a good idea, no?

But wait. The grocery industry has historically relied on funding itself with 10-year bonds. Till now, it hasn't had to compete with the government for the attention ten-year bond investors. Grocery store owners are furious over the impending decision. We could have difficulties funding ourselves! they fret. We might have to cut back on selling food!

Meanwhile, the restaurant industry in our imaginary world prefers to fund itself by issuing 30-year bonds. If the government raises more money in the 10-year end of the debt market and less in the 30-year end of the spectrum, restaurants will face less competition for investor attention. Go for it! say restaurant owners.

Which sector should the government choose to favor, grocery stores or restaurants? The choice seems entirely arbitrary. Government shouldn't be picking winners or losers, right? Civil servants should choose the most cost-effective form of financing.

The same argument goes for CBDC.

Bonds, bills, and CBDC are all just forms of transferable government debt.* But instead of having a fixed maturity like a bond, CBDC never matures. And whereas the interest rate on a bond is fixed and its price floats, the interest rate on CBDC is periodically adjusted while its price is fixed to $1. Either way, the government can use these instruments for funding projects and investments.

(For the rest of this post I'll use the terms CBDC and fixed-value floating-rate perpetual debt interchangeably.)

For whatever reason, modern governments choose not to fund themselves in the fixed-value floating-rate corner of the debt market.** No industry benefits more from this than banks. Individuals and businesses who want to buy fixed-value floating-rate perpetual debt have only one option available to them: bank-issued deposits. Regulations prevent all other industries from participating in this end of the debt market. So these non-banks have to turn to the 3-month to 30-year segment of the debt market where they must face the full brunt of government competition.

The presence of government competition means that non-banks' funding costs will be more onerous than otherwise. Conversely, banks' funding costs will be less onerous given a lack of government competition.

I don't see any compelling reason for why the government should avoid one end of the debt market and, in the process, favor the banking industry over other industries. I mean, if the government can cost-effectively issue CBDC in a way that reduces its overall interest obligations, then that's a win for taxpayers, no? It shouldn't go with an option that hurts taxpayers because it wants to help out a certain sector, should it?

The argument could be made that the banking industry is far more important than other industries because it does a lot of lending, and if lending slows then everyone loses. 

If the banking sector really deserves to be subsidized, why doesn't the government just pay the subsidy in a more transparent way, say by taking money directly from the pockets of individuals and non-banks and giving it to banks? 

Also, banks aren't the economy's only lenders. There are many non-bank lenders too. Sure, if a government were to issue CBDC, banks would now face more competition in the fixed-price floating-rate corner of the debt market, and perhaps would choose to lend less. But at the same time the government would be issuing less 30-year bonds, or 10-year bonds, or treasury bills. Non-bank lenders that issue debt in these ends of the debt market would face less competition than before, and might lend more.

In the end, it's a wash. One industry's loss is another's gain.

So let governments issue CBDC and compete for the attention of the fixed-price floating-rate investor, just like they already compete for the attention of the 30-year bond investor. This would remove an inefficient distortion, namely a subsidy to banks and a penalty on non-banks. This seems to be the free market position, no?

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*It could be argued that one type of debt is a currency, and can be transferred from you to me, while the other isn't. But I don't buy that. Both types of debt are liquid. They can be bought and sold on exchanges. Or they can be transferred bilaterally. With bonds, a bilateral transfer can be conducted by conveying an old style physical bearer bonds, or by transferring a bond to a recipient using Treasury Direct.

**The government does issue banknotes, which are sort of like perpetual floating-rate debt, where the decision has been made to keep the rate at 0%. And it does issue reserves to the banking sector. But the quantity of banknotes and reserves is quite small relative to overall government borrowing.

Getting up to monetary mischief

By Harcourt Romanticist [source]

This post is dedicated to the protesters in Hong Kong. I am awed at how courageous they have been in the face of continuing pressure from China's Communist party. The same regime is complicit in persecuting Uighur Muslims and imprisoning two Canadians, Michael Spavor and Michael Kovrig.

There are all sorts of creative forms of non-violent mischief that citizens can use to protest against oppressive governments. This post explores a sub-category of non-violent mischief: monetary mischief.

Money stamping

One of the most popular forms of monetary protest is to overstamp currency. This involves stamping banknotes or countermarking coins. Coins and banknotes are vital to trade and circulate widely. Which makes them a great way to advertise a cause or complaint. The message automatically propagates itself via hand-to-hand commerce.

The monetary authorities will react to the threat by hastily withdrawing marked notes and coins from circulation. When bills or coins enter the wholesale cash system—i.e. when they are collected by banks, cash-in-transit firms, or ATM companies—they are typically sorted by machines (or hand) for fitness. Defaced currency will get filtered out and returned to the central bank (or mint) to be destroyed and replaced.

This form of protest goes far back in history. For instance, below is a photo of a 1903 penny that has been defaced with a suffragette rallying cry:

"It was said at the time, that the suffragettes had copied the practice from anarchists, who were defacing similar coins with the phrase ‘Vive l’Anarchie’." Source: British Museum

Wayne Homren, editor of E-Sylum, has recently explored some modern U.S. examples of money stamping as protest:

Source: E-Sylum

Source: E-Sylum

Here are a few examples from Ireland during the Troubles:

© Fitzwilliam Museum. "The one illustrated in Figure 6 is a 1971 UK two-pence which has been stamped with ‘SMASH H BLOCK 8' on the obverse bust. The H-blocks at the Maze/Long Kesh prison housed prisoners convicted of scheduled offences after 1 March 1976, with H-block 8 reserved for IRA prisoners. The hunger strikes of 1981 came in protest at the removal of Special Category Status from prisoners and led to the deaths of ten IRA hunger strikers." Source: Richard Kelleher, Money and Medals Newsletter 77

Hong Kongers still use plenty of cash. Which would seem to make Hong Kong ideal for money stamping. However, I haven't seen many examples of this form of mischief being used by Hong Kong protestors. About the only evidence I've located is provided below. It is a warning from a Thai money changer that it will not accept Hong Kong notes that have been stamped with political messages:

Source: Facebook

Which leads directly into my next point. For every form of monetary mischief, the authorities have a defence. The simplest line of defence against overstamping is to declare the practice illegal. Luckily for protestors, it is almost impossible to enforce this law. Money stamping can be safely performed behind closed doors. If a money stamper is caught passing along a note or coin, they can just say they accidentally received it as change or from an ATM.

A more effective line of defence is to declare that any stamped banknote is henceforth no longer money. This is basically a form of demonetization, a very focused one. To initiate this defence, the central bank refuses to accept any note or coin that has been altered. Good bills can continue to circulate. If the central bank refuses to accept marked bills, then wholesalers like banks (and forex dealers like the Thai one above) will likewise refuse, and so retailers won't accept it. And so angry members of the public who have stamped their notes with protest messages will find that their cash has become unspendable.

To avoid being left out of pocket, protesters will avoid stamping their currency in the first place. Which is why this line of defence is fairly effective.

Small, not large denominations

Protestors have a good counter to the threat of demonetization. They can focus on stamping large amounts of small denominations, not small amounts of large denominations. In Canada and U.S., the relevant small denominations are $1 coins/bills, $2s, and $5s. In Hong Kong's case, the relevant small denominations would be the HK$10 and HK$20 notes, which are equal to around US$1.20 and US$2.40 respectively. 

There are two reasons for focusing on small notes. First, it is far safer for a student protestor to overstamp a few HK$10 notes. If the notes are to becomes unspendable thanks to a demonetization, the protestor may have to do without a meal at McDonald's. But if a protestor stamps a few HK$1000 (US$126) bills and they subsequently becomes worthless, that will be far more damaging to their finances.

The second reason for focusing on small denomination notes is that their supply is much less flexible than larger denominations. Think about it for a moment. For each $500 that a central bank printing press produces, it takes fifty times the effort to create an equivalent amount of $10s. Which means that it will be harder for the central bank to replace a large amount of defaced $10s than to replace an equivalent value of defaced $500s.

This difference in replacement rates is important. When notes that have been stamped with political slogans are declared void by the monetary authorities, the supply of banknotes will be reduced. A shortage has been created. The central bank can quickly remedy a shortage of large denominations like HK$500s. But fixing a shortage of HK$10s will take more time. The monetary authorities are left with a choice. They can either allow the shortage of small denomination notes to continue, or they can bring it to an end by re-allowing defaced notes to circulate.

Either way, the government ends up looking bad. Shortages of change are extremely inconvenient to businesses. Those in charge will be derided as incompetent. But allowing small denomination defaced notes to return to circulation will allow the protesters to continue advertising their cause.

Cashing out of bank accounts

A second form of monetary protest is mass cash-outs of bank accounts. In 2010 Eric Cantona, a former French footballer, started to champion this form of mischief. I'm pretty sure he wasn't the first to come up with the idea. (Anyone else have prior examples?). Anyways, here he is:

"We don't pick up weapons to kill people to start the revolution. The revolution is really easy to do these days. What's the system? The system is built on the power of the banks. So it must be destroyed through the banks.

"This means that the three million people with their placards on the streets, they go to the bank and they withdraw their money and the banks collapse. Three million, 10 million people, and the banks collapse and there is no real threat. A real revolution."

"We must go to the bank. In this case there would be a real revolution. It's not complicated; instead of going on the streets and driving kilometres by car you simply go to the bank in your country and withdraw your money, and if there are a lot of people withdrawing their money the system collapses. No weapons, no blood, or anything like that."

Last January French protestors, the gilets jaunes, gave it a try.

How effective are mass cash withdrawals?

Banks rely on multiple sources of funding, one of which is its base of retail depositors. They also tap investors (who buy their bonds and shares) as well as depositors from the government and corporate sectors. If a portion of their retail depositors close their accounts, this will probably hurt the banks. But given the diverse nature of bank funding, I think Cantona overplays his hand when describes it as a "really easy revolution."

Banks also have access to the most powerful lender of all, the central bank. If protestors do succeed in pressuring certain banks with a cash-out campaign, the central bank will step in and support the targeted bank by lending it funds. Since the bank is being pressured for political reasons, and not because it is fundamentally unsound, the central bank will be quite liberal in support. Ultimately, central bank support should staunch the run.

Like the gilets jaunes in France, protestors in Hong Kong have launched their own cash-out campaign—with a twist. Hong Kong pegs its currency to the U.S. dollar. Not only are protestors cashing out of their bank accounts. They are also converting their Hong Kong funds into U.S. dollars in the hope of pressuring the peg.

Someone please tell my friend Kyle Bass that on LIHKG, HK protestors have started their USD Challenge, in which they are getting cash out of their accts and converting to USD cash. This is going to break the HK banking system and the HKD peg for sure!!!! pic.twitter.com/ix6ANmyzQT

— LFC (@goldencaskcap) August 15, 2019

I combed through Hong Kong Monetary Authority statistics to see if the cash-out campaign is having any effect. Banks and other financial institutions will typically keep a small amount of banknotes and cash in their vaults to satisfy customer redemption requests. Below I chart out the evolution of the cash held by Hong Kong banks by year.

Hong Kong banks always keep some cash in reserve to prepare for customer cash-outs.

They usually only store small amounts in August (~HK$20 billion). Check out the large out-of-season jump in cash holdings this summer (to HK$31 billion) as banks prepare for redemption requests. pic.twitter.com/Rzqo9kmcFr

— John Paul Koning (@jp_koning) October 13, 2019

You can see that Hong Kong banks have currently stocked up on over HK$30 billion in currency, far more than the typical HK$20 billion they tend to hold in August. This amount exceeds the Christmas spike, when the public typically withdraws the largest amounts of cash for purposes of gifts and travel. (Apparently the early 2018 jump may have been related to the installation of facial recognition hardware on neighboring Macau's ATMs).

It's hard to say why cash inventories have spiked. It could be related to banks being worried about protestor-led cash withdrawals. Or alternatively, they may fear that even non-protestors may start to ask for cash-outs, albeit for economic reasons, not political ones.

As I said earlier, I think that cash-out campaigns probably won't have a big effect. Banks have very strong lines of defence. As for attacking the Hong Kong dollar peg, that's quite ambitious. In theory, it would work. But every depositor in Hong Kong would have to participate.

Again, focus on small denominations

If I was to start a monetary protest here in Canada that involved cash withdrawals, I'd set my ambitions lower. The way to make any cash-out campaign more effective is to focus on withdrawing small denomination notes. Go into the bank and ask to withdraw $1/$2 coins and $5 notes. (In Hong Kong, HK$10s and HK$20s instead of HK$500s). Or withdraw large denomination notes from ATMs and then go to stores and ask them to break them for you. If the store won't break them, than buy a $1 chocolate bar with a $20 and hoard the change.

Earlier, I mentioned that the supply of small denomination notes is not as elastic as the supply of large ones. By way of illustration, I've provided a screenshot of Hong Kong's cash supply:

Source: Hong Kong Monetary Authority annual report [link]

Like most countries, Hong Kong has far more small denomination notes and coins in circulation than large ones. As the chart on the right shows, the HK$10 and HK$20 constitute 11.6% and 35.7% of all bills in circulation. But the total value of these small denomination notes tends to be quite small, as the left chart illustrates. They comprise just 0.6% and 3.5% of total banknote value. You can see the same distribution in Canada, too. The value of $100 bills dwarfs the $5 bill, but we've got about the same amount outstanding.

So there are a boatload of small denomination banknotes in circulation that are responsible for bearing a large load of the nation's transactional work. But the combined value of these work-horse notes is quite low.

This set of features makes small denomination currency an easy target for a would-be monetary protestor. A motivated group of Canadians could conceivably hoover up a large share the small denomination note and coin supply, thus creating a shortage of change. If enough people participate, the Bank of Canada's printing press would not be able to keep up. This would impede the ability of the Canadian payments system to facilitate transactions.

Most people have forgotten what small change shortages look like. But anyone who has read a bit of monetary history will know that many of the large monetary disturbances in the last five or six centuries leading up to 1800 were coin shortages. They were a nuisance.

In this post I've explored two types of non-violent monetary mischief that protestors have turned to in the past. I'm sure there are more. For instance, I haven't mentioned any digital types of mischief. In the comments below, feel free to provide some examples. As for the Hong Kongers who my be reading this, I wish you the best. Hang in there.

A fifty-year history of Facebook's Libra

Last week, we finally got some information about what Libra's currency basket would look like.

A Libra currency basket will reportedly include...
-no Chinese yuan
-50% dollar
-18% euro
-14% yen
-11% pound
-7% Singapore dollarhttps://t.co/YNbRY9Q02x

Libra could have automated the decision by adopting an established unit of account, say the IMF's SDR...

— John Paul Koning (@jp_koning) September 20, 2019

If you haven't heard, Libra is a proposed global blockchain-based payments network. It is being spearheaded by Facebook along with a coalition of other companies including Uber, MasterCard, PayPal, and Visa.

The hook is that rather than going the conventional route and expressing monetary values using existing units-of-account like the dollar, yen, pound, or euro, the Libra network will rely on its own bespoke Libra unit-of-account as its "base language." Libra originally revealed in its whitepaper that the Libra unit would be defined as a basket, or cocktail, of other currencies. Now we know what that mix will likely look like.

Interestingly, the Libra isn't the world's first private unit-of-account. Back in the 1960s and 1970s, several financial institutions came up with their own bespoke units. I learnt about this strange and fascinating episode courtesy of a very readable paper by two economists, Joseph Aschheim and Y.S. Park.

Libra isn't the world's first private currency basket. This paper https://t.co/hfTtHsofgC discusses four earlier attempts...
-Eurco (1973) Rothschild & Sons
-B-Unit ('74) Barclays
-Arcru ('74) Hambros Bank
-International Financial Unit ('75) Credit Lyonnais
Good luck, Libra! pic.twitter.com/di01mzqbab

— John Paul Koning (@jp_koning) September 23, 2019

As I gathered from the paper, the first private artificial currency unit was Luxembourg-based Kredietbank's European Accounting Unit (EUA). Originally devised in 1961 as 0.88867 grams of fine gold, the EUA was soon used to denominate a bond issue by SACOR, a Portuguese oil company. Over the next two decades, Aschheim & Park claim that around sixty or so bond issues would rely on Kredietbank's EUA as their accounting unit.

Between 1968 and 1971, the U.S. Treasury ceased to redeem dollars with gold. When the Smithsonian Agreement—a band-aid attempt to re-cement all currencies to the U.S. dollar—collapsed in 1973, the post WWII system of fixed currencies came to its final end. To help people cope with the sudden babble of floating currencies, several new private units-of-account joined Kreietbank's EUA.

N.M. Rothschild & Sons kicked things off in 1973 with its European Composite Unit, or Eurco. The Eurco was made up of nine currencies issued by members of the European Community, including Deutsche marks, French francs, and Danish kronor. According to Aschheim & Park, Rothshild developed the Eurco "to elicit investors' confidence" in long-term bonds, but as of 1976 only three bond issues had been denominated in Eurcos.

In 1974 Hambros Bank introduced the Arab Currency-Related Unit, or Arcru. The Arcru was comprised of twelve Arab currencies and designed to appeal to Arab investors flush with oil profits. The next year Credit Lyonnais created a bouquet of the ten currencies, both European and non-European, and dubbed it the International Financial Unit, or IFU. This was a far more broad-based unit than the Arcru or Eurco, the relative weights of the IFU's component currencies being based on each country's share of international trade.

Barclays Bank also got into the game in 1974 with the Barclays Unit, or the B-Unit. The B-Unit was made up of five currencies: the U.S. dollar, the British pound, the German mark, the French franc, and the Swiss franc. Aschheim & Park note that whereas the Arcru, IFU, and Eurco were primarily intended for denominating bonds, the B-Unit was designed to be used for making international payments.

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Which makes the B-Unit a direct predecessor of the Libra unit.

Look around you today, however, and not one of these private units-of-account listed below exists. Anyone want to pay me in B-Units? I didn't think so. I think this says something quite fundamental about the market's demand for artificial currency units. Businesses and consumers don't really like to use them.

Table from Aschheim & Park

If private artificial currency units have been failures, what about government-provided ones?

Take the International Monetary Fund's Special Drawing Right (SDR) basket, which has been in existence since 1970, almost fifty years. If there was a demand to make international payments using public artificial units of account, surely commercial banks would eventually have met that demand by implementing SDR-denominated payments systems. Indeed, Aschheim & Park speculate on the possibility in their 1976 paper. It's worth reading this section in full:

"International banks may soon be willing to accept deposits denominated in SDRs because a potential demand for SDR funds already exists, as manifested by recent SDR bond issues by the Swiss Aluminum Company, the Swedish Investment Bank, and Electricite de France. The process, indeed, is already under way. In July 1975 the Bank Keyser Ullmann in Geneva (a subsidiary of Keyser Ullmann of London) announced that it would henceforth accept demand and time deposits denominated in SDRs. These SDR deposits are to be convertible at any time into any currency at the SDR exchange rate applicable on that day. Similarly, in August 1975 the Chase Manhattan Bank in New York instituted a range of banking facilities in SDRs, including loans, deposits, and futures trading. As this process spreads and as more international transactions are denominated in SDRs, banks may begin to allow direct transfers between SDR accounts, internally and then between banks. In consequence, the SDR may be transformed from mere numeraire (international quasi-money) into an outright means of payment (full-fledged international money)."

Again, look around you today. How many banks let you open an SDR-denominated bank account and make SDR payments? None that I'm aware of. Maybe the IMF's SDR was never well designed, or maybe Barclays was too small to drive B-Unit adoption. Or more likely SDRs, B-Units, and the other artificial currency units mentioned in Aschheim & Parks paper are all monetary dead-ends. In pursuing the same path, Libra could be making a big mistake.

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What is it about artificial currency baskets that makes them non-starters? My first post about Libra delved into this question. Let me repeat my argument below to spare you the effort of clicking through.

In an alternative reality, let's imagine that Facebook only allows users to join and converse on its platform after having learnt Facebook's artificial language, Facebookish. English, French, Chinese, and all other languages are banned.

In this alternate reality, all Facebook users understand each other because each one is fluent in Facebookish. Comprehension is a great thing. But hardly any of us would be on Facebook to begin with. Who wants to go through the effort of learning a new language? Not me.

In the real world, Facebook has long since decided against the Facebookish approach. Instead, it supports a multitude of local languages—Arabic, Chinese, English, Hindi, and more. Sure, the drawback is that we can't always understand what other Facebook users are saying. But at least users don't have to go through the hurdle of learning new grammar and syntax. And Facebook has thrived as a result of this simple and obvious design choice.

The adoption of a Libra unit of account is the monetary equivalent of forcing users to learn Facebookish. Sure, at least with Libras we'll all be using the same currency units. But this ignores the costs we'd all have to incur as we learn a new monetary patois. From a very young age we all figure out how to "speak money". We speak in our local unit-of-account. As a Canadian, the Canadian dollar has always been the means by which I describe prices to people around me, and remember values, and engage in cost-benefit calculations. Facebook wants to force us all to learn a new monetary language, a Libra-based one. But in doing so it's setting a huge hurdle to adoption.

So I'll just repeat. No matter how skillfully it goes about designing Facebookish (or Libras), artificial languages and artificial units are dead-ends. They're utopian, and definitely not user-friendly. (Ok, I may have described it all better in my original post, so just head on over.)

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That being said, over the last few months I've been slowly warming up to Libra. Out of the millions of crypto projects that have come out over the last decade, it comes close to the Fedcoin vision I originally outlined on my blog back in 2014, and twice now for R3.

To begin with, a Libra token would be stable (unlike bitcoin) thanks to credible and strong issuers. Since it would be decentralized, the network would be resilient. And since a Libra is a token, and not an account, it should be relatively open for everyone to use. At the same time, David Marcus, the architect behind Libra, is making the right noises about financial privacy. (Whether his intentions are genuine or not, it's tough to say.)

From the Libra whitepaper

I think (and I could be wrong here) that there is a growing desire on the part of consumers for more financial privacy. Unfortunately, governments hew to a post-9/11 mindset that regards privacy as a pervasive threat. Facebook may be one of the only organizations with the financial heft to articulate consumers' desires for more privacy in a way that regulators can't ignore.

Having Facebook as financial privacy advocate is a fragile win, no? It would be too bad if Libra (and whatever level of financial privacy it promises to bring to mainstream consumers) never attains widespread usage because of a basic design flaw, one that obligates us all to adopt the monetary-equivalent of Facebookish

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If not an artificial currency basket, what should Facebook do? I think that most consumers who engage in cross-border transactions want to keep swimming in their domestic currencies up until the last minute. Only at the 'buy now' or 'send now' moment—i.e. when a purchase it to be consummated or funds transferred to a friend—do we want to leave the bubble of our home currency. Pre-accumulating some strange alien token, whether those be SDRs, B-Units, or Libra, just isn't on the table.

If it wants to stay customer friendly, Libra needs to design its network to allow for the flow of tokens denominated in state currencies (U.S. dollars, Chinese yuan, British pounds, Indonesian rupee). And then it needs to design a cheap, transparent, and easy way for these tokens to move from person to person. This is what PayPal does. It's also worked for Transferwise. Visa and MasterCard too. None  of these platforms have created their own curious units, PayPalios or TransferWise-units or Visa-oos. They've allowed customers to remain safely ensconced in their domestic currency bubbles until the final 'send now' moment.

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Putting aside my criticisms of Libra's decision to use an artificial currency unit, what do I think about its choice of basket?

I am left wondering what sort of process David Marcus and the folks at Facebook have used to generate the basket components. Potential Libra users will want to know ahead of time how they can expect a basket's components to be updated as time passes. After all, if their wealth is to be held on the platform, customers will wonder what is to prevent a sudden rewriting of the basket in a way that favors the network at their expense?

One important rule that everyone will want to know is what economic thresholds are being used to filter out or include various currencies. For instance, if the Korean won starts to become a popular international currency, at what point will Libra decide to include it in the basket? If so, would it boot out another currency to make way for the won, or keep it?

The current Libra components are definitely odd, and give no indication of what process the architects are using to populate the Libra basket. For instance, I'm not aware of any selection process or rule that would lead to the Singaporean dollar comprising 7% of what is supposed to be a "global currency." Don't get me wrong. I like Singapore. It punches above its weight. But Singapore doesn't account for 7% of world trade, or 7% of the world's population, or 7% of global anything.

Or why does the euro account for just 18% of the Libra basket while the U.S. makes up a mammoth-sized 50%? The European Union has twice the population of the U.S. and accounts for a far larger share of exports. And where is the Chinese yuan? Exiled for political reasons?

One wonders if the euro's small share has to do with the effect that Europe's negative interest rates might have on network profits. For each Libra it has issued, the consortium will have to keep a Libra's worth of assets in reserve. Far larger profits can be earned it it reduces the euro portion of the basket and increases the U.S. dollar portion. After all, that would mean more exposure to high-yielding U.S. dollar assets and less to negative-yielding European ones. But that's a terribly ad hoc way to construct a currency basket.

My last thought is this. If Libra has its heart set on choosing an artificial currency unit as the basis for its global currency, it should have probably just go with the IMF's SDR basket rather than brewing its own strange currency concoction.

The IMF's SDR basket (source)

Consider how exchange-traded funds which track an index outsource all of the decisions about index methodology and components to third-parties like Standard & Poors, MSCI, and FTSE. This makes the exchange-traded fund more credible. Using SDRs would pre-commit Libra to avoiding conflicts of interest and thorny politics, the IMF becoming the theater for determining the basket. One could find worse third-parties than the IMF.

The life and death of an internet monetary meme

Over the last few years I've increasingly crossed paths with the following claim on the internet: "The average life expectancy for a fiat currency is 27 years." Is this claim true? What definitions are being used? I mean, are we talking about inconvertible paper money here, or currency that was convertible into gold, too?

I finally got curious enough that I decided to chase down the source of this meme. After all, without knowing what data it is based on, it's hard to evaluate the claim's truthfulness. Below I give a description of my trek through internet history.

The average-life-of-fiat meme has become particularly popular among cryptocurrency types. For instance, here is Jimmy Song, a popular bitcoin educator/developer, confidently invoking the slogan back in 2017:

"When a society lacks prudence, what happens is that the society collapses or goes into chaos. It’s not a coincidence that the average lifespan of a fiat currency is only 27 years."

A long list of cryptocurrency luminaries have dutifully mentioned the meme including Dan Held (2018), Taylor Pearson (2019), Barry Silbert (2019), Tuur Demeester (2015), Francis Pouliot (2018), and Adam Back (2019). Grayscale Investments, a firm that provides cryptocurrency-based investment products, even includes it in their marketing material:

Hey @GrayscaleInvest. You say on your website that fiat currencies have "an average life expectancy of just 27 years." Do you have the data to back up your claim? https://t.co/sscStL8efj @barrysilbert pic.twitter.com/bIj7D3ZWaS

— John Paul Koning (@jp_koning) September 17, 2019

As is often the case these days, crypto bugs have cribbed their ideas from their older cousins, the gold bugs. Nathan Lewis, author of Gold: The Once and Future Money, mentioned the idea in written testimony to Congress in 2012. Ralph Benko, a gold standard advocate, invoked the meme in a 2011 article. And Max Keiser, a long-time gold bug turned cryptocurrency advocate, began mentioning it as early as 2013. Where did Keiser, Benko, and Lewis get the meme from?

One of the meme's earliest and most cited appearances comes from Washington's Blog, a platform for a group of anonymous financial writers. We know little about this group except for the fact that George, "website owner and lead writer – is a busy professional, a former adjunct professor, an American and a family man." 

In August 2011, Washington's Blog published an article with the brutally long title The Average Life Expectancy of a Fiat Currency is 27 Years... Every 30 to 40 Years the Reigning Monetary System Fails And Has To Be Retooled. The author failed to explain how the 27 years claim was derived. Instead, he/she relied on another article by a writer named Chris Mack for backup. In a disclaimer the author noted that "I don't know Chris Mack," and thus couldn't vouch for the figures. "However," he/she went on to say, "the general concept is correct."

That's an odd way to do analysis, no? I've got this number for you, 27. I don't know how the number was generated, or who came up with it. But it's good enough. So go ahead and use it.

After a bit of hunting, I found Chris Mack's article here (the link at Washington's blog is dead). It is dated January 2011, pushing back the meme's genesis by another few months. At the time, Mack was President of Trade Placer, a "real-time marketplace where you can buy or sell items such as gold, silver, platinum, wine and other collectibles." Now he is the CEO at Levidge, a platform for trading cryptocurrencies. Note again the well-trodden corridor between gold buggery and crypto buggery.

Anyways, in 2011 Mack wrote:

"According to a study of 775 fiat currencies by DollarDaze.org, there is no historical precedence for a fiat currency that has succeeded in holding its value. 20 percent failed through hyperinflation, 21 percent were destroyed by war, 12 percent destroyed by independence, 24 percent were monetarily reformed, and 23 percent are still in circulation approaching one of the other outcomes.

The average life expectancy for a fiat currency is 27 years, with the shortest life span being one month. "

Mack mentions a study by DollarDaze, but doesn't provide a link to the article. Aha, the missing data! I hopped over to DollarDaze's website, a blog dedicated to talking about the failings of the U.S. dollar. But there are no blog posts older than 2018. No study, folks.

This puts all the meme users – Jimmy Song, Grayscale, Max Keiser, and the rest – in an absurd situation. There are some words on some websites about a study, but ask our meme users where the study is and none of them can actually find it. Did it ever exist? Why are they so confidently transmitting data when there is no data? DollarDaze has got to be right, no? How could you doubt it, JP?

Since no one was able to help me, I turned to the Wayback Machine to see if I could pull up older versions of the DollarDaze website. It took a while, but I finally found pay dirt. Back in 2009 the editor of DollarDaze, Mike Hewitt, wrote an article entitled The Fate of Paper Money. I tried to track Hewitt down, but he seems to have disappeared from the internet.

No matter. Finally, some data to evaluate! In his article, Hewitt claims to have counted 176 currencies in circulation and 599 currencies that are not in circulation. Of the 599 in his discontinued list, Hewitt comments that the "median age for these currencies is only fifteen years!" He provides links to both lists (1 and 2).

I downloaded Hewitt's list of 599 defunct currencies and put it into an Excel spreadsheet. The median age is indeed 15 years, as Hewitt claims, and the average is 27 years, as Mack claims in his subsequent 2011 article. So voila, we finally have the basis for the modern internet meme that the average age of a fiat currency is just 27 years. It's based on Hewitt's list of 599 dead currencies, with Mack taking the average duration. (They conveniently don't include the list of 176 existing currencies in their calculation, which would have increased the number). 

Now for my criticisms.

The 27-years meme has been used for many years now as a prop for making gold and cryptocurrencies look good. "Ha ha, suckers! Only 27 years until your paper is worthless!" But many of the 599 defunct currencies in Hewitt's list weren't failures. Rather, they were replaced for political, economic, and cultural reasons.

And things haven't improved much from there other than getting better at not imploding in 5months flat, tho there are appalling stats about the lifetime of fiat currencies since inception (27 years average). the oldest is the GBP at 317 years and even it lost > 99.5% of value.

— Adam Back (@adam3us) July 31, 2019

For instance, the list contains all of the pre-euro currencies (Dutch gulder, French franc, Italian lira, etc). These currencies had good reasons for disappearing: they were swapped for a new monetary unit. Existing currency holders weren't robbed. They were fairly compensated for this switch.

Another example of monetary reorganization occurred in East Africa. From 1919 to the 1960s, Britain's former east African colonies relied on the East African shilling, produced by the East African Currency Board. When these countries gained their independence, the currency board was dismantled. In its place Kenya began issuing its own shillings at par with the old ones, as did  Tanzania and Uganda.

In each case, existing owners of East African shillings could convert their holdings into new currency. No wealth was being destroyed during any of these switches. But people who throw around the phrase the average life expectancy for a fiat currency is 27 years as a criticism of the very institution of currency are using the data in a way that implicitly assumes that the East African experience – and others like it – were negative. They weren't.

So the idea that Hewitt's list somehow measures the length of time between a fiat currency's birth and its impending worthlessness is just wrong. I'd go even go so far as to say that the plasticity of the listed currencies is one of their strengths. As national borders change and political circumstances shift, the writing on the bills should be updated too. 

Hewitt's list contains many data errors. He makes the odd claim that the Japanese gold oban and silver momme were created in 1904 and met their end in a hyperinflation in 1905. But these were both historic Japanese coins that had existed for centuries. Hewitt also lists the U.S. greenback ("US Paper Dollar) as lasting from 1862 to 1878. But this isn't correct. Greenbacks were repegged to gold in 1878, but they continued to be issued for many decades after.

Or take Hewitt's categorization of British Military Authority (BMA) lira as dying in hyperinflation. This is an odd claim to make. BMA Lira were issued in Libya by occupying British forces both during and after World War II to provide the nation with a circulating medium. These notes were basically a military version of the British pound, with 480 lira equal to a pound sterling. In 1951 BMA Lira notes were converted into Libyan pounds, issued by Libya's new currency board, at a rate of 480-to-1. No hyperinflation here.

Finally, take Hewitt's claim that the Hawaiian dollar was "destroyed" by WWII. Not so. I've written about the Hawaiian overprints before. To protect against a potential Japanese invasion of Hawaii (and a confiscation of dollars by Japanese soldiers) all dollars on Hawaii were overprinted. Once the threat of Japanese invasion had disappeared they were swapped for regular U.S. dollars and withdrawn . But not a single Hawaiian lost anything during the entire process.

I don't want to nitpick too much, but given that it only took me a few minutes to find these four mistakes, one can only conclude that the rest of Hewitt's list is riddled with errors.

Finally, there are some semantic issues. Fiat currency is generally considered to be inconvertible money. It can't be redeemed for gold or silver. The world really only shifted onto a fiat standard between 1968-71 as the dollar ceased to be redeemed in gold. But Hewitt's list is replete with many metallic currencies (i.e. the riksdaler riksmynt). Are people using his data to make a claim about currencies in general, or just fiat ones? The meme isn't clear on this.

So having examined the life of an internet monetary meme, I'd like to kill it. It's time for us to retire the idea that says that "the average life expectancy for a fiat currency is 27 years." God knows there's plenty of problems with currencies. But good criticism requires diligence and accurate data. The meme in question is an example of sloppy work and bad data.

I know that the crypts and the bugs and the fiats are engaged in constant meme warfare, the bugs and the fiats for many decades now, the crypts only joining the battle a few years ago. Messages must be crafted for best efficiency, whether this be to pump bitcoin to the moon, or to push gold into the stratosphere, or to lock the fiat system in place. But most of the serious people involved in these debates, no matter which side, still keep at least one foot in the truth. Let's flush the 27-years meme down the toilet, folks.  

Why the discrepancy?

Vitalik Buterin had a thought-provoking tweet a few days back about interest rates.

Lending DAI to Compound offers 11.5% annual interest. US 10 year treasuries offer 1.5%. Why the discrepancy?

— Vitalik Non-giver of Ether (@VitalikButerin) August 23, 2019

Today's post explores what goes into determining interest rates, not blockchain stuff. So for those who don't follow the blockchain world, let me get you up to speed by decoding some of the technical-ese in Buterin's tweet.

DAI is a version of the U.S. dollar. There are many versions of the dollar. The Fed issues both a paper and an electronic version, Wells Fargo issues its own account-based version, and PayPal does too. But whereas Wells Fargo and PayPal dollars are digital entries in company databases, and Fed paper dollars are circulating bearer notes, DAI is encoded on the Ethereum blockchain.

Buterin points out that DAI owners can lend out their U.S. dollar lookalikes on Compound, a lending protocol based on Ethereum, for 11.5%. That's a fabulous interest rate, especially when traditional dollar owner can only lend their dollars out to the government—the U.S. Treasury—at a rate of 1.5%.

Why this difference, asks Buterin?

Interest rates are a lot of fun to puzzle through. I had to think this one over for a bit—so let's slowly work through some of the factors at play.

Let's begin by flipping Buterin's question around. When the U.S. Treasury borrows from the public, the bonds it issues are promises to pay back regular dollars (i.e. Federal Reserve dollars). But what if the U.S. Treasury decided to borrow DAI by issuing bonds promising to repay in DAI? What would the interest rate on these Treasury DAI bonds be? Would it be 11.5% or 1.5%? Perhaps somewhere in between?

Credit risk

First, there's the question of credit risk. The U.S. Treasury is a very reliable debtor. It won't welch. If it issues both types of bonds, it'll be just as likely to repay its DAI bond as it will its regular dollar bond. Since the market already requires 1.5% from the Treasury to compensate it for credit risk (and a few other risks), the Treasury's DAI bonds should probably yield 1.5% too. (I'll modify this later as I add some more layers).

Now let's look at Compound. A DAI loan made on Compound (for simplicity let's just call it a Compound DAI bond) is surely much riskier than our hypothetical Treasury DAI bond. Compound is a blockchain experiment. It could malfunction due to buggy code. Maybe every single Compound borrower goes bust. To compensate for this risk, a prospective bond buyer will require a higher return from Compound DAI bonds than they will U.S. Treasury DAI bonds.

So Compound credit risk (Buterin's third option) probably explains a big chunk of the huge gap between the 11.5% interest rate on Compound DAI bonds and our hypothetical 1.5% interest rate on the U.S. Treasury's DAI bonds. But not all of it.

Collapse risk

Buterin mentions a second risk: the chance that DAI, the entity that creates blockchain dollars, collapses. Like Compound, DAI is a new monetary experiment. The code could be buggy. It might get hacked. By comparison, conventional dollar issuers—say Wells Fargo or PayPal—are far less likely to malfunction.

How does DAI collapse risk get built into the price of a hypothetical Treasury DAI bonds

The average market participant (I'm not talking about crypto fans here, but large & smart institutional actors) should be genuinely worried about purchasing a Treasury DAI bond—not so much because the Treasury is unlikely to pay it back—but because the DAI tokens that the Treasury ends up repaying could, in the even of DAI breaking, be worth 99% less than their original value. Average bond buyers will expect some compensation for bearing this risk. How much? Say 5.5% (I'm just guessing here).

Earlier I said that a Treasury DAI bond would yield 1.5%. But if we add 5.5% worth of failure risk to 1.5% in basic risk, a Treasury DAI bond should yield 7.0% before the average investor is going to hold it.

Now let's go back and look at a Compound DAI bond. As Buterin pointed out, they yield 11.5%, which is much higher than the 7.0% yield on our hypothetical Treasury DAI bond. We've already assumed that DAI collapse risk works out to 5.5%. If we subtract collapse risk from a Compound DAI bond's 11.5% yield, the remaining 6% is accounted for by risks such as Compound failing (11.5% - 5.5%). Put differently, investors in Compound DAI bonds will require 5.5% and 6.0% to compensate for collapse risk and credit risk respectively, for a total of 11.5%. Again, these are hypothetical numbers. But they help us puzzle things out.

Two different blockchain dollars: USDC vs DAI

Interestingly, Compound doesn't just facilitate DAI loans. It also expedites loans in another blockchain dollar, USDC. We'll refer to these as Compound USDC bonds. As Buterin points out later on in the thread, the rate on Compound USDC bonds is 6.5%, quite a bit lower than Compound DAI bonds.

What might explain this discrepancy?

Not credit risk, since in both instances the same creditor—Compound—is responsible for creating the bonds. Which leaves varying levels of collapse risk as an explanation. USDC is a regulated stablecoin (i.e. it has the government's approval). DAI isn't. And USDC has genuine U.S. dollars backing it, whereas DAI is backed by highly volatile cryptocurrencies. So the odds of USDC collapsing are surely lower than DAI.

How much interest do USDC bond holders require to compensate them for collapse risk? Assuming that Compound's risk of failing is worth 5.5% of interest (as we already claimed), that leaves just 1% attributable to the risk of USDC failing (6.5%-5.5%). Put differently, investors in Compound USDC bonds will require 5.5% and 1.0% to compensate for credit risk and collapse risk respectively, for a total of 6.5%.

Oddly, the yield on a Compound USCD bond is less than the hypothetical yield on our safe Treasury DAI bond (6.5% vs 7.0%). Why is that? Even though Compound is riskier to lend to than the Treasury, a DAI-linked return is riskier than a USDC return. Another way to think about this is that if the Treasury were to also issue USDC bonds, those bond would only yield 2.5%. To account for credit (and other) risks investors would require a base 1.5% with an extra 1.0% on top for the risk of USDC breaking.

The convenience yield

Let's bring in one last layer. Something called the convenience yield is lurking behind this.

When you lend me some tokens, you need to be compensated for more than just credit risk i.e. the risk that I won't pay back the tokens. You are also doing without the convenience of these tokens for a period of time. The replacement, my IOU, won't be very handy. For instance, the convenience of a dollar bill can be though of as the ability to mobilize it whenever you need to meet some pressing need. But if you've lent a $100 bill to me then you've given up all that bill's usefulness. Instead, you're stuck with my awkward $100 IOU. You need some compensation for this. (Unconvinced? Head over to Steve Randy Waldman's classic ode to the convenience yield).

So when we break down the components of the interest rate on DAI bonds, there must be some compensation required for forgoing the convenience of DAI, its convenience yield. Earlier I attributed the big gap between rates on Compound DAI and USDC bonds to varying odds of each scheme failing. However, the gap could also be explained by varying convenience yields. If the convenience yield of a DAI token is higher than that of a USDC token, we'd expect an issuer of a DAI bond to pay a higher rate than on a USDC bond, in order to compensate DAI holders for giving up on those superior conveniences. 

If DAI's convenience yield is higher than USDC's, what might explain this gap? DAI is completely decentralized and can't be monitored. USDC isn't. It is less censorship-resistant than DAI. So perhaps USDC just isn't as handy to have around.

So some of the 11.5% rate on Compound DAI bonds—say 2%—may be due to the convenience yield forgone on lent DAI. If DAI had the same features as USDC, and thus had a lower convenience yield, a Compound DAI bond might only yield 9.5% (11.5% - 2.0%). If so, the discrepancy between the Compound DAI and USDC bonds—9.5% vs 6.5%—wouldn't be as extreme.

Summing up, let's revisit Buterin's tweet:

Lending DAI to Compound offers 11.5% annual interest. US 10 year treasuries offer 1.5%. Why the discrepancy?

— Vitalik Non-giver of Ether (@VitalikButerin) August 23, 2019

If my line of thinking is right, the discrepancy is accounted for a messy mix of the higher risk of lending to Compound (3), the danger of DAI cracking (2), and whatever convenience yield one forgoes when one no longer has DAI on hand (4-other). And of course, Buterin's first option is right too. I'm assuming that people are rational and can easily buy and sell various assets. But the sorts of large institutional players who set market prices may not be operating in crypto markets.

Starbucks, monetary superpower

I recently spent some time on Twitter discussing the monetary wonders of Starbucks. In this post I'll bring a bunch of tweets together into a single blog post.

I don't go to Starbucks very often, so I only recently learnt that the company has succeeded in getting many of its customers to stop using cash and debit/credit cards to buy coffee. Instead, they are using  Starbucks's own payments option:

Wow Starbucks, what a great gig.

Starbucks has ~$1.6 billion in 'stored value card liabilities' i.e. the Starbucks Card. So ~6% of the firm's liabilities are comprised of coffee addicts paying 0% for the privilege of lending to their supplier.
Source: https://t.co/nGH2arujYz pic.twitter.com/cGcSW3L4MM

— JP Koning (@jp_koning) August 11, 2019

Starbucks has around $1.6 billion in stored value card liabilities outstanding. This represents the sum of all physical gift cards held in customer's wallets as well as the digital value of electronic balances held in the Starbucks Mobile App.* It amounts to ~6% of all of the company's liabilities.

This is a pretty incredible number. Stored value card liabilities are the money that you, oh loyal Starbucks customer, use to buy coffee. What you might not realize is that these balances  simultaneously function as a loan to Starbucks. Starbucks doesn't pay any interest on balances held in the Starbucks app or gift cards. You, the loyal customer, are providing the company with free debt.

Starbucks isn't the only firm to get free lending from its customers. So does PayPal. That's right, customers who hold PayPal balances are effectively acting as PayPal's creditors. Customer loans to PayPal currently amount to over $20 billion. Like Starbucks, PayPal doesn't pay its customers a shred of interest. But Starbucks's gig is way better than PayPal's. PayPal is required to store customer's funds in a segregated account at a bank, or invest them in government bonds (see tweet below). So unfortunately for PayPal, it earns a paltry amount of interest on the funds that customers have lent it.

PayPal is a good example of a modern 'narrow bank'. Customers have deposited ~US$20 billion at PayPal. And PayPal invests these funds in very boring things listed below, like bank deposits, time deposits, government debt etc.

Source: https://t.co/snJel203QM pic.twitter.com/EDfMA2Wkux

— JP Koning (@jp_koning) August 21, 2019

Starbucks, on the other hand, doesn't have to keep customer funds in a low yielding segregated account or government bonds. Why is that? PayPal allows people to cash-out of PayPal dollars into regular dollars, so for regulatory purposes it must keep an adequate reserve on hand to facilitate redemptions. But the only way to cash out of Starbucks balances is to buy a coffee--a promise that Starbucks can always keep! And so Starbucks can immediately put its customer loans to work in higher-yielding opportunities like funding its operations and expansion.

In addition to borrowing from its customers, Starbucks also borrows from professional investors. Here's a list Starbucks's long-term debt:

Starbucks is paying an interest to bond and note-holders that ranges as low as 0.46% (on its yen notes maturing in 2024) to 4.5% (on its 2048 notes). You can see why borrowing from customers in the form of stored value card liabilities is the better option. By expanding its borrowing from its non-professional lenders and using the proceeds to cancel its debts to professional lenders, Starbucks can make an immediate profit.

But there's more. As I pointed out in the following tweet, don't forget breakage. Bond and note holders are pros. They don't forget about debts. But customers aren't so exact. They are sloppy, or busy, or forgetful, which means that many gift cards and balances will go unspent:

Few companies can get that much free financing. But don't forget breakage—balances that will never be redeemed. In 2018 Starbucks recorded breakage of $155 million,~10% of all card balances.

So the true rate at which customers are lending to Starbucks is probably closer to -10%. pic.twitter.com/hRaN7LGoEf

— JP Koning (@jp_koning) August 11, 2019

Each year Starbucks recognizes that a portion of its stored value liabilities will be permanently lost. This is known as breakage. Starbucks recognizes this amount as profit. In 2018 the company recognized $155 million in breakage, around 10% of all stored value balances. Wow! Starbucks already pays just 0% on its debts to customers, but add in breakage and that equates to a roughly -10% interest rate!

On Twitter, Wayne points out to me that I need to add back the impact of Starbucks rewards. App users receive stars on each purchase which can be saved up for free coffee. This functions as a form of implicit interest that Starbucks pays to its customers.

I earn about 50% equivalent interest per year on my Starbucks card. 2 Americanos per week earns me a free one about once every 3 months. Roughly $12 per year in free purchases. I keep between $10-$25 balance on the card. Earning $12/year on a $25 investment is a good return.

— Wayne Culbreth (@wayne_culbreth) August 11, 2019

That's a good point. But if were going to bring rewards into our calculation, then there are other non-pecuniary flows that need to be added in too. Keep in mind that each payment made through the Starbucks app is a payment that isn't made by credit card. Since each credit card payment will cost Starbucks 1-2% in interchange fees paid to the card networks and banks, the company saves a lot of money by guiding customers to its payments app. As for Wayne, while he may earn an implicit interest return in the form of Starbucks points, by forgoing a card payment he's giving up on the associated cash-back or airline points.

Another flow that needs to be accounted for is data. By capturing the customer's wallet, Starbucks is getting loads of free but valuable personal information that would otherwise be lost, or for which it would have to pay. Any customer who pays with cash forgoes rewards, but at least they get to retain their information. 

Adding all of this up, (0% interest + breakage - rewards + interchange savings + customer information), Starbucks's stored value liabilities are a terrific liability to have.

More generally, I think this calculation demonstrates how providing financial services to a retail customer base is a great business. Retail customers don't seem to be too fussy about the return they get. And they are busy and distracted and sloppy and forgetful. Take central banking, for instance, which serves a retail clientele. People are pretty happy to hold banknotes that pay 0%. But you never see businesses or professional investors hoarding banknotes. They quickly return the cash they take in during the course of the day to their bank so that they can harvest interest. Commercial banking is also a good example. Like Starbucks, banks are able to borrow from their retail customers at a measly rate approaching 0%. But professionals who lend to banks by purchasing their bonds require a much higher rate. To top it off, retail customers unnecessarily sign up for high-fee products and avoid changing banks when there is a cheaper option.  

Why doesn't every retail chain try get into this game? By borrowing as much as they can from the non-professional public, they'd steal plenty of profitable business from central banks and retail banks. Well they do. Gift cards are a big business. And if you think about it, retailers are perfect candidates for providing monetary services to the masses. Like banks, they already have a network of physical stores. But none of them have been successful at it as Starbucks. Walmart is much bigger than Starbucks, for instance, but it has just as many gift card balances outstanding:

Starbucks is really good at harvesting seigniorage.

Walmart's annual sales are 20x larger than Starbucks sales (~$500b vs $25b). But Walmart only has $1.9 billion in unredeemed gift card balances, not much more than Starbucks. Source: https://t.co/LBs6DE1cGq pic.twitter.com/wtJltMt26L

— JP Koning (@jp_koning) August 11, 2019

Perhaps Starbucks's success has to do with the regularity and homogeneity of Starbucks purchases? And so customers are willing to preload a dedicated account? I'm not sure.

In any case, there are probably a few Starbucks executives who'd love to grow the amount of negative yielding liabilities that the firm issues. Why stop at $1.6 billion in stored value liabilities? Why not grow the program to $5 billion, $10 billion, or $100 billion? It would be a terrific business line to get into.

The problem here is that Starbucks only sells coffee. Coffee is great, but the demand for dollars that are only useful for buying coffee will always be limited. To really grow the amount of stored value liabilities it issues, Starbucks would have to increase the usefulness of Starbucks dollars. One way to do this would be to open up the Starbucks app up to other stores. If consumers could also buy Big Macs with the balances on Starbucks App, this would increase the demand for Starbucks balances. To secure McDonald's cooperation, Starbucks would have to share the savings, breakage, and data. Maybe companies like Home Depot and Costco would join the Starbucks-McDonald's alliance. (And other chains, say Kroger and Burger King, might join the competing Walmart Pay alliance).

Sure, each of these companies could simply pursue their own independent stored-value liability programs. But wouldn't an alliance be better? From the customer's perspective, balances held in a single payments app that can be spent at Starbucks, McDonald's, Home Hardware, or Costco would be far more useful then dollars held in four separate and walled-off apps. And so collectively these stores should be able to get the public to hold more stored value card liabilities than they could individually. Which means more breakage, free loans, and data for everyone (and less for the banks, card networks, and central banks).

Who knows if it would be successful. And it might not even be possible from a regulatory perspective. But it would be tempting, no? In a world where most debtors have to pay interest, being  a debtor who earns interest is pretty hard to beat.

---

*I believe that current portion of deferred revenue is equal to around $174 million. This comes courtesy of the current portion of an up front royalty payment from Nestlé. So the stored value card liability is actually closer to $1.46 billion. Still pretty high. 

Stigmatized money

Some payments systems are so awkward they scare away the average user. The only people with the patience to stick around must have a motivation for doing so. These include ideologues with an ax to grind, hobbyists who happily embrace complicated features, and criminals/weirdos who are shut out of everything else.

Here are a few examples of awkward payments systems:

-Local Exchange Trading Systems, or LETS
-Bitcoin/Dogecoin
-Labor notes
-Stamp scrip

When usage of a payments system is confined to a narrow group of like-minded individuals, this may stigmatize these systems, scaring away mainstream users. Stigmatization only compounds the initial awkwardness. After all, if fewer venues accept the stigmatized payments option then it becomes harder for the small band of users to make purchases. A vicious circle has been created. Initial awkwardness leads to stigma which leads to more awkwardness etc.

While this vicious circle is the death knell for a payments system, it is less of a problem for other products. You can make a decent living by targeting a small niche of consumers, say communists who eat vegan food. Every big city needs a communist vegan restaurant. But a payments network is only as good as the size of the payments pathways that it facilitates. A payments entrepreneur won't get very far by building a platform that only allows communist vegans to pay other communist vegans. 

How to evade the awkwardness-stigma spiral? What is needed is a frictionless, non-awkward payments system. With little to learn, everyone—not just nerds and those with an ax to grind—can quickly start using it. Think M-Pesa or Visa or Octopus.

Even the haters will get onboarded. Gold bugs and bitcoiners may rail against banks and fiat money. But because everyone else is using these relatively simple systems, the bugs and the bits have no choice but to go along. By bringing the vast hoard of normies on board along with the weirdos, these systems avoid all connotation. They are safe for broad consumption. No stigma can attach to them. And so the vicious awkwardness-stigma circle I described gets sidestepped.

I'd argue that LETS are an example of a system that suffer from the awkwardness-stigma spiral. LETS are a pain to use. This article on the famous Comox LETS and its founder Michael Linton, an earlier proponent of LETS, explains some of the problems. And so the only people who use LETS will be those willing to put up with the awkwardness: folks who self-identify as leftist with anarchic views. Those who don't share those views might feel weird joining a LETS. So LETS remain small and fragile, or as Linton says, they're like "sandcastles on the beach."

You see the same awkwardness-stigma cycle at play in bitcoin. Bitcoin is an awkward payments medium. The stuff is so volatile that retailers don't like to accept it. Risk averse consumers don't want to hold it. So only a subset of the population will ever feel comfortable using bitcoins for payments.

This subset has developed its own norms and codes. Bitcoin steak dinners are a good example. A large group of predominately male bitcoiners will get together to eat meat while avoiding vegetables, then broadcast it on Twitter:

Thank you @pierre_rochard for organizing the Bitcoin Steak Dinner last night! It was a pleasure and a blast meeting with so many bitcoiners! Tag yourselves so we can connect on Twitter 😎☇ pic.twitter.com/UzD40SNqF6

— Gustavo J. Flores E. (@GustavoJ_Flores) March 10, 2019

I'm sure it's a lot of fun. But these sorts of traditions will inevitably be perceived as weird by the majority. And so the majority will go out of their way to avoid bitcoins for fear of being tarred as an oddball. Other niche groups who can't sympathize with male carnivores, say lesbian vegans, will avoid bitcoin payments on principal. This stigma cuts down on the potential pool of bitcoin payees, which only makes bitcoin more annoying to use.

Mastercarders don't have their own set of traditions. For instance, you won't see Mastercard users setting up meetups to eat organic food and talk about the latest development in tokenization technology. The Mastercard/Visa user-bases are devoid of culture and character. This lack of a class consciousness is one of the features that makes them such effective  payments networks. Systems without norms and traditions never face the risk of falling into the stigmatization hole.

Facebook's Libra has attracted plenty of attention over the last few months. But Libra risk encountering the same awkwardness-stigma cycle as Bitcoin and LETS. Unlike other social media-based  payments tools (Wechat, Kakao, Line etc), Libra's architects have chosen to create a new unit of account rather than marrying Libra tokens to existing units like the dollar or euro.

But as I suggested in a previous post, it's a pain to learn a new unit of account, just like it's a hassle to learn a new language. So only a certain type of motivated person will bother using Libra, just like only motivated people—language nerds—learn Esperanto. This weirdo factor could stigmatize the system. Hey, look at those Libra-using elitists! What snobs! By crowding out normies (and the massive number of potential payment pathways they bring to the table) Libra runs the risk of never self-actualizing as a payments system. Better to take the safe and boring route of linking Libra to dollars and yen and whatnot. 

The vicious awkwardness-stigma cycle has already started to hit cash. In places like Sweden, cash is being stigmatized. When the middle and upper class are convinced that only the poor and criminals use coins and banknotes, many of them will go out of their way to avoid using cash. Cash becomes "grungy and unsexy," as Brett Scott puts it. Unfortunately, an ever narrower base of cash users will only make the stuff more expensive for retailers to handle, leading to a rise in cashless stores (especially ones that cater to the rich), leading to more awkwardness and stigma, leading to less users, etc.

David Birch has an interesting parable from William Gibson's Count Zero that illustrates what happens when this stigmatization is brought to its logical conclusion. Basically, cash is still around in Gibson's imagined future, but it has disappeared from "polite society". And so the story's protagonist, Bobby Newmark, describes it as unspendable:

William Gibson imagined a future where 'polite society' won't accept cash. From 'Count Zero' ht @dgwbirch pic.twitter.com/Bh9ZKVDmJz

— JP Koning (@jp_koning) October 3, 2016

If cash is to avoid a Gibsonian future, it needs to be de-stigmatized. But this requires that it re-attracts many of the people and businesses that have deserted it because it is no longer convenient. In a post  at the Sound Money Project (and earlier on this blog) I suggested paying interest on cash. Thus individuals and businesses would be compensated for the relative inconvenience of note storage and handling. And with a wider range of people using notes, any stigma that they have attracted would dissipate.

Stigma is dangerous for a payments system. A system will become stigmatized if it attracts a clique rather than a broad group of users. Cliques kill a payments system since they suppress the system's connectiveness. To avoid the potential for clique-ization, systems should try to be as easy to use and accessible as possible.