Saturday, July 14, 2018

The €300 million cash withdrawal

The eyes of the world are on one of history's largest cash withdrawals ever. Earlier this week, the Central Bank of Iran ordered its European banker, Hamburg-based Europaeisch-Iranische Handelsbank AG, to process a €300 million cash withdrawal. Germany's central bank, the Bundesbank, is being asked to provide the notes. If the transaction is approved, these euros will be counted up, stacked, and sent via plane back to Iran. German authorities are still reviewing the details of the request.

Iran claims that it needs the cash for Iranian citizens who require banknotes while travelling abroad, given their inability to use credit cards, says Bild. Not surprisingly, U.S. authorities are dead set against the €300 million cash transfer and are lobbying German lawmakers to put a stop to it. They claim the funds will be used to fund terrorism.

The picture below illustrates $1 billion in U.S. dollars, so you can imagine that €300 million in euro 100 notes would be about a third of that. That's a lot of paper.

One Billion Dollar Art Piece by Michael Marcovici (source)

The fate of this transaction is important not only for Iran but the rest of the world. It gives us a key data point for answering the following question: just how resistant is the global payments system to U.S. censorship? If a payments system is censorship resistant, third-parties do not have the power to delete a user or prevent them from accessing the system. If the U.S. can unilaterally cut off any nation from making cross border payments, then the global payments system isn't censorship resistant.

We already know that the global payments system is highly susceptible to U.S.-led censorship. From 2010-2015, Barack Obama successfully severed Iran from the world's banks, driving the nation's economy into the ground and eventually forcing its leaders to negotiate limits to their nuclear plans.

The global payments system's susceptibility to U.S. censorship stems from the fact that an incredibly large chunk of international trade is priced in and conducted using U.S. dollars. To make U.S. dollar payments on behalf of clients, a foreign bank must be able to keep a correspondent account with a large U.S. bank. This reliance on U.S. correspondents allows U.S. authorities to use their banks as hostages. International banks can either comply with U.S. requests to cease doing business with Iran, or have their access to U.S. correspondent banks cut off. Dropping Iranian customers is generally the cheaper of the two options.

Following in Obama's footsteps, Donald Trump has decided to inaugurate the next round of Iranian payments censorship. But this time around Europe has not gone along in declaring Iran to be a banking pariah. (I wrote about this here). Europe is responsible for managing the world's second-most important currency: the euro. Its reluctance to sign on to the U.S.'s new censorship drive is a sign that the global payments system may be a little more resistant to censorship than the first round of Iran sanctions might have implied. If a nation is prohibited from using one end of the global payments system, the U.S. dollar end, but not the other (albeit smaller) end, then they haven't really been cutoff.   

Digital euros flow through pipes operated by the European Central Bank, the ECB. This financial piping system is otherwise known as Target2, the ECB's large value payments system. Any bank that is connected to Target2 can route euro-based payments on behalf of its customers to the customers of any other bank that is connected to those same pipes. While a Target2 connection might not be as good as being connected to the US-based financial pipes, it's a close second.

In addition to facilitating digital euro transfers, the ECB also makes euro cash available to member banks when they need it. The way this works is that European commercial banks like Deutsche Bank or Santander or Europaeisch-Iranische Handelsbank have accounts at the ECB. They can ask the ECB to convert balances held in these accounts into euro cash to meet their customer's withdrawal requests.

The ECB can censor a bank—and its customers—by cutting of said bank's access to Target2. It can also censor a bank by refusing to allow the conversion of that bank's ECB account balances into cash. Europaeisch-Iranische Handelsbank's request to withdraw €300 million on behalf of Iran's central bank is a litmus test of the ECB's willingness to continue providing the second of these services: cash withdrawals. Will it comply with U.S. demands and censor Europaeisch-Iranische Handelsbank, and thus Iran, or will it treat Europaeisch-Iranische Handelsbank like any other bank and process the withdrawal? If Europe can successfully resist U.S. pressure, and the cash is sent, then the world's payments systems will be significantly more resistant to censorship than it was before.   

It may be tempting to belittle the topic of censorship resistance as only being relevant to a small group of international pariahs like North Korea or Iran. Only the "bad" guys will ever be cutoff from the global payments system, not us. But nations like Turkey, Russia, and China could one day become tomorrow's pariahs, and thus targets of U.S. monetary sanctions. Heck, in Trump's America, even traditional allies like Canada, South Korea, and UK should probably be worried about being targeted by the U.S. for censorship from the global payments system.

There are sound political and moral reasons for both censoring Iran and not censoring it. Moral or not, my guess is that most nations will breathe a sigh of relief if German authorities see it fit to let the €300 million cash withdrawal go through. It would be a sign to all of us that we don't live in a unipolar monetary world where a single American censor can prevent entire nations from making the most basic of cross-border payments. Instead, we'd be living in a bipolar monetary world where censorship needn't mean being completely cutoff from the global payments system.

The sooner the Bundesbank prints up and dispatches the €300 million, the better for us all.

Wednesday, June 27, 2018

Failed monetary technology

Archaic and ignored monetary technologies can be very interesting, especially when they teach us about newer attempts to update our monetary system. I recently stumbled on a neat monetary innovation from the bimetallic debate of the late 1800s, Nicholas Veeder's Republic of Eutopia coin:
If you've read this blog for a while, you'll know that I like to talk about monetary technology. Unlike financial technology, monetary tech involves a technological or sociological upgrade to the monetary system itself. And since we are all unavoidably users of the monetary system—we all think and calculate in terms of our nations unit of account—each of us is immediately affected by the change.

Veeder's Eutopia coin is an old monetary technology that was never adopted. More recent examples of unadopted (or as-yet not adopted) montech include Fedcoin, NGDP futures targeting, or Miles Kimball's technique for evading the zero-lower bound, which would decouple the value of paper money from electronic money. Examples of recent monetary tech that went on to be adopted include the switch from paper to plastic banknotes, the replacement of older end-of-day clearing systems to real time gross settlement systems, and inflation targeting.

Fintech is more limited in scope than monetary tech. Only that portion of the population that uses these innovations is affected—everyone else's financial habits continues on as before. Recent examples include bitcoin, p2p lending, and roboadvisors. (If bitcoin ever became the standard unit of account, it would have made the trek over to becoming monetary technology, and not just fintech.)


To make sense of Veeder's Republic of Eutopia coin, we need to understand the problem that his monetary innovation was meant to solve. Most nations were on a gold standard by the 1870s, and with the price of gold rising, the world price level was generally falling. This development provided an unexpected boost to the creditor class, who were owed gold, while hurting the debtor class, who owed gold. A higher price for the yellow metal meant that the loan contract to which a debtor had signed their name now required them to work that much harder to pay it off.

In that context, a broad popular movement for the remonetization of silver emerged. Prior to being on gold standards, nations were generally on a pure silver standard or a bimetallic standard. On a gold standard the debtor class had only one way to settle the debt, by providing the proper amount of gold coins. But if silver coinage was reintroduced at the old rate of sixteen-to-one, debtors could instead sell their labour to buy cheap silver, have it minted into legal tender silver coins, and use those silver coins to pay off the debt. Paying their debts with silver rather than gold meant they'd have a bigger amount of wealth remaining in their pocket.

The movement to restore bimetallism wasn't purely a populist one. The smartest economists of the time--folks like Irving Fisher, Leon Walras, and Alfred Marshall--also preferred bimetallism. A bimetallic standard recruits more monetary material into service than a gold standard. This is advantageous because, as Fisher put it, it "spreads the effect of any single fluctuation over the combined gold and silver markets." In other words, the evolution of the price level under a bimetallic system should be more stable—and thus more fair—than under a monometallic system, since it can absorb larger shocks.

The problem with bimetallism is that it very quickly runs smack into Gresham's law. The traditional way to bring the two metals into service as monetary material was to offer to mint both high denomination gold coins and lower denomination silver coins. So if a merchant needed £20 worth of coins, he could bring either a chunk of raw gold to the mint, or an even bigger chunk of pure silver, and the mint would convert either chunk into £20 for him. The specified amounts of raw silver or raw gold that were required to get a certain number of £-denominated coins constituted the mint's official gold-to-silver exchange rate.

Inevitably the market's gold-to-silver exchange rate would diverge from the mint's official exchange rate, effectively over- or undervaluing one of the two metals. In this situation, no one would bring any of the overvalued metal to the mint to be turned into coins. After all, why bother minting a chunk of gold (assuming the yellow metal was the overvalued one) into £20 worth of coins if that same amount of gold has far more purchasing power overseas? The overvalued metal would thus disappear as it was hoarded and exported, leaving only the undervalued metal in circulation. A monometallic standard had accidentally emerged, and all the benefits of bimetallism were for not.

To prevent Gresham's law from being engaged, the mint had to constantly adjust its official rate so that it stayed in-line with the ever-evolving market rate. Not only would these changes have been politically costly, but they would required an expensive series of recoinages in order to ensure that coins always had the proper amount of silver or gold in them.


Enter Veeder's Eutopia coin. Nicholas Veeder was no economist, but an executive at C.G. Hussey, a copper rolling mill in Pittsburgh. In 1885, he published a pamphlet with the wordy title Cometallism: A Plan for Combining Gold and Silver in Coinage, for Uniting and Blending their Values in Paper Money and For Establishing a Composite Single Standard Dollar of Account.

Rather than defining a dollar as simultaneously a fixed amount of gold OR a fixed amount of silver, Veeder's pamphlet suggested defining it as a fusion of the two together. Specifically, Veeder's dollar was to contain 12.9 grains of gold AND 206.25 grains of silver. It's worth noting that under a proposed cometallic standard, paper dollars needn't be redeemed with actual Eutopia coins, but could be converted into separate silver and gold bars or coins. The important rule was that each dollar's worth of debt had to be discharged with 12.9 grains of gold and 206.25 grain of silver.

A model of a cometallic gold certificate, from page 60 of Veeder's pamphlet on cometallism

Veeder's cometallic scheme was a neat way to keep all the benefits of bimetallism with none of its drawbacks. Cometallism would draw on the combined supplies of the gold and silver markets, so that the system would be much more elastic than a pure gold standard, and thus fairer to both creditors and debtors. At the same time, Gresham's law would be avoided. Under traditional bimetallic coin systems, the mint established an exchange rate between the two metals. This rate inevitably became the system's undoing when it diverged from the true rate.

But a mint that was operating under a cometallic standard would only accept fixed quantities of silver AND gold before it would mint a $1 coin, and so it would no longer be setting an exchange rate between the two precious metals. The undervaluation of one of the metals, a key ingredient for Gresham's law, could never emerge under cometallism.


A year after Veeder published his pamphlet, Alfred Marshall—one of the world's leading economists—described a remarkably similar system. Here is part of his response to the Royal Commission on the Depression in Trade and Industry in 1886, which had been convened to address the Long Depression:
"I propose that currency should be exchangeable at the Mint or Issue Department not for gold, but for gold and silver, at the rate of not £1 for 113 grains of gold, but £1 for 56^ grains of gold, together with, say, twenty times as many grains of silver. I would make up the gold and silver bars in gramme weights, so as to be useful for international trade. A gold bar of 100 grammes, together with a silver bar, say, twenty * times as heavy, would be exchangeable at the Issue Department for an amount of the currency which would be calcalated and fixed once for all when the scheme was introduced. (It would be about .€28 or .€30 according to the basis of calculation)."
Marshall's proposal was later dubbed symmetallism. (I wrote about it here.) If you study monetary systems, you'll run into the gold & silver basket idea sooner or later. The concept is invariably refereed to as symmetallism (and not cometallism) and attributed to Marshall (not Veeder). In the 1800s academics were not required to provide references, and from what I understand plagiarism was rampant. Did Marshall develop his idea separately from Veeder, or did he rip it off? Whatever the case, Veeder was an unknown executive at a small manufacturing concern, whereas Marshall a world famous academic. Celebrity carried the day.


Interestingly, Veeder himself probably borrowed the idea, or at least part of it, from someone else. Almost a decade earlier, William Wheeler Hubbell had tried to get the U.S. congress to adopt the so-called "goloid dollar," a coin containing silver and gold alloyed together.
Hubbell owned the patent to the goloid alloy, so he would have made a good profit if the goloid dollar had been adopted by the U.S. Treasury. Unlike Veeder, Hubbell doesn't seem to have been a very good monetary economist, and the case he makes for goloid misses much of nuances of the benefits of bimetallism and the hazards of Gresham's law. He lists a number of advantages for his proposed coin, including: superior durability to gold and silver coins; not susceptible to oxidization (unlike silver); a goloid dollar was smaller than a silver dollar and thus more convenient for consumers to carry around; the mint would be able to make more goloid dollars than silver dollars with its existing capacity; and goloid coins could not be easily melted down for usage in the arts as was the case with gold and silver coins.

Hubbell's idea foundered on the fact that a goloid coin, despite containing gold, has almost the exact same colour as a silver coin. Hubbell's critics believed this set the coin up to be widely counterfeited. A counterfeiter could make a replica with lower gold content, this alteration unlikely to be noticed by the public since the colour of a genuine goloid coin and the fake would be the same.

The difficulties that Hubbell experienced alloying gold and silver were not lost on Veeder. In has pamphlet he mentions that "my first approach, as with many other persons, was to combine the two metals as an alloy for coinage, but, owing to certain difficulties... this idea was soon considered impracticable and abandoned." To avoid Hubbell's color problem, Veeder ended up mechanically wedding the two metals rather than chemically combining them, the Eutopia coin being comprised of a ring of silver and a gold plug embedded inside.


The topic of goloid and Eutopia dollars seem a bit obscure, but the issues of stability and fairness that concerned monetary technologists in the late 1800s remain relevant today.

Today, most western central banks define the national currency in terms of a basket of consumer goods and services rather than a fixed amount of gold (gold monometallism) or a basket of gold & silver (cometallism, symmetallism). This makes a lot of sense. If we want to create a stable monetary standard, one that provides creditors and debtors with an even playing field, better to use a broad basket of stuff that regular people buy than a narrow basket of metals. That way all parties to a contract know many years ahead of time exactly how much consumer goods they will get (if they are creditors) or give up (if they are debtors). Knowing how much gold and silver baskets they will owe or be owed is less relevant to the average person, since gold and silver are a very small part of most people's day-to-day consumption profiles.

There is an important debate going on today about whether to continue defining national currencies in terms of a consumer goods & services basket, or whether to move to something more fluid like a nominal gross domestic product (NGDP), or output. One problem with using a consumer goods basket is that, in the event of a large economic shock that leads to significant loss of jobs, debtors take on all the macroeconomic risk. After all, they owe just as many CPI baskets as before, but have less capacity to meet that obligation because they might not have a job. This doesn't seem like a fair splitting up of risks and rewards.

The nice thing about defining the national currency in terms of NGDP, or output, is that the risk of a large shock, and the associated loss of jobs, is shared between creditors and debtors. This is because if a recession occurs, debtors will owe a smaller amount of real wealth to creditors than they otherwise would. And during a boom, when the job offers are rolling in, creditors will owe more.

Cometallism was never adopted. Perhaps it was a bit too fancy. NGDP is a bit exotic too, but then again so were many forms of monetary technology, until they were actually adopted and became part of the background. We'll have to see what happens.

Friday, June 8, 2018

Evading the next Iranian monetary blockade

Network view of cross-border banking, IMF, Minoiu and Reyes (2011) PDF

I recently blogged at Bullionstar on the topic of the upcoming Iranian monetary blockade.

Many years ago when I was taking a political science class at university, I remember the professor teaching us two criticisms of sanctions. The first is that they don't really work—people can always get around them. And secondly, even if they are so tight that they can't be evaded, sanctions don't change the behaviour of the party being sanctioned.

The Iranian monetary blockade that ran from 2010-2015 seemed to contradict both of these claims. The sanctions were very difficult to evade. And they forced Iran to come to the bargaining table and agree to end their nuclear program in exchange for economic relief. According to the International Atomic Energy Agency, Iran has complied with its promise.

The Trump administration has announced that it is reneging on the nuclear deal and re-imposing sanctions in order to force Iran to agree to a new and stricter terms. Most nations who were signatories remain comfortable with the existing deal. Will the next monetary blockade—the Trump blockade—be as effective as the last one? There's a good chance that it won't.

I refer to Iran sanctions as a monetary blockade because the U.S. banking system is being levered to extract concessions from the rest of the world. Think how large retailers like Walmart force suppliers to sign exclusivity agreements, or face the threat of being cutoff from store shelves. Do business with us, or them, but not both! Suppliers often accept these exclusivity agreements because large retailers like Walmart are too big to abandon.

The U.S.'s first monetary blockade, which ran from 2010-2015, worked along the same principles. Foreign banks in places like Europe were free to continue providing transactions services to Iran, but if they did so they would not be able to maintain correspondent accounts at U.S. banks. To ensure these rules were enforced, U.S. banks were to be fined and U.S. bank executives incarcerated if found guilty of providing accounts to offenders. Fearful bank executives were very quick to comply by carefully vetting those that they offered correspondent banking services to.

Having a U.S. correspondent account is very important to a non-US bank. If a European bank has a corporate customer who wants to make a U.S. dollar payment, the bank's correspondent relationship with a U.S. bank allows it to effect that payment. Since the revenues from U.S. dollar payments far exceeds revenues from providing Iranian agencies and corporations with payments services, a typical European bank would have had no choice but to abandon Iran in order to keep its U.S. correspondent account.

This was a very effective tool. With ever fewer foreign banks willing to facilitate Iranian trade, it became tougher for Iran to sell its lifeblood: crude oil. Lacking hard currency, Iran suffered from shortages of vital foreign products including medicine and refined oil products. After enduring much hardship, it finally gave in.     

So let's get to the fun bit: can Trump's monetary blockade be evaded?

That hinges on what happens in Europe. The euro, after all, is the world's second-most important medium of exchange. Let's say that Europe is committed to the existing Iran deal. Which means it will have to continue to facilitate Iranian trade in exchange for Iranian nuclear compliance. But how to facilitate this trade when no European bank wants to open accounts for Iranian businesses out of fear of losing access to the U.S. payments system?

One scheme would be to set up a single sanctions-remote bank that conducts all Iranian business. To defang the U.S. Treasury's threat "do business with us, or them, but not both!", this bank should not be dependent on U.S. dollar business. Without a U.S. correspondent, the Treasury's threat to disconnect it from the correspondent network packs no punch. A private European bank that already specializes in Iran business, say like  Hamburg-based Europäisch-Iranische Handelsbank AG, could serve as the sanctions-remote bank. Alternatively, a newly-created government bank that focuses only on Iranian transactions might fill the role.

Let's assume Europäisch-Iranische Handelsbank (EIH) is chosen. Iranian companies that sell crude could open accounts at EIH. How would they get paid? Like other European banks, EIH has a settlement account at the European Central Bank (ECB). Crude oil buyers from all over Europe could have their banks wire payments to EIH's account via the ECB's large value payments sytem, Target2. EIH could also open accounts for companies in India, China, and elsewhere who want to buy Iranian crude oil with euros. In this way, Europäisch-Iranische Handelsbank could theoretically process payments for every drop of Iranian crude, via Target2, and the U.S. Treasury's banking dragnet could do nothing to stop this.

The U.S. could always impose travel bans on EIH bank officials and freeze their U.S. assets. That would surely be annoying, but it wouldn't be decisive. I remember the officials of Canadian-based Sherritt being subject to these sorts of bans many years ago because they did business in Cuba—yet Sherritt gamely trudged on.

Screenshot of Europäisch-Iranische Handelsbank's website. "We are open for business."

There is also the extreme possibility that the U.S. would impose travel bans on the ECB itself, in an effort to force ECB officials to remove Europäisch-Iranische Handelsbank from Target2. Here is one such threat: "Treasury this week designated the governor of Iran's central bank—does any European country think Treasury can't designate their own central bank governor too?" Look, the idea of preventing Mario Draghi from travelling to the U.S., or blocking his U.S. assets, sounds so unhinged that it's not even worth entertaining.

So why was Europäisch-Iranische Handelsbank not used as a sanctions-remote bank during the last monetary blockade? In short, the EU wouldn't allow it. In 2011, it decided to impose its own sanctions on the bank that resulted in EIH's bank accounts being frozen, the banning of all new business, and its removal from the SWIFT and Target2 financial communications networks. According to this report, Chancellor Angela Merkel did so at the urging of Obama.

The key point here is that the U.S. was not itself capable of forcing a sanctions-remote EIH to comply—it had to ask European officials to do the dirty work. Back then, this would have been an easy sell. Obama was respected and had a good working relationship with European leaders. The sanctions had been a carefully negotiated effort that had United Nations support, and therefore broad buy-in, including that of the Russians and Chinese. Trump, on the other hand, has chosen to rudely upset the existing consensus rather than carefully gaining the tacit support of other nations. Unlike the last time around, Merkel can't be asked to take one for the team—there is no team. And as Steve Randy Waldman points out, this time Europe and others have a morally and politically defensible grounds for enabling a work-around.

So rather than shutting down its sanction-remote bank like it did last time, Europe may simply turn a blind eye and allow it to stay open, EIH (or some other government-anointed financial institution)  becoming the go-to bank for conducting Iran's worldwide crude oil business. And if Iran has a means for selling its oil, it may be able to ignore Trump. Thus, the success (or not) of Trump's sanctions is ultimately a European policy variable. 

Supposing that Europe caves into pressure from Trump, then India or China could also set-up their own sanctions-remote banks. But these would be in rupee or yuan, neither of which has the wide usefulness of the dollar or euro. Realistically, only Europe can engineer a credible resistance. Here's hoping it does. 

Thursday, May 31, 2018

Ethereum is full of ponzis, is that a problem?

Charles Ponzi

Ethereum is being used as a platform for a bunch of ponzi schemes. Is this an indictment of the system; or is it a sign that it is generally working?

For those who aren't familiar with it, Ethereum is often described as a distributed computer. A network of independent and anonymous nodes keep the system running, and on top of it developers can write smart contracts and distributed apps, known as Dapps.

If you go to dappRadar, you can see what sort of apps are currently active on Ethereum. There are casino apps, including vDice, Etheroll, EOSbet. There are a bunch of distributed cryptocurrency exchanges, like IDEX and ForkDelta. And a whole range of games, the most famous of which is probably CryptoKitties.

There are also a collection of ponzis and pyramids. At the time of writing, PoWH 3D was the largest with around 4,500 ETH committed ($2.3 million). There is a gang of other smaller copycat ponzis including EthPhoenix, Proof of Community, Gandhigi, POWM, Proof of Fair Launch, Proof of only Hodling, Revolution1, and more.

Nouriel Roubini mocks the collection of apps built on Ethereum:

Roubini has a point. We've been told that cryptocurrencies like bitcoin and Ethereum were supposed to deliver the unbanked, protect Venezuelans from inflation, help end dictatorships, destroy the banking cartel, take over online commerce from Visa and MasterCard, and undo insidious money transfer businesses like Western Union. But all it's given us are a bunch of games and ponzis. Hardly world changing stuff.


I'm going to try and provide a qualified defence of Ethereum's ponzis. First, I'm going to draw a distinction between ponzi games and ponzi schemes. Let's start with the former. Like a poker game or a lottery, a ponzi game is a zero-sum financial game. Whereas lotteries reward whoever happens to have the winning set of numbers, ponzis reward early birds at the expense of late comers. An honest ponzi game is transparent about this. It doesn't try to camouflage itself as win-win investment opportunity, but flat-out declares that participants can only win if someone else joins the game.

Ponzi games are maintained by an administrator. Their job is to diligently distribute all of the incoming money from new entrants to old entrants. Just like a poker dealer gets a bit of the poker pot, the ponzi administrator gets to take a small cut to compensate them for their time and effort.

Ok, now let's do ponzi schemes. A ponzi scheme is a bastardized version of a ponzi game. First, it isn't transparent. In order to recruit more entrants, a ponzi scheme will market itself as an investment—say a high-yielding everyone-wins-game—not a zero-sum game. As for the administrator, rather than paying out each cent of the late money to the early entrants, he/she is likely to perform what is called an exit scam. This involves fleeing with a large chunk of the funds that are due to game players, thus bringing the game to an early end.   

As I suggested here, the public has an ever-present demand to play ponzi games. This may seem odd, but it's no different from the public's demand to play poker or lotteries. For many people these games are a fun escape from reality, a chance to fantasize about making a big win. Given a demand for ponzis, the world is probably better off with more of the game type and and less of the scheme type. Ponzi schemes hurt people, honestly run games don't. Which is where Ethereum comes in. It seems to be pretty good at providing honest ponzis.


It's worth exploring Ethereum's largest ponzi, Proof of Weak Hands 3D (PoWH 3D), which at its peak on April 3, 2018 had a pot of 16,000 ETH, around US$6.4 million. It has since been depleted to 4,500 ETH as depositors are in full flight.

PoWH 3D isn't structured like a traditional ponzi game. With a traditional ponzi, players buy in at say $1 and cash out at $1 (assuming there is still money left). Before cashing out, they are paid a steady stream of funds from the pot, until the pot is all used up.

With PoWH 3D, the ponzi token has a floating price rather than a fixed one. To begin playing, a participant needs to own some of the already-existing Ethereum payment medium, ether (ETH). By sending some ether to the P3D smart contract (more on smart contracts later), the player get some P3D tokens. The smart contract determines the price at which the purchase is made. For every token purchase the contract will raise the price by a marginal amount, and for every token sale (i.e. sending tokens to the smart contract and getting ether back) the price will be reduced.

So while PoWH 3D is no doubt a version of a ponzi, innovations like the fluctuating price probably make it more fun to play than the traditional type. Below is a chart showing how the price of P3D tokens has behaved over the last few months:


In addition to the floating price mechanism, all purchases of P3D tokens incur a 10% tax. This tax gets distributed to all existing token holders. So if you were to buy ten ETH worth of tokens, one ETH of that would be automatically sent to everyone who is already in the game. The same goes for a sale. If you want to cash in one P3D token, for instance, and the price is 1 ETH, you only get 0.9 ETH, the remaining 0.10 going to all remaining token holders. So the "strong hands", the ones who keep holding, are provided with a constant stream of ether from the "weak hands."

The game is implemented via a smart contract, a bit of code running on top of Ethereum. The advantage of running a ponzi game using a smart contract is that everyone can see the code, and thus understand the rules of the game. Even if a would-be player can't understand the code, they can always find someone who can. The point is, Ethereum ponzis are auditable. And since the code can't be changed, all game players are assured that the rules of the game will stay the same. (The caveat here is that the code can't be buggy; if it is, the pot might be drained by an attacker.)

Proof of Weak Hands 3D is based based off an idea called Ponzi Token, conceived by Jochen Hoenicke in 2017. Writes Hoenicke:
"This is a Ponzi Token. Early investors are paid by the fee later investors pay. All in all it is a zero-sum game. This means, if you make money using the token, then somebody else loses money. If you don't understand this, it is much more likely that you are the one who loses money, in the worst case, your whole investment." 
That's an admirable amount of transparency for a ponzi scheme, don't you think?

So Roubini's derogatory reference to Ethereum ponzi schemes needs to be asterisked. People like to play poker and other zero-sum games like ponzis. PoWH 3D and its many different versions (Revolution1, EthPhoenix etc) fill this need. They aren't "schemes" as I earlier defined them. They are ponzi games. Because they are implemented transparently as smart contracts, they can't be disguised as an investment. Nor can the administrator perform an exit scam. So these are safe, perhaps even innovative, zero-sum games for gamblers to participate in. They're certainly superior to the alternative: scummy underground ponzi schemes.


In the U.S., the SEC has declared all ponzis to be fraudulent. So any ponzi game has to go underground lest it be pursued by the law. And that's exactly when ponzi game administrators are most likely to go rogue and set up an exit scam. When a business is driven underground, the typical trappings of a legitimate commercial entity—a fixed place of doing business, advertising, and branding—are no longer present. So the standards of doing business are lower than they would otherwise be. This means that fly-by-night operators will find it easier to introduce dangerous ponzi schemes, say like Sergei Mavrodi's MMM.

As a decentralized system, Ethereum can't be shut down by the authorities. Nor can the authorities request that certain Dapps be disabled. So legitimate ponzi game administrators can safely re-establish a fixed-place of doing business—on the Ethereum blockchain—without having to fear incarceration. And instead of laying low, they can advertise and brand themselves. A non-sleazy alternative emerges. 

In some sense, Ethereum may be playing a role here that is akin to those charities that provide free needles to drug users. Both drug usage and running a ponzi are punishable offences. Since criminalizing drugs doesn't stop usage, perhaps the best we can do is provide a safe environment for drug users, say by offering free needles and a medically-supervised place to shoot up. This reduces the harm that drug users do to themselves and society. Likewise, Ethereum provides a safe haven for ponzi players to congregate, hopefully displacing some of the more dangerous underground fly-by-night operations that would otherwise attract, and hurt, players.

Providing the world with an open backup platform seems to have some value. Sure, it would be nice to see something more substantial than ponzis and games cropping up on Ethereum, especially given the massive amounts of electricity being sucked up by these distributed systems.

On the other hand, if Ethereum Dapps are a symptom of crackdowns and prohibitions, maybe we should be happy the network doesn't seem to be getting much use, apart from a few games and ponzis—a lack of Dapps might indicate our society is (still) fairly free. Maybe Ethereum is sort of like a fire extinguisher. Just because a fire extinguisher spends most of its time in a closet unused doesn't mean that it is useless. There are certain moments when it could save our lives.     

Thursday, May 24, 2018

A tax, not a ban, on high denomination banknotes

Ken Rogoff has famously called for a ban on high denomination banknotes in order to help combat tax evasion and hurt criminals. But rather than banning notes, why not implement a market-based approach such as a tax? Among other advantages, a tax leaves people with flexibility to determine the cheapest way to reduce their usage of the targeted commodity. This is how society is choosing to reduce green house gas emissions. So why not go the tax route for banknotes too?

My recent post for the Sound Money Project on pricing financial anonymity delves into this idea. The anonymity provided by banknotes is both a "good" and a "bad". People have a legitimate demand for financial alone time; a safe zone where neither their friends, family, government, nor any other third-party can watch what they are buying or selling. These days, cash is pretty much the only way to get this alone time.

But cash's lack of a paper trail can be abused when it used to evade taxes. The resulting gap in government finances forces the honest tax-paying majority to pay more than their fair share for government services. This state of affairs isn't just.

One way to fix this inequity is to raise the price of banknote usage high enough so that it includes the costs that tax evaders impose on everyone else. A tax on banknotes, call it a financial privacy tax, can do this. It internalizes the externality, or the harm done to others. 


Interestingly, financial privacy taxes already exist. For each banknote that it has issued, a central bank typically holds a risk free interest-yielding asset in its vault. In a free market, this interest would flow through to banknote holders, say by the implementation of note serial number lotteries. Rather than allowing the interest to flow through, however, the central bank withholds it. The amount it withholds constitutes the financial privacy tax.

In Canada, for instance, the overnight risk-free interest rate is currently 1.25%. The yield on banknotes being 0%, the Bank of Canada is withholding $1.25 in interest payments for each $100 bill held. So a note-using Canadian is effectively being taxed $1.25 year for each $100 worth of financial privacy he or she chooses to use. Anyone who wants to avoid the tax need only deposit the note into a bank account and earn 1.25% per year.  But once they do that, they will be giving up their privacy.


Modern taxes on banknotes aren't consciously designed as financial privacy taxes. By that I mean, it's not like central bankers have sat down at a conference table and thought long and hard about the costs and benefits of anonymity only to settle on the most appropriate level for the tax. Rather, the size of the tax has been arrived at by accident. Historically, central bankers have simply assumed that it was technologically impossible for banknotes to yield anything other than 0%. (Fully adjustable interest rates on notes, both positive and negative, are actually quite easy to implement, as I'll show). Which means by default, the privacy tax has always been at least as large as the foregone overnight interest rate.

The overnight rate is in turn a function of an entirely different thought process: monetary policy. Central bankers ratchet the overnight rate up or down in order to to hit their chosen inflation target. The problem with this setup is that two separate decisions have been jumbled together. The level at which the central bank sets its financial privacy tax has become the ill-conceived byproduct of its chosen macroeconomic policy.

Here's an example of this muddle. If the Bank of Canada decides to tighten monetary policy tomorrow by increasing its interest rate from 1.25% to 1.5%, it has simultaneously made an entirely separate decision to increase the privacy tax on banknotes by 0.25%. But whereas the monetary policy decision is guided by plenty of data and number crunching, the increase in the privacy tax is purely arbitrary—no thinking has gone into justifying an increase. It's a fait accompli.

Or think about it from another angle. Say that the Bank of Canada has determined that it is appropriate to increase the financial privacy tax by 0.25%. Using its current toolkit, the only way it can accomplish this is by increasing the overnight rate by 0.25%. But this tightening of monetary policy could potentially send the entire economy into a tailspin, all for the sake of satisfying an entirely different policy goal, that of setting the appropriate tax on privacy.

There's no reason that the two decisions can't be split up. The tool that would allow central bankers to do this is the ability to pay positive and negative interest rates on banknotes. I talked about note serial number lotteries as one way to pay positive interest here. Later on in this post I'll discuss a way to pay negative interest. To see how these tools could successfully split the monetary policy decision from the privacy tax decision, let's return to our previous example. If the Bank of Canada were to increase the overnight rate for monetary policy purposes from 1.25% to 1.5%, but it did not want to alter the financial privacy tax, it could simultaneously increase the interest rate on banknotes from 0% to 0.25%. The original 1.25% privacy tax stays intact. While the owner of a banknote is now forgoing the 1.5% overnight rate, he or she is also collecting 0.25% in interest.  

Conversely, these tools would allow the privacy tax to be increased or lowered without requiring a potentially damaging change in monetary policy. Using our example, to increase the privacy tax from 1.25% to 1.5% per year while keeping monetary policy constant, for instance, the Bank of Canada would move the interest rate on banknotes from 0% to -0.25% while keeping the overnight rate at 1.25%. So a banknote owner is now taxed 1.5% per year, of which 1.25% is due to the forgone overnight rate while the other bit is the 0.25% negative interest rate. This has been accomplished without any tightening or loosening of monetary policy. 

So there you go, the monetary policy decision has been split from the privacy tax decision. The advantage of having the ability to split up these two thought processes is that it is now possible to think long and hard about what the proper privacy tax rate should be.


One question we might ask is if the current financial privacy tax on banknotes is sufficiently high. Remember, the problem we are trying to solve is that a small group of citizens are not paying their fair share of income taxes by taking advantage of the untraceability of banknotes. The 1.25%/year financial privacy tax on banknotes that is currently being imposed by the Bank of Canada may not be enough to recoup the damage that this untraceability is doing to everyone else. Maybe we need a 2% tax on banknotes, or 5%, or 10%.

Say we increased the Canadian financial privacy tax rate from 1.25% to 5%. (For now let's not be too concerned about how the tax gets levied. I'll get into that later). One unfortunate side effect is that licit users of banknotes—the unbanked and those who want financial alone time for reasons other than evading taxes and crime—would be caught up in a tax net that is intended for illicit users. This doesn't seem very fair. Might there be a finer sorting mechanism that allow us to tax crooks while letting non-crooks through?

In his controversial book on banning high-denomination notes, Ken Rogoff has proposed exactly this sort of fine sorting mechanism. Based on the assumption that criminal usage of bills is largely confined to high-denomination note, he proposes that only $100s, $50s, and maybe $20 bills be banned. We are interested in a tax in this post, of course, not a ban. But if Rogoff's assumption about criminal usage is right, then a graduated tax on banknotes might be a better option than a flat tax, with higher denominations facing a more aggressive levy than low denomination notes.

All central banks currently tax the full range of banknote denominations at the same rate. In Canada's case, the 1.25% tax rate that is currently applied to a C$1000 bill (yes, we have them in Canada, see top) comes out to the same amount incurred by one hundred $10 bills: $12.50 per year. But a $1000 note is far better for evading taxes because it contains more anonymity services per gram than a $10 note. After all, a bag full of tens is bulky and visible, an envelope with a few $1000 bills isn't.

Given the outsized anonymity provided by the $1000, perhaps we should keep the 1.25% tax rate on $10 bills but boost the tax rate on $1000s to (say) 12.5%. A tax evader who holds a $1000 bill would now incur a tax of $125 instead of just $12.50 while a regular Joe with just a few $10 bills would see no increase in banknote-related taxes. (Heck, it might even be a good idea to reduce the tax on small notes to zero.) By boosting the tax on high denomination banknotes, the Bank of Canada enjoys a larger revenue stream than before. Which means that at least some of the revenue gap due to tax evasion can now be plugged, thus fixing some of the damage inflicted on honest tax payers.


How would we go about increasing the financial privacy tax on high denomination notes?

Central banks currently have a policy of maintaining perpetually fixed exchange rates between various note denominations. Your $10 bill is always convertible into ten $1 bills, and your $100 into ten $10 bills. But this needn't be the case.

To implement the tax, central banks would begin to vary the exchange rate between banknotes. Let's take the U.S. as our example. Instead of redeeming the $100 bill at par, the Federal Reserve would slowly reduce the rate at which it redeems the $100 over time. This ratcheting down of the price of $100s would be passed off to the cash-using public in the form of a capital loss, this capital loss functioning as a tax. (For those with long memories, this is basically Miles Kimball's crawling peg idea, applied to the idea of financial privacy rather than evasion of the zero lower bound).

Let's work through an actual example. Say that the Fed wants to impose an extra 5% financial privacy tax on the $100 bill, but not on other bills. It sets December 31, 2018 as the last day that it will redeem a $100 bill for either: a) $100 worth of central bank deposits; or b) $100 worth of bills in $1s, $5s, $10s, $20s, and/or $50s. On the first day of the new policy—January 1, 2019—a $100 bill can be redeemed for a tiny bit less, say $99.93. Daily reductions continue so that by the end of 2019, the Fed will have scaled its redemption rate back by 5% to $95.

This means that if you deposit a $100 banknote at your bank on December 31, 2019, your bank in turn depositing said note at the Fed, the Fed will credit the bank with just $95 in deposit balances, not $100. In anticipation of this, your bank would have only credited you with $95 when you initially deposited the note. Voila, a financial privacy tax. Everyone holding a $100 note for any period of time will have incurred an 5% annualized tax. But if you hold twenty $5 bills, the tax is avoided.

Continuing with our example, by the end of 2020 the Fed's redemption rate will have declined by another 5% to $90.25. And by the end of 2021, the $100 would be worth $85.74, and on and on.

At some point things start to get a bit silly. By 2031, the market value of the $100 will have fallen below the $50 bill, and by the the first decade of the next century it will be worth less than the $1. To prevent this inversion, the Fed will at some point—say in 2026—demonetize the old issue of $100 bills and introduce a new $100 bill, resetting its market value at $100. The whole process of steady reductions starts anew.


This post has been a heavy one, so I'll just quickly summarize it before signing off.

The anonymity provided by banknote is often abused, but rather than banning notes why not tax the abusers? We wouldn't have to start from scratch. Banknotes yield 0% when overnight rates are positive, so society is already imposing a financial privacy tax of sorts on notes. Unfortunately, central banks set the privacy tax arbitrarily, as the unplanned by-product of monetary policy. New tools for increasing /decreasing the return on banknotes could facilitate a separation of the two decision-making processes. These tools could be used to set a higher tax on large denomination notes while leaving smaller notes untaxed, the true costs of anonymity being recognized for the first time.

P.S. If you're interested in this topic, David Birch has a good post on Austin Houldsworth's Crime Pays System or CPS. It's sort of tongue in cheek, but also quite relevant:
"During this talk, ‘Mr Rogers’ proposed the Crime Pays System, or CPS. Under this system, digital payments would be either “light” or “dark”. The default transaction type would be light, and free to the end users. All transaction histories would be uploaded to a public space (we were of course thinking about the bitcoin blockchain here), which would allow anybody anywhere to view the transaction details. This type of transaction is designed to promote an environment of social accountability.
The alternative transaction type would be dark. With this option, advanced cryptographic techniques would make the payment completely invisible, leaving no trace of the exchange, thus anonymising all transactions. A small levy in the region of 10-20% would be paid per transaction. The ‘Dark Exchange’ would therefore offer privacy for your finances at a reasonable price.
The revenue generated from the use of this system would be taken by the government to substitute for the loss of taxes in the dark economy."
Another worthwhile source is Josh Hendrickson's recent paper "Breaking the Curse of Cash" (written along with Jaevin Park). It's a pretty technical paper, but it explores a model in which coins and paper money circulate, but coins are a burden for illegal traders to use because they make noise, leading to detection.
"If illegal traders impose an externality on society,  the government can generate seigniorage from the illegal traders by setting low rate of return on paper money and providing transfers to legal traders by setting high rate of return on coins. Then the amount of illegal trade is reduced while the amount of legal trade increases. This is a standard solution to an externality problem."

Thursday, May 10, 2018

A case for bitcoin

Mavrodi "biletov"

In this post I'm going to outline a case for bitcoin. I still think bitcoin is a bad medium of exchange and a rubbish store of value. It's just too volatile and unhinged, and it'll always be that way. But bitcoin still has an important role to play... just not the role that most people assume.

Sara Hess and Eugene Soltas recently published a fascinating article on the life of Russian ponzi-scheme architect Sergei Mavrodi, who passed away last month. I found it interesting that in the latter part of his career, Mavrodi openly advertised that his schemes were pyramids, yet people still bought in.

This got me thinking. I've always sort of assumed that ponzi schemers were just con men who fooled innocent people into giving up there money. But even after Mavrodi lifted his skirt and told the truth, people still flocked to join his schemes. Maybe there is a constant demand on the part of willing and informed individuals for ponzis. Which would mean that folks like Mavrodi aren't just conmen. Rather, society genuinely needs them to manage ponzi games.


We already knew that anyways, you might say. After all, Las Vegas exists, right?

The role that lottery and casinos operators play is certainly similar to that played by ponzi schemers. People take joy in gambling, and lottery operators and croupiers make sure these games run smoothly. Ponzis, lotteries, and poker are all versions of a zero sum game. If you win $10, it's only because someone else who was playing the game lost $10. Zero sum games are different from win-win games, say like stocks, bonds, and other liabilities including banknotes. Someone doesn't have to lose $10 on Google shares for you to be able to make $10 on Google. The underlying business generates income from its customer base and this provides each and every shareholder with a return.

What differentiates one type of zero-sum game from another is the rule used for redistributing money from losers to winners. Ponzis and pyramids are early-bird zero sum games: the jackpot goes to the earliest entrants and is funded by money provided by the latest entrants. A lottery, on the other hand, awards a randomly chosen participant with everyone else's money. Being the last buyer of a lottery ticket provides one with the same odds of winning the jackpot as the first buyer.

The coexistence of different types of zero sum games indicates that while the public has an ongoing demand for the chance to win jackpots, it also values the way those jackpots are rewarded. Perhaps early bird game like a ponzis provide a different set of psychic returns than other zero sum games; getting in line early and looking back at all the late comers may offer a sense of satisfaction that a lottery can't provide.

Society has typically legalized lotteries while criminalizing ponzis and pyramids, although in Mavrodi's case there was some ambiguity since he cheekily advertised them as ponzis rather than trying to decieve the publi. Luckily for authorities, ponzis and pyramids are easy targets. They have central points of failure. An administrator needs to collect money from new entrants and then pay it out to older entrants. So there is a physical entity with an address that can be sued by unhappy participants or pursued by the authorities.

Because they are illegal, ponzis have been driven underground. Unfortunately, the delegitimization of markets can have perverse effects. For instance, street drugs are often mixed with dangerous contaminants, say like how heroin is laced with carfentanil, an elephant tranquilizer. If the drug market were brought into the open, it could be that producers would be pressured by market forces to provide a purer product and fewer users would die from accidental overdoses.

The same argument applies to ponzis. Those who play them have to rely on fly-by-night operators who may abscond with the funds at any moment, the ponzi collapsing before reaching its natural end. If ponzis were legitimized, it would be much easier to have a transparent and well-run ponzi market.


Like ponzis and pyramids, a chain letter is an early-bird game, a type of zero-sum game that use entrance order as its redistribution rule. And like ponzis and pyramids, they are illegal. The Circle of Gold chain letter that began in San Francisco in 1978 and spread to the rest of the U.S. through 1979 and 1980 is a good example of the genre.

In brief, I buy an existing copy of the letter from you for $50, and simultaneously mail $50 to the name at the top of the list, for a total outlay of $100. I then make two copies (removing the name at the top of the list an inserting my own at the bottom) and sell them for $50 each, for a total of $100, thus breaking even. By selling the letters directly rather than sending them via the mail, presumably I avoid mail fraud. The buyers in turn make copies and sell them on, the chain continuing. Once my name starts arriving at the top of the list the money will pour in. The letter exhorts recipients not to break the chain.

Whereas a ponzi relies on a central node—or operator—for managing the game's flow of funds, a chain letter decentralizes the role of operating the system. Any participant who has bought a copy of the letter is delegated the job of faithfully modifying their version of the ledger (by removing the name at the top and inserting theirs at the bottom), sending the $50 by mail, and then passing the updated ledger on. Lacking attackable central nodes, chain letters are more difficult for the authorities to shut down than ponzis.

There are still a few key flaws with a chain letter. The first is that everyone who joins the chain letter needs to leave their physical address. And so it is possible for the authorities to target participants by getting a copy of the chain letter, visiting their home, and shutting it down that way. To avoid this risk, many would-be ponzi players will probably choose not to play.

The second flaw is that chain letters are not secure. Each participant has an incentive to mis-copy the list and put themselves at the top, thus cutting into the queue. This lack of credibility hurts the chain letter's ability to propagate.


All of which gets me back to bitcoin.  Bitcoin is not a win-win game. It is a zero-sum game that uses entrance order as its redistribution rule, or an early bird game like a ponzi, pyramid, or chain letter. The only way to get ahead is if a subsequent participant buys one's bitcoins at a higher price.

But bitcoin brings a few unique features to the table. To begin with, Bitcoin is decentralized. Rather than a lone administrator like Sergei Mavrodi handling the scheme, the ledger is maintained by a disparate set of nodes. This makes bitcoin much harder to shut down than a ponzi.

Chain letters are also decentralized, but Bitcoin doesn't inherit the weaknesses of a chain letter. Although there are many different copies of the bitcoin ledger, these copies are constantly being checked against each other to ensure that they are all in sync. This means that—unlike a chain letter—there is no way to budge in line, say by re-writing the bitcoin ledger in one's favour. And this improves the durability of bitcoin.

Before I bring this all together and make my case for bitcoin, there is one other early bird game I haven't got into yet: the speculative bubble.


Unlike chain letters, ponzis, and bitcoin, which are pure early bird games, bubbles occurs on the back of an already useful asset, say like a stock or commodity. During the late 1990s internet mania, for instance, the return on an internet stock could be decomposed into two components: a fundamental component and a zero-sum game that was being played on top of the stock's fundamental value. Those playing a zero sum game by purchasing internet stocks didn't give a damn whether the underlying internet business made sense. No, they were betting that a late-comer would arrive to take the stock off their hands at a much higher price.

To a fundamental investors (say like Warren Buffett), zero-sum game players are a nuisance. The zero sum game that they are playing adds a wasteful premium to stocks, pricing fundamental investors out of the market. At the same time, zero sum game players are probably just as annoyed by the fundamental component of the asset they are buying and selling. Its presence dampens the jackpot that they stand to win.

Prices provide useful signals to society. A zero-sum game that runs on top of an intrinsically valuable asset like a stock or a commodity distorts that signal. This can lead to wasted resources. Producers who decide to add capacity—say a new production plant—in response to a commodity's high price may only be reacting to the transitory mood changes of those playing that commodity's attached zero-sum game, and not a fundamental need for new supply.


So having said all that, let me finally make my case for bitcoin. Bitcoin shouldn't be categorized along with monetary instruments like bank deposits, coins, and banknotes. Nor does it belong in the same category as win-win games like the stock and bond market. No, bitcoin should be grouped with other zero-sum games such ponzis, pyramids, speculative bubbles, and chain letters.

But this isn't necessarily a bad thing. It should be embraced.

City planners build bike lanes in order to prevent the dangerous mixing of cars and bikes. Likewise, if people who are playing zero-sum games on top of regular stocks and commodities can be diverted into bitcoin (and other pure early bird games like ponzis) instead, maybe that would make for a more ordered financial system. Early-bird games that are played on top of useful assets taint their price, and thus play havoc with the signal this price provides. But bitcoins, ponzis, and chain letters have no use as commodities, so there is no underlying real good that can be contaminated by the presence of zero-sum game players.

When criminalization drives ponzis underground, the supply of trustworthy ponzis shrinks and the supply of untrustworthy ones increases. Bitcoin has a role to play here. It is an open system. The set of rules that governs it are automatic and available for all to see, unlike the closed books of a ponzi administrator. There is no way for the system operator to abscond with everyone's funds. So bitcoin is a safer zero-sum game than an illegal ponzi. If people have a genuine need to play zero-sum games, shouldn't they at least be able to play a good one?

Is bitcoin expensive? Sure. Lots of electricity is required to ensure the integrity of bitcoin. But if bitcoin has managed to displace a bunch of poorly-run underground ponzis and pyramids, as well as reducing the signal-destroying participation of zero-sum game players in traditional financial markets, maybe the expense was worth it.

Friday, April 27, 2018

There's water everywhere, but John Taylor wants us all to be thirsty

"Water water everywhere, and not a drop to drink" - Rime of the Ancient Mariner (Gustave Doré woodcut)

In a recent paper, John Taylor rhapsodizes about bringing back the good ol' federal funds market:
I think the case can be made for such a framework. Peter Fisher ran the trading desk at the New York Fed for many years, and knows well how these markets work. His assessment is that such a framework would work, saying “we could get back and manage it with quantities; it’s not impossible. We could just re-engineer the system and go back to the way we were.” I spent time in the markets for federal funds watching how they operated in those days, and I wrote up an institutional description of how good experienced people traded in these markets, and I developed a model showing how the market worked.
The fed funds market is currently moribund, but just a few years ago it was buzzing with activity. Banks that didn't have enough reserves at the end of the day to meet requirements could go to the fed funds market and buy them from banks who had excess reserves, the price they negotiated referred to as the fed funds rate.

I disagree with John Taylor. Resuscitating the fed funds market is not a good idea. The fed funds market is no longer used because the Federal Reserve has stuffed the market with so many reserves that banks no longer need to buy them from other banks to meet their requirements. But this cornucopia is a good thing. Any effort to bring back the fed funds market would ruin it.

Let's set up an analogy. Imagine a country called Waterland that gets tons of rain and has plenty of lakes and rivers. Since everyone has immediate access to water, there is no market for the stuff. The price of water is zero. Say that the government establishes control over the waterways and rainfall. It decides to limit the amount of water that is available to the citizens of Waterland. In response to this artificially-imposed scarcity, a market develops in which citizens buy and sell water among each other. 

Markets are great. They allow those with too little of something to trade with those who are good at conserving what they need, both sides improving their lot in life. But this particular market should never have existed in the first place. Water is plentiful in Waterland, and so it should be a free good, not a market-traded one. The entire apparatus that has been built around the exchanging of water—informed dealers, speculators, exchanges, warehouses, networks for transporting water to and from market, auditors and lawyers involved in verifying water transactions—represents a waste. By consuming resources in constructing and operating the market, other more important projects never see the light of day. If the absurd water scarcity were to be removed, the market for water would disappear, freeing up resources for more socially beneficial uses. 

Reserves, like water in the previous example, should by all rights be free. The only effort the Fed incurs in introducing a new unit of reserves into circulation is a keystroke or two. This means that the Fed can provide a bunch of new reserves, say by conducting open market operations, without incurring any costs whatsoever. As the Fed continues to mouse-click new reserves into existence, the demand that each individual bank has for reserves will eventually be satiated. Once that point is reached not a single bank will need to bid for the reserves of another bank, and so there will be no activity in the market for reserves. The fed funds market is effectively dead, as is currently the case.

Taylor wants to bring back the fed funds market. But this would mean putting an artificial constraint on the amount of reserves that the Fed supplies, much like Waterland's frivolous constraint on water. Banks, their satiation for reserves now being replaced by an artificial hunger, would suddenly be willing to pay a fee to other banks in order to get their hands on some reserves.

A whole fed funds trading apparatus would re-emerge. Traders would have to be hired and trained to to fill newly-formed fed funds desks. Bank resources would be diverted away from other valuable projects towards plotting the best way to time outgoing payments, the idea being to reduce the need to hold reserves in order to lend them out in the fed funds market. The Fed itself would have to rehire Peter Fisher to run its open market desk. All of this would be an expensive investment of time and money, diverting resources from other more socially beneficial activities.

In calling for a return to the days of an active fed funds market, it is as if Taylor were advocating for an artificial constraint to Waterland's supply of water, solely because he admired the market for water that emerged. Never mind that the whole water trading apparatus, though wonderfully efficient, represents a massive missallocation of resources. Given that I'm pretty sure Taylor would not want to kickstart a water market in a hypothetical Waterland, I don't understand why he is so keen to reboot the fed funds market.

Sunday, April 15, 2018

Critiquing the Carney critique of central bank digital currency

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

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

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

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

Carney's contention is that the introduction of a digital currency could hurt the banking system:
"...a general purpose CBDC could mean a much greater role for central banks in the financial system. Central banks may find themselves disintermediating commercial banks in normal times and running the risk of destabilising flights to quality in times of stress."
First, let's deal with Carney's normal times critique. The idea here is that by introducing a digital version of the banknote, a significant proportion of existing depositorsthose with chequing and savings accountswill desert their bank because they want to hold sleek and shiny central bank digital currency instead. (Presumably they didn't desert their banks when banknotes were around because cash was bulky and couldn't be transferred instantaneously over a communications network.) By causing a mass draining of depositsi.e. disintermediating commercial banksa new digital currency would impair the ability of banks to make loans, and this would affect the economy in a negative way. 

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

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

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

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

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


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

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

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

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

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

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


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

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

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

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

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