Sunday, September 23, 2018

Did Brexit break the banknote?

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

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

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

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

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

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

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

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

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

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

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

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

Source: Bank of England

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

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

Friday, September 7, 2018

"The Narrow Bank"

 A strange new bank called TNB, or The Narrow Bank, recently applied to get a clearing account at the Federal Reserve Bank of New York, only to be refused. Funny enough, TNB is run by the New York Fed's former director of research James McAndrews, who left in 2016 in order to get the bank up and running. McAndrews and TNB are now suing the New York Fed.

There's a backstory to all of this kerfuffle. While still employed by the New York Fed, McAndrews coauthored a paper in 2015 entitled Segregated Balance Accounts. The paper proposed a solution to the following problem. Interest rates in wholesale lending markets were refusing to align with each other. Wholesale markets are the sorts of markets which neither you nor I have access to but are reserved for large institutions. For some reason, banks that kept interest-bearing overnight accounts at the Fed were not passing the rate they earned on these accounts to other overnight lending markets in which they were active, say the repo market or the federal funds market. The fed funds rate, for instance, tended to always be 0.2% or 0.3% below the interest rate the Fed paid to depositors.

Why wasn't this gap being arbitraged? After all, if a bank can deposit funds at the Fed and earn 1.95% overnight, then by borrowing in the fed funds market at, say, 1.85%, and putting the proceeds in its Fed account, said bank can earn a risk free return 0.1%. The ensuing competition to profit from this arbitrage should drive the fed funds rate within a hairline of the rate paid by the Fed to depositors. But the massive 0.2-0.3% gap implied that this trade was not being made. 

McAndrews and his co-authors posited that the fed funds market was crippled by a lack of competition. Specifically, there seemed to be a limited number of credible borrowers willing & able to wade into the fed funds market to conduct the trade. This group of borrowers was too small to absorb the funds of all the institutions that were shopping around to lend in the fed funds market. For the most part these lenders did not qualify to get interest from the Fed and were confined to buying fed funds. Thus the small group of borrowers operating in this market exercised a degree of bargaining power over the lenders, allowing them to extract artificially low borrowing rates.

The idea behind the paper was to have the Fed fix these rate distortions by re-introducing competition among borrowers in overnight wholesale lending markets. In short, all those banks that were not considered sound enough to qualify as fed funds borrowers would be able to partner with the Fed to offer risk-free accounts. Specifically, these banks would be able to go to a wary lender and say, "hey, if you lend to us we'll keep your funds hived off from all of our other assets by just depositing them directly at the Fed."

To sanctify this promise, the Fed would create a new type of account, a segregated balance account, or SBA. Once a customer had deposited funds at the the borrowing bank, the bank would transfer these funds into an SBA at the Fed. If the borrowing bank went bust, the swarm of creditors pursuing the bank's assets would not be able to touch the funds locked into its Fed SBAs. The bank itself could not use the funds in an SBA for any other purpose than paying back its customer. By hiving off a wary customers' funds, a risky bank could emulate a Fed account and re-enter wholesale lending markets.

The interest that the bank earned on SBAs would be passed-through to its customer, less a small fee incurred by the bank for providing the service. So if the Fed was paying 1.95% on deposits, the bank might be able to offer 1.90%, thus keeping 0.05% for itself. And since borrowers in the fed funds market were only offering 1.75%, say, then lenders would would avoid them, preferring to invest their funds at banks that offered an SBA solution. To compete, a borrower in the fed funds market would have to offer at least 1.90% themselves. Thus the various wholesale interest rates would be in better alignment.


Maybe upper level Fed officials took McAndrews aside and said, hey James, we're not going to implement this idea. And he thought to himself, but this is a good idea, why don't I run with it by setting up a private bank. I'm not sure, but whatever the case McAndrews quit the Fed and co-founded The Narrow Bank in what seems to be an effort to implement a market-provided version of SBAs.

TNB is a designed as a pure warehousing bank. It does not make loans to businesses or write mortgages. All it is designed to do is accept funds from depositors and pass these funds directly through to the Fed by redepositing them in its Fed master account. The Fed pays interest on these funds, which flow through TNB back to the original depositors, less a fee for TNB. Interestingly, TNB hasn't bothered to get insurance from the Federal Deposit Insurance Corporation (FDIC). The premiums it would have to pay would add extra costs to its lean business model. Any depositor who understands TNB's model wouldn't care much anyways if the deposits are uninsured, since a deposit at the Fed is perfectly safe.

In theory, TNB (and any potential copycat) should fix the competition problem that McAndrews and his coauthors alluded to in their Segregated Balance Accounts paper. Presumably all those lenders in the fed funds market that can't find suitably sound borrowers, and thus submit to being gouged by the only banks that qualify, will turn to TNB. After all, TNB is clean. Unlike regular banks, it doesn't partake in all of the traditional banking activities that make a bank risky, such as lending to consumers or businesses, or trading for their own accounts. TNB does one thing only, it acts as a portal to the Fed. Since TNB collects 1.95% from the Fed and has minimal costs, it should be able to pay interest of around 1.90% to its customers, who might otherwise get a paltry 1.75% from competing borrowers operating in the fed funds market. Thus the presence of TNB should remove, or at least minimize, some of the distortions in wholesale lending markets.   

But all is for nought. The Fed has refused to grant TNB a master account. John Cochrane has recently blogged about this as well as helpfully uploading the lawsuit that TNB has filed against the New York Fed. We don't know why Fed officials are dragging their heels, so all we can do is speculate. Cochrane has a few theories, including potential worries among Fed officials about controlling the size of its balance sheet.


But even if TNB succeeds in its lawsuit, there is a larger threat. The gap the bank is trying to exploit is shrinking. Back in 2016 when McAndrews and his colleagues first embarked on the effort to build a new bank, the fed funds rate was typically 13 to 14 basis points below the rate offered by the Fed. Fourteen basis points was a lot of rope for TNB to work with. But this gap has since shrunk to just 4 basis points (see chart below). Possibly wholesale markets have become more competitive while the bank was being constructed, in which case there may no longer be much of a role for TNB to play. If TNB borrows at 1.91% and invests at 1.95%, that doesn't leave it much wiggle room to pay its fixed costs and salaries.

Even if the gap disappears, could TNB serve as more than just a conduit for engaging in arbitrage? Let's say that in the future rates have normalized. Banks now offer to lend at an overnight rate that is in-line, or even exceeds, the rate that the Fed pays to depositors. TNB no longer has a sweet deal to offer. Even then, large institutions who can't directly bank at the Fed may like the idea of keeping an account at TNB. Although they will earn slightly less then they otherwise would in competing overnight markets, the Fed is a risk-free place to park one's money, unlike say the fed funds market. These institutions could also invest in treasury bills. But even though a treasury bill would provide a higher return than parking funds at the Fed, there is always a risk that it cannot be immediately sold for its face value. Put differently, a treasury bill has duration risk. Funds held at the Fed via TNB have no duration risk. They can be withdrawn in a moment at par.


How big might this demand be? Interestingly, TNB isn't the first of its kind. On Twitter, Karl Storvik informs me that an analog exists in Norway, the Safe Deposit Bank of Norway. SDBN is a self described "conduit" established in 2013 to provide ultra-high net worth individuals, asset managers or corporate treasurers a means to park funds at the Norges Bank, Norway's central bank.

According to the SDBN's website, its license prevents it from holding any other asset than Norges Bank deposits. The interest that the central bank pays on these deposits flow back to SDBN's customers, SDBN taking a fee for itself. This is basically TNB, Norwegian style. But as best I can tell, SDNB's function isn't to arbitrage small differences between the rate of interest that the Norges Bank pays and other overnight rates. It is trying to provide a product that is in and of itself useful to folks like high net worth individuals and corporations.

From a glance at its most recent balance sheet, I'd say that The Safe Deposit Bank of Norway hasn't been terribly successful. Sure, it is still in start-up phase, but as of the end of 2017 it had only NOK 53 million on deposit at the Norges Bank, or a piddling US$6.3 million. Assuming TNB gets Fed approval, one wonders if this wouldn't be its fate as well.


Matt Levine has an interesting take on the whole thing. What if TNB were to allow regular folks like you and me to open an account? The overhead involved in serving a retail customer base would be higher than if TNB served a purely institutional clientele, notes Levine: "you’d need at least a website, a customer service department, ATM cards—but the opportunity is intriguing." But unlike a regular bank it wouldn't need to hire loan evaluators or absorb credit losses. So TNB might be able to provide many of the same payments capabilities as a regular bank (debit card payments, ACH payments, and wire transfers), but pass through a larger share of central bank interest payments to depositors.

If it went this route, TNB wouldn't be the first financial institution to operate as a narrow bank, i.e. to swear off lending in order to focus solely on satisfying the public's payments requirements. This is exactly what mobile money platforms like M-Pesa do. Mobile money providers accept incoming customer funds, park this money in trust at a bank, and issue 100%-backed liquid IOUs to the customer. These IOUs can be used to buy stuff at retailers or exchanged with other users on a person-to-person basis. Unfortunately, liquid deposits held in trust at the commercial bank don't yield much interest, so even if a mobile money operator wanted to flow some interest through to its customers it wouldn't have much to draw on.

The novelty introduced by a retail-facing TNB is that the customer's funds would be parked directly at the central bank instead of an intervening commercial bank. So central bank interest payments could flow straight to the narrow bank rather than being sucked up by an intermediary. And so it would be possible, in theory at least, for TNB to offer retail depositors not only a useful payments option but also a financially meaningful flow of interest.

That seems like a decent financial innovation, no? For instance, the Bank of Canada currently pays 1.25% to banks that have clearing accounts, while I make a meagre 0.15% on my no-fee chequing account. If a Canadian version of TNB could offer me a 1% interest rate on an absolutely-no-frills account with a debit card attached to it, I'd definitely consider it. If James McAndrews and TNB get rebuffed by the Fed, maybe they should come up here and try the Bank of Canada.

P.S. By coincidence, I recently wrote about some of James McAndrews work on financial privacy at the Sound Money Project. And he commented on my Cato Unbound proposal to introduce taxed $500 and $1000 banknotes. Small world.

Friday, August 31, 2018

Norbert's gambit

I executed one of the oddest financial transactions of my life earlier this week. I did Norbert's Gambit.

These days a big chunk of my income is in U.S. dollars. But since I live in Quebec, my expenses are all in Canadian dollars. To pay my bills, I need to convert this flow of U.S. dollars accumulating in my account to Canadian dollars.

Outsiders may not realize how dollarized Canada is. Many of us Canadians maintain U.S. dollar bank accounts or carry around U.S. dollar credit cards. There are special ATMs that dispense greenbacks. Canadian firms will often quote prices in U.S. dollars or keep their accounting books in it. I suppose this is one of the day-to-day quirks of living next to the world's reigning monetary superpower: one must have some degree of fluency with their money.

Anyways, the first time I swapped my U.S. dollar income for loonies I did it at my bank. Big mistake. Later, when I reconciled the exchange rate that the bank teller had given me with the actual market rate, I realized that she had charged me the standard, but massive, 3-4% fee. In an age where the equivalent fee on a retail financial transaction like buying stocks amounts to a minuscule $20, maybe 0.3%, a 3-4% fee is just astounding. But Canadian banks are an oligopoly, so no surprise that they can successfully fleece their customers.

So this time I did some research on how to pull off Norbert's gambit, one of the most popular work-a rounds for Canadians who need to buy or sell U.S. dollars. From a moneyness perspective, Norbert's gambit is a fascinating transaction because it shows how instruments that we don't traditionally conceive as money can be recruited to that cause. The gambit involves using securities listed on the stock market as a bridging asset, or a medium of exchange. More specifically, since the direct circuit (M-M) between U.S. money and Canadian money is so fraught with fees, a new medium--a stock--is introduced into the circuit (like so: M-S-M) to reduce the financial damage.

To execute Norbert's gambit, you need to move your U.S. dollars into your discount brokerage account and buy the American-listed shares of a company that also happens to be listed in Canada. For instance, Royal Bank is listed on both the Toronto Stock Exchange and the New York Stock Exchange. After you've bought Royal Bank's New York-listed shares, have your broker immediately transfer those shares over to the Canadian side of your account and sell them in Toronto for Canadian dollars. Voila, you've used Royal Bank shares as a bridging medium between U.S. dollar balances and Canadian ones.

These days, Norbert's gambit no longer requires a New York leg. Because the Toronto Stock Exchange conveniently lists a wide variety of U.S dollar-denominated securities, one can execute the gambit while staying entirely within the Canadian market. In my case, I used a fairly liquid Toronto-listed ETF as my temporary medium of exchange, the Horizon's U.S. dollar ETF, or DLR. I bought the ETF units with my excess U.S. dollars and sold them the very next moment for Canadian dollars.

Below I compare how much Norbert's gambit saved me relative to using my bank:

Using the ETF as a bridging asset, I converted US$5005 into C$6465, paid $19.90 in commissions, for a net inflow of $6,445.10 Canadian dollars into my account. Had I used my bank, I would have ended up with just $6265, a full $180 less than Norbert's gambit. That's a big chunk of change!

What is occurring under the hood? Norbert's gambit is providing a retail customer like myself with the same exchange rate that large institutions and corporations typically get i.e. the wholesale rate. Because there is a market for the DLR ETF in both U.S. dollar and Canadian dollar terms, an implicit exchange rate between the two currencies has been established. Call it the "Norbert rate". Large traders with access to wholesale foreign exchange rates set the Norbert rate by buying and selling the DLR ETF on both the U.S. and Canadian dollar side. If any deviation between the Norbert rate and the wholesale exchange rate emerges, they will arbitrage it away. Small fish like myself are thus able to swim with the big fish and avoid the awful retail exchange rate offered by Canadian banks.

This workaround is called Norbert's gambit after Norbert Schlenker, a B.C-based investment advisor who it to help his clients cut costs. Says Schlenker in a Globe & Mail profile:
"In 1986 I moved down to the States, and while I was there I needed to be able to change funds from U.S. dollars to Canadian and vice-versa, and I had a brokerage account in Canada. It came to me that I could use interlisted stocks to do this."
Thanks, Norbert!

But using stock as money isn't just a strange Canadianism. Back in 2014, I wrote about other instances of stocks serving as a useful medium-of-exchange. During the hyperinflation, Zimbabweans used the interlisted shares of Old Mutual to evade exchange controls, lifting them from the Zimbabwe Stock Exchange to London. Earlier, Argentineans used stocks (specifically American Depository Receipts) in 2001 to dodge the "corralito". But I never imagined I'd use this technique myself to skirt around Canada's banking oligopoly!

Thursday, August 23, 2018

Europe's SWIFT problem

SWIFT headquarters in Belgium (source)

German foreign minister Heiko Maas recently penned an article in which he said that "it’s essential that we strengthen European autonomy by establishing payment channels that are independent of the US, creating a European Monetary Fund and building up an independent Swift system."

So what exactly is Maas's quibble with SWIFT, the Society for Worldwide Interbank Financial Telecommunication? SWIFT is a proprietary messaging system that banks can use communicate information about cross border payments. This November, U.S. President Trump has threatened to impose sanctions on SWIFT if it doesn't remove a set of Iranian banks from the SWIFT directory.

For Heiko Maas, this is a problem. Iran and Germany remain signatories to the same nuclear deal that Trump reneged on earlier this year. The deal committed Iran to cutting back its uranium enrichment program and allowing foreign inspectors access to nuclear sites, in return obligating signatories like Germany to normalize economic relations with Iran, including allowing the unrestricted sale of oil. If Iran is bumped from SWIFT, it could prevent Germany from meeting its side of the deal, potentially scuppering the whole thing. So a fully functioning SWIFT, one that can't be manipulated by foreign bullies, is key to Germany meeting its current foreign policy goals.

SWIFT is vital because it is a universal standard. If I want to send you $10,000 from my bank in Canada to your bank in Singapore to pay for services rendered, bank employees will use SWIFT terminals and codes to communicate how to manipulate the various bank ledgers involved in the transaction. If a bank has been banished from SWIFT, then it can no longer use what is effectively a universal banker's language for making money smoothly flow across borders.

It would be as-if you were at a party but unlike all the other party-goers were prohibited from using words to communicate. Sure, you could get your points across through hand gestures and stick drawings, but people would find conversing with you to be tiring and might prefer to avoid you. Without access to SWIFT, Iranian banks will be in the same situation as the mute party-goer. Sure, they can always use other types of communication like email, telex or fax to convey banking instructions, but these would be cumbersome since they would require counterparties to learn a new and clunky process, and they wouldn't necessarily be secure.

It seems odd that Maas is complaining about SWIFT's independence given that it is located in Belgium, which is home territory. But Trump, who is on the other side of the Atlantic, can still influence the network. The way that he plans to bend SWIFT to his will is by threatening members of its board with potential asset expropriations, criminal charges, travel bans, as well as punishing the companies they work for by restricting them from conducting business in the U.S.

How credible is this threat? As I pointed out here...

...SWIFT's board is made up of executives from twenty-five of the world's largest banks, including two Americans: Citigroup's Yawar Shah and J.P Morgan's Emma Loftus. No matter how erratic and silly he is, I really can't imagine Trump following up on his threat. Would he ban all twenty-five banks, including Citigroup and J.P. Morgan, from doing business in the U.S.? Not a chance, that would decimate the global banking system and the U.S. along with it. Requiring U.S. banks do stop using SWIFT would be equally foolish. Would he risk ridicule by putting two American bank executives—Shah and Loftus—under house arrest for non-compliance? I doubt it.     

No, the SWIFT board is TBTP, or too-big-to-be-punished. But even if Trump's threat is not a credible one, surely SWIFT will fall in line anyways. Large international businesses generally comply with the requests of governments, especially the American one. But there's a kicker. European law prohibits European businesses from complying with foreign sanctions unless the have secured EU permission to do so. This leaves SWIFT in an awfully tight place. Which of the two jurisdictions' laws will it choose to break? Assuming it can't get EU permission to comply with U.S. sanctions, then it can either illegally comply with U.S. law, or it can legally contravene U.S. laws. Either way, something has to give.  

Europe can win this battle, a point that Axel Hellman makes for Al-Monitor. After all, SWIFT is located in Belgium, not New York, and jurisdiction over SWIFT surely trumps lack of jurisdiction. Indeed, on its website SWIFT says that its policy is to defer to the EU on these matters:
"Whilst sanctions are imposed independently in different jurisdictions around the world, SWIFT cannot arbitrarily choose which jurisdiction’s sanction regime to follow. Being incorporated under Belgian law it must instead comply with related EU regulation, as confirmed by the Belgian government."
Consider too that SWIFT itself is supposed to be committed to a policy of non-censorship. Chairman Yawar Shah once said that “neutrality is in SWIFT’s DNA.” So from an ideological perspective it would seem that SWIFT would be aligned with Europe's more inclusive stance.

Of course, SWIFT's stated commitment to neutrality conflicts with the fact that it has banned Iran from the network before. In early 2012, U.S. pressure on SWIFT grew in the form of proposed legislation that would punish the messaging provider should it fail to ban Iranian users. SWIFT prevaricated, noting in early February that it would await the "right multilateral legal framework" before acting. In March 2012, the EU Council passed a resolution prohibiting financial messaging providers from servicing Iranian banks, upon which SWIFT disconnected them. It was only in 2015, after passage of the nuclear deal, that SWIFT reconnected Iran. (I get this timeline from the very readable Routledge Global Institutions book on SWIFT, by Suzan Scott and Markos Zachariadis).

The takeaway here is that SWIFT only severed Iranian banks in response to European regulations, in turn a product of a conversation between American and European leaders. SWIFT will seemingly compromise its neutrality if there is a sufficient level of global agreement on the issue followed up by a European directive, not an American one.

If Heiko Maas wants an "independent SWIFT," the above analysis would seem to illustrate that he already has it. Thanks to its European backstop, SWIFT is already independent enough to say no to U.S. bullying. As long as they are willing, European officials can force a showdown over SWIFT that they are destined to win, thus helping to preserve the Iranian nuclear deal.

But maybe European officials don't want to go down this potentially contentious path. Perhaps they would prefer to preserve the peace and grant SWIFT an exemption that allows the organization to comply with U.S. sanctions, thus cutting Iran off from the messaging network, while trying to cobble together some sort of alternative messaging system in order to salvage the nuclear deal. Maybe this alternative is what Maas is referring to when he talks of a building an "independent SWIFT."

An alternative messaging service would have to be capable of providing bankers with sufficient usability so that Iranian oil sales can proceed fluidly. In a recent paper, Esfandyar Batmanghelidj and Axel Hellman give some clues into what this system would look like. During the previous SWIFT ban, several European banks were able to maintain their relationships with Iranian financial institutions by using "ad hoc messaging systems." These ad hoc solutions could be revived, note Batmanghelidj and Hellman.

Using this ad hoc system, so-called gateway banks—those that have both access to the ECB's large value payments system Target2 and limited exposure to the U.S. financial system—would conduct euro transactions on behalf of buyers and sellers of Iranian oil. Since presumably only a few gateways would be necessary to conduct this trade, it would be relatively painless for them to learn the new messaging language and the set of processes involved. For instance, instead of using SWIFT bank identifier codes to indicate account numbers, Batmanghelidj and Hellman point to the possibility of using IBAN numbers, an entirely different international standard.

This independent ad-hoc system would probably work, on the condition that the European monetary authorities continue providing gateway banks that serve Iranian clients with access to the ECB's Target2 payments system. This is a point I stressed in my previous blog post. It isn't access to SWIFT that is the lynchpin of the nuclear deal, it is access to European central banks. But as long as folks like Heiko Maas get their way, I don't see why this sponsorship wouldn't be forthcoming. In response, Trump could always try to sanction the European central bank(s) that allow this ad-hoc system to continue. But an escalation of U.S. bullying from the mere corporate level (i.e. SWIFT) to the level of a friendly sovereign nation would constitute an even more nutty policy. I just don't see it happening.

At stake here is something far larger than just Iran. As I recently wrote for the Sound Money project, financial inclusion is a principle worth fighting for. If one bully can unilaterally ban Iran from the global payments system, who is to say the next victim won't be Canada, or Qatar, or Russia, or  China? Europe needs to stand up to the U.S. on this battle, either by forcing a SWIFT showdown or by sponsoring an ad hoc alternative—not because Iran is an angel—but because we need censorship resistant financial utilities.

Friday, August 17, 2018

Two notions of fungibility

A few centuries ago, lack of fungibility used to be a big weakness of monetary systems. But technological and legal developments eventually solved the problem. Nascent systems like bitcoin are finding that they must wrestle all over again with fungibility issues.

Fungibility exists when one member of a population of items is perfectly interchangeable with another. So for instance, because your grain of wheat can be swapped out with my grain without causing any sort of change to our relative status, we would say that wheat grains are fungible. Fungibility is a desirable property of a monetary system. If all monetary items are interchangeable, then trade can proceed relatively smoothly. If monetary items are not fungible, then sellers cannot accept the monetary item without pausing for a few moments to verify and assay it, and this imposes frictions on trade.   

In this post I argue that there are two ways for something to be fungible. They can be fungible for physical reasons or for legal reasons.

By physical fungibility, I mean that members of a group are objectively indistinguishable from each other. In the previous example, our wheat grains are physically fungible because a cursory inspection shows that they look, feel, and smell exactly the same. Now, a deeper analysis might reveal that the two grains are not in fact perfectly fungible. For instance, it may be the case that your grain of wheat is the hard red winter variety and mine is durum, in which case they are not substitutes, durum being better for making pasta. Or perhaps we each have durum grains, but yours enjoyed an excellent growing season—plenty of sun and sufficient rain—whereas mine isn't so healthy. And so your grains can produce more pasta per than mine. And thus they aren't exact substitutes.

We could even go down to the molecular level and determine that the grains are not perfectly equal and thus not quite interchangeable. But for commercial purposes, there is typically some sufficiently-deep level of analysis at which fungibility between types of wheat grains can be established by an experienced grain inspector and accepted by the market. 

Among commodities, gold and silver achieve a notably high level of physical fungibility. As long as a gram of gold is pure, it is perfectly exchangeable with any other gram of pure gold. Gold's fungibility doesn't necessarily carry over to gold coins, however. Earlier processes used to make coins, in particular hand striking, were not very effective at creating perfectly equal specimens. The edges of coins were often irregular, leaving coins vulnerable to clippers who would safely cut off some gold (or silver) without fear of being detected. Thanks to natural wear and tear, coins that had been in circulation for a few years would contain less precious metals than new coins. Both clipping and natural wear & tear meant that the metal content of coins was not uniform.

New technologies helped increase the physical fungibility of coins. For instance, reeded edges—those little lines on the edge of a coin—prevented people from clipping off bits without detection.  It was now obvious to the eye if someone had attacked the coin. Likewise, shifting from hand-hammered coinage to mechanical screw presses allowed for a more circular final product, one less susceptible to clippers (see comparison below). The invention of restraining collars—which prevented metal disks from shifting around while they were being stamped—also helped. With clipping much reduced, coins that had been in circulation for a while were more likely to be equal in weight to new ones.

These two photos compare hammered coins to milled ones (source)

In addition to physical improvements, an attempt was also made to buttress the fungibility of coins with laws. There are two types of laws that achieve this: legal tender and the so-called "currency rule." Legal tender laws required debtors and creditors to accept all coins deemed legal tender by the authorities at their stipulated face value. So even if two different shillings were not physically fungible--say one was clipped and worn and thus contained far less silver than the second newer one--those participating in trade were obligated to treat them as if they were perfectly interchangeable.

Legally-enforced fungibility was no panacea. In the absence of physical fungibility, the imposition of legal tender laws often had  perverse effects. If two coins were not exact physical substitutes because their metal content differed, but law required them to be treated as interchangeable tender, then the owner would always spend away the lighter one while hoarding the heavier one. Legal tender laws, after all, had artificially granted the "bad" coin the same purchasing power as the "good" coin. Thus the good money is chased out by the bad, which is known as Gresham's law.
The second set of rules that courts formulated in order to help fungibility, the currency rule, requires us to shift our attention to banknotes. Like coins, banknotes are not particularly fungible in the physical sense, but for a different reason. Banknotes have historically carried a unique identifier, a serial number—coins haven't. An owner of a banknote can carefully jot down the serial number of each note and, if it is stolen, use that number to help track it down.

In 1748, Hew Crawfurd did exactly this. Before sending two Bank of Scotland £20 notes by the mail, Crawfurd not only recorded their numbers but also signed the back of each one with his name, thus further breaking down their physical fungibility. When they went missing, Crawfurd was able to use this lack of fungibility to his advantage by advertising in the newspapers the numbers of the two stolen notes and the fact that they had been signed by him. One of the notes was eventually identified after it had been deposited at a competing bank, presumably long after the robber had spent it. The bank, however, refused to return the stolen property to Crawfurd.

In the resulting court case, the judge ruled in favor of the bank. Crawfurd would not have his stolen property returned to him. The court reasoned that if the note was returned to Crawfurd, then no merchant would ever risk accepting a banknote unless they knew its full history. This would damage the "currency" of money. After all, requiring merchants to pour through newspaper after newspaper to verify that no one was advertising a particular serial number as lost or stolen would be prohibitively expensive. Banknotes would be rendered useless, depriving the Scottish economy of much of its circulating medium. By allowing merchants to ignore the lack of physical fungibility of banknotes, i.e. the unique marks on each banknote, the court recreated fungibility by legal means. To this day, the currency rule that was first established in Scottish courts in the 18th century continues to apply to banknotes in most legal systems. (Kenneth's Reid's full account of this case is available here).

Bitcoin, a purported monetary system, is interesting because it: 1) lacks physically fungible and 2) is unlikely to ever be granted legally fungibility in the form of legal tender status or via an extension of the currency rule.

Bitcoin's lack of physical fungibility is more similar to that of banknotes than coins. It arises from the fact that all bitcoin transactions are publicly recorded. This means that it is possible to trace the history of a given bitcoin. If the token has been stolen, say in a highly-visible exchange hack, then said token may not be as valuable as a bitcoin that has a clean history. In theory, a forward-thinking actor will only accept a tainted coin at a discount because there is always a risk that the original owner will be able to reclaim his or her stolen property.

There seems little likelihood that the courts will solve bitcoin's lack of physical fungibility by fashioning a form of legal fungibility for it. The state will probably never be friendly enough toward bitcoin to grant it legal tender status. Nor do I think it is advisable that courts extend the currency rule to bitcoin by granting merchants the right to ignore the trail left by a given bitcoin, as they do with banknotes. As I pointed out here, to do so would violates the property rights of the original owner of the stolen objects. Only a select few instruments, those that have already proven themselves to be vital to facilitating society's trade, should be protected in this way.

With no legal route to establish fungibility, the only path remaining for bitcoin's architects is to go back to square one and try to improve the physical equivalency between bitcoins. One way they can do so is by anonymizing the blockchain. If transactions can no longer be traced, than clean and dirty bitcoins all look exactly the same. Full anonymity is easy to implement in new cryptocurrencies. Monero and Zcash, for instance, have gone this route.

In the case of a legacy cryptocurrencies like bitcoin, this functionality would have to be added on to its existing codebase. I have heard rumours that bitcoin developers like Adam Back and Greg Maxwell are working on developing code for anonymizing the bitcoin blockchain. But even if the technology is up to snuff, given the difficulties of achieving sufficient consensus for upgrading bitcoin, it remains to be seen if a fungibility-restoring technology could ever get off the ground.

In my view, the idea that bitcoin developers must try to achieve the same level of fungibility as coins and banknotes is misguided. Proponents of this idea are operating on the assumption that bitcoin is, like coins and banknotes, a payments medium or monetary system. But this is wrong. Whatever its original purpose might have been, bitcoin's first and foremost role is as a new type of gambling machine, a global and decentralized financial game. Like lotteries, casinos, and poker tournaments, and other types of zero-sum games, the main service that bitcoin provides its users is the fun of gambling and the allure of becoming very rich. If they want to benefit their users, Bitcoin developers should be working towards furthering its role as a gambling machine rather than mistakenly pursuing the dream of becoming the next monetary system.

People who play financial games such as lotteries benefit from the unique serial number on lottery tickets. If their tickets are stolen from them, this identifier may allow the original owner to get their ticket back. And that way they can still potentially win the big pot.

The same applies to bitcoin. Most people who hold bitcoins are doing so because they expect its price to hit $1 million. At least if their coins can be traced, a bitcoin owner who has been robbed may still have a chance to win that jackpot (and buy that Lamborghini they've been dreaming about). Removing the very feature that makes bitcoin non-fungible—and thus potentially traceable in the case of theft—would only do harm to the average bitcoin user. Anonymizing the bitcoin blockchain would make about as much sense as removing the serial numbers on lottery tickets.

Bitcoin's lack of fungibility isn't a bug, it's a nice feature.

Tuesday, July 31, 2018

Tainted money

In many parts of the world, cash held in ATMs or in cash-in-transit vehicles is protected by so-called intelligent banknote neutralization technology. When a thief tries to force the ATM open, plastic packs filled with dye explode, spraying both the thief and the banknotes. These notes have now been demarcated as stolen. A shopkeeper may refuse to accept marked notes or may only accept them at a large discount to their face value. At this point, cash has ceased to be fungible. One banknote is not a perfect substitute for another.

The dye used in banknote neutralization is often mixed with a taggant, a chemical marker that contains a unique combination of elements chosen from thirty or so rare earth metals. This ensures that a given block of cash is protected by a one-of-its-kind dye pack. So if the authorities apprehend the ink-stained thief with the marked cash, they can actually trace the stuff back to its original owner and return it. This incentivizes any would-be ATM thief to think twice.
An analogy can be drawn to bitcoin. Each bitcoin's history is indelibly recorded on the bitcoin blockchain. So if a coin is reported stolen, it is theoretically possible for law authorities to see the movement of the stolen coin as it passes from owner to owner. Any buyer of bitcoins needs to be concerned with the possibility that they will be confronted by the authorities and obliged to return that coin to its original owner. This possibility could affect the fungibility of bitcoins. Coins with clean histories may trade at a premium to those without clean histories.

This similarity between tainted bitcoins and banknotes is only superficial, however. In most parts of the world accepting stolen bitcoins is far more risky than accepting stolen banknotes. Even if a seller does their best to make sure that a buyer's bitcoins aren't stolen, they could be legally obliged to return the bitcoins to their rightful owner if their analysis is wrong. The legal treatment of stolen banknotes is different. A seller can mistakenly accept stolen banknotes but as long as they have done so in good faith, they cannot be legally obliged to return them to their original owner.

Good faith means honestly. If a seller knows that the buyer is using stolen banknotes, then the seller would not be acting in good faith if they accepted those notes. If the seller has no knowledge about whether the notes have been stolen, then they are acting in good faith if they accept them. This state of mind is sometimes referred to as acting with a pure heart and an empty head.

The difference between bitcoins and banknotes is best illustrated by an example. Say I am holding a garage sale. A thief buys a knickknack from me using a stained $10 note. I am not familiar with intelligent banknote neutralization, so I do not know that the banknote has been stolen. I try to deposit the stained note at the bank and the bank notifies the police. Thanks to the taggant, it can be proven that the note was stolen from Bank X's ATM a few days before. Since I innocently accepted the note i.e. I did so in good faith, I am not obligated to give it up to Bank X. If, on the other hand, I knew about intelligent banknote neutralization, and this could be proven in court, then I would be obliged to give the note back. But it was an honest mistake, and so I am forgiven.

Continuing the example, say the thief bought another knickknack at my garage sale using bitcoins. Prior to accepting his bitcoins, I did a careful analysis of the blockchain to see if the coins had been stolen, but nothing turned up. It turns out my analysis was flawed. In actuality, the thief held-up a bitcoiner at gun point the night before and stole her bitcoins. Even though I did my very best to ensure they weren't stolen, I could be obliged by the law to give the bitcoins back to their original owner.   

The law is very forgiving towards users of banknotes. Sellers can be fairly uninformed, or objectively stupid if you will. They can make honest mistakes accepting banknotes. But an honest mistake with bitcoin could be very costly. With bitcoin, there is no protection for fools.

In the above example, bitcoins are treated by the law as regular property. When someone steals a piece of property, say a painting or a car or a piece of jewelry, and sells it, the law needs to determine which of two innocent parties gets to keep the property; the owner who was robbed or the buyer who innocently gave up something to the thief in return for the stolen property. For almost all types of property, including paintings and cars and jewelry (and bitcoin), the law usually favours the original property owner. Even though the new owner participated in the transaction in good faith, they must return the stolen goods. 

Banknotes have been granted special status by the law. They are one of the few types of stolen property that an innocent third party gets to keep. As a result of this exception, trade conducted with banknotes is far more fluid than trade conducted with other types of property. A seller who is offered a banknote doesn't have to worry about investigating that note's past history to verify that it was stolen. This greases the wheels of commerce. But it comes at a price. The property rights of the original owner have been thrown under the bus.

Should the exemption that has been granted to banknotes be extended to bitcoin? Probably not. Property rights are very important. If we trample on them at all, it should only be in certain situations where there is a very good reason for doing so. At the time that English courts originally granted the property exemption to banknotes they were already responsible for a large portion of England's commerce. This is still the case, with cash generally participating in for around half of the UK's retail payments.

Treat banknotes as regular property and people would have to take on the full risk of accepting stolen notes. This would put a significant damper on trade. Bitcoins are not used for buying and selling things at a retail level. When bitcoins pass from one hand to the other, it is almost always for speculative reasons, not mercantile ones. Given that the bar for removing the property rights of the original owner should be a high one, bitcoin probably doesn't clear the hurdle.

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.