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.


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)


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.



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.     


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:



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.



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.



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












Saturday, July 14, 2018

The €300 million cash withdrawal




One Billion Dollar Art Piece by Michael Marcovici (source)











Wednesday, June 27, 2018

Failed monetary technology





























Friday, June 8, 2018

Evading the next Iranian monetary blockade



















