Crypto vs Fedcoin

Given the cryptocurrency mania, it felt necessary to express a few thoughts on the matter.  The following uses the article, Will cryptocurrencies trash cash? 'Fedcoin' could do it, as means to explore the topic. 


Initial thoughts:

1.  Electronic bank deposits have already "trashed" cash.  Physical notes and checks still play a role in exchange, but it's evident that electronic transfers & payments and their attached balances are of far greater importance.

2.  Regulated banks use electronic Fed reserves to settle balances between themselves.  Through the Fed's new reverse repo facility, the central bank now offers their balance sheet to a wider range of counterparties.  Much like reserves and reverse repos, a Fedcoin would be another form of Fed liability.  Since only regulated banks are able to hold Fed reserves as their assets and RRP operations are only offered to certain counterparties, what would be a game changer is whether Fedcoin would enable anyone to hold deposits issued by the Fed.  At the moment my electronic deposit is issued by Bank of America.  Because of government guarantees/insurance, I have no risk of loss.  However, large corporation that hold their liquid assets in this form or in some other privately issued short-term security can't escape credit and liquidity risk.  From a pure safety perspective, holding a large balance at the Fed would be far safer.

3.  Bank deposit balances do not fluctuate in terms of exchange value to the dollar.  If one exchanges a portion of their bank account (or the entire sum) for physical USD, they can do so because retail bank deposits and physical USD trade at parity.  Moreover, these bank balance can be used to make debt and tax payments as well as electronic purchases of goods/services/assets.  When an employee is paid electronically, their money balance increases seamlessly.  These obvious but underappreciated realities ensure that electronic deposit liabilities issued by regulated banks are a workable medium of exchange.    

From the article:

Alternatives, such as the US dollar and gold bullion, have faded in stature as prices have fallen all year while bitcoin has pushed near $6,000 over the past week. Both China and Russia are exploring the use of blockchain technology to create their own, state-backed cryptocurrencies. A recent Bank of America Merrill Lynch fund manager survey showed "long bitcoin" as one of the most popular trades on Wall Street right now.

The highlights how bitcoin is a speculative financial asset comparable to equity shares that investors/traders/speculators are recommended to go long.  The irony is that the price fluctuations are what fail to make it an ideal medium of exchange which it is advertised as being.  The writer also laughably implies that the dollar's importance has faded relative to bitcoin because of the latter's price rise when in reality the dollar's role in the global financial system is unrivaled by it's developed market peers never mind cryptocurrencies.  Bitcoin in terms of global capital flows, credit creation, and total transactions is irrelevant at the moment.  

Initial coin offering activity is red hot, an area we have covered at length recently in light of intense VC interest in blockchain startups. Many show promise, like Tezos, which is trying to decentralize the governance process behind the blockchain. Or Tether, which is trying to refocus interest on cryptos as an actual medium of exchange (vs. the current obsession with speculating for fast gains) by tethering it via a peg to the US dollar and other national currencies.

Tether in an attempt to actually become a viable medium of exchange is seeking to stabilize its value to the dollar.  So in a disguised way, Tether is becoming an unregulated money market mutual fund that issues Tether coins as their liabilities (*cough money market shares*) in exchange for US dollar and other foreign denominated deposits.  How will they manage the assets backing their coin liabilities?  How will holders of Tether coins know whether those running Tether will manage their assets appropriately?  Presumably there are administrative costs associated with running Tether.  This will require that they make some return on their dollar and foreign denominated assets.  Who stands to hold them accountable should they take too much risk seeking a desirable return in a world where dollar and foreign deposits are yielding near zero interest rates?  For that matter, how can holders of Tether coins be sure that their holdings aren't being diluted by unbacked issuance?

But many more stretch the limits of reasonableness. Paris Hilton and Floyd Mayweather have promoted ICOs on Twitter, for example. Others don't really need any further explanation: Dogecoin, PotCoin, TrumpCoin, PonziCoin, and Jesus Coin. Not a bubble, clearly.

Bingo.  What prevents others and especially fraudsters from issuing their own digital coins?  Is this simply a case where unregulated entities are able to successfully convince others to hold their risky financial securities?

This brings to mind the following from Modern Monetary Theory: The Basics,

Hyman Minsky used to say that “Anyone can create money”; but “the problem lies in getting it accepted”. You must understand that “money” is by nature an IOU. You can create a dollar-denominated “money” by writing “IOU five dollars” on a slip of paper. Your problem is to get someone to accept it.

Thus what drives the issuance of any financial security whether cryptocurrencies, stocks, bonds, or deposits is acceptance by others.

While sentiment has likely come too far too fast, the underlying technology shows great promise. I guess that makes my position similar to JPMorgan Chase CEO Jamie Dimon, who attracted a lot of attention for calling bitcoin a "fraud" while his bank rolled out a blockchain-based system to expedite cross-border payments. This is also motivating the efforts by China and Russia to create a central bank-backed cryptocurrency using distributed ledger technology—all while regulators squeeze out private-market competitors

The settlement technology may be of value (this aspect is beyond my technical understanding).  Right now it takes a few days to settle transactions which involves verifying counterparties and complying with regulations.  Perhaps this process can be sped up, but doing so may come with costs that turn out to be excessive and more susceptible to fraud. Plus, as users of deposits, it's not as if the settlement process delays transactions that retail customers make.  It's the financial intermediaries that have to deal with delays in the settlement process (T+1. T+2, T+3 etc) on the backend.

Economist Ed Yardeni of Yardeni Research asks the obvious question: Why would central banks—which derive their power as the centralized gatekeepers of fiat currency creation, check clearing and payment processing—embrace a movement that's primary motivation has been to usurp this power in a decentralized way?

Part of that, according to St. Louis Federal Reserve president James Bullard, is recognition that the technology has achieved critical mass. Thus, there's a fear of being left behind as the very foundations of banking and monetary policy—intermediation, funds transfers, transactions—rapidly change, not unlike the way the creation of mortgage-backed securities and credit default swaps changed housing finance in the mid-2000s. 

There's another, more self-serving purpose: Central banks could use their own cryptos to put the squeeze on paper currency. Why? To facilitate the use of negative interest rate policy, which has been deployed in Europe and Japan in recent years in half-baked forms. Currently, in Switzerland, short-term interest rates are at -0.75% 

Nothing prevents the Fed right now for paying a negative interest rate on excess reserve balances held by regulated banks beyond a bank's option to convert Fed reserves into physical notes.  The cost of the latter involves insurance, storage, and security.  As the article highlights, Switzerland instituted negative rates as well as the ECB and BOJ.  These negative rates then filter into the short-term money markets with reverberations throughout the broader financial system and currency markets.  None of this involved the creation of new central bank coin liabilities. 

Regardless should Fedcoins enable anyone to hold liabilities issued by Fed as their financial assets, the policy implications have the potential to go far beyond the application of deeply negative rates.  Imagine a nominal GDP level targeting central bank that could (with the consent and support of congress and the president) regularly increase individual accounts of the citizenry as a way to stabilize aggregate domestic spending.

If this sounds crazy, remember that the "dollar" already largely exists as a digital construct moved electronically between the Fed, reserve banks and commercial banks. Bill pay and ACH wire transfer services use electronic settlement. The current share of the money supply that's in paper currency form is only about 11%.

Exactly!  (Why didn't they just lead with this to start the article?)  Digital "money" balances have played a preeminent function for decades.  All financial assets exist in the ether/cyberspace!  Future generations may find it absurd that "money" existed in physical form in the first place.

This illustrates how money is a social construct that formalizes exchange and relationship.  Credit is also a relationship (exchange goods/services/securities/assets today for some form of repayment in the future).  In the real economy, the total quantity of goods and services are determined by the productive capacity of the global economy.  In contrast, the issuance of different types of "money" and financial securities are not limited physically.  In other words, we can't run out of digital dollars.  With that said, institutionally governments and the private financial sector are constrained in how much they can issue.  The US government is restricted by self-imposed laws involving the budgetary process and debt limits.  The banking system and private financial institutions are curbed in their ability to issue deposits and money-like securities (banks create deposits when they lend or buy assets) for reasons of profitability, solvency (capital adequacy), liquidity, and government regulations.  

Fedcoin, or whatever they decide to call it, would enable widespread digital peer-to-peer payments and money transfers. Properly structured, it provides a best of both worlds: A level of anonymity and widespread acceptance that cash provides with the efficiency and security of blockchain. Negative interest rates could be built into the blockchain's ledger, slowly eroding the Fedcoin's value, encouraging the frantic spending the Fed desires while penalizing savings.

This potentially eliminates the need for large paper bills, potentially giving the kiss of death to the $100 and maybe the $50; not unlike the $1,000 and higher denominations killed by the Fed back in the 1960s. Anyone remember the $10,000 bill with Chief Justice Chase? Last year, the European Central Bank announced it would phase out the €500 note, ostensibly to combat illicit activities like drug dealing but perhaps sounding the death knell for cash money.

Who are the peers in the first sentence in this passage?  Regulated financial institutions?  Money market funds?  Regular retail bank costumers?  In the future, will regular citizens be able to hold a balance at the Fed?  The creation of individual accounts at the central bank in itself would exceed the importance of a more efficient settlement system.

Although the article states how only 11% of the money supply is comprised of physical cash, the writer focuses too much attention on this when it comes to how Fedcoin could revolutionize the financial plumbing.  First, I see no reason why Fedcoin balances offered to the public and physical Fed reserve notes couldn't coexist just like retail deposits, money market mutual funds, coexist today with physical currency.  Secondly, ensuring that regulated banks are able to safely issue short-term deposits at par requires an exhaustive regulatory, institutional, political apparatus.  Rather than spend an inordinate amount of resources regulating and subsidizing the private system, why shouldn't the Fed or some other government institution instead allow the public to hold deposit balances issued directly by the government?  Nothing would prevent the private banking system from still offering higher yielding deposits in order to attract lenders, but they would do so without government backing to the degree that we see today.  In other words, commercial banks would need to turn into money market mutual funds or riskier investment banks.  Since the public would have the choice of holding deposits with the Fed or with a private bank, there would be no need for deposit insurance.  Forget about Fedcoin replacing cash, imagine how it would upend the current private banking system. 

Paper and coins are archaic, inefficient and oh so analog. The future of money is coming. My bet is that even if it's in an ethereal, digital form, it will have "Federal Reserve Note" somewhere on its 1s and 0s.

The future has been here.  Ordinary people don't care about T+1, T+2, T+3 settlement as their immediate involvement in transactions occur at the time of payment.  The opening up of the Fed's balance sheet to the public via Fedcoin has far greater ramifications than this article even attempts to imagine. 

1.  It would upend the commercial banking system.  Fedcoin balances accessible to all would go a long way toward turning retail banking into a public utility.

2.  It would definitely show (I hope), that "money" has and will always be a social relationship built on trust and law. 

3.  There is no physical limit as to how much "money" can be issued.

4.  Banks create digital deposits (a private form of money) when they lend or buy assets.  Much like taxes, debt payments in part drive demand for bank deposits.  

5.  Presumably we want banks to create deposits as part of the lending process in order to fund worthwhile investments that will end up producing the goods and services that the public desire.  In doing so, this process gives the created deposits value now and in the future by ensuring that there will be a sufficient quantity of goods/services worth exchanging deposit balances for.  Watch this short video to see Greenspan explain this idea concisely.  The efficient allocation, use, and creation of real resources are what matter!*  

This isn't to bash bitcoin or other unregulated, risky, financial securities/coins or deprive bitcoin of its importance.  If people can make a buck or a great deal of profit trading it, why not assuming they understand the risks?  As long as it goes up in price (for whatever reason), it's not necessary to believe or understand the story behind it.  Psychologically, it's understandable that the attractive story behind bitcoin and how it involves a potentially breakthrough technology or the thrill of being part of an anti-establishment movement, can drive buy-in.  Holding bitcoin or talking it up may signals to others that one is tech savvy, not a sheep, and rebellious.  That is all well and good, as long as the price keeps rising and profits can be attained.  This is not all that different to how stock stories grab attention and drive imaginations.  In 1997, Amazon's stock price was $1.49.  Today a share trades for $986.  It went from a book selling to whatever massive business it is today.  One didn't need to comprehend the full story to profit as long as they held on as the price exploded by a factor of 660x.  Like bitcoin, Amazon's story still drives imaginations.  Unlike bitcoin, Amazon's shares are backed by a business enterprise.  

Caveat emptor...

For all things coin related, I can't recommend reading FT Alphaville enough.  They have been on top of this with a degree of financial insight that can't be matched.  A must read for all things finance. 

*This is going off on a tangent, but in Hilary Clinton's book she brings up how Sanders metaphorically promised a pony to all Americans.  What she gets totally wrong is that a lack of "money" isn't what limits the government from buying and distributing ponies to all citizens.  The limiting factor that prevents the government from doing so is that there aren't 320 million ponies lying around waiting to be purchased and distributed.  Even if there were 320 million ponies available in some absurd reality, the question then becomes why should the government use it's financial resources to purchase and distribute ponies to it's citizens?  As long as resources are available, it's a question of politics not financial limitations.

As far as the virtues of the banking and financial system are concerned, the common critique has been that too much of finance is used to fund unproductive, speculative, and socially costly investment all in order to enrich a small elite.  Should the financial system be unable or unwilling to channel real resources efficiently in a socially beneficial way, which institutions should?  The rise of cryptocurrencies don't address these issues and may actually be symptomatic of them.