Tag: cryptocurrency

Stable Coins

Digitizing our bank deposits (digital dollars—stable coins) would (will) represent another step forward in the ease and efficiency with which we can make payments and will enhance bank stability. Most of the US supply of money (US dollars) is in the form of our dollar deposits at our banks and most of our payments these days are already made by electronically transferring bank deposits from me to you via my bank to yours. I have discussed all of this in more detail earlier: “Econ 101-Money”

Developing the rails for paying with stable coins is a further improvement on our existing payment options. It is not revolutionary. The payment of cash (currency) requires no infrastructure (e.g. Merchant contract with credit card issuer and card reader, etc.). You just hand it over and anyone can accept it (hopefully the person you intended to receive it). The electronic transfer of a bank deposit balance (e.g., Zelle, Venmo, e-wire) requires the enrollment of the recipient in that particular payment vehicle.  It took decades for credit cards to be widely accepted. Hundreds of companies now issue Visa cards (mine is issued by United Airlines) and all are accepted wherever any of them are accepted. But it took a lot of work to build that system.

What do stable coins issued by banks add that might be useful? From the bank side issuing stable coins from deposit balances simplifies the bank’s management of the assets that back them. When its customers withdraw cash these days, the bank must purchase it from the Federal Reserve in order to pass it on to you. It pays the Fed for the cash from its reserve deposits at the Fed, which reduces its ability to extend credit to businesses and households. If its reserves at the Fed are not sufficient, it will need to borrow from another bank or sell another asset.

The withdrawal of cash from bank deposits tends to follow seasonal patters. Thus the squeeze on its reserves at the Fed would tend to create seasonal fluctuations in bank credit hence in the money supply.  Thus the Fed attempts to offset the impact of currency fluctuations on bank reserves and thus credit with offsetting purchases and sales of government securities (so called open market operations) or with temporary loans to banks in its “lender of last resort” function. If a bank can issue its own currency (as they did in the old days) when a customer withdraws cash from its deposits, its asset backing (and reserve deposits at the Fed) will not be affected. Banks will now be able to do this by issuing their own stable coins. While the customer’s deposit balance will fall when withdrawing cash (or stable coins), its total of stable coins “cash” plus deposit balance will not change thus the bank assets backing them do not need to change. Thus, such fluctuations in the currency/deposit ratio would not product a fluctuation in the money supply.

From the customers side the stable coins are as good as traditional cash only to the extent that the infrastructure to accept them (e.g. phone wallets) has been designed and widely acquired/accepted. Just as it took many years for credit cards (Visa, Mastercard and American Express) to be widely adopted, the same will be true with stable coins. Just as you might now swap addresses via your respective mobile phones, you will be able to make payments.

If everyone can issue their own money it degenerates to barter, i.e. it would not be money at all. The essence of a successful means of payment is the certainty of its ultimate claim on the central bank’s official monetary liability (the dollar). When central banks were limited to issuing currency redeemable for “something” such as gold or silver, the amount they issued was limited by their holding of gold or silver, etc.  Today the Fed’s supply of money is limited by Congress’s mandate for price stability and full employment. And ultimately the government must accept such dollars in payment for our tax obligations stated in the same currency.

Econ 101:  Money

My Ph.D. in economics from the University of Chicago dealt with a monetary policy issue. My five years as an Assistant Professor of Economics at the University of Virginia allowed me to lecture extensively about monetary policy and my 26 years at the International Monetary Fund were largely devoted to providing technical assistance to member (primarily post conflict) county central banks (including Afghanistan, Bosnia, Croatia, Egypt, Iraq Israel, Kazakhstan, Kenya, Kosovo, Kyrgyzstan, Moldova, Serbia, South Sudan, Turkey, West Bank and Gaza, and Zimbabwe). In case you didn’t know, central banks issue the currency (money) of their respective countries. So, I know a lot about “money” and like talking about it.

And it’s not that I haven’t already written a lot about the subject. For a few examples see: “Econ 101-the Value of Money”   “Money”  “A Libertarian Money”

A lot of interesting things are happening these days in the monetary area, but they pertain to payments (transferring money from one person to another via PayPal, Venmo, Zelle, Visa, etc.) rather than money itself. I want to talk to you about “money” (not payments) as I might with my granddaughter. Money is what is transferred in payment.

Money exists because none of us are self-sufficient and must trade what we produce with others who produce the other things we want. I will skip the presumably well-known story of barter trade and its challenge of the double coincidence of wants (you have what I want, and I have what you want so we trade). Giving you a commonly accepted asset, that you can hold until you want to buy something from someone else and can “pay” for it by passing that asset on to the next seller is the essence of money. In addition, it becomes the unit of account (the unit for stating prices). Thus, money is a unit of account, means of payment and store of value.

But now dear granddaughter, lets dig deeper to discuss where this money comes from and its key features in today’s modern electronic (digital) world. First of all, I can’t pay you with any old asset equal in value to your sale price (the barter problem). I must pay you with “money,” an asset universally accepted within the country. To cut to the bottom line, money is the asset issued by our central bank (any of our twelve Federal Reserve Banks) or creditable claims on the Fed’s monetary liability—the U.S. dollar. Until 1933 these dollars could be redeemed for gold at $20.67 per once. Now the U.S. government accepts them in payment of our taxes denominated in dollars, which insures their ultimate value.

Federal Reserve notes (dollar bills) are the most direct manifestation of our money. But almost 90% of our money (the asset with which we can pay for things) is in the form of deposits at American banks, and credit unions. These figures can be a bit misleading because over 60% of our currency is held abroad.

When you pay someone with cash, they receive a direct claim on the Federal Reserve. When you pay with your bank deposit, your bank’s deposit with (claim on) a Federal Reserve bank is transferred to the payee’s bank, which credits the payee’s bank account with the designated amount. The asset paid and received is still ultimately a claim on the Fed.

But our demand deposits with our banks amount to 15.9 trillion dollars, while the reserves that our banks keep with the Federal Reserve Banks amount to only $3.3 trillion reflecting our “fractional reserve” system. What is going on here? How did banks create more of our money (ultimate claims on the central bank) than it backs with its reserves at the Fed?

When teaching money and bank at the U. of Virginia I loved walking the class through the money/banking multiplier that resulted from our fractional reserve backing system. It has become fashionable for some to claim that banks create deposits (money) by making loans. When you received a mortgage loan from your bank, they say it creates the deposits placed in our deposit account. This is sort of true and sort of not true. Your bank actually pays your mortgage loan to the account of the person selling their home and their account is almost surely in another bank. That means that your bank must have sufficient reserve balances at the Fed to transfer to the seller’s bank.

I will leave the details of the bank money multiplier to the Money and Banking class you will hopefully take when you go to college, but the fact that your deposits are only partially backed with reserves at the Fed (the rest of the backing being the bank’s loans and other financial assets, is what lies behind the occasional bank runs we saw in the movies before deposit insurance was introduced to assure depositors that they could get the money back even if their bank failed. If enough bank borrowers default on their loans, the bank could become insolvent. Only the first to withdraw their deposits will be able to get their money back. The potential risk of such runs on a bank only partial backing your deposits with reserves at the central bank motivated the Chicago Plan of 100% reserve banking. “Protecting Bank Deposits”

If bank deposits of US dollars are money, what about cybercurrencies? What are they ultimately claims on? Bitcoin, as you hopefully know, is not a claim on anytime. They can’t be redeemed for anything. It is not unit of account or means of payment for hardly anything—it is not money. It is a speculative “asset” for those who like to speculate (gamble). “Cryptocurrencies-the bitcoin phenomena”  “The future of bitcoin exchanges”  “Bitcoin-Cybercurrencies and Blockchain”  “The difference between bitcoin and FTX”

But there is a class of cryptocurrencies that claim to be redeemable for money, such as US dollars—so called stable coins. The validity of this claim, as with your bank re your deposits there, depend on the details of its contract and the faithfulness of its adherence to that contract. Tether and USD Coin are the most popular US dollar stable coins.

But to use a stable coin for making payments, the person or firm you are paying must have the software or card reader needed to use the cryptocurrency you want to use. You might remember (probably not you, dear granddaughter) when not so many stores could accept visa, or MasterCard (or the Shell Oil, or Texico gas cards). Payment technology has continued to evolve and improve, but if it is not transferring money (US dollars in our case)—i.e. an asset ultimately redeemable for the Federal Reserve’s liability, it will not get you very far.

Other than handing someone cash, paying with your bank account requires a messaging and authorization system. Do you still write checks occasionally—so sorry. A check both indicates the amount to be paid and authorizes its transfer. Almost all payment instructions and authorizations are made electronically these days. Many central banks are considering introducing digital cash in place of or along side their currency notes (Central Bank Digital Currency). When offered through a bank, a CBDC would have the advantage of 100% reserve backing (it would be a direct claim on the Fed). On the other hand, modern electronic means of payment leave little room for further improvement as might be offered by CBDCs. “Econ 101-Retail Central Bank Digital Currency-CBDCs”

To make payments, or send money, abroad, your money must be exchanged for the money of the recipient. I regularly send dollars to Afghanistan, which are received as Afghani. A massive foreign exchange market in which the exchange rate of one currency for another is determined exists for that purpose. Such payments can be made more quickly and cheaply if both parties are willing to use the same currency. Thus, the US dollar is rather widely accepted for cross border payments. “The Dollar Again”  The Special Drawing Right (SDR) of the International Monetary Fund serves this purpose for governments but is not widely used. “What are SDRs?” Stable coins redeemable for gold provide another promising potential unit given golds historical importances. The best existing example is e-gold by Global Standard (to which I am an advisor).

But not all monies behave the same. The behavior of the value of each (its inflation rate) depends on how its issuing central bank manages its supply. Some central bank’s supply whatever their government needs, generally resulting in high inflation rates. Some, such as our Federal Reserve, regulate its money’s supply in an attempt to maintain an inflation target (in the US the target is 2%). Others follow currency board rules that leave to the market the determination of a supply that keeps the currency’s value consistent with that of another currency (The Euro in the case of the Bosnian dinar or the Bulgaria lev). So dear granddaughter there are many interesting things to study about money.

Why don’t you pop over and let’s discuss it more over lunch? Oh, I forgot that you are in the West Coast Washington (state) while I am near the East Coast Washington (DC). Well at least we can meet on FaceTime or Zoom (or even the old fashion telephone). But I would love to meet one way or the other.

P.S. In 2002 as Patrick Honohan and I were finishing up the Bank-Fund Financial Stability Assessment of Egypt (Patrick led the World Bank team and I led the IMF team) I said in an email “Patrick, why don’t you just come across the street and discuss this over tea?” Patrick replied: “Warren, I am in Dublin. I moved here several months ago.” He later became the Governor of the Central Bank of Ireland.

The difference between Bitcoin and FTX

Bitcoin is a digital currency (cryptocurrency) that can be paid to another bitcoin user willing to accept it via a blockchain account.  It is backed by nothing and promises nothing. Its US dollar value has fallen from $65,496 on November 14, 2021, to $15,630 on November 21, 2022.

“FTX Exchange was a leading centralized cryptocurrency exchange specializing in derivatives and leveraged products. Founded in 2018, FTX offered a range of trading products, including derivatives, options, volatility products, and leveraged tokens. It also provided spot markets in more than 300 cryptocurrency trading pairs such as BTC/USDT, ETH/USDT, XRP/USDT, and its native token FTT/USDT.12 In early November 2022, the exchange and the companies in its orbit began a steep fall from grace….  According to its bankruptcy filing, FTX, which was once valued at $32 billion and has $8 billion of liabilities it can’t pay, may have as many as 1 million creditors…. On November 16, a class-action lawsuit was filed in a Florida federal court, alleging that Sam Bankman-Fried created a fraudulent cryptocurrency scheme designed to take advantage of unsophisticated investors from across the country. ” “FTX exchange”

The difference between Bitcoin and FTX is that Bitcoin is a digital coin/token that some believe might achieve wide adoption as money and thus a stable demand that could stabilize its price. In my opinion, this is HIGHLY unlikely. I explained this potential eight years ago: “Cryptocurrencies the bitcoin phenomena”   “The future of bitcoin exchanges”  But most people buying Bitcoin are gambling that they can sell it for a higher price than they paid for it (first cousins to slot machine addicts).

On the other hand, FTX and its related products and services promised real things and to play by known rules (contracts). On November 11, FTX and its affiliated firms were put into bankruptcy. Billions of dollars where missing? Founder Sam Bankman-Fried (SBF) claims that he was just careless. It appears more likely that he was a lying fraudster. “An attorney also said the firm had been run as a ‘personal fiefdom’ of Bankman-Fried with $300 million spent on real estate such as homes and vacation properties for senior staff.” “Crypto lender genesis says no plans to file bankruptcy imminently”  Presumably to promote himself as a good guy and to win influential friends, SBF also contributed millions to charities and politicians. 

Most crypto product and service providers want regulations that will give potential investors and customers more confidence in their products but that will not stifle the potential creativity of a dynamic industry.  Hopefully congress will get on with it — carefully. “Crypto bill criticized”

“Sam Bankman-Fried, the founder of the FTX exchange and Alameda Research, a cryptocurrency trading platform, seemed to confuse his bank and his companies. According to John Ray, the new CEO in charge of the restructuring of his empire which went bankrupt on November 11, Bankman-Fried received a personal loan of $1 billion from Alameda. He is not alone: ​​the firm, which is a kind of cryptocurrency hedge fund, has also lent $543 million in personal loan to Nishad Singh, an associate of Bankman-Friend, and $55 million to Ryan Salame, the co-CEO of FTX Digital Markets, one of FTX’s affiliates.  

“’Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,’ Ray wrote. ‘From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.’”  “Bankman-Fried received 1bn in personal loan from his company”

“Bankman-Fried’s net worth peaked at $26 billion.[11] In October 2022, he had an estimated net worth of $10.5 billion.[12] However, on November 8, 2022, amid FTX’s solvency crisis, his net worth was estimated to have dropped 94% in a day to $991.5 million, according to the Bloomberg Billionaires Index, the largest one-day drop in the index’s history.[13][10] By November 11, 2022, the Bloomberg Billionaires Index considered Bankman-Fried to have no material wealth.[14]”  “Sam Bankman-Fried”

I assume that jail is next, perhaps in the cell previously used by Bernie Madoff.

If you subscribe to The Economist you can read fascinating details here: “The failure of ftx and Sam Bankman-Fried will leave deep scars”

Econ 101: The Value of Money

During a discussion of Bitcoin with friends, it became clear to me that it might be helpful if I explained some fundamentals of how the value of money is determined. Like most everything else, money’s value is ultimately determined by its supply and demand.

Demand for money reflects the public’s need to keep an inventory of it in order to use it for making payments.  Bitcoin are generally held as a speculative asset rather than for payments as almost no one will accept them in payment. “Cryptocurrencies-the bitcoin phenomena”

The supply of money is determined by those who created it, generally central banks. Generally central banks issue their currency, thus increasing its supply, by lending it (generally to banks) or by buying assets, generally their government’s debt.  When anyone holding that currency no longer wants it and has the right to redeem it, the central bank takes it back in exchange for the asset it purchased in the first place, thus reducing the money supply.  Under the gold standard, currency was redeemed for gold.  The rules governing a central bank’s issuing and redeeming its currency defines the nature of its monetary regime.  That is the topic of this econ 101 lesson.

As none of us has ever redeemed our currency, it is understandable that my friends confused spending their money with redeeming it.  Spending it transfers it to someone else without changing its supply, while redeeming it reduces its supply.  Cryptocurrencies add a new category to our discussion of money.  As noted by “a billionaire hedge-fund manager… cryptocurrencies are a ‘limited supply of nothing.’”  “Crypto skeptics growing”

As discussed further below, the supply of Bitcoin increases slowly and steadily over time as determined by an unchangeable formula and Bitcoin cannot be redeemed for anything.  The U.S. dollar and virtually every other national currency in the world grow at more erratic rates as determined by their issuing central banks.  So what makes the value of the dollar relatively stable over long periods of time?  The fall in its value by about 8% over the last month is nothing compared to bitcoin’s fall of 23% over the same period and over 50% over the last half year.  Over the past 15 years the dollar’s value has declined less than 2% each year.  Unlike Bitcoin, dollars are widely accepted for payments that are denominated in dollars, including our taxes, and thus held (demanded) to make such payments.  Almost no Bitcoins are held to make payments as almost no one will accept them for payments.  But I want to focus on a currency’s supply.

There are fundamentally three broad approaches to determining the supply of a currency.  Historically, the supply of most currencies were determined by fixing their price to what they could be redeemed for, such as gold or silver. I have called such a system for regulating money’s supply, a hard anchor. “Real SDR Currency Board”  The value of a currency can be fixed (the price set) to something real such as gold or a basket of goods.  A country with a strict gold standard, which the U.S. never really had, issues its currency (dollars) whenever anyone wants to pay the fixed gold price for more of them.  If the dollar price of gold in the market rises above its official price, there would be an arbitrage profit from buying gold from the central bank at its lower official price.  Such gold could be resold in the market at the higher price.  But the key point is that this mechanism (what I call currency board rules) of redeeming currency reduces its supply and thus reduces prices in this currency in the market (deflation).  Several of the monetary systems I helped establish, work in this way (Bulgaria and Bosnia and Herzegovina). “One Currency for Bosnia”

The most common system of monetary control today is for the central bank to determine its currency’s supply by buying or selling it in the market (the Federal Reserve can buy treasury bills, etc. to increase the supply of dollars).  Most central banks today adjust their money supplies in an effort to achieve an inflation target (a much more complicated subject). “Czech National Bank: Inflation Targeting in Transition Economies”  Generally they do so by setting an intermediate target for a short-term interest at which market participants (banks) can borrow from the central bank.  Such fiat currencies, such as the U.S. dollar, are not redeemable but are widely accepted in payment for goods, services and debts.

This brings us to Bitcoin.  The supply of Bitcoin is determined by a formula that predetermines its gradual growth to 21 million by 2140.  There are currently about 19 million in existence.  The supply is increased by giving them to successful miners for verifying the legitimacy of each transaction (another complicated subject).  Thus, the issuer (the formula) received services (protection against double spending the same coin) but no assets such as gold or treasury bills for creating and issuing new Bitcoins.  Once created, an issued bitcoin can never be redeemed (i.e. the outstanding supply can never be reduced).  When you spend or give away your Bitcoins you are circulating them to other holders, not redeeming them.

When my imaginary aunt Sally discusses Bitcoin and cryptocurrencies more generally, she tends to mix up the marvelous new payment technologies for paying my dollars all over the world with private money such as Bitcoin and Tether.  She also doesn’t seem to quite understand that most money has always been privately produced including the U.S. dollars that we spend in various ways (occasionally even by handing over cash).  “A shift in monetary regimes”

But these distinctions are critical when considering what role the government should play in our monetary system.  The truly amazing technical progress we have experienced and the dramatic increase in the standard of living of the average person it has delivered over the last century was made possible by a government that provided a general framework in which we, the consuming beneficiaries of this progress, could make informed choices.  Our government, wisely, generally did not make such decisions for us.

With that in mind consider “a letter addressed to Senate Majority Leader Charles E. Schumer (D-N.Y.), Senate Minority Leader Mitch McConnell (R-Ky.), House Speaker Nancy Pelosi (D-Calif.) and other congressional leaders, [from 26 influential technology personalities that] outlined what it described as potentially grave dangers of cryptocurrencies.” They are absolutely correct to expose and condemn the technical and economic weaknesses of blockchain technology—the distributed ledger with which Bitcoin claims to avoid the need for trusted third parties to record and document payment transaction (as happens on a centralized ledger when you pay from your bank deposit). 

But the fact that foolish people invest in Bitcoin and other cryptocurrencies does not justify our government prohibiting and restricting them from doing so.  The government requires the banks in which we put our money to publish properly audited financial statements of the assets backing our deposits and to set minimum capital requirements to protect against the possible loss of bank asset value (e.g., loan defaults).  Cryptocurrencies claiming redeemability at a stable value (so called stable coins) should similarly be required to disclose the rules by which they operate and the composition and value of the assets backing their digital coins.  In short, government regulations should help us decide what we want to buy and/or hold without restricting the ability of fintech pioneers to explore and innovate products to offer.

Overly restrictive regulations create incentives for incumbents to create barriers to competition.  Large and intrusive governments tend toward corruption.  The Federal Reserve System seems quite aware of these risks as it cautiously explores whether to compete with the private sector in developing a central bank digital currency.  “Econ 101-Central  Bank digital currency-CBDC”

So when considering the government’s role in money and payments be sure to clearly distinguish money from payment technology and limit government to setting the rules of the game that maximize the ability of private consumers to make wise choices. But perhaps the biggest policy decision of all is how the government should determine/regulate the supply of its currency, most of which is privately created.  I support a currency whose value is fixed to something real (a hard anchor) and whose supply is determined by the market via currency board rules.  “A libertarian money”  

A shift in monetary regimes?

By Warren Coats[1]

This Sunday, August 15, is the 50th anniversary of President Richard Nixon’s closing of the gold window as part of the “Nixon Shock.” “Fifty years later Nixon’s August surprise still reverberates”  He announced on that day that the U.S. Treasury would no longer redeem its dollars for gold at $35 an ounce. Over the subsequent few years, the world moved from national currencies whose values were anchored to the market value of gold, to currency values determined by central banks’ regulation of their supply relative to the market’s demand. The value of one currency for another floated in the foreign exchange market. Central banks have deployed various approaches to determining the supplies of their currencies and most have now settled on targeting an inflation rate (often 2% per year) in one way or another.

With the rapidly increasing interest in cryptocurrencies, some have asked whether we are on the brink of another monetary paradigm shift? Specifically, might the dollar be replaced as the dominant international reserve currency. To explore that question we need to understand how the existing monetary systems work and how the widespread use of cryptocurrencies might add to or change these systems.  

In describing the existing and potential future monetary systems, we need to distinguish “money” from the “means of payment.” Money is the asset that people accept in payment of debts or for the purchase of goods and services. The U.S. dollar and the Euro are “money.” The means of payment refers to how money is delivered to the person being paid. Do you personally hand dollar bills and coins to the Starbucks cashier, write out a check (bank draft) and put it in the mail, or electronically transfer “money” from your bank account to an Amazon merchant via eWire, Zelle, Venmo, PayPal, or some other digital payment service? Or perhaps you purchase goods and services with borrowed money (Visa, MasterCard, American Express) that you pay back at the end of each month or over time. Or if you don’t have a bank account (a form of digital money) you might hand-deliver physical currency to a Hawala dealer or a MoneyGram or Western Union office to be electronically transferred to their office nearest to the person you are sending it to, potentially anywhere in the world. If you are paying in a currency that is different than the one the payee wishes to receive, your currency will be exchanged accordingly along the way in the foreign exchange market.

Discussions of cryptocurrencies include both the latest and evolving means of payment (digital payment technologies) as well as new, privately created moneys such as bitcoin, Ethereum, or Ripple.  Private currencies vary enormously with regard to how their value is determined. By private currencies I do not mean privately created assets redeemable for legal tender, such as our bank accounts. When we speak, for example, of the U.S. dollar, we invariably include dollar balances in our bank accounts, dollar payments made via our Visa card, etc. These are all privately produced assets that are ultimately redeemable for Federal Reserve currency or deposits at a Federal Reserve Bank. They are credible claims on the legal tender of the United States. Most U.S. dollars are privately created.

The value of all money is determined by its supply and demand. The demand for money arises from its acceptability for payment of our obligations and the quantity of such obligations (generally closely related to our incomes). Within each country, its legal tender money (e.g., the U.S. dollar in the U.S.) must be accepted by payees. In particular, it must be accepted by the government in payment of taxes.  Truly private currencies (those not redeemable for legal tender, of which there are over 11,000 at last count) have a serious challenge in this regard. Very few people or businesses will accept bitcoin, or any other such private cryptocurrency. As a result, the demand for such currencies for actual payments is very low. The demand for bitcoin, for example, is almost totally speculative–a form of gambling like the demand for lottery tickets. Such private currencies are more attractive in countries whose legal tender is rapidly inflating or has unstable value (e.g., Venezuela). 

The acceptability of a currency in cross border payments raises special challenges. My currency is not likely to be the currency in general use in other countries. Someone in Mexico paying someone in Germany will generally have Mexican pesos and the recipient in Germany will want Euros. The pesos will need to be exchange for Euro in the foreign exchange market. It would be very costly for dealers in the FX market to maintain inventories of and transact in every bilateral combination of the world’s 200 or so currencies. It has proven more economical to exchange your currency for U.S. dollars and to exchange the U.S. dollars for the currency wanted by the payee. The dollar has become what is called a vehicle currency.

The economy of a so-called vehicle currency can be illustrated with languages. Two hundred and six countries are participating in the 2021 Olympic Games in Japan. To communicate with their Japanese hosts participants could all learn Japanese. It is unrealistic to expect the Japanese hosts to learn 205 foreign languages. But what about communicating with their fellow participants from the other 205 countries. For this purpose, English has become the default second language in which they all communicate. Unlike more isolated Americans, most Europeans speak several languages, but one of them is always English. English as the common language is the linguistic equivalent of the dollar as a vehicle currency.  

The rest of the value of money story focuses on its supply. Bitcoin has the virtue of having a very well defined, programmatically determined gradual growth rate until its supply reaches 21 million in about 2040. The supply today (Aug 2021) is 18.77 million. See my earlier explanation: “Cryptocurrencies-the bitcoin phenomena”  The other 11,000 plus cryptocurrencies each have their own rules for determining their supply, some explicit and some rather mysterious. The class of so called “stable coins” are linked to and often redeemable for a specific anchor, sometimes the U.S. dollar or some other currency. The credibility of these anchors varies.

The highly successful E-gold (from 1996-2006) is an example of a digital currency that had well-defined and strict backing and redemption for a commodity at a fixed price. “E-gold”  The supply of such currencies is determined by market demand for it at its fixed price–what I have elsewhere called currency board rules. I describe how currency board rules work in my book about establishing the Central Bank of Bosnia and Herzegovina:   “One currency for Bosnia-creating the Central Bank of Bosnia and Herzegovina”

The dominance of the U.S. dollar in cross border payments reflects far more than its use as a vehicle currency. Many globally traded commodities, such as oil, are priced in dollars and thus payments for such purchases are settled in dollars. Pricing a homogeneous commodity trading in the global market in a single currency makes that market more efficient (the same price for the same thing).  Making cross border payments in dollars (or any other single currency) also avoids the costly need to exchange one for another in the FX market. The dollar is most often chosen because its value is relatively stable, and it has deep and liquid securities markets in which to hold dollars in reserve for use in cross border payments.

So, what are the chances that current cryptocurrency developments might precipitate a shift from the dollar to some other currency and means of payment. Several factors of U.S. policy have heightened interest by many countries in finding an alternative.  Specifically, from my recent article in the Central Banking Journal on the IMF’s $650 billion SDR allocation:

“Cumbersome payment technology. Existing arrangements for cross-border payments via Swift are technically crude and outmoded.

The weaponization of the dollar. The US has abused the importance of its currency for cross-border payments to force compliance with its policy preferences that are not always shared by other countries, by threatening to block the use of the dollar.

The growing risk of the dollar’s value. The growing expectation of dollar inflation and the skyrocketing increase in the US fiscal deficit are increasing the risk of holding and dealing in dollars.”  “The IMF’s 650bn SDR allocation and a future digital SDR”

Most central banks are upgrading their payment systems. But the Peoples Bank of the Republic of China (PBRC) is one of the most advanced in developing a central bank digital currency (CBDC), the e-CNY. However, it has little potential for displacing the dollar for several reasons. The Federal Reserve is also modernizing its payment technology, including exploring the design of its own CBDC, and can match China’s payment technology in the near future if necessary. More importantly, China’s capital controls, less developed Yuan financial markets, and less reliable rule of law make the Yuan an unattractive alternative to the dollar. These latter impediments do not apply to the Euro, however. “What will be impact of China’s state sponsored digital currency?”

Rather than looking for another national currency to replace the dollar, there are several advantages to using an international one. These include greater ease in making cross border payments and the reduced risk of political manipulation, or a national currency’s domestic mismanagement.  Bitcoin, for example, can make payments anywhere in the world without being controlled by any one of them. The serious drawbacks of Bitcoin’s blockchain payment technology might be overcome with one or another overlaid technology. But to become a serious currency, bitcoin must be dramatically more widely accepted in payment than it is now. Widespread acceptance in payments could generate the demand to hold them for payments, which would tend to stabilize its very erratic value. This seems very unlikely. A digital gold-based currency, such as the earlier E-gold, would enjoy the advantage of an anchor that is well known and that has enjoyed a long history. However, gold’s value has been very unstable in recent years. Aluminum has enjoyed a very stable price and elastic supply and will be the anchor for Luminium Coin to be launched in the coming weeks: https://luminiumcoin.com/

But the world has already established the internationally issued and regulated currency meant to supplement if not replace the dollar, the Special Drawing Rights of the International Monetary Fund. The IMF has just approved a very large increase in its supply.  “The IMF’s 650bn SDR allocation and a future digital SDR”  The SDR’s value is determined by the market value of (currently) five major currencies in its valuation basket. While all five of these currencies have a relatively stable value, the value of the basket (portfolio) of these five is more stable still. The rules for determining the SDR’s value and supply, as well as its uses, are well established and transparent and governed by the IMF’s 190 member countries. In short, the SDR is truly international. However, it can only be used by IMF member countries and ten international financial institutions such as the World Bank and the Bank for International Settlements.

While the SDR has played a limited useful role in augmenting central bank foreign exchange reserves, it has failed to achieve a significant role as an international currency because of the failure of the private sector to invoice internationally traded goods and financial instruments (such as bonds) in SDRs and the absence of a private digital SDR for payments. If the IMF is serious about making the SDR an important international currency it should turn its attention to encouraging these private sector uses of the unit. “Free Banking in the Digital Age”

In the long run the IMF should issue its official SDR according to currency board rules and anchor its value to the market value of a small basket of commodities rather than key currencies: “A Real SDR Currency Board”

[1] Warren Coats retired from the International Monetary Fund in 2003 where he led technical assistance missions to the central banks of more than twenty countries (including Afghanistan, Bosnia, Egypt, Iraq, Kazakhstan, Kenya, Kyrgyzstan, Serbia, South Sudan, Turkey, and Zimbabwe). He was a member of the Board of the Cayman Islands Monetary Authority from 2003-10. He is a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  He has a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago.

Whither Libra?

Every other day, it seems, we witness the launch of a new crypto (digital) currency.  Each combines a medium of exchange (a currency) and a means of payment (a technical process of delivering the currency—of making a payment with it). While many of us have watched the ups and downs of bitcoin and its imitators with amusement, none of us (hopefully) take it seriously as a currency. Bitcoin is a speculative vehicle for gambling.  Processing bitcoin payments is too slow, and its value is too volatile to succeed as a medium of exchange or as a means of payment. Only about 1% of bitcoin transactions are actual payments.  Many new means of payment do not involve a new currency.  Thus, debit and credit cards, checks, wire transfers, PayPal, Popmoney, Zelle, etc., are means of payment of US dollars, or Euros or other sovereign currencies.

Unlike the bitcoins of the world, Libra is a currency and means of payment that is designed to ensure that its tokens will have a stable value.  The legacy members of Facebook, Visa, Uber, and other partners in the Libra Association promise the possibility of rapid adoption. Libra’s value will be fixed to that of a basket of major currencies, its supply will be regulated by market demand at that fixed price (issued via currency board rules), and it will be fully backed by assets of the same value ensuring that holders of Libra can redeem them for the same value at any time.

Suddenly potential regulators are on high alert such as witnessed in the recent Congressional testimony of David Marcus, head of Facebook’s Calibra, to Congress.  By whom and how should Libra be regulated?  Obviously, it will need to comply with Anti Money Laundering (AML/CFT) requirements and whatever else each jurisdiction in which its participants reside (holders of “accounts” with Libra or of its tokens) require of money service providers. Banks take deposits and lend, so Libra would not be a bank. While its tokens might be treated as deposits, it will not lend (its purchases of government debt and other securities with the money paid to buy Libra are investments not loans).  In this short note I will explain why Libra—the coin/token/currency—is not a claim on a mutual fund and thus should not be regulated in the US by the Securities and Exchange Commission.  I will not, however, examine its claim to be a more efficient means of payment.

The nature of Libra’s claim of stability rests on how its value is determined.  Its value is to be fixed to the market value of a basket of currencies yet to be determined. But how does that work exactly?  The world already has an internationally determined and managed unit of account, the Special Drawing Right (SDR) of the International Monetary Fund.  Rather than introduce yet another, competitive unit the case for Libra to fix to the SDR is so overwhelming that I will illustrate the difference between a currency basket as a unit of account and as an investment portfolio with the SDR. The composition of the SDR’s valuation basket is established by international agreement following a well-specified and transparent process.  Fixing the value of a Libra to that of the SDR would remove any risk of its value being manipulated by Facebook or other Libra shareholders. That would strengthen the status of the Libra but also contribute to enhancing the IMF’s SDR as a supplement or substitute for the dollar in international reserves, as called for in the IMF’s Articles of Agreement.

The SDR’s value is determined by a basket of five currencies (the dollar, euro, pound sterling, yen and renminbi).  The IMF computes the dollar value of one SDR (and thus the value in every other currency) daily on the basis of the market exchange rate of each of the five currencies in the valuation basket into dollars.  The dollar values of each currency are added up to determine the dollar value of the basket.  By fixing the value of one Libra to one SDR it sets the price at which Libra can be purchased and the currency value that would be returned if Libra were redeemed.

This might seem similar to, but is in fact very different than, the value of one Libra being determined by the value of the portfolio of investments that back it.  The “Reserve” backing Libra would consist of SDR denominated assets (e.g., SDR bonds) or assets in each of the five basket currencies in the same proportion as in the SDRs valuation basket. Thus, it would bear no exchange rate risk.  However, the investment would have other risks, specifically interest rate and default risks.  To the extent that some of the Reserve’s investments are relatively long term (say ten-year Treasury bonds), changes in market interest rates would change the current market value of these investments. While Reserve investments would presumable be made only in the safest assets and would be limited to relatively short-term instruments, the risk of default or loss in value would not be zero.  So, if one Libra is a claim on its share of the Reserve, its value could differ from the daily dollar value of the SDR valuation basket.

Libra wishes to include the unbanked in its market, thus opening financial and payment services to this broad group now unable to enjoy them. If Libra’s value is fixed to the value of its Reserve, and thus regulated by the SEC (in the US), consumer protection investment regulations would likely exclude the very people Libra is most interested in serving. Thus, Libra should fix its value to that of a unit of account and not to the value of its Reserve.