Tag: Trust

Forms of Money, How They are Stored, How They Move

While exploring the impact of stablecoins on the future of money, I have found that public discussion of digital money often tends to conflate three things that are analytically distinct: the monetary instrument itself, the form in which it is stored or represented, and the infrastructure used to move it between parties. I believe that separating them assists understanding what is genuinely new about stablecoins and tokenised deposits, what is merely a change of form or rail, and where the real regulatory and systemic questions lie.

The three questions are: 

• what is the money (the underlying claim and who stands behind it)? 

• how is it held (the representation or storage form)? and 

• how does it move (the payment rail or transmission infrastructure)? 

Each has a different answer for central bank money, bank deposits, and fiat-backed stablecoins — and the differences matter at each level independently.

The Monetary Instrument

The monetary instrument is the underlying claim: i.e. the asset you actually own when you hold money. For central bank money, this is the liability of the central bank — a claim on the state that is backstopped by the sovereign’s taxing power and the central bank’s capacity to create reserves. For commercial bank deposits, it is a claim on an individual bank, convertible at par into central bank money on demand, and backstopped by deposit insurance, banking regulation, and lender-of-last-resort facilities. For a fiat-backed stablecoin, it is a claim on the issuer, redeemable for the reference fiat currency, and backstopped only by the reserve assets held and the legal framework governing redemption.

The monetary instrument is defined by who is liable (central bank, commercial bank, or stablecoin issuer), what backs that liability (sovereign authority, deposit insurance and capital, or reserve assets), and what rights the holder has (redemption at par, deposit insurance coverage, bankruptcy priority).

These are properties of the instrument regardless of how it is stored or how it is transmitted. A bank deposit is the same instrument whether it is accessed via a cheque book, a debit card, an online banking portal, or a tokenised deposit on a blockchain. The underlying claim — and its legal, regulatory, and credit characteristics — does not change because the representation changes.

The Representation and Storage Form

The representation form is how the monetary instrument is recorded, held, and evidenced. This is the dimension most directly affected by digitisation. Historically, representation forms have included: physical notes and coins (bearer instruments, value in the object); entries in a bank’s paper or electronic ledger (account-based, value in the record); and book entries in a central bank’s reserve account system (account-based, institutional access only).

Tokenisation is a change of representation form, not of monetary instrument. A tokenised deposit is the same bank deposit claim represented as a programmable token on a distributed ledger rather than as an entry in the bank’s conventional core banking system. The EBA (December 2024) is explicit on this point for EU law: a tokenised deposit remains a deposit for all legal and regulatory purposes.

The token is the envelope; the deposit is the contents. Similarly, a fiat-backed stablecoin token is the representation of a claim on the issuer — the token itself is not the money, it is the bearer instrument evidencing the money claim.

The representation form matters because it determines: programmability (can conditional logic be embedded?); composability (can the instrument interact with other on-chain instruments without conversion?); and bearer versus account-based character (does transfer require identity verification, or does possession of the token suffice?).

But changes in representation form do not, by themselves, change the nature of the underlying monetary claim or its regulatory treatment — though they may reveal that the regulatory framework was not designed with that representation in mind, creating classification gaps.

The Payment Rail

The payment rail is the infrastructure used to transmit value between parties: the pipes, protocols, and settlement systems through which money moves. The rail is analytically independent of both the instrument and its representation form. The same bank deposit can be transmitted via SWIFT (correspondent banking), Faster Payments (domestic push), RTGS (large-value settlement), a debit card network (Visa/Mastercard acquiring infrastructure), or a mobile payment app (M-Pesa, Venmo). The instrument does not change; the rail does.

For stablecoins, the blockchain is the payment rail. Solana, Ethereum, Tron, and Base are rails — infrastructure choices that determine transaction speed, cost, finality, programmability, and geographic accessibility. A USDC token on Solana and a USDC token on Ethereum represent the same underlying claim on Circle (the issuer) but travel on different rails with different properties. The rail choice affects the user experience and operational risk profile of a payment, but does not change what the USDC token is: a claim on Circle’s reserve pool, redeemable 1:1 for US dollars.

Some implications

The conflation of rail and instrument is I believe the source of several analytical errors that appear in policy discussions. When commentators argue that stablecoins are ‘just a payment method’, they are (correctly) identifying that the blockchain is a rail, but they may also be (incorrectly) implying that this makes the stablecoin token equivalent to a bank deposit. Comparisons of stablecoin transactions with credit card payments are I think equally problematic. It is rare in my experience to see much discussion of how fast payment systems stack up against stablecoins in terms of cost and speed. The added cost and complexity of the on/off ramps with the traditional banking system may also be missing.

The rail properties of a blockchain — open access, programmability, pseudo-anonymous transfer, irreversible finality — are genuine and consequential differences from RTGS or card networks. But there are significant differences between a stablecoin and a bank deposit at the instrument-level: who is liable, what backs the claim, whether deposit insurance applies, and whether settlement occurs in central bank money.  

A further rail-level property requires explicit treatment: settlement finality on public blockchains is probabilistic, not absolute. On proof-of-work networks, finality accumulates over multiple block confirmations; on proof-of-stake networks such as Ethereum, economic finality is reached after two checkpoint epochs (approximately 12–15 minutes), though transactions may be practically irreversible within one or two blocks in most conditions. Solana’s optimistic confirmation model offers near-instant practical finality but with a technically distinct guarantee than Ethereum’s checkpoint-based economic finality. This contrasts with RTGS systems (Fedwire, TARGET2, CHAPS) where settlement is legally final and irrevocable the moment it is posted to the central bank’s books. 

The finality distinction has direct institutional adoption implications: settlement finality is a legal and operational requirement for securities settlement (Delivery vs. Payment), large-value interbank transactions, and any use case governed by the EU’s Settlement Finality Directive or equivalent. A public blockchain rail that cannot offer the same finality guarantee as an RTGS system is not a direct substitute for those use cases until either the regulatory framework recognises on-chain finality as legally equivalent, or wholesale CBDC rails provide a bridge between blockchain settlement and central bank money finality.

I suspect that I am only scratching the surface of this topic and I am straying way outside my area of expertise so treat the above with caution. I am writing it down to clarify for myself the extent to which I have an understanding of the topic.

Feedback welcome on anything I have wrong or that I am missing

Tony – From the Outside

Marc Rubinstein on deposit insurance

Marc Rubinstein offers a nice summary of the history of deposit insurance in the USA. The post is short and worth reading but the short version is captured in his conclusion…

Deposit insurance was never meant to preserve wealth … It was meant to preserve the functioning of the banking system. What the correct number is to accomplish that is a guess, but it’s going up.

Red flags in financial services

Nice podcast from Odd Lots discussing the Wirecard fraud. Lots of insights but my favourite is to be wary when you see a financial services company exhibit high growth while maintaining profitability.

There may be exceptions to the rule but that is not how the financial services market normally works.

podcasts.apple.com/au/podcast/odd-lots/id1056200096

Tony — From the Outside

Matt Levine on stuff that gets lost in translation

I have been referencing Matt Levine a lot lately. No apologies, his Money Stuff column is a regular source of insight and entertainment for banking and finance tragics such as myself and I recommend it. His latest column (behind a paywall but you can access a limited number of articles for free I think) includes a discussion of the way in which the DeFi industry has created analogues of conventional banking concepts like “deposits” but with twists that are not always obvious or indeed intuitive to the user/customer.

We have talked a lot recently about how crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account.

Matt Levine “Money Stuff” column 28 June 2022 – Crypto depositors

How banks can create safe assets is a topic that I have looked at a number of times but this post is my most complete attempt to describe the process that Matt outlines above. To me at least, this is a pretty fundamental part of understanding how finance works and Matt also did a good post on the topic that I discussed here.

One of the key points is that the tranching of liabilities also creates a division of labour (and indeed of expertise and inclination) …

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.

The DeFi industry argues that they want to change the ways that traditional finance operates for the benefit of users but it also expects those users to be motivated and engaged in understanding the details of the new way of doing things. A problem is that some users (maybe “many users”?) might be assuming that some of the rules that protect depositors (and indeed creditors more generally) in the conventional financial system would naturally be replicated in the alternative financial system being created.

Back to Matt …

The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.

The problem according to Matt is ….

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.

This feels like a problem to me. As the industry becomes more regulated I would expect to see the issues of seniority and deposit protection/preference more clearly spelled out. For the time being it does seem to be very much caveat emptor and don’t assume anything.

Tony – From the Outside

“Safe” assets can be risky – check your assumptions

Anyone moderately familiar with crypto assets is no doubt aware that the Terra stablecoin has been experiencing problems with its algorithmic smart contract controlled peg mechanism. There are lots of lessons here I am but I think Matt Levine flags one of the more interesting ones in his “Money Stuff” column (13 May 2022).

Safe assets are much riskier than risky ones.

Matt goes on to expand on why this is so …

This is I think the deep lesson of the 2008 financial crisis, and crypto loves re-learning the lessons of traditional finance. Systemic risks live in safe assets. Equity-like assets — tech stocks, Luna, Bitcoin — are risky, and everyone knows they’re risky, and everyone accepts the risk. If your stocks or Bitcoin go down by 20% you are sad, but you are not that surprised. And so most people arrange their lives in such a way that, if their stocks or Bitcoin go down by 20%, they are not ruined.

On the other hand safe assets — AAA mortgage securities, bank deposits, stablecoins — are not supposed to be risky, and people rely on them being worth what they say they’re worth, and when people lose even a little bit of confidence in them they crack completely. Bitcoin is valuable at $50,000 and somewhat less valuable at $40,000. A stablecoin is valuable at $1.00 and worthless at $0.98. If it hits $0.98 it might as well go to zero. And now it might!

The takeaway for me is to once again highlight the way in which supposedly safe, “no questions need be asked”, assets can sometimes be worse than assets we know are risky due to the potential for them to quickly flip into something for which there is no liquidity, just a path to increasingly large price falls. This is a theme that I regularly hammer (so apologies if you are tired of it) but still for me one of the more important principles in finance (right up there with “no free lunch”).

Tony – From the Outside

The elasticity of credit

One of the arguments for buying Bitcoin is that, in contrast to fiat currencies that are at mercy of the Central Bank money printer, its value is underpinned by the fixed and immutable supply of coins built into the code. Some cryptocurrencies take this a step further by engineering a systematic burning of their coin.

I worry about inflation as much as the next person, perhaps more so since I am old enough to have actually lived in an inflationary time. I think a fixed or shrinking supply is great for an asset class but it is less obvious that it is a desirable feature of a money system.

Crypto true believers have probably stopped reading at this point but to understand why a fixed supply might be problematic I can recommend a short speech by Claudio Borio. The speech dates back to 2018 but I think it continues to offer a useful perspective on the value of an elastic money supply alongside broader comments about the nature of money and its role in the economy.

Borio was at the time the Head of the BIS Monetary and Economic Department but the views expressed were his personal perspective covering points that he believed to be well known and generally accepted, alongside others more speculative and controversial.

I did a post back in March 2019 that offers an overview of the speech but recently encountered a post by J.W. Mason which reminded me how useful and insightful it was.

The specific insight I want to focus on here is the extent to which a well functioning monetary system relies on the capacity of credit extended in the system to expand and contract in response to both short term settlement demands and the longer term demands driven by economic growth.

One of the major challenges with the insight Borio offers is that most of us find the idea that money is really just a highly developed form of debt to be deeply unsatisfying if not outright scary. Borio explicitly highlights “the risk of overestimating the distinction between credit (debt) and money” arguing that “…we can think of money as an especially trustworthy type of debt”

Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.

Borio: Page 9

I did a post here that explains in more detail an Australian perspective on the process by which unsecured loans to highly leveraged companies (aka “bank deposits”) are transformed into (mostly) risk free assets that represent the bulk of what we use as money.

Borio outlines how the central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled …

“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”

Borio: Page 5

… but also recognises the problem with too much elasticity

While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.

This is a big topic which means there is a risk that I am missing something. That said, the value of an elastic supply of credit looks to me like a key insight to understanding how a well functioning monetary system should be designed.

The speech covers a lot more ground than this and is well worth reading together with the post by J.W. Mason I referenced above which steps through the insights. Don’t just take my word for it, Mason introduces his assessment with the statement that he was “…not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker”.

Tony – From the Outside

Never let the facts stand in the way of a good story

Shout out to Tim Harford for this introduction to the study of how, in his words, ignorance can be deliberately produced. The technical term “agnatology” is I suspect unlikely to catch on but the underlying message is one worth understanding. At a minimum it is a handy addition to your Scrabble dictionary.

The article was originally published in March 2017 but I only came across it recently via this podcast interview Harford did with Cardiff Garcia on “The New Bazaar”. The context in 2017 was the successful campaign for the US presidency that Donald Trump ran during 2016 with a bit of Brexit thrown in but this is a challenge that is not going away anytime soon.

Harford notes that it is tempting to think that the answer to the challenge posed by what has come to be known as a post truth society lies in a better process to establish the facts

The instinctive reaction from those of us who still care about the truth — journalists, academics and many ordinary citizens — has been to double down on the facts.

He affirms the need to have some agreement on how we distinguish facts from opinions and assertions but he cautions that this is unlikely to solve the problem. He cites the tobacco industry response to the early evidence that smoking causes cancer to illustrate why facts alone are not enough.

A good place to start is by delving into why facts alone are not enough – a few extracts from the article hopefully capture the main lessons

Doubt is usually not hard to produce, and facts alone aren’t enough to dispel it. We should have learnt this lesson already; now we’re going to have to learn it all over again…

Tempting as it is to fight lies with facts, there are three problems with that strategy…

The first is that a simple untruth can beat off a complicated set of facts simply by being easier to understand and remember. When doubt prevails, people will often end up believing whatever sticks in the mind…

There’s a second reason why facts don’t seem to have the traction that one might hope. Facts can be boring. The world is full of things to pay attention to, from reality TV to your argumentative children, from a friend’s Instagram to a tax bill. Why bother with anything so tedious as facts?…

In the war of ideas, boredom and distraction are powerful weapons.
The endgame of these distractions is that matters of vital importance become too boring to bother reporting…

There’s a final problem with trying to persuade people by giving them facts: the truth can feel threatening, and threatening people tends to backfire. “People respond in the opposite direction,” says Jason Reifler, a political scientist at Exeter University. This “backfire effect” is now the focus of several researchers, including Reifler and his colleague Brendan Nyhan of Dartmouth…

The problem here is that while we like to think of ourselves as rational beings, our rationality didn’t just evolve to solve practical problems, such as building an elephant trap, but to navigate social situations. We need to keep others on our side. Practical reasoning is often less about figuring out what’s true, and more about staying in the right tribe…

We see what we want to see — and we reject the facts that threaten our sense of who we are…

When we reach the conclusion that we want to reach, we’re engaging in “motivated reasoning”…

Even in a debate polluted by motivated reasoning, one might expect that facts will help. Not necessarily: when we hear facts that challenge us, we selectively amplify what suits us, ignore what does not, and reinterpret whatever we can. More facts mean more grist to the motivated reasoning mill. The French dramatist Molière once wrote: “A learned fool is more foolish than an ignorant one.” Modern social science agrees…

When people are seeking the truth, facts help. But when people are selectively reasoning about their political identity, the facts can backfire.

So what are we to do?

Harford cites a study that explores the value of scientific curiosity

What Kahan and his colleagues found, to their surprise, was that while politically motivated reasoning trumps scientific knowledge, “politically motivated reasoning . . . appears to be negated by science curiosity”. Scientifically literate people, remember, were more likely to be polarised in their answers to politically charged scientific questions. But scientifically curious people were not. Curiosity brought people together in a way that mere facts did not. The researchers muse that curious people have an extra reason to seek out the facts: “To experience the pleasure of contemplating surprising insights into how the world works.”

It is of course entirely possible that Tim Harford’s assessment is just calling to my own bias. I will admit that one the things that I always looked for when hiring, or working, with people was curiosity. These people are surprisingly rare but (IMHO) worth their weight in gold. An intellectually curious mind makes up for a lot of other areas where the person might not be perfect in terms of skills or experience. The general point (I think) also ties to the often cited problem that people with lots of knowledge can sometimes be prone to not being so street smart. Nassim Taleb makes this argument in nearly everything he writes.

So Tim Harford might not be offering the entire answer but I think his article is worth reading on two counts

  • Firstly as a cautionary tale against expecting that all debates and disputes can be resolved by simply establishing the “facts”
  • Secondly as a reminder of the power of a curious mind and the value of the never-ending search for “what am I missing?”

Let me know what I am missing

Tony – From the Outside

Dee Hock, the Father of Fintech

Marc Rubinstein writing in his “Net Interest” newsletter has a fascinating story about the history of Visa. The article is interesting on a number of levels.

It is partly a story of the battle currently being played out in the “payments” area of financial services but it also introduced me to the story of Dee Hock who convinced Bank of America to give up ownership of the credit card licensing business that it had built up around the BankAmericard it had launched in 1958. His efforts led to the formation of a new company, jointly owned by the banks participating in the credit card program, that was the foundation of Visa.

The interesting part was that Visa was designed from its inception to operate in a decentralised manner that balanced cooperation and competition. The tension between cooperation (aka “order”) and competition (sometimes leading to “disorder”) is pervasive in the world of money and finance. Rubinstein explores some of the lessons that the current crop of decentralised finance visionaries might take away from this earlier iteration of Fintech. Rubinstein’s post encouraged me to do a bit more digging on Hock himself (see this article from FastCompany for example) and I have also bought Hock’s book (“One from Many: VISA and the Rise of Chaordic Organization“) to read.

There is a much longer post to write on the issues discussed in Rubinstein’s post but that is for another day (i.e. when I think I understand them so I am not planning to do this any time soon). At this stage I will just call out one of the issues that I think need to be covered in any complete discussion of the potential for Fintech to replace banks – the role “elasticity of credit” plays in monetary systems.

“Elasticity of credit”

It seems pretty clear that the Fintech companies offer a viable (maybe compelling) alternative to banks in the payment part of the monetary system but economies also seem to need some “elasticity” in the supply of credit. It is not obvious how Fintech companies might meet this need so maybe there remains an area where properly regulated and supervised banks continue to have a role to play. That is my hypothesis at any rate which I freely admit might be wrong. This paper by Claudio Borio offers a good discussion of this issue (for the short version see here for a post I did on Borio’s paper).

Recommended

Tony – From the Outside

The potential for computer code to supplant the traditional operating framework of the economy and society

I am very far from expert on the issues discussed in the podcast this post links to, I am trying however to “up-skill”. The subject matter is a touch wonky so this is not a must listen recommendation. That said, the questions of DeFi and cryptocurrency are ones that I believe any serious student of banking and finance needs to understand.

In the podcast Demetri Kofinas (Host of the Hidden Forces podcast) is interviewed by two strong advocates of DeFi and crypto debating the potential of computer code to supplant legal structures as an operating framework for society. Demetri supports the idea that smart contracts can automate agreements but argues against the belief that self-executing software can or should supplant our legal systems. Computer code has huge potential in these applications but he maintains that you will still rely on some traditional legal and government framework to protect property rights and enforce property rights. He also argues that it is naïve and dangerous to synonymize open-source software with liberal democracy.

I am trying to keep an open mind on these questions but (thus far) broadly support the positions Demetri argues. There is a lot of ground to cover but Demetri is (based on my non-expert understanding of the topic) one of the better sources of insight I have come across.

Tony – From the Outside

What is the alternative to Friedman’s capitalism?

I have been digging into the debate about what Milton Friedman got right and wrong about the social responsibility of business. I am still in the process of organising my thoughts but this discussion on the “Capitalisn’t” podcast is, I think, worth listening to for anyone interested in the questions that Friedman’s 1970 essay raises.

You can find the podcast here

podcasts.apple.com/au/podcast/what-is-the-alternative-to-friedmans-capitalism/id1326698855

Tony – From the Outside