Forget Church and State: The Coming Separation of Money & Banks

by Noah Jessop

Photo: Anthony Quintano

The many Bitcoin derivatives, Altcoins, and other token-based protocols have created a thriving, if wild, marketplace. To understand our manic monetary moment, examining the history of classical monetary policy can be helpful. Through most of history, central banks or other regulatory agencies determined how much money would be issued and how fast, which in turn determined how much interest could be earned.

Just as each country’s central bank gets to set the rules for their citizens, crypto projects and token-backed economies get to set the rules for creation and growth of their tokens. From the founding of PayPal to the latest ICO, we’ve learned that when you put 10M+ free market participants together, with billions of dollars on the line, outlier behavior will be more extreme than anything its creators may have architected. But this isn’t unique to cryptocurrencies. US currency has a history of user-led distortions. After all, the majority of US Dollars held were actually created in private hands. That sounds crazy, how did the US Government lose control of its own currency to this extent?

Photo: Pixabay

It’s simple: the invention of lending.

Say I buy your (small) one bedroom apartment in San Francisco. I borrow $1M from my local credit union or similar institution. I pay you this $1M and assume ownership of the condominium.

Two things happen here:

  1. You put this new $1M into your bank account (ignoring FDIC insurance for a minute here)
  2. But the original $1M I gave you came from the deposits at my local credit union — where to the depositors, it’s still waiting, ready for withdrawal at any time.

Welcome to banking’s Alchemy: $1M in deposits has just become $2M in deposits.

The price stability of a currency is based on presumed predictability in supply — almost any policy will do — so long as it’s a generally predictive path that market observers can perceive. So in the best of times, nations aspire to set monetary policy to produce slow, minimal inflation. People can at least know what to expect.

But I’ve just shown you that we can double money in the supply with the snap of our fingers.

Our central bankers — trying to juice the economy to behave like the ‘90s — have kept real interest rates pegged at zero for years. What has this done?

October 7th’s issue of the Economist has an idea: the cover proudly announces the arrival of “The bull market in everything.”

But if asset prices are just rising on real basis, we’re actually speeding up the engine for money creation I just showed you. Bigger prices lead to more money being created through the core alchemy of banking.

Liquidity Crunch

Banking’s alchemy goes unnoticed in good times. Problems only arrive when both you and the original depositor try to withdraw your money at the same time: the lending bank cannot force me to sell the condo in a snap (and if I did, it’d be at a discount). Liquidity is tricky like that.

Imagine you and the original depositors were the only participants in the entire banking system. If you both demanded your money at the same time, the issuing bank would be unable to pay. To prevent bank runs, US banks have insurance for depositors — and now the depositors would be made whole by US tax dollars. And the bonuses paid to bank employees for originating and issuing the mortgage may have been paid out long ago. This would be a micro-bailout.

The only instance the bank would be able to pay is if it had sufficient buffer of its own equity — i.e., stockholders and owners of the bank would have sufficient reserves to cover the cost. But this bank has only one loan and thus would have no real “equity” value. Bank equity-to-book sizes have fallen dramatically over the last 30 years from de-regulation.

So how can we prevent bank incentives from being “heads I win / tails you lose?” In the wake of the Great Depression, some of the smartest minds came together for a solution back in 1933: The Chicago Plan.

The Chicago Plan: 100% Collateral

Photo: Ibrahim Old

The notable economists behind the plan (including Irving Fisher, Frank Knight, and Henry Schultz, to name a few), proposed a relatively simple plan: banks must put up 100% of the value of the loans they would issue. Thus, if any of the loans went bad, there’d be ready funds to pay out the depositors.

A very important element of this proposal is that it would break the link between credit and the creation of money.

The plan eventually got watered down and never implemented to this degree. Credit would likely be harder to obtain in this new world with higher credit requirements — some lending is easier served by debt than equity in the company. For instance, it would be impractical to issue equities for the sale of every apartment. But the ideas of giving currency issuers control — instead of banks — remain powerful to this day.

Enter Crypto

Crypto has no banks yet — no set interest rates. So the lending market has not been copied from locally issued currency norms. What’s emerged is far more powerful.

Lending in Crypto economy is unlike anything we’ve seen in history so far. Rather than depositors turning over the obligations to a bank, receiving passive growth for their capital, these early days have produced a far more active system.

Those seeking credit can do something remarkable, in historical terms: they simply create their own “monetary country.” This monetary country releases its own currency to anyone who would like to exchange their reserve currency instead.

This allows “lending” of money that doesn’t directly double the reserve currency money supply — it converts “liquid” deposits (generally Bitcoin or Ethereum) to a lending cum equity hybrid. The loan is the money, which is the equity as well.

By Example: One-bed-condo-coin

Let’s look back to our earlier lending example. Rather than taking out a loan from a series of bank depositors, I may simply create a new monetary country (“my-one-bed-condo-coin” if you will) tying the future value of this condo to its reserve currency price, or a stream of reserve-currency payments I will make to inhabit the condo. Individual money holders may choose to convert a portion of their reserve currency to this new coin, in whatever proportion fits their financial goals.

If any of the individual money holders (or all of them) chose to return the value (plus any upside or downside) to reserve currency, they may trade their stake in my condo seamlessly to another individual (or financial institution) on an open exchange. If the monetary country of “my-one-bed-condo-coin” goes bad, buyers of these tokens will have lost value in their reserve currency — no government backing or FDIC insurance here.

Lots of challenges remain, particularly when connecting crypto economy to real-world assets like a condo or other things legally tied to a nation’s local currency. Regulation still has to evolve — and may be augmented with crypto-based trust and rating mechanisms in the shorter term.

Eventually, we will see market participants emerge that will bundle these types of holdings to give you return on your reserve currency — and portfolio construction will look more like mutual or index funds than pure deposits.

New World

Crypto has given us the Chicago plan: lending that is 100% backed by real capital. We’ve blended equity-like-notions in — which may help all market participants have “skin in the game.”

This new era has de-coupled monetary policy and currency value from banking and issuing credit. It may prevent much of incentive we’ve seen for financial alchemy from classical local-currency denominated banking. Many more risks for non-savvy holders in these early days, but no more bailouts.

A race for liquidity within any of these individual smaller monetary countries could cripple them. But the ecosystem of the reserve currencies will remain resilient and otherwise stable.

What nations have tried for years — full control of their currency — has arrived as an emergent property of this new crypto economy. Better buckle up.

Disclosure: this author invests (both personally and through Founder Collective) in crypto assets and startups.

Much of this piece has emerged from discussions with and thoughts from central banking professionals. If you are thinking about these issues as they relate to your currency or state and would like to continue the discussion, please do reach out to the author.