The Fed's Disastrous Confusion about Money by@kameir

The Fed's Disastrous Confusion about Money

July 9th 2022 58,905 reads

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The term “money” is often used as a synonym for currency. However, the determination of the former qualification is observably a distinction left entirely to users of the latter. The Federal Reserve has taken the lead on discussing a potential U.S. CBDC with a paper titled “Money and Payments: The U.K. Dollar in the Age of Digital Transformation” The paper enumerates multiple forms of money, differentiating these mostly by their credit and liquidity risks across the central bank, commercial bank and 'nonbank money'
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Christian Kameir

Blockchain VC @ Sustany Capital

The term “money” is often used as a synonym for currency. However, the determination of the former qualification is observably a distinction left entirely to users of the latter. Which is to say that money is a contract between two or more parties. The arrangement solves a central challenge in trade referred to as the coincidence of wants problem, entailing an agreement over one or more units of account and media of exchange.


To reduce frictions in commerce, communities, organizations and countries frequently standardize these agreements, creating more efficient systems referred to as currencies. As such, a five-dollar Federal Reserve note may solve the trade problem between the seller and buyer of a pack of cigarettes, while the contents of the latter may be a common medium of exchange and unit of account in a friendly poker game. While a merchant may refuse Federal Reserve notes over a certain denomination, legal tender laws may require him to accept the same as a settlement for an outstanding debt.


A Federal Reserve note is a physical manifestation of a fiat currency. The latter is often contrasted to commodity currencies—where the price for the good matches the unit of account imprinted on it. The term 'fiat' refers to the proclamation of authority that it wishes a particular unit of account to be used as money. As such, casinos may declare that poker chips should be considered the default medium of exchange within its place of business, and an online business may pronounce that the only currency it finds acceptable is a digital bearer instrument such as bitcoin or other digital currency.


The historic definition (dating back to 1875) of a unit of account, medium of exchange and a store of value may be an appropriate definition of a commodity currency but, in general, do not describe its function as money. The latter is defined solely by the parties of a trade. It is surprising to find the conflation of currency and money in many contemporary papers of government agencies around the globe as the foundation of a discussion around new forms of payment such as central bank digital currencies (CBDCs).


In the United States, the Federal Reserve has taken the lead on discussing a potential U.S. CBDC with a paper titled, “Money and Payments: The U.S. Dollar in the Age of Digital Transformation.” The document purports to summarize the current state of domestic payments systems and further discuss the different types of digital payment methods and assets that have emerged in recent years.


However, the discussion fails to distinguish between the legal nature of money and its technical implementation of currency. Moreover, rather than clearly identifying the current technologies that are available, the paper enumerates multiple forms of money, differentiating these mostly by their credit and liquidity risks across the central bank, commercial bank and 'nonbank money'. The latter refers to digital balances held by financial service providers such as PayPal, Square, and other applications which hold balances via web or mobile payment applications. Unlike commercial banks, these applications do not create new currency but enable users to move account entries with greater ease and/or adding other features to the exchange of funds.


In an attempt to discern a central bank digital currency from existing forms of money, the Fed's paper defines a CBDC as a digital liability of a central bank that is widely available to the general public and analogous to a digital form of paper money.* The latter implementation currently takes on the form of Federal Reserve notes in seven denominations and various forms of coinage.


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As bearer instruments, cash—as it is commonly referred to—is frequently accepted without a fee and minimizes settlement risks for the party accepting it in return for goods or services. However, notes have largely been displaced in commerce by digital currency transfer. As of today, only commercial bank money—and to a lesser extent nonbank money—are available in digital form.


While Federal Reserve Banks are set up like private corporations, their purpose is to serve the public, and thus consumers do not pay fees for using central bank money. However, commercial banks and most nonbank financial service providers operate as for-profit entities and, therefore, optimize their operations to increase earnings, and ultimately shareholder value. As such, banks derive revenue from consumers and companies, using commercial bank currencies to settle economic activities.


As a comprehensive report by McKinsey & Company shows, banks generate roughly 30% of their revenues from payments. However, much of these proceeds are going toward compliance costs and anti-money laundering prevention. According to a report by LexisNexis, financial crime compliance costs amounted to nearly $9 billion in 2021 for U.S. financial service providers. Every digital transaction carries detailed information about the sender and receiver—and in some cases, the goods purchased, which are then screened by all financial intermediaries for illegal activities.


As much as 95% of transactions flagged are false positives, costing banks billions in wasted investigation times. Ultimately all these costs are passed on to customers as fees. At an average cost of 2% of the digital exchange of commercial bank currency, its entire value is essentially absorbed by financial intermediaries after just 50 transactions.


A CBDC analogous to a digital form of paper money—a digital bearer instrument, would not require intermediaries for most transactions carried out by consumers today. Payments for everyday purchases could be done without revealing the identities of the parties involved in the same way that users may choose to pay in cash. This would help combat cybercrime while freeing up resources to identify truly illicit activities.


Conclusion

Currencies are technologies that depend on network effects. In economies dominated by digital solutions, the medium of exchange has de facto defaulted to bytes expressing a particular type of agreement - i.e., the terms of a demand deposit account, or certificate of deposit etc. In as much as the latter introduces counter-party risks, these can be offset by holding U.S. Treasuries, or Federal Reserve notes. Should the latter be available as digital bearer instruments, investors can expect to see an explosion of new solutions in the form of programmable money, or what could be referred to as Fintech 2.0.


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P.S. These are excerpts from our upcoming book Streaming Money, which you can pre-order here.


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