We already have a utility settlement coin: it’s called the euro
Four banks have stolen loads of column inches on Wednesday with news that they are developing
“a new form of digital cash that they believe will become an industry
standard to clear and settle financial trades over blockchain, the
technology underpinning bitcoin”.
In the fanfare, however, lots of common sense has been abandoned.
The big idea here (allegedly) is that banks will use a “utility settlement coin” to bypass the need for costly and inefficient fiat liquidity from the cbank.
Prior to the introduction of the euro as the go-to “bridging currency” for the multi-currencied eurosystem, cross-border international settlements in Europe were mainly settled using the dollar as a “bridging currency”. As Patrick Mcguire at the BIS recounted in 2004, throughout the 1970s and 1980s, almost all trading of convertible currencies used the US dollar as a conduit currency. When the euro was introduced US dollar transactions shrank by about 15 per cent. And yet, because demand for higher yielding eurodollar deposits didn’t go away, these excess dollars were instead put to use financing US dollar borrowing by non-banks, primarily in the United States.
In short there is a viable argument to be made that the creation of a eurozone master settlement currency (aka the euro) augmented cross-border imbalances in the global monetary system. So there’s that to consider when flouting new master settlement currency systems as controlled by new bank cartel systems.
But there’s also the RTGS issue.
Since time immemorial, banks have used private techniques to square or “net” intraday obligations between themselves to cut the cost of having to source final settlement currency every time they transact. As a result these processes have minimised the capital intensity of their operations. Under such systems if and when imbalances between the banking system and the central bank did pop up they did so either because of unexpected demand for banknotes the banks couldn’t print directly or because somewhere in the system they had double-counted something or over-extended credit which had no chance of being squared ahead of a regulatory check. In the latter situation such imbalances resulted either from temporal lags in the squaring system due to administrative errors or an inability to liquidise existing assets quickly enough to make reserve requirement (aka a liquidity issue) or simply because the system as a whole was operating on an unfunded basis (implying bank-specific or system-wide solvency issues).
The difficulty of predicting who would might be caught short turned it all into a bit of an arbitrary game of musical chairs.
In a bid to prevent banking panics or price instability scenarios, central banks would punish whatever banks drew were left holding the short straw at pre-determined times — denying them liquidity unless they had viable assets to pledge. The fear of being caught out created a mutual incentive amongst all banks to act prudently.
All this changed, however, when real-time-gross settlement (RTGS) systems were introduced to the world of central banks in the 1990s. To avoid the nasty problem of some banks finding themselves without a seat in the liquidity musical chairs game, the system moved to a continuous settlement system instead. Thanks to digital technological tools, it was now believed banks could finally have the best of both worlds: the low risk scenario of a real-time clearing system, where system imbalances never amounted to much because everything was squared on the go, as well as the low capital cost of a netting system, because the instantaneity of the system meant the overall daily imbalance of the system was so small it needed hardly any reserve capital at all.
The problem with RTGS systems, however, was that even one teeny tiny delay could snowball into a system-wide freeze. To keep the system flowing, liquidity had to be dispensed to members on an on-demand basis. As a result whatever liquidity banks needed, they got. And banks determined how much “final settlement currency” was consequently in circulation at any given point rather than the central bank.
For the most part banks would only be punished if they had badly forecast their liquidity needs. Credit quality, some might say, became an after thought.
Fast forward to 2008, and it’s fair to say things started to go wrong. Over time, the quality of the underlying assets which could be used by banks to raise emergency funds began to lose their market appeal and trust. The story of what happened next is well known. The one thing we’ll add is that by injecting permanent liquidity into the system against government-issued bonds to cope with the distress, central banks arguably intensified the capital costs of the clearing system. The sheer volume of additional idle reserves made this inevitable. We’d also add that central banks may have inadvertently broadcast via this process that Tbills were now a better and more universal form of final settlement unit than central bank reserves.
So how does the introduction of a new real-time clearing conduit-currency combat the capital intensity of the current settlement system? We’re not sure it does.
What the proposal really amounts to is the introduction of a parallel clearing system that claims to be less capital intensive than the underlying system, and which can as a consequence minimise the amount of flow which needs to be transacted through the capital intense system. Except rather than being based on a netting system it’s based on a zero-reserve RTGS system run on a blockchain, with the ultimate objective of phasing out the need to settle through the central bank reserve system altogether.
All this sounds lovely in theory. Except… if what’s really plaguing the market is an overall loss in faith in unbacked bank reserves, then just substituting a final settlement system which has finally been backed with something of significance (government bonds) for one that is backed by nothing isn’t going to solve the capital intensity problem of the clearing system or the real capital shortage issue in the market (a.k.a the scarcity of safe assets).
Moreover, if the expectation is that a “utility settlement coin” will be so good at squaring value within its own parallel closed system that it will never need to source additional intraday liquidity from the central bank to cover unexpected logjams (something we think is super unlikely in a competitive system)…we’d note, that doesn’t necessarily free up spare capital either.
If any potential liquidity jams are to be dealt with by the blockchain issuing its own liquidity against high quality collateral encumbered in a self-governed multilateral escrow account, that doesn’t solve the capital intensity issue either.
If, however, the blockchain plans to issue liquidity against nothing at all, then the question becomes why bother calling this a clearing system at all?
To wit, Bloomberg’s Matt Levine nails the real innovation in play:
And even if one specific blockchain-based pseudo currency could convince all the world’s banks to accept it over all other reserves, there’s still another paradox in play. The less capital intensive a pseudo currency is, or the easier it is for one bank faction to produce it over another bank faction (like err Irish and Greek banks vs German banks) the less likely it is to be a universally accepted pseudo currency. Universal “final settlement” status isn’t necessarily something that can be engineered, especially in a world where Tbills are still the preferred balancing unit.
Bitcoin’s proof of work mechanism may be a hugely capital intensive waste of energy, but it’s also the thing which keeps it honest and endows the scheme with some known value set.
That a handful of banks feel inclined to create and treat a psuedo-currency as a final settlement unit between themselves, says nothing about whether the rest of the world will agree with them on that categorization. After all, the top of the money hierarchy tree isn’t determined by a “final settlement unit’s” capacity to balance a bunch of arbitrary numerical inputs in ways that a computer deems appropriate (the euro achieves that job fine). It’s determined by a final settlement unit’s ability to create real value so as to give rise to a socio-economic system which benefits as many people as possible (something the euro currently certainly does not do).
Related links:
The eurodollar as an economic no-man’s land – FT Alphaville
Brexit, the Target2 angle – FT Alphaville
Big banks plan to coin new digital currency – FT
In the fanfare, however, lots of common sense has been abandoned.
The big idea here (allegedly) is that banks will use a “utility settlement coin” to bypass the need for costly and inefficient fiat liquidity from the cbank.
The utility settlement coin, based on a solution developed by Clearmatics Technologies, aims to let financial institutions pay for securities, such as bonds and equities, without waiting for traditional money transfers to be completed. Instead they would use digital coins that are directly convertible into cash at central banks, cutting the time and cost of post-trade settlement and clearing.Except none of this is new. And none of this is really all that pioneering. In fact, we’d argue, it’s more of a step back to the logic that brought us the euro than it is a step forward. As we’ve noted before, the Target settlement system underpinning the euro was from the outset supposed to fulfill two objectives: to allow the European central bank to transmit its monetary policy decisions to the money markets and to develop a sound and efficient payments and clearing system by introducing a real-time gross settlement systems and one overarching common clearing currency (a.k.a the euro).
Prior to the introduction of the euro as the go-to “bridging currency” for the multi-currencied eurosystem, cross-border international settlements in Europe were mainly settled using the dollar as a “bridging currency”. As Patrick Mcguire at the BIS recounted in 2004, throughout the 1970s and 1980s, almost all trading of convertible currencies used the US dollar as a conduit currency. When the euro was introduced US dollar transactions shrank by about 15 per cent. And yet, because demand for higher yielding eurodollar deposits didn’t go away, these excess dollars were instead put to use financing US dollar borrowing by non-banks, primarily in the United States.
In short there is a viable argument to be made that the creation of a eurozone master settlement currency (aka the euro) augmented cross-border imbalances in the global monetary system. So there’s that to consider when flouting new master settlement currency systems as controlled by new bank cartel systems.
But there’s also the RTGS issue.
Since time immemorial, banks have used private techniques to square or “net” intraday obligations between themselves to cut the cost of having to source final settlement currency every time they transact. As a result these processes have minimised the capital intensity of their operations. Under such systems if and when imbalances between the banking system and the central bank did pop up they did so either because of unexpected demand for banknotes the banks couldn’t print directly or because somewhere in the system they had double-counted something or over-extended credit which had no chance of being squared ahead of a regulatory check. In the latter situation such imbalances resulted either from temporal lags in the squaring system due to administrative errors or an inability to liquidise existing assets quickly enough to make reserve requirement (aka a liquidity issue) or simply because the system as a whole was operating on an unfunded basis (implying bank-specific or system-wide solvency issues).
The difficulty of predicting who would might be caught short turned it all into a bit of an arbitrary game of musical chairs.
In a bid to prevent banking panics or price instability scenarios, central banks would punish whatever banks drew were left holding the short straw at pre-determined times — denying them liquidity unless they had viable assets to pledge. The fear of being caught out created a mutual incentive amongst all banks to act prudently.
All this changed, however, when real-time-gross settlement (RTGS) systems were introduced to the world of central banks in the 1990s. To avoid the nasty problem of some banks finding themselves without a seat in the liquidity musical chairs game, the system moved to a continuous settlement system instead. Thanks to digital technological tools, it was now believed banks could finally have the best of both worlds: the low risk scenario of a real-time clearing system, where system imbalances never amounted to much because everything was squared on the go, as well as the low capital cost of a netting system, because the instantaneity of the system meant the overall daily imbalance of the system was so small it needed hardly any reserve capital at all.
The problem with RTGS systems, however, was that even one teeny tiny delay could snowball into a system-wide freeze. To keep the system flowing, liquidity had to be dispensed to members on an on-demand basis. As a result whatever liquidity banks needed, they got. And banks determined how much “final settlement currency” was consequently in circulation at any given point rather than the central bank.
For the most part banks would only be punished if they had badly forecast their liquidity needs. Credit quality, some might say, became an after thought.
Fast forward to 2008, and it’s fair to say things started to go wrong. Over time, the quality of the underlying assets which could be used by banks to raise emergency funds began to lose their market appeal and trust. The story of what happened next is well known. The one thing we’ll add is that by injecting permanent liquidity into the system against government-issued bonds to cope with the distress, central banks arguably intensified the capital costs of the clearing system. The sheer volume of additional idle reserves made this inevitable. We’d also add that central banks may have inadvertently broadcast via this process that Tbills were now a better and more universal form of final settlement unit than central bank reserves.
So how does the introduction of a new real-time clearing conduit-currency combat the capital intensity of the current settlement system? We’re not sure it does.
What the proposal really amounts to is the introduction of a parallel clearing system that claims to be less capital intensive than the underlying system, and which can as a consequence minimise the amount of flow which needs to be transacted through the capital intense system. Except rather than being based on a netting system it’s based on a zero-reserve RTGS system run on a blockchain, with the ultimate objective of phasing out the need to settle through the central bank reserve system altogether.
All this sounds lovely in theory. Except… if what’s really plaguing the market is an overall loss in faith in unbacked bank reserves, then just substituting a final settlement system which has finally been backed with something of significance (government bonds) for one that is backed by nothing isn’t going to solve the capital intensity problem of the clearing system or the real capital shortage issue in the market (a.k.a the scarcity of safe assets).
Moreover, if the expectation is that a “utility settlement coin” will be so good at squaring value within its own parallel closed system that it will never need to source additional intraday liquidity from the central bank to cover unexpected logjams (something we think is super unlikely in a competitive system)…we’d note, that doesn’t necessarily free up spare capital either.
If any potential liquidity jams are to be dealt with by the blockchain issuing its own liquidity against high quality collateral encumbered in a self-governed multilateral escrow account, that doesn’t solve the capital intensity issue either.
If, however, the blockchain plans to issue liquidity against nothing at all, then the question becomes why bother calling this a clearing system at all?
To wit, Bloomberg’s Matt Levine nails the real innovation in play:
Having a pseudo-currency does not solve problem 1, though of course there is much discussion of blockchains to record entitlements to securities. Having a pseudo-currency also does not solve problem 2: You don’t get your dollars any faster; you just get your pseudo-dollars faster. (To get the dollars faster, you’d need to speed up the Fed’s central-ledger technology.) But for many purposes — for example, just doing more transactions with other banks — the pseudo-dollars are just as good as dollars. If every bank signs on for this, then they can go out and buy more securities with their pseudo-dollars, and rarely need to bother with the Fed.This we think supports our overall point. For a final “pseudo currency” settlement system to properly trump the capital intensity of today’s central banking system, the pseudo currency being unleashed must be deemed universally acceptable by all banks everywhere not just a subset of four banks. That’s a big ask in a world where those carrying over international imbalances at the margin demand Tbills for final settlement rather than bank reserves.
This is what blockchain is: It’s banks developing better and faster systems to agree with each other on what they all own. (I mean, the bitcoin blockchain is a wilder and woollier thing, but too scary for many banks.) That seems good! I have no real complaints! It is all just, like, 20 percent less magical than it is usually made out to be.
And even if one specific blockchain-based pseudo currency could convince all the world’s banks to accept it over all other reserves, there’s still another paradox in play. The less capital intensive a pseudo currency is, or the easier it is for one bank faction to produce it over another bank faction (like err Irish and Greek banks vs German banks) the less likely it is to be a universally accepted pseudo currency. Universal “final settlement” status isn’t necessarily something that can be engineered, especially in a world where Tbills are still the preferred balancing unit.
Bitcoin’s proof of work mechanism may be a hugely capital intensive waste of energy, but it’s also the thing which keeps it honest and endows the scheme with some known value set.
That a handful of banks feel inclined to create and treat a psuedo-currency as a final settlement unit between themselves, says nothing about whether the rest of the world will agree with them on that categorization. After all, the top of the money hierarchy tree isn’t determined by a “final settlement unit’s” capacity to balance a bunch of arbitrary numerical inputs in ways that a computer deems appropriate (the euro achieves that job fine). It’s determined by a final settlement unit’s ability to create real value so as to give rise to a socio-economic system which benefits as many people as possible (something the euro currently certainly does not do).
Related links:
The eurodollar as an economic no-man’s land – FT Alphaville
Brexit, the Target2 angle – FT Alphaville
Big banks plan to coin new digital currency – FT
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