Nett Gains
There are a number of interesting contrasts thrown up by the interaction of finance and technology in the fintech space. Or more specifically, between the differing conventional wisdoms, or even psychologies that the various participants bring with them. On the technology side the verve and zeal for change is driven by a belief in the transformative power of computing. This manifests itself in a practical sense of technical improvement, but sometimes also in an indignation at what are perceived as the predations of the existing financial system.
The former, more sober mindset is aghast at the clunkiness of financial plumbing, its costs and prehistoric turnaround times. One of the great benefits of digital technology is the incredible processing speeds it can achieve. As is the want of the human mind, tech proponents subtly finesse ‘things it does well’ into ‘things that are good’. Viewed in this light, processing times that are usually measured in hours if not days are barbaric and are ripe for transformation. Anyone who defends such practices must be a luddite, and there is little examination of why things take so long. The assumption is simply that things went as fast as they could in the old world, and we are now in a position to accelerate them exponentially.
The latter, ideological perspective is less prevalent but still common. Many techbros’ worldview was forged in the financial crisis and coalesced around two key objections to the financial system. Most outrageous in their view was the process of money creation. To be fair this is a process that appears outrageous to most people on first encounter. As Henry Ford said:
It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.
In this case there was a revolution, or what is considered one by its advocates. It is no coincidence that Nakamoto’s founding paper for bitcoin appeared in 2008. The revolution has not yet succeeded but nor has it been extinguished.
The other aspect of finance that drew their ire is more mundane. Again, it was the speed of payment systems, but now viewed not only as a pre-digital relic but as an artifice of the large banks in order to extort customers and restrain the free flow of people’s hard-earned money. The people involved were often exceptionally smart and had had their smartness vindicated by their status and salaries in the technical sphere. They generalised their wisdom and approached the problem as a technological one, rarely pausing to consider other reasons why the system was the way it was.
One of those reasons is a very simple financial trick which lies at the heart of many of the core activities in the financial systems, and indeed is key to enabling them to function as they do: netting. Perhaps we should avoid the word ‘trick’ with its association of deception. Netting is transparent and in essence neutral, but its use is beneficial to us all.
Indeed money creation and the existence of fractional reserve banking itself is reliant on netting. It is essentially a two-tier system whereby the general public exchange bank deposits on a gross basis, but the banks themselves settle this multitude of claims on each other on a net basis using central bank money, as attested by ostensibly opposed figures such as Keynes and Friedman:
If we suppose a closed banking system, which has no relations with the outside world, in a country where all payments are made by cheque and no cash is used, and if we assume further that the banks do not find it necessary in such circumstances to hold any cash reserves but settle inter-bank indebtedness by the transfer of other assets, it is evident that there is no limit to the amount of bank money which the banks can safely create provided that they move forward in step.
J.M. Keynes: A Treatise on Money[1], Chapter 2, Section 1
Like cash deposits at other banks need be only a small fraction of assets Banks are continuously receiving funds from other banks as well as transferring funds to them, so they need reserves only to provide for temporary discrepancies between payments and receipts or sudden unanticipated demands. For Chicago banks, such “prudential” reserves are clearly far smaller than the reserves that they are legally required to keep.
M. Friedman: “The Euro-Dollar Market: Some First Principles”[2]
The beauty of this system is that it imposes a constraint on the creation of money by banks but largely avoids the chronic deflationary aspect of commodity money, which is also a feature of cryptocurrency and in fact the basis for the riches envisioned by HODLers. These benefits apply to goldsmiths in Amsterdam, the development of clearing houses[3], or the fiat system of today. Yes, it seems counter-intuitive at first sight, and, yes, it is not without risks but the benefits in terms of providing currency to fuel the economy are far greater.
But for some none of these benefits make it worth tolerating the spectre of inflation, not just in the broader economy but as a threat to hard-earned personal savings. Crypto supporters follow their goldbug forebears in falsely believing that a quasi-barter system using a scarce token will somehow protect them from the risk and uncertainty inherent in hoarding purchasing power for future use. This extreme risk aversity bordering on paranoia seems rooted more in psychology than economics.
Money is an asset but it is not a unilateral possession. It is not like a bed or a chair where your ownership is total, and the full usefulness is inherent in that ownership. Its value depends on the existence and willingness of someone who is prepared to give you something in exchange for it. It is not too fanciful to suppose that it is this dependency on others which unnerves some, and leads them to seek comfort in just such a unilateral view of money as a possession, with the concomitant belief that value should be set the moment it is earnt rather than the moment it is spent.
Turning to payments, finance is awash with examples of situations where large number of cashflows in different directions can be netted down and settled periodically with a single net payment. On the surface this may be slow, but the efficiency gains in terms of overall funding requirements and reductions in processing can deliver real economic benefits. This isn’t to say there is no room for innovation, nor to discount the possibility of exploitative charging, but only that real-time, gross settlement isn’t an unalloyed good and may be more cumbersome and expensive in some circumstances. We need to harness technology where necessary but evaluate use-cases on the full pros and cons in financial terms, as that is the area of application. Real-time needs to be justified economically not technically, and certainly not just because the idea of any counterparty risk with its inherent reliance on others terrifies some people.
Furthermore, it should be noted that real-time retail payments are already available in a number of jurisdictions[4], based on traditional banking practices and existing technology; blockchain is not a necessity for the provision of instant payment. But again, it is possible to detect a harder ideological/psychological requirement that considers anything developed by financial institutions to be suspect and adheres to ‘true’ real-time transfer as part of the unilateral concept of money.
These are not the only areas where netting plays a fundamental role. Central counterparties are a cornerstone of the enhanced risk framework in financial markets since the crisis and they make extensive use of netting in calculating exposures and applying margin requirements to their members. ISDA employs netting in the contractual agreements that govern the world of derivative trading. The risk management practices enforced on banks by the succession of Basel accords also prescribe how netting should be used to assess the value of risk assets.
In all these cases netting allows more efficient use of capital and simpler operational processing, delivering lower costs across the systems. This is not without its trade-offs as leverage can be increased and systemic risks can be obscured but, overall, a judgement can be made, and revised, about where the balance should be struck. If we take an insurance company as an example it is clearly inefficient for it to hold reserves that would make it capable of paying out on claims on all the policies it has written at a single point of time, as the likelihood of such a coincidence is vanishingly small. Instead, it calculates the likely flow of demand and invests the rest of the money it holds. The result is cheaper policies for its customers with a slightly elevated liquidity risk.
This abhorrence of redundant capital wherever it occurs in the system and its removal through netting is a general feature of traditional finance. That it is apparently at odds with the crypto ethos may not be eternally true. Much has been written about concerns that Tether, effectively the central bank of crypto, is not fully backed by dollars as it claims. Obviously if it is misrepresenting its position that requires investigation, but that it is not fully backed is in itself less surprising. It has been observed elsewhere that crypto can be viewed as a project to relearn the lessons of a thousand years of financial evolution (© Matt Levine).
Like its predecessors down the centuries, Tether will have noticed that the netting of its cashflows to and from other institutions and its customers mean that it actually requires a small fraction of those dollar holdings to function. It is therefore left with a large amount of cash on the asset side of its balance sheet which is essentially doing nothing. Wouldn’t it make more sense to invest this cash pile elsewhere? Or perhaps increase its balance sheet by creating Tether loans until its cash holding is more of the order of what is required to service the dollar cashflow demanded? This would be a pleasing irony in light of crypto’s blindspot on credit creation.
Otherwise, the unilateral concept of money holds that lending can only be by transfer of existing cryptocurrency from the holder to a borrower. Money here is something that you have and, temporarily, give. But this is a narrow, distorted view of how an economy functions. Like with its kin-theory of loanable funds there is the problem of how to initiate an economy that always requires pre-existing money, and therefore some kind of infinite regress. An economy can only be conjured into being if someone is prepared to initially do something for nothing, other than a future promise of reciprocation, ie. credit.
[1] http://tankona.free.fr/keynescw5.pdf
[2] https://files.stlouisfed.org/files/htdocs/publications/review/71/07/Principles_Jul1971.pdf
[3] T. Congdon: Central Banking in a Free Society, chapter 3, https://iea.org.uk/wp-content/uploads/2016/07/upldbook450pdf.pdf
