“End the Fed”? — Maybe Learn What the Fed Does First!

I was recently lurking on one of the online crypto forums where a bunch of ‘connectors’ and social media mavens use to bring developers and venture capitalists together with people who want to get involved in crypto but are not sure what they can do to help.

The topic turned (as it often does) to how we should ‘take down’ the fiat money system.  *sigh*. This is quite often the battlecry used by the crypto mavens to galvanize support from developers and armchair anarchists, as the anti-establishment theme seems to be able to rouse the most revolutionaries to action. (That, and free pizza seems to work equally as well).  The discussion spiraled into a lecture where I very calmly, coldly, explained how the Fed system of money works and why fiat money was already digital to people who didn’t understand how our money system works and was hell-bent on ‘fixing’ it with crypto money, because it was digital, and therefore, modern, new, and definitely what we want for Christmas. *sigh* (again).

The problem with the crypto space in general that has become very apparant to me is that people don’t really understand how the existing money system works, and yet, they proprose to have great solutions for it.  It’s likely listening to a fengshui guru try to design and architect your house for you.  He has neither the experience or qualifications to do any sort of structural engineering or design, but he thinks that this window definitely needs to face southwest otherwise your life will certainly suffer ruin and misfortune.

Making matters worse, a lot of the misinformation comes from people who have ostensibly worked in the financial sector, albeit likely were IT in a financial tech company like Bloomberg or some other ancillary industry to the finance sector.  Unfortunately, due to the speed at which the industry of crypto has grown, there are way too many instantly rich ‘lucky fools’ to who are the new breed of venture capitalists, and an even larger cohort of ‘lucky idiots’ who found themselves involved in crypto not because of their contributions to the art, but because they got into the space early enough to be seen as ‘experts’.

Take it from me, the ratio of true experts to charlatans in crypto is a very very small fraction.  Most of the experts in the field don’t have time to write blogs, lurk on forums and prostelitize on reddit.  (Which incidentally explains why the rate at which my blogs are updated these days has fallen drastically in recent months).  But I digress.  This blatent affront on the fiat system by charlatans which clearly did not understand anything about how the money system worked demanded that I rouse myself from my productive work to explain.  After I was done, I realized that perhaps it wasn’t all the fault of the mavens who speak as if they know but know not what the speak… maybe it was the simple fact that not many people know how banking and money really works. I thought back to how I learned about this, and it was through my own research while working at Goldman Sachs, coupled with a colleague who I worked with at JPM who worked as a treasury trader.  Certainly not the kind of information or experience that is easily digestable by laypeople.

So I thought, maybe it was high time that somebody explained, in SIMPLE terms, the basic misconceptions about our money system.

Firstly, know this: Although all its operations and structure of the Federal Reserve is public information, they don’t go out of their way to teach the general public about how money works.  This is, I believe, part of the design. If too many people knew how the money system works, then they would likely find fault and think it wasn’t totally fair to [some special interest group or demographic].  So when desiging a money system that is based on the general trust and belief that money is worth something of value, then it behooves the designers not to explain the details to everyone, as faith is much stronger a motivator than logic.

But you knew this already, otherwise you wouldn’t be a reader of my blog. You want the logical facts. You want to make up your own mind about things.  Good. So here comes the firehose. Brace yourself.

I will structure this lesson as a series of commonly misunderstood things about the fiat money system.

Misunderstanding #1 – The central banks (Fed) prints money. That is how fiat is created.

Truth: Not really. Well, that isn’t how most money is created anyhow.

Contrary to popular belief the Fed while actually creating the notes and bills that represent money, (literally printing the physical bills) they don’t actually CREATE the money it represents whenever they feel like it. Money is created by the Treasury Dept (government) selling bonds to the Fed, which creates money in order to buy them. So the government is the ones actually creating money from nothing (the hallmark of a fiat money system) when they decide to print and sell more bonds to the Fed. (usually because they need to fund government spending that taxes isn’t enough to cover).  The Fed actually makes a profit from the interest on these bonds, which is shared among the Fed’s shareholding banks. The Federal Reserve system (or simply central banking system for other countries) is that banks can have a lender of last resort, in case they find themselves in a shortfall for their liabilities.  This prevents economic downturns from making banks go bankcrupt, which may have a domino effect and cause more issues for other banks, causing a meltdown.

Misunderstanding #2 – The Fed is run by the Government

Truth: No. The Fed is actually a privately owned bank, which is owned by shareholder banks and some super secret entities (cue tin hat conspiracy theories here). They operate on a government mandate, but they are their own masters.  The only pull the gov has over the Fed is that the president gets to nominate the Chairman of the Board of the Fed. Effectively assigning its “CEO”.  But the shareholding parties also have their own governing board members and it acts very much like a bank.  Other central banks around the world may have different setups, but they are generally not directly controlled by the government.

Misunderstanding #3 – The government creates most of the money we use.

Truth: No. Actually your local bank that you get a loan or mortgage from is how most of the money in the system is created.

Both retail and commercial banks are the only ones that create money outside of the Gov issuing treasury bonds.  They do this by creating loans.  Every bank is allowed to have outstanding loans as a ratio to the actual cash reserves that they have on hand at their reserve bank accounts (an account which is held at a local Reserve Bank which is part of the Federal Reserve system). In accordance to this, e.g. if they accept $100 worth of deposits from customers they are allowed to create $900 of outstanding loans.  This 900 dollars is created from thin air, added as a cash credit to the borrowers account, and added as a loan asset on the banks balance sheet, balanced by a liability for the borrower.  This is how MOST money is created in the economy.  So the banks create money in response to the market’s demand for loans. This is a good thing, as it ensures that money is always ‘available’ to fund developments.  It is a bad thing, when too many banks given out loans to people to can’t actually repay them, which was the case in the financial crisis of 2007.

What? You mean banks can just create money they need to lend to people? But what about inter-bank loans? Overnight swaps? LIBOR swaps? And the whole FX market of derivatives? How can they just create all this ‘fake’ money? This leads us to the next one…

Misunderstanding #4 – Investment Banks and Commercial Banks are the same

Truth: False. Ever since the Glass Steagall act, they cannot be the same company. In fact, they were only licensed equally because of the obvious benefits of being the lender of money and also the facilitator of fund raising for companies.  Investment Banks cannot create money. Commercial Banks can.  Investment banks (the guys like Goldmans) who engage in the securities market activities have their primary purpose hedge risk, raise funds, and to do M&A and IPOs, acting as a ‘facilitator’ for businesses who need capital. Even though some of Glass Steagall has been since repealed, and the same company can be both a commercial bank and an investment bank, the point is still that the commercial banks are the parts that can create money via loans. Not the investment bank businesses. So banks cannot create money to pay for their debts to other banks.  They have to borrow money from other banks in order to fufill their daily cash settlement demands. This is one of the reasons why an overnight swap, spot, and forward markets exist (among others). Because if any bank (or company for that matter) cannot settle their daily liablitities, then they are technically in insolvancy. Not a fun place to be if you are a bank. (or any entity for that matter).

Misunderstanding #5 – Fiat money isn’t digital

This is actually how the debate on the online forum started.  Some person was adament that fiat money wasn’t digital.  They likely took an old Economist magazine front page headline a bit too literally. (and didn’t have the wherewithal to realize it).
Actually this is even where most people who you would think know better (even ones that worked in the industry) get it wrong.  Fiat money is >90% digital.  M0, which is the classification of money that is in the form of notes and coins, makes up for less than 10%.  And of that M0, 2/3 lives outside of the US.  All other forms of USD, live in bank account balances, which is reconciled up to the the top level Fed accounts.  Therefore, fiat currency is very much digital.  It’s just not cryptographically secured, nor is the supply of it metered by some algorithmic process as is the case with cryptos such as Bitcoin.  Instead the Fed system uses a hierarchical tree of double entry accounting books to reconcile from your bank account at your local bank all the way up to the accounts at the Fed and other central banks around the world.  The way this is structured is that each bank in addition to keeping the books for their clients must keep accounts for other banks they have dealings with.  This is the system of NOSTRO and VOSTRO accounts and it is necessary that each bank in order to have a banking license in a country must have a NOSTRO account at a bank further up the chain, ending with a bank that has an account with the Fed (central bank) itself.  Normally this layering is only 2 levels deep for the big banks, but smaller regional banks may have to bank with a larger bank who in turn will have a NOSTRO account with a bank which is directly part of the Federal Reserve network.  This is how all daily reconciliations are done, so that every penny is counted and the system is ties out. The only potential source of error to this balanced accounting system is due to the paper notes and coins that could be counterfeit or lost to the system.  Which is the reason why banks want to reduce the use of physical bearer instruments such as notes and coins as much as they can.  You can go look up the Fed’s balance sheet which is public and see for yourself, but knowing you are likely too lazy to click on the link and find it I’ll put it here for your convenience. You see that number under liabilities labelled “Federal Reserve notes in circulation”? that is the exact number of M0 money of USD that exists in the world, (excluding the exceptions mentioned). Yep. You read right. That is 1.6 trillion dollars in cash floating around in the system.  How can the fed possibly come up with this number in a reliable fashion if it were not reported back up to the Fed by the Reserve banks who have their master accounts at the Fed themselves?

Which leads us to the last one…

Misunderstanding #6 – Banks are evil because they can create money when they want to make loans, while at the same time when they need money they can always borrow from the Fed

Well, this is somewhat true.  Banks which are part of the Fed system that have accounts with the Fed directly CAN borrow money from the Fed through what is called the Discount Window.  This is supposed to be the lender of last resort. As such, the discount rate (interest charged) is not attractive nor meant to be.  Instead banks borrow from each other through what is called the Fedfunds rate. This is somewhat controlled (through a market process) by the Fed board of governors, but in practice this is just the average rate that depository institutions will lend to each other.  If too much or too little lending is happening at a given rate, then the Fed will step in with open market operations (buying or selling of treasury bonds or other instruments) to reduce or increase the amount of money in the system so that the Fedfunds rate move closer to what is targeted by the Fed’s board of governors.  What is borrowed needs to be repaid with interest, so it isn’t in a banks best interest to borrow more than they need, or to hoard cash and not lend.  Banks that borrow too much, or make too many bad loans and end up not being to meet their obligations will go bust.  (or should go bust).

The last point is really the main problem with the central banking system.  Banks need to be allowed to go bust if they, through the process of making too many bad business decisions, end up not being able to make their interest payments.  That, and simply the fact that by centralizing the management of money, a single failure in a system of highly inter-dependant banks, stands to have large scale systematic effects if any bank large enough (thus having many liabilities owed to other banks) were to fail.

Crypto may have some part to play in improving the system.  But I believe it will be more on the aspect of making financial transactions transparent, and accountable. Not simply from the fact that it will make things digital or more readily reconciliable.  The current system is already pretty good at accounting and keeping balances straight.  All that is needed is to make the system more transparent, and perhaps reintroducing the notion that banks should once more be in the business of raising capital, instead of simply creating it when needed.

/EOL

Update:

It works now!

Hard Fork Risk Analysis: If the worse happens, how bad can it be?

This post is a culmination of about a year’s worth of thoughts and research that I have been informally gathering, which started with a simple question that started last year when I first read a piece which was written in the middle of the Bitcoin XT heyday describing what would be so bad about having 2 persistent forks by core developer, Meni Rosenfeld.

Forks are not scary, they are upgrades!

Forks are not scary, they are upgrades!

The post described the general understanding of forks at the time, and it was in this context that I wrote my original piece which was very much a pro-Core stance on the dangers of hard forks.  I was wrong on some of my assumptions when I wrote that, which I have over the course of the year corrected, but nevertheless that original piece earned me many twitter RTs and ‘follows’ by core devs and supporters at the time (who have mostly now, funny enough, all banned me).

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On Ponzi’s, Equity Derivatives, and Ethereum

Charles_Ponzi

Many people will talk about ponzi schemes without actually thinking about what that actually means. They say that Ethereum will fail because it was founded on and funded by lies. But when it comes down to it, how are these different from that of the current central banking debt based fiat money system?

Fund first, ask questions later

Ethereum was a project funded with 18m USD of value mostly in BTC. After writing a whitepaper and creating a proof of concept prototype, they hired developers to write it. Most of them were loaned money and worked for free but were promised exorbitant 20% bonuses after the crowd-sale.  They made a windfall after selling ETH before the blockchain was even in operation in what is called an initial coin offering or ICO to the public. Once the money was raised they patted themselves on the back, and all the developers who were promised pay in stock options (ETH) simultaneously breathed a sigh of relief and cheered.

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Bitcoin: Getting to the Moon 101

Easter weekend.  Family reunions, liturgical services, fasting for some, feasting for others, a time for renewal, time to dispel some crypto myths!

Everyone talks about “going to the moon” in crypto but few if any really knows what that means.  Cypherpunks care about privacy and censorship resistance, libertarians care about political ideology and businesses care about making money. But how many of them actually think through how to get there?

I don’t mean in a metaphoric sense, I mean pragmatically. What is the adoption roadmap? What do we mean by ‘moon’? Price?  Resistance to government usurpation? Censorship resistance? Self sustaining system without any oversight?

True, most people who say “To the moon!” are just pumpers or speculators trying to incite a windfall profit from the penny stock altcoin that they purchased for the express purpose of dumping it for a profit on unsuspecting suckers.  But let’s consider a moment the goal of Bitcoin –becoming a widely accepted alternate money to fiat currencies– how does Bitcoin get to there from where it is today?  What challenges and obstacles must it overcome?  What different stages of development and growth must it evolve through?

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How do YOU measure Decentralization?

The disagreements between the ‘big blockers’ and the ‘small blockers’ in Bitcoin are heating up.  Bitcoin Classic is poised to release its first client to compete with Bitcoin Core, and Bitcoin Unlimited has had its first vote on its new feature set.  It is a time of peril in the galaxy…

Now as the credits fade into the star field background picture a big wedge shaped Star Destroyer with the banner reading “Decentralization” filling the screen.  This word is really the Battle Cry of most crypto-currencies, and as I have written in the past, it is so poorly understood.

decentralisation

Everyone wants it, but few know what it is

It is a repurposed term, that simply describes a quality of network topology, transformed into a rallying call of rebellion.  The problem is that almost everyone that I read or encounter in the industry uses this term as a panacea for all the problems that they see in the world today, without actually knowing what it truly means. They believe it because of faith from authority, and through basic reasoning, that it is good and thus must be fought for without actually knowing why.  This is dangerous, as this is how cults start.  The Cult of Decentralization.

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Part 2 – Mining and The Valuation of Bitcoin

DISCLAIMER: this is an OpEd piece. Opinions expressed are my own. Do not take it as or use it as advice on investments.

In part 1 of this article, I discussed how decentralization is really a measure of security in the network and having a more secure network means having one that costs more to corrupt it than to work within its rules.  This in turn results in a system that is trust-minimized, which means you need to trust 3rd parties less to ensure everyone plays by the rules.  This is the basis of why Bitcoin can actually work as a currency, but you have been reading my blog, so you already knew that, right?

In this segment, I would like to breakdown and explain the components that comprise the Bitcoin price, in terms of economic drivers.  I will apply some high level fundamental analysis on Bitcoin, to see if we can tease out what factors affect it’s price, and whether or not that price is stable.

The current market Bitcoin price is composed of 4 components:

  1. Hoarders Value
  2. Mining economics Value
  3. Speculative Value
  4. Medium of Exchange Value

The first people valued it for ideological reasons, from libertarian anarchists to those from the Austrian school of economic thought.  These are the hoarders and will be the last to sell.

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Why only Bitcoin Matters — (and why everything else matters less)

The industry is abuzz with the new poster child of ‘disruptive’ innovation, Permissioned Ledgers.  I spent quite a bit of time earlier in the year consulting for big name firms on bitcoin blockchain and permissioned ledgers.  At the time I didn’t really view one preferably over the other, I considered each on its merits and useful applications.  Of course when you are paid to technically consult for a company, they don’t want your biases, they want your technical expertise.   Without fail, those of them who were interested in B2B models were interested more in a permissioned ledger, and those who were doing B2C models were interested in using Bitcoin to monetize their online business models.  Most that were interested in B2B solutions had very bank-like businesses dealing with near-money like value systems.  Decentralized ledgers are great as payment systems.  Bitcoin is digital money,  that runs on a decentralized ledger.  Notice the difference? The ledger part is just a small part of Bitcoin’s innovation which is the money aspect.  Because it is a money it is natural that banks or bank-like entities would want to steer clear of Bitcoin.  There are very strict laws surrounding the control of who gets to print money, what is legal tender, currency control laws, and Bitcoin turns all of that on it’s head.

When I used to compare the two for my clients I would tell them that Bitcoin was harder to create a business model on top of due to the yet unclear legal issues while with permissioned ledgers I saw a clear potential for profit in developing cost saving systems. I was quite impartial to this difference until only 6 months ago, seeing both as equally beneficial as a technology.  However, something happened in the interim that changed my views — Greece.  With the Greek crisis, the world witnessed how the will of the common people matters little against the will of the privileged few.   Many would like to blame the Germans but that would be unfair.  The german economy suffers with continued bailouts as well; “throwing in good money after the bad” those of us in the industry call it.  The central banking system is to blame, as whether deliberately or by greed or by chance, the world economy is starting to collectively crumble under the weight of our bad habits of spending, lending and investing with debt.  And we witnessed first hand that when the chips are down, it will be everyman for themselves. Bail-in clauses have been put in place in all major countries of the world, so that the banks have a right to take your money to save themselves before you.  They justify this as necessary to save the system as a whole.  But is it really?

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Is Money the Same as Currency? — The True Nature of Money

It’s a simple question.

But it is one that 95% of people will answer wrong. Don’t feel bad. I would have as well if you were to have asked me 10 years ago.

Ans: They are not the same thing.

Those in power would like you to think of them as the same thing. In fact, we have been taught since we were children that they were the same. That is, if you were lucky enough that they taught you anything at all about money in school (more than just recognizing coins and dead presidents faces that is).

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Bitcoin the Global Reserve Currency, and our Multi-coined Future

So long as we are careful, we can learn from our past mistakes

So long as we are careful, we can learn from our past mistakes

Last time, I was detailing the reasons why Bitcoin requires a constitution, or a corpus of its own, in order to avoid any such existential debates about its vision in the future.  If we can avoid excessive hard forks, then we can surely safely lower the ‘jump to default’ risk of the Bitcoin network.  Any other type of risk would surely happen slowly and gradually, whether it be a slowing of adoption, or an increase in transactions.  This is not to say that we should be ignorant of those risks, but just that if we are all cognizant of them, we won’t be boiled like all of the other frogs in the kettle.

This is not a radical new view, many in the core dev group feel the same way, as you can see in Jeff Garzik’s prelude to his BIP100 proposal.  He clearly defined the dangers of both action and inaction within the context of block size limits.  He also quite succinctly commented on the lack of a clear definition of what Bitcoin is.  I agree with this opinion, and it drove me to appeal to the core devs on revisiting the dialog about creating a manifesto or a constitution for Bitcoin.  Having such a guide for all future protocol changes would only serve to make such discussions easier, for everyone can agree on what Bitcoin’s priorities should be.

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PoW and the evolution of commodity currency

The last couple of posts were devoted to the complications arising from Proof of Stake coins which I argued serve little purpose other than as a digital equity and move corporate and governmental powers to developers from the bankers and industrial magnates of the real world.  I have since been asked to give more details of Proof of Work and why it and it alone is different and can result in the creation of a commodity money.  Fair enough, so here it goes…

Commodity Money

Commodity money, as I have detailed in the past, is commodity that is naturally adopted by society to serve as a common medium of exchange, i.e. money.  The ability of a  commodity to serve as a money depends mostly on its intrinsic characteristics of divisibility, immutability, fungibility, and scarcity.  But, what makes a commodity, say, different from a credit note, or a bill?  Simply stated, a commodity is an asset or a thing (physical or virtual) that:

1) Required work to produce it

2) Had some initial intrinsic value

Let’s look at each of these in turn.  First, it must have taken some work or energy to produce or to prepare it for use.  That work or energy was consumed in a physical (or computational) process and the process cannot be reversed, or whose energy cannot be otherwise reclaimed.  We innately understand this, as every commodity we produce in the real world is a product of human labour and work, requires energy, and results in an asset produced.  Symbolically:

Work + time * efficiency ==> asset

Expend energy in producing useful work, put in some time, subtract waste losses, and out pops an asset, whether it be a gold bar, plutonium ore, or bitcoins.

The ‘birth by work’ concept is important because the producers of the commodity are 1 level removed from the politics of the commodity’s use as a money.  The producers (or miners) of a commodity are simply interested in improving their ability to extract or mine the commodity and sell it into the market for use as money.  In this way, the creation of the commodity money is pure as it first enters the economy through the free market, regulated and controlled only by the natural forces of supply and demand and price.  Contrast this to fiat money which is regulated and controlled by ‘experts’ in an ivory tower, who believe that they have the magic formulas to make decisions for the economy, because they are smarter than the collective opinions of everyone else.  (To those of you who believe this fallacy, I implore you to watch this: Why Socialism doesn’t work ).  Astute readers will be thinking right now, “hmm… this sounds a lot like all the criticisms you wrote about previously with PoS systems!” and you would be exactly right. Essentially a PoW produced coin is a free market money, whose supply is controlled by the market, while PoS ecosystems are just digital forms of socialism.  Centralized control of a rule-based system, no matter how noble in conception, will inevitably fail, as history has shown us.

The second important aspect of a commodity money is that it must have originally had some intrinsic value to it.  As Ludwig v Mises describes in The Theory of Money and Credit, the value of a commodity money (or the price) derives from its previous value the day before, and the value it had the day before, on the value on the day before that, etc. If one could trace back until the origin of the first exchange of the commodity asset for something else, you will discover the value of commodity money comprised of only the value of it as a asset (consumable) alone.  This initial intrinsic value as a commodity is what initializes the objective exchange value of a commodity money and as it slowly gains acceptance, it acquires value as a money.  The relationship can be seen as:

commodity money value = value as a money + value as a commodity(intrinsic value)

Where the intrinsic value of a commodity money is more or less stable, its value as a money is what fluctuates greatly and rises as it is demanded for in its use as a money instead of as a commodity.

With bitcoin, and other virtual assets, we for the first time find ourselves lacking the language to properly describe the phenomenon of how a digital commodity money can come into being.  The notions of work being the means to convert some atoms from one state to another (more useful) state don’t apply as nicely.  But if we ignore the physical reality of the creation of a digital asset for a moment, and assume that it is done via some magical mining process akin to the mining of a physical metal, what then, is the initial intrinsic value of a bitcoin?  This is the key sticking point that has prevented the acceptance of bitcoin by many of the hard money advocates and Austrian economists around the world.  This is where I will likely draw a line between them and I, although we hold many of the same beliefs:  I believe that the intrinsic value of bitcoin is in the utility of the blockchain.  The initial value which bootstrapped the digital commodity of bitcoin into the mystical category of money was that it provided a measurable, quantifiable, utility.  Which was this: the ability for the first time to have a shared database owned by everyone and no one, and have it maintained by trust-less parties acting all according to their own interests alone.  The value of an immutable, incorruptible transparent record, is what that initial intrinsic value of a bitcoin represented.  To own one was to take part in an incorruptible public record system, which is something that could certainly have been used many times in human history to solve many disputes, even wars (the corrupt Byzantine Empire may have fallen sooner, to be sure).  The fact that the value of the token derives from the network in which it exists is the reason many detractors may call Bitcoin a ponzi scheme.  Indeed this same feature is present in all crypto-currencies, where the reward in participating in the network is paid for by in-system tokens.  The difference between them though, is that work is expended in their creation, and thus Bitcoin and other PoW tokens are commodities, and not equities.  That being said, the digital commodity we call bitcoin is the only digital commodity to date to have reached a ‘money’ level of valuation and use.

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