Thursday, October 27, 2016

How anonymous is cash?

Dutch 10 guilder note. Holland and Lebanon are the only countries to have issued banknotes with bar codes.

One of the interesting things that we've all learnt about Bitcoin is that it isn't actually anonymous, it's pseudo-anonymous. While anyone can deal in bitcoins without providing personal information like a phone number or photo ID, all bitcoin transactions are broadcast to the public. By analyzing these transaction patterns, it may be possible to flush a user's true identity out into the open.

Bitcoin is an attempt to digitally replicate many of the features of the old fashioned banknote, but even banknotes are to some degree pseudo-anonymous. Each banknote has a unique serial number on it. By tracking serial numbers, it may be possible to connect a note to a noteholder and thereby destroy their anonymity. The process of unveiling note users occurs most often in kidnapping cases. When their child was kidnapped in 1932, the Lindbergh family paid a $50,000 ransom in non-sequential banknotes. In an effort to identify the kidnapper, a list of the serial numbers of notes used to pay the ransom was published in the New York Times and circulated in pamphlet form to banks all over the New York area. Anyone who found the note was to immediately alert the authorities, this information being useful in helping to triangulate the guilty party:

Published list of banknotes the Lindbergh's used to pay the ransom

Kidnappers prefer to be payed in non-sequential numbered bills. It is easy for a bank teller to cross reference incoming notes against a list that contains an easy-to-remember range of sequential numbers. When serial numbers are randomized, the list becomes much harder for the human eye to parse; just try to work through the above example. The non-sequential nature of the ransom payment probably explains why only a few of the Lindbergh blacklisted notes were found... least at first. The final pinpointing of the Lindbergh kidnapper really only became possible when Franklin D. Roosevelt decided to temporarily take the U.S. off the gold standard in 1933. Somewhat serendipitously, the authorities who were helping the Lindbergh family had decided to pay the 1932 ransom in gold certificates, a Treasury-issued instrument that was redeemable in a fixed quantity of gold. At the time, gold certificates circulated along with a motley crew of other private and government-issued note types including Federal Reserve notes, U.S. Notes, Federal Reserve Bank Notes, silver certificates, and National Bank Notes (see here).

As part of the process of going off the gold standard, Roosevelt issued Executive Order 6102 requiring all Americans to bring in their gold, gold coins, and gold certificates to be exchanged for Federal Reserve notes. The Lindbergh kidnapper would only tender a few of his gold certificates in 1933, perhaps worrying that bringing in all $50,000 at once would attract attention.

Subsequent to Roosevelt's Executive Order, gold hoarding became an illegal act. So when the kidnapper bought gas with a $10 gold certificate in September 1934, the gas station attendant—probably worried that he might not be able to deposit it—wrote the license plate of the car on the note. Three days later the station managed to deposit the note at its bank where it was successfully cross-referenced against the black list, a much easier process now that the population of gold certificates was so small. Bruno Richard Hauptmann, the kidnapper, had been unveiled.

Using serial numbers to unveil identity requires the cooperation of private banks as well as some luck, in the Lindbergh's case the coincidental alteration of the monetary standard. However, there is no reason that central banks themselves can't be aggressive in monitoring serial numbers. In 1973 the Dutch central bank, the De Nederlandsche Bank (DNB), set up the first real-time database of banknotes in circulation. All banknote serial numbers are registered in the database. As used banknotes are brought into DNB processing points each day, machines read their serial numbers and update the database to indicate that these notes are no longer in circulation. When these same notes are paid out to banks the next day, the system once again updates its database to indicate that they have re-entered circulation. Over time, the system gleans information about the paths taken by each individual note, including how long it stays in circulation and its geographical exit point. It also provides excellent protection against counterfeits. If the DNB detects two banknotes entering its system with identical serial numbers on the same day, then one of them is by definition a fake.

While many central banks were "intrigued" by the Dutch registration system none of them actually implemented the concept (see page 263 of pdf). As of 2012, the DNB  remains the only central bank to register banknotes on a daily basis, a fact which I find kind of shocking. Why have serial numbers if not for tracking? Decoration?

The upshot is that if you had to choose a place to be kidnapped, Holland would probably be it. As long as the serial numbers are recorded by the authorities before the ransom is paid, then the DNB's registration system can be mobilized to catch kidnappers. For instance, the DNB claims it was instrumental in catching the kidnapper of Gerrit Jan Heijn, an heir to the Albert Heijn supermarket empire, in 1987. When the kidnapper spent NLG 250 to buy groceries, the note was soon deposited at the DNB and read into the database, at which point authorities had enough information to trace it back to the commercial bank and then the supermarket.

Interestingly, there are a number of private banknote trackers on the internet, the most well known of which is Where's George. A user logs into the website and registers a U.S. banknote by entering its serial number. When someone else subsequently registers the same banknote, the ‘route’ of the bill is displayed. Where's George tracks around 266 million bills. EuroBillTracker, the equivalent for the euro, tracks around 160 million notes. Below is a map showing the "hits," or connections it has established over the last week:

Hits registered by EuroBillTracker

So cash is somewhat less than anonymous, or anonymous-ish, since behind the curtain an organization like the DNB may be recording serial numbers, and this data might be useful in learning about users' real life identities. By tracking serial numbers more robustly, the anonymity of cash can be further eroded. Imagine a Where's George world where each time a bills is used, the receiver is required to submit the serial number to a government-run central registry. If so, the banknote system would have attained the same level of pseudo-anonymity as bitcoin, where anyone is free to transact using banknotes but transaction chains are fully public.

We could go further and imagine a world where a central bank like the DNB requires that the circulation of high denomination banknotes, say the €200 note, be confined to 'legitimate' channels only. Cash is perpetually being withdrawn from the central bank, used in payments, and then redeposited at the central bank. To confine €200s to legitimate channels, the DNB would simply announce that it intends to limit redeposits to those notes that have fully verified transactions histories. Verification means that when someone receives a €200 note, they must register it by submitting its serial number to the central bank via an app along with some sort of proof of identity.

When someone fails to either register a note or provide adequate identification, that note effectively falls out of the system. After all, because the DNB won't allow a note with an incomplete chain of verified transactions to be redeposited, banks will refuse to accept any note that hasn't been registered by its current owner. And knowing that banks won't accept them, neither will retailers. Bills that have fallen through the cracks will only have value in an alternative black market where they'd likely trade at a large discount to legitimate notes. Incidentally, establishing a verification system for €200s is very similar to Ken Rogoff's idea of abolishing high denomination notes, except instead of withdrawing €200s, they'd be allowed to stay in circulation in 'cleansed' form.

Thanks to a distinctive earmark—their serial number—the anonymity of banknotes is never fully assured. While serial numbers are rarely used these days for tracing, who knows what might happen in the future. Privacy advocates can take some comfort in the fact that, unlike paper money, coins have no distinctive markings and are therefore capable of serving as a purely anonymous exchange medium. Unfortunately coins have a low value to weight ratio so lugging the stuff around is a pain. The Swiss and Japanese stand out here for issuing the highest value coins, the five franc coin and 500 yen coin respectively, each worth around US$5.

As for cryptocoin fans, tomorrow Zcash will be launching. Whereas the entire history of bitcoin transactions is public, Zcash succeeds in hiding everything about the transaction. That's true anonymity.

Monday, October 17, 2016

The strange mania for Swiss National Bank shares

The shares of the Swiss National Bank (SNB), Switzerland's central bank, have almost doubled since July, despite there being no real news. Yep, you read that right, the SNB is listed on the stock market. There are four other central banks with listed shares: Belgium, Japan, Greece, and South Africa. I discussed this odd group back in 2013.

Why are SNB shares catapulting higher? This is a staid central bank, after all, not a penny stock.

Let's look at the fine print. Swiss National Bank shares aren't regular shares. To begin with, the dividend is capped at 6% of the company's share capital. The SNB was originally capitalized back in 1907 with 25 million Swiss francs, an amount that hasn't changed in 109 years. Which means that the dividend is, and always has been, limited in aggregate to a minuscule 1.5 million francs per year (about US$1.5 million). Because this amount must be divvied among the 100,000 shares, each share gets just 15 francs per year.

The SNB has faithfully paid this 15 franc dividend since its founding (apart from 2013, when it was omitted due to massive capital loss on its gold holdings). For instance, here it is paying the dividend throughout the 1980s:

Once the 1.5 million franc dividend is paid, Swiss law dictates that all remaining profits get sent to the Swiss central government and the cantonal governments. It further stipulates that if the SNB is to be liquidated, shareholders will only receive a cash payment equal to the nominal value of their shares. This means that if shares are trading for 1025 Fr, but there is residual firm value (after paying debtors) of 10,000 francs per share, well too bad—shareholders only get 1025 Fr.

Given these peculiar details, an SNB share isn't really equity; it's best thought of as a perpetual government bond with a 6% coupon, sometimes known as a consol. It throws off 15 francs per year for the rest of time. With the SNB as issuer, these securities are pretty much risk-free.

The math behind SNB shares is straightforward. Just use the Finance 101 formula for a perpetual bond, PV=c/r, or present value (PV) equals yearly cash flow (c) divided by yield (r). With annual interest payments of 15 francs and SNB shares trading at 2000 Fr, the yield comes out to 0.75%.

Here's what I think explains the rise in SNB shares. In July, an odd thing happened. The yield on the Swiss 50-year bond, the closest instrument in Switzerland to a perpetual government bond, fell below 0%. SNB shares (i.e. perpetual bonds) were themselves trading at around 1000 francs at that point for a yield of 1.5%. A few large investors probably began to ask themselves: Why the devil are we accepting a negative nominal return on our ultra long-term government bond portfolio if these other government bonds, which happen to be issued by the central bank and masquerade as shares, still have a positive yield? And so they started to buy SNB shares in quantity, driving the price up and the yield down.

This sort of thinking explains why SNB shares have risen, but not necessarily the explosive nature of the move. The shares haven't just risen by a few bucks, after all. They've almost doubled!

Let's take a closer look at the perpetual bond formula. If nominal interest rates fall from 1.5% to 0.5%, a fifty-year bond with a par value of 1000 francs and a 15 franc yearly coupon will rise from 1000 to 1,441 francs. Not bad, but compare that to a perpetual. For the same decline in rates, SNB shares will double in value from 1000 to 2000 francs. As rates continue to fall towards zero percent, the price of a perpetual goes parabolic. At 0.25%, the perpetual will be worth 6000 Fr, at 0.1% it trades at 15,000 Fr, and at 0.01% it sells for 150,000 francs. At 0.001%, they'd be valued at 1,500,000 francs each!

In the table below, I've illustrated the relative dynamic of a 50-year bond and a perpetual as rates fall to zero.
Price of a 50-year bond and perpetual at various interest rates

At the limit of 0%, SNB shares will have an infinite price. If all existing and yet-to-be-issued government fixed term bonds are guaranteed to lose money over the course of their existence, but there exists a government security that is guaranteed to perpetually offer a positive cash flow, then an investor will pay *any* amount of money to own those cash flows. There is no price to which SNB perpetual bond can rise that chokes off their demand.

The behavior of perpetual bonds at low interest rates *might* explain why SNB shares have gone hyperbolic. It also means that if Swiss rates continue to fall, the shares could have another double or two in the tank. So much for staid Swiss central banking.

Hat tip to Leon Oudejans for alerting me to the recent rise in SNB shares.

P.S. Does anyone know how rare perpetuals are, specifically perpetuals like SNB shares that don't provide the issuer with the option to call it? My understanding is that this sort of security just isn't issued anymore, at least not since British consols.

What the difference between an SNB share and a 1000 Swiss banknote? Not much, right? They're both perpetual bonds, one paying 15 francs a year, the other paying zero francs per year. If you were to write the number 1000 on an SNB bearer share, and 500 on a half share, and 100 on a fifth share, etc you'd have the entire series of Swiss banknotes. Cut the dividend on shares to zero, and won't banknotes and shares be exactly the same?

Here's a chart of the Bank of Japan, which is also a perpetual bond underneath the hood.

Wednesday, October 12, 2016

Bitcoin, drowning in a sea of credit card rewards

Satoshi Nakamoto kicked off his famous 2008 white paper with the line: "Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments." He created Bitcoin, a form of decentralized cash, to deal with this problem. But as Meltem Demirors points out, Bitcoin adoption seems to have peaked. Eight years after Nakamoto published his paper, not many people are using the stuff as money.

Here's a way to get more people using bitcoins as money on the internet:

Commerce on the Internet has come to rely on a Visa/MasterCard pricing standard. Although a few online stores like Dell, Expedia, and Microsoft accept bitcoin payments, they still set their prices in terms of Visa/MasterCard dollars. Because the dominance of this pricing standard is preventing innovative money like bitcoin from emerging, it needs to be hacked.

The Visa/MasterCard standard

Credit card issuers aren't mere intermediaries. Along with their core payments offering, they sell a broad range of goods and services. This includes but is not limited to: 1) rewards in the form of points, air miles or cash back; 2) car rental and travel insurance; 3) warranty extensions; 4) coverage of goods purchased against loss/damage; and 5) price protection i.e. should the price of a good fall after you buy it, the card issuer refunds the difference.

Credit card issuers don't give all this stuff for free. Some of the costs are recouped by annual fees and interest on unpaid balances. But by far the biggest line item is something called 'interchange'. An interchange fee is a levy that merchants must pay to the credit card issuer each time a card is used. The better the card reward the larger the interchange fee. In Canada, for instance, the MasterCard World Elite interchange rate for internet transactions is 2.49%. Regular cards are docked interchange of just 1.61%. [source]

Retailers recoup interchange fees by passing them off to customers. The way they do this is to build interchange into sticker prices. In a world without credit cards, Dell accepts nothing less than $1000 for a laptop. But in an economy with credit cards Dell faces an average interchange rate of 2%, or $20 per laptop, reducing revenue-per-laptop to $980.

To recoup its costs, Dell marks laptop prices up to $1020.40. Of this amount, 2%, or $20.40, goes to the credit card issuer to cover the cost of the customer's rewards, insurance, warranty extensions, etc, leaving Dell once again with revenues of $1000/laptop. Dell doesn't actually tell us they are on-charging us for these things. They surreptitiously build this premium into the sticker price.

On the internet, every retail price has been marked up by around 2%. That's what it means to be on a Visa/MasterCard standard.

Bitcoin is being undervalued

The Visa/MasterCard standard has the effect of repelling bitcoin use.

Imagine Alice, a bitcoin user who wants to buy a laptop. In paying $1020.40 worth of bitcoin for a Dell, Alice effectively overpays. She gets the $1000 laptop but does not get the $20.40 in associated rewards, points, insurance, or price protection that are built into the laptop's sticker price. Rather, Dell gets to keep the $20.40 premium for itself, since it doesn't need to pay interchange on Alice's bitcoin payment.

Because retailers like Dell are undervaluing bitcoin, consumers like Alice are always better off using their credit card. The more rewards that credit card issuers add to their cards, the better the get at locking out bitcoin. This isn't just a problem with bitcoin and cryptocoins. The Visa/Mastercard standard has the potential to inhibit the adoption of other new media of exchange like mobile money.

No amount of code can hack the standard

If bitcoin could somehow be altered to pay rewards, cash back, and car rental insurance then it would be competitive with credit cards. This isn't a realistic option. Instead, the best fix is for retailers to offer bitcoin price discounts. If a Dell laptop retails online for $1020.40, bitcoin users should be charged just $1000 so that they aren't paying for points, rewards, car rental insurance and other benefits that they never get to enjoy. This would put bitcoin on an even playing field with credit cards.

How to convince retailers to offer bitcoin discounts? This isn't a problem that can be fixed by the bitcoin brain-trust making alterations to bitcoin source code. It's an interface problem: bitcoin hasn't been properly integrated into the real world, specifically into online shopping carts.

Cash has the same problem. The growing popularity of credit cards has led to the emergence of a Visa/MasterCard standard in the bricks & mortar economy. In a fully competitive economy retailers would compete to reduce their cash prices. However, retailers do not generally offer cash discounts, perhaps because they are worried about causing confusion, distrust, and delays at checkout counters (see discussion here). Alternatively, many retailers seem to believe that offering discounts is in contravention of Visa/MasterCard rules (it isn't.)

There is one big difference between cash and bitcoin. Cash lacks a community of users that can agitate for changes to the Visa/MasterCard standard. Central banks, which issue banknotes, don't really care that cash discounts aren't being offered because they lack a profit motive, and cash-using consumers, which tend to be poor or criminals, lack the means to organize. Lined up against cash is an incredibly powerful credit card lobby that has implemented all sorts of tricks (like prohibiting card surcharging) to prevent cash usage.

Unlike cash, Bitcoin boasts an active community of individuals and businesses with a strong interest in the success of the Bitcoin network. To hack the standard, this community needs to start agitating for discounts. Bitcoin payments providers Coinbase and Bitpay currently offer retailers the technology for setting bitcoin discounts. But Microsoft, Expedia, and Dell haven't taken them up on their offer, opting to keep the Visa/MasterCard standard in place. That's one place for activism to start. If the big three can be convinced to implement changes, this might be enough to kickstart an industry-wide practice of offering a 0.5 to 2% bitcoin discount. If the Bitcoin community succeeds in unbundling the Visa/MasterCard standard, it'll have leveled the playing field not only for itself but all subsequent forms of digital cash, whatever form they take.

P.S. I wrote a similar piece in 2015 on Bitcoin and the VISA/MasterCard standard. That piece focused on the superior stability of credit cards and the fact that credit card users, unlike bitcoin users, needn't incur foreign exchange costs since they spend most of their lives in the dollar universe. This version is more explicit about the reward side of the equation. All facets need to be integrated to determine how large of a bitcoin discount to be applied by retailers.

Thursday, October 6, 2016

Does money enjoy a home advantage?

Do citizens benefit by owning money that is pegged to the nation's own unit of account rather than a foreign unit of account?

Let's start by imagining a money that is not pegged to the national unit of account. Say that U.S. banking giant Wells Fargo establishes branches all over Canada. Instead of issuing chequing accounts that are pegged to the Canadian dollar, it decides that it will steal business from Canadian banks by issuing U.S. dollar-pegged chequing accounts to Canadians. Wells Fargo execs reason that the U.S. dollar is at least as stable as Canadian dollars, if not more so, and this could give their product an edge.

Further imagine that Wells Fargo is able to ensure that its U.S.-denominated money is just as liquid as that of competing Canadian money. Say that Canada's national ATM network is modified to dispense U.S. dollars to Wells Fargo cardholders. Retailers are convinced to accept U.S. dollar electronic payments, and so is Revenue Canada, the national tax authority. The upshot is that within Canadian borders, a U.S. dollar can do anything that a Canadian dollars can. Any Canadian in need of liquidity will be entirely indifferent between regular C$ deposits and Wells Fargo US$ deposits.

Let's also assume that shifting funds between U.S. and Canadian dollars is free, so Canadians who are paid in one unit have no compunctions about exchanging into the other. Apps and other technologies remove all inconveniences of calculating exchange rates. Finally, Wells Fargo's U.S. dollars are FDIC-insured and its Canadian branches have access to the Fed's discount window, making them just as safe as Canadian dollars.

This leaves just one difference between the two types of money; Canadian dollars are the unit of account. This means that retailers set prices in Canadian dollars, not U.S. dollars. Will this feature have any influence on whether Canadian consumers choose to open an account with Wells Fargo or stay with their existing bank?

Consumer prices are peculiar because, unlike asset prices, they stay constant for long spells of time. When examining the frequency of price changes for 350 categories of goods and services, Bils and Klenow found that prices tend to stay fixed for 4.3 months before they are updated.  Coin-operated laundry prices exhibited price spells of 79.9 months, driver's license fees 56.3 months, and newspapers 29.9 months (see below). On the short end of the spectrum, the price spell for gas is just 0.6 months, eggs 1 month, and women's suits 1.6 months.

Source: Bils & Klenow

One reason for this stickiness is that retailers are said to have made an "invisible handshake" with consumers that requires them to avoid raising prices when demand suddenly increases. Retailers bind themselves to this implicit contract because they do not want their loyal customers to view them as being unfair, spitefully bolting to the competition when prices are adjusted. Customers may prefer stable nominal prices because these allow them to carefully match their daily and weekly spending plans with the money currently available in their accounts. Put differently, if you've got $100 in your account, and the set of retailers at which you shop have promised not to budge on pricing for a few weeks, you can determine ahead of time what bundles of goods you can afford. Without the sticky price "handshake," you're in the dark.

So money that is denominated in the unit of account comes with a major ancillary benefit. In Canada's case, the nation's retailers have agreed to offer Canadian dollar owners a convenient planning mechanism, much like a day planner or personal organizer. This mechanism provides anyone who owns Canadian dollars around 4.3 months of  uncertainty alleviation within national borders.

Whereas Canadian sticker prices are characterized by long price spells, the U.S. dollar prices faced by Wells Fargo's Canadian customers will fluctuate by the second. To see why, consider that when a customer wants to pay in U.S. dollars, they will have to indicate their preference at the checkout counter. The retailer inputs the Canadian dollar sticker price of the good, multiplies it by the USD/CAD exchange rate, and arrives at the U.S. dollar price. The foreign exchange market is a 24 hour "flex-priced" market, so the exchange rate--and thus the U.S. dollar sticker price of goods--will always be fluctuating.

Wells Fargo money will therefore not be able to provide the same set of uncertainty-minimizing features that Canadian money provides. Anyone who holds, say, $100 U.S. dollars in their account cannot know ahead of time how much stuff they'll be able to buy over the ensuing three or four days. An equivalent C$100 provides near certainty. Lacking this nice property, Wells Fargo money faces significant headwinds at the outset.

This explains a point I was trying to make in my previous post on bitcoin. Bitcoin's battle to gain general acceptance will be a harder one to win than Wells Fargo's in Canada because the price of bitcoin is so much more volatile than U.S. dollars. Even if bitcoin's price eventually stabilizes so that it is just about as volatile as the U.S. dollar, it must still overcome the same unit-of-account hurdle as Wells Fargo i.e. neither can mimic the 'day planner' properties of the Canadian dollar. I don't think is an easy problem to overcome.

PS: Another complicating factor is product returns. If someone doesn't like the t-shirt they bought, and they paid in bitcoin, refunds are usually issued in U.S. dollars at the bitcoin-to-dollar conversion rates in play at the time of the transaction. So it's possible to make or lose bitcoin on refunds. For bitcoin owners, this adds an extra degree of uncertainty. Pay in dollars and you can be certain you'll get the exact same nominal amount back if the product is unsatisfactory. Pay in bitcoin and who knows what the amount of bitcoin you'll be refunded.

Friday, September 30, 2016

In praise of anonymous money

A while back I was paying for gas at a nearby gas station when the clerk fumbled my credit card. When he bent down to pick it up he momentarily disappeared behind the counter. Because credit card transactions are always such repetitive affairs, this slight break from routine raised my hackles. Might the clerk have done something with my card while out of sight, perhaps taken a quick photo of it?

Credit and debit payments require the relay of personal information. But this information-richness is also their weakness, since valuable data can be "skimmed" and used to attack the payer later on. That's why an anonymous payments medium is so important; it provides buyers with a shield from everyone else involved in a transaction. The next time I payed for gas at the nearby station, I bought myself some peace of mind by handing the clerk a few $20 notes instead.

Like banknotes, bitcoin is a (near) anonymous payments medium. My gas station doesn't accept bitcoin, however, nor would I be able to pay for a tank of gas with bitcoin since I'm wary of holding more than a few dollars of the volatile stuff. There is no inherent reason that an anonymous digital money must be volatile. David Chaum's eCash, first proposed in the 1990s, was a monetary product that, unlike bitcoin, offered stability while still allowing for anonymity.

Here's a broad-brush description of how eCash worked. A customer would kick the process off by creating $x worth of digital coins, each with a unique serial number. The bank would in turn sign the coins and debit the customer's bank account for that amount. Thanks to Chaum's invention of blind signatures, the bank would not be able to see the serial numbers of the coins it had signed, and thus could not match those coins to a specific person. This 'blinding' provided a measure of anonymity.

What about the double spending problem that bedevils digital cash? Because digital coins can be copied ad infinitum, a mechanism must be introduced to prevent a dishonest actor from buying up the entire world. Chaum solved this by having the bank rig up a database of already-spent coins. When the customer spent $x at a merchant, the merchant would call up the bank and provide it with each coin's unique serial number. The bank would check the number against its database to ensure that the coins had not been spent. If they hadn't, the transaction was free to proceed. The merchant in turn had to return the $x to the bank to be redeemed.

Bitcoin's creator(s) Satoshi Nakamoto doesn't seem to have been a fan of Chaum's eCash. In his famous white paper, Nakamoto says (not referring to eCash in particular) that the "problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank." Later on in a forum post Nakamoto talks about the "old Chaumian central mint stuff," noting that:
a lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990s. I hope it's obvious that it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we're trying a decentralized, non-trust-based system.
Nakamoto thus designed Bitcoin so that it had no central points of control. There is no third party database to record serial numbers; instead, the task of validating transactions is outsourced to a distributed network of anonymous miners and nodes. As for the money supply, there is no "Chaumian central mint" that issues and redeems tokens; rather, the evolution of bitcoin supply is set ahead of time by the Bitcoin protocol.

By sacrificing this last central point of control, Nakamoto condemned bitcoin to being a permanently volatile instrument. Unlike eCash, which is stable because the issuing bank pegs its price to that of bank deposits at a rate of 1:1, bitcoin's purchasing power is left entirely to the whims of market demand. Should market demand suddenly rise, bitcoin can double in price. Should it collapse, bitcoin will be worth $0.  

Sacrificing the Chaumian issuer/redeemer leads to another, more nuanced, trade-off; because bitcoin is not pegged to the dollar, retail prices will always be expressed in dollars with the bitcoin equivalent bobbing up and down every few seconds or so. Put differently, bitcoin users must get accustomed to the unit of account and medium of exchange being divorced from each other.

Contrast this to eCash. Thanks to the peg, the two functions of money—unit of account and medium of exchange—are married. Anyone who owns eCash can relax knowing that they possess the same exact unit that all other economic actors are using to express prices. This provides eCash users with a degree of certainty. As a service to their customers, retailers tend to keep prices sticky in terms of the unit of account for days, even months. So if carrots are going for $2 today, an eCash owner knows that they'll be going for that same amount next week. This fixity makes planning one's life a much easier affair. Those who own bitcoins enjoy no such certainty. Carrots that cost 0.005 bitcoins today may cost 0.01 next week.

So these two monetary products provide users with a degree of anonymity while asking them to make very different sacrifices. Bitcoin foregoes both stability and the convenient marriage of unit of account and medium of exchange. Chaum's eCash retains both stability and a marriage but introduces several central points of control that might render it subject to attack. Pick your poison. My gut feeling, however, is that over the long term, the public will prefer to stomach some degree of centralization in return for a stable anonymity product that doesn't suffer from medium of exchange/unit of account divergence. But I could be wrong.

Friday, September 23, 2016

The French shareholder revolution

I recently stumbled on a new and innovative capital structure that, as far as I can tell, only exists in France.

Since 2011, French beauty giant L'Oréal has been rewarding long-term investors with a loyalty bonus. It goes like this: if you buy L'Oréal shares, register them before the end of 2016, and hold them till 2019, you'll start to enjoy a 10% dividend bonus come January 1, 2019. So if L'Oréal declares a dividend of €1.00 in 2019, anyone who has held since 2016 gets €1.10. Not bad, eh?

Think of this as an obligatory transfer payment from short-term L'Oréal shareholders to long-term ones. Put differently, if you want to speculate in L'Oréal shares, expect to pay investors a fee, or tax, for that luxury. Unlike most taxes, this one hasn't been instituted by the government. Rather, it's the corporation that is decreeing this particular redistribution of income.

How big is the tax? Let's imagine an investment of $10,000 in the shares of a company that consistently appreciates 5% each year and increases its dividend by 5%. The dividend yield is 2% and all dividends are re-invested.

Fig 1: Comparative return from investing $10,000 in a firm that offers a loyalty bonus program

Assuming no loyalty dividend, the initial stake will be worth $79,851 upon retirement thirty years later. However, if the shares are registered in the 10% loyalty program for the entire period then the stake grows to $84,851. See figure above. The patient investor who takes the second option is 6.3% richer thanks to the premium. Tens of thousands of impatient speculators over that thirty year period will have effectively provided the patient investor with this boost to their wealth, most of these speculators probably not even aware of the subsidy they are providing. That's the magic of compound loyalty dividends! Note: By playing with the assumptions, say by making dividends grow at a faster rate (7%) than the share price (3%), the final wealth differential can be as high as 11.8%.  

The loyalty dividend structure, otherwise known as prime de fidélité in French, goes back to 1993 when Groupe SEB, a French appliance manufacturer, adopted it. That same year it was copied by industrial gas giant Air Liquide, Siparex, and De Dietrich (which went private in the early 2000s). Despite ensuing controversy in the French legislature over the fairness of elevating one class of shareholder above the rest, the ability to provide prime de fidélité was enshrined in French law in 1994, with several limits.

These limits include: 1) Shareholders must hold for at least two years; 2) The bonus cannot exceed 10% i.e. if the regular dividend is €1.00, nothing over €1.10 can be paid, and; 3) If a given shareholder owns, say, 10% of the company, they can only earn a bonus on the first 0.5% of that, the other 9.5% qualifying for the regular dividend.

After the first wave of adoption, the prime de fidélité structure was largely ignored by French firms, the exception being concrete giant Lafarge which began paying a loyalty dividend in 1999. But post credit-crisis, the idea has found a second wind. L'Oreal votde to institute a prime de fidélité in 2009; Credit Agricole, Energie de France, and Sodexo did so in 2011; and GDF Suez and Albioma in 2014. These are not small companies. Five of them—Lafarge, GDF, EDF, Credit Agricole, and Lafarge—are in the CAC 40, France's bellwether equity index.

I'm a fan of the prime de fidélité structure. If firms want to encourage an investing mentality among their shareholder base, setting up an an incentive mechanism like a loyalty bonus scheme seems a good way to go about it. Shareholders who are incentivized to think in terms of the long game will be more likely to elect a board of directors with that same mindset, the board in turn exerting pressure on management to adopt long-term goals. Even better would be a version of this program that allows investors to begin enjoying loyalty dividends from the moment they buy shares, say by giving new shareholders the option to lock-up their shares for a fixed two year term in return for a reward.


Addendum: All of this ties into a favorite topic of mine. The world is missing a key financial product that I like to call the equity deposit. Indexed ETFs and mutual funds allow for immediate or end of day redemption, but this sort of uber-liquidity simply isn't required by the large population of passive equity investors who expect to hold till retirement.

To buy these indexed equity deposits, investors would be required to lock-in their investment for, say, ten years, with redemption only possible upon maturity. With captive funds in hand, the manager of the equity deposit scheme would be able to move a large percentage of the fund's assets out of unregistered shares and into registered loyalty programs. Mutual funds and ETFs, which offer instant or end of day redemption, need to stay relatively liquid in order to meet potential redemption requests. Putting shares into registered share programs like L'Oréal's would introduce liquidity risk, so mutual funds and ETFs would probably only be able to make limited usage of loyalty programs.

Equity deposits would thus be able to lever the magic of compound loyalty dividends to provide those with long-term goals a higher return than an equivalent index mutual fund or ETF. After all, if your plan is to buy once in your thirties and sell once in your sixties, why waste money paying for all the liquidity services that come in between?

Thursday, September 15, 2016

Is the Fed breaking the law by paying too much interest?

George Selgin had an interesting post describing how the Fed appears to be breaking the law by paying too much interest to reserve-holders. This is an idea that's cropped up on the blogosphere before, here is David Glasner, for instance.

I agree with George that the the letter of the law is being broken. That's unfortunate. As Section 19(b)(12)(A) of the Federal Reserve Act stipulates, the Fed can only pay interest "at a rate or rates not to exceed the general level of short-term interest rates." With three month treasury bills currently around 0.33% and the fed funds rate at 0.4%, the current interest rate on reserves (IOR) of 0.5% exceeds the legal maximum.

Unlike George, I don't think the Fed deserves criticism over this. If the letter of the law is being broken, the spirit of the law surely isn't.

If there is a spirit residing in the law governing IOR, it's the ghost of Milton Friedman. Since the Fed's inception in 1913, IOR had been effectively set at 0%, far below the general level of short term interest rates. This has acted as a tax on bankers. They have been forced to hold an asset—reserves—that provides a below-market return. Friedman's big idea was to remove this distortionary tax by bringing IOR up to the same level as other short term interest rates. Banks would now be earning the same rate as everyone else. The Fed would only get the authority to set a positive rate on reserves in 2008, long after most modern central banks like the Bank of Canada had implemented Friedman's idea.

Friedman wanted to remove the tax, but he didn't want to introduce a subsidy in its place. To prevent central bank subsidization of banks, the Federal Reserve Act is explicit that IOR should not exceed other short-term interest rates.

In practice, how might the Fed set IOR in a way that subsidizes banks? This is more complicated than it seems. If the Fed sets IOR at 1%, arbitrage dictates that all other short term rates will converge to that same level. After all, why would a financial institution buy a safe short term fixed income product for anything less than 1% if the central bank is fixing the yield of a competing product, reserves, at 1%?

Short-term yields won't converge exactly to IOR. Some will trade a hair above IOR, others a bit below. This is because each short-term fixed income product has its own set of peculiarities and these get built into their yield. For instance, buying federal funds is riskier than parking money at the Fed; in the latter transaction the Fed is your counterparty while in the former it's a bank, So the fed funds rate should trade a bit above IOR. But we wouldn't say that a higher fed funds rate is a sign of a below-market return on reserves, or that this spread represents an implicit tax on reserve owners. The fed funds rate exceeds IOR only because that is how the market has chosen to appraise the risk of owning fed funds.

Conversely, because a treasury bill is ofttimes less risky then parking money at the Fed, its yield should regularly dip below IOR. When it does, no one would say that the Fed is providing an unfair subsidy to reserve holders by paying IOR in excess of the treasury bill rate. The lower treasury bill rate is simply the free market's way of accounting for the superior risk profile of treasury bills relative to reserves.

Nowadays, with IOR at 0.5% and treasury bills yielding 0.33%, the Fed is clearly contradicting the wording of the Federal Reserve Act. IOR has been set at a rate that "exceeds the general level of short-term interest rates." But this by no means implies that the Fed is breaking the spirit of the law. The spirit of the law only tells the Fed not to pay subsidies to banks. As I explained above, the yield differential may simply reflect the market's assessment of the unique risks of various short-term fixed income products, not  a policy of paying subsidies.

To get the ghost of Milton Friedman rolling in his grave, here is how to structure IOR so that it offers a subsidy to banks. The Fed would have to set up a tiered reserve system where a bank's first tier of reserves earns a higher rate than the next tier. To begin with, assume that Fed officials deem that a 0.5% fed funds rate is consistent with a 2% inflation target. The Fed offers to pays interest of 100% on required reserves (I'm exaggerating to make my point) while offering just 0.5% on excess reserves. Banks will hold required reserves up to the maximum and reap an incredibly 100% yearly return. All reserves above that ceiling will either be parked at the Fed to earn 0.5% or lent out in the fed funds market.

Thanks to arbitrage, the 0.5% rate on excess reserves ripples through to other short term rates. Because a bank can always leave excess reserves at the Fed and earn an easy 0.5%, a borrower will have to bid up the fed funds rate and t-bill rates to at least 0.5% in order to coax the marginal lender away from the Fed.

And that's how the Fed would subsidize banks. The "general level" of rates as implied by the rate on fed funds and treasury bills hovers at 0.5% while banks are earning a stunning 100% on a portion of their reserve holdings. It's highway robbery! Milton Friedman would be furious; the distortionary tax he so disliked has been replaced with a distortionary subsidy.

By the way, if you really want to know what tiering and central bank subsidies to banks look like, this is the exact same mechanism the Bank of Japan and Swiss National Bank have introduced to help banks deal with negative interest rates. See here and here.  

So the bit of legalese that says that IOR should not exceed the "general level of short-term interest rates" is really just a poorly chosen set of words meant to describe a very specific idea, namely, a prohibition against setting a tiered reserve policy where the first tier, required reserves, earns more than the second, excess reserves, the ensuing subsidy flowing through to banks.

At the end of the day, what accounts for the current divergence between IOR and the other short term rates? Because the Fed has not set up a tiered reserve policy, there is simply no way that the divergence reflects a subsidization of banks. There is only one remaining explanation. Peculiar developments in the microstructure of the fed funds and t-bills markets have led traders to discount these rates relative to IOR.

So you can rest easy, Milton.

The peculiarities bedeviling the fed funds market are explained by Stephen Williamson here. There are several large entities, the GSEs, that can keep reserves at the Fed but are legally prevented from earning IOR. Anxious to get a better return, they invest in the fed funds market market, but only a limited number of banks have the balance sheet capacity to accept these funds. This oligopoly is able to extract a pound of flesh from the GSEs by lowballing the return they offer, the result being that the fed funds rate lies below IOR.

As for treasury bills, they are unique because, unlike reserves held at the Fed, they are accepted as collateral by a whole assortment of financial intermediaries. Put differently, treasury bills are a better money than reserves. Because the government is loath to issue too many of them, the supply of treasury bills has been kept artificially scarce so that they trade at a premium, a liquidity premium.

George ends his post by appealing to his readers to sue the Fed. I don't think think a lawsuit will bring much justice. If there are to be any legal battles to be fought, better to petition Congress to adjust the wording of the Federal Reserve Act so that it better fits the spirit of the law. We don't want the law to misidentify a situation involving IOR in excess of the "general level of interest rates" as necessarily implying subsidization when microstructure is actually at fault. While Milton Friedman had a lot of reasons to criticize the Fed, this probably wouldn't be one of them.

Tuesday, September 6, 2016

What finance can learn from automakers

Arnold Kling is appalled by Lynn Stout, who accuses Wall Street of providing too much liquidity:
Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”
Kling disagrees, saying that liquidity is a good thing:
I have said that as individuals and nonfinancial firms we wish to hold liquid, riskless assets and issue risky, illiquid liabilities. Financial firms do the opposite. I am quite sure that this produces real benefits.
I'm going to walk the line between Kling and Stout in an effort to show how they're both right; liquidity is an awesome product that Wall Street just happens to be providing too much of. And I'm going to use the market for cars as my foil.

Given a choice between buying a car that has an old-fashioned manual transmission or a modern automatic, the easier option beckons. That's probably why automatics have become so popular with consumers since being introduced back in the 1940s. But the advent of the automatic transmission hasn't stopped automakers from selling vehicles with manual transmissions and consumers from buying them. If you're willing to put up with the constant pumping of the clutch in rush hour traffic, the smaller sticker price of a manual is quite attractive, as are its lower maintenance costs. By selling cars with either transmission, car companies satisfy the preferences of both sets of consumers.

This same strategy of product splitting (for lack of a better term) should also be used for liquidity, but it isn't.

When Wall Street improves the range of liquidity services that are built-in to bonds and shares, it does so for every instrument in existence. This sort of broad improvement in liquidity is what Kling is celebrating in his post. Now there should be no doubt that liquidity is a product that offers very real benefits, as Kling points out. But improving the liquidity of every instrument is like a car manufacturer adding only automatic transmissions to every car it produces. If you think that neither the ease of an automatic transmission nor the improved liquidity services embedded in a stock are justified by their higher price—tough luck: you can't exercise an opt out clause. You've simply got to eat the cost of these features.

While car manufacturers have chosen to appeal to both sets of customers by continuing to sell manual transmissions, Wall Street doesn't provide an equivalent liquidity-lite option to go with its regular fare of increasingly-liquid instruments. If you're a buy-and-hold investor like me, then you've probably purchased a few ETFs that you're going to unthinkingly hold for a x decades until retirement. Folks like us—slow investors—simply don't put much value on the ability to sell our ETFs at lightning speeds between now and then. So in a sense Stout is right to accuse bank executives of profiting from the overproduction of liquidity. Slow investors like me would be quite content with a good ol' manual transmission, but because Wall Street is only hawking fancy automatics, we're paying up for a product—liquidity—that we simply don't need.

And that's why I agree with both Kling and Stout. Kling is surely right that the huge quantity of liquidity created by Wall Street over the last 40 years has been a boon for many investors, but Stout is right that these liquidity services exceed the needs of a certain set of investors. Automatics are great, but unfortunately they're all that the finance industry builds—some of us just want manuals.


If you're interested, here's a solution.

The way to satisfy both sets of investors, those who crave liquidity and those who don't, is for Wall Street to start engaging in the same product splitting that car manufacturers do. For every existing stock or ETF, offer both automatics & manuals: an expensive liquid option as well as an illiquid but cheaper version. As an example, consider that banks already offer manuals & automatics in their deposit businesses. Depositors can choose to hold easily transferable demand deposits or forgo liquidity by investing in higher-yielding (i.e. cheaper) term deposits.

Here are ways to implement a manual & automatic program in the world of equities:

1. Publicly-traded companies should start slow share programs.

By implementing a slow share program, companies provide those investor who are willing to forego liquidity for at least two years with bonus stock dividends. The shares of these investors are locked up; they cannot be sold. Short term investors, those who prefer to hold for less than two years—and therefore refuse to lock up their shares—won't qualify for the bonus. Stock dividends provided by a slow share program improve the returns of long-term investors by diluting the ownership position of short-term investors. To complete our car analogy, locked-in slow shares are Wall Street's cheap but inconvenient manual transmission; regular unlocked shares are the expensive but handy automatic.

I go into some of the reasons that firms may have for rewarding long term investors here.

2. Financial services firms should provide equity deposits.

When an investor buys an ETF or an index mutual fund, it's as if they've deposited the underlying shares at a bank and have received a receipt in return. The receipt for the world's most popular ETF, the SPDR S&P 500, is incredibly liquid; as long as it's not the weekend or late at night, anyone can cash out in just a moment. An index mutual fund receipt is a little less liquid; it can only be redeemed at the end of each trading day.

If ETFs and index mutual funds are the expensive automatics of the finance world, here's how to create a cheap manual. The idea behind an equity deposit is to push the redemption period out even longer. A three-month equity deposit could only be cashed in after three months have expired, a five-year deposit after five years have passed, and likewise for a twenty-year deposit.

Because the manager of an equity deposit scheme has a set of investors who have committed to being illiquid for a fixed term, he/she can lock up more shares in slow share programs than the manager of an ETF or index mutual fund, who always requires a certain degree of flexibility to meet the liquidity needs of investors. Greater participation in slow share programs means that the returns that flow to an equity deposit holder will always be higher than those that flow to ETF or index mutual fund owner, or, put differently, that those willing to forgo liquidity can buy a dollar's worth of corporate earnings for less than those who are not willing to forgo it.

While slow share schemes are just science fiction, stock lending provides a real life way for equity deposit managers to reduce costs. ETFs and index funds earn significant amounts from lending out stock, see for instance here. Because they have a committed deposit base, equity deposit managers would be able to commit to lending out stock for long periods of time, say for a fixed 365-day term. Because their base of depositors can cash out at any moment, ETF and index fund managers can only rollover a series of 1-day stock loans for 365 days. This flexibility allows equity deposit managers to harvest the stock lending term premium. Put differently, you can make a lot more money by committing to lend once for a full year than to lend 365 times for one day.

I've gone into more detail on equity deposits, the potential manual transmission of the finance world, here and here.

Friday, September 2, 2016

Kocherlakota on cash

Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:

I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.

P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.