Tuesday, February 20, 2018

Cash, cat, and mouse

Bruno Liljefors, 1899, link

The tax authority and the tax payer are engaged in an age-old cat and mouse game, tax payers trying to perfect tricks that allow them to pay as little tax as possible and the tax authority trying to close these loopholes. Retail cash payments are one of the fields on which this battle is waged. It's interesting to see how sophisticated this cat and mouse game has become.

There are two weak points in the sales process that allow cash-accepting retailers to avoid paying sales taxes or VAT. The first weak point is at the very outset of a payment. When a customer pays with cash, the person behind the till can avoid ringing up the payment. Without a record of the payment having been made, the retailer needn't pay tax.

But even if a retailer rings up all cash payments and provides receipts, they can still avoid paying taxes. At the end of the business day, they need only doctor the cash register's data using a zapper—add on hardware or software designed for this purpose—in effect purging all or a portion of the cash payments registered during the course of business. With the only record of that day's cash payments now being the paper receipts held in customers' wallets—most of which will have been thrown away—the retailer needn't worry about the tax authority discovering the doctoring. (Erasing card based payments is much riskier for the retailer because a paper trail still exists with the card-issuer.)

Tax authorities have been targeting the second point of weakness for a few decades now by requiring retailers to use certified cash registers that have tamper-proof memory units. These are variously known as a fiscal control units, electronic tax registers, or fiscal tills. These tills are designed in such a way that any attempt on the part of the retailer to break into its memory using a zapper or some other technique will be discovered. Additionally, these units have the potential to be connected directly to the tax authority, allowing for instantaneous transmission of sales data and constant real-time tax auditing. That sounds a bit intrusive, no?

Below is a chart from the IMF showing nations that have implemented fiscal till plans:

Source: IMF, Electronic Fiscal Devices, 2015

Progressing to the next stage of the cat and mouse game, retailers will try to evade tamper proof memory units in the cash register by making recourse to the first weak point in the sales process; not entering the transaction into the cash register in the first place. Recognizing this, the tax authorities who have implemented fiscal till schemes have made it illegal to not issue a sales receipt. But illegality doesn't seem to me like a big hindrance to a retailer who has already set their mind on evading taxes.

One neat trick to get retailers to provide receipts—and therefore run all transactions through the tamper-proof cash register—is to recruit the customer into the cat and mouse game as helper. Public information campaigns exhorting people to ask for receipts are one technique. But the more interesting trick is implementing a tax-receipt lottery. All invoices issued from the tamper-proof cash register come with a unique lottery number. Anyone who keeps their invoices will be able to participate in a periodic lottery. Customers thus have an incentive to ask the retailer for a receipt, obliging the retailer to run the transaction through the fiscal till.

Taiwan implemented the first tax receipt lottery back in the 1950s, the Uniform Invoice lottery. I've included a picture below, and here is the website. In the last fifteen years, a number of nations have begun to copy it including Czech, Slovakia, Slovenia, Malta, Portugal, Poland, China, Sao Paulo, and Lithuania.

Taiwan sales receipts with lottery numbers on them

The next stage of the cat and mouse game occurs as the retailer, desperate to adapt to the government's crafty invoice lottery, tries to coax the customer over to his side. On a $50 meal, a restaurant may be able to say $2.50 in tax (assuming a 5% tax rate) if the the fiscal till is avoided. If the restaurateur says that he will share some of this savings with the customer, he may be able to induce her to not ask for an invoice and thus avoid the till. The amount of money he must dangle in front of her will have be large enough to compensate her for the foregone fun of playing the lottery, potential lottery winnings, and guilt.

China is the most interesting example of the cat and mouse game being played at this level. To incentivize cash-paying customers to ask for invoices, or fapiao, the Chinese authorities have created a scratch and win game. Restaurateurs have reacted by offering customers a free soda, or a discount, if they don't ask for the fapiao. Presumably the value of a soda is just sufficient to compensate the customer for foregoing the lottery. More entertaining accounts of fapiao here and here

I'm sure these methods of attacking tax avoidance work to an extent. In Québec, for instance, as of March 2016 the tax authorities say that they have recovered CAD$1.2 billion in taxes following the introduction of fiscal tills in the restaurant industry. However, I'll hazard that the biggest determinant of tax avoidance is good government. If people trust the government to do smart things with tax revenues and they don't see evidence of corruption, then they will be more likely to view paying taxes and reporting on cheaters as one of their public duties.



Other sources:
OECD: Technology Tools to Tackle Tax Evasion and Tax Fraud (link)
Ainsworth: Québec’s Sales Recording Module (SRM) - Fighting the Zapper, Phantomware, and Tax Fraud with Technology (link)
Steenbergen: Reaping the benefits of Electronic Billing Machines (link)

Tuesday, January 30, 2018

The big ol' €500



Production of the European Central Bank's €500 notes is scheduled to come to an end later this year. But a chart of the quantity of €500 banknotes in circulation (see below) reveals something odd. The supply of €500s began to plummet way back in early 2016, long before note production was supposed to be halted. What gives?

It was back on May 4, 2016 that the ECB officially announced that it would stop printing and issuing the €500 note, one of the world's most valuable banknotes ranked by purchasing power. The reason it gave was concerns that the €500 "could facilitate illicit activities." You may remember that this was in the midst of ex-banker Peter Sands screed against high denomination notes, echoed by economist Larry Summers and later amplified by Ken Rogoff's book The Curse of Cash.

While the €500 is undoubtedly popular with organized crime, there is some evidence that regular people use €500s, as Larry White points out here. In the recently published survey on the use of cash by households in the euro area, 19% of respondents reported having a €200 or €500 in their possession in the previous year. A quarter of respondents held banknotes (they don't specify the denomination) as a precautionary reserve, with 12% of these reporting a stash greater than €1000. So that means that around 3% of Europeans keep a large hoard of notes under their mattresses. This presumably gives the €500 a role to play as a store of value. After all, hiding thirty €500s under the bed is more convenient than three-hundred €50s.

But concerns over illicit usage of the €500 won out. Issuance of new €500s is set to stop near the end of 2018, although after that date people will be free to continue holding existing €500s as a store of value or to buy things. Any note deposited in the banking system after that point will be sent to the ECB to be destroyed. With no new supply and a steady removal of existing €500 notes, the quantity outstanding after 2018 will steadily shrink.

Below, I've charted out the total value of euro high denomination banknotes in circulation.



Although the €500 has eight or nine months left before this deadline is reached, the supply has already fallen by around €50 billion from its peak level of €300 billion outstanding in January 2016. Has the ECB jumped the gun and already kiboshed the €500 without telling anyone?

Luckily, the ECB provides incredibly fine-grained data on banknotes. Not only can we get the total value of banknotes in circulation, but also the monthly flow of banknotes issued by the ECB to private banks and returned by private banks. I've charted these flows below.



No, the ECB has not jumped the gun. It continues to issue several billion euros worth of €500s each month (the black line). But whereas issuance tended to exceed note returns in the past—the result being growth in the total stock of €500s in circulation—the tables have turned and note returns (the grey line) have generally exceeded issuance since early 2016, and thus the stock has dwindled. So the observed decline in the supply of €500s is entirely the result of the public's preference to have less of them.

This highlights an important point that I often mention on this blog. One of the most popular motifs of central banks is that they print cash willy nilly, forcing it onto an unsuspecting and virginal economy. This wildly misses the mark. Central banks do not push banknotes into the economy. Rather, the public pulls banknotes out of the central bank into the economy and pushes them back to the central bank. Each month Europeans return whatever quantity of €500s they don't want to the banking system, commercial banks in turn forwarding this currency to the ECB. Others withdraw whatever amounts of €500s they desire from their bank accounts, private banks in turn calling on the ECB to provide sufficient €500s. The net effect is an increase or decrease in the total stock of €500 banknotes in circulation. The ECB itself has no direct control over the public's decision to build or diminish the total supply of €500s.

I suspect that the relatively large increase in €500 note returns since 2016 is due to worries of an aggressive demonetization. As the second chart shows, returns of €500s began to accelerate in February and March 2016, well before the May 2016 announcement date. At the time, hints of the €500's imminent demise were being leaked to the press. Now, imagine that you are the head accountant at a large criminal organization with multiple suitcases full of €500s. You are hearing rumours that something is about to be done to the €500 note. The worst case scenario is that the note is to be suddenly cancelled—or demonetized—by the ECB, the period for converting €500s into €100s and €200s limited to a harrying few weeks. If the conversion window is being monitored by the authorities, your organization's attempts to convert €500s into smaller denominations might be flagged for further inspection.

Given this scenario, you'd want to change your suitcases full of €500s into €100 and €200s as fast as possible, before the actual announcement hits. Otherwise your organization might end up forfeiting a large chunk of the value of those notes—and you might be fired, literally. So my guess is that the rumours surrounding the fate of the €500 probably caused a mini "banknote run" in the months prior to the May announcement. Even after the ECB assuaged worries about an aggressive demonetization by promising to exchange €500s for an unlimited period of time, note returns have remained high relative to issuance. This suggests that the underground market still has worries about a potential aggressive demonetization, and are shifting into safer alternatives.

Once the ECB stops issuing €500s at the end of this year, the pull-push mechanism I described above will cease to function. There are two ways to set monetary policy. The first way—the one that regulates all banknotes including the €500—is to fix the price and let the quantity fluctuate as the public pulls what it needs and pushes back what it doesn't. The other policy is to fix the quantity and let the price fluctuate. This is the policy governing assets like gold, or the S&P 500, or bitcoin. 

After 2018 the ECB will have switched from fixing the price of €500s to fixing their quantity. At that point, the price will become a floating one determined by public demand, just like gold or bitcoin or the S&P 500. The higher the public's demand for €500s, the more its price will rise relative to pegged banknotes like the €100. A few years from now, it might take six or seven €100s to buy one €500.

Thursday, January 25, 2018

Paying interest on cash

Freigeld, or stamp scrip, is designed to pay negative interest, but it can be re-purposed to pay positive interest.

Remember when global interest rates were plunging to zero and all everyone wanted to talk about was how to set a negative interest rate on cash? Now that interest rates around the world are rising again, here's that same idea in reverse: what about finally paying positive interest rates on cash? I'm going to explore three ways of doing this. As for why we'd want to pay interest on cash, I'll leave that question till the end.

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The first way to pay interest on cash is to use stamping. Each Friday, the owner of a bill—say a $50 note—can bring it in to a bank to be officially stamped. The stamp represents an interest payment due to the owner. When the owner is ready to collect his interest, he deposits the note at the bank. For example, say that 52 weeks have passed and 52 stamps are present on the $50 note. If the interest rate on cash is 5%, then the banknote owner is due to receive $2.50 in interest.

Alternatively the note owner can collect the interest by spending the $50 note, say at a local grocery store. The checkout clerk will count the number of stamps, or interest due, and tack that on to the face value of the note. With 52 stamps, the owner of a $50 note should be able to buy $52.50 worth of groceries, not $50. After all, the store has the right to bring the $50 note to its bank and collect the $2.50 in interest for itself.

Stamped currency seems like a pretty big hassle to me. The clerk behind the counter must count out the stamps on the note by hand, and the owner of the note has to trek back and forth to the bank each week to get the stamp affixed. Instead, imagine that each banknote has a magnetic strip that records how long the bill had been in circulation. This would remove some of these hassles. Weekly trips to the bank for stamping would no longer be necessary, and a note reader installed at a bank or retailer would automatically record how much interest was due, precluding painstaking counting of stamps.

"They use this magnetic strip to track you." says Byers to Agent Scully, The X-Files

Apart from stoking conspiracy theories, there's still a major problem with a magnetic strip scheme. Because each note has entered circulation at a different time, each is entitled to a varying amounts of interest. And this means that banknotes are no longer fungible. Fungibility—the ability to cleanly interchange all members of a population—is one of the features of money that makes it so easy to use. Remove it and money becomes complicated, each piece requiring a unique and costly effort to ascertain its value.

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Our second way of paying interest on money doesn't destroy the fungibility of banknotes. The central bank needs to sever the traditional 1:1 peg between deposit money and cash, and then have cash slowly appreciate in value relative to deposits.

For instance, a central bank might start by setting an exchange rate of $1 note = $1 deposit on January 1, but on January 2 it adjusts this rate so $1 note is equal to $1.0001 deposits, and on January 3 adjust this rate to $1:$1.0002, etc. So the cash in your wallet is benefiting from capital gains. By December 31, the exchange rate will be around $1 note to $1.0365. Anyone who has held a banknote for the full year can deposit it and will have earned 3.65 cents in interest, or 3.65%. 

The major drawback with this scheme is the calculational burden imposed on the population by breaking the convenient 1:1 peg between cash and deposits. Assuming that retailers price their wares in terms of deposits, anyone who wants to pay in cash will have to make a currency conversion using that day's exchange rate. For instance, if the central bank's peg is currently being set at $1 note = $1.50 in deposits, then a popsicle that is priced at $1 will require—hmmm... let me check my calculator—$0.667 in cash. Phones will make this exchange rate calculation easy, but it is still likely to be a bit of a nuisance.

There are other hassles too. Would a capital gains tax have to be paid on the appreciation of one's cash? How would existing long-term contracts deal with the divergence? For instance, if my employer is paying me $50,000 per year, obviously I'd prefer this sum be denominated in steadily appreciating cash rather than constant deposits, and she will prefer the latter. What becomes the standard unit of account?

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The last way to pay interest (at least as far as I know) is to run lotteries based on banknote serial numbers, an idea independently proposed by Hu McCulloch and Charles Goodhart back in 1986.

Central banks would periodically hold draws entitling the winning serial numbers to large cash prizes. For example, if there was $100 billion in banknotes in circulation, the central bank could set the interest rate on cash at 5% by offering prizes over the course of the year amounting to 5% of $100 billion, or $5 billion.

This technique of paying interest on cash solves the fungibility problem that plagues the earlier stamping technique. Every note has the same chance of winning the lottery, and non-fungible winners are immediately withdrawn. And unlike the crawling peg idea, banknotes and deposits remain equal to each other so burdensome exchange rate calculations don't need to me made.

However, it introduces the threat of bank runs. The day before the big lottery is set to occur, everyone will withdraw deposits for cash so that they can compete in the draw. To prevent a bank run, it may be necessary to randomize the date of the big lottery so that no one knows when to withdraw notes, an idea proposed by Tyler Cowen. Another way to preclude bank runs is to have a regular stream of small weekly lotteries rather than one or two big ones each year.

Another drawback to note lotteries is the cost that is imposed on society by having everyone constantly checking serial numbers. As Brian Romanchuk points out, employees who are working behind their employer's tills may be tempted to switch out winning notes with losers. Employers may protect themselves by setting up scanning hardware to read in serial numbers as banknotes enter the tills, maintaining their own internal database of cash inventories so that winners can quickly be isolated and returned. But all of that is costly. Would it be worth it?

Interestingly, there is some precedent for these sorts of lotteries. In Taiwan, receipts are eligible for a receipt lottery, a neat way to incentivize people to avoid under-the-table transactions (ht Gwern). Lotteries can also be useful in attracting depositors, as outlined in this Freakonomics podcast (ht Ryan). George Selgin and William Lastrapes have gone into the idea of lottery-linked money in some detail:
Though the suggestion may appear far fetched, in many countries lotteries are presently being used with considerable success to market bank deposits. According to Mauro Guillen and Adrian Tschoegl (2002), “lottery-linked” deposit accounts have been especially popular with poorer persons, including many who might otherwise remain “outside the banking system.” ... In two popular Argentine schemes, for instance, depositors receive one ticket or chance of winning for every $200 or $250 on deposit (ibid., p. 221). Lottery-linked banknotes, in contrast, would themselves serve as tickets, allowing persons to play for as little as the value of the lowest note denomination, and with no apparent cost to themselves save that of occasionally inspecting their note holdings.
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Some readers may recognize these three techniques for paying interest on cash as the inverse of the three go-to ways of applying negative interest rates to cash being discussed a few years ago. For instance, one of the most well-known ways of imposing negative interest rates on owners of cash is to apply a Silvio Gesell style stamp scheme (see picture at top), whereby a currency owner must buy a stamp and affix it to the note in order to renew the validity of their currency each month. (I once discussed Alberta's experiment with Gesell's "shrinking money" here). Without the appropriate number of stamps, the note is illegitimate. In my first example above, Gesell's stamp tax has been re-engineered into a stamp subsidy. As for the magnetic strip modification, this is Marvin Goodfriend's 1999 update of Gesell, flipped around to award interest rather than docking it.

Miles Kimball has written extensively on escaping the zero lower bound to interest rates by setting a crawling peg on currency. But just as Kimball's crawling peg can impose a negative interest rate on banknotes, it can be used to pay interest, as I described above. Indeed, Miles (along with Ruchir Agarwal) frequently mention this possibility in his blog posts and papers (see this pdf).

Finally, remember Greg Mankiw's controversial 2009 article on imposing negative interest rates by serial number? He wrote:
Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
Mankiw's idea is just the reverse of Goodhart and McCulloch's earlier lottery idea, the lottery replaced by with a demonetization.

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So why pay interest on currency? I can think of two reasons. One is based on fairness, the other on efficiency.

The decision to avoid paying the market rate of interest on currency amounts to a tax on currency users. Who pays this tax? Cash is often the only means for the poor, new immigrants, and unbanked to participate in the economy. So the tax falls on those who can least afford it. This hardly seems fair. By conducting note lotteries or stamping notes, those consigned to the cash economy can get at least the same return on banknotes as the well-off banked receive on deposits.

Now hold up JP, some you will be saying at this point. What about criminals? Yep, the other group of people who suffer from the lack of interest on banknotes are criminals and tax evaders. Rewarding them with interest hardly seems appropriate. One would hope that if central banks did adopt a mechanism for rewarding currency with interest, it would be capable of screening out bad actors. For instance, criminals may be leery of collecting their interest or lottery prize if making a claim at a bank means potentially being unmasked. Another way to set up the screen would be to pay interest or prizes on small denominations like $1-$10 notes, and not on $20s and above. Since criminal organizations prefer high denomination notes due to their compactness, they wouldn't benefit from interest.

As for the efficiency argument, this is nothing but the famous Friedman rule that I described in my previous post. All taxes impose a deadweight loss on society. When a good or service is taxed, people produce and consume less of it than the would otherwise choose, tax revenues not quite compensating for this loss. From a policy maker's perspective, the goal is to reduce deadweight loss as much as possible by selecting the best taxes.

In the case of cash, the deadweight loss comes from people holding less of it than they would otherwise prefer, incurring so-called shoe leather costs as they walk to the bank and back to avoid holding too much of the stuff. If a 0% return on cash is an inefficient form of taxation relative to other alternatives types of taxes, then it would be better for the government to just pay interest on the stuff and recoup the lost revenues elsewhere, say through consumption taxes or income taxes.

Sunday, January 14, 2018

Floors v corridors



David Beckworth argues that the U.S. Federal Reserve should stop running a floor system and adopt a corridor system, say like the one that the Bank of Canada currently runs. In this post I'll argue that the Bank of Canada (and other central banks) should drop their corridors in favour of a floor—not the sort of messy floor that the Fed operates mind you, but a nice clean floor.

Floors and corridors are two different ways that a central banker can provide central banking services. Central banking is confusing, so to illustrate the two systems and how I get to my preference for a floor, let's start way back at the beginning.

Banks have historically banded together to form associations, or clearinghouses, a convenient place for bankers to make payments among each other over the course of the business day. To facilitate these payments, clearinghouses have often issued short-term deposits to their members. A deposit provides clearinghouse services. Keeping a small buffer stock of clearinghouse deposits can be useful to a banker in case they need to make unexpected payments to other banks.

Governments and central banks have pretty much monopolized the clearinghouse function. So when a Canadian bank wants to increase its buffer of clearinghouse balances, it has no choice but to select the Bank of Canada's clearing product for that purpose. Monopolization hasn't only occurred in Canada of course, almost every government has taken over their nation's clearinghouse.

One of the closest substitutes to Bank of Canada (BoC) deposits are government t-bills or overnight repo. While neither of these investment products is useful for making clearinghouse payments, they are otherwise identical to BoC deposits in that they are risk-free short-term assets. As long as these competing instruments yield the same interest rate as BoC deposits, a banker needn't worry about trading off yield for clearinghouse services. She can deposit whatever quantity of funds at the Bank of Canada that she deems necessary to prepare for the next day's clearinghouse payments without losing out on a better risk-free interest rate elsewhere.  

But what if these interest rates differ? If t-bills and repo promise to pay 3%, but a Bank of Canada deposit pays an inferior interest rate of 2.5%, then our banker's buffer stock of Bank of Canada deposits is held at the expense of a higher interest elsewhere. In response, she will try to reduce her buffer of deposits as much as possible, say by reallocating bank resources and talent to the task of figuring out how to better time the bank's outgoing payments. If more attention is paid to planning out payments ahead of time, then the bank can skimp on holdings of 2.5%-yielding deposits while increasing its exposure to 3% t-bills.

Why might BoC deposits and t-bills offer different interest rates? We know that any differential between them can't be due to credit risk—both instruments are issued by the government. Now certainly BoC deposits provide valuable clearinghouse services while t-bills don't. And if those services are costly for the Bank of Canada to produce, then the BoC will try to recapture some of its clearinghouse expenses. This means restricting the quantity of deposits to those banks that are willing to pay a sufficiently high fee for clearing services. Or put differently, it means the BoC will only provide deposits to banks that are willing to accept an interest rate that is 0.5% less than the 3% offered on t-bills.

But what if the central bank's true cost of providing additional clearinghouse services is close to zero? If so, the Bank of Canada should avoid any restriction on the supply of deposits. It should provide each bank with whatever amount of deposits it requires without charging a fee. With bankers' demand for clearing services completely sated, the differential between BoC deposits and t-bills will disappear, both trading at 2.5%.

There is good reason to believe that the cost of providing additional clearinghouse services is close to zero. It is no more costly for a central bank to issue a new digital clearinghouse certificate than it is for a Treasury secretary or finance minister to issue a new t-bill. In both cases, all it takes is a few button clicks.

Let's assume that the cost of providing clearinghouses is zero. If the Bank of Canada chooses to  constrain the supply of deposits to the highest bidders, it is forcing banks to overpay for a set of clearinghouse services which should otherwise be provided for free. In which case, the time and labour that our banker has diverted to figuring out how to skimp on BoC deposit holdings constitutes a misallocation of her bank's resources. If the Bank of Canada provided deposits at their true cost of zero, then her employees' time could be put to a much better use.

As members of the public, we might not care if bankers get shafted. But if our banker has diverted workers from developing helpful new technologies or providing customer service to dealing with the artificially-created problem of skimping on deposits, then the public directly suffers. Any difference between the interest rate on Bank of Canada deposits and competing assets like t-bills results in a loss to our collective welfare.

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Which finally gets us to floors and corridors. In brief, a corridor system is one in which the central bank rations the number of clearinghouse deposits so that they aren't free. In a floor system, unlimited deposits are provided at a price of zero.

When a central bank is running a corridor system, as most of them do, the rate on competing assets like t-bills lies above the interest rate on central bank deposits. Economists describe these systems as corridors because the interest rate at which the central bank lends deposits lies above the interest rate on competing safe assets like t-bills and repo, and with the deposit rate lying at the bottom, a channel or corridor of sorts is formed.

For instance, take the Bank of Canada's corridor, illustrated in the chart below. The BoC lets commercial banks keep funds overnight and earn the "deposit rate" of 0.75%. The overnight rate on competing opportunities—very short-term t-bills and repo—is 1%. The top of the corridor, the bank rate, lies at 1.25%. So the overnight rate snakes through a corridor set by the Bank of Canada's deposit rate at the bottom and the bank rate at the top. (The exception being a short period of time in 2009 and 2010 when it ran a corridor floor).



Let's assume (as we did earlier) that the BoC's cost of providing additional clearinghouse services is basically zero. Given the way the system is set up now, there is a 0.25% rate differential (1%-0.75%) between the deposit rate and the rate on competing asset, specifically overnight repo. This means that the Bank of Canada has capped the quantity of deposits, forcing bankers to pay a fee to obtain clearing services rather than supplying unlimited deposits for free. This in turn means that Canadian bankers are forced to use up time and energy on a wasteful activity: trying to skimp on BoC deposit holdings. All Canadians suffer from this waste.

It might be better for the Bank of Canada (and any other nation that also uses a corridor system) to adopt what is referred to as a floor system. Under a floor system, rates would be equal such that the rate on t-bills and repo lies on the deposit rate floor of 0.75%--that's why economists call it a floor system. The Bank of Canada could do this by removing its artificial limit on the quantity of deposits it issues to commercial banks. Banks would no longer allocate scarce time and labour to the task of skirting the high cost of BoC deposits, devoting these resources to coming up with new and superior banking products. In theory at least, all Canadians would be made a little better off. All the Bank of Canada would have to do is click its 'create new clearinghouse deposits'  button a few times.

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The line of thought I'm invoking in this post is a version of an idea that economists refer to as the optimum quantity of money, or the Friedman rule, first described by Milton Friedman back in the 1960s. Given that a central bank's cost of issuing additional units of money is zero, Friedman thought that any interest rate differential between a monetary asset and an otherwise identical non-monetary asset represents a loss to society. This loss comes in the form of people wasting resources (or incurring shoe leather costs) trying to avoid the monetary asset as much as possible. To be consistent with the zero cost of creating new monetary assets, the rates on the two assets should be equalized. The public could then hold whatever amount of the monetary asset they saw fit, so-called shoe leather costs falling to zero.

In my post, I've applied the Friedman rule to one type of monetary asset: central bank deposits. But it can also be applied to banknotes issued by the central bank. After all, banknotes yield just 0% whereas a t-bill or a risk-free deposit offers a positive interest rates. To avoid holding large amounts of barren cash, people engage in wasteful behaviour like regularly visiting ATMs.

There are several ways to implement the Friedman rule for banknotes. One of the neatest ways would be to run a periodic lottery that rewards a few banknote serial numbers with big winnings, the size of the pot being large enough that the expected return on each banknote as made equivalent to interest rate on deposits. This idea was proposed by Charles Goodhart and Hugh McCulloch separately in 1986.

Robert Lucas once wrote that implementing the Friedman rule was “one of the few legitimate ‘free lunches’ economics has discovered in 200 years of trying.” The odd thing is that almost no central banks have tried to adopt it. On the cash side of things, none of them offer a serial number lottery or any of the other solutions for shrinking the rate differential between banknotes and deposits, say like Miles Kimball's more exotic crawling peg solution. And on the deposit side, floor systems are incredibly rare. The go-to choice among central banks is generally a Friedman-defying corridor system.

One reason behind central bankers' hesitation to implement the Friedman rule is that it would threaten their pot of "fuck you money", a concept I described here. Thanks to the large interest rate gaps between cash and t-bills, and the smaller gap between central bank clearinghouse deposits and t-bills, central banks tend to make large profits. They submit much of their winnings to their political masters. In exchange, the executive branch grants central bankers a significant degree of independence... which they use to geek out on macroeconomics. Because they like to engage in  wonkery and believe that it makes the world a better place, central bankers may be hesitant to implement the Friedman rule lest it threaten their flows of fuck you money, and their sacred independence. 

That may explain why floors are rare. However, they aren't without precedent. To begin with, there is the Fed's floor that Beckworth describes, which it bungled into by accident. At the outset of this post I called it a messy floor, because it leaks (George Selgin and Stephen Williamson have gone into this). The sort of floor that should be emulated isn't the Fed's messy one, but the relatively clean floor that the Reserve Bank of New Zealand operated in 2007 and Canada did from 2009-11 (see chart above). Though these floors were quickly dropped, I don't see why the couldn't (and shouldn't) be re-implemented. As Lucas says, its a free lunch.

Wednesday, January 10, 2018

XRP and bitcoin as bridge currencies

Eshima Ohashi Bridge, Japan


The value of all outstanding XRPs recently surpassed that of bitcoin, hitting $300 billion or so last month. XRPs are a cryptocurrency issued by Ripple, a company that is trying to shake up the business of cross border payments. Ripple has a number of strategies for doing this, but the one that has caught people's imaginationespecially as the price of XRPs rocket higheris to have banks and other financial institutions use XRP as a 'bridging asset' for moving value across borders. The idea of using a cryptocurrency as a bridge isn't a new idea. Bitcoin remittance companies have been trying to do this for several years now, without very much success.

So what do I mean by using a cryptocurrency like bitcoin or XRP as a bridge asset? Does it make any sense? To answer these questions, let's dissect a hypothetical cross border payment.

Straddling two universes

As users of banks and other financial institutions, we rarely think about what is going on underneath the hood of a money transfer. If I send money from my account to yours, the language of this transaction implies that money is flowing from my bank account to bank account. But moving funds from one bank to another bank is physically impossible. If my account is at Bank A, and yours is at Bank B, I cannot send value directly from my account to your account. Our two accounts may as well exist in entirely separate universes.

The only way I can make a bank-to-bank payment to you is indirectly, by turning to a third-party who straddles both universes. Say my hair dresser has accounts at both my bank and your bank, and for a small fee she'll do the transaction for us. I tell my bank (Bank A) to credit my hairdresser's account at Bank A by $10, and my hair dresser in turn tells her bank (Bank B) to debit her account and credit you account at Bank B by $10. The payment is done. I have $10 less, you have $10 more, and my hair dresser is flat, her $10 having been erased from Bank B's ledger with a new $10 deposit appearing in her account at Bank A.

The same principle is at work in cross border payments, except the person who is doing the straddling between the two bank—my hair dresserwill need to have a domestic bank account, say in Canada, and an international account, say Philippines. And instead of crediting you $10, she will have her Filipino bank send you the peso equivalent of $10, which is around ₱400 at the current 40:1 exchange rate. But apart from that, the concept is the same.

In principle, a cross border payment like this could go very fast. Assuming that it only takes the Canadian bank a few moments to transfer $10 from my account to my hair dresser's account, then she can quickly start the Philippines leg of the transaction. And if the Filipino bank is just as fast, you'll have the ₱400 just a few moments after she clicks the send button. This whole chain needn't take more than twenty minutes of fiddling with bank websites.

The benefits of queues

But there are factors militating against speed. Say that I need to send you money several times a day. It would be a hassle for my hair dresser to log in to her Philippines bank account and process each payment as it arrives in her Canadian accountshe has to cut hair, after all. Instead, she chooses to wait till the end of the day when several of my payment requests have accumulated, upon which she batches the payments into one large payment and clicks the send button.

There is a trade-off here between speed and cost. Putting transaction requests into a queue slows down each of my payments to you, but it imposes less costs on my hair dresser. Slow speeds aren't necessarily a bug. If we all want to save some money, sluggishness may be the best solution for all of us.

Pre-funding: expensive but speeds things up

Imagine that over the course of a few weeks I make so many payments to you that my  hairdresser's Filipino account runs out of funds. When this happens she will no longer be able to make outgoing payouts to your Philippines bank account. To keep the system up and running, she will have to replenish her account with pesos. One of her options would be to withdraw cash from her Canadian account, fly it to Philippines in a suitcase, trade it at the airport for peso banknotes, and deposit these into her Filipino account. This would be slow, expensive, dangerous, and potentially illegal, but it's a theoretical option.

A more realistic option would be to sell her Canadian dollar deposits to a foreign exchange dealer and get Filipino peso deposits in return. This dealer, who will have accounts in both Philippines and Canada, will execute this trade for a commission. My hairdresser will have to ask her Canadian bank to credit the dealer's dollar account while the dealer asks his Filipino bank to credit my hair dresser's peso account. There will be some lag as the dealer processes the transaction, say because helike my  hairdresseruses a queue to batch payments together so as to save on fees. But once my hair dresser's Filipino account has been topped up, I can once again make payments to you.

Instead of allowing her Filipino account to periodically run down to zero, my hairdresser may try to maintain a permanently-funded peso account. After all, if she doesn't prefund the account, then you and I will have to cope with constant delays as she waits for the foreign exchange dealer to refill her account. Prefunding her Philippines account isn't without  cost, however. Instead of being able to invest the money in bonds or upgrading her salon, my hair dresser must tie her capital up in a low-yielding bank account as she awaits my payments requests.

Thus, as in the case of queuing on the Canadian side, prefunding on the Philippines side involves a trade-off between cost and efficiency. Reducing the amount of pesos held in anticipation of incoming payment request will allow my hairdresser to reduce costs, but it will simultaneously slow down payments from you to me since the odds of having to wait for a refill increase.

To sum up, for cross border payments to occur someone must straddle the divide between isolated banks. This straddler uses techniques like queuing and prefunding in order to make cross border payments proceed as fast as possible without costing too much.

Cryptocurrency as a bridge

So where do XRP and bitcoin come in? The two of us want little more than a flow of recurring peso payments to arrive in your Filipino bank account as fast and cheaply as possible, but what goes on underneath the hood doesn't concern us. If she can increase payment speeds without having to pay a higher cost (or, alternatively, if she can reduce costs without sacrificing speed), it may make sense for my hairdresser to incorporate an asset like XRP or bitcoin in the payments process.

Say at the end of Monday my hair dresser has amassed four $10 payments in her queue, or $40. She logs into her Filipino bank account, and sends you one ₱1600 payment. She wants to rebuild her Filipino account balance in preparation for the rest of the week's incoming payments. Normally she would do so by asking her foreign exchange dealer to swap her some Filipino deposits for her Canadian dollar deposits.

Instead, she decides to pre-fund by turning to the market for cryptocurrencies. One option is to take the $40 I've transferred her and buy $40 worth of XRPs from her foreign exchange dealer, then sell these XRPs to another dealer for ₱1600 in deposits. Alternatively, she may turn to an organized exchange to complete the refunding. She sends the $40 to a Canadian cryptocurrency exchange, buys some bitcoin or XRP, quickly sends these coins to a Filipino cryptocurrency exchange, and then sells them for pesos. At which point she will transfer the pesos to her bank. Voila, her Filipino bank account has been reloaded using cryptocurrency as a bridge.

Comparing fees and speed

Let's compare these two routes. By exchanging dollars directly for pesos via a foreign exchange dealer, only one transaction had to be completed, and thus one set of hassles and fees incurred. By going through the cryptocurrency market, my hairdresser must make two transactionsa purchase of XRP or bitcoin on the Canadian crypto exchange (or from a dealer) using Canadian dollars, and a sale of XRP/bitcoin on the Filipino crypto exchange (or to a dealer) for pesos. If the sum of these two sets of hassles and fees is less than the traditional single set of hassles and fees, then going the cypto route may make some sense for her. But I confess that I think it is highly unlikely that two sets of fees beat one.

It could very well be quicker for my hair dresser to reload her Filipino account via XRP/bitcoin than the traditional route. For instance, the dealer who is buying her Canadian dollars and selling her pesos may delay the peso leg of the transaction for twenty-four hours. But this sluggishness isn't inherent to a fiat-to-fiat transfer. If she asks nicely, there is no reason the dealer can't expedite the transaction so that the pesos appear in her account within the hour. By queuing her request with many others over a twenty-four hour period the dealer reduces his overall costs, these benefits flowing back to my hair dresser in the form of reduced fees. Likewise, my hair dresser could choose to queue her XRP/bitcoin payment into a big chunk along with other people's cryptocurrency payments. This would slow things down, but reduce fees.

US dollars a bridge currency

Not all traditional cross border payments involve one transaction. Canada-Philippines is a relatively popular payments route, but rarely used payments corridors, say like Canada to Uzbekistan, will incorporate a third fiat currency—probably U.S. dollarsas a bridge currency. For this payment to proceed, my hairdresser will need both a Canadian dollar account and a U.S. dollar account. She will have to find a counterpart who straddles the U.S. and Uzbek banking systems by maintaining a U.S. dollar account and an Uzbekistani Som account. Once she transfers her counterpart some U.S. dollars, then he can execute the Uzbek leg of the payment.

Even on exotic corridors I have troubles seeing how XRP/bitcoin can compete as a bridge. The dollar is the world's most entrenched currency. The CADUSD market will always be deeper than the XRP-to-CAD or bitcoin-to-CAD market, and same on the Uzbek Som side. This depth means that transaction costs on U.S. dollar trades will be lower than on crypto trades. For this calculus to change, bitcoin or XRP will somehow have to displace the U.S. dollar as the world's most liquid medium of exchange. But this is unlikely to happen due to the incredible volatility of cryptocurrencies.

Crypto-volatility

Which leads into the next defect of crytocurrencies as bridge assets. XRP and bitcoin are inherently volatile assets, so using crypto as a bridge means the risk of encountering a plunge in value.  In the case of XRPs, my hairdresser will have to hold them for at least a few moments (or even minutes), but that could be enough time to cause some damage. As for bitcoin, which is slower, she will have to carry them for an hour or two before they can be sold in Philippines. That's an eternity in cryptoland. To top it off, crypto exchanges are notoriously risky, outages and thefts being a regular occurrence. These are pretty big risks for my hair dresser to take, so using crypto markets will only make sense if they provide her enough compensating efficiencies.

Where might these come from? Traditional cross border payments have typically offered very little in the way of transparency. If my hair dresser's payment is stuck, it'll be hard for her to get information on its status. To cope with this informational gap, she may choose to constantly over-fund her peso account, which hurts her pocket book. One advantage of something like Ripple is that all XRPs are recorded on the public Ripple ledger, and thus my hair dresser should have a better idea about what stage her payment has progressed. And this may give her the confidence to reduce the amount by which she pre-funds her peso account, the freed up capital being invested in her salon.

That's a nice feature, but I don't quite see how increased transparency can possibly make up for 1) the inherent risks of holding cryptocurrencies, even if just for a few moments, and 2) the aforementioned transactions costs involved in running the bridge. Furthermore, the transparency advantage is being eroded as traditional payments systems respond to the competitive threat posed by players like Ripple. SWIFT, the communications network that is relied on to facilitate traditional cross border payments, has recently incorporated a tracking number to all payments, thus allowing users to get a real-time end-to-end view on the status of their payments.

So for now, I don't think there is much merit to using crypto as currency bridge in cross border payments. That doesn't mean XRP must crash because it has no use case. Dogecoina parody cryptocurrency that recently rose above $1 billion in valuedemonstrates that coins don't need a fundamental use case to justify their price. But I've been wrong many times about cryptoland, so let's see what happens.