Monday, August 22, 2016

End of a stablecoin

Bitcoin has had another white knuckle year, rising from a low of $350 in January to a high of $780 in June. As I've said many times before, if crytpocurrency is going to make a genuine dent in the world monetary order, it'll only happen when its price isn't so volatile. And one of the best ways to smooth things out is by creating a stablecoin, specifically by choosing to peg a cryptocurrency to a popular existing medium of exchange like the U.S. dollar.

Stablecoin isn't just theoretical, a number of these tokens exist. They fail too. It's worth investigating the recent collapse of one the fledgling stablecoins, NuBits, to look for clues about the dangers and pitfalls of maintaining a stablecoin peg.

Back in September 2014 a developer going by the pseudonym JordanLee set out on a brave attempt at pegging a cryptocurrency, NuBits, to the U.S. dollar. The $1 peg lasted for around twenty months before falling in late May to 95 cents and outright failing on June 8. See the chart below.

Source: Coinmarketcap

My understanding is that at its peak, NuBits was registering a healthy $3-4 million in trading volumes every day. While it never grew to be a genuine medium of exchange--you couldn't buy a coffee with it--the tokens were a popular way to hedge against bitcoin volatility. Had the peg held, who knows what might have happened?

In late May, a single large seller of NuBits emerged, offloading around 10% of the entire NuBits supply in a day or two (you can see the volume spike in the chart above). To keep the price of NuBits at $1, the NuBits team that was tasked with maintaining the peg had to use up a large quantity of its reserves. In the course of events the team decided to widen the peg to $0.95-$1.01 in order to slow the reserve bleed. However, the next round of selling broke the peg for good and the now-floating NuBits price quickly plummeted below 50 cents.

Did NuBits fail because it was well-thought out but poorly implemented idea? Or was it unsound from the get-go? I lean towards the latter.

To understand how the NuBits peg works, we need to back up and investigate the architecture of NuBits a bit more. NuBits are digital tokens issued by overlying "Nu network," which is sort of like a digital corporation with no physical hub and no real legal structure. In addition to NuBits, the Nu network also issues shares which give shareholders the right to earn profits from the network and participate in governance. These shares are called NuShares, and as I'll show later on these NuShares are a key part of maintaining the NuBits peg.

Protecting the peg when there is a large increase in demand for NuBits is easy; just create more NuBits. Protecting it when there is an excess supply of NuBits is trickier. In this respect, NuBits is no different from any currency issuer maintaining a peg, say like the People's Bank of China which must have enough resources to keep the yuan anchored in place when a run into dollars begins.

A small quantity of Bitcoin reserves is just one of the Nu network's bulwarks. Once used up, the peg's next line of defence is referred to as parking. Think of this as paying an interest rate on term deposits. When NuBits sellers are pressuring the peg, the Nu network relieves that pressure by offering, say, 10% interest to anyone who is willing to park, or freeze, their NuBits for a period of time. Instead of selling on the open market, the idea is that people will decide to stay put.

Unfortunately, I think that parking may have actually contributed to a failure of the peg. The problem is that the Nu network's parking rates are paid with new NuBits rather than existing NuBits and thus they increase the supply. If a peg is being threatened by an excess supply of money, it makes little sense to relieve said pressure by creating even more NuBits. Instead, the Nu network could have avoided parking-related supply bloat by paying interest using existing NuBits. And it should have earned these NuBits out of the regular course of its operations, say by charging a small user fee, or cutting down on costs. Whatever the case, it means that the Nu network needs to be profitable.

In addition to parking, the Nu network has another mechanism for maintaining the peg. It can issue new NuShares (by engaging in a stock split) and use these to buy back NuBits. The actual route taken seems to have been more lengthy, specifically selling new NuShares for bitcoin, and then using bitcoin to buy back enough NuBits so the $1 peg holds.

But using NuShares to 'back' the NuBits side of the network seems to me like a ticking time bomb. Consider the following dynamic: the moment the peg is challenged by NuBits sellers, speculators will push down the price of NuShares in anticipation of potentially dilutive issue of new NuShares. Which means that the Nu network will have to issue even more NuShares to protect the peg, which only makes the peg that much more costly to maintain and therefore more vulnerable. This leads to more speculation against the peg, and yet another round of NuShares panic as speculators unload in anticipation of dilution. It's a vicious circle that ends in a price of zero for NuShares, and for NuBits too.

There's also an inherent conflict of interest. If maintaining the peg means that shareholders must bear a collapse in the price of their NuShares, at some point is it worth it for them to maintain the peg? Perhaps it's better to pull a Richard Nixon and close the window. Scan the NuBits discussion boards and there seems to have been a bit of this self-serving thinking during the breaking of the peg episode.

Better to use a stable asset like gold or dollars in a vault to back a NuBits-style scheme than volatile share tokens. Of course, this isn't as elegant a solution, since it requires a lifeline to a real world safety deposit box. Nevertheless, it would have helped keep the peg in place.

In sum, NuShares is a good attempt, but it didn't quite succeed. That it lasted so long is a testament to the value of the community that emerged around it. As a tight-knit group it was probably able to self-support the peg at least for a while, insulated from its own inherent short comings by its own momentum. That being said, the Nu network is still around, and according to some rumours, trying to re-peg themselves at $1. I wish them luck!

Related links:

A Report on Peg Abandonment and How to Proceed From Here [link]
The Search for a Stable Cryptocurrency [link]
NuBits - The price stable currency... until it’s NOT!! [link] [update]
My Interpretation of Jordan Lee’s Liquidity Engine Model & Why its First Attempt at Pegging Failed [link]
Theoretical Fedcoin, Meet Operational NuBits [link]
Hayek-Style Cybercurrency [link]
Some Thoughts on Cryptocurrencies and the Block Chain [link]
Robert Sams: Bitcoin, Volatility and the Search for a Stable Cryptocurrency [link]

Wednesday, August 10, 2016

Central banks deposits for you and me

The Bank of England recently announced that it will end a 300-year tradition of allowing employees to keep chequing accounts at the Bank. You can see an example of a cheque above, which is marked with the sort code 10-00-00. Traditionally, folks like you and me have only been able to get a piece of the central bank's balance sheet by holding banknotes. Central bank deposit accounts, which are far more convenient, have been limited to banks and other financial institutions. But the BoE provides a rare example of regular people, specifically employees, being permitted to directly own fully transferable central bank deposits, at least until recently.

The BoE's termination of this seemingly archaic practice is especially interesting in the context of growing efforts to crack open central bank balance sheets to those who have traditionally been hived off from them. A concrete step in this direction is the Federal Reserve's overnight reverse repurchase facility, which allows money market mutual funds to hold overnight balances at the Fed. More ambitious (but less concrete) is the Bank of England's Ben Broadbent, who describes the idea of a central bank adding more counterparties-
"perhaps a wide range of non-bank financial companies, say.  It might mean something more dramatic:  in the limiting case, everyone – including individuals – would be able to hold such balances."   
Echoing Broadbent, BoE Deputy Governor Minouche Shafik has spoken of the need to rethink "about to whom we give access to the advantages of central bank money with its unique qualities of finality of settlement." The idea here is to allow non-banks involved in fintech direct access to the Bank's real time gross settlement system, as Mark Carney goes on to illustrate here.

Turning to the blogosphere, John Cochrane has recently written about having all money backed by the government in order to end bank runs. And in the same vein, here is David Andolfatto's idea of allowing TreasuryDirect balances to be tradeable, thus providing individuals and firms with a safe place to keep cash other than the banking or shadow banking system.

This democratization of central banking sounds like a novel idea. Nosing deeper into the Bank of England's history, however, we learn that it was not just employees who could hold Bank of England deposits; most people could. Some of them were quite famous. An interesting anecdote from the 1700s has Sarah, Duchess of Marlborough, asking her bankers at the Bank of England to provide her with a freebie, namely some pens because she 'could get none that were good.' [1]

Moving forward a century, we learn that upon opening for business in 1855 the Bank of England's Western branch tended to attract small businessmen and private individuals "of modest means" as clients, including the accounts of the University of London, a Regent Street hatter, and a Sackville Street clothier—all on its first day of operations. Later that year the household of Queen Victoria left its private bank in order to do business with the Western branch. By all accounts, the Bank of England seems to have had excellent service:
"Staff were expected to recognize customers on sight and have a good, clear hand for writing up passbooks. Two porters were always on duty at the main entrance, clad in the pink livery of the Bank of England with silk top hats, and even the cashiers wore top hats when serving at the counter." [2]
The Bank of England kept up a retail presence well into the 1900s. But as public service came to be regarded as the Bank's main role, the aggressiveness of its commercial and retail businesses was reduced and it transitioned into a purely bankers' bank. The Western branch would be sold in 1930 to the Royal Bank of Scotland. [3]

By 1963 the Bank of England's services to the public were limited to a small number of accounts for existing customers. Presumably as they died, these accounts were closed. The most recent example of the Bank of England allowing non-banks to set up accounts comes from 2003, when Bank officials decided to provide Huntingdon Live Sciences, a drug company facing threats from animal rights activists, with a BoE account because commercial banks refused to offer their services.

So while it may seem that the Bank of England's Broadbent and Shafik are introducing a modern approach to central banking, the practice of allowing private individuals and non-financial businesses to directly hold central bank balance sheet space (in a non-cash form) is actually an old one. What lessons can we take from this historical example?

Many people believe that an open central bank balance sheet has the potential to render our traditional banking system extinct. Banks are special. They provide the world's most popular exhange media—deposits—as an offshoot of their primary business, lending. But as Robert Sams points out, if individuals are allowed to own safe central bank deposits directly there may no  longer be a reason for them to hold risky bank accounts. Demand for bank deposits falling to zero, banks will have to fund their loans to the public with regular bonds or equity, even as payments are re-routed through the books of the central bank. Fractional reserve banking as we know it is dead.

Depending on who you ask, the replacement of fractional reserve banking with so-called narrow banking, or 100% reserve banking, can be either good or bad. I'll leave that discussion for another day. Whatever the case, Bank of England history illustrates that private bank deposits can coexist with an open central bank balance sheet. Given the choice between keeping accounts with the safe Western branch or a risky private bank, individuals did not collectively flock to the former.

No doubt this was partly due to the two things, the Bank of England's policy of charging for servicing unprofitable accounts and of not paying interest on deposits. Its competitors, on the other hand, did pay interest. In essence, private banks had to retain customers by offering better services.

Which brings us back to the Bank of England's recent decision to close employee accounts. Given the Bank's stated intention of opening up its balance sheet, wouldn't it have been an opportune time to open up its retail banking business to all of England rather than shutting it down? The Bank maintains that it had been having trouble competing with services like online banking being offered by private banks. But as history shows, since a central bank offers something private banks can't —safety—it needn't be as competitive in the services it provides. Alternatively, it could be that the Bank will be following a different strategy of opening itself up, say through a distributed ledger or something like PositiveMoney's Digital Cash Accounts. Whatever the case, don't be fooled by the technological terminology; if the Bank were to open itself up, this would be more of a returning to the fold than a bold new future.

[1] Bank of England: first report, session 1969-70 (link)
[2] Western Branch of The Royal Bank of Scotland - The Story of a Bank and its Building (pdf)
[3] Branches of the Bank of England, 1963 (pdf)

Sunday, July 31, 2016

Monetary policy as a system of connected lakes (a post for John Hussman)

I always like reading fund manager John Hussman because he writes very well, but I feel like he's dug himself into a bit of an intellectual rut—a situation that happens to all of us. For a number of years now Hussman has been accusing the Federal Reserve of setting off a massive bubble in equity markets. But if you ask me, his claim really doesn't square with the observation that we haven't seen a shred of consumer price inflation over that same time frame. Let's explore more.

Hussman recently penned an admirable description of the hot potato effect, the process that is set off by an easing in central bank policy:
Initially, central banks focus on purchasing the highest-tier government securities (such as Treasury bonds in the case of the U.S. Federal Reserve). Central banks buy these interest-bearing securities, and pay for them by creating “base money” - currency and bank reserves. That base money takes the place of interest-bearing securities in the hands of the public, and someone then has to hold that amount of zero-interest money at every moment in time until it is actually retired by the central bank. 
Now, having traded their high-quality, interest-bearing securities to the central bank in return for zero-interest cash, a portion of those investors will simply hold the cash in the form of currency or bank deposits, but some investors will feel uncomfortable earning nothing on those holdings, and will try to pass the hot potatoes onto someone else. To do so, these investors now have to buy some other security that is lower on the ladder of credit quality, and more speculative. The sellers of those securities then get the zero-interest cash. Some of those sellers, unwilling to reach for yield in even more speculative securities, hold the cash, but some climb out to a further speculative limb. Ultimately, the process stops when yields on speculative securities have fallen low enough that investors are indifferent between holding zero-interest cash and holding low-yielding but more speculative securities. At that point, all of the new base money is passively held by somebody.
For those who didn't bother reading the above quotes, here's a quick summary. Start out with a market where everyone is happy with their holdings of cash and securities. New base money is suddenly introduced by the Fed. In an effort to rid themselves of the excess cash, people drive the prices of securities to a high enough level (or their yields low enough) that everyone is once again content with their portfolio of cash and securities. In other words, we get asset price inflation.

A nice way to think of this is to imagine a system of lakes connected by channels, the water level representing prices. When water is poured into one lake the system is disturbed. Water quickly flows out of the first lake through the various channels into the other lakes, the water level of each body of water rising until they are equal. The agitated water becomes stagnant again. Likewise, when the Fed creates and spends new money it quickly courses through the various asset market until the price of each security has risen to a point that all new money is willingly held.

Hussman uses the hot potato effect a lot in his writing. And while I like his description of the effect, it always seems incomplete. He's missed how a Fed-induced asset price inflation might be conveyed to consumer goods markets.

Securities are really just promises of future consumption. By buying Google shares now, we delay consuming stuff now and push it off to some future date. So when Hussman says that easy monetary policy is driving up securities prices, we can think of this as the price of future consumption rising relative to present consumption.

Prior to the monetary expansion, investors will have already chosen whatever balance between present and future consumption feels right to them. Assuming these preferences stay the same throughout, the Fed-induced rise in future consumption prices (ie. Hussman's asset price inflation) means that people are now getting more future consumption than they had originally bargained for. Using our lake metaphor,  the water level of the future consumption lake has risen above the present consumption lake.

Uncomfortable holding too much future consumption, people will begin to rebalance into present consumption—after all, it offers a better bang for the dollar. Consumer price inflation is stoked as everyone buy goods and services. This inflationary process stops only when yields on present consumption have fallen low enough that people are once again indifferent between future consumption and present consumption. Or, returning to our lake metaphor, water has to flow out of the future consumption lake into the present consumption lake until water levels are equal and the surface is once again calm.

Over the years, Hussman has made use of the hot potato effect to say that the stock market is in a massive bubble thanks to Fed easy monetary policy. But I don't buy this claim. If the Fed really was causing such an enormous disturbance in securities markets, we'd have seen some sort of spillover into consumer prices as investors rebalance out of future consumption into present consumption. However, inflation in the U.S. has been well below 2% for several years now.

If the Fed is to be accused of causing an asset bubble, Hussman needs a theory to explain why people have not been arbitraging the markets for future and present consumption. Why haven't we seen a roaring CPI? This seems like a tall order. From what I've read of his work, Hussman traces easy money to as early as 2009. So his theory needs to explain why Fed monetary policy could inflate asset markets for seven years without affecting goods markets.

One way to patch up the story would be to resort to the good ol' Shadowstats trick, or the idea that there is consumer price inflation, we just don't see it in official statistics. But that's a weak argument, and thankfully I don't see Hussman using it. Alternatively, maybe something is inhibiting the rebalancing process. Returning to the lake metaphor, if a network of locks are being used to connect the lakes, then the water level of one lake can rise far above the others insofar as movement between them is inhibited by a locking mechanism. Like the picture at top. Thus we might be able to get asset price inflation without consumer price inflation. But what force could possible be strong enough to hold back such a torrent? I'd love to hear. It's possible it's not Hussman who's in a rut, but myself.

Until Hussman gives a decent explanation, I'll stick to the theory that there never was a Fed-induced financial bubble in the first place. Despite what many fund managers might claim, Fed monetary policy really hasn't been very easy, and that's why we haven't seen any froth develop in consumer goods markets. We need a better explanation for rising asset prices than Hussman's irresponsible Fed theory.

Tuesday, July 26, 2016

Helicopter money, Canadian-style

Proponents of helicopter money have been getting a lot of press lately, but I don't really get what all the excitement is about. I live in Canada, and no nation is closer to implementing helicopter money than mine. But if I work through the basic steps involved in implementing Canadian helicopter money drops, I'm underwhelmed. As far as I can tell, deploying loonie-filled CH-147 Chinooks just doesn't do anything that other government tools don't already achieve.

Helicopter money means using the nation's central bank to fund government spending. If a government wants to spend money, it typically auctions bills and bonds to the public and uses the money to fund programs, all the while paying interest on the debt it has issued. Cue the helicopter money advocates: why not have a central bank create money from scratch and gift it to the government for spending? This certainly seems to be a more stimulative approach than regular debt-funded government spending. The added bonus is that the government gets to provide extra services to people without having to pay interest on bonds.

As I said earlier, Canada is the closest nation to implementing helicopter money. This is because the Bank of Canada is permitted to credit the government's account with newly printed money by direct purchases of Federal government bonds at government debt auctions. Canada is unique in this regard; the U.S., Europe, U.K., Japan and most other central banks have set up a fence between the nation's central bank and its executive branch that prevent the latter from financing the former. Central banks can acquire government debt, but they can only do so by buying from the private sector in the second hand market for bonds, i.e. *after* the public has first acquired government debt. This means that central bank can't create new money for the government; they can only create new money for the public, specifically banks.

Ok, so what—the Bank of Canada has no fence. While it can provide new money directly to the government,  this money is free, right? After all, in order to get its hands on the funds the government still has to provide a bond to the Bank of Canada and pay interest on that bond.

But this ignores the fact that the Bank of Canada is owned by the Federal government and therefore pays all its profits to the government in the form of dividends. Thus any interest that the Federal government pays to the Bank is simply returned to the government. So the lack of a fence between the two institutions really does mean that the Bank of Canada can gift the Federal government with free money. The Bank buys new government bonds at government bond auctions, creates fresh money for the government, and re-gifts all interest it receives back to the government.  

Not only does Canada lack a fence between central bank and government, but it has been making extensive use of this feature for the last five years. In 2011, the government announced a measure called the Prudential Liquidity Management Plan (PLMP), the goal of which was to increase Federal government cash reserves by an amount sufficient to cover at least one month of net projected cash flows, or around $35 billion. The Bank of Canada was to directly supply around $20 billion of this amount.

To understand how it went about this, consider that the Bank usually buys around 15% of each government bond auction. It does so in order to maintain the size its existing portfolio of government bonds. After all, bonds are always maturing and need to be 'rolled over' if the funds are to stay invested. By raising the proportion of new Government of Canada bonds that it directly purchases at government securities auctions from 15% to 20%, the Bank of Canada's rate of purchases began to exceed the rate at which bonds matured, thus leading to a steadily growing balance in the Government's account at the Bank of Canada. That's right; cue helicopter money.

The arrow on the following chart illustrates what the 5% increase in participation did to the liability side of the Bank of Canada's balance sheet:

Note how the Federal government's deposits (in red) have grown quite considerably as a result of the PLMP. By the way, if you are interested in more details on the PLMP, I've blogged more fully about it here and here.

Canada hasn't fully gone down the path to helicopter money. To qualify as helicopter money, the funds must not only be created but also be spent. While the Bank of Canada has loaded up the helicopters, the Federal government has not yet allowed any of the $20 billion to be rained down on Canadians. That is understandable since the PLMP was always supposed to be a rainy day fund.

But let's say it did deploy the helicopters. Imagine that next month Justin Trudeau, Canada's new Prime Minister, decides to spend the $20 billion in PLMP funds held at the BoC by mailing a $1000 check to every adult Canadian. Would anything out of the ordinary happen?

The heli drops complete, Canadians will deposit these checks in the banking system, either saving the funds or spending the funds. Whatever the case, the $20 billion that had previously been held in the government's account at the Bank of Canada does not disappear. It flows out of the government's account at the Bank of Canada and into the accounts that private banks maintain with the central bank. In the chart above, the entire red area would be replaced by a large jump in the green area.

The Bank of Canada pays interest to depositors at a rate that is quite close to the rate that the Federal government pays on treasury bills. Interest payments made to banks reduce the Bank of Canada's profits, which means that the dividend flowing to the Federal government is much smaller than if the helicopter drop had not been deployed.

In the end, the government ends up in the same position as it would have if it had funded its mailing of cheques with traditional bond financing. Consider the traditional way of doing things. Trudeau issues $20 billion worth of T-bills to the market at 0.5%, paying interest of around $100 million yearly. Canadians all get nice fat checks. If Trudeau instead routes his efforts through the Bank of Canada, it is the Bank that ends up paying $100 million in interest each year to private banks given a deposit rate of 0.5%. This in turn reduces government revenues by $100 million because interest costs reduce the size of the dividend that the Bank of Canada is able to pay. Either way—traditional financing or helicopter money—we get to the same ending point; Canadians get $20 billion to spend and the Trudeau government faces a cost of $100 million.

So there seems to be no difference between Justin Trudeau providing cheques to Canadian via helicopters or the regular bond-financed route. Why then are so many people quite keen on helicopter money? I'm not sure, but it could be that the advocates already know that helicopter money isn't special. Instead, helicopter money is just a way to get increased government spending without calling it government spending. Add a veneer of central bankishness to anything and it becomes sterile and boring, effectively removing any political charge that new spending brings with it.

Or maybe not, I could be missing some good reasons for why helicopter money is a truly unique tool. Feel free to correct me in the comments section, although please illustrate using Canada as your example; it's always easiest to work off of real world data.

Friday, July 8, 2016

Hyperinflation 2.0?

If you haven't heard, protests are breaking out in Zimbabwe and unpaid civil servants are going on strike. This sort of thing hasn't happened in many years.

It's possible to trace at least some of the motivation for these developments to monetary mischief. Over the last twenty years, no nation has suffered more problems with its money than Zimbabwe has. Everyone remembers the hyperinflation and subsequent dollarization in late 2008. The most recent episode has seen a nation-wide bank run break out as Zimbabweans queue at ATMs to withdraw U.S. dollars, the local currency.

Remember last year's Greek bank run? I'd argue that Zimbabwe's bank run is similar. If you recall, Greek depositors were worried that—in the event of a Greek exit from the Eurozone—their deposits would be redenominated from euros to a Greek version of the euro or even a new drachma. Better to cash out in good euros before getting stuck with something worse. Line-ups grew outside Greek banks until authorities had no choice but to shut the system down.

Like Greece, there is a decent chance that Zimbabwean bank deposits might be made payable in funny money, namely a Zimbabwean version of the U.S. dollar rather than the actual U.S. banknotes. This may explain why Zimbabweans have been desperately queuing up at bank machines—they want to cash out before the worst case scenario happens.

To understand what I mean by 'Zimbabwean version of the U.S. dollar', we need to take a quick tour of the Zimbabwean banking system. A nation's central bank usually runs the plumbing that connects local banks. These banks keep accounts at the central bank—in Zimbabwe's case the Reserve Bank of Zimbabwe (RBZ)—and use balances held in these accounts to clear and settle among each other. These accounts, along with central bank-issued banknotes, constitute a nation's supply of base money, the quantity of which determines its price level. When Zimbabweans spontaneously stopped using the local currency, the Zimbabwean dollar, in late 2008, RBZ accounts (and cash) became worthless. The RBZ-managed plumbing system had imploded.

Zimbabweans still needed to bank, however, so local banks soon began offering U.S. dollar accounts to clients. A new plumbing system was re-erected overseas; instead of maintaining clearing accounts at the now defunct Reserve Bank of Zimbabwe, local banks held U.S dollar accounts at banks in Europe and the U.S., otherwise known as nostro accounts. They used these offshore accounts to settle interbank Zimbabwe payments. [1]

To understand how this offshore plumbing system worked, say Joseph (who lives in the capital Harare) writes a cheque to Robert (who lives in Bulawayo). Joseph's local bank might settle the cheque thousands of miles away by having its New York bank wire funds to the nostro account of Robert's bank, which might be based in London. Circuitous, right?

As for cash, say Joseph wants to withdraw $100,000 in U.S. banknotes from his Zimbabwe bank account. His bank would request its New York bank to debit its nostro account by $100,000 and then ship the $100,000 in banknotes to Zimbabwe. Joseph now has a suitcase full of Ben Franklins.

This offshore plumbing system worked pretty well. However, it didn't take long for the RBZ to re-insinuate itself into the works by offering local banks U.S. dollar accounts. These accounts allowed the local banks to use the RBZ's re-christened real-time gross settlement system (RTGS) to settle interbank payments rather than using the offshore plumbing system. After having lost its printing press, the RBZ had got back into the monetary printing game. It had created a Zimbabwean version of the U.S. dollar.

My understanding is that as time passed the RBZ forced local banks to "repatriate" their clearing accounts from the overseas system and deposit them at the RBZ. In effect, local banks were told to wire U.S. funds from their foreign-based nostro accounts into an RBZ account held at a European/American bank. In turn, the local bank was credited with an equal quantity of U.S. dollar deposits on the RBZ's own books. Voila, local banks had gone from holding U.S. dollars in relatively safe foreign banks located in places like London to holding the domestic RBZ version of the dollar. I can't imagine that bank managers were terribly fond of this forced switch given the RBZ role in igniting the 21st century's first hyperinflation.

Let's see how this new system works. Now when Joseph wants $100,000 in cash, Joseph's bank—call it the Commonwealth Bank of Zimbabwe—has two choices. Use its foreign nostro account as before. Or it can ask the RBZ to debit the Commonwealth Bank RTGS account and provide the proper number of U.S. banknotes. The RBZ in turn sources the cash by requesting its foreign bank to debit the RBZ account—now plump with confiscated dollars—and send the cash to Zimbabwe by plane. The RBZ's overseas dollar accounts in effect "back" the dollar deposits that the RBZ has issued to local banks.

On paper this sort of system should work fine... as long as the RBZ doesn't abscond with the funds in the foreign bank accounts. Unfortunately, this may be exactly what happened. The RBZ had effectively gone from being bankrupt to having amassed large amounts of U.S. funds overseas. This proved tempting, and according to former finance minister Tendai Biti the regime began dipping into the RBZ's foreign stash to pay for expensive junkets and to finance public sector salaries. The upshot it that there may not be enough U.S. funds in the RBZ's foreign accounts to back its promises to local banks.

This means that now when Zimbabweans go to their banks to get U.S. cash, the banks—which before had no problems meeting these requests via their nostro accounts—are hamstrung. They have U.S. dollar accounts at the RBZ but the RBZ is unable to draw on its depleted overseas accounts to get the requested cash. The lineups that have developed are the public's attempt to squeeze out whatever spare dollars remain in the system, an attempt that is rendered much hard given the withdrawal limits that have been instituted to slow down the run.

Zimbabweans are already starting to see a divergence between the price of an electronic dollar and a paper dollar. Various media reports say the practice of "cash burning" has re-emerged for the first time since the hyperinflation of 2007-08. Anyone who needs to convert deposits into cash, frustrated by long lines at ATMs and withdrawal limits, can instead approach an informal dealer who offers to buy their deposits at a discount of 10-20% of their cash value (see here and here). Think of the 'cash burning' discount as the market value of an RBZ-backed bank deposit. If the regime has indeed wasted all the money in its nostro accounts, this discount will only widen.

The theory that the regime has absconded with the RBZ's overseas funds is consistent with a flurry of official proclamations over the last month or two. If the RBZ is indeed bankrupt, it would make sense for the ruling regime to adopt the same strategy that Greece did last year; implement capital controls to trap as many U.S. dollars in the banking system as possible, thus limiting the damage and buying time for the government to rebuild the balance sheets of both the RBZ and the local banks before reopening for business. This would probably require some sort of loan from China or elsewhere. Under this scenario, Zimbabwean deposit holders could very well have to take a large haircut.

As in Greece, the RBZ has started to ring-fence the system by instituting daily withdrawal limits (of around $100); enough to allow Zimbabweans to get by but not enough to hurt the banking system. To coax people into accepting electronic dollars rather than paper dollars, the central bank has suddenly decreed much lower fees on bank payments and transfers. The government has also invoked the Bank Use Promotion and Suppression of Money Laundering Act, which punishes citizens and business if they refuse to deposit their money in banks. More radically, it has imposed severe import restrictions on a broad variety of goods from furniture to beans to fertilizer, a policy that presumably prevents cash leaking over the border. Together, all these regulations seem designed to help stuff as many U.S. banknotes back into the RBZ as possible.

Alternatively, it's possible the Zimbabwe government cribs from the Argentina play book and sets up a corralito, or coral, followed by a redenomination of dollar accounts into the local unit. Unlike Argentina, which had pesos, Zimbabwe is fully dollarized and doesn't have its own paper currency in which to redenominate deposits. But so-called bond notes (which I wrote about last month), an issue of paper money set to debut this fall in denominations of $2, $5, $10 and $20, may be a step in the Argentinean direction. Rather than meeting conversion requests by providing U.S. dollars, the RBZ will be able to print off any quantity of bond notes it deems necessary. In this way U.S. dollar claims on Zimbabwean banks will cease to be payable in actual dollars but in the RBZ's peculiar brand of U.S. banknotes, probably worth far less than the real thing.

It seems perverse that Zimbabwe could see another hyperinflation while on the very dollar standard that was meant to immunize it from a hyperinflation scenario, but I'm starting to worry this could happen. Consider that Robert John Mangudya, the head of the RBZ, claims that retailers are beginning to put two different price tags on one product, a higher one for electronic payments and a lower one for cash. If the RBZ-issued electronic dollar continues to inflate then electronic dollar sticker price will rise but the U.S. paper dollar price will stay constant. This second set of prices would at least provide some modicum of price stability to the nation.

Not so fast. Mangudya warns that the central bank will prosecute any retailer that sets two prices. If retailers comply and set only one price for their wares, that effectively undervalues U.S. banknotes and overvalues RBZ-issued U.S. electronic dollars. Gresham's law will take hold as shoppers use only bad electronic dollars to pay for things while hoarding their good, and undervalued, paper dollars in their wallets. Unwilling to be the dupes and accumulate overvalued and unwanted electronic dollars, retailers will have no choice but to jack up their prices, essentially adopting the RBZ U.S. e-dollar as the standard unit of account, or unit in which they set prices. With U.S. dollars no longer being used as a medium of exchange and unit of account, price stability in Zimbabwe will cease to exist.

One hopes that rumors that the regime has absconded with the RBZ's funds are false and that the current bank run and potential inflation is just a temporary spate of animal spirits. But in my experience, most sustained bank runs are underpinned by something real.

[1] I get much of this information from here.

Tuesday, June 28, 2016

The Fedwire recession

I last wrote about Fedwire data two years ago. Since then, Fedwire has entered into a (nominal) recession. Is this something we need to worry about?

We should be interested in this data because Fedwire is the U.S.'s most important financial utility. Operated by the Federal Reserve, Fedwire processes payments between the nation's commercial banks using central banks money, or reserves, as the settlement medium. It accounts for a significant chunk of U.S. spending, or aggregate demand.

Below you'll see a chart of quarterly Fedwire transaction values using data back to 1992. It shows the total dollar volume sent over Fedwire each quarter:

You can see that the flow of spending conducted over Fedwire has been declining since the third quarter of 2014; a six quarter decline. How rare is it to see this degree of stagnation? To check, I've plotted Fedwire yearly data going back to 1987:

Assuming 2016 continues to trend lower (as it has in the first five months), then we are on the verge of seeing two consecutive years of declines in Fedwire transaction flows. The only other time we've seen this sort of pullback is from 2008-2010.

What makes the current Fedwire recession especially interesting is that the go-to measure of spending, nominal gross domestic product, continues to grow, at least tepidly. Fedwire provides a much broader measure of U.S. spending than nominal GDP, which confines itself to measuring spending on final goods and services. To get a feel for this difference, in 2015, U.S. NGDP amounted to $17.9 trillion. Fedwire transactions came out to $834 trillion, exceeding NGDP by a factor of 40x.

Why is Fedwire in a recession while NGDP isn't? Fedwire spending reflects a host of items that don't end up in NGDP. Any of the following could explain the discrepancy.

1. For starters, NGDP includes only spending on final products whereas Fedwire includes a host of intermediate spending. As an example, let's say that consumers spend $100 on bread over the year. Fedwire might include not only the $100 spent on bread, but also all the transactions involved in the course of producing that bread. If the miller wires the farmer $10 for the wheat to make flour, and the baker then pays the miller $50 for the flour, and the retailer wires $75 to the baker for the loaves, then Fedwire transactions sum to $10+$50+$75+$100=$235, far more than the $100 included in NGDP.

So if the U.S. economy's supply chain is undergoing big changes, look for this to get reflected in changes to Fedwire spending even as NGDP stays the same. When corporations become more vertically integrated, they will be do less payments over Fedwire while still providing the same amount of input to NGDP. If they turn to outsourcing, then Fedwire will see more value transacted while NGDP remains constant.

Could the current Fedwire recession be due to a shortening of the supply chain, or a decline in what Austrian economists would refer to 'roundaboutness?'

2. When it comes to spending on housing, NGDP includes only residential investment (spending on new homes) and 'housing services' such as rent and imputed rents. Fedwire, on the other hand, is a popular way for home buyers to settle housing purchases, not only for new homes but the much large category of already-constructed houses.

A housing bubble will get reflected in Fedwire data as ever more housing sales are pumped through Fedwire. NGDP won't get the same lift. Could the current Fedwire recession be due to a slackening in existing home sales?

3. Old houses aren't the only existing capital good that shows up in Fedwire but not NGDP. Firms may use Fedwire to pay for large ticket items like second hand airplanes, used Caterpillar construction equipment, commercial property, and farm equipment. None of this trade in second hand equipment gets reflected in NGDP.

4. Next up are financial assets. Payments for securities, especially government bonds, are often dispatched through Fedwire. NGDP, on the other hand, doesn't contain any financial assets. Mergers and acquisitions are often routed through Fedwire as well, but NGDP won't see a lick of that.

If financial markets and M&A are booming, expect Fedwire spending to grow faster than NGDP, and if they are stagnating, the reverse. Perhaps the Fedwire recession is due to a stagnation in capital markets activity?

5. Developments in payments efficiency may may affect the pattern of Fedwire payments. Banks will often net transactions among each other prior to using Fedwire for settlement. For example, say a client of Bank A pays a client of Bank B $100 while another client of Bank B pays a second client of Bank A $100. Rather than doing two Fedwire payments, $100 from A to B and from B to A, the two banks can just net out their debts and avoid using Fedwire. The same quantity of goods and services is being traded among individuals but the number of payments being conducted via Fedwire has been cut. If banks are becoming more efficient at netting, Fedwire transactions will decline while NGDP remains constant.

6. Cash payments, at least legitimate ones, are registered in NGDP but not in Fedwire. So as society uses less (more) cash and more (less) electronic payments, NGDP will stay constant while Fedwire payments will rise (fall).

My guess for why Fedwire has been weak relative to NGDP? Spending in markets not covered by NGDP—namely existing homes, equity, M&A, and bond markets—has been mute. Those who have criticized the Fed for abetting financial bubbles thanks to easy monetary policy should pay heed to this data. Sure, interest rates may be low compared to their historical levels, but it's not as if reems of transactions are being pushed through Fedwire, as we'd expect with bubbles.

Rather than easy monetary policy, it could very well be that the opposite is in effect. As David Beckworth has pointed out, the Fed has been embarking on campaign to tighten monetary policy since mid-2014. Interestingly, this move towards a tightening bias corresponds quite closely with the Fedwire recession that kicked off in the fourth quarter or 2014.

Wednesday, June 15, 2016

Another Fedcoin sighting

Early map of Fedwire. Source: FRBNY

The pace of Fedcoin sightings has been accelerating this year. If you're new to this blog, Fedcoin is a catch-all term I like to use for a central bank-issued cryptocurrency. Earlier this month the Federal Reserve itself hosted a conference called Finance in Flux: The Technological Transformation of the Financial Sector. The keynote presentation was given by Adam Ludwin, CEO of blockchain firm Chain Inc, who had some interesting things to say about a central bank digital currency.

A criticism I have of blockchain advocacy in general and Fedcoin in particular is that evangelists tend to understand little of the history or qualities of the institutions that they are trying to overthrow. The result is that they invariably end up mis-estimating the benefits of replacing existing systems with new ones.

For instance, Ludwin calls his presentation Why Central Banks Will Issue Digital Currency, a title that must have got Janet Yellen scratching her head since the Fed has been issuing digital currency, or reserves, for a long time now. A system called Fedwire, one of the most important utilities in the U.S., allows some 9,000 financial institutions to transfer these digital reserves among each other.

Ludwin goes on to provide more details on the sort of blockchain-style digital currency he is promoting:
...I find it more helpful to look back to bearer instruments, like banknotes, to appreciate what this new medium enables: a digital bearer instrument... With bearer instruments the payment is also the settlement. It is one step. This is a neat property of a bearer instrument...The goal of the blockchain industry is to collapse these steps into a single step, where payment is the settlement, just like with physical notes. 
Ok, Ludwin wants not just digital currency but instantly-settled digital currency. But Fedwire already achieves this. In a Fedwire payment between banks, the exchange of reserves constitutes settlement. Put differently, in the same way that a banknote or bitcoin payment involves a single step, a Fedwire payment also involves but one step. Say bank A wants to pay bank B $10,000 in reserves via Fedwire. The moment a bank hits the button to complete the payment, reserves change hands and the transaction is complete. An ensuing clearing process does not need to be initiated, nor does an underlying set of assets need to be mobilized to settle the payment. To top it off, trades cannot be undone. Fedwire payments are final. The moment reserves enter your account, you own them.

Fedwire is what is known as a real-time gross settlement system (RTGS); payments are made in real time and are irrevocable. Most of the world's central banks operate an RTGS. Ludwin's firm is leading the battlecry for central bank blockchains, but the main selling point—that Fedcoin collapses payments into a single step—brings nothing to the table that an RTGS like Fedwire doesn't already provide. So why bother?

Ludwin mentions security. Is he claiming that Fedwire is in any way insecure? Fedwire is a robust system that in 2015 processed 143 million transfers with a total value of $834 trillion. It has been operating without major mishap for decades. He also floats the idea that there will be "perfect clarity around where the asset is at any point in time." I'm sure that the Fed always knows the exact location of each reserve it has ever issued. He also brings up the question of speed. But as I pointed out above, Fedwire payments are instantaneous. In fact, Fedwire would probably be faster than Fedcoin.

As far as I can tell, the only difference between the two networks is that a proposed Fedcoin would be distributed while Fedwire is centralized. What this boils down to is that the Fedcoin network would be maintained by a large number of independent nodes whereas Fedwire is run out of a lone data centre in New Jersey (see my old post here for a map). If you take out a Fedcoin node the remaining nodes will continue to operate the payments network. Destroy Fedwire's New Jersey data centre (and its two back-up locations), however, and the system collapses. Redundancy is great, but is it enough to justify switching from Fedwire to Fedcoin? I'm not convinced.

What about operating costs? If Fedcoin and Fedwire have the same capabilities, but Fedcoin costs half as much  to operate, then an infrastructure switch could make a lot of sense. We know how much it costs for the Fed to process a Fedwire transaction because it publishes a set of fees that is designed to recoup its costs:

Source: Fedwire

A Fedwire transfer can cost as little as 15.5 cents (before incentives) for the Fed to process. So a $100,000 transfer might cost just 0.0002% in fees. That's not much. For comparison sake, the UK-equivalent RTGS—called CHAPS—costs just 16.5 pence per transfer. On a large transaction that's a pittance. Can Fedcoin beat theses costs while providing the same degree of speed and security? I'm not sure, but these are the sorts of questions that an advocate of Fedcoin needs to answer.

It's with small-value payments that Fedwire trips up. Between 1.55% to 7.9% of a $10 Fedwire payment will be eaten up by fees. That's not cheap. Payments of this size are the sort that a retail customer would typically originate, which means Fedwire is not a great retail payments network. If a proposed Fedcoin could bring down the cost of operating a small-value central bank payments than it might help banks serve retail clients. That's a worthwhile use case.

In addition to their RTGSs, central banks typically maintain a retail payments system. While the U.S.'s archaic system ACH is just awful (it takes several days to settle), more recent systems like the UK's Faster Payments Service (FPS) are decent. The drawback to FPS is that it isn't capable of collapsing a payment into a single step, say like Fedcoin or Fedwire. Instead of instantaneous settlement, FPS payments will typically be settled via CHAPS during one of three daily settlement cycles. Three times daily isn't bad, but it's not immediate. However, FPS fees are paltry, running around 3.51 pence per transaction. Even if Fedcoin achieves instantaneous settlement, would it be able to do so at a cost that is competitive with FPS? That's something Fedcoin advocates like Ludwin need to demonstrate before folks like Janet Yellen will make a move into small-value blockchain.

Finally, Ludwin suggests that central banks issue cryptocurrency not only to banks but also to non-bank financial companies, corporations, and individuals. He suggestion is a bit too casual for my taste and it probably made Janet Yellen wince. Central banks have a long tradition of steering wide of competition with banks. If the Fed (or any other central bank) were to begin providing digital money directly to the public, it would be breaking with this tradition; central bank digital tokens would effectively be competing head-to-head with private bank deposits. This would be one of the most momentous policy changes in Federal Reserve history and would have many far-reaching consequences.

Even if the Fed thinks the time is ripe to embark on such a historical path, Ludwin hasn't made the case for the blockchain. Why not just allow individuals to keep accounts at the Federal Reserve and make Fedwire payments via a Fedwire app?

Blockchain technology is cool and interesting and sexy. But I'm not convinced that the old fashioned centralized incumbents like Fedwire aren't up to snuff. I suppose time will tell.

PS: I won't be able to answer comments on this till the weekend.

Tuesday, June 7, 2016

Zimbabwe Shouldn't Be Printing Banknotes Again

A Zimbabwean washes U.S. dollars, from NPR Planet Money

Here's a surprising development.

Zimbabwe, a dollarized nation, is on the verge of issuing its own $2, $5, $10, and $20 banknotes. Here is is the central bank's press release. Let's back up a bit. Zimbabwe suffered one of the worst hyperinflations in history during the 2000s thanks to awful policies by the government. Citizens were so fed up that they spontaneously dropped the Zimbabwe dollar in late 2009, the U.S. dollar being recruited as media of exchange and unit of account and the South African rand serving a backup role as small change.

Since then the rand has been steadily moving to the background in Zimbabwe monetary affairs:

Currency utilization levels in Zimbabwe [source]

Another change is that last year Zimbabwe re-entered the world of monetary production by minting its own 1, 5, 10, 25, and 50 cent coins, otherwise known as bond coins. At the time I was in favor of bond coins because Zimbabwe was following the blueprint set by dollarized nations like Panama and Ecuador. These nations mint their own small change to complement Federal Reserve-printed dollar banknotes, and for good reason. Coins are heavy while not being particularly valuable, which means that shipping costs are prohibitive. As a result, local banks prefer to import paper dollars, the ensuing coin shortages that develop making it difficult for locals to engage in basic transactions.

While I was a fan of bond coins, I don't like the Reserve Bank of Zimbabwe's decision to print bond notes. It departs from the dollarization blueprint--neither Panama nor Ecuador (or any other dollarized nation that I know of) have chosen to get into the business of printing notes. Panama in particular is a highly successful dollarized nations, so if Zimbabwe wants to depart from the Panama model one would expect it to have a very good reason for doing so.

John Mangudya, head of the Reserve Bank of Zimbabwe, says that he wants to get back into the note-printing game thanks to a "shortage of U.S. dollars" that seems to be bedeviling the nation. Since March, line-ups have developed at ATMs all over the country as people try to withdraw U.S. dollar cash. This is true, the local press is full of articles on banking queues. Strict limits have been placed on the amount of cash that Zimbabweans can withdraw from their accounts.

I'm skeptical of Mangudya's dollar shortage story. There is a very simple process whereby a dollar shortage in a dollarized nation is remedied. Zimbabwean farmers, desperate to get their hands on U.S. dollars, will reduce their selling prices for tobacco and cotton, two important cash crops with flexible prices. Gold miners will do the same. The moment Zimbabwean crop and gold prices fall below the international price arbitrageurs will bring dollars into Zimbabwe to buy cheap these goods for shipment overseas. Since cash crystallizes a large amount of value in a small volume, handling costs are very low--unlike coins. Domestic commodity prices need only deviate by a small wedge from the international price before arbitrage is profitable and U.S. paper currency flows back into the country. Unless the government is interfering with this process, I can't see it taking more than a week or two for markets to rectify a dollar shortage.

Zimbabwean authorities are notorious for tampering with Zimbabwean industry--this may be short-circuiting the simple process I've just described. If so, why introduce bond notes to fix the problem when the underlying cause is silly government rules preventing cross-border markets from functioning?

On the other hand, if the government hasn't been preventing this process from playing out then Zimbabwe doesn't have a genuine dollar shortage. Lineups at ATMs may simply be the result of an insolvent banking system. Zimbabwe is currently battling a slowdown in growth as commodity prices fall. The U.S. dollar's  rise over the last year or two has reduced the nation's competitiveness. This slowdown may be taking a toll on banks. However, wads of newly-imported U.S. dollar bills or freshly-printed bond notes can't fix a sick banking system.

So Mangudya's reason for departing from the Panama model seems like a poor one to me, one made worse by the fact that the same nutcase who destroyed Zimbabwe's monetary infrastructure in the previous decade, Robert Mugabe, remains in power. Bond coins were one thing, but bond notes give Mugabe much more latitude to engage in monetary mischief.

How much mischief? Many Zimbabweans are worried that the introduction of bond notes will bring about a repeat of the hyperinflationary 2000s. I'm not as worried as them. The U.S. dollar not only circulates as Zimbabwe's medium of exchange but also serves as its unit of account. The fact that prices across the nation are expressed in terms of the dollar affords Zimbabweans a significant degree of protection from Mugabe.  If bond notes are to be introduced, they may very well circulate along with U.S. dollars as a medium of exchange but they will not take over the unit of account role. A nation's unit of account, like its language or its religion, is a set of rules and standards that, once adopted, is not easily changed. In the same way that society is locked-in to using the QWERTY keyboard, it gets yoked to using a certain language of prices.

This means that if the bond note turns out to be a sham and begins to inflate, Zimbabwean prices--expressed in U.S. dollars--will stay constant. Instead, the exchange rate between the U.S. dollar and bond notes will bear the burden of adjustment, bond notes falling to a discount to dollars. Because this leaves the price level unaffected, the process of adjusting to a bond note collapse would be far less burdensome to Zimbabweans than the hyperinflation of the 2000s. The move might even backfire and cause Mugabe significant embarrassment since a bond note discount could not be blamed on anything other than his own incompetence.

Even if the bond notes can never do as much damage as Zimbabwe dollars did in the previous decade, the fact remains that there is no rational for issuing them. Let the market work its magic as it does in Panama and solve any cash shortage problems. The decision to return to paper money is a particularly insensitive one given the fact that many citizens' livelihoods were destroyed by Mugabe's Zimbabwe dollar hyperinflation. Zimbabweans are right to be upset over the bond note; it's a shame that Mangudya, having so ably brought the bond coin idea to fruition, is now promoting a regressive idea.      

Thursday, June 2, 2016

What happens when a central bank splits in two?

Say the San Francisco Fed decided to secede from the Federal Reserve System or the Bank of Greece started to print its own euro notes without the consent of the Eurosystem. What happens to a nation's currency when the central bank is split into parts? There is a possibility we might be seeing such a situation developing in Libya with the emergence of two different Libyan dinars.

Libya's political scene is ridiculously complicated so I'll paint the picture in broad brush strokes. The Central Bank of Libya has several offices, the two relevant ones being the western one in Tripoli and the eastern one in Bayda. Prior to the Arab spring, each area was under the control of the Gaddafi government but both have since come under the control of competing regimes. Tripoli is run by the U.S.-backed Government of National Accord (GNA) while Bayda is under the control of the Tobruk-based House of Representatives.

As I understand it, over the last few years of strife the two offices have usually been able to work together despite being under different regimes.Yesterday, however, the Bayda branch announced that it would be putting new 20 and 50 dinar denomination notes into circulation. Both the Tripoli government and their U.S. backers quickly declared that the new issue was illegitimate. The U.S. Embassy's statement on Facebook said that "the United States concurs with the Presidency Council's view that such banknotes would be counterfeit and could undermine confidence in Libya's currency and the CBL's ability to manage monetary policy to enable economic recovery."

This brings up an interesting conundrum. Say the Bayda branch of the Central Bank of Libya starts to spend the new 'counterfeit' dinars and the U.S.-backed Tripoli branch refuses to recognize them. Will the public accept the new issue of Bayda dinars, and if so, at what rate will the notes trade relative to Tripoli's notes? Could Libya end up with two different dinar currencies?

Were the two note issues identical, it would be impossible for Libyans to discriminate between them. They'd happily accept the new notes and all dinars would continue to be fungible. But this doesn't seem to be the case. Unlike Libya's legacy note issue, which was printed by De La Rue in the U.K., the Bayda branch's new dinars are printed by Goznak in Russia. Apparently Goznak has used different watermarks and a horizontal serial number rather than a vertical one. Most importantly, the new notes bear the signature of the head of the Bayda office while the old notes have the Tripoli branch's chief on them.

If it does not recognize Bayda's 'counterfeit' notes as its liability, the Tripoli branch voids its responsibility to buy them back in order to maintain their value, effectively walling off its resources from the Bayda branch. These resources include any foreign reserves it might have, U.S. financial backing, and financial support from the local regime. And without any guarantee that those notes will have a positive value, the public—which can easily differentiate between the two bits of paper—may simply refuse to accept Bayda dinars at the outset when the Bayda branch tries to spend them into circulation. Long live the Tripoli dinar.

The Bayda branch might try to promote the introduction of Baydar dinars by pegging them at a 1:1 rate to existing Tripoli dinars. This is how the euro, for instance, was kickstarted. But that peg will be tested. Libyans will bring Bayda dinars to the Bayda branch to exchange for Tripoli dinars. If the branch runs out of Tripoli banknotes, it will have to buy more of them in the open market to maintain the peg, but with what? If it lacks the resources to buy them, the peg will be lost and Bayda dinars will fall to zero, or to a very large discount.

But the Bayda branch isn't without its own resources. First, it has the financial support of the local regime. Furthermore, according to this surreal article there is a vault in Bayda that contains 300,000 gold and silver sovereigns minted in honour of the late Colonel Gaddafi, worth nearly £125 million. The Bayda branch doesn't know the combination and Tripoli refuses to provide it. If the safecrackers that the Bayda branch has hired are able to get in, that amount will provide it with enough firepower to buy back Bayda dinars and help support the peg. In which case the two notes would circulate concurrently and be fungible.

If two dinars emerge, which central bank would control monetary policy? That depends on which brand of dinar Libyans choose to express prices and debts. As long as the existing Tripoli dinar is the medium of account—the physical object that people use as the definition of the dinar unit ل.د.—then any policy change adopted by Tripoli's central bankers will be transmitted to the entire Libyan price level, both the east and west. Usage of Tripoli dinars rather than Bayda dollars for pricing is likely to prevail for the same reason we all use QWERTY keyboards when better alternatives exist, force of habit is difficult to overcome. Even if Bayda dollars do emerge as a medium of account, as long as they are pegged to the Tripoli dollar, then Tripoli still gets to call the shots.

The situation isn't resolved yet—the Tripoli branch could very well accept Bayda dinars as its liability, thus defusing the situation. In any case, it will be interesting to follow. Incidentally, Libya's situation reminds me of one of the ideas put forth during the 2015 Greek crisis; a secession of the Bank of Greece from the Eurosystem so that Greeks could print their own type of euro. If Greece boils over again and the separation idea pops up, Libya may serve as a reference point.