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Money: dynamics and definitions
Clearing and settlement. Clearing is the process of authorizing a transaction; settlement is the process of completing it. Clearing and settlement are flip sides of a coin. They are sometimes difficult to distinguish, but the actual distinction is useful to remember. Clearing is the undertaking of a legal liability and settlement is the discharge of that liability. Clearing never comes after settlement but may occur before it or simultaneously with it.
The static confusion. One common misunderstanding about technologies broadly known as digital cash or digital money concerns their basic function. Digital cash is a means for transferring value and not a means for storing value. The store of value is with its definer, ultimately. Digital cash is a way of rearranging the ownership of assets, not a way of defining those assets or establishing their worth. Digital cash is entirely a clearing process; it has nothing itself to do with settlement.
The confusion is a linguistic one. Cash, as in paper bank notes, can act as a store of value. The old cash-stuffed-in-the-mattress saving method still resonates, likewise piggybanks. Digital cash is only a store of value when stuffed in a virtual mattress. A piggybanker of this type is not storing money indefinitely but rather delaying the completion of the digital cash withdraw-spend-deposit cycle. Delaying final deposit uses the float as a storage mechanism. Cycling a portfolio of digital cash does store value, even if it doesn't define a source of value such as the dollar or yen.
Stable stores of value. The oldest stores of value are commodities whose value as storage rests with the human body: a harvest of grain, a herd of cattle. One kind of commodity, specie (gold and silver), is the transition into the second oldest store, namely money. Gold-based fractional reserve paper money used the circulational fact of economic activity to create a new store of value. It kept the old mode, coin transfer, for fallback.
Fiat currency is the ultimate extension of specie-backed paper. The specie backing has completely disappeared. Paper money was the first system to rely upon continued economic activity for validity. Fiat money relies not only upon continued economic activity but also upon the issuing government's ability to collect taxes. This historical process illustrates an increasingly interconnected trust of humans for each other. The wealth of a modern economy depends profoundly upon specialization and trade. It is only fitting that the money of such an economy should reflect this necessary interconnection.
Just as paper money arose from specie as a transition to fiat currency, so too future forms of money will grow out of the current fiat money system. An analogy: paper currency is to gold as a fluid market in liquidity is to fiat money. In both systems, the quantity of the foundational store of
value (gold, fiat money) decreases as contingent relationships (bank notes, explicit failure agreements) build upon the foundation. That is, promises, linkages and other relationships expand the amount of money in circulation, while the underlying store of value remains relatively constant.
The conclusion of this process is the elimination of fiat currency as money, just as gold has passed away as money. The form that the replacement may take is still uncertain, but it will certainly contain both explicit representations of financial relationships and a sophisticated valuation system.
The composition of money. Money itself is not a technology. Various technologies implement money and thus become a form of money, but these are not themselves money. Specie (gold and silver), coins, book entries, paper bank notes, digital automation and smart cards all act as money, but no single one can lay claim to being money itself.
Even gold is not money itself, but rather its preeminent example. Gold is not currently money in the US, for example. You can't take a Krugerrand to your local Sears and buy a washing machine with it. Gold is also useful for jewelry, dental work and circuit boards. Gold has value as money only when people agree that it is money.
Money itself is a social fiction, like property, political parties, governments, gender and marriage. As a specific example, a corporation is a legal fiction. The socially fictive nature of money is key to understanding its transfer. Social fictions are real, even though they exist only in people's heads. When money moves across electronic networks, no substance called money is in motion. What is in motion is knowledge about rearrangements of money.
Money is ultimately a communications process. Any technology that implements a conserved and transferable quantity is usable as money. The physical properties of gold satisfy these two sufficient properties of money; therefore, gold works as money. These sufficient properties are also design criteria. Creating new forms of money involves two steps: inventing a suitable technology, then persuading society to use it as money.
Where did I get this beautiful car? Payment systems are a necessary epiphenomenon of an underlying economy. Payments themselves always arise from some exchange or transfer. Each payment, therefore, necessarily refers to some relationship outside itself. (Note that the payment vehicle need not carry a reference to the primary economic activity with it. Representations of this linkage always lie somewhere and last for a certain time. The location and duration of the linking information determine important properties of scale, dispute and privacy.
Every discussion of electronic money inevitably touches upon the whole of economic activity. Trends in the automation of money movement presage those in the rest of the economy. Many of the issues that arise in payment systems arise also in systems for negotiation, delivery, billing and protest. The same principles for making payment systems more effective apply to commerce as a whole.
Synthetic currencies. The transition out of fiat currencies will be much easier with the presence of commodities that act like currencies but which
are not, strictly speaking, currencies. Two developments in the securities industry, derivatives and securitization, point the way.
Derivatives are items of value that are not themselves tangible but are mediated through some agent. An example of an aggregate derivative is an indexed security based upon the Standard & Poors 500. Conceptually, one trade of an S&P 500 index equity makes 500 different trades. The issuer of an index derivative does all these individual trades, but on net flow, not on each index trade.
Contingent derivatives are contracts for purchase or sale under some conditions other than here and now. The simplest derivative is a forward contract, which is an agreement to buy something tomorrow with a price set today. Other such derivatives include options, futures, futures options, interest swaps, strips and all sorts of more exotic arrangements. A corporate financier may use derivatives to stabilize price fluctuation or minimize exchange-rate risk. The same tools can be used to create what are essentially amplified bets on price motion; involvement of this kind led to trouble for Orange County, Procter & Gamble and Metallgesellschaft.
The second trend, securitization, is a general way to turn non-fungible property like home mortgages, business loans and real estate into fungible securities. A securitized asset is essentially a derivative asset based on an underlying basket of similar goods. Securitization allows more of the world's wealth to exchange in financial markets, which have efficient price discovery mechanisms. It leads to more efficient capital allocation as well as more information about the economy.
A synthetic currency is a stabilized derivative asset based over as broadly a secured base as possible. The ideal synthetic currency's goal is not speculation but value maintenance. It should seek to minimize price fluctuation by targeting a broad market average. No single enterprise will be able to pull this off. The issuer of a broad synthetic currency will doubtless rely upon many other issuers. Derivative assets may derive from other derivative assets, and so on.
Synthetic currencies truly thrive with small value transactions. The cost of negotiating and processing a foreign exchange trade for each small transaction would be overwhelming. Commerce denominated in synthetic currencies avoids this issue by parceling out this trading function to the issuer of the synthetic currency. In addition, denomination in a synthetic currency avoids some of the fluctuation risk, particularly if present on both sides of the balance sheet. This application provides a potential initial market, namely, low-level trading where the exchange risk and transaction costs currently prevent commerce.
Non-inflationary currencies. The word "inflation" has different meanings in the phrases "price inflation" and "currency inflation". The two meanings are historically related but not identical. Price inflation is just a synonym for price increases. News reports are usually of this kind of inflation. Currency inflation, however, is an increase in the total number of nominal units of the currency.
The real value of any currency is unrelated to the total number of available accounting units. This variability of nominal value is a source of great mischief. Under the current fiat money regime, the issuing government can decide at any point simply to print more money and assign it all to itself. It's not always this blatant, of course. In the long term, an inflation of the money supply by 100 percent is a 50 percent tax on the real value of currency holdings. In the short term, the illusion of freer money stimulates economic activity. The transient effects of a credit relaxation are much more significant now than in a more highly networked future where the money illusion disgipates faster.
Inflationary currencies were at the center of last year's Brazilian presidential elections. The new president, Cardoso, is the former finance minister who was responsible for bringing the inflation rate down from three digits to two digits. The poor overwhelmingly voted for him over even a strong leftist labor candidate, who nominally had their interests more at heart. In truth, Cardoso broke the crushing effective tax on cash which is the means of savings of the poor, assuring his election.
Here's how to create a non-inflationary currency: A currency issuer announces in advance the total number of nominal units of value and makes an initial disbursement to currency holders. From then on, all transactions in the currency are zero-sum. The public can continuously verify that the number of nominal units is constant, either by legal assurance or by a function called remote auditing (see page 25). Unlike government currencies, the issuer does not simply create more money.
If the non-inflationary currency is a synthetic currency, the real value of one unit of currency increases at the same rate that productivity rises in the economy. Technological progress increases real wealth. One unit of non-inflationary currency pays real interest (not nominal interest) just by sitting around.
Power shift. The rapid expansion of the foreign exchange market has usurped a long-held power of governments to control exchange rates. Inexpensive and reliable long-distance telephony available in the 1960s allowed New York-to-London currency trading in real time rather than with periodic price fixings. The market responded more quickly to disparities in real economies and to various governments' fiscal misbehavior, two trends that should continue. Automation further increased the size of these capital flows. As technologies accelerated international capital flows, governments lost the ability to set exchange rates between their currencies.
Another such transfer of power is imminent. Financial institutions will soon be able to create a store of value that can outcompete government-issued currencies in retention of value and in swiftness of transaction. The real issue then at hand is whether the governments of the world will allow for a smooth transition.
COPYRIGHT 1995 EDventure Holdings, Inc.
COPYRIGHT 2004 Gale Group
Clearing and settlement. Clearing is the process of authorizing a transaction; settlement is the process of completing it. Clearing and settlement are flip sides of a coin. They are sometimes difficult to distinguish, but the actual distinction is useful to remember. Clearing is the undertaking of a legal liability and settlement is the discharge of that liability. Clearing never comes after settlement but may occur before it or simultaneously with it.
The static confusion. One common misunderstanding about technologies broadly known as digital cash or digital money concerns their basic function. Digital cash is a means for transferring value and not a means for storing value. The store of value is with its definer, ultimately. Digital cash is a way of rearranging the ownership of assets, not a way of defining those assets or establishing their worth. Digital cash is entirely a clearing process; it has nothing itself to do with settlement.
The confusion is a linguistic one. Cash, as in paper bank notes, can act as a store of value. The old cash-stuffed-in-the-mattress saving method still resonates, likewise piggybanks. Digital cash is only a store of value when stuffed in a virtual mattress. A piggybanker of this type is not storing money indefinitely but rather delaying the completion of the digital cash withdraw-spend-deposit cycle. Delaying final deposit uses the float as a storage mechanism. Cycling a portfolio of digital cash does store value, even if it doesn't define a source of value such as the dollar or yen.
Stable stores of value. The oldest stores of value are commodities whose value as storage rests with the human body: a harvest of grain, a herd of cattle. One kind of commodity, specie (gold and silver), is the transition into the second oldest store, namely money. Gold-based fractional reserve paper money used the circulational fact of economic activity to create a new store of value. It kept the old mode, coin transfer, for fallback.
Fiat currency is the ultimate extension of specie-backed paper. The specie backing has completely disappeared. Paper money was the first system to rely upon continued economic activity for validity. Fiat money relies not only upon continued economic activity but also upon the issuing government's ability to collect taxes. This historical process illustrates an increasingly interconnected trust of humans for each other. The wealth of a modern economy depends profoundly upon specialization and trade. It is only fitting that the money of such an economy should reflect this necessary interconnection.
Just as paper money arose from specie as a transition to fiat currency, so too future forms of money will grow out of the current fiat money system. An analogy: paper currency is to gold as a fluid market in liquidity is to fiat money. In both systems, the quantity of the foundational store of
value (gold, fiat money) decreases as contingent relationships (bank notes, explicit failure agreements) build upon the foundation. That is, promises, linkages and other relationships expand the amount of money in circulation, while the underlying store of value remains relatively constant.
The conclusion of this process is the elimination of fiat currency as money, just as gold has passed away as money. The form that the replacement may take is still uncertain, but it will certainly contain both explicit representations of financial relationships and a sophisticated valuation system.
The composition of money. Money itself is not a technology. Various technologies implement money and thus become a form of money, but these are not themselves money. Specie (gold and silver), coins, book entries, paper bank notes, digital automation and smart cards all act as money, but no single one can lay claim to being money itself.
Even gold is not money itself, but rather its preeminent example. Gold is not currently money in the US, for example. You can't take a Krugerrand to your local Sears and buy a washing machine with it. Gold is also useful for jewelry, dental work and circuit boards. Gold has value as money only when people agree that it is money.
Money itself is a social fiction, like property, political parties, governments, gender and marriage. As a specific example, a corporation is a legal fiction. The socially fictive nature of money is key to understanding its transfer. Social fictions are real, even though they exist only in people's heads. When money moves across electronic networks, no substance called money is in motion. What is in motion is knowledge about rearrangements of money.
Money is ultimately a communications process. Any technology that implements a conserved and transferable quantity is usable as money. The physical properties of gold satisfy these two sufficient properties of money; therefore, gold works as money. These sufficient properties are also design criteria. Creating new forms of money involves two steps: inventing a suitable technology, then persuading society to use it as money.
Where did I get this beautiful car? Payment systems are a necessary epiphenomenon of an underlying economy. Payments themselves always arise from some exchange or transfer. Each payment, therefore, necessarily refers to some relationship outside itself. (Note that the payment vehicle need not carry a reference to the primary economic activity with it. Representations of this linkage always lie somewhere and last for a certain time. The location and duration of the linking information determine important properties of scale, dispute and privacy.
Every discussion of electronic money inevitably touches upon the whole of economic activity. Trends in the automation of money movement presage those in the rest of the economy. Many of the issues that arise in payment systems arise also in systems for negotiation, delivery, billing and protest. The same principles for making payment systems more effective apply to commerce as a whole.
Synthetic currencies. The transition out of fiat currencies will be much easier with the presence of commodities that act like currencies but which
are not, strictly speaking, currencies. Two developments in the securities industry, derivatives and securitization, point the way.
Derivatives are items of value that are not themselves tangible but are mediated through some agent. An example of an aggregate derivative is an indexed security based upon the Standard & Poors 500. Conceptually, one trade of an S&P 500 index equity makes 500 different trades. The issuer of an index derivative does all these individual trades, but on net flow, not on each index trade.
Contingent derivatives are contracts for purchase or sale under some conditions other than here and now. The simplest derivative is a forward contract, which is an agreement to buy something tomorrow with a price set today. Other such derivatives include options, futures, futures options, interest swaps, strips and all sorts of more exotic arrangements. A corporate financier may use derivatives to stabilize price fluctuation or minimize exchange-rate risk. The same tools can be used to create what are essentially amplified bets on price motion; involvement of this kind led to trouble for Orange County, Procter & Gamble and Metallgesellschaft.
The second trend, securitization, is a general way to turn non-fungible property like home mortgages, business loans and real estate into fungible securities. A securitized asset is essentially a derivative asset based on an underlying basket of similar goods. Securitization allows more of the world's wealth to exchange in financial markets, which have efficient price discovery mechanisms. It leads to more efficient capital allocation as well as more information about the economy.
A synthetic currency is a stabilized derivative asset based over as broadly a secured base as possible. The ideal synthetic currency's goal is not speculation but value maintenance. It should seek to minimize price fluctuation by targeting a broad market average. No single enterprise will be able to pull this off. The issuer of a broad synthetic currency will doubtless rely upon many other issuers. Derivative assets may derive from other derivative assets, and so on.
Synthetic currencies truly thrive with small value transactions. The cost of negotiating and processing a foreign exchange trade for each small transaction would be overwhelming. Commerce denominated in synthetic currencies avoids this issue by parceling out this trading function to the issuer of the synthetic currency. In addition, denomination in a synthetic currency avoids some of the fluctuation risk, particularly if present on both sides of the balance sheet. This application provides a potential initial market, namely, low-level trading where the exchange risk and transaction costs currently prevent commerce.
Non-inflationary currencies. The word "inflation" has different meanings in the phrases "price inflation" and "currency inflation". The two meanings are historically related but not identical. Price inflation is just a synonym for price increases. News reports are usually of this kind of inflation. Currency inflation, however, is an increase in the total number of nominal units of the currency.
The real value of any currency is unrelated to the total number of available accounting units. This variability of nominal value is a source of great mischief. Under the current fiat money regime, the issuing government can decide at any point simply to print more money and assign it all to itself. It's not always this blatant, of course. In the long term, an inflation of the money supply by 100 percent is a 50 percent tax on the real value of currency holdings. In the short term, the illusion of freer money stimulates economic activity. The transient effects of a credit relaxation are much more significant now than in a more highly networked future where the money illusion disgipates faster.
Inflationary currencies were at the center of last year's Brazilian presidential elections. The new president, Cardoso, is the former finance minister who was responsible for bringing the inflation rate down from three digits to two digits. The poor overwhelmingly voted for him over even a strong leftist labor candidate, who nominally had their interests more at heart. In truth, Cardoso broke the crushing effective tax on cash which is the means of savings of the poor, assuring his election.
Here's how to create a non-inflationary currency: A currency issuer announces in advance the total number of nominal units of value and makes an initial disbursement to currency holders. From then on, all transactions in the currency are zero-sum. The public can continuously verify that the number of nominal units is constant, either by legal assurance or by a function called remote auditing (see page 25). Unlike government currencies, the issuer does not simply create more money.
If the non-inflationary currency is a synthetic currency, the real value of one unit of currency increases at the same rate that productivity rises in the economy. Technological progress increases real wealth. One unit of non-inflationary currency pays real interest (not nominal interest) just by sitting around.
Power shift. The rapid expansion of the foreign exchange market has usurped a long-held power of governments to control exchange rates. Inexpensive and reliable long-distance telephony available in the 1960s allowed New York-to-London currency trading in real time rather than with periodic price fixings. The market responded more quickly to disparities in real economies and to various governments' fiscal misbehavior, two trends that should continue. Automation further increased the size of these capital flows. As technologies accelerated international capital flows, governments lost the ability to set exchange rates between their currencies.
Another such transfer of power is imminent. Financial institutions will soon be able to create a store of value that can outcompete government-issued currencies in retention of value and in swiftness of transaction. The real issue then at hand is whether the governments of the world will allow for a smooth transition.
COPYRIGHT 1995 EDventure Holdings, Inc.
COPYRIGHT 2004 Gale Group
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