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Digital Currencies and Issues Concerning Moneyness GIC Conference on Payments Systems in the Internet Age San Diego, CA February 5, 2017

Dr. Robert Eisenbeis Vice Chairman & Chief Monetary Economist bob.eisenbeis@cumber.com

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Issues concerning role of digital currencies as money are not new • US from the very beginning has had a mix of fiat and commodities based currencies – As early as 1650s gold, silver, foreign coins, paper currency in the form of bills of exchange of prominent people, script issued by colonial governments, and commodities like skins all circulated and functioned as money – In 1780s after the formation of the country, the US adopted a commoditybased bimetallic monetary system based upon gold and silver – About the same time, newly chartered banks began making loans by issuing bank notes Well into the 1880s and leading up to the Civil War, state chartered banks issued both notes and deposits and attempted to maintain convertibility into gold.

• Notes were widely issued but traded at premiums and discounts and notedealers evolved markets for note exchange

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Private Sector Currency Controls • In Boston, the Suffolk Bank began accumulating notes and then presenting them for redemption at the discount they were accepted, provided the country bank maintained a correspondent balance with Suffolk. The process had the effect of eliminating and/or reducing the discount that notes issued by country banks traded in New England, and especially Boston, since failure to keep a deposit would result in surprise demand for redemption in gold, which caused liquidity and solvency problems for non-complying country banks.

• In NY the Safety Fund system was established as the first governmental attempt to regulate and supervise banks. It functioned as a precursor to deposit insurance as a way of protecting the value of notes.

• States began actively chartering and regulating banks but many problems were associated with ascertaining the value of notes and counterfeiting was prevalent. ©Copyright 2016 Cumberland Advisors®. Further distribution prohibited without prior permission.

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National Banking Act • The problems of funding the Civil War lead the north to create the National Banking System in 1864 which provided for the issuance of national bank notes and attempted to drive the issuance of state bank notes out of existence via a tax.

• But by that time bank deposits had grown in sufficient importance that they dominated trade

• By the time the Federal Reserve was created, bank deposits had become the dominant means by which transactions were conducted, but it was the case that only National Bank Notes and Federal Reserve Notes and government minted coin was legal tender • So what gave both state bank-issued bank notes and deposits their “moneyness?”

– Acceptability combined with credible function as • A medium of exchange • Store of value and • Unit of account (which was determined by the fact that government issued currency was denominated in dollars as were state bank notes and deposits. ©Copyright 2016 Cumberland Advisors®. Further distribution prohibited without prior permission.

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Payments System Alternatives • • • •

Credit cards Debit cards Travelers’ checks Fedwire – for large dollar payments • ACH’s both run by the Fed and private sectors for • EPN Electronic Payments Network – a private alternative to the Fed-run ACH service • Fedwire security service – to transfer ownership of government agency and certain securities of international organizations ©Copyright 2016 Cumberland Advisors®. Further distribution prohibited without prior permission.

• National Settlement Service – Fed-run system permitting multilateral clearing and settlement service • SWIFT • Paypal • Bitcoin and some 72 crypto currencies • Apple Pay • Google Wallet • M-Pesa -worldwide payments • Gift cards • Dinner coupons (piece of paper with a bar code) 5

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Moneyness •

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The funds transferred in these retail and wholesale payments services are technological extensions and analogs of traditional paper-based transactions and have many if not all the traditional attributes of money including – Medium of exchange – Store of value and – Unit of account Distinguishing features, especially when it comes to clearing and settlement – Cash transaction, clearing and settlement occur simultaneously when the transaction occurs – Credit and debit cards, a transaction is completed but settlement is delayed in the case of a credit card to the end of the month or through the extension of additional credit, whereas a debt card is settled as soon as it is cleared – In the case of a traveler’s check, payment is settled first but transaction payment and clearing is deferred until an actual transaction is made.

– With some of the more recent private sector methods, like Paypal, customer anonymity is provided by separating the seller from actual information • In addition, there is also an option to delay conditional settlement, in the case of ordered goods until the goods have actually been received.

– In the case of gift cards and dinner coupons, settlement by the customer takes place before the transaction, which is then cleared and settled by the intermediary with the seller of the good or service. ©Copyright 2016 Cumberland Advisors®. Further distribution prohibited without prior permission.

Moneyness • None of the distinguishing features affect the fundamental moneyness or function of the different transaction modes • Current federal law treats some of the methods differently when it comes to retail customer liability. For example, liability is different for a credit card transaction as compared with a debt card transaction.

– Credit card liability is only $50 if a lost card or fraudulent transaction is reported, an no liability if no fraudulent transactions are made.

– In the case of a debt card, liability is escalated with only a $50 limit if loss is reported within 2 days, $500 if reported more than 3 days or less than 60 days and unlimited thereafter.

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Crypto Currency Weaknesses • Non-legal tender • If stolen there is no way to recover since ownership is with the holder • Fluctuations in value – presently crypto currencies fluctuate widely in value and in this sense the problems are similar to those associated with bank issued notes • Crypto currencies are not universally accepted • The total amount of bitcoins in existence is limited to 21 million, and with a limit that each coin can only be subdivided into 8 decimal places = .00000001. This means that there is an upper limit on how many units can exist and as an economy grows, this suggests that if a market is successful, inflation might ultimately set in and or transactions may be constrained by price.

• Fluctuate in value ©Copyright 2016 Cumberland Advisors®. Further distribution prohibited without prior permission.

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Policy Issues and Questions – Legal status – How important is government insurance and regulation to the viability and efficacy of a digital currency?

– How does one verify ownership in the case of theft?

– Should digital currencies be regulated and supervised?

– How does one control security with mixed payments systems like credit cards where merchants as well as banks are intertwined?

– What are the appropriate weights to apply when calculating the money supply?

– How does one distinguish in such calculations velocity when one can’t identify the source of a transactions – ie. domestic v international?

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Policy Issues and Questions • Monetary theory and multiple real and fiat currencies – Models suggest that if a real asset can be used as a medium of exchange, then a fiat currency may also function as money depending upon the fundamental value of the real asset.

• If an economy has multiple payment media serving as money, how does this affect the choice of a policy instrument and what does it imply about the ability to affect the economy? Is the issue irrelevant if the policy maker has an interest rate target?

• Why not a Fedbits digital currency for all?

• If you start with a centralized digital currency (Fedbits?), will the market force the moves to decentralized, or if you start with a decentralized digital currency, will the need for clearing, regulation, and the lender of last resort needs force a move to a centralized digital currency?

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Disclosure All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed. Past performance is no guarantee of future results. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk.

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