By Henri Lepage
Libertarians are rightly cheering to the rise of crypto-currencies. For the first time ever, initially with Bitcoin and now with Libra, central banks national monopolies are facing the prospect of a real market competitive challenge.
That being said, the idea of central banks having to face private rivalry is not as far fetched as many imagine. Libertarians do not need a Libra project to give birth to such competition. It is something that already exists. It even has a name: the Eurodollar System.
You have surely heard of “eurodollars”. Formally speaking, a eurodollar is a dollar account deposited in a bank located outside the United States, i.e. out of reach of American regulators.
The new world of “global money”
Milton Friedman was the first economist to mention that central banks overlooked the monetary creation potential of eurodollars. In one of his articles dating from the seventies, he showed how, with conventional bank accounting practices, chains of cross border money transactions and credits ended in a cumulative extension of the world float of dollar supply that owed nothing to the United States’ balance of trade deficit. It is a pure bank money creation of offshore dollars (which are “dollars” in name, but not real US dollars).
About the same time, a Princeton economist went to London to study eurodollar transactions. He observed that corporate cash needs on that market were increasingly met with short term debt assets which did not qualify as money proper but offered liquidity properties close to the traditional components of money included in monetary aggregates: commercial paper, repos, MMF shares, swaps, derivatives… In a paper entitled “The Missing Money”, he came to the conclusion that central bank econometric models were based on money statistics that missed a large chunk of actual payment instruments. They did not fit the standard definition of money. But they were increasingly used in the real world as alternative dollar instruments because they were characterised by a degree of moneyness close to that of true monetary instruments.
Over the years the use of these money-like instruments increased so much and so fast that it gave rise to a wholly new international banking structure (Gary Gorton): a global offshore dollar system. This offshore banking network has by now become the main source of access to dollar liquidity in the world – and thus the main source of dollar supply for the globalised economy. But, because of accounting conventions and a short-sighted definition of what counts as “money”, most of this actual money creation does not appear in statistics. It is shadow money.
Economists still depend on Keynes’ vision of the macroeconomic world. His representation basically remains that of semi-closed economic islands, each with its own monopoly hierarchy of banking and money institutions ordered around a central bank that is sovereign. Within this mental universe, there is conceptually no room for such shadow money.
Modern banking relies less and less on the traditional tools of national money markets.
Thanks to globalisation, digitalisation, financial innovation and the end of capital controls, this common view is now obsolete. In the old world, to grow their business, banks basically needed to collect more deposits. That was a marketing job. When faced with a balance sheet mismatch, they borrowed standard base money from other local banks with excess reserves at the national central bank. In the new globalised world they rather directly call the dealer desk of an offshore global bank department located in London or elsewhere. They will immediately be offered tailor-made eurodollar rolling repo loans or currency swaps obtained from large world cash flow pool aggregators (such as big multinationals with global value added networks, insurance groups, pension funds, mutual money and equity funds). This is finance. Market refinancing.
As a consequence, to solve its liquidity problems, modern banking relies less and less on the traditional tools of national money markets. Even in the United States, Fed funds and Fed reserves are no more the exclusive source of last resort funding. Repos markets have become the largest liquidity and refinancing choice of last resort.
Wholesale money market
However there is a problem. This is not a market for everyone. This new global banking network is basically a wholesale money market whose main parties are very large institutions acting both as lenders and borrowers. What are usually transacted are exchanges of millions, hundred of millions, and even billions of dollars. Such accounts do not benefit from any statutory state insurance (as bank deposits usually do up to a certain limit). Therefore, this offshore system developed only because private markets spontaneously developed a highly complex and sophisticated hedging industry based on the use of collateral and derivatives techniques whose prototype is the repo contract.
The essence of a repo contract is not only the exchange of two promises: I promise you a loan of a certain amount for a certain duration while you promise me to repay the loan at maturity date; but the borrower also backs his promise by transferring to the lender the temporary possession of a portfolio of securities in exchange for the lender’s promise to return it to its legal owner (the borrower) when the loan is repaid. Moreover, repo legislation gives the lender the legal right to re-use these securities as collateral for obtaining for his own benefit another personal repo loan from a third party. This practice is known as re-hypothecation. It is the source of a powerful leverage and multiplier mechanism (Manmohan Singh).
The best of all collaterals, the most searched for are USTs (United States federal bills and bonds). But they are only in limited supplies. Therefore markets had to find alternative private solutions. They came from the derivatives industry. Through securitisation and other derived mathematical techniques that redistribute risk (like the infamous CDS and CDOs), its role is to produce private securities which may qualify for collateral use and re-use. But this multi-steps transformation process relies on chains and matrices of intermediated cross-border credits, loans and swaps that are themselves highly collateral intensive. It is this hyper complex financial architecture based on the central concept of collateral hedging – even over-collateralisation – that nurtured the explosive growth of modern finance and eurodollar markets.
As a result, the current international monetary system is an hybrid which works in ways very different from traditional textbook presentations. Today national monetary systems are collectively capped and embedded in a new banking layer of global dimension whose monetary output variations supersede and trump national monetary policies – even those of the American Fed. Nowadays it is this wholesale eurodollar global money system, Global Money to make it short (Perry Mehrling), that effectively rules the world economy tempo.
Who rules Global Money?
Assembling and marketing highly rated securities that qualify for use as collateral backing is the backbone of modern finance. Thus, the one who finances and controls this process rules the show. Today, it is a handful of huge global dealer banks (about 20 so-called Systemic Financial Institutions like Citibank, Bank of America, JP Morgan, Goldman, HSBC, BNP Paribas, Credit Agricole, DeutscheBank) whose wholesale experience, dealership expertise in derivatives and market making activities put them in a position of turning on or turning off the flow of global liquidity.
This new monetary structure is the hallmark of a momentous revolution: central banks are being competed out in the supply of one of the most important attributes of money (liquidity). They are de facto no more central. They are no more the centre of the system.
Failure by the central banks community to acknowledge and understand the reasons and the consequences of this change, means that their present monetary policies are totally disruptive. Consequently, after 12 years, the crisis is still with us.
To fix it, one may imagine some sort of new Bretton Woods. But there is nothing to expect from such a conference reset. To fix the system one must first understand the system. Politicians and central bank economists still do not.
An alternative direction may emerge from the spontaneous innovation market process initiated 50 years ago. At that time it brought private shadow solutions to overcome the postwar structural dollar shortage (Triffin paradox). Since the end of the great recession, we have faced renewed episodes of recurrent dollar shortage as a consequence of the failed response of central banks (the current episode being the fourth in 12 years).
Digital alternative private payment platforms, bitcoin, blockchain, crypto-currencies, “stable coins” are today higher technology supplementary and evolutive solution tools proposed by the market process. Let us hope that with his Libra project, Zuckerberg will not choose the side of monopoly hungry crony capitalism and obsolete central bankers. It would definitively jeopardise the future of these more freedom friendly experiments.
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