Some Economists Really Do Get It


It’s not true that all economists and central bankers hate cryptocurrencies and stablecoins! It is my honor to be asked by a respected economist in the Washington, D.C. establishment to write this post for inclusion in his forthcoming book about the impact of fintech trends on monetary policy. He and I have had ongoing dialogue for nearly a decade, which started when I came across his awesome work in the collateral and repo markets following the financial crisis, and expanded this year into a frequent dialogue about stablecoins and central bank digital currencies. He has taught me a great deal! When his book is published in early 2020 and I’m able to write about it, I’ll be back to share more. Meanwhile, he gave me permission to publish my unedited submission. Enjoy!

It is important to ask, “what problems are the new fintech platforms purporting to solve, specifically regarding payments?” Too many observers have false confidence in their belief that status-quo payment systems work well, ignoring two problems posed by traditional payment systems: (1) the high but hidden cost of payment latency, and (2) counterparty risk posed by traditional depository institutions. Those who ignore these problems are at risk of being blindsided by the trend that users will increasingly turn to these new payment systems precisely because they solve these two specific problems.

No group of payment-system users experiences these problems more acutely than corporate treasurers—especially those that move money across borders.


Status quo payment systems were designed to settle payments on a delayed net settlement basis rather than a real-time gross settlement basis.

Historically, this made sense. Computer processing power and data storage were too expensive to consider settling payments on a gross basis until little more than a decade ago. Legacy payment systems were designed to live within these constraints by aggregating and then netting payments within correspondent banks, which in turn settled on a net basis with central banks. By design, such systems minimized the total quantity of payments settled—and, historically, each bank in the settlement chain processed transactions in batches, usually overnight. Because each bank processed in sequence, it normally took days for businesses to settle a payment. There simply was no alternative that provided businesses a faster, more efficient way to settle. Moreover, until the early 1980s, money and credit were created via fractional reserve methods exclusively within the traditional banking system (i.e., not within securities markets, as they are today). Until the early 1980s, this multi-layered, fractionally-reserved system design meant that the growth of M2 could be predicted fairly accurately by tracking the growth of the monetary base. All the netting that happened within the banking system meant that central bank balance sheets could remain a small fraction of the size of system-wide total money and credit outstanding.

Before examining the rise of securities markets in credit creation, and their impact on payment systems, a critical question must be asked: who funds the cost of such delays in payment settlement? When a payment doesn’t settle instantly, someone carries the risk of the unsettled payment—which includes both time value (interest rate risk) and the risk of default (counterparty risk). Who funds this cost?

By definition, either the financial system or non-financial businesses must fund this cost.

Answer: by design, the status quo financial system forces non-financial businesses to shoulder this expense. But here’s the rub: nonfinancial businesses usually have a higher weighted average cost of capital than financial businesses do. Consequently, forcing nonfinancial businesses to shoulder the cost of payment latency is an economic inefficiency—a deadweight loss on society.

To see this, ponder this question: if two parties are settling a payment, and the cost of technology is no longer a constraint so that parties could settle the payment peer-to-peer nearly instantaneously (i.e,. as fast as the speed of light), then why do interest rate and counterparty risks exist in payments? These two risks are not inherent to payments—they are introduced where they would not otherwise exist due to the delayed net settlement structure of the legacy payments system.

In other words, counterparty and interest rate risks are exogenous factors in payments. They exist only due to the design of the status quo financial system, which is hostage to legacy constraints delaying settlement that need no longer exist today—but which powerful incumbents are not very interested in changing, as they capture rent-seeking profits in the meantime.

To illustrate, let’s consider the example of a global company that manufactures technology components, that has a global supply chain, and that uses roughly 1,000 different bank accounts located around the world. Let’s assume the company has no debt in its capital structure (so that the company is 100% equity-financed), and that its weighted average cost of capital is 15%. Let’s also assume that its cash-management bank has a weighted average cost of capital of 3%.

In a pareto-optimal world, the cost of payment latency related to this company’s payments would be borne by its bank, whose weighted average cost of capital is 12% lower than that of the company (15% minus 3%).

However, status quo payment systems incentivize the opposite. Specifically, the company’s bank can only assume a finite amount of credit exposure to the company, so the bank allocates this credit risk budget to the highest-margin products—such as bridge financing for mergers & acquisitions, leveraged loans, accelerated stock buyback programs, deal-contingent derivatives and other high-margin products. The last thing its bank wants to do is finance the company’s payment latency, which is a very low-margin business. Consequently, the bank requires the company to finance its own payment latency by trapping cash in its myriad bank accounts around the world in so-called “comfort deposits” (while the bank captures profits on this float).

But here’s the problem. This practice is a deadweight loss on society because this company’s payment delays are financed by the company’s own trapped capital, which has a 15% cost, instead of by the bank, which has a 3% cost of capital.

The math I just outlined—the company financing its own payment latency with expensive, 15%-cost capital—provides a powerful incentive for the company’s treasurer to seek more efficient payment solutions that enable the company to reduce the amount of capital it must trap in its own bank accounts. Companies with the highest cost of capital have the greatest incentive to use real-time gross settlement systems, which can minimize their trapped cash and speed up their balance sheet velocity relative to the status quo.


Corporate treasurers also face another calculation that is not widely discussed: they must manage cash balances that far exceed the limits of deposit insurance, such as FDIC insurance in the US (and similar insurance limits in other countries).

Consequently, corporate treasurers must do something that few retail depositors have even thought about doing since the 1930s: good old-fashioned counterparty credit risk analysis on their deposit banks. Most corporate treasurers are highly sophisticated on this very topic—even though this topic is barely discussed in the mainstream financial press. For example, owing to concerns about the creditworthiness of European banks, by the early 2010s some of the largest and most sophisticated US companies had already transferred their European cash deposits to US money market funds and swapped back them to euros via the FX swaps market.


The discussion is not complete without returning to the topic of securities markets, whose role in credit creation today is as important as that of the traditional banking system—and in some countries, even more important. While corporate payments still settle on a delayed net basis within the traditional banking system, what has changed since the 1980s is that banks now have the opportunity to finance themselves in both the traditional banking system and in global securities markets.

The US dollar remains the dominant intermediary currency of cross-border trade, and it is used daily (in very high volume) between non-US parties transacting with other non-US parties—i.e., never directly touching the US financial system, but transacting with the US dollar nonetheless. Some say (correctly, in my view) that the so-called “eurodollar”—defined as a US dollar issued outside of the US, rather than on-shore in the US—is really the world’s reserve currency.

Significant US dollar balances have accumulated outside of the US as global trade flourished outside of the US—in other words, outside of the Federal Reserve’s direct control and even its ability to measure. This trend began in earnest in the early 1980s and has accelerated since then. As the trend accelerated, two things started happening in the early 1990s: (1) banks required other banks to post high-quality liquid collateral to each other, in order to collateralize their counterparty credit risk to each other, and (2) the market for trading this collateral (i.e., the repo market) increasingly became the de facto lender of last resort—yes, arguably even more powerful than central banks in day-to-day operations.

The connection between the repo market and corporate payments isn’t obvious, and very little has been written about it. However, the two are highly intertwined. The primary job of the financial sector, after all, is to intermediate transactions between nonfinancial businesses, and, indeed, national statistics (such as the Federal Reserve’s Z.1 data) confirm that the financial sector’s aggregate balance sheet is not that much bigger than that of the nonfinancial sector. The problem, as [the author] has noted many times in his research, is that a significant quantity of US dollar liabilities have built offshore (outside of the US banking system)—and it’s impossible to measure the size of these US dollar liabilities accurately.

One possible way to gauge it is to measure the collateral backing these US dollar exposures in the repo market, which is where this collateral changes hands—yet, owing to rehypothecation and other collateral re-use practices, the true magnitude of the offshore US dollar-based credit exposures cannot be measured accurately in this manner either. Periodically, when liquidity dries up in the repo and foreign exchange swap markets, the shortage of US dollar collateral can cause the US dollar to spike—which can trigger losses for businesses, financial institutions and even countries that have short positions in the US dollar. Such instances—beginning with the financial crisis in 2008 plus three subsequent instances since then—lead corporate treasurers to hunker down and focus on the counterparty risk of their banks even more closely.


Here’s the bottom line: corporate treasurers have strong economic incentives to use real-time gross settlement systems for payments, especially if their company has a high weighted average cost of capital. As true alternatives gain steam it makes no sense for corporate treasurers to keep using status quo systems, which require them to keep capital trapped in bank accounts—often to fund their own payments between their own subsidiaries around the world! One mid-capitalization technology company alone calculated that the benefit of speeding up payment settlement to same-day was $200 million—$200 million! In other words, the opportunity to strip out that much lazy capital from its capital structure is a powerful incentive for its corporate treasurer to switch payment systems.

Owing to these strong economic incentives, corporate treasurers will likely be among the first to jump to real-time gross settlement systems as they gain momentum. Multiple Fortune 500 companies have quietly been using Bitcoin in small amounts since 2014, predominantly for transactions in countries without well-developed banking systems. Readers should assume that corporate treasurers are up to speed on all developments in the faster payments area, and are quickly able to pivot to solutions that make sense for them.

Consequently, I believe that if one of the big superregional central banks—the Federal Reserve, the Bank of Japan, the Bank of England or the ECB—were to issue a central bank digital currency that offered real-time gross settlement, corporate treasurers would have a strong economic incentive to switch to it as an intermediary currency in global trade. The US dollar’s current supremacy in global trade is far from durable. 

The switch to faster payments may take many forms—from a central bank digital currency, to a bank-sponsored digital currency (such as Fnality or JPMCoin), to a private stablecoin (such as Libra or Tether) to a decentralized cryptocurrency (such as Bitcoin). As corporate payments migrate away from heavily netted systems toward gross systems, central bank balance sheets are likely to need to expand. But make no mistake:  the economic incentives for corporate treasurers to switch from legacy payment systems to new, real-time gross settlement systems, are powerful. The big questions are these: which one, and how fast?


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