Re: In Search of Genuine DigiCash
At 11:00 AM 8/27/94 -0700, Eric Hughes wrote:
Digital cash has to be issued by someone, who *really should* back it up with real money, and should thus receive real money as collateral for the digicash on the net.
The basic distinction that is missing in your analysis is that between legal structure and financial structure. Here is my very short clarification of the difference.
-- The financial structure matters when things go right. -- The legal structure matters when things go wrong.
Your financial analysis is fine, but also mostly irrelevant for determining legalities. I've never worried too much at all about the financial structure for digital cash issuance, because I've always thought it a straightforward problem to manage the backing portfolio.
Unfortunately, Eric, I think you'll agree in hindsight that financial structure and legal structure is a little more tightly coupled than that. The law and the enforcebility of agreements is what makes financial instruments exist. Their behavior is a direct result of their legal underpinnings. Thus, the financial structure is the legal structure. The financial behavior of a security can thus be predicted just by assuming the efficacy of the legal system they're written in. If you break the law or agreements creating a market, say if people didn't make their margin calls and got away with it, there wouldn't be a market on margin for very long. Thus, by collateralizing what you would call a digital banknote, you are agreeing with the person you issued it to that at the very least, that dollar-for-dollar, there's money to back the note up. By the way, I figured out just now why this can't be called a digital bank note, though I can't figure out what to call it except digital cash for the time being. Digital cash isn't issued by a bank in the scenario I outlined, at least a bank of deposit. The issuing underwriter isn't anymore a bank than an institution offering any other piece of collateralized paper, like GNMA, a railroad offering an equipment mortgage bond, whatever.
I think you misunderstand me. Secured and unsecured are legal concepts, not financial ones. Merely saying that the money sits somewhere while it's in transit (which it clearly does) does not make the instruments secured.
But it does, Eric. Especially if the underwriter says at the outset that the money's secured (collateralized). If money isn't secured dollar for dollar, especially in the early stages, you get a whole mess of legal, not to mention financial problems. It should be possible to keep an issue of digital cash fully collateralized (secured) and still make money.
What happens during bankruptcy of the issuer?
This probably won't happen except in cases of fraud. [...] Unwinding a position in the money markets is not really a scary proposition at all.
I would strongly suggest that you go look up some references to systemic failure in payment systems, which is a big concern these days. And unwinding a position in the case of bankruptcy can create real negative value in the system, and cause other banks to collapse. Unwinding can be _very_ expensive.
Again, Eric, if one digital cash underwriter has to unwind a fully collateralized bunch of digital cash, what's the problem? If the underwriter isn't fully collateralized, he's in violation of his issuance covenants and is likely to be sued by the trustee for the instruments, at the very least, long before a run on the cash started. Thus, the shareholders of the company doing the underwriting take the hit for a bankruptcy, while the suspension account and the portfolio backing it may not even have to be unwound at all. They may simply be transferred to another underwriter for safer keeping. It's not at all like banks, where they get to make money by creating a little, and thus should have insurance to keep the their liabilities and their reserve requirements. Having a fully collateralized digital cash (for lack of a better term) system is pretty simple to do from a financial, and legal standpoint. Thanks! Bob Hettinga ----------------- Robert Hettinga (rah@shipwright.com) "There is no difference between someone Shipwright Development Corporation who eats too little and sees Heaven and 44 Farquhar Street someone who drinks too much and sees Boston, MA 02331 USA snakes." -- Bertrand Russell (617) 323-7923
To review, I said the following:
-- The financial structure matters when things go right. -- The legal structure matters when things go wrong.
The reply: The law and the enforcebility of agreements is what makes financial instruments exist. Their behavior is a direct result of their legal underpinnings. This is absolutely false. Both a promissory note and a bond can have identical financial structure, but the legalities are completely different. The financial behavior of a security can thus be predicted just by assuming the efficacy of the legal system they're written in. Certainly the probability of transaction failure can be factored into the face value and behavior of the instrument, but the actions in case of transaction failure are not determined by how the financial transactions around the instrument are governeed. If you break the law or agreements creating a market, say if people didn't make their margin calls and got away with it, there wouldn't be a market on margin for very long. Sure, the legal system creates the stability that allows the financial structure to become significant. But neither side determines the other. Thus, by collateralizing what you would call a digital banknote, you are agreeing with the person you issued it to that at the very least, that dollar-for-dollar, there's money to back the note up. Well, no. At the _very_ least, you promise that there will be money for them when they redeem the note. There's no necessity to make any promise about what happens to the money in the meantime. Here, then, is most of the answer to the earlier pop quiz. Promissory notes need not be secured, whereas bonds by definition are securities. Money paid for a promissory note might, for example, be immediately lent out. As long as there's money for redemption when it becomes due, everything is OK. In bankruptcy, secured debt is paid off entirely before unsecured debt. By the way, I figured out just now why this can't be called a digital bank note [...] The issuing underwriter isn't anymore a bank than an institution offering any other piece of collateralized paper [...] Even though the issuer need not be a bank, the phrase digital banknote still captures most all of the intent of what these instruments are meant to be used for.
Merely saying that the money sits somewhere while it's in transit (which it clearly does) does not make the instruments secured.
But it does, Eric. Especially if the underwriter says at the outset that the money's secured (collateralized). You are merely _assuming_ that the digital notes are secured; you do not seemed to have considered the possibility that they are not. If money isn't secured dollar for dollar, especially in the early stages, you get a whole mess of legal, not to mention financial problems. If I say that the notes I issuer are not secured, and yet for convenience keep the money in 100% liquid reserves, is there a contradiction? No, because security is a legal issue, namely promises to the holders of notes, and reserve structure is a financial property, namely where the money sits for the duration of the issuance. It should be possible to keep an issue of digital cash fully collateralized (secured) and still make money. You are confusing here, very clearly, the promise to keep a fund in a particular way, and actually keeping that fund in that way. If you undertake a legal responsibility, that will affect you financial structure, but merely naming some financial structure does not determine the legalities around it. Again, Eric, if one digital cash underwriter has to unwind a fully collateralized bunch of digital cash, what's the problem? Go do some reading. In the case of bankruptcy, for example, the issuer is not around anymore to do any unwinding. If the underwriter isn't fully collateralized, he's in violation of his issuance covenants and is likely to be sued by the trustee for the instruments, at the very least, long before a run on the cash started. Finally the hidden assumption of full collateral is revealed. Why on earth are you assuming that this has to be the case? Reasoning from a particular model about a set of properties is a good way to ensure that you don't see all the possibilities. Eric
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