Money as layers


Whenever I try to come up with a metaphor for the monetary and banking system I think about the 2010 film Inception, one of my favorite films. After falling into a dream state, the protagonists sedate themselves within the dream so that they can move to an even deeper dream level, and so on; a dream piled on a dream piled on a dream piled on a dream. Conversely, by setting up a series of "kicks," the protagonists progressively wake themselves up from each dream level until they eventually reemerge back in reality. 

Like Inception, our monetary system is a layer upon a layer upon a layer. Anyone who withdraws cash at an ATM is 'kicking' back into the underlying central bank layer from the banking layer; depositing cash is like sedating oneself back into the overlying banking layer.

Monetary history a story of how these layers have evolved over time. The original bottom layer was comprised of gold and silver coins. On top this base, banks erected the banknote layer; bits of paper which could be redeemed with gold coin. The next layer to develop was the deposit layer; non-tangible book entries that could be transferred by order from one person to another. Bank customers could "kick" out of their deposits and back into banknotes, and then kick out of banknotes into coin. Conversely, they could sedate themselves from coin into notes and finally deposits.

We can use this metaphor to think about all sorts of things. One of the defining themes of modern monetary history has been the death of the original foundation layer; precious metals. This happened progressively over time as central banks chased private banks from the banknote layer (see here) and then gradually severed the banknote layer from the gold layer. By 1971, thanks to Richard Nixon, there was simply no way to kick out of banknotes into gold. Banknotes issued by the central bank had become the foundation layer. The trend towards a cashless world is a repeat of this script, except instead of the gold layer being slowly removed it is the banknote layer.

Another big story is financial technology, or fintech. For the most part, this has been about improving the various layers. Think about efforts to make the deposit layer more efficient by allowing for more ways for deposits to move, say online payments rather than just cheques, and (centuries before that) cheques rather than the necessity of visiting one's banker in person to issue verbal payment instructions. Fintech is also about improving and increasing the interconnections between layers so that customers can kick/sedate from one layer to another more efficiently. In banking lingo, this is called interopability. So rather than having to wait for a bank teller to move funds from the overlying deposit layer into the cash layer, just go to a machine.

Fintech isn't just about improving existing layers and interconnections, it is also about adding new layers on top of the old layers. As I mentioned earlier, banknotes and deposits were the two most revolutionary layers to be added to the original metal edifice. This happened centuries ago. In modern times, we get technologies like M-Pesa, a third layer on top of Kenya's banknote and deposit layer. Call this the mobile money layer. Kenyans exchange lower-layer units, cash or deposits, at kiosks in return for higher-layer M-Pesa entries. Safaricom, the operator of the M-Pesa layer, keeps these funds deposited in traditional bank accounts, one shilling of bank deposits for each shilling of M-Pesa outstanding. That way there will always be funds available to those who want to kick out of the M-Pesa layer and back into underlying layers. Until then, Kenyans can easily exchange M-Pesa using their mobile phones.

Innovators may run into a tough time building on top of the top-most layer, the bank deposit layer, because banks jealously guard their terrain. Bankers may impede innovators from creating smooth interconnections between new layers and the bank's own layer, thus rendering the kicking/sedation process unattractive for consumers. Alternatively, they may lobby regulators to clamp down on new entrants who are trying to build on top of incumbent layers. In Kenya's case, regulator's allowed M-Pesa to proceed on an experimental basis despite bank attempts to shut it down. In U.K., the Bank of England is considering allowing fintech companies to bypass the banking layer by offering them direct access to the bottom-most central banking layer. This is probably a good idea if innovation is to be promoted.    

Bitcoin is unique. Starting from scratch, the Bitcoin movement is trying to erect an entirely independent financial system. Even now there is talk of a new layer being developed on top of the original bitcoin foundation, the Lightning network. The idea here is that the majority of payments will occur in the Lightning layer with final settlement occurring some time later in the slower Bitcoin layer.

The newer "blockchain" movement is taking a different route from the Bitcoin movement and grafting some of Bitcoin's innovations into the traditional financial edifice, the most prominent of these innovations being a distributed method of transferring value rather than a centralized one.  How will all this play out? Fintech, which has been going on for centuries, has always innovated within and on-top of the existing system of layers. Off the top of my head, I can't think of a single example of a successful monetary innovation that hasn't developed on top of the existing edifice. Can you? While I love the idea of starting from scratch, monetary history is against bitcoin and in favor of the traditional banking system. But history has been proven wrong before.

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