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Saturday 23 September 2017
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Cash and Credit in a Cryptocurrency Economy, part 1 – The Legacy Financial System

The success of Bitcoin has created the possibility for an new free market, cross-border, online economy with Bitcoin serving the role of base money (cash). There’s certainly room for optimism on this point, however it’s not going to do it alone. Bitcoin is the new cash, or base money, for this economy. Cash by itself is not enough to meet all the needs of an economy, so building that future economy will require additional supporting technologies. Open-Transactions is one of those supporting technologies, and the this article will explain how and why it fits into the new economy we are building.

CASH AND CREDIT IN A CRYPTOCURRENCY ECONOMY

This article is part of a series describing the complementary relationship between Bitcoin and Open-Transactions as tools for creating a new digital economy. This is the first article, describing the legacy financial system. Other articles in the series are Open-Transactions, and Practical Applications of Open-Transactions.

Before we can talk what the future of money will look like, it’s important to establish some context first by talking about the present and how it got to be this way.

A brief history of currency

The origins of modern currencies started with gold and other precious metals. Over the past few thousand years, people in a variety of cultures around the world discovered gold and decided to trade it as a commodity. Over time, as finance and commerce became more sophisticated, the concept of a unit of account emerge and gold generally became the default unit. Much has been written regarding why gold fell into this role, but for our purposes here it’s sufficient to note that it did.

The next major step in the evolution of currency came when people trading with gold coins realized that gold isn’t a particularly good medium of exchange when it comes to transactions that involve either high denominations and/or long distances, or else very small denominations. They discovered that it was more efficient to store their gold with a third party who specialized in that service, and trade information about their ownership of the gold rather than the gold itself.

This arrangement was the beginning both of banks and of paper currency notes. Banks were trusted third parties to whom depositors would hand over their gold for safekeeping, without relinquishing their claim of ownership. The proof of their gold ownership came in the form of paper notes with a specific face value that the bank promised to redeem for gold on demand. This arrangement can be thought of as a custodial relationship, and it can also be thought of as a loan. Depositors loaned their gold to the bank, in exchange for a promise to return it. The promises represent the bank’s liability (debt), which depositors could use as a medium of exchange. The invention of banks and paper notes was also the invention of debt trading.

This basic structure has been preserved to the present day, even though modern government-issued currencies are no longer promises to deliver gold from a vault. For example, other than coins, every form of the US Dollar is a debt instrument. Federal Reserve Notes are liabilities of the Federal Reserve, redeemable in US Dollars (theoretically). Bank account balances are liabilities of the banks. Every other financial instrument (stocks, bonds, CDs, checks, futures, etc.) are liabilities of the issuer.

Every transaction involves the transfer of liabilities from one party to another, with the sole exception of (some) physical cash transactions. Financial instruments, in all of their various forms are contracts between the issuer and the bearer which represent the issuer’s promise to redeem the instrument for some specified form of value.

Cash in the Cryptocurrency Economy

Once we understand where our modern financial instruments came from, and if we know something about the features of Bitcoin, it should be clear that in the future the role for financial instruments which represent money will be diminished. Bitcoin is like what gold would be if it came with built-in teleportation. It is almost as easy to move a representation of a bitcoin as it is to move a bitcoin itself – after all, both are just information. With that ease of movement the need to hand over bitcoins to third parties custodians for easier transactions is nearly eliminated.

Nearly eliminated, but not totally. There are two areas in which there is room for trading representations of Bitcoin:

  • Currency trading platforms: Transactions on the Bitcoin network are fast compared to something like a bank wire or ACH transfer, but still take an average of 10 minutes to finalize. In certain applications where individuals want to rapidly exchange bitcoins, the exchange needs to happen outside the blockchain. This means recreating the same custodian-representation model, using a suitable mechanism.
  • Trade credit: Trade credit is a form of B2B (business to business) loan that is critical to the smooth flow of commerce in an economy. Few people who are not directly involved with the B2B financial dealing are aware of it, but it represents the largest use of capital for businesses of all sizes in developed economies.

Trade Credit

Consider the businesses which might operate in a small town. If the town is reasonably sized, then one of these businesses is will be an auto repair shop. Where there are auto repair shops, we would also expect to see an auto parts store which would act as the repair shop’s supplier.

Suppose a customer arrives to the repair shop with a car that requires a new alternator. Typically that customer isn’t going to pay until after the job is done. The repair shop needs to obtain an alternator from the parts store, but does not yet have the customer’s payment for the repair. How do they resolve this chicken-and-egg problem?

There are two ways: either the repair shop keeps enough cash on hand to pay for everything up front, or else the parts store gives them the alternator immediately and allows them to pay later.

The latter option is trade credit. Suppliers of a business typically set up accounts with their businesses that allow for delayed billing, typically with 30, 60, or 90 day delays. The effect of this delayed billing is exactly equivalent to a short term loan of currency.

How common is trade credit? Collectively it represents the largest P2P loan market in the world. How large is that, exactly? To take Walmart as an example, the capital they have in trade credit exceeds the amount of shareholder equity by a factor of 8. Trade credit is the largest and most important facilitator of modern commerce that you’ve never heard of.

Net Billing

Businesses of all sizes are constantly issuing and redeeming liabilities in the form of trade credit – it’s part of their daily operations. However, many individuals are not familiar with this concept since they may not be directly involved with B2B finance. For that reason, a brief explanation of net billing is in order.

Suppose the parts store has created a charge account for the repair shop with the following terms: “2% 10, net 30″. This means the part store expects every invoice to be paid in full within 30 days from the date it was created. If the repair shop pays early, no later than 10 days after the creation of the invoice, they can take a 2% discount.

Imagine the alternator cost $100, and was picked up on the 2nd of the month. The shop can pay the invoice with a $98 payment as long as the payment was received no later than the 12th, or the full amount if paid between after the 12th and before 30 days have elapsed. If the payment is late, usually other terms in the contract between the parts store and the repair shop would contain a monetary penalty. The time-based system of discounts and penalties in the billing contract are equivalent to an interest rate if we are viewing the arrangement from the point of view of a short term loan.

The parts store and the repair shop will probably have many outstanding invoices open at any given time. The repair shop might pick up parts several times per day and issue a single payment each week. The parts store will typically take incoming payments and apply them to the outstanding orders from oldest to newest.

It is beneficial for businesses to operate in this way for two reasons. First, because prior to the invention of Bitcoin, paying invoices tended to be a slow and manpower-intensive operation. Being able to write a single check that covers many invoices at the same time is a great way to reduce overhead. This reason will less urgent in a cryptocurrency economy.

The second reason is that this billing arrangement allows businesses to better manage their cash flow, especially for those businesses operating on thin margins. This reason remains relevant in a cryptocurrency economy. It’s much easier for a business to pay its suppliers after the customers have paid. The ability of businesses to issue running loans to one another acts as lubrication for the machine we call the economy.


Now that we’ve explained the basics of legacy financial instruments the series will continue with a description of Open-Transactions.

(Originally published on Open Transactions News. Used with Permission.)