A continuation of The Five Attributes of Money series
Of the five main attributes of money, openness is the most important one because it dictates the limit on how many participants comprise the network and therefore how much utility that network can serve. Today’s modern fiat banking system is the dominant system, yet it is still closed to billions of people around the world. Society stands to gain advantages in access, autonomy, privacy, greater innovation and lower fee structures with a more open system.
Money is characterized by five main attributes: anonymity, centralization, openness, limit of supply and physicality. Arguably, the most important, and often the least appreciated, is the degree to which access to the money ledger is open. Openness determines who can participate, why they would get involved and what potential benefits they stand to gain. One ledger built for just a few counterparties will have a completely different purpose and governing rules than one built to be completely available to anyone. Openness also has a direct impact on the size of the network and, in turn, the usefulness of the related money. To illustrate this point one need only compare, as an extreme example, the difference between the US’ “greenback” dollar and the North Korean won.
Any monetary system is, at its core, a network. Participants are connected to each other because they have agreed to operate by the same governing principles including a shared understanding of the value of the currency, how it fluctuates, how it changes hands and who is responsible for accounting for these changes. For example, a very small network of a few neighbors can entrust one person among them to maintain a ledger of IOUs amongst each other. Unfortunately, the trust that members have in the network quickly disintegrates if the network expands beyond known entities. At that point, other mechanisms are needed for the network to continue to operate.
The modern banking system is the backbone of the global economy and a very large, private network which allows for an enormous amount of utility. It is a very large, complex, but not sufficiently open system. To support this network, we have created centralized systems with larger and larger central counterparties like central banks, clearing houses and commercial banks. The relationships between counterparties to these networks require increasingly complex standards of internal accountability (with corporate governance and departments like finance, risk and internal controls) and external accountability (oversight from regulatory regimes, laws and enforcement bodies). Yet, though it seems ubiquitous, it is a system of gatekeepers that restricts who can participate, either as a consumer or provider of these services.
Let’s examine how openness changes the utility of some of the most important monetary ledger systems in use today, and why participants in open markets should embrace social constructs of ethical behavior to mitigate against risky behavior.
Differences in Openness Across Money Ledgers
Across each of these systems, openness has been modulated in different ways, depending on the technology or tools deployed. The utility of these networks is therefore also affected by each network’s level of openness.
Physical Cash – very open, physical only
Fiat cash, or government-issued currency that is not backed by a physical commodity such as gold or silver, is still one of the most open money ledgers in existence. Physical bills can be given to anyone else without restrictions, without an intermediary and in near total privacy. What limits physical cash from having greater utility is its physical (bearer) nature—it is cumbersome to use and unsafe to transport very far. It is also a system that is intrinsically reliant on the trust that users have in the issuing government. Additionally, its network effect diminishes as it is becoming less accepted, especially for large purchases. There are also certain government-mandated reporting requirements between businesses and people for transactions above threshold amounts.
The truly open nature of cash limits its utility in an increasingly global and digital world. Also unique to cash, the combination of its physicality and openness enables significant amounts of illicit activity; by some estimates, “more than a third of all US currency in circulation is used by criminals and tax cheats.”1
Physical Gold – very open, physical only
Another example of a highly open network is gold. It has existed as a bearer money ledger for thousands of years without requiring any centralized ledger keeper. Anyone can join the network by owning physical gold, which has few restrictions and in many jurisdictions is still considered legal tender (including even some US states like Utah and Oklahoma). Like physical cash, however, the openness of physical gold has the cost of being restricted by its physical nature which is even more cumbersome and difficult to safely transport. More importantly, while the network is highly open, the utility is limited because it is not widely accepted in transactions by the general public, businesses, merchants or governments.
Digital Banking – closed, digital only
A good example of a closed network is the digital systems banks use to manage fiat accounts.
In today’s traditional banking world, digital fiat currencies are money ledgers generally run by centralized issuers, whether the government directly or through central banks. Unlike physical cash or gold, this is an account-based system with restricted access. The US dollar, the global reserve money ledger2, is issued by the Federal Reserve which relies on over 3,000 member banks to intermediate with consumers and institutions. Unlike physical cash, all digital dollars have to be held in bank accounts. In other words, the Federal Reserve is a centralized issuer of digital dollars only to its member banks, and those digital dollars never leave those member banks. It is an entirely closed system.
Only authorized banks can hold cash in the name of account holders who are personally identified and vetted and only they are allowed to participate – with strict oversight. These tight controls allow the banks to provide a direct accounting for all money in the system. But the functional cost of this system is the loss of control by the participants who cannot directly hold money themselves. There is always an intermediary with greater control, and there are many disadvantaged individuals who are left out of the system entirely given the high costs for intermediaries to maintain this system. Nevertheless, despite the depth of controls, this system is still heavily utilized for money laundering. In 2019, large banks were fined over $10 billion for illegal transactions.
In a very closed system, utility is limited because the only services that can be provided are ones authorized through regulation. In the US, regulation varies based on the type of entity, activities and registration – and depending on the foregoing, state and/or Federal regulation may apply.
Crypto, Tokenized Assets and Stablecoins – very open, digital only
Blockchain technology has introduced the concept of digital assets that are actually open. Though oversight is possible on these types of networks, the movement and control of these assets do not require an account at an intermediary. Whereas authentication in the electronic banking system is conducted by verifying the identity of account holders, blockchain-based assets shift authentication from the account to the asset token. Verified tokens have freedom of movement throughout the blockchain, regardless of the participants interacting with it. This creates a far more open network allowing anyone to participate without requiring a controlling intermediary; instead, the technology itself provides the governance.
With a US dollar stablecoin each token represents a physical US dollar. Just like with physical dollars, no one has to grant you permission to access your tokenized digital dollars; you hold dollars in your own wallet. Both physical dollars and stablecoins represent US government-issued dollars that the owner controls. The US dollar in physical form is ubiquitous, open and a bearer instrument that retains value, and therefore remains a “popular and persistent method of illicit commerce and money laundering.”3 A digital dollar stablecoin instrument has very similar properties but also offers the potential for greater regulatory and lawful monitoring of on-chain movements depending on the level of privacy, anonymity and centralization with which it is constructed (we’ll cover these topics in our next post).
Because these systems are very open, however, the utility of these networks has nearly limitless upper bounds.
The Benefits of Greater Openness
The greatest inherent benefit of open systems is that everyone can participate. No one is left out. Closed systems are restricted by design, creating obvious immediate disadvantages. For example, in the United States, more than one-third of all American adults are unbanked or underbanked4. They have limited access or are entirely left out of the banking system and unable to meaningfully participate in the prevailing monetary system. This is often taken for granted. Worldwide, there are over 1.7 billion unbanked because of the frictional costs of an account-based closed system5, with the underbanked a multiple of that number. It is expensive for banks to maintain appropriate and compliant recordkeeping for every transaction from each account holder, so they only prioritize account holders who have more assets. This effort to be safe and controlled has resulted in significant disenfranchisement from the financial system.
Clearly that trade-off has major consequences and costs that are often not appreciated because the disenfranchised are on the lower rungs of socioeconomics and power. This results in a self-perpetuating cycle that makes it harder for them to advance. Certainly, in a time of significant wealth inequality, the costs of a high-cost playing field have never been more stark.
Building a network that allows full participation of all Americans, or all people globally, for that matter, requires drastic alterations to the system with meaningful cost reductions to accommodate everyone while maintaining safety and protection.
One of the major, inherent benefits of an open system is the absence of any requirement for a central counterparty controlling who can access the ledger system. Individuals, businesses and service providers can all directly connect to the network without having to meet gating qualifications. There will always be intermediaries that do exist, which entities can choose to use and connect through, perhaps to access certain types of services or protections, but these intermediaries are not structurally necessary or required. Therefore, such networks, offer participants a greater degree of autonomy, access and privacy.
Competition and Innovation
Generally speaking, it is beneficial within any industry for there to be competitors vying for the same markets. Competition tends to be beneficial to end users because competition leads to better pricing and better products. In order to compete, the players must innovate and be more efficient. However, a free market cannot fulfill its function or benefits if there are high barriers to entry or are too many intermediaries, creating more distortions, opacity and unnecessary costs.
If we could upgrade the financial system to one that has greater openness, greater efficiency and increased direct connectivity between participants, we could truly create a level playing field. Rather than rely on the members of the closed system for innovation, an open system would allow anyone to develop and create new products, similar to other open source projects. This would create real competition and potentially unleash meaningful and beneficial innovation overnight.
In fact, that is exactly what we are seeing right now in the crypto economy.
Now, imagine what would happen to our financial system if we embraced openness everywhere. The result of this move more broadly could allow hundreds of billions in capital to move more safely and more freely. In turn this would help grow the economy faster, bring more people into the workforce, create more and better-paying jobs, and foster more economic opportunities.
The current dollar network, as currently exists, is controlled by a small number of incumbents, including the Federal Reserve, who rely on archaic COBOL mainframes and less than 10 banks who utilize standard technologies for interoperability (like APIs). They have not proven capable of driving development cycles, within their closed system, that can keep pace with broader technological trends. (Read more about how we are providing competition and securities settlement innovation through our Paxos Settlement Service.)
The cost to deliver financial services is inversely proportional to how open it is. As an example, one only need think about the costs of ATM fees or the minimums imposed to make a credit card charge. Where the costs of the current networks justify these rules in a digital currency network one can send $0.0001 for the same cost as one can send $1,000,000. Furthermore, in the current fiat network the per-customer-requirements of careful gatekeeping, ongoing risk monitoring and recordkeeping are all resource-intensive. Openness leads to greater economies of scale and can get to universal digital access without being cost-prohibitive. Of course, even with digital assets there is a need for service providers that offer safe and secure access. However, this could be achieved through open digital wallets and leverage open source technology, which is more scalable, accessible and cheaper, as compared to a system where corporations function as intermediaries.
The Balance Between Openness and Oversight
The opportunity for people, organizations and developers to participate in an open network inevitably leads to greater innovation, products and general utility. Like any network, the utility of a financial system grows logarithmically to its users. This follows Metcalfe’s Law that as the network grows in users, so does its value. More open networks grow faster and become larger from greater participant adoption.
However, there are costs as well. A system with complete openness would inherently have fewer barriers that some may consider to be protections for participants and users. With fewer barriers, it could be argued that there is greater potential for fraud and illicit usage of the system. On the other hand, high levels of oversight and restrictions degrade utility and are inhospitable to adoption. There is a balance to achieve.
However, at the height of openness, the incremental utility of openness degrades as the potential for misuse increases, perhaps even becoming negative. Today, the financial system is at the lower end of the utility curve with a less open system. I believe that we can achieve much greater utility without sacrificing much, if any, user protection. Frankly, the oversight in today’s closed system is not achieving the controls intended given the enormous fines ($10bn+) financial institutions are paying each year. Some of the potential adverse effects of openness — such as fraud and illicit usage — can be mitigated by moving the dial on other attributes like centralization and anonymity/privacy, or by adopting a system-wide construct for ethical conduct.
Social constructs are innate to human behavior. By ascribing to a standard set of principles defining ethical and unethical behavior, participants in an open system can promote good behavior within an open system without jeopardizing the innovation and equitable access that comes with openness. ADAM’s Code of Conduct is a prime example of this.
Why This is Important Today
Inequality and income disparity are on the rise and our financial system exacerbates and perpetuates this divide. Even though our world has become digital, the current banking system is expensive, leaving out huge swaths of the population or only offering them exorbitantly high cost services like high fee accounts, check cashing services, prepaid cards or payday loans. We must democratize access to the system or the divide will only deepen.
Additionally, it is critically important for innovation in this space to happen in a free market. Openness and competition are core American values, and the United States thrives when its citizens and companies can compete in open environments (like the internet) rather than closed ones. Today, the whole world benefits from the US dollar serving as the reserve currency and incumbent money network. It’s a powerful place to be, but in order to continue to be competitive against state-sponsored digital innovation in other countries like China, it will have to evolve into an open ledger format. Otherwise, the dollar risks getting replaced by a digitized currency under the geopolitical influence of another, and perhaps less benevolent, government.
Finally, it is of critical importance today that we innovate in the area of openness of money because our monetary system is just as prone as any other industry to suffering from the phenomenon of Innovator’s Dilemma (Clayton Christensen) in which successful companies lose their market leadership to disruptors. We’ve seen this happen in telecommunications, media, energy, air travel and other large infrastructural systems. The large incumbents became disrupted by new technology because they are too slow, or too incapable of, adopting these technologies before getting disintermediated or disrupted. Given all the innovation currently underway in digital, open, token-based economies and the utility they bring it is absolutely possible for this to happen to our current monetary system. If we do not respond to and embrace these new technologies quickly enough, innovations like bitcoin, digital gold or central bank digital currencies could go from seeming implausible to inevitable in a short period of time. Government efforts to stifle these new technologies will only assure that assets will flee to more accommodative, and perhaps more problematic jurisdictions. We must recognize that we are currently in the midst of this process and we urgently need to consider rational policy choices.
Open ledgers are here to stay and provide a net benefit to society by increasing inclusiveness, decreasing costs to the system and participants, increasing speed, efficiency and enabling greater rates of innovation and therefore functionality. We need to accept this inevitability and harness the power of open ledgers for the greater good.
Many thanks to the following Paxos friends and advisors for reviewing this essay: Sheila Bair (board member), Joshua Rosner, Jerry Brito and Michelle Bond.
1American Institute for Economic Research, “How Much Cash is Used by Criminals and Tax Cheats?” – William J. Luther, February 7, 2017, retrieved from https://www.aier.org/article/how-much-cash-is-used-by-criminals-and-tax-cheats/.
2Bank for International Settlements, “US dollar funding: an international perspective,” June 2020, retrieved from https://www.bis.org/publ/cgfs65.pdf.
3Testimony of Jennifer Fowler, Deputy Assistant Secretary, Office of Terrorist Financing and Financial Crimes, Senate Judiciary Committee Hearing, November 28, 2017, retrieved from https://www.judiciary.senate.gov/imo/media/doc/Fowler%20Testimony.pdf.
4FDIC, National Survey of Unbanked and Underbanked Households, 2017, retrieved from https://economicinclusion.gov/surveys/2017household/.
5World Bank Group. (2017). The Global Findex Database, retrieved from https://openknowledge.worldbank.org/bitstream/handle/10986/29510/9781464812590.pdf.