Updating Gresham

For an asset to be money, it must be a medium of exchange. In Awrey’s framework, it need not also be a unit of account or a store of value.

He distinguishes between “good money” and “bad money.” Two characteristics make a medium of exchange good money. One is that it exhibits a “stable nominal value.” The author explains, “A stable nominal value means that when you go to spend one dollar, euro, or peso, it is accepted as representing that precise value and not, for example, 95 cents.” To paraphrase, if the price of a loaf of bread is $5, handing over $5 will get you the loaf of bread. One wonders when handing over more or less than $5 would happen; perhaps during a period of hyperinflation sellers want more than the posted price, and during deflation sellers will accept less.

The other characteristic of good money is that it serves as a “means of payment.” If an asset serves as a means of payment, Awrey explains, “users should be able to quickly, easily, and securely use it within a relatively large network of individuals, households, businesses, and governments.” Dollar-denominated currency and dollar-denominated bank deposits are good money. Cryptocurrency is bad money because people use it in few transactions relative to all transactions.

A reader will encounter the term “monetary IOUs.” These are “debt contracts” between an institution and a customer. Awrey writes, “Bank deposits are the quintessential monetary IOUs: a contractually enforceable promise made by a bank to its depositors that serves as both a nominal store of value and a means of payment.” The law makes bank deposits the ultimate monetary IOUs. Ordinary bankruptcy procedures do not apply to banks. “Bankruptcy law is then replaced with tailor-made bank resolution frameworks,” Awrey informs us, that are “specifically designed to reduce the risk that depositors will have their money frozen or be forced to write down the value of their monetary IOUs.” Bank customers do not fear losses much, even if their bank fails. That is not necessarily the case with owners of cryptocurrency, stablecoins, or other monetary IOUs.

Readers will remember Gresham’s Law, the idea that “bad money drives out good.” Ostensibly, this means that if there are two currencies, one reliable and one not, people will hoard the reliable currency and use the unreliable. This notion is debatable, though: Why would anyone accept unreliable currency? It’s just as likely that reliable currency will drive out unreliable. Awrey tries to fix this conundrum:

First, during periods of institutional and systemic stability, where consumers are more sensitive to the benefits of good payments, bad money will drive out good. Second, during periods of institutional and systemic instability, where consumers are more sensitive to the benefits of good money, the resulting flight to safety means that good money will drive out bad.

Today, he writes, “Make no mistake: what we are witnessing is Gresham’s new law in action.” Central banks in the major economies have gained people’s confidence. As a result, bad money is crowding out good money and the implications are serious. If the economy becomes turbulent, people holding bad money may suffer from a decrease in its value. If the institutions creating bad money go bankrupt, financial crisis and deflationary recession may occur.

Awrey fears a crisis so severe that it causes government instability. Nevertheless, he believes that by designing appropriate regulations, consumers will reap the benefits of good money and good payments.

Renovation, Regulation, and Risk

Those unfamiliar with the evolution of money and banking will find it in this book; those already familiar may learn something new. For instance, “credit-based” money predates “commodity-based” money. Sometimes people primarily used commodity money such as precious metal coins. Other times people primarily used monetary “IOUs.” And sometimes both types of money circulated together. During one period, goldsmiths discovered that they could create monetary IOUs against their customers’ deposits of gold and silver, which the public adopted as a medium of exchange. Other significant developments include the central bank, the clearinghouse, and the “financial safety net.”

Banking is different. Bankers use leverage: They use debt to finance their acquisition of assets. Their primary source of funds (deposits) is short-term. Their primary use of funds (loans) is long-term. Bank liabilities and bank assets are mismatched another way: The deposits are liquid—that is, easy for depositors to withdraw—and the loans are illiquid—hard for the banks to effectively call in. These characteristics contribute to “bank fragility.”

Governments created a “safety net” to make banks safer, reducing bank runs and financial crises. The safety net consists of central bank lending in times of crisis, deposit insurance, and “special bankruptcy or ‘resolution’ regimes.” The safety net makes bank deposits good money. There are, however, unintended consequences. Bank depositors and other creditors neglect to sufficiently monitor bank management, which can use too much leverage and take too much risk. Thus, there are additional government interventions: reserve requirements, capital requirements, and bank examinations.

Having explained why banks are regulated, Awrey reasons that “the enormous costs of ongoing compliance with bank regulation and supervision can represent a formidable barrier to entry—especially smaller, technology-driven firms that we might expect to serve as important catalysts of innovation.” He puts it bluntly, “The US banking industry has been relatively slow to roll out a variety of new payment technologies.” His solution is to let entrepreneurs have a go.

Another phrase a reader will encounter is “new institutions and platforms.” These are the innovators in the shadow monetary system. One group is “stablecoin issuers” such as Tether, Circle, and Paxos. Another group is “cryptocurrency exchanges like Binance, Coinbase, and Kraken.” There are “peer-to-peer (P2P) payment platforms like PayPal, Wise, WeChat Pay, and Alipay,” and “mobile money platforms” such as Kenya’s M‑PESA.

These institutions and platforms apply new technology to payments. In conducting business, they “issue new and exotic types of monetary IOUs.” This is where Gresham’s new law becomes relevant. According to Awrey, “While the monetary IOUs of these new entrants may initially seem like close functional substitutes for good old-fashioned bank deposits, the reality is that many are an important and growing source of bad money.” We should be concerned that bad money will drive out good and precipitate a financial crisis.

The gist of the public’s problem is financial naivete. Consumers opt for good payments, acquire bad money, and take on risk without realizing it. If an institution goes bankrupt, regular corporate bankruptcy law will apply, and holders of the institution’s monetary IOUs will be surprised to lose much of what they thought was their “money.” To get both good money and good payments, institutions may self-regulate. “These private law strategies” that institutions may adopt “include contractual portfolio constraints, the use of trusts, bailment, and other property law tools, and structural separation.” Few firms self-regulate because some strategies, such as restricting their investments to the most liquid, least risky assets, reduce profits. Also, few firms self-regulate because of state regulations. States regulate “money transmitters” by stipulating the assets they may purchase, imposing minimum capital levels, and mandating reserves to pay off customers in case of insolvency.

Awrey’s Proposal

These regulations do not convince Awrey that the money transmitters, “a veritable Who’s Who of the shadow monetary system,” are creating good money for their customers that will be safe in the event of a bankruptcy. Thus, he shares his ideas for regulation.

His “blueprint for reform” has three features: a “payments charter,” an “open access rule,” and a “new governance structure.”

A traditional bank charter would remain in existence. New firms, however, could operate with a payments charter that establishes “a separate ring-fenced subsidiary—a payments entity.” The payments entity would issue monetary IOUs on the conditions that it refrains from financial intermediation, invests in “high-quality liquid assets (HQLA)” or “central bank reserves,” and refrains from issuing debt other than its monetary IOUs. In return for operating within those confines, the open access rule grants a payments entity “direct access to central bank reserve accounts.” “Open access” means new payment entities will have an expanded network of payers and payees, which will enable them to achieve economies of scale in delivering payment services and more effectively compete against banks. The new regulator would oversee both the open access rule and “long-term planning and investment in the technological infrastructure supporting the US payment system.”

Entrepreneurs are applying new technology in the realm of payments faster than the public can understand it and faster than legislators can regulate it. Awrey believes that if we adopt his proposal, several advantages would follow: Consumers would get good money and good payments. There would be greater stability at the firm level in the financial industry. (For illustration, the author describes how the failure of the crypto exchange FTX in late 2022 led to the demise of the commercial bank Silvergate the following year. Also in 2023, the failure of Silicon Valley Bank destabilized the shadow money operator Circle. The author figures his scheme would reduce the likelihood that the failure of a new institution would take down a conventional bank and vice versa.) The financial industry in general would be more stable. Awrey reckons that as new institutions grow, “thereby reducing our structural reliance on a small number of large incumbents,” the too-big-to-fail problem would become less threatening.

The author is confident that his plan would produce good outcomes, but he is not overconfident. He admits that “regulatory arbitrage” would be a problem. If “state money transmitter laws” remain on the books, new institutions may prefer that regulatory structure to his plan, which would severely restrict their investment options. To prevent that from happening, Awrey would have Congress redefine “deposit” so that the types of monetary IOUs new institutions create would fall under federal regulation. New institutions would have to choose “either a conventional bank charter or a new payments charter.” If state regulators do not impose similar regulations, institutions with federal charters would be barred from “accepting transactional deposits” from institutions without federal charters. One may wonder how new institutions that may only acquire funds by issuing monetary IOUs and may only use those funds to buy HQLAs or central bank reserves would make a profit. Awrey’s answer is that if a firm sells goods such as video games, consumers may use the firm’s IOUs to buy those goods. If a firm doesn’t sell goods, its payment services would have to be so good that consumers would pay “user fees” that cover costs.

Critics of this regulatory overhaul may argue that the banking industry would contract because of the new competition. Awrey recognizes that new firms issuing their monetary IOUs would compete against banks issuing their deposits, and he maintains that the competition would be good for consumers. Bank customers would have alternatives to bank deposits, but the safety net would remain in place. Critics may argue that competition between banks and new firms—coupled with new firms being barred from financial intermediation—would reduce business investment. The author downplays this possibility not least because nonbank financing is already on the rise and banks have alternative sources of funds besides deposits. Finally, he welcomes the possibility that technology firms such as Google and Amazon would enter the payments market, but he would not object to “separating payments from commerce.”

Awrey has faith in what his “legal engineering” can accomplish. He tempers that faith by imagining unintended consequences and how to deal with them. Economists, legal scholars, and financial regulators would benefit by engaging with his ideas. Legislators currently grinding out legislation on cryptocurrency and stablecoins would be wise to consider what he knows.