Open Source Banking

The power to create money “out of thin air” through fractionalization of a bank’s reserve assets is the foundation of modern finance and its most effective mechanism for generating wealth. Ever since the end of the Free Banking Era (1860), this power has been increasingly monopolized by the nation-state, and shared with an increasingly small number of increasingly large financial institutions. Now that blockchain technology is producing alternative monies for almost zero cost, an abundance of monetary systems is once again becoming possible, and that abundance will lead to the democratization of fractional reserve lending and other banking functions.

The entities best positioned to benefit from the emergence of free/libre/open-source banking technologies are ones that have assets that could be used to back the value of their own currencies. This could look like a Free Banking Era reserve bank using an Ethereum cryptocontract similar to the one described in the post “how to build your own transparent bank on the blockchain”. This “bank” would engage in market operations to turn its pool of assets to create a “stablecoin”: a cryptocurrency designed to hold a stable per unit price over time.

The goal of a stablecoin is to maintain a consistent value so people will want to use it for transactions instead of buying it as an investment that they’d hold and try to sell for profit in the future. While cryptocurrencies designed to appreciate in value certainly succeed in bringing wealth to their holders, they fail to provide the public with an effective means of exchange they can use to engage in basic exchange: such as buying food at the supermarket.

Here’s how a stablecoin “bank” can work. A cryptocontract is established that makes a cryptocurrency (let's call them “tokens”) redeemable from a “bank” for the assets in its reserve. For example, the contract could say that each token is redeemable for at least 1 avocado, so if you send the bank one token, you get one avocado. As long as the bank is operational, its token has, at the very least, the value an avocado. If people value the token more than an avocado, they won’t redeem it at the bank. If they value an avocado more than they value a token, they will redeem it.

When the value of the token begins to go up too much, the bank would have to release more coins into circulation to compensate for the increase in demand. The method for releasing and distributing new money could be done in a variety of ways. It could be distributed centrally by using it to finance investments (ex. Loaning funds to avocado farmers in exchange for contracts for future production), it could be done in more decentralized ways by giving tokens to existing coin holders (ex. giving tokens to bank members) or giving them to network operators (ex. rewarding people who run servers with tokens.)

When the value of the token begins to go down, the bank has to buy up tokens to reduce the supply of tokens in circulation so prices go back up. There are a few ways to do this, such as buying tokens on the open market, working with vendors to organize discounts for using tokens and selling avocados for less than a token. Remember: the bank promises that a token is redeemable for at least one avocado. It could certainly be redeemable for two.

Avocados are, of course, not an ideal benchmark for value. Anyone who regularly buys avocados knows that their prices aren’t very stable. Prices in the US can easily range from $.50 to $2.50 depending on a variety of factors including the type of avocado, season, location and international trading dynamics. Indeed, the price fluctuations of commodities, including gold, make it impossible for any single commodity to back a price-stable currency. The Consumer Price Index (CPI), which the Federal Reserve uses to benchmark the value of US dollar, is calculated by analyzing the US dollar-price of hundreds of goods people tend to consume: milk, gas, prescription drugs, etc. The Fed uses that information to fulfill its two mandates: to maintain a low inflation rate and to encourage full employment through inflationary and other monetary policies. Instead of using the CPI to keep inflation near zero as Hayek would recommend for a private token currency, it tries to keep it around 3% per year. This inflation makes the US dollar a less than ideal benchmark for a price-stable cryptocurrency.

Another option for a benchmark is the International Monetary Fund’s (IMF) Special Drawing Rights (SDR), which holds a basket consisting of the four major global currencies: US dollar, Japanese Yen, British Pound and the Euro. At least one cryptocurrency project focusing on price stability is already using the SDR as a benchmark. The project, which is called Maker and run as a DAO on the Ethereum blockchain, keeps the value of their “stablecoin” cryptocurrency pegged to the SDR through market mechanisms organized by a central group. While this project succeeds in creating a price-stable cryptocurrency, it’s stability mechanism requires the the project to hold significant reserves of fiat currency on hand, making it expensive to maintain.

Instead of using fiat currency as a reserve, Maker or another “stablecoin” project could use a more diverse set of assets. Any asset that is relatively liquid can be used as a reserve item. Different people, groups and institutions have different access to different types of assets. Municipal governments could use tax credits as an asset to back their own cryptocurrencies. Corporations can use their products. Community groups can use tickets to local events. Nonprofits can use in kind donations they’ve received from supporters. In each instance, the entity providing assets to the reserve can, in exchange, get a valuable cryptocurrency they can use to offers loans, make investments, and award as grants and engage in other types of financial activities previously reserved for banks, national governments and formal financial service providers. Once the “reserve-backed stablecoin” gets into circulation, it increases the supply of the means of exchange available to that FLO bank’s community, facilitating economic activity and exchange, and providing more people with more access to capital.

This is quite a significant value proposition, but one that has, by and large, been overlooked by the public. One reason for this could be that creating a crypto-bank requires the synthesis of people who understand cryptocurrency with people who control real-world assets. People who understand cryptocurrencies are busy making lots of fiat money selling their talents to financial institutions or creating speculative cryptocurrencies that can be quite lucrative over time. The people with assets who could be leveraging these systems are busy enjoying their wealth and expecting financial service professionals to manage it most effectively. Within the often opaque world of cryptocurrency-powered financial technology (fintech), you will find cryptocurrency professionals and finance professionals working vigorously to apply stable-coin style systems to the challenges of modern banking. One of the first challenge banks are using crypto-contracts to solve is cross-border payments. The current SWIFT system is slow and expensive, and Santander estimates adoption of crypto-contracts could save the industry $20 billion per year by 2022.

That type of savings incentivizes the banks to employ as many crypto-contract specialists as possible, making it hard to assemble the type of team one would need to build the type of “FLO bank” being proposed in this essay. But this state of affairs won’t last forever. As cryptocurrency technologies continue to reduce the cost of developing this type of institution, and financial crisis continue to pressure people to develop new systems, the emergence of crypto-finance seems all but inevitable.