As I described in my introduction to this series, a grasp of the principles of Currency exchange is crucial for understanding many of the subtleties of Better Money.
In this post I'll describe basic principles and provide an illustration of why such principles matter with respect to how a monetary regime is conceived. The focus is on Currency exchange services provided as a business. These principles may not pertain to a private individual unloading some modest amount of an unwanted Currency on a friend or family member willing to offer a few bucks for it in a casual one-off transaction. Likewise, while such an exchange could be thought of as Person-to-Person, I am reserving the term P2P exchange for a more structured market arrangement that is a topic unto itself.
The players
Let’s start with a relatively simple example - the walk-up counter at an airport where you exchange cash. The exchange service in this scenario acts as Market Maker. This means they proffer terms in accordance with which they offer to perform exchanges. These terms, at a minimum, include:
- a list of Currencies they deal in,
- payment methods accepted (e.g. kiosk/cambio typically accepts only cash)
- exchange rates at which they will buy and sell,
- other fees they will charge, plus,
- additional stipulations pertaining to their warranty of liquidity (such as maximum order size).
Their counterparty, the customer, is cast in the role of Price Taker.
The term Market Maker carries additional connotations in other contexts but here the main takeaway is that by setting the pertinent exchange rate the Market Maker establishes a take-it-or-leave-it price or rather, as detailed below, pair of prices. The customer qua Price Taker, may accept these terms or shop around for another provider offering better ones.
Exchange rates
Exchange rates are essentially prices at which a provider of exchange services offers to buy or sell a particular Currency, expressed in terms of the other Currency being exchanged. An alternative way of referring to the provider's selling price is the Asking price, (or "Ask price", or just "Ask"). The other price, always lower, is commonly referred to as the “Bid”.
Whatever you call them, the difference between Bid and Ask is referred to as the Spread.
A Market Maker charges a Spread. A Price Taker pays the Spread. This Spread typically comprises the primary source of revenue for the Market Maker's exchange activities.
The Currency Exchange Transaction
Once agreement on terms is achieved and mutual commitment to proceed is signified the Currency Exchange Transaction can proceed.
Every Currency Exchange Transaction entails two payments, one in the Funding Currency, the other in the Fulfillment Currency. The customer makes the first payment, the Funding Payment, to the provider of exchange services. Then, when the provider is adequately confident the Funding Payment is good, a Fulfillment Payment is made from provider to customer.
Over-the-counter exchanges of physical cash such as the airport example are completed in the space of a few minutes. Currency exchange becomes more challenging if the provider accepts Funding Payments or makes outbound Fulfillment Payments by means of conventional remote payment systems such as bank wire. This situation arises, for example, with online provision of Currency exchange where the customer is not physically present. Reliance on conventional remote payment systems adds delay (latency), drives up cost and exposes the recipient to the risk of payment reversal (repudiation).
Trading balances
Every Fulfillment Payment draws down the provider’s trading balance of the Fulfillment Currency. Every Funding payment increases the provider’s balance of the Funding Currency.
The provider must be mindful of trading balances, avoiding depletion that would impede timely fulfillment of an Exchange Order. Commonly the provider formulates internal business rules specifying relative target proportions for maintaining trading balances of the various Currencies in which it Makes a Market.
For example, a provider making a market in four Currencies may seek to maintain nominally equal values, 25% in each, with a band of acceptable deviation perhaps ranging from 10 – 40%. By providing a two-way market with each Currency, the provider ideally replenishes trading balances drawn down by Fulfillment Payments with incoming Funding Payments in that Currency. In this balanced situation, the exchange business maximizes revenue, capturing the full exchange rate Spread.
In order to avoid or correct imbalances that threaten to deplete trading balances of a Currency, the provider has two primary options:
- Adjust the terms offered to customers.
- Resort to an external market, as a Price Taker.
Adjusting terms
In routine circumstances the provider may keep trading balances in trim by adjusting Bid and/or Ask rates. For example, an exchange service Making a Market between USD and EUR facing depletion of EUR may try to reduce the volume of outgoing Fulfillment Payments in EUR by raising the Ask rate at which it sells EUR. It may simultaneously raise the Bid rate at which it offers to buy EUR, seeking a larger volume of incoming Funding Payments of EUR. Setting exchange rates entails complexity because the Exchange Provider must also pay attention to the rates of other providers. Significant discrepancies between prices offered by different providers create arbitrage opportunities for canny Price Takers that, if exploited, could be costly to the Market Maker.
During intervals of increased volatility, an exchange service may also widen its Spread or lower its limits on maximum order size as self-protective measures.
Resort to an external market
At times the provider may encounter an imbalance of demand that leads to an excess or shortage of a Currency despite exchange rate and other adjustments. This is especially likely during periods of increased market volatility. For example the exchange value of JPY may be falling precipitously relative to USD. During the plunge, even though exchange rates are repeatedly adjusted, an imbalance may result if most customers are dumping JPY on the Exchange Provider and few or none are buying it. Each Funding Payment causes a greater excess of JPY and each Fulfillment Payment further depletes USD holdings. The Exchange Provider may find the only way to correct the surplus of JPY and to replenish USD is to resort to an external market. Some external provider may have the capacity to buy the excess JPY and pay for it with USD. In this circumstance, the exchange service is likely to find itself in the role of Price Taker, paying the Spread of this other provider capable of Making a Market in that exchange rate environment.
Currency exchange as a channel of adjustment
There is a substantial literature examining what is called "demand for money". It is a fascinating and rather complex topic and I intend to eventually weigh in with some opinions regarding the intersection of this phenomenon with the doctrines of Better Money.
The concept of variations in demand for money in general though is distinct from another demand-related dynamic pertinent to Currency exchange.
How do monetary systems adjust to variations in demand for particular Currencies relative to other Currencies?
As a general rule, I propose that with all brands of Real Money a sustained decrease in relative demand ultimately leads to a decrease in the proportional amount of that Currency in circulation relative to other Currencies. This decreased relative demand does not, however, cause a collapse in the exchange rate for the Currency in question (provided that the Monetary Authority is not insolvent).
With a major reserve Currency such as USD the pathway from decreased relative demand to a decrease in circulation is complex and circuitous. Adjustment is not automatic and may be delayed for a considerable period by discretionary interventions on the part of the Monetary Authority. Pending corrective adjustment, an excess of money supply beyond the needs of the real economy may manifest as a combination of asset bubbles and decreased monetary velocity.
With Better Money, the feedback loop from decreased demand to a decrease in money supply is direct and automatic. End users dump unwanted money on the exchange markets. Retail providers of exchange may experience trading imbalances temporarily causing excessive accumulation of the out of favor Currency. The retail providers respond by resorting to external markets, unloading their excess on wholesale providers who in turn may turn to Primary Dealers. The Primary Dealers can never be overwhelmed; unwanted balances can be returned to the Issuer for Redemption, a process that decreases the amount of Base Money in circulation. The most dire "run" would simply result in an orderly liquidation of the money supply, without significantly impacting exchange rates.
In contrast, as touched on in my Real Money post, no such adjustment mechanism exists with play money such as Bitcoin. A precipitous decrease in demand would not (can not) trigger a decrease in money supply. It would not even resemble a "run on the bank" since even a failed bank has all sorts of assets available to the receiver overseeing its liquidation. Exchange markets adjust to a collapse in demand for play money with a collapse in exchange rates.
A collapse in exchange rates for play money still understates the wreckage that would ensue. Recall that a provider of exchange services facing a severe imbalance in demand may resort to an external market, though such resort may be costly. Play money lacks the ultimate external market - an Issuer with assets sufficient to buy back all of its Monetary Liabilities. A panic could lead to exchange services choking on the incoming deluge of unwanted play money and depleting their trading balances of Real Money Fulfillment Currencies. The result would be default as these exchange services renege on trades they are incapable of fulfilling.
Our exploration of Currency exchange will next examine the institutional arrangements governing providers of Currency exchange services in the Better Money System. As you will see they are designed to enable immediate adjustment to fluctuations in demand for Better Money without disrupting its relative exchange value.
