The Role of Currency exchange in Better Money, part 3 - Financial Institutions

Beginning in 2000, I and the other e-gold founders launched and then fostered a (second) new global industry – of independent businesses competing to provide Currency exchange services between privately issued alternative Currencies and conventional (government-issued) brands of money.

A dramatic learning curve ensued. It was a textbook example of market forces favoring providers who realized and implemented sound practices while quickly driving poorly conceived or crooked services out of business. (If you are writing that textbook feel free to reach out.)

By 2005 there were multiple exchange services in the US, UK, Europe, Australia, Africa and Asia Making a Market for e-gold capable of reliable prompt fulfillment of Exchange Orders at competitive Spreads. Many routinely handled orders in the 10-50k USD (or equivalent) range and some could readily take individual orders exceeding 100k USD in stride.

Other exchange services got it wrong. The worst were those determined to accept payment methods fraught with chargeback risk in exchange for e-gold – which featured payment finality akin to that of cash. In other words, they faced the risk that a Funding Payment might be reversed, even after sending out a Fulfillment Payment that could not be clawed back. These attracted a "tsunami of fraud" which, by facilitating reputation attacks against e-gold, were very damaging.

I felt a strong sense of deja vu when the Mt. Gox failure was in the news, echoing the "we-wuz-hacked!" alibi of bad apple exchange services that failed circa 2001-3. Then too unteachable and, in some cases, ethically impaired principals were overwhelmed by operating losses before themselves lapsing into a terminal phase of outright larceny.

The many lessons learned regarding sensible institutional arrangements for Currency exchange have informed the design of the Better Money System.

A number of System safeguards, applicable to all Members, form a framework in which participating Financial Institutions will operate: 

• Customer Identification/verification (CIP) and due diligence (CDD) measures must be successfully completed before System Permissions are extended;
• A wide range of near-frictionless constraints (channelization) will foster best practices on the part of customers, especially businesses, while impeding and flagging potentially abusive activity. 

Safeguards specific to Member provision of financial services include:

• The System Provider does not itself provide Currency exchange services (e-gold implemented this separation of roles in 2000);
• Prohibition on commercial provision of financial services (such as Currency exchange) except by approved providers,
• Enhanced Due Diligence (EDD) for Financial Institutions;
• Uniform standards for Financial Institutions, memorialized by contract with, and enforced by, the System Provider,
• Transaction Monitoring provides a System-wide backstop for Financial Institutions otherwise incapable of detecting exploits that entail structuring or flow paths involving multiple providers;
• Federated log-in (optional).

As we go along, I will elaborate extensively on all these topics. This post serves only as an introduction, narrowly examining two models of how Currency exchange services are provided in the Better Money context.

Exchange Provider contrasted to Depository Institution

Let's start with the distinction between what I call an Exchange Provider and a Depository Institution.  These labels are somewhat arbitrary in the sense that a Depository Institution providing currency exchange services could readily be regarded as an exchange provider. It's just that the transaction models of these defined Roles are distinct.  The primary differences between the two are:

• A Currency Exchange Transaction as provided by an Exchange Provider always requires at least one Spend. This is not the case with a Depository Institution – the entire exchange transaction is conducted by accounting entries involving only its own liabilities.
• An Exchange Provider does not hold customer value on account beyond the delays imposed by reliance on external remote payment systems plus transient accounts payable liabilities. A Depository Institution, in contrast, holds customer value on account and this comprises an integral part of its business model.

Exchange Provider

Let's look first at an Exchange Provider.

"Currency Exchange Transaction...always requires at least one Spend."

An Exchange Provider, as I define it, Makes a Market for the Base Money form of AUG, which is only conveyed by Spends. 

This should be pretty obvious. I'm mostly mentioning it to set the stage for my subsequent discussion of the advantages a Depository Institution enjoys in its provision of exchange services. 

If someone wants to exchange some USD for AUG, the Currency Exchange Transaction consists of:

1. First, the customer makes a Funding Payment of USD (by some means) to the Exchange Provider.
2. Then, once satisfied the payment is good, the Exchange Provider completes the transaction with a Fulfillment Payment—a Spend—of AUG to the customer.

The opposite, AUG for USD, is a mirror image. The Spend comes into play with the Funding Payment.

"Exchange Provider...does not hold customer value on account..."

As we saw, an exchange service such as the airport vendor described in part 2 deals in cash. The entire Currency Exchange Transaction is completed in the space of a few minutes, before the customer leaves the counter. It's different though with Exchange Providers such as online services that accept payments via conventional remote payments mechanisms. Existing remote payments systems introduce latency (delay). With bank-administered systems there is a gap between payment leaving the payer's account and showing up as available funds in the recipient's account. There may also be an interval of minutes, hours or days between receipt of a Funding Payment and the outbound Fulfillment Payment. For some of the overall interval (skipping over detailed particularities of the accounting) the Exchange Provider may have an Accounts Payable (AP) liability. 

But that isn't what I mean by an Exchange Provider model that would entail holding customer value on account. I'm referring instead to a business model where the Funding Payment might be advanced well in advance of Exchange Order entry and even the Fulfillment Currency might remain on account with the exchange service.  

In the Better Money System, the System Provider will not, as a rule¹, classify/credential Financial Institutions as Exchange Providers if they have business models that entail holding customer value on account. There are two mutually reinforcing reasons:

1. Holding customer value on account is more challenging (for the provider) and potentially risky (for the customers) that it may seem. 
2. Mindful of these risks, the regulatory regime for Money Services Businesses does not contemplate the business of a Depository Institution.

Holding customer value: fiduciary considerations

Safeguarding other people's money is hard enough in more normal economic times. In the current interest rate (and economic, and monetary) environment the risks are increased. This is an issue, whether recognized or not, not only for emerging models for online exchange and trading but also for online gaming operations such as the fantasy sports genre. Not uncommonly such businesses overtly accept "deposits" and support "withdrawals". These practices do not simply invoke the terminology of banking; they engage in some of the very activities that make banking so risky and which historically have served as the major premise for governments to intervene with their ever-growing corpus of legislation and regulation.

The problem (of a non-bank holding customer value) is similar to one every bank faces. The business accumulates liabilities (deposits), some of which it must stand ready at all times to pay back on demand. What assets can it hold that afford it the wherewithal to meet these obligations?

Imagine you are running some innovative new payment-related (or sports betting) business and your model entails holding customer value on account. Like a bank, customer deposits (your liabilities) fund your asset portfolio. Wouldn't it make sense to generate a bump in operating income by investing a portion in remunerative (income-producing) assets?

This was a significant aspect of (one of) Paypal's early business models. In 2000, 14% of total revenues came from "Interest from funds held for others". During the six months ended June 30, 2001, their total amount due to customers grew to over $100 million. The assets held against those liabilities were invested generating an average annual return for Paypal of 5.11 %.

Multiple states raised a fuss along the lines that Paypal was engaged in unauthorized banking. One outcome was that Paypal abandoned its strategy for generating income from investing customer deposits and switched more fully to a fee-based model. Assets backing customer liabilities were rolled over into non-interest bearing bank accounts and over time the whole notion of holding value in one's Paypal account was de-emphasized as they modulated into becoming a credit card intermediary².

Why were the states alarmed? The problem is that investing to generate income (or any other goal, such as capital gains) is risky. Interest bearing debt instruments are subject not only to default risk but a range of other risks relating to market conditions and prevailing levels of interest rates. I will discuss these at length in later posts.

Suppose then that a business holding customer value on account eschews the risks attendant to investing per se and instead holds all assets in demand deposits with banks. This still potentially puts their customers at greater risk than if they had their money on deposit in their own bank accounts. How so?

Contrast two scenarios. You have, say, $100,000 in your own checking account with an actual bank. It is FDIC insured, well within current limits. But what if you have $100,000 on deposit with some non-bank that, in turn, is holding all of its money on deposit in a bank account such that the balance far exceeds FDIC insurance coverage limits? Let's assign some numbers to the scenario. Suppose they have $5 million in their bank account and their bank fails and goes into receivership. Worst case, they might end up with $250,000, 5 cents on the dollar, available to honor their customer obligations. You, as their customer, might be able to pull out $5,000 of your $100,000. 

There are of course all sorts of devices (e.g. brokered deposits or even "CDARs" (Certificate of Deposit Account Registry Service)) that would enable a business to spread around its deposits such that a higher proportion or even the entire balance is covered under FDIC guidelines.  Maybe some particular online entity that holds customer value on account is really really good with regard to prudential arrangements and can adroitly navigate these complexities.

But how would you know? Like banks, they may impose all sorts of terms-of-use restrictions on their customers but utter nary a peep regarding the policies and practices they observe to safeguard customer value. Normally, entities that solicit debt or equity investment from the public (mutual funds, for example) are obliged to offer prospectuses detailing how they will use/hold/invest the money. Banks don't have to do that - they can borrow without prospectus. But bank-like lack of disclosure is not defensible for exchange service (or trading platform, or fantasy sports) operations that hold customer value on account.

Holding customer value: regulatory aspects

The Better Money business rules require, with respect to participating Financial Institutions, that only a:

• depository institution as defined by 12 U.S.C. § 3201(1) (i.e., some sort of bank),or,
• broker or dealer as per 15 U.S.C. § 78c (and eligible for SIPC insurance), or,
• member of the National Futures Association (NFA) registered with the Commodity Futures Trading Commission (CFTC) as a Retail Foreign Exchange Dealer (RFED)

(or equivalent jurisdiction-specific regulatory provisions in the case of non-US Financial Institutions) may be credentialed by the System Provider to perform the Role of Depository Institution. In terms of the basic economic logic, this means banks or institutions with bank-like regulatory safeguards.

Application of this restriction to Financial Institutions in the Better Money System requires drawing a distinction between business models that entail holding customer value as an integral element vs. transient and incidental holding of  customer balances. (Note also, that this discussion of Financial Institutions does not pertain to a Member such as an attorney or accountant that/who may be providing escrow services to clients. Escrow entails its own complexities.)

In the US, most Financial Institutions with models congruent with the Exchange Provider model would be classified as Money Services Business (MSBs). MSBs are regulated at the federal and state level. Licensing of MSBs, when required, is handled by the various states. Many of these states specify a range of assets eligible to be held by an MSB while a money transmission transaction or stored value/payment instrument is "outstanding". The usual regulatory term for this designation/categorization  of assets is Permissible Investments.

The combined logic of specifications of what "outstanding" means and the sort of assets that may be held against outstanding liabilities of an MSB does not contemplate the business of a Depository Institution. Depository institutions are bound to more stringent standards virtually across the board. This is due to the fact, noted above, that holding customer value on account in a way that maximally assures it can be paid back when demanded or due is subject to a Pandora's box of ways to screw up.

So, to summarize, the Better Money System:

• draws a distinction between the Roles and business models of Exchange Providers and Depository Institutions,
• requires that only a depository institution or Retail Foreign Exchange Dealer as defined by law can be credentialed as a Depository Institution as Better Money defines the Role;
• will not credential a would-be Exchange Provider that holds customer value on account much beyond the latency imposed by its reliance on conventional remote payments systems;
• imposes this restriction to avoid the risk of a non-bank holding value on account messing up and defaulting on its obligation to pay customers back (and also because such a restriction is congruent with regulations that appropriately address the same concerns).

Multi-Currency Accounts:  How Depository Institutions provide AUG Currency exchange services

In the US and many other parts of the world there currently isn't much of a business case for a bank to offer multi-Currency accounts to retail depositors, i.e. regular people. Multi-currency accounts, when provided by banks, are typically a service offering targeted to high end customers such as companies with income/expenses in multiple Currencies. Regular people don't have much call to mess with foreign brands of money except when they travel abroad and need some pocket cash. (People in jurisdictions where there are acute concerns about the local Currency might constitute an exception. Unfortunately such places not uncommonly discourage their citizenry from having access to hard foreign currency accounts.)

The emergence of Better Money will change that (in jurisdictions where permissible). All sorts of people may like the idea of having a multi-currency bank account. Imagine, for example, if your online banking interface featured USD and AUG subaccounts.

The USD sub-account would be conventional, affording the usual banking services:

• ATM/debit card,
• checking and access to other existing remote payments capabilities,
• (optional) overdraft protection,
• FDIC insurance.

The AUG sub-account, in contrast, would function primarily as:

• an alternative store of value,
• an efficient gateway between the conveniences afforded by banks and the transaction advantages of the Base Money form of AUG.

With a few clicks, AUG deposits could be exchanged for USD and vice versa. Let's look first at this exchange process.

Currency exchange as provided by a Depository Institution

 From the depositor's perspective, Currency exchange is simply a matter of using the online banking interface to specify "I want to exchange xxx.xx amount of my USD for AUG" (or "...AUG for USD").

For the Depository Institution, fulfillment of the exchange is accomplished entirely by book entries involving only the liability side of its balance sheet. No Spend is required for either funding or fulfillment. In addition, the more balanced the bank's exchange book (i.e. the closer USD->AUG volumes match those of AUG->USD exchanges) in a given interval of time, the greater the possibility for realizing efficiencies due to netting.

Figure 1 (link will open in new tab) illustrates an example where three customers enter exchange orders.

A depositor (Customer A) draws from her USD deposit balance to acquire AUG in deposit form. Two other depositors (Customers B and C) draw down their AUG balances to acquire USD in deposit form, let’s say to plump up the amount of USD available via their ATM/debit cards. No actual Spends are required, so neither depositors nor the Depository Institution have to bear the cost of a Spend Fee.

And as it happens, the three transactions in our example cancel each other out from the Depository Institution's perspective. The amount of AUG bought by Customer A equals the sum of that sold by Customers B and C. The Depository Institution realizes revenue of $32.00 USD for an automated series of transactions—a few processor cycles on a server—reminiscent of the Dire Straits lyrics "Money for Nothing" (and clicks for free?).

Of course USD-->AUG and AUG-->USD exchange volumes would not always match and the Depository Institution would have to manage its asset portfolio accordingly.

But what if a depositor wants some of her AUG in Base Money form, the form that circulates only on the Better Money Settlement Platform?

Withdrawals and Withdrawal Spends

She would simply make a withdrawal from her AUG subaccount. A withdrawal of AUG consists of an instruction to her bank to draw down her AUG balance and make a Withdrawal Spend from the banks's Better Money System Account to hers. In other words, she'd select "Withdraw AUG", probably from a dropdown menu, and specify the amount. A withdrawal and Withdrawal Spend is the mirror image of the process of making a deposit by means of a Deposit Spend as illustrated in Figure 2 below.

Now let's back up and look at the scenario where someone is starting with conventional money (e.g. USD) in a bank account and wants to obtain AUG in Base Money form. National Currency to AUG Currency exchange as provided by a Depository Institution combined with an AUG withdrawal is a convenient and cost effective way of obtaining the Base Money form of AUG.

• The exchange of USD for AUG (in deposit form, as per Figure 1) should be fulfilled immediately.
• The AUG withdrawal order should also be fulfilled immediately.

Any Financial Institution that meets the Better Money requirements for a Depository Institution and wishes to be credentialed as a Depository Institution, must enter into a Supplemental Agreement for Depository Institutions with the System Provider. This entails (among many other things) a service level agreement that includes a warranty of timely fulfillment of orders of withdrawal.

Deposits and Deposit Spends

Let's examine the use case of a deposit. Suppose a Better Money System Member receives some Spends of AUG for whatever reason. There are two general reasons the Holder may elect to deposit the AUG in a Depository Institution.

1. Better interest rate. AUG in Base Money form is a wasting asset. That is, it yields what amounts to negative interest due to the System's assessment of Account Maintenance Fees. In this respect it is very similar to holding gold bullion in Allocated Storage. A Depository Institution may, in contrast, find it worthwhile to bid for AUG deposits since their provision of exchange services is so lucrative and since Deposit Spends enable them to acquire AUG reserves at a low cost basis (Spot). But even a zero interest rate is higher than a negative one. 
2. Faster, cheaper exchanges. A Depository Institution should be able to process and fulfill AUG->USD exchanges faster and at lower cost (for its own depositors) than an Exchange Provider.

Figure 2 (link will open in a new tab) illustrates the two stages of a Deposit with a Depository Institution.

First the depositor makes a Deposit Spend. This is initiated from the Depository Institution's online banking interface which integrates the Better Money System's Shopping Cart Interface. The Deposit Spend automatically is properly routed to the Depository Institution's Deposit Receipts Account and a notification alerts the Depository Institution to process the deposit. 

Second, the Depository Institution credits the depositor's account.

In the next post, I will wrap up this series on Currency exchange with an introduction to the Role of Primary Dealer as implemented in Better Money.

1 An AUG --> national Currency exchange where the Fulfillment Payment consists of loading value onto a conventional debit card is a special case that involves generally well conceived safeguards.

2 Sometime in 2012 , however, PayPal returned to generating income by investing customer deposits, purportedly due to changes in the law in California extending the reach of money transmitting regulations, which continues to be the case as of this writing .