Virtual Liquidity---An Elusive New Form of Liquid Asset

March 22, 1999

Book Review
James Case

Virtual Money: Understanding the Power and Risks of Money's High-Speed Journey into Electronic Space. By Elinor Harris Solomon, Oxford University Press, Oxford and New York, 1998, 298 pages, $27.50.

The title of this unusual book is inspired not by the notion of a virtual computer, as I expected when I plucked it from a display table in Toronto, at the 1998 SIAM Annual Meeting, but by the notion of a virtual subatomic particle. Solomon explains the concept---originally put forth by Feynman---as follows:

"Electrons always have a cloud of virtual particles surrounding them. An electron is always sending out these virtual photons, but they don't really exist until they are grabbed by another electron. When this occurs, the virtual photon becomes a real photon that kicks the two electrons apart. In the meantime, before the photon self-destructs, the little particle can do such impressive things as tunneling over the edges of glasses or out of black holes or the nuclei of atoms."

What her explanations lack in precision they often make up for in enthusiasm and visual imagery.

Solomon is a well-known authority on bank regulation and an expert on electronic funds transfer (EFT). Having written often, lectured internationally, and edited two books on the subject, she was the natural choice to write the entry on EFT for the scholarly and authoritative New Palgrave Dictionary of Money and Finance. For these and other reasons, the prospective reader can have confidence in the facts concerning the world of electronic finance as she presents them, and should be prepared to indulge her excursions to the frontiers of modern physics, which plainly fascinate her. Quotes from the popular writings of Feynman, Gell-Mann, Hawking, Heisenberg, Mandelbrot, Doyne Farmer, and James Gleick are sprinkled throughout her account.

The book begins with a discussion of money in its most primitive forms, among them livestock, Native American wampum, Yap Island wheels of stone, and the cartons of Chesterfields and Lucky Strikes that served as currency in post-World War II Europe. This discussion is followed by descriptions of gold-transfer procedures at the Federal Reserve Bank of New York, and of the mini-museums of money and banking maintained by some of the world's larger and more prestigious banks. Of particular interest are the "Coins of the Ancient Mediterranean World" exhibit at the Federal Reserve Bank of Philadelphia, which includes specimens minted by Alexander the Great and Ptolemy I during the fourth century B.C., and the Currency Museum of the Bank of Japan, which has some of the first gold coins minted (A.D. 708) and the first paper money circulated (A.D. 1600) in Japan.

Although the Assyrians, Babylonians, and Ancient Greeks all practiced simple forms of banking, and although relatively full service banks were established in Venice (1171) and Genoa (1320) during the late Middle Ages, the goldsmiths of the European Renaissance were really the world's first modern bankers. They got into the business, naturally enough, when people started to leave gold with them for safe keeping, even when it was not to be fashioned into ornaments. Such depositories almost had to emerge, as travel alone or in small groups was famously unsafe in Renaissance Europe for those suspected of carrying even modest riches. It was equally natural for the smiths to observe that, whereas the total amount of gold on deposit with any one of them varied from day to day and week to week, it tended to do so within predictable upper and lower limits. Hence, they could safely lend out at interest any amount up to the lower limit on the number of ounces (or shekels, or livres) ordinarily in their possession.

So lucrative did the practice become that the more aggressive smiths began to solicit additional deposits, and to offer interest on them. In so doing, they were in effect "creating money"---while the sums lent out at interest were never removed from depositors' accounts, they appeared as if by magic in borrowers' accounts, from which they passed into circulation. Because money cannot be in two places at once, one is forced to conclude that additional sums are created in the course of such transactions. From time to time, word got around that a particular "bank" had become overextended, and a "run" on its assets would take place. If unable to meet depositors' demands, the unfortunate banker was in real physical danger. In Renaissance Europe, as later along the American frontier, angry lynch mobs treated defaulting bankers as the moral equivalent of horse thieves.

What emerges from the foregoing analysis is that money is little more than a list of locations or "accounts" in which specified sums are certified to reside and from which they can emerge on short notice to pay bills and satisfy creditors. The Federal Reserve recognizes several gradations of money and keeps elaborate records of the whereabouts of supplies of each. The measure of the money supply known as M1 consists of (1) coins and paper money, (2) traveler's checks, and the "demand deposits" kept in (3) checking accounts or (4) accounts of certain other types against which checks can be written. The more inclusive measure known as M2 differs from M1 only in its interpretation of the phrase "on short notice," since it comprehends such semiliquid assets as savings deposits, small-denomination time deposits, money-market funds, and a few other stores of value held mainly by financial institutions. M3 consists of M2 plus large time deposits, term Eurodollars, and certain institution-only money-market balances, while L includes M3 plus all other tangible liquid assets. At 4:30 P.M. each Thursday, the Fed publishes M1 and M2 for the previous week.

At one time, controlling the growth of the money supply was considered by many to be the most important function of the Board of Governors of the Federal Reserve System in its fight against inflation. But that thinking has changed, in large part because the money supply has become increasingly difficult to measure. In addition to the uncertainty as to which of the above series constitutes the most relevant measure, the emergence of electronic money, or e-money, increasingly complicates the issue. The extent to which it does so is indicated in Figure 1.

In 1995, as shown in the figure, more money changed hands electronically than by check, and by check than in the form of cash. Yet cash transactions far outnumbered check transactions, which in turn outnumbered purchases made with electronic money. International transactions follow a similar pattern. The inversion is due to the fact that the important "players" in financial markets switched over long ago to electronic payment systems. Indeed, the second generation of technology is already in place, as dedicated phone lines and hardwired telecommunications links have been replaced by faster satellite and fiber-optic systems.

It is here that Solomon's concept of virtual money becomes illuminating. Countless opportunities are generated, in the course of these national and international interactions, to create money---more or less as the goldsmiths did---by putting it into circulation without removing it from existing accounts. Any time funds are received one day and need not be delivered until the next, they can safely be lent out until daybreak, at often astronomical (by APR standards) rates of "overnight" interest.

Each such opportunity, in that it creates no actual money until exploited, can be regarded as a virtual act of (money) creation. Nobody knows, at any given time, how many such opportunities exist, how large they are, or what fraction of them will ever be exploited. Traditionally, the right to create money has been reserved by law unto banks. But at present, any number of nonbank institutions have the opportunity to create money, and nobody seems to know how many of them realize their opportunities. In other words, technology has created a new form of liquid asset, one that might be termed "virtual liquidity" (VL). But nobody seems able to measure VL, or to specify the whereabouts of such assets. Bank regulators worry whenever money begins to circulate without their knowledge.

At present, large-dollar transfers usually follow one of two routes. The one favored for large domestic transfers continues to be known as Fedwire, although it has long since abandoned the Morse code and telegraph wires with which (in 1918) it began. Like everyone else, Fedwire now favors fiber-optic cable and Internet-style packet switching and technology. As in the past, the purpose is to transfer reserve balances (deposits at a Federal Reserve Bank) in real time by dedicated wire, between private "corresponding" banks.

Value transfers made by Fedwire are always direct, final, and irrevocable. The amount transferred has grown from a paltry $2.6 trillion in 1977, to some $223 trillion today. Compare that figure with the national debt, which lies somewhere between $5 and $6 trillion. The Clearing House Interbank Payments System (CHIPS) is run by private banks out of New York. Its focus is international, and its volume has jumped from $16 trillion in 1977 to more than $310 trillion today. CHIPS usually handles foreign exchange and other big-ticket international transfers. Net settlement is in dollar reserves through the Federal Reserve Bank of New York. The formal loss-sharing agreement between the approximately 130 CHIPS participants is backed by dedicated collateral held on a custodial basis at the Federal Reserve Bank of New York. The bulk of the transactions are carried out by 40 or so of the more active members, on behalf of the rest, which include major foreign banks.

Solomon, who began her career in the Antitrust Division of the Department of Justice, where she worked mainly on bank-related matters before moving to the Federal Reserve, points out that networks of all descriptions are historically proven difficult to regulate. Since the railroad rate-fixing scandals of the 1880s, the airlines, the trucking companies, the oil and gas pipelines, and the telephone company have been the targets of any number of bitterly contested antitrust disputes. Now the Internet, and proposed schemes for transferring money over it, promise to provide the sternest challenge yet to central bankers' ability to maintain sound national (and/or regional) currencies without becoming a drag on economic growth. A particularly vexing issue is that of money laundering, on national and international scales, and Solomon devotes an entire chapter to the subject. She also directs the interested reader to more comprehensive sources, including at least one do-it-yourself manual.

Although credit cards and debit cards are by now familiar to all, and prepaid "electronic wallets" are well into the test-marketing stage, the retail use of the Internet for money transfer is just getting off the ground. Quite a few banks offer accounts that enable the holder to access by e-mail more or less the same services available at a wall-banker-such as the transfer of funds between checking and savings, or the payment of local taxes and utility bills. But the range of such services seems to be expanding very slowly. Large East Coast banks have been forced to impose a $2 service charge each time the holders of such accounts require the services of a teller, either in person or by phone, because account holders have been slow to exploit the power of the new services. The banks justify the charge by pointing out that customers who want to deal with flesh-and-blood tellers can do so through ordinary accounts, which are significantly more expensive. The jury is still out on the overall security of such systems, which depend heavily on the use of secure passwords.

Among the more unexpected topics covered by Solomon are "chaotic market patterns," to which she devotes a chapter. Her point of departure is an oft-repeated remark by Doyne Farmer, who likens the search for chaotic patterns to the observation of a river rising after a rain. Sometimes, he says, by close inspection, one can predict the formation of a powerful eddy, more or less certain to evolve in a predictable manner until the water reaches a level sufficient to cover it over. Solomon points out that similar windows of predictability---if they exist at all in financial markets---are short-lived and must be exploited promptly. Electronic communications are tailor-made for the purpose. She notes that the search for chaotic market patterns has been under way for some years now (Farmer and others had already formed a company to search for them at the time of his 1992 invited talk at the SIAM annual meeting in Los Angeles) and that, to the best of her knowledge, relatively few have ever been found. Yet the search continues.

Solomon writes with a minimum of bankers' jargon and explains (sometimes more than once) most of what the reader would like to know* about her timely and potentially controversial subject. I suspect that the same information could be condensed, for a technically sophisticated audience, into a few chapters of a book on emerging issues in electronic communication. Until such a volume is written, however, Virtual Money will remain a useful and (moderately) readable introduction to a traditionally boring subject. The determined reader can learn much from this book.

James Case is an independent consultant who lives in Baltimore, Maryland.

*Extensive footnotes furnish a beginners' guide to more technical information.

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