Hal Finney’s Theory of Bitcoin Backed Banks

27 min readNov 17, 2022



In the early Bitcoin days the possibility of an exploit caused Satoshi to add a transactional throughput limitation to the system. The implications of these limitations are widely disagreed upon and range from the need to remove it to the need to innovate around it.

In response to this debate Hal Finney, someone often cited as a prime candidate for being Satoshi, made reference to a type of self-regulating stability that he felt would arise as natural order in response to the technological limitations Bitcoin was perceived to have. This observation was based on the work of an economist George Selgin:

Selgin is considered a Bitcoin OG (“Original Gangsta”),[9] having taken part in the original cypherpunk mailing list (with Wei Dei and Nick Szabo) that led to Bitcoin’s invention, which Hal Finney and Nick Szabo say he helped to inspire.[9] He was one of the first economists to explore the economics of Bitcoin and other cryptocurrencies.[10] He is also an expert on the history and economics of old-fashioned metallic coinage. His book Good Money[11] tells the story of the private minting of coins during Great Britain’s Industrial Revolution. He is one of the foremost authorities on Gresham’s Law — the oldest of all economic laws concerning money.[12][13]~wiki

This article sets out to explain the comparison of what Finney foresaw in reference to Selgin’s work and how he felt it would relate to the emerging digital money technology.

Whether or not this article succeeds in defending the relevance or reasonableness of Hal Finney theory is up to the reader however as a side quest we are able to update the general lexicon of the ‘crypto-community’ to include references to Selgin’s work. Such an upgrade is helpful for this author to gain a larger readership for the General Theory of Bitcoin presented in the totality this series of work.

The inquiry here is not meant to be controversial in regard to the application of Selgin’s work. It is fortunate that he can be consulted today about his work. The intention here is that he would approve of the correctness of any expression of his work and that this writing would be corrected otherwise. The truest intention here is to call attention the nature of Ruritania by George Selgin’s account of it and compare it to emerging (crypto-) currency technology.

On Relevant Selginian Distinctions of Money

Our instinctive use of money, regardless of our difficulty in understanding it, is an artifact of it evolving naturally rather than being designed from intuition and foresight.

Money is not intuitive.

The biggest problem most people have today in understanding money stems from a specific distinction between two types of ‘money’ that most people might not make even though they are quite accustomed to the use of each type.

We treat them as the same even though there is a significant underlying difference.

Since there are different schools of economics and different levels of formalness when it comes to discussing money, and since by definition everyone uses it and thus has a lexicon for it, making observations about money for a general readership can be difficult.

Most people can understand an observable or basic difference in the concept of paper bills and/or metal coins versus money they spend with a plastic/electronic bank card. This is the crux of the distinction we mean to make.

Specifically that (to the surprise of some but not all) the electronically displayed numbers for their bank account do not actually represent a corresponding amount of paper and/or coinage in a bank vault and thus when we deposit or hold our “cash” or physical type money at a bank in order to spend it from our electronic bank cards we afford the bank the ability to use that physical currency in a way that we effectively forfeit with our electronic bank account.

Cash or paper money or coins of course is provided by the central bank which has a monopoly on their issuance. The smaller banks can hold central bank issued money in the form of cash, paper, or coins like individuals or they themselves can have deposit accounts at the central bank with which they hold central bank reserves. When the smaller private or commercial banks acquire physical money in exchange for providing the efficiency of deposit accounts they are then able to extend credit in the form of loans to the extent of their reserve ratio requirements.

It is often argued by the hobbyist that self-interest will always drive such a setting to increase the loan credit to unsustainable levels. But George Selgin argues if the scenario were arranged such that there was no sole monopoly issuer of bank notes the system would naturally trend towards a well functioning and sustainable equilibrium of supply of credit (here the distinctions and disambiguation between the differing uses and definitions of money versus credit have purposefully been glossed over or rather deferred to Selgin, however, we will demystify them later in this writing and such is this writings purpose and thus credit may not end up being the most useful word for what is being referenced etc).

The Finnian Theory of Money

In order to understand how such a scenario would promote self-regulation of credit expansion we will explore the concepts of free-banking in relation to the emerging digital exchange economy that Bitcoin and alternate digital currencies have given birth to. And thus in effect we will explore and understand Hal Finney’s Theory of Bitcoin Banks:

Actually there is a very good reason for Bitcoin-backed banks to exist, issuing their own digital cash currency, redeemable for Bitcoins. Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain. There needs to be a secondary level of payment systems which is lighter weight and more efficient. Likewise, the time needed for Bitcoin transactions to finalize will be impractical for medium to large value purchases.

Bitcoin backed banks will solve these problems. They can work like banks did before nationalization of currency. Different banks can have different policies, some more aggressive, some more conservative. Some would be fractional reserve while others may be 100% Bitcoin backed. Interest rates may vary. Cash from some banks may trade at a discount to that from others.

George Selgin has worked out the theory of competitive free banking in detail, and he argues that such a system would be stable, inflation resistant and self-regulating.

I believe this will be the ultimate fate of Bitcoin, to be the “high-powered money” that serves as a reserve currency for banks that issue their own digital cash. Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as… well, as Bitcoin based purchases are today.

Hal’s observations arose in relation to the growing understanding of the computational tradeoffs Satoshi made in order to preserve what is effectively the security of the network. Nick Szabo explains:

In computer science there are fundamental security versus performance tradeoffs. Bitcoin’s automated integrity comes at high costs in its performance and resource usage. Nobody has discovered any way to greatly increase the computational scalability of the Bitcoin blockchain, for example its transaction throughput, and demonstrated that this improvement does not compromise Bitcoin’s security.

It is probable that no such big but integrity-preserving performance improvement is possible for the Bitcoin blockchain; this may be one of these unavoidable tradeoffs. Compared to existing financial IT, Satoshi made radical tradeoffs in favor of security and against performance. The seemingly wasteful process of mining is the most obvious of these tradeoffs, but Bitcoin also makes others. Among them is that it requires high redundancy in its messaging.

Mathematically provable integrity would require full broadcast between all nodes. Bitcoin can’t achieve that but to even get anywhere close to a good approximation of it requires a very high level of redundancy. So a 1 MB block consumes far more resources than a 1 MB web page, because it has to be transmitted, processed, and stored with high redundancy for Bitcoin to achieve its automated integrity.

These necessary tradeoffs, sacrificing performance in order to achieve the security necessary for independent, seamlessly global, and automated integrity, mean that the Bitcoin blockchain itself cannot possibly come anywhere near Visa transaction-per-second numbers and maintain the automated integrity that creates its distinctive advantages versus these traditional financial systems. Instead, a less trust-minimized peripheral payment network (possibly Lightning ) will be needed to bear a larger number of lower-value Bitcoin-denominated transactions than Bitcoin blockchain is capable of, using the Bitcoin blockchain to periodically settle with one high-value transaction batches of peripheral network transactions.~Money, blockchains, and social scalability.

Unfortunately Hal succumbed to ALS (although he is cryogenically frozen and hopes are he will return) and was not able to see Bitcoin come to fruition nor participate in the scaling debate of it since the technological innovation of lightning payments was implemented after this time. In understanding the nature of money and the origin and future of it (since Bitcoin is now a well established phenomenon in the global markets) with respect to Selgin’s observations of free-banking we must then consider the implication of lightning payments on the need for Bitcoin banked banks and alternative competing ‘digital notes’ such banks would issue.

Are Bitcoin Backed Banks Still Relevant With Lightning Payments?

Selgin’s theory of free banking is based on the natural order of the unfolding of an economic model he calls Ruritania. Ruritania is a metaphorical land that exists on the premise that there is no monopoly issuer of the base currency of the land. More specifically it implies there are multiple banks that each have the freedom of issuing their own notes.

This scenario with multiple banks competing to issue their own private currencies is not the premise but the outcome of the natural order Selgin extends from Menger’s and Mises’ respective theories of money beginning from the moneyless state of barter, to the election of a most saleable good from the repeated process of barter, to the storage of that good for safekeeping, to the ability to exchange the receipts of storage, to consent of lending out the stored money commodity for stake in the profits earned from lending it. Such a practice arises under the pretense of certain conditions that naturally arise in Ruritania:

The first is the fungibility of money, which makes it possible for depositors to be repaid in coin or bullion other than the coin or bullion that they originally handed to the banker. The second is the law of large numbers, which ensures a continuing (though perhaps volatile) supply of loanable funds even though single accounts may be withdrawn without advance notice.

This foreshadows our first interesting point and contribution that will become the theme of this paper which is the effects of the cost of ‘holding’ (or what Bitcoiners readily know as self-custody) of the base layer commodity money on the need or want to use a custodial service. Without such a need or want there is not the basis for the natural order of Ruritania to evolve privately backed currencies.

Furthermore in regard to whether or not lightning transactions serve the demand that would otherwise inspire what Finney foresaw as ‘Bitcoin backed banks’ the author here feels is best understood with an inquiry into the nature of the types of banks that might unfold if such demand wasn’t served.

Cryptoexchangelandea and the Introduction of Proto-Digital Deposit Money

In order to make this inquiry we refer to a hypothetical extension of Ruritania we call “cryptoexchangelandea”. As silly as it sounds the name has a purpose in its similarity to the name Pangea referring to the interconnectedness of the different entities considered. The entities are hypothetical crypto-exchanges, hypothetical because they refer to no particular existing exchange, but referring to the evolving phenomenon of emerging crypto-currency exchanges of the time of 2022.

That “cryptoexchangeleandea” means to refer to some sort of ‘all, entire, whole’ is in reference to the considerations of an effectively isolated economy (between crypto-currency exchanges) but which is otherwise internally connected. Here connected loosely refers to a surmountable cost of transport between the exchanges. When put this way, cost can be used to sometimes blur the distinction between physical travel and transport of a commodity money and the cost to transfer ownership of a digital commodity (ie fee).

Exchanges provide match-making for digital commodity trades and a reduction in cost of transferring such assets by providing central clearing possibilities. This setting can be seen as the evolution of proto-deposit accounts even though in the beginning the exchanges themselves weren’t the issuers of the currencies they provided markets for.

Here a scenario already arises by which an exchange COULD theoretically cheat and not actually hold onto or honor the traders deposits (depending of course on the real world transparency of the blockchains associated with digital commodities). Furthermore an exchange can cheat and offer trades on currencies it doesn’t hold and therefore cant redeem.

This reveals the concept of proto-digital inside money. To truly understand inside money in a later section we will contrast it with outside money, for now consider how inside money arose in Ruritania:

Under Ruritania’s pure commodity-money regime traders who frequently undertake large or distant exchanges find it convenient to keep some of their coin (and bullion) with foreign-exchange brokers who can then settle debts by means of less costly ledger-account transfers. Money-transfer services also develop in connection with deposits initially made, not for the purpose of trade, but for safekeeping. Wealthy Ruritanians who are not active in commerce begin placing temporarily idle sums of commodity money in the strongboxes of bill brokers, moneychangers, scriveners, goldsmiths, mintmasters, and other tradespeople accustomed to having and protecting valuable property and with a reputation for trustworthiness. Coin and bullion thus lodged for safekeeping must at first be physically withdrawn by its owners for making payments. These payments may sometimes result in the redeposit of coin in the same vault from which it was withdrawn. This is especially likely in exchanges involving money changers and bill brokers. Such being the case, it is possible for more payments to be arranged, without any actual withdrawal of money, at the sight of the vault, or better still by simply notifying the vault’s custodian to make a transfer in his books.

In Ruranita the use of warehouse storage of the commodity money (ie gold) reduced the transaction and securing/holding cost for the owner. Initially arrangement was for storage only:

In transfer banking of this kind money on deposit is meant to be “warehoused” only. The custodian is not supposed to lend deposited money at interest, and receipts given by the “banker” for it are regular warehouse dockets. Thus, primitive Ruritanian bankers are bailees rather than debtors to their depositors, and their compensation comes in the form of depositors’ service payments.

The warehousing of the commodity money gave a mutual benefit between the depositors and the warehouse to the advent of lending and proto-bank notes:

The lending of depositors’ balances is a significant innovation: it taps a vast new source of loanable funds and fundamentally alters the relationship between Ruritanian bankers and their depositors. “The … bailee develops into the debtor of the depositor; and the depositor becomes an investor who loans his money … for a consideration” (Richards 1965, 223). Money “warehouse receipts” or bailee notes become IOUs or promissory notes, representing sums still called deposits but placed at the disposal of the banker to be reclaimed upon demand (ibid., 225).

The continuous storage demand of a fungible commodity money are necessary driving forces for the receipt and redemption evolution thus an efficiency gained from custodial service is critical for the evolution of inside money.

The ability of bankers, in Ruritania and elsewhere, to lend out depositors’ balances rests upon two important facts. The first is the fungibility of money, which makes it possible for depositors to be repaid in coin or bullion other than the coin or bullion that they originally handed to the banker. The second is the law of large numbers, which ensures a continuing (though perhaps volatile) supply of loanable funds even though single accounts may be withdrawn without advance notice.

Early Digital Commodities as Proto-Digital Commodity Money

There are some similarities between Ruritanian banks and cryptoexchanges but one notable difference is that they offer a market for different digital commodities. When customers deposit onto an exchange it is as if they are storing commodity money (whether Bitcoin litecoin or gold or silver) in exchange for the inside money which functions ‘inside the local market of that specific exchange’.

Because cryptoexchangelandea has multiple exchanges with their own prices which digital commodities can be sent to in order to be exchanged for there arises an ability for arbitrage. Prices across accessible exchanges should converge to reveal the truth of the cost of arbitrage. In our inquiry we draw on the present day evolution that there is an external valuation of market assets to reveal the reasonableness of a local exchange price of a digital commodity.

Because of this phenomenon of ‘foreign valuation’ we can consider these digital commodities today as having a Selginian commodity money nature LOCALLY viewed from an exchanges market (the concept of an externally ported market valuation is the crux of the Menger, Mises, Selgin origin of money theory and thus readily available to us). In another paper, Selgin has a similar reference for the use of a digital money as a Selginian commodity type money he refers to as ‘synthetic commodity money’.

In short we mean to skip any reasoning as to the legitimization of the prices of the exchanges noting there is a norm to be compared to without worrying about how or why that norm arose or exists. Then we can skip chapters about the evolution and competition of trading and exchange prices for digital commodities. Today these things are well established and their history isn’t relevant.

On a given exchange then, digital commodities deposited, which on a period of time basis are traded against but not withdrawn, become a potential source of usable capital for the exchange. This illuminates the setting that is the growing concern of Bitcoin maximalists or those that warn cryptoexchangelandea is destined to create digital commodity based bubbles.

In Ruritania the evolution of the storage and (sanctioned!) lending of stored commodity money leads to the potential for efficiency gains by internal settlement of otherwise external market transactions (ie moving gold based transactions between bank sharing individuals to internal bank ledger transactions):

Up to this point Ruritania’s most important banking procedures and devices have yet to emerge. Since purchases must still be made with actual coin, substantial savings remain locked up in -circulation. Bank depositors, in order to satisfy changing needs for transactions balances, have to make frequent cash withdrawals from their balances. Though the withdrawals might largely offset one another, they still contribute to the banks’ need for precautionary commodity money reserves. What is lacking is some negotiable alternative to standard IOUs which can pass easily in exchange from one person to another, replacing coin in transactions balances. Lacking also are efficient means for reassigning deposit credits represented, not by IOUs, but by ledger entries, which could also reduce the need for coin in circulation.

The fulfillment of these efficiency gains gave rise to circulating private bank notes as well as demand deposit accounts (ie for checks and electronic type transactions).

In the considerations of cryptoexchangelandea a crypto-exchange which previously was tasked with custody of users’ Bitcoin and other “digital-wares“ might now have evolved to issue its own “private digital currency” (in which digital currency is in no way meant reference the qualities of proto-digital commodity money or what are colloquially called crypto-currencies) with varying qualities to advertise to those that might choose to exchange for it. This evolution would come first as credit usable on the exchange as incentive to use the exchange over competitors as a share of the cost savings benefit implied.

Early or Proto-Digital Money Versus Exchange Issued Digital Money

These types of digital currencies have similarities and differences with the previous or proto-digital currencies. Functionally they do the same thing and might transfer the same way. But constitutionally they are centrally controlled or rather their supplies are quite purposefully subject to the political whims of their issuers. Here we can make a fuzzy distinction and think perhaps about the difficulty or likelihood of a change in the promised issuance or redemption guarantee for a specific digital currency being offered.

It might be declared that the determination of the evolution path of Bitcoin’s code is decentralized. Here we would expect that to mean changes to its consensus rules are unlikely or impossible. Whether this is true or not of a given constitutional claim isn’t necessary to evaluate in this writing. It’s simply noted that privately issued currencies have constitutions that are highly malleable and subject to the whims of the issuers of it.

Of the promise associated with such a privately issued digital currency there can be a reward offered to hold that currency at the exchange that issues it (or any other exchange that accepts it). This reward or interest rate signifies an evolution of cryptoexchangelandea that allows us to make Ruritanian inferences from.

With Bitcoin as the commodity or base money that Selgin refers to, crypto-exchanges that offer their own brand of exchangeable digital tokens, and the distinction between self custody versus custodially held privately issued digital money, we now can inquire into the nature of the self-regulation of cryptoexchangelandea and whether or not lightning payments preclude such an enfolding.

The Role of The Cost of Settlement in Need For A Clearing Layer

It will eventually be our argument that such an inquiry will lead to a new theory of the evolution and origins of money and specifically how our instinctive lust for gold arose as a result of the evolution of the extent of our markets, an insight which derives from the critical observation that the differences between a central banking scenario versus a free-banking scenario is simply a matter of recalibrating the scope over a recursive (or fractal) field with differing costs implying certain self organizational paths.

In other words the non zero cost to transport a settlement medium (ie to transact) inspires the need or use of a higher layer settlement medium recursively backwards and forward which is a subtle but extremely powerful point for nature to finally have revealed to us and which is hidden when our observation and historical evidence suggests to us that money arose to be eventually based on gold partially because it had favorable non-monetary usefulness.

The observation of the role of cost of settlement using the settlement medium creating demand or value in a higher layer of settlement speaks to the benefit of clearing houses in Ruritania where banks can net their obligations to save the cost associated with each specific transaction.

We have evidence of this type of batching in cryptoexchangelandea today. In the real world of nations with central banks, the central banks are used for clearing houses for the central bank notes that circulate. Here without getting into any specifics of a central bank digital currency it can be understood that there is a specific ramification that a CBDC can be sent digitally whereas a bank note for example is transported by armored truck. This example helps paint our understanding.

And there are global scale clearing institutions of differing sorts notably including the IMF.

On Natural Ruritanian Order

Consider Ruritania which is a (theoretical but) physical land where the cost to transport a medium is significant (compared to differing digital costs that would be associated with transferring digital money which might not be as bold) between the commodity money (ie gold) and a private currency alternative (ie paper). It is obviously most costly to transport commodity money yet there is some cost or risk associated with looking to exchange a private currency at a foreign or competing bank. Private banks will accept each other’s notes perhaps but minus some cost of risk and transport associated with redeeming such notes back at the private bank that issued them.

However this scenario provides opportunity and thus profit seeking arbitrages the Ruritania banking system to the point of acceptance of others notes at par:

Competition eventually reduces note discounts to the value of transaction and transportation costs, plus an amount reflecting redemption risk. In accepting the notes of unfamiliar banks at minimal commission rates, brokers unintentionally increase the general acceptability of all notes, promoting their use in place of commodity money

That differing Ruritanian banks naturally accept differing and competing privately issued currencies is comparable with the existing scenario in cryptoexchangelandea. This scenario arises slightly differently, however, because exchanges existed before they issued their own currencies.

Outside Money Versus Inside Money

Here it’s helpful to understand what Selgin distinguishes as the difference between ‘outside money’ and ‘inside money’.

Outside money is the base layer or commodity money. In Ruritania the outside money is basically thought of as gold. But it could in theory be Bitcoin, a different commodity, or even a certain traditional central banked money such as the USD (this is provided the other Ruritanian banks are able to create their own currencies and self-determine the supply of their own currencies).

Inside money then includes the privately issued currencies but also the deposit accounts the private banks offer their customers. This can be a little confusing but is better understood when looking at the differences between Ruritania, cryptoexchangelandea , and the existing global financial system (before the Advent of Bitcoin).

In today’s global financial system, the commodity money or base money we use is our currency or bank notes (and coins). Our demand deposit accounts, like electronic bank cards, are inside money. All of the rest of the types of money that exist aren’t important in this inquiry to classify but central bank reserves, or M0 in total, are outside money and the rest is inside money.

In Ruritania we contrast that with the introduction of bank notes that are not solely issued by the central bank where all of the differing privately issued currencies (as well as deposit accounts held as the private banks) are considered inside money. Whatever the base layer that all of the differing banks settle with between each other is the outside money. The significance here is that each bank now is responsible for its own set of inside monies which now includes private currencies they issue but also the demand deposit accounts they offer (in other words what people generally want to call credit).

Digital Inside Money: Private Digital Demand Deposits and Private Digital Currency

The difference between crediting an amount of private digital currency or actually holding the digital currency highlights the difference between what Selgin refers to as demand deposits versus the actual currency. From Ruritania to cryptoexchangelandea some of the comparison is lost. If both forms of money show up as electronic numbers from our perspective what is the distinction? It is the introduction of a privately issued digital currency that can be sent to, and traded, in other markets.

In cryptoexchangelandea baselayer settlement is provided by Bitcoin. In reality it has a well established price market valuation outside of cryptoexchangelandea . This wasn’t always so. The question of how or at what cost one could redeem Bitcoin was a significant consideration. In cryptoexchangelandea this isn’t a consideration anymore. Bitcoin is as good as gold. It is ultimately what everyone in the land accepts. You don’t redeem Bitcoin, you redeem other currencies for Bitcoin. In reality of course this is because Bitcoin is externally redeemable for real world centrally banked money.

Thus what an issuer of a private digital currency owes the totality of its customers (ignoring other exchange duties and services) in digital commodity money is the sum of both types of inside money (units ‘credited’ locally and units sent externally).

Having 100 units of a certain privately issued coin is somewhat meaningless to a holder but having X amount of satoshis in a certain coin is a statement of value to a cryptoexchangelandea . The evolution of proto-demand deposit accounts of proto-digital banks (ie digital exchanges) can now be transferred and accepted around cryptoexchangelandea but only based on the trustworthiness and market value ascribed to it.

Where The Yield Comes From

It would be a controversial explanation with today’s news which is days after the FTX meltdown of the crypto markets to simply suggest that a sufficient amount of transaction cost is saved by replacing Bitcoin based settlement transactions with a private issued exchange coin nonetheless the difference between the cost of settling on the Bitcoin network and using any alternative means equals the available profit to be shared between any facilitators of such an alternative.

Exchanges have incentive to entice customers to ‘store’ digital commodity money with them in exchange for their privately issued digital currency because the evolution allows them to export their efforts without incurring the implicit cost of base layer settlement.

For holders of the privately issued currency they benefit from the well-management of the issuing exchange (if the exchange is well-managed) as well as the reduced transfer fees implied from not settling on the base commodity layer (Bitcoin).

In other words the more customers an exchange can serve without the need for base layer settlement the more value it can harness (and employ as investment) from the cost savings.

There is no impressive yield here of course, but there is incentive for this type of evolution.

Private Digital Currencies In Competition

Since cryptoexchangelandea has no monopoly over the creation and issuance of digital currency we observe many such ventures arising in competition in an attempt to capture the economy with this efficiency gain. This creates a new plane for competition:

In the evolution of Ruritania’s free banking system, bank reserves do not entirely disappear, since the existence of bank liabilities that are promises to pay continues to presuppose some more fundamental money that is the thing promised. Ruritanians forego actual redemption of promises, preferring to hold them instead of commodity money, so long as they believe that they will receive money if they ask for it. Banks, on the other hand, have a competitive incentive to redeem each other’s liabilities regularly. As long as net clearing balances are sometimes greater than zero, some kind of reserve, either commodity money itself or secondary reserves priced in terms of the commodity money unit of account, has to be held.

Proto Crypto-Clearing Arrangements

It’s not immediately obvious to the Bitcoin maximalist why such a thing would exist but from an exchange’s point of view it makes sense to want to elevate to the role of “clearing”. From a Bitcoin user perspective Bitcoin is the ultimate clearing medium. If lightning can provide the same security at a significantly and comparably reduced cost to transact (i.e. zero) then what would be the reason for users to use an exchange’s network and privately issued digital currency?

But here we aren’t trying to justify the existence of this evolution or the reason why a user would choose to support such a network.

It is easy to see from the exchange’s point of view how other smaller exchanges would appear as large value customers, or sister exchanges that themselves might appreciate having a high level clearing option.

A large exchange has incentive to make efforts to get a consortium of smaller exchanges to accept the privately issued digital currency. Within the clearance network now these exchanges can settle with the private currency thus saving the cost of base layer transactions.

Whether or not other exchanges will adopt another exchange’s private currency as a settlement medium and why is discussed in subsequent sections here we are just noting it is in an exchange’s interest to lobby for the use of their currency.

Here a larger exchange can offer deeper markets between exchanges that wouldn’t otherwise trust each other to leave the more expensive base layer settlement process.

Another benefit to joining such an arrangement is that a larger exchange can provide emergency liquidity for otherwise honest exchanges that simply can’t meet their liquidity needs for the various products they have created or offer which might include their own privately issued digital currencies.

The sister exchanges join the ‘union’ at the cost of membership which obviously most notably includes accepting and using the private clearing medium as the base settlement layer of the newly formed network network. Notice something interesting. We have illuminated the recursive nature of the unfolding of our economic history. Within the currency network implied by the clearing union the exchange that issues the clearing medium is now the monopoly issuer of supply of the base settlement medium!

For as long as the union is relevant the issuer can dictate the rules as it sees fit. Although this isn’t a part negation of the Ruritanian environment because the sister exchanges so far can still issue their own private digital currencies it’s easy to see how there could be oscillation on different economic planes which imply either a free banking scenario that fosters competition or a monopoly type scenario and the possibility of a range in between.

Allegedly the exchanges are providing a desired service where there is cost savings to be had from the central based solution. Ultimately this cost savings is settled in Bitcoin. If Bitcoin transaction cost was reduced towards zero it is not necessarily true that these services would then be served on the base layer of Bitcoin and not batched and settled.. If alternative digital commodities have utility, and/or if exchange markets exist, a low transaction fee would increase Bitcoin’s preferability over other alternatives for settling but can’t necessarily provide all the custom benefits of holding privately issued digital currencies.

The above point isn’t an argument that private digital should or will exist but that the existence of lightning payments don’t necessarily preclude them simply because they offer lower transaction costs. To the Bitcoin Maximalist it there hasn’t yet been shown to be (or perhaps even proposed to be) a private digital currency that solves an existing world problem such that its existence and issuance imply a non-monetary value (some people feel Bitcoin is included in this) but IF THERE WAS then lightning transactions wouldn’t preclude its non-zero market valuation. To this point, Bitcoin Maximalists need not fear-that digital currencies might exist other than for the reason to settle value still means they will still probably ultimately redeem down to Bitcoin because of its ability to securely scale to handle transactions of any increased value.

Economy that is facilitated by, and links to, Bitcoin is good for the external valuation of it.

Competition of Clearance Coins

In cryptoexchangelandea there is no monopoly issuer so competitors are allowed to naturally arise who will themselves, at least at first, resist any sort of clearing union that prevent them from issuing their own settlement cost saving private digital currency. Keeping in mind we mean to show that cryptoexchangelandea leads to self-regulating supplies of privately issued digital currencies we can compare this evolution with Ruritania:

During that period, banks’ sought to bankrupt their rivals by “note dueling”-aggressively buying large amounts of their rival’s notes and presenting them for redemption all at once. For a bank to stay solvent during such raids it has to keep substantial reserves, so that its contribution to the process of fiduciary substitution is small.

Though it does not catch on immediately in Ruritania, regular note exchange has advantages that guarantee that it will eventually be adopted, as it was in every historical instance of relatively unregulated plural note issue. Note dueling ceases to be advantageous to any bank as all of them learn how to protect themselves in response to it by holding large reserves. Because of this, Ruritania’s banks soon find it more convenient to accept their rival’s notes only as they are brought to them for deposit or exchange. They do not continue actively to buy notes in the marketplace since this is both costly and unreliable as a means for expanding circulation. Also, instead of being accumulated in large sums, rivals’ notes are immediately returned at once to their issuers for redemption in commodity-money reserves, which can be profitably employed. Finally, as banks in Ruritania realize the savings to be had by offsetting note debits with one another, they may formally agree to engage in regular note exchange and to refrain from purchasing rivals’ notes except as they are brought to them for deposit or exchange.

The equilibrium of course implies neither team could find an advantage otherwise.

Here again we observe the recursive field of our economic history. We can imagine on a long enough time scale and large enough market that surviving competing exchanges might eventually decide to enter settlement networks and agreements once all of their competitive strategies have been exhausted. And these newly created settlement networks might join with other such networks after a similar periods of non-cooperative attacks.

What’s notable so far is that today’s reality reflects the story of cryptoexchangelandea to the extent that it needs to for the premise or axioms to hold. What is left is to argue how much value can be captured specifically from providing scaling solutions and especially now that there are lighting transactions available. It is also left to argue whether or not an issuer of a private digital currency has the possibility at all of providing captured value in the form of a token above and beyond a scaling solution that may or may not exist.

Perhaps this is why the mantra ‘not your keys not your Bitcoin; keep your keys of exchanges’ is so popular with Bitcoin maximalists. The premise for Ruratian order certainly exists and so doesn’t need to argue for a bootstrapping mechanism for the value of privately issued digital currencies. As long as people hold Bitcoin on exchanges there is funding for this kind of scenario to continue.

The Decentralization of Clearance Coins as Peaceful Cooperation and Truces

With multiple competing exchanges or network of exchanges there is the decision for each player or team to allow competing privately issued digital currencies to trade on their own exchanges and thus the opportunity to make agreements to swap the adoption of such currencies between otherwise competing exchanges.

The relevant pressures are not only the survival of an exchange’s respective digital currency but the survival or relevance of the entire notion of such currencies. Self-interested exchanges tend to themselves at the expense of other exchanges unless the program is otherwise in jeopardy. They plan to expand and conquer all competition, cooperate with those that are more powerful, and seek to destroy those that will not abide and therefore do harm to the overall program.

Consider the scenario where two exchanges enter an agreement to support each other’s privately issued digital currencies. An honest exchange means to put up something of value in exchange for what their competitor allegedly values all the same. Obviously depending on the agreement and true nature of the competing exchange the agreement might end up effectively being a free loan! But if there are proper restraints and limitations in place a nefarious practice of exchanging worthless tokens for a well established counterpart could be brought back on the nefarious exchange with a manufactured bank run.

In Ruritania private banks use customer deposits of commodity money to justify the creation of new loans in the form of new demand deposits and privately issued bank notes (inside money). This is as if they function as fundraising mechanisms for investment. In this sense cryptoexchangelandea works no differently.

Cryptoexchangelandea and The Real World

At this time in the inquiry beyond this source of capital the intricacies and implications of the real world financial system participating in and being affected by cryptoexchangelandea aren’t yet considered.

We can see two different vectors of ‘management’ here however. If an exchange has something of value to offer through the expansion of its currency network then it will seek to bridge its network with other exchanges offering the same. It will not be afraid to swap its currency with other well established counterparts and will not be afraid to settle in the base commodity.

In contrast an exchange that has no value to offer and thus no business expanding the currency that represents its ‘credit’ will at some point not be able to honor redemption of its currency with Bitcoin unless it finds some perpetual source of external funding of Bitcoin (perpetual here refers to it being a black hole for anyone that thinks they are making a good investment).

We haven’t really said anything controversial. If there is an efficiency captured by the introduction of a currency then the participants in the network would naturally be the beneficiaries of its use. If there is no such efficiency gained then the significant momentum such a currency and network could have would be ill-placed investment. Ill placed investment as opposed to efficiency gaining investment and in comparison is obviously un-sustainable. But that it is not sustainable for all time cannot be our reasonable grounds that a Bitcoin backed bank environment would be self-regulating.

We have said however that sustainable projects have a mutually favorable want to push out unsustainable projects and cooperate further by accepting and legitimizing each other’s ventures if they can’t conquer one another.