Sharia Lite

Whereas in my earlier blogposts, I have always commented that Ijara comes closest to or rather IS Islamic finance, however, the way many Sukuks (mainly Sukuk Al Ijarah) are structured, this does not hold true. In a utopian world, Sukuk owners should be the true owners of the assets which should be leased to the lessees at the Ijarah rate. However, majority of the Memorandums or Prospectus of Sukuks issued are at pains to show that whereas there are underlying assets, there are many layers and agreements between the Sukuk holders and the assets such that Sukuk holders may get the financial benefits of owning the assets but they are not true owners. Thus defeating the whole purpose. Anyway, at least they tried to keep a modicum of being Sharia compliant issues. Now we also have a Sukuk Al Wakalah. This year, Hong Kong government issued its second Sukuk. Whereas their earlier Sukuk was Sukuk Al Ijarah, the current Sukuk is Sukuk Al Wakalah. And this is how they market it in their Press Release:

“Building on the momentum from the successful issuance of the inaugural sukuk last year, the latest issuance strengthens our relationship with global investors and demonstrates the flexibility of Hong Kong’s Islamic finance platform.  Compared with Ijarah structure of the inaugural sukuk which requires underlying tangible assets of at least 100% of issuance amount, this latest structure allows the use of substantially less tangible assets, which is one-third of issuance amount, for this purpose.  The use of the “asset light” structure can set a benchmark for potential issuers in the private sector,” the Financial Secretary of Hong Kong, Mr John C Tsang, said.

Asset Light? What is Asset Light? Reminds me of conversation that I had with a conventional bank in Dubai. I asked him what is the sharia structure of the transaction already agreed by existing Islamic bank in the transaction. The conventional bank replied to me, “don’t worry about them. They are sharia-lite.”

Islamic Banking: A Charade

This is going to be slightly long post.

I have always been a proponent of Islamic finance and have been promoting it at all forums since my undergrad. I worked in conventional banking for 5 years yet I kept promoting Islamic Banking. Then I did my masters in finance from one of the top business school of the world. Subsequently I have worked in Islamic investments as well as Islamic banking for almost 8 years and got a chance to see the transactions and structures used in Islamic financing up close and personal. After working on a few landmark transactions recently in structured finance, Sukuk and syndicate financing, I have come to the definite conclusion that Islamic banking as practiced today is total charade.

No need to repeat the Quranic verses here but the essence of Quranic injunctions is that debt should be interest free or a non-profit transaction. If you want to engage in profitable transactions, do trade which entails taking equity stake. That was the argument at the Prophet’s time that both trade and lending for profit are the same i.e. if you treat money as commodity, there is no difference between trading and interest based lending in letter of the law. However, Quran forbade lending and approved trading. I like to think of it as difference of spirit of the law and letter of law.

Anyway, my smell test is the duck test. If it looks like a duck, walks like a duck, and quacks like a duck, then it is a duck. Similarly in Islamic finance transaction, if the transaction is a debt based transaction, and then it is Riba, no matter how many commodities we trade to show it as a trading transaction.

Initially it used to stated that global system is interest based system and we can’t just remove it and establish an Islamic system overnight. We need a mid way approach. Hence, a Murabaja structure was devised as mid-way structure wherein by carrying out certain steps, a debt transaction would be Islamized i.e. made into a trading transaction. Probably the Islamic scholars thought they were innovating but they were following in the footsteps of the Christian clergy who gave their blessing to Contractum Trinius allowing Christian merchants/bankers to bypass Christian rulings against Usury.

What is worse that today Murabaha instead of being considered the mid way faulty stop gap arrangement that it is, it is now considered a standard uncontroversial instrument of Islamic finance beyond reproach. A more disservice to Islamic finance hasn’t been done.

The size of global Islamic finance is touted anywhere from US$1.5 trillion to US$ 4 trillion. This amount has everyone salivating and trying to come up with products to get a piece of this pie. The international bankers have been very active in this segment and sharia scholars have been very happy to guide them (for a fee of course) on how to Islamize the products available in the conventional financing sphere.

To take a small digression. Regulations are there to safeguard market participants. But there is a low of money to be made in regulatory arbitrage products. Before the credit crisis, such products allowed sophisticated investors including banks and other institutions to bypass the limits set up by regulators for investors’ protection. Lawyers and investment bankers would come with most convoluted structures to bypass legislation/regulations. Lawyers, investment bankers and accountants earned handsome fee for this business. Investors eventually were at the losing end. Similarly there are significant tax arbitrage opportunities wherein foreign investors’ to US can invest through Cayman Island structures to take benefit of the loopholes in tax codes. US treasury loses out on taxes, investor loses out on expenses of capital structures/ multiple SPVs. Only people who make money are lawyers and accountants for coming up with this structure. Similarly, we have sharia arbitrage wherein a product or service may not be sharia compliant, but enough lawyers and sharia scholars bang their heads together on it for a while (and the incentive of hefty fee of course) they will make it a sharia compliant product.

Some of the recent most used products that I have seen that are down right riba with just a lip service (read sharia fatwa) to sharia compliance are:

1. Tawarruq or reverse murabaha
2. Wa’ad
3. Sukuk
4. Sharia compliant derivates (oxymoron if ever there was one)
5. Profit rate swaps

There will always be people who will continue to justify one product or other and have detailed fatwas and explanations that how a certain transaction is sharia compliant but if it doesn’t pass the smell test, it is Riba.

The irony of it all is that Islamic finance doesn’t ask you to change the world or come up with paradigm shifting products. The best product that fulfills the criteria of Islamic finance and has been in existence for ages is operating lease or Ijara. The bank owns the equipment (there is no lending of money at all, no need to rotate commodities just to islamize the transaction). The bank leases/rents the equipment for its use. At the end of lease term, the bank gets the equipment back. The bank takes the risk in any increase in demand for the equipment or excess depreciation in the value of the equipment. Whereas Islamic banks and central banks in Islamic countries may look down on such transactions, banks in the west have their operating lease arms as well as operating lease portfolios in their books. As such, it is not like Islamic banks are being asked to do reinvent the wheel.

The other transaction is where the bank acts a developer. For example, you bring a real estate project to a bank. Rather than giving you debt for construction financing, bank has two choices: one) if it believes in the economics of the project (it was willing to give you finance, wasn’t it) it should invest as equity holder sharing both on the upside and downside of the project when it is completed. Two) it can act as a developer i.e., sign an agreement with you to develop the project against some agreed upon costs to be paid to the bank upon delivery of the complete project or as per agreed terms. This is similar to Istisna. For banks in Islamic countries this sounds radical but western banks are already doing the similar transactions under the aegis of banking.

From a depositor perspective how will this work. Depositor has two main options. To place money with the bank in current account. Or deposit money with the bank in an investment account. There can be multiple types of investment accounts to cater to the need of depositor in terms of liquidity, risk and return parameters. The lowest risk product could be in the form of a REIT fund with weekly/monthly etc liquidity. Bank on behalf of investors/depositors buys rented real estate. Depositors will get rental income from the property as return on their deposits (after bank deducts the necessary fees etc). The depositor is allowed to withdraw his investment at the NAV of the fund which can go up and down based on the real estate market performance. Similarly, investors seeking higher returns can invest in higher risk products such as equipment leases, istisna transactions etc.

This is risky and requires due diligence on part of customer. Believe it or not, depositing in any conventional bank is risky. There is this illusion among depositors that conventional deposits are safe. They don’t realize that conventional bank are highly regulated organizations and carry implicit or explicit guarantees from government. In US, federal government under FDIC insures your deposit up to a certain amount. In other countries, central bank steps in or is their is implicit guarantee. Islamic banking is no more riskier provided they have similar appropriate regulations, controls and compliance mechanisms in place.

The aforementioned idea of the bank taking a loss when property value goes down is not that radical either. Amir Sufi and Atif Mian in their award winning and critically acclaimed book House of Debt also propose a similar solution for mortgage financing. Their justification which they argue through data and statistics is that this is more fair for everyone (for the bank and mortgagee) as well as leads to less frequent or severe bubbles. 

Obviously all transactions cannot be done on Ijara or Istisna basis. The banks may actually have to engage in real commodity transactions_ buy commodities, have warehouses to store them, act as market maker and occasionally sell them at losses. Again not a radical concept. Goldman Sachs and JP Morgan do it. In the words of Goldman Sachs’ chairman, “we are doing God’s work”. Ironically conventional banks are doing the transactions and leading the market which the Islamic banks should have been doing. But the latter and their central bankers do not even consider such transactions which are by design sharia compliant. (No fees for the sharia scholar I presume.)

Does this mean that Islamic finance banks will not fail, they will not have frauds, there will not be bubbles? No, we may have all of those things because any system is only as good as the people running it and checks and balances built in to it. Why is it that when conventional banks fail and are bailed out, it is the fault of management or regulator but if an Islamic bank fails it is the fault of underlying Islamic economics.

Anyway, Islamic finance is not a radical concept. All the products already exist rather conventional banks carry out such transactions all the time. It is a concept which avoids debt and debt like structures. The only disadvantage it has is the tax code. Tax code treats interest (or profit on financing) payments as tax deductible compared to returns on equity. From capital structure perspective, Modgiliani and Miller proved decades ago that capital structure doesn’t make a difference on before tax basis. Now only if the tax code is modified that it doesn’t penalize equity investors and benefit debt providers.

Two posts I wrote earlier on the same topic earlier are:

1. Whither Islamic Finance
2. Whither Islamic Finance – II

Elevator Pitch

A lot of bankers come to visit us for marketing their services and request to give an overview so that they can offer services to us accordingly. Recently, we made our first trip abroad to introduce our bank to other banks. Initially, the description that came out of our mouths was in awkward pauses and stutters but after a few meetings we had refined our pitch. Though not necessarily an elevator pitch but we felt that it described us perfectly as well as gave the person we were meeting a perfect idea of what we are looking for. The bank is still trying to figure out what it wants to be so as time goes by we may refine it further or it may change altogether. Right now, this is the spiel:

We are a new bank and young bank in a market which is already over banked with large and well established banks, We cant compete with those banks in standard products. Our balance sheet size is small so we cant write a cheque of $100 million. We cant even write a cheque of $50 million. On the other side, our cost of fund is high so we can’t grow by offering cheap funding to blue chip corporations. Not to say that we don’t participate in standard thinly priced transactions that are there in the market. We do. But those just help us to break even. Moreover we just turned nominally profitable this year so we really can’t bet the bank on high risk speculative transactions. We need to find a sector or niche which enables us to grow sustainably.

Just to give you an overview, from revenue generation perspective, broadly our bank is divided into 3 departments: Corporate, Retail and Investments.Corporate looks after local corporate plain vanilla financing, retail looks after local retail financing and everything else comes to us: international syndication, international real estate, funds, sukuk, equity, structured finance (local as well as international) etc

Corporate and Retail will grow the bank in line with the economy, but the real differentiation will come from Investment Department. Till last year we mainly participated in syndication and funds but it wasn’t participation for participation’s sake. We cast a wide net to gauge which banks we want to forge a relationship with. This year we have started origination. And we are originating land mark deals relative to our size and age. We will be launching an international syndication for a local corporate shortly. We have been appointed JLMS for a first corporate sukuk coming out of Asian country. Shortly we will be launching a US real estate fund and US Equipment leasing fund to offer to our private banking customers. We are doing a sharia compliant securitization program for one of the largest vehicle financing  company in country. You will be reading about all these transactions soon in the press.

Most importantly we have assembled a young energetic team which is not afraid to roll up its sleeves and gets its hands dirty. I have a background in funds, real estate & private equity. Y was part of DCM team in one of the oldest and largest islamic finance institution in the region and lead managed large number of syndication and sukuk transactions. T is a structured finance maestro. T is also the head of department but as I said we are not afraid to roll up the sleeves. Depending on the nature of transaction one of as becomes a champion but all of as work together as a team.

What we are looking for is partnerships. We may participate once or twice but if we see that you treat us as we are just another bank writing a cheque, we may not value that relationship. Our mandate is very wide and we are looking for partners who have skin in the game and co-invest and co-partner with us in transactions.

So this is us.

You are a small banker, so act like one

I have been thinking over this issue for some time. Then I read this article today and it crystallized my fragmented thoughts and I decide it to put it online. Initially I was planning to tweet this but then I realized it will take many tweets to say what I want to say. I am not like @pmarca Marc Andreessen whose legendary tweet storms are lapped up by his cult followers as divine revelations.

I had mentioned in one of my earlier posts that I have changed my job. Its a relatively new bank in a market that is very liquid and over-banked. The challenge with working with a small and new institution is that you can’t take on the big boys (large and well established old banks) in this game. You might be able to have a quicker turnaround compared to large bureaucratic banks but with decade long established corporate relationships this is not much of an advantage. Say you are used to borrowing $200 million each from Citibank singly and it takes them a month to approve the line. Suppose we can get back to you within a fortnight with our approvals but due to regulatory and risk concentration reasons, can only offer you US$27M max (not even a round number) . You’d rather wait another fortnight and get a nice lump sum from Citibank without the hassles of opening new account and completing KYC for such irregular sums with a new bank like us. Anyway, once you get $27Million from us, you will need to approach someone else to raise the remaining $173M.

What we can do is search for opportunities that these big banks are ignoring. These may not necessarily be riskier but are not plain vanilla either. We may need to structure them differently, crossall the “t”s and dotting all the “i”s in legal documents, ring fence the assets etc. Such customers may not come to us. We have to seek them out. The problem with bankers we hired is that they all come from well established large banks where the corporate borrower came to them because they have the balance sheet to singly finance the needs of the customer. It didn’t matter who was the relationship manager in the large bank. The corporate had a relationship with the bank and not the relationship manager.

Anyway the problem is not with the relationship manager. The problem is much higher than that. The CEO, the Corporate Head, etc all have come from large banks and do not display the zeal that is required for the small bank to expand. I am not saying that we need out-of-box thinker as I am not one. But what we need are people who are willing to put in the extra effort. People willing to roll up their sleeves and go out to acquire customers. A corporate head who is actually willing to meet and work with less than blue chip companies. Issuing a press release for being a part of 29 bank consortium that provided funding to a government backed entity is not how small banks make a name for themselves.

Now we are hiring a treasurer as our last treasurer resigned few days ago. I have heard that this treasurer worked for a government owned investment vehicle for 30 years. What the fuck will he know about running a bank treasury where you have daily liquidity requirements. Just because we are a small bank doesn’t mean our treasury requirements are small. We need to setup lines with international banks, ask local banks to increase our limits, monitor liquidity on daily weekly basis. I don’t think a 60+ guy who has worked in sedentary government treasury for 30 Years is the man for it.

Don’t think that the bank will grow much if we keep acting like a large bank.

The first credit crisis : Roman Edition

In such an extensively monetised economy, it is hardly surprising that the Romans were also well acquainted with another familiar feature of modern finance: the credit crisis. Occasionally, the similarities with the modern age are nothing short of eerie. In AD 33, the Emperor Tiberius’ financial officials were persuaded that the recent boom in private lending had become excessive. It was decided that regulation must be tightened in order to extinguish this irrational exuberance. After a brief review of the statutes, it was discovered that none other than the father of the dynasty, Julius Caesar, had in his wisdom instituted a law many decades before specifying strict limits on how much of their patrimony wealthy aristocrats could farm out in loans.9 He had, in other words, introduced a rigorous capital adequacy requirement for lenders. The law was clear enough: but not for the first time in history, industrious lenders had proved remarkably skilled at circumventing it. Their ingenious evasions, the historian Tacitus reported, ‘though continually put down by new regulations, still, through strange artifices, reappeared’.10 Now the emperor decreed the game was up: the letter of the old dictator’s law would be enforced. The consequences were chaotic. As soon as the first ruling was made, it was realised with some embarrassment that most of the Senate was in breach of it. All the familiar features of a modern banking crisis followed. There was a mad scramble to call in loans in order to comply. Seeing the danger, the authorities attempted to soften the edict by relaxing its terms and announcing a generous transitional period. But the measure came too late. The property market collapsed as mortgaged land was fire-sold to fund repayments. Mass bankruptcy threatened to engulf the financial system. With Rome in the grip of a credit crunch, the emperor was forced to implement a massive bailout. The Imperial treasury refinanced the overextended lenders with a 100-million sesterces programme of three-year, interest-free loans against security of deliberately overvalued real estate. To the Senate’s relief, it all ended happily: ‘Credit was thus restored, and gradually private lending resumed.’

Excerpted from “Money: an unauthorized biography” by Felix Martin

What is money?


On 4 May 1970, a prominent notice appeared in Ireland’s leading daily newspaper, the Irish Independent, with a simple but alarming title: ‘CLOSURE OF BANKS’. The announcement – placed by the Irish Banks’ Standing Committee, a group representing all of Ireland’s main banks – informed the public that as a result of the severe breakdown in industrial relations between the banks and their employees, ‘a position has now been reached where it is impossible for the undermentioned banks to provide even the recent restricted service in the Republic of Ireland’. ‘In these circumstances it is with regret,’ the notice continued, ‘that these banks must announce the closure of all their offices in the Republic of Ireland on and from Friday, 1st May, until further notice.’


It may come as a shock to learn that virtually the entire banking system in an advanced economy could have shut down overnight as recently as in 1970. At the time, however, this development was widely expected – not least because it had happened once before, in 1966. The matter of dispute between the banks and their employees was a familiar one in the Europe of the late 1960s: the extent to which pay was keeping up with prices. High inflation throughout 1969 – by the autumn, the cost of living had risen by more than 10 per cent over the previous fifteen months – had prompted a demand by the employees’ union for a new pay settlement. The banks had refused, and the Irish Bank Officials’ Association had voted to strike.

From the beginning, it was expected that the banks’ closure would not be short-lived, so preparations were made. The first reaction of businesses was to stockpile notes and coins. The Irish Independent reported that:

There were massive withdrawals of cash throughout the country as firms built up their reserves in anticipation of a shutdown. Insurance companies, safe dealers, and security firms are expected to do brisk business while banks remain closed. Factories and other concerns with large payrolls have arranged to obtain ready cash from large retailers such as supermarkets and department stores to meet wage bills.31

But in the first month of the crisis, it became apparent that things might not turn out quite as badly as feared. The Central Bank of Ireland had deliberately accommodated the additional demand for cash in March and April, so there were about £10 million more notes and coins in circulation in May than usual. There was an inevitable tendency for the stream of payments to give rise to gluts of small change in some places – generally shops and other retail operations – and dearths in others – usually wholesalers and public institutions which had no reason to take in cash in the course of their daily business. The Central Bank even made a vain plea to the state-owned bus company to have it distribute cash to passengers. But these blockages in the circulation of coins and notes proved a relatively minor inconvenience.

The reason was that the vast majority of payments continued to be made by cheque – in other words, by transfer from one individual’s or business’ current account to another’s – despite the fact that the banks at which these accounts were all held were shut. In its review of the whole affair, the Central Bank of Ireland noted that prior to the closure ‘some two-thirds of aggregate money holdings are in the form of credit balances on current accounts, the remainder consisting of notes and coin.’32 The critical question, therefore, was whether this ‘bank money’ would continue to circulate. For individuals in particular, there was really no other option: for any expenses in excess of the cash they had in hand when the banks shut their doors on 1 May, their only hope was to write IOUs in the form of cheques and hope that they would be accepted.

Remarkably, as the summer wore on, transactions continued to take place and cheques to be exchanged almost exactly as usual. The one difference, of course, was that none of the cheques could be submitted to the banks. Normally, this facility is what relieves sellers of most of the risk of accepting credit payments: cheques can be cashed at the end of every business day. With the banking system shut, however, cheques were for the time being just personal or corporate IOUs. Sellers who accepted them were doing so on the basis of their own assessment of buyers’ credit. The main risk, therefore, was of abuse of the improvised system. Since cheques were not being cleared, there was nothing in principle to prevent people writing cheques for amounts that they did not have. For the system to work, payees would have to take it on trust that payers’ cheques were not going to bounce – and all this when they had no clear idea when the banks would reopen and allow them to find out. The Times of London was following events over the Irish Sea with interest – and in July it noted both the extraordinary fact that nothing much seemed to have changed, and the apparent fragility of the situation. ‘Figures and trends which are available indicate that the dispute has not had an adverse effect on the economy so far,’ wrote its correspondent. ‘This has been due to a number of factors, not least of which is the prudence which business has exercised against overspending.’ But could the balancing act continue? ‘There is now, however, a psychological risk that if the dispute drags on, caution will be cast aside, particularly by smaller businesses.’33

Sure enough, cracks did begin to appear here and there. A month into the closure, there was a scare when some livestock markets announced that they would no longer accept private cheques.34 In July, a farmer from Omagh who had been convicted of smuggling seven pigs into the Republic was unable to pay the £309 fine handed down to him, for want of ready cash.35 And over the summer, the business lobby – encouraged by the banks and exasperated by the expenses they were incurring to find ways round the closure – began planting scare stories in the newspapers claiming, for example, that ‘a rapidly growing paralysis is spreading through the economy because of the banks dispute’.36 But the evidence collated by the Central Bank of Ireland once the crisis was finally resolved in November 1970 showed quite the opposite. Their review of the closure concluded not only that ‘the Irish economy continued to function for a reasonably long period of time with its main clearing banks closed for business’, but that ‘the level of economic activity continued to increase’ over the period.37 Both before and after the event, it seemed unbelievable – but somehow, it had worked: for six and a half months, in one of the then thirty wealthiest economies in the world, ‘a highly personalized credit system without any definite time horizon for the eventual clearance of debits and credits substituted for the existing institutionalized banking system’.38

In the end, the main impediment imposed by this highly successful system turned out to be logistical. By the time the banks and their employees finally reached a new pay settlement, and it was announced that the banks would reopen on 17 November 1970, an enormous volume of uncleared cheques had accumulated with individuals and businesses. Advertisements were placed in the newspapers warning customers not to submit all of them at once, and forewarning that it was unlikely that account balances would be reconciled fully for several weeks. It was another three months – until mid-February, 1971 – before matters had returned completely to normal. By then, a total of over £5 billion of uncleared cheques written during the period of the closure had been submitted for clearing. This was the money that the Irish public had made for itself while its banks were on strike.

How had this apparent miracle of spontaneous economic co-operation come to pass? The general consensus after the event was that several features of Irish social life were uniquely conducive to its success: not least, that most famous feature of all, the Irish public house. The basic challenge was that of screening the creditworthiness of those paying by unclearable cheque. Ireland had an advantage in that communities, both in the countryside and in the cities, were close-knit. Individuals had personal knowledge of most of the people they transacted with, and so were comfortable forming judgements as to their creditworthiness. But by 1970 Ireland was nevertheless a diverse and developed economy, so this could not always be the case. It was here that the Republic’s pubs and small shops came into their own, by serving as nodes in the system, collecting, endorsing, and clearing cheques like an ersatz banking system. ‘It appears,’ concluded the Irish economist Antoin Murphy, with admirable circumspection, ‘that the managers of these retail outlets and public houses had a high degree of information about their customers – one does not after all serve drink to someone for years without discovering something of his liquid resources.’39


The case of the Irish bank closure provides an unusually useful opportunity to understand more clearly the nature of money. Like Furness’ report from Yap, it forces us to reconsider what is essential to the functioning of a monetary system. But because the Irish case is so much closer in time and technology to our own, it is much more suitable for economic triangulation. The story of Yap showed that the conventional theory of the origins and nature of money is confused. The story of the Irish bank closure helps point the way to a more realistic alternative.

The story of Yap stripped away a central, misleading preconception about the nature of money that had bedevilled economists for centuries: that what was essential was the currency, the commodity coinage, which functioned as a ‘medium of exchange’. It showed that in a primitive economy like Yap, just as in today’s system, currency is ephemeral and cosmetic: it is the underlying mechanism of credit accounts and clearing that is the essence of money. We were left with a very different picture of the nature and origins of money from the one painted by the conventional theory. At the centre of this alternative view of money – its primitive concept, if you like – is credit. Money is not a commodity medium of exchange, but a social technology composed of three fundamental elements. The first is an abstract unit of value in which money is denominated. The second is a system of accounts, which keeps track of the individuals’ or the institutions’ credit or debt balances as they engage in trade with one another. The third is the possibility that the original creditor in a relationship can transfer their debtor’s obligation to a third party in settlement of some unrelated debt.

This third element is vital. Whilst all money is credit, not all credit is money: and it is the possibility of transfer that makes the difference. An IOU which remains for ever a contract between just two parties is nothing more than a loan. It is credit, but it is not money. It is when that IOU can be passed on to a third party – when it is able to be ‘negotiated’ or ‘endorsed’, in the financial jargon – that credit comes to life and starts to serve as money.Money, in other words, is not just credit – but transferable credit. As the nineteenth-century economist and lawyer Henry Dunning Macleod put it:

These simple considerations at once shew the fundamental nature of a Currency. It is quite clear that its primary use is to measure and record debts, and to facilitate their transfer from one person to another; and whatever means be adopted for this purpose, whether it be gold, silver, paper, or anything else, is a currency. We may therefore lay down our fundamental Conception that Currency and Transferable Debt are convertible terms; whatever represents transferable debt of any sort is Currency; and whatever material the Currency may consist of, it represents Transferable Debt, and nothing else.40

As we shall see, this innovation of the transferability of debts was a critical development in the history of money. It is this, rather than the graduation from a mythical barter economy, which has historically revolutionised societies and economies. In fact, it is barely an exaggeration – if we make allowance for the unmistakable overtone of Victorian melodrama – to say, as Macleod did:

If we were asked – Who made the discovery which has most deeply affected the fortunes of the human race? We think, after full consideration, we might safely answer – The man who first discovered that a Debt is a Saleable Commodity.41

The recognition of this third fundamental element of money is important. It explains what determines money’s value – and why money, even though it is nothing but credit, cannot just be created at will by anyone. For sellers to accept buyers’ IOUs in payment, they must be convinced of two things. They must have reason to believe that the debtor whose obligation they are about to accept will, if it comes to it, be able to satisfy their claim: they must believe, in other words, that the money’s issuer is creditworthy. This much would be enough to sustain the existence of bilateral credit. The test for money is more stringent. For credit to become money, sellers must also trust that third parties will be willing to accept the debtor’s IOU in payment as well. They must believe that it is, and will remain indefinitely, transferable – that the market for this money is liquid. Depending on how powerful are the reasons to believe these two things, it will be easier or harder for an issuer’s IOUs to circulate as money.

It is because of this third critical element of transferability that money issued by governments, or by the banks which governments endorse and backstop, is thought to be special. Indeed, there is an influential school of thought – known as chartalism – which argues that governments and their agents are the only viable issuers of money.42 But the story of the Irish bank closure exposes this as another misleading preconception. The closure of the Irish banks showed that the system of credit creation and clearing need not be the officially sanctioned one. The official system – the banks – was suspended for the best part of seven months. But money did not disappear. Like the infamous fei that sank to the bottom of the sea, the associated banks suddenly vanished – and with them the official apparatus of credit accounts and clearing – and yet money continued to exist.

The Irish bank closure demonstrates that the official paraphernalia of banks and credit cards and solemnly printed notes with unforgeable insignia is not what is essential to money. All of this can disappear and yet money still remains: a system of credit and debt, ceaselessly expanding and contracting like a beating heart, sustaining the circulation of trade. What matters is only that there are issuers whom the public considers creditworthy, and a wide enough belief that their obligations will be accepted by third parties. For governments and banks to fulfil those two criteria is generally easy; whereas for companies, let alone individuals, it is generally hard. But as the Irish example goes to show, these rules of thumb do not apply universally. When the official monetary arrangements disintegrate, it is surprising how effective society is at improvising an alternative.


Simplistic history of money and fractional reserve banking

The sovereign’s capacity to issue money afforded one specific benefit: the creation of seigniorage, the ability to profit directly from the issuance of currency. These days, seigniorage arises because of the interest-free loan that a government obtains by printing money on comparatively worthless pieces of paper. But when currencies were associated with particular weights of precious metals, monarchs exploited this power through more overt methods. Many would “clip” gold or silver coins to melt down and redeem the value of the shavings. Before coins were assigned specific numerical values, rulers would “cry down” the arbitrarily assigned value of a specific coin—by declaring that it could now buy less of a certain useful commodity or contribute less than previously to the settlement of a tax bill. In effect, the monarch was recanting on a promise to honor IOUs at a certain rate and so got to write off his or her debts in accordance with the size of the cry-down. By the same token, the crown’s subjects were forced to come up with more money to meet their debts. Needless to say, this irritated the moneyed classes—the nobles and aristocrats, and later the bourgeoisie, for whom the periodic, arbitrary depreciations could amount to significant reductions in wealth. As their resistance to this abuse of power grew, it gave rise to some of the great liberal ideas upon which modern democracy is based, ideas behind the founding of America and the French Revolution. Now, this same spirit of resistance is found among bitcoin evangelists.

Well before the medieval European monarchs even had coins to tinker with, Chinese emperors were taking money into its next phase of technological development. In the ninth century A.D., when regions such as Szechuan experienced shortages of the bronze they’d used for coins, government officials began experimenting with letters of credit that functioned as a form of paper money. Then, in 1023, the Song dynasty issued full-blown sovereign-issued paper money across the kingdom.

In Europe, the struggle between the private and the public sectors for control over money has a much deeper history. While many complained about the sovereign’s constant debasement of the currency, some developed work-arounds that created de facto private money.

The most impressive of these was the écu de marc, a form of currency developed and used by the merchant bankers who emerged out of the Italian Renaissance and which allowed them to expand their business internationally. Based on an exchange rate jointly agreed upon by the merchants, the écu de marc allowed the exchange of bills of trade from different banks in different countries. The sovereigns in each land kept tight control over their currencies, but this banking class was developing its own international exchanges through the wonder of credit creation. The bills financed shipments—say of shoes made in Venice to an importer in Bruges—that enriched the manufacturer, but the real profit spinner lay in trading the paper, a lesson that would be passed down through generations of bankers to the present day. “For the first time, a private-sector community had come up with a de facto money-creation machine. This direct threat to the sovereignty of monarchs gave rise to a political clash as the kings and queens of Europe feared that their monopoly powers were being eroded.

But the bankers didn’t want political power per se. They were pragmatic businessmen, as they would prove to be for centuries afterward. They would use the leverage of private money to strike deals with governments, sometimes as a threat but mostly to wheel and deal their way to more wealth.

This negotiation between the sovereign and these new private generators of money would find its ultimate expression in the royal charter that founded the Bank of England in 1694. The BOE, as bond traders in London’s City now call it, was formed at the behest of King William III, who wanted to build a world-class navy to take on France, then the dominant power on the high seas. “The privately owned bank—the BOE was not nationalized until after the Second World War—would lend the Crown £1.2 million, a massive sum for its time, and could then issue banknotes against that debt, effectively relending the money. Then, to give the banknotes value as a de facto currency, the sovereign agreed to accept them in payment of taxes. In one fell swoop, the agreement created a form of paper money effectively endorsed by the sovereign, established fractional-reserve banking—a guiding principle of modern banking that allows regulated banks to relend most of the money they take in as deposits—and conceived the idea of a central bank. The Bank of England had, in effect, been given a license to print money.

This was the dawn of modern banking, and it had a profound impact on England’s economy. The new financial architecture not only helped the kingdom develop a top-class naval fleet with which it would rule the world from pole to pole, but also financed the industrial revolution. Bank credit effectively became money, since it was deemed to be backed by the sovereign. This new definition of money has prevailed ever since.

Excerpt From: Vigna, Paul. “The Age of Cryptocurrency.” St. Martin’s Press.