Re: In Search of Genuine DigiCash

[rah@shipwright.com (Robert Hettinga)]

At 11:00 AM 8/27/94 -0700, Eric Hughes wrote:

>   Digital cash has to be issued by someone, who
>   *really should* back it up with real money, and should thus receive real
>   money as collateral for the digicash on the net.
>
>The basic distinction that is missing in your analysis is that between
>legal structure and financial structure.  Here is my very short
>clarification of the difference.
>
>-- The financial structure matters when things go right.
>-- The legal structure matters when things go wrong.
>
>Your financial analysis is fine, but also mostly irrelevant for
>determining legalities.  I've never worried too much at all about the
>financial structure for digital cash issuance, because I've always
>thought it a straightforward problem to manage the backing portfolio.

Unfortunately, Eric, I think you'll agree in hindsight that financial
structure and legal structure is a little more tightly coupled than that.
The law and the enforcebility of agreements is what makes financial
instruments exist.  Their behavior is a direct result of their legal
underpinnings. Thus, the financial structure is the legal structure. The
financial behavior of a security can thus be predicted just by assuming the
efficacy of the legal system they're written in.

If you break the law or agreements creating a market, say if people didn't
make their margin calls and got away with it, there wouldn't be a market on
margin for very long. Thus, by collateralizing what you would call a
digital banknote, you are agreeing with the person you issued it to that at
the very least, that dollar-for-dollar, there's money to back the note up.

By the way, I figured out just now why this can't be called a digital bank
note, though I can't figure out what to call it except digital cash for the
time being. Digital cash isn't issued by a bank in the scenario I outlined,
at least a bank of deposit. The issuing underwriter isn't anymore a bank
than an institution offering any other piece of collateralized paper, like
GNMA, a railroad offering an equipment mortgage bond, whatever.

>I think you misunderstand me.  Secured and unsecured are legal
>concepts, not financial ones.  Merely saying that the money sits
>somewhere while it's in transit (which it clearly does) does not make
>the instruments secured.

But it does, Eric. Especially if the underwriter says at the outset that
the money's secured (collateralized).  If money isn't secured dollar for
dollar, especially in the early stages, you get a whole mess of legal, not
to mention financial problems.  It should be possible to keep an issue of
digital cash fully collateralized (secured) and still make money.

>   >What happens during bankruptcy of the issuer?
>
>   This probably won't happen except in cases of fraud.  [...]
>   Unwinding a position in the money markets is not really a scary
>   proposition at all.
>
>I would strongly suggest that you go look up some references to
>systemic failure in payment systems, which is a big concern these
>days.  And unwinding a position in the case of bankruptcy can create
>real negative value in the system, and cause other banks to collapse.
>Unwinding can be _very_ expensive.

Again, Eric, if one digital cash underwriter has to unwind a fully
collateralized bunch of digital cash, what's the problem?  If the
underwriter isn't fully collateralized, he's in violation of his issuance
covenants and is likely to be sued by the trustee for the instruments, at
the very least, long before a run on the cash started.  Thus, the
shareholders of the company doing the underwriting take the hit for a
bankruptcy, while the suspension account and the portfolio backing it may
not even have to be unwound at all.  They may simply be transferred to
another underwriter for safer keeping.

It's not at all like banks, where they get to make money by creating a
little, and thus should have insurance to keep the their liabilities and
their reserve requirements.  Having a fully collateralized digital cash
(for lack of a better term) system is pretty simple to do from a financial,
and legal standpoint.


Thanks!
Bob Hettinga

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