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Scotland, Free Banks, and Stablecoins

Murmurations
Murmurations
Good morning everyone. The paper I alluded to last time got pushed back but will be coming out Monday morning. I believe it will be very important and enduring. A huge amount of resources went into it. This has been a weird year of writing for me because I dialed back the columns and dialed up the academic stuff. I wrote or contributed to four papers this year: one on Proof of Reserves, one on DeFi risk factors, one on open banking compared to DeFi, and this latest one on Bitcoin’s energy outlay.
In Nic news this week, I wrote a column called Ethereum’s Design Choices Are Inherently Political, discussing a new incentive incompatibility that has emerged as the consequence of a protocol change called EIP1559. Basically, Ethereum recently changed the fee logic and started burning fees, creating a possible ‘capital return’ to tokenholders. What I wanted to point out is that this puts the interest of tokenholders at odds with those of heavy consumers of the blockchain; the tokenholders want lots of high fees (and thus lots of tokens being retired) whereas transactors want low fees and cheap blockspace. A Luke Gromen likes to say (regarding the Fed), Ethereum developers are trying to ride two horses with one ass. On the one hand, they want Ethereum to be widely used for economic activity; on the other they want to create deflationary mechanics and represent it as a ‘digital gold’ alternative. In this case, the two objectives conflict with each other.
There may be good engineering reasons to include the new mechanic, but there are unacknowledged political outcomes. There’s probably a theorem in here: every technical protocol decision is inherently redistributive, whether it’s acknowledged or not. Writing about Ethereum is always tough because Ethereans often allege that I haven’t done the work and thus cannot be an eligible critic. But I have done the work and have spent an inordinate amount of time understanding the protocol and its dynamics. And indeed, it’s normally outsiders that can look at things with a fresh set of eyes and generate good critiques. There was a bit of hate directed my way but I’m encouraged that quite a few Ethereans responded positively.
In other news, I have been obsessed with wearables and biometrics lately. My stack is quite something: I use an Oura ring, the folks at 8 Sleep very kindly sent me a mattress which I’ve been using, I use a Garmin Fenix 6 for activity tracking, and I’ve been experimenting with Levels. I recently also got a DEXA scan to measure body composition, and bloodwork which I submitted to InsideTracker. A few have asked, so I will devote a whole subsequent post to reviewing these. But I want to collect more data first; I’ve only had the 8 Sleep and Levels for a week or so.
I think the ability to monitor your biometrics and biomarkers with increasing granularity is absolutely transformative. I believe that in a few years, we will be able to predict and anticipate disease based on a constant data stream deriving from wearables (blood work might be substituted for breath or sweat monitoring, or subdermal implants). We will personalize diet based on constant biomarker feedback. We will have far more understanding of how our bodies respond to diet, activity, and environmental factors. Routinely using one or more wearables will become totally mainstream. If you’re working on a startup tackling these important ideas, please get in touch (you can just reply to this email). It’s outside the scope of my fund but I invest personally.

In 2015 or thereabouts, I decided that I wanted to work in finance. I had a degree in philosophy and little in the way of financial training, but I had managed an equity portfolio (quite haphazardly I may add) for a number of years, and had long maintained an interest in security analysis. I was bored with journalism and publishing and figured finance would be more exciting (and frankly, more lucrative). I also wanted to determine how I might end up working “for Bitcoin” and I believed that some more training in finance might be my port of entry to the industry. Knowing relatively little about how to “get into finance” I decided to pursue a one-year MSc in Finance and Investment at the University of Edinburgh. I picked Edinburgh because it was just down the road from St Andrews, where I had spent four years as an undergraduate. I liked the city, I liked Scotland, and I wanted to be close to the site of the Scottish enlightenment. Hume, Ferguson, Darwin (who studied medicine at the University of Edinburgh), JS Mill (well, he was half Scottish), Adam Smith – these were some of my favorite thinkers. I felt that perhaps I could absorb some of their auras by physically locating myself in the city. Edinburgh is sometimes dubbed the ‘Athens of the north’. It even has a half-finished Parthenon-like structure atop Calton hill.
Edinburgh's half finished monument
Edinburgh's half finished monument
The course was intensive, effectively compressing most of the key topics you would learn in an MBA into a single year. Valuably, I picked up a fair amount of stats and econometrics skills, which served me really well in the early days of the project that would become Coin Metrics. In fact, it was a statistics assignment which catalyzed my desire to build a large, denoised repository of data for a variety of blockchains. The contrast between my modest needs at inception and the sheer scale of Coin Metrics today boggles my mind.
I had my hands full learning STATA, playing around with on-chain data, studying Bitcoin (this was midway through my serious period of learning), and reading endless papers about corporate governance and the correlation between the time CEOs spend golfing and subsequent equity returns (yes – there are papers about this). My friends at the time can attest to just how unfun and studious I was. I mean, I still am that way. But I was like that back then, too.  
When I had free time, I loved to hike or run up a rock formation bordering the city called Arthur’s Seat. There are many incredible things about Edinburgh – the medieval layout of the city, the castle hunched atop a gigantic rock in the center of town, the cultural explosion that is the Fringe festival every summer, the absolutely gorgeous Princes Street gardens running through the center of it all, the hulking carcasses of the former banks on George street, the yellow gorse that illuminates the city and the adjoining countryside in the springtime – but my very favorite is the presence of Arthur’s Seat not more than a 10 minute walk from the downtown. Arthur’s Seat is actually an extinct volcano.
Arthur's seat seen from Edinburgh, with Scottish Parliament in the foreground
Arthur's seat seen from Edinburgh, with Scottish Parliament in the foreground
You generally climb it in two phases – first, up a ridge named Salsbury’s crags that provides stunning views of the town, then up a steep dome with a rounded top. My more demanding runs would take me up the ridge. On certain pink wintry mornings after a brisk scramble up the ridge, I’d watch the sun rise over Leith on the one side, and downtown Edinburgh on the other. (The photos included here are my own.)
Edinburgh seen from Salsbury's crags with St Anthony's chapel ruins in the foreground
Edinburgh seen from Salsbury's crags with St Anthony's chapel ruins in the foreground
Edinburgh is known for its sizeable asset management industry. Baillie Gifford, where my dear friend Allen Farrington works, is based there, as is Ruffer Asset Management. BG recently led Blockstream’s Series C round, and Ruffer took a well-publicized Bitcoin position in 2020. At that time, you could still tally up all the firms digging into Bitcoin and taking a position. Throughout Edinburgh, you can find the legacy of Scotland’s financial sector. George Street is full of grand old buildings which were formerly bank headquarters – dramatically overbuilt and excessively ornate to convey trust and credibility – and have now been converted to bars and restaurants.
The largest banks in Scotland’s feted free banking era towards the end of the 18th century were all based there – The Bank of Scotland, the Royal Bank of Scotland, and the Linen bank. The Scottish free or laissez-faire banking system is of critical interest to economic historians, because it was inarguably successful, and because it offers such a good counterfactual compared to England. During Scotland’s free banking era (generally understood to have lasted from 1714 to 1844), England had a centrally-controlled banking system. The two economies were linked and generally subject to the same pressures and exogenous shocks. Therefore, England’s experience during the period offers a fantastic control case relative to Scotland’s experiment with free and laissez faire banking.
At the time England’s banking system was heavily restricted and largely controlled by the Bank of England. By contrast, in Scotland, no central bank existed, and commercial banks competitively issued banknotes. Banknotes were liabilities of commercial banks, redeemable for specie. The banks did not pay interest on the notes (but did pay interest on deposits) and thus benefited when clients deposited specie and took non-interest bearing notes in return. The longer the notes went unredeemed, the lower bank specie reserves could be, and the more profitable the banks became.
This was not a full-reserve system (nor is it clear that free market systems ever equilibrated at a Rothbardian full reserve). During the period, banks generally held 2-3% in specie reserves corresponding to their demandable liabilities. Equally astonishing, given this narrow margin, was the lack of bank failures. (There was one infamous failure, the Ayr bank, which we shall discuss later.) How could this be possible? Well there were some features of the system that kept banks in check and ensured that they were strongly incentivized not to indulge in the over-issuance of notes. These are well-documented in Krozsner’s 1995 ‘Free Banking: The Scottish Experience as a Model for Emerging Economies’, which is actually a World Bank publication, although I’m not sure they’d publish something like this today. In short, Scotland’s banks had the following features which kept it stable:
  • Competitive ‘note dueling’
  • A private clearinghouse
  • Full liability partnership models
  • Until 1765, clauses permitting the temporary suspension of convertibility
  • Branching and diversification
Note dueling was one of the direct market mechanisms that prevented banks from over-issuing. This was effectively a form of institutionalized, competitive bank run, designed to push competitor banks into illiquidity and disrepute should they issue too aggressively. Krozsner describes it as follows:
The Royal Bank of Scotland, for example, would attempt to gather up as much of the outstanding note issue as possible from its rival, the Bank of Scotland. The bank hired people called “note pickers” to collect the rival’s notes, some of whom might even offer a little reward to individuals who would exchange their Bank of Scotland notes for the Royal Bank’s notes. The note pickers would then simultaneously converge upon the Bank of Scotland and demand: “redeem these notes as you promised, give us the gold now.”
This was a completely spontaneous market mechanism which kept reserve ratios in check, but it worked startlingly well over the period.
Bank failures were very rare. Aside from the note dueling, another reason for this was a symmetry of risk borne by shareholders. Banks at the time were full liability partnerships; that is, shareholders faced personal liability if the bank were to fail. Due to the significant cost of allowing a bank to fail, such failures seldom occurred. One infamous example, which Adam Smith wrote about in the Wealth of Nations, was the Ayr Bank. They lent too freely and collapsed in 1772; the partners (who were wealthy lairds and landowners) had to make the depositors whole. Over a 20-year process (things happened more slowly back then) creditors were eventually made whole, but a number of shareholding lairds were ruined in the process. A huge fraction of the land in Ayrshire was sold to resolve the Ayr Bank debts, and the shareholders who could not pay went to prison. How quaint now, to have bankers bear personal costs for poor decisionmaking!
Another structural, and spontaneous, feature of the market, was the private clearinghouse that naturally emerged between a subset of banks. Recall that the banks wanted to promote the usage of their notes, but they also had an incentive to accept the notes of other banks from clients, as clients would grumble and complain if they couldn’t deposit a Royal Bank note at a Bank of Scotland. This meant that banks would end up with their rival’s notes, and they began bilaterally exchanging them in the 1760s. The inefficiency of major banks engaging in bilateral settlement became evident and a clearinghouse emerged in 1771, starting with the major Edinburgh banks.
In a clearinghouse, the banks would net their balances against each other. If a bank dramatically over-issued, they’d suffer ‘adverse clearings’ – that is, rival banks would end up with a lot of their notes, and would start to demand redemption in the form of specie. So the clearinghouse would provide an early warning system for a bank engaging in reckless lending. The clearinghouse was private and not overseen by the government, but it worked wonderfully. As Krozsner says,
The clearing system thus turned into a system of prudenitial private regulation because being in the note exchange system was sending a clear signal to the public that if these other banks, who best knew what was going on within the bank, are willing to accept these notes, then an ordinary person might be willing to accept them also. It thus performed an important information function.
There was no regulatory body, no nasty government entity concern trolling about ‘systemic risks’ or market stability. There was simply a legal structure that discouraged excessive lending, market mechanisms through which banks could competitively keep each other in check, and a vibrant information environment the public could benefit from. The Scottish banking system during the period was remarkably stable; financial crises and panics were rare, contrasting favorably with neighboring England. The Scottish experience of lightly regulated banking shows clearly that such a model can work, and that regulation does not necessarily make a financial system more stable, and in fact is more likely to throw it into disarray.
Now what lessons should stablecoin issuers take from free banking? You don’t have to be particularly astute to see that there are some key similarities there, and indeed our central bank high priests have begun to take note of the resemblance too. I pointed out the similarities in a whitepaper in June 2020. (It’s worth noting that George Selgin has pushed back at the comparisons.) I’ll be brief because I’ve already gone on long enough. First, as exchanges (oftentimes, it’s exchanges issuing stablecoins) continue mutually accepting each others notes, they might consider a private clearinghouse. That way they can achieve efficiency in settlement – moving from real time gross settlement to a net settlement model, saving on fees and on-chain headaches. If they do this, they will be fully incentivized to surface information regarding the solvency of their counterparties. This would solve the coordination problem inherent in entities like Tether being untransparent; their clients don’t have a sufficient economic motive to diligence them. A clearinghouse might in its charter insist that stablecoin issuers disclose their collateral to the group.
Second, one tool that Scottish banks developed in 1750, as an alternative to deposit insurance, was an ‘option clause’. This allowed the bank to suspend redeemability of their notes for specie for a given period of time, effectively allowing solvent but illiquid banks to honor client withdrawals (albeit on a slower schedule). For the privilege, they would pay note holders interest on the normally non-interest bearing notes. This massively reduced the risk of a bank run and it was popular until it was outlawed in 1765. Now for stablecoins to eliminate run risk, they could be structured more like Money Market Mutual Funds, in which you can only withdraw a proportional share of the underlying assets, rather than a fixed claim redeemable for $1. So as a depositor you have no incentive to be the first out the door, as you do with a bank. Or they could implement something similar to the option clause, suspending redeemability if they were faced with a liquidity crunch. Larry White has suggested this, and I believe Tether may have a similar option clause in their ToS but I’d have to double check that.
But the key lesson is simply that unregulated or lightly regulated financial markets can work, and they have worked. There are 60 examples of laissez faire banking over history, and they were only done away with because the modern state demanded control over the economy, and banking was a key part of that. But the track record of central banks is dismal; there’s really no arguing that true laissez faire banking (the American episode was not ‘true’ free banking, as I write here) is superior to the centrally planned and managed alternative. Central bankers need to lie and misrepresent the track record of free or lightly regulated banking, because they want to eliminate stablecoins and install a CBDC. But it’s profoundly embarrassing to them that stablecoins – a fully market-based mechanism – work great, while their CBDCs are still in utero. Stablecoins restored cash to the internet, with its true assurances – privacy and autonomy – plus additional programmability and openness. CBDCs will do no such thing.
For our central banker high priests, afflicted with dizzying ambitions of a fully controlled CBDC system, I prescribe a full dose of the Scottish sunshine. They should take a walk up Arthur’s Seat and gaze upon those old elegant bank headquarters in Edinburgh and reflect on why and how the Scottish system was so remarkably stable. They are either ignorant of the history of free banking, as Selgin relates, or cynically misrepresenting it for political gain; the rest of us don’t have to be. On this, the facts are firmly on our side.
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Murmurations
Murmurations @nic__carter

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