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the latest source of comment and analysis from the Institute for Security & Resilience Studies at UCL.


Archive for the 'Financial resilience' Category

The Next Shoe

By Mandeep K Bhandal, on 19 July 2013


ISRS Senior Research Fellow, Chris Cook in this article addresses the susceptibility of financial markets to a price discontinuity, and why the current regulatory policy might almost have been designed to make a bad situation worse.

The Next Shoe

In the summer of 2005 I was invited to speak – in relation to energy markets – at a conference in Lausanne convened by the Geneva Centre for Security Policy on the subject of ‘Economic Terrorism’.  Essentially this conference concerned the resilience of financial rather than physical infrastructure to attack by terrorists using economic rather than physical means.

My message was that the existing market architecture concentrated risk in centralised organisations such as banks and clearing houses to an extent that was not appreciated. I made the wry observation that the only difference between a hedge fund and an economic terrorist was their motive.

In October 2008 the first shoe dropped.  Following the collapse of Lehman Brothers, which I regard as a milestone in the evolution of markets, we saw the financial system freeze up almost entirely. In fact, in the UK we came two hours away from the ATMs being switched off, and a day or so from what has been described as ‘shopping with violence’.

In the aftermath of this seminal event we saw dollar interest rates crash to zero, and the Federal Reserve Bank embarking on the massive money creation and injection into the financial system known as Quantitative Easing (QE). The reaction of investors to these events was to pour their dollars into the new breed of Exchange Traded Funds (ETFs) which invested in non-income producing assets such as gold, metals and commodities as a ‘hedge against inflation’, to use the marketing phrase adopted by the investment banks who manufactured these funds

In a cosmic irony, this inflation hedging passive investment had the effect of financialising the markets in which it became dominant; creating correlated bubbles; and causing the very inflation these risk averse (the complete opposite of risk taking speculators) and passive investors sought to avoid.

Regulatory Response

As a response to the Lehman meltdown the regulators acted to address the revealed systemic financial instability.

They decided that the best response was to bring the opaque bilateral ‘over the counter’ market in the derivatives, whose leverage was a major factor in the problem, into a central clearing house.

The good news is that this does indeed provide transparency to regulators: the bad news is that it concentrates market risk in a single point of failure which is susceptible to discontinuities in price following ‘Black Swan’ events.

Market Discontinuities

The best known example of a market discontinuity was the 1985 Tin Crisis which occurred when a  cartel of tin producers which had been supporting the tin price using London Metal Exchange forward/futures contracts ran out of money. The price literally collapsed overnight from $8,000 per tonne to $4,000 per tonne; the exchange imposed a settlement price at $6,000 per tonne, and litigation by those adversely affected rumbled on for many years.

Such a discontinuity is quite possible today, particularly in the market in crude oil, which has been the subject for years of a macro manipulation by producers who obtain cheap finance from the ‘inflation hedger’ funds mentioned above.  Essentially the producers lend oil to passive investors – using derivatives or the prepay contracts rediscovered by Enron – while the passive investors lend dollars to producers.

The prepay mechanism is now in routine use. For instance, Russia’s Rosneft is unwilling to sell ownership (equity) while banks are unwilling to lend to Rosneft (debt).  So we now see, as a third way between equity and debt, the major trading houses Glencore, Trafigura and Vitol entering into crude oil prepay contracts with Rosneft, where they buy crude oil at a discounted price for cash now and delivery later.

These trading houses borrow the necessary dollars from banks and then offload their market price risk onto the relevant clearing houses.  In my view, the transparent and direct use of prepay instruments for financing (Peer to Peer credit) and funding (Peer to Asset credit) will lead to a resilient networked financial system.

But the current opaque use of prepay instruments by intermediaries – notoriously pioneered by Enron – is an accident waiting to happen, exacerbated by the wave of demutualisation of exchanges and the fragmentation of clearing houses into proprietary siloes.

This is because Risk is akin to Energy: it cannot be destroyed: it can merely be moved around and change state. The market risk formerly taken by banks has now been outsourced to Clearing Houses which are not in my view capitalised for the true risks they run.

Many of those investors who were worried enough about inflation to hedge it using ETFs are now selling their units and buying into asset classes like stocks and property which offer at least some yield.

As this fund money drains out, the financialisation comes to an end and commodity price bubbles will deflate: the only question is the rate at which this fall in price will occur, and I believe that there is a significant possibility that a market price discontinuity like that in the 1985 tin market could well be the next shoe to drop.

Not only are the regulators failing to address this systemic risk: the centralising policies they have been developing might almost be designed to create it.

Bitcoin: Threat or Menace?

By Mandeep K Bhandal, on 4 April 2013


ISRS Associate Fellow, Vinay Gupta provides an assessment of bitcoin.

Bitcoin: Threat or Menace?

It’s easy to get carried away by the rhetoric around bitcoin. A “came from nowhere” new financial instrument with murky anonymous origins, associated with non-state anarchocapitalist libertarians, seems like something sprung to life out of science fiction.

Really we should not be surprised. Bitcoin is the unexpected interaction of three trends.

Firstly, there are ongoing efforts to make digital systems replicate the properties of real objects. Copyright holders have created generation after generation of digital rights management (DRM) systems to try and make files on a DVD as hard to illicitly copy as bulky, expensive 35mm cinema projector prints rather than infinitely replicable bits on a spinning disk. That other groups would try to produce hard-to-clone property rights in the digital medium should be a surprise to nobody.

Secondly, bitcoin is decentralized. Many modern computer utilities are decentralized: Skype, Spotify, Bittorrent and more are all “peer to peer” below their smooth exteriors. When you are running Skype, your computer is helping other users make calls, and nobody really cares. As sophistication increases, and user’s own computers increasingly do the work that was done in expensive data centers, it gets easier and easier to build systems which take the last jump and simply have no center at all.

Finally, dotcoms have recently been acquiring value faster than ever. Instagram went from zero to a billion dollars of value in two years, and was then sold to Facebook. Value sloshes around in these ecosystems at stampede rates with very little predictability. Was a photo sharing service with some cool image processing filters ever really worth a billion dollars? Only the market knows – a greater fool purchases your stock, and to you, in that moment, the value is completely real. Is it real for the greater fool? That depends on access to an even greater fool. But fools have never been in short supply.

In bitcoin these three trends combined: technical creation of hard property rights meets decentralization and an extremely rapid acquisition of perceived value. It should also be noted that “crypto-currencies” of this type go back at least 20 years in practice, and further in theory.

Really, the only surprise is that it is happening now, and in this particular rather strange form.

The end game for cryptocurrencies has always been the collapse of the State through tax starvation. Theorists like Tim May (formerly of Intel) predicted the collapse of the state as an inevitable consequence of widespread digital networks, and viewed the fall of the USSR as a direct result of information and communication technologies. They predicted that once cryptocurrencies became established, mass migration away from national currencies would spell and end to the current status quo. When we consider small nations like Cyprus, it’s easy to imagine a speculative future in which mass migration to a new currency standard leaves the European Central Bank largely without influence.

To assess the plausibility of those scenarios, we need only ask one simple question: “is the internet bigger than the State?” In most cases, the answer is “no.” A few very small, very fragile states might be actively at risk from digital currencies, but for the most part, State regulation of the internet is still possible, and a currency which was becoming a genuine threat to the national currency could be killed one way or another. Draconian measures might be required, but where there’s a will, there’s a way.

However, if Google-Facebook-Amazon-Apple-Microsoft-eBay-PayPal got in to the currency game, this situation could change rapidly. An internet currency backed by a consortium of that size could seriously upend many of our expectations about how the world should work. They would be capturing the last remaining part of the value chain left behind by the credit card companies.

If they got it right, they might wind up bigger than VISA.

The narrow libertarian reading of the State roots its power in finance and the coercive power of taxation. A broader understanding of the State might root its power in national identity or even simplistic notions on the monopoly on legitimate violence. Within that wider context, it’s obvious that for cryptocurrencies to have substantial impact, they are going to have to grow very broad shoulders indeed. The table is very large, the players many, and the histories long.

It’s going to take more than a digital analogue of the old Swiss anonymous banking system to cause a real upset. It may yet come, but not today.



The Community is the currency

By Mandeep K Bhandal, on 4 April 2013


ISRS Senior Research Fellow, Chris Cook discusses the need for new and ‘bottom up’ community-based economic tools. This article was also published in the business magazine, the3rdimagazine.

The Community is the currency

As the economy of Cyprus implodes, UK austerity measures begin to bite and the banking industry retreats further into itself, the need for new and ‘bottom up’ community-based economic tools has never been greater.

One such tool is the Credit Unions, where people make deposits which fund loans within a community with a ‘common bond’, which may be geographic, functional (eg the Metropolitan Police) or possibly both.

Another emerging tool is the complementary currency, of which the best known is probably the emerging range of Transition currencies such as: the Totnes Pound; Lewes Pound; Bristol Pound; Brixton Pound and so on.

While both of these tend to keep economic value local, which is unequivocally a good thing, what they essentially do is move existing economic value around; they don’t actually do a great deal to stimulate new economic activity, the need for which is growing daily more urgent.

Maybe there’s another way of doing it?

A Linlithgow Guarantee Society

The concept of a Guarantee Society is not a new one. For the last 140 years ship owners have clubbed together in a range of ‘Protection and Indemnity’ (P & I) Clubs which mutually insure risks which commercial insurers would not cover. For the last 135 years the same service provider, Thomas Miller, has served P & I Clubs by: managing risks, handling the pool of resources backing these risks; handling claims and providing other services to P & I Club members.

Since 1992 some 18 European countries have seen the formation of Guarantee Societies which enable members of an association, typically businesses, to join together to mutually guarantee bank loans by their members.

Anyone familiar with the work in the field of micro-credit of Dr Muhammad Yunus with Grameen Bank in Bangladesh will know that one of the key success factors was the way in which micro-loans are supported by the guarantees and support of small circles of friends and relatives.

The advent of pervasive direct instant connectivity and paperless accounting and administration now enables the concept of the Guarantee Society to mobilise a new approach to Community Credit.

A Linlithgow Community Credit Card

What might this look like? Well, firstly, in the future, it will probably be an element of the SIM card on everyone’s mobile phone. In the meantime it will look and operate just like any other credit card, but ‘under the bonnet’ it will be very different.

Let’s imagine a Linlithgow Credit Card, because it is the green and pleasant ‘Garden Burgh’ in Scotland where I live. Local businesses will club together, as they are doing already in a Business Improvement District (BID) initiative, as enterprise members of the Linlithgow Guarantee Society (LGS). They will then extend interest-free credit, time to pay, to local people who become individual members of LGS.

While this credit is interest-free, it will not be cost-free. A subscription will cover the agreed costs of the necessary accounting system, of which there are several cheaply available, and of the service provider. This could be perhaps a credit union or even a local bank such as our local Airdrie Savings Bank, which is the sole survivor of the Trustee Savings Banks which were privatised with the depositors’ own money.

The role of this service provider is to set and manage ‘guarantee limits’ on credit extended by enterprises, and the credit extended to individuals, and also handle problems and defaults. In other words, the service provider will do precisely what it does now but the difference is that it would no longer be exposed to the risk of defaults. Banks would queue up and compete to provide such a service.

If a bank doesn’t take the credit risk, who does?

It is the Guarantee Society members collectively who will be exposed to the risk, and they will protect themselves simply through the making of a ‘guarantee charge’ to both businesses and individuals in respect of the use of the guarantee. In other words, both businesses and customers would pay into a ‘Default Pool’ held in common by a bank as custodian for the members, rather than by a bank as proprietary owner.

Here Linlithgow benefits from being in the West Lothian region, whose council is one of four Scottish local authorities which still maintains a Municipal Bank. The very restricted purpose of the West Lothian Bank is purely to receive deposits from West Lothian Council staff and pensioners, pay them a decent rate of interest and lend money at a reasonable rate of interest to the Council.

Wherever the default pool of funds is held, a service provider ‘managing partner’, in addition to covering agreed costs, could be incentivised with an agreed bonus based upon service level and default experience.

The Co-operative Advantage

Anyone familiar with how credit cards work, which is to make a fat transaction charge to sellers, and to charge substantial interest and other charges on unpaid balances, will see that a community credit card will operate essentially as a co-operative of sellers sharing credit risk with a co-operative of buyers.

Any surplus from operation could be distributed to members as they see fit, possibly to relieve poverty or simply as a co-op dividend so that those who provide the guarantee, but do not use it, are recompensed for the risk they shoulder.

The outcome would be that such a Linlithgow Community Credit Card could out-compete conventional cards simply because it has the Co-operative Advantage of not paying returns to rentier shareholders and payments to management not reflected by performance.

The Community is the Currency

The really interesting possibilities arise from the fact that every individual is also an ‘enterprise’; it’s just that the value of the service they can provide is not recognised. So the growing number of unemployed could be extended credit by their fellow Guarantee Society members and in return could provide care for each other, and for the place in which they live or provide cultural value like music, art and drama.

As with conventional credit cards, there are no deposits necessary in such a system, which could be introduced tomorrow using conventional software. The result in Linlithgow would be a Linlithgow Pound, which spends just like a conventional pound, but does not require, as do Transition Pounds, the pound for pound backing of conventional sterling manufactured by the banking system.

So Linlithgow Pounds would be created and would circulate only within the community of members of the Linlithgow Guarantee Society.

The Linlithgow Community is the Currency.



The case for Cypriot National Equity

By Mandeep K Bhandal, on 28 March 2013


ISRS Senior Research Fellow, Chris Cook discusses how the Cyprus National Debt may be resolved into a Cyprus National Equity.

The article was posted on the Financial Times, Alphaville on March 25, 2013.

The case for Cypriot National Equity

The second attempt to resolve the unsustainable debt burden of Cyprus’s over-leveraged banks spreads the pain differently to the disastrous initial attempt, but looks likely to leave Cyprus as an economic wasteland for generations. Frances Coppola outlined brilliantly yesterday the sort of financial disaster zone which Cypriots can expect.

Cyprus, in common with many other countries, but far more urgently, requires resolution and transition: Resolution of existing debt; and transition to a sustainable and low carbon economy. Surely there must be a better way of achieving this? Well, my research leads me to conclude that there was; there is; and there will be again; if Cyprus ceases to attempt to resolve 21st century problems with 20th century solutions and instead uses an updated version of a financial instrument which pre-dates modern debt and equity finance capital.

In this post I will suggest how the Cyprus National Debt may be resolved into a Cyprus National Equity… but not equity as we know it.


The first step is for the Cyprus Treasury to create a new class of undated – by which I do not mean permanent – ‘Stock’.

This instrument consists of a non interest-bearing promissory note or unit which is returnable at any time (i.e. undated) in payment of €1.00 par value of Cyprus tax. The second step in the process is the nationalisation of the key banks, Bank of Cyprus and Laiki Bank, with shareholders receiving one €1.00 unit of Cyprus Treasury stock at par – i.e. they will receive a zero discount – in exchange for each existing €1.00 share.

The third step will be for all demand deposits, term deposits, and all classes of bonds to be exchanged for Cyprus Treasury €1.00 stock at graduated discounts reflecting the seniority, term and interest rate which applies.

The fourth step is that all existing Cyprus Treasury dated interest-bearing Stock – the Cyprus National Debt — will also be exchanged for and consolidated into €1.00 units of undated stock, again with a discount reflecting the term and interest rate.

The result will be a Cyprus National Equity: a single consolidated fund of Cyprus undated Treasury Stock returnable in payment for Cyprus taxes.

This will be supplemented by the flow of debt repayments (after operating costs) to the Cyprus Treasury from the borrowers of nationalised banks.

Rate of Return

The phrase ‘tax return’ comes from the way in which the ‘stock’ portion of a ‘loan tally’ record of prepaid tax would be returned to the Exchequer for cancellation by a tax-payer who had chosen to prepay tax. The phrase ‘rate of return’ was literally the rate at which such loan tally stock could be returned to the Exchequer.

Naturally, no creditor who prepaid tax by advancing money or money’s worth of goods and services to the sovereign would do so other than at a discount, and the rate at which the stock could be returned was literally the rate over time at which the profit derived from the discount could be realised.

By way of example, £10 of stock exchanged for £8 of value from the tax-payer and would give rise to a profit of £2, but the rate of return depended – literally – on the rate over time at which the stock could be returned to the Exchequer for cancellation. So a £10 annual tax obligation would mean the discount was realised in one year and would give rise to a £2 profit on the £8 advanced – i.e. a 25 per cent rate of return.

A £5 p.a. tax obligation would give a 12.5 per cent rate of return and so on.

Return on National Equity

The rate of return applying to this Cyprus National Equity will therefore literally be the rate over time at which the units of prepaid Cyprus taxes may be returned to the issuer at €1.00 par value, and the profit arising from any initial discount may be realised.

This is where it gets interesting.

Firstly, Cyprus taxpayers will always be in the market for stock at the best price below €1.00 so they may pay their taxes at €1.00 and make a profit. Secondly bank borrowers will also be in the market for stock, at the best price below €1.00, to pay their debt with it.

There is no possibility of a default since there is no dated debt obligation.

However, the rate of return will be determined by the levels of tax levied by Cyprus, and will be supplemented by demand for stock returnable against the flow of payments made to the nationalised banks by borrowers. Such Cyprus Treasury €1.00 stock units will not actually be euros or even (not quite) generally acceptable retail Cyprus currency, but will rather be investments priced in and exchangeable for euros at a level which reflects likely future demand from taxpayers and bank borrowers.

Through the creation of a Cyprus National Equity – not permanent equity as we know it, but an ancient form of undated equity – the Cyprus crisis may be resolved to create an interim breathing space as Cyprus funding costs are drastically reduced.

It will be seen that the debt has been resolved by a conversion or consolidation into a form of undated, rather than permanent, equity.

There’s nothing new about such a consolidation: in 1888, the UK Chancellor, George Goschen enacted “Goschen’s Conversion” which consolidated the existing disparate classes of undated ‘gilt-edged’ stock into a single class of undated ‘Consols’ which remain to this day.


In the medium and long term, however, there must be a transition to a low carbon and fiscally sustainable Cyprus economy.

Firstly, Cyprus must address resource resilience: in other words, how energy infrastructure and energy reserves, in respect of which Turkey explicitly and unequivocally staked out a claim over the weekend, may be equitably shared and optimally developed.

Secondly, Cyprus must become financially resilient, and while attention is currently away from the isolated and friendless North Cyprus it is clearly the case that some kind of economic co-operation, if not integration, is long overdue.

In that context, there was an interesting post by Nick Dunbar recently as to how the use of structured products could perhaps lead to a re-unification of Cyprus. How such resource resilience and financial resilience might be achieved simply, consensually and without the need for either power-seeking or rent-seeking intermediaries, is for another post.


What’s worth €17bn?

By Mandeep K Bhandal, on 20 March 2013


The Institute for Security and Resilience Studies (ISRS) provides a Net Assessment Bulletin (NAB) of the latest economic crises erupting through Cyprus.

What’s worth €17bn?

The latest cascade of economic crises erupting through Cyprus provides even more evidence – as if that were needed – of a severe lack of strategic grip from EU elites (be they technocratic officials, rent seeking bankers or out of touch politicians). Nevertheless, the Cyprus crises need not be wasted. A grand strategic move would be to make re-unifying Cyprus the best outcome for Cypriots, EU citizens and all our allies. Indeed, it would be worth the investment of €17Bn and certainly a better outcome than playing the financial folly blame game, when all parties are culpable in one way or another. The virtue of such a strategic move could be its honest transparency not just the important strategic advantages to be gained on several fronts.

It is worth remembering that in 2004 the Greeks threatened to veto EU expansion if the accession of Cyprus was not included as the tenth new EU member that year. The veto threat left some EU partners and allies feeling blackmailed. It need not have done so, if the Annan Plan to resolve the partition of Cyprus had won the backing of both the north and the south of the island in the referendum that same year. Inasmuch as Greek Cypriots can claim secret diplomacy undermined their confidence in the re-unification offer, the referendum result sowed discredit that has only been exacerbated by Greek and Greek Cypriot Eurozone performances since. The whole of Cyprus being an EU member but not a member of NATO adds significantly to the strategic implications of how the current crises are handled.

Today, in an effort to prevent any run on banks in Cyprus, Cypriots have woken up to another day where the banks are closed to them. The manoeuvres by the Cypriot President, Nicos Anastasiades over the last few days may have been more of an attempt to protect its off-shore financial centre business than resolve its public debt problem. Sucking more Russian money into Cyprus’ financial and energy sectors may have parochial and Byzantine appeal but ill serves Cypriots as EU citizens and the alliances Cypriots rely on for their security. Nevertheless, the Cypriot parliament was given easy populist cover for unanimously rejecting the proposal of the technocratic Troika (comprising the European Commission (EC), European Central Bank (ECB) and International Monetary Fund (IMF)). Predictable public outrage at the one-off 6.75% levy on savings of less than €100,000 will result in more than crude gestures and rhetoric involving German flags.

Politics and economics are inextricably linked. They are transnational rather than just national or international. This couples the fortunes of the few with the many in ways that are not healthy by default. Cyprus allowed its banking sector to balloon. Even if that ballooning did not involve all Cypriot banks or the informed consent of all citizens, it was their government that created a permissive environment in which too few questioned the credibility of their growing prosperity. We are left once again in a situation where the self-righteous can chant “moral hazard”, particularly if it seems that in easing the plight of Cypriots, some non-EU citizens and their illicit finances will be protected and continue their corrupting work. Yet the precedent of bailing-in the savings of insured depositors is politically toxic and contagious. It is quite at odds with how the EU obliged Eire to honour not just the letter of depositor insurance but the spirit too. The Irish have endured with good grace and done their bit to prevent contagion since 2008.

The Troika’s decision on a ‘haircut’ reaching ordinary savers demonstrates just how out of touch the political elite and technocratic officials are. Claiming Cyprus is a “special case” and other periphery countries need not fear the same fate is naïve. This policy initiative could reveal once more the fragility of the Eurozone, as depositors elsewhere in the periphery consider moving their savings into safe havens, including old-time notes under the mattress or more advanced crypto-currency bitcoins. The Troika’s political maladroitness might have been thought helpful to Merkel’s re-election prospects but lurid headlines about Russian criminals getting their hands into German taxpayers’ pockets allows populist tactics to obscure strategic wins. Putin does not shy from populism, as his rumoured statement to the Cypriot President concerning German flags underscores. However, for now any populist outburst from Putin will have strategic intent.

Cyprus as a convenient off-shore financial centre (OFC) has its advantages but Russia will be more interested in their growing energy security racket and disadvantaging NATO. Russia is seeking to shape Europe on its Byzantine terms. These continue to diverge from the shared interests and values of all EU and NATO members. Whether Putin’s strategy advantages Russians as a nation rather than their rentier state elite is doubtful. Conversely, Angela Merkel defaulting into reparation mode for a September election could mark a failure of leadership born more of bad populist tactics than strategy. This approach to Greek Cypriots is only compounded by politicians being too coy to challenge what many Germans think of the Turks next door. Turks are far more than freeloading one-time gastarbeiters; they can amplify their allies otherwise declining power, not least in a regional neighbourhood that still matters. The outlook from Moscow and Berlin does not advantage Cyprus, the EU or NATO.

Instead of leaving strategy to Putin and tactics to German populist politics, the EU could do something very worthwhile for €17Bn – re-unify Cyprus! Doing so could turn Turkish garrisons into a few more NATO bases and enable real power to be projected with energy and enterprise by the EU for the good of the whole region. Bad mouthing Russians, Greeks and Turks simultaneously is crass. A United Republic of Cyprus would create a hub for EU and NATO partners. From there options open up across the Levant, Caspian, and Caucasus that offer rewarding growth for all rather than more corruption, decline and conflict.


The Myth of Debt

By Mandeep K Bhandal, on 11 March 2013


In a recently published article in the Sunday Herald, ISRS Senior Research Fellow, Chris Cook discusses the global debt problem and the road to recovery. The below article is published with the kind permission of the Sunday Herald.

The Myth of Debt

From the latest cuts to economic forecasts to the Italian elections to the gathering debate about how George Osborne should play this year’s Budget, all discussions about the financial system now lead swiftly back to the world’s sovereign debt problem. It towers over every effort to get back to prosperity, threatening to take decades at best before it can be resolved, very possibly with an almighty crash along the way.

But maybe that is because we are looking at a 21st Century problem in a 20th Century light. My research at University College London’s Institute for Security and Resilience Studies indicates that the answers might lie in modern versions of legal structures and instruments which pre-date the modern financial system and even the Act of Union. But before I explain this ‘Back to the Future’ proposal for recovery, a warning: we’ll need to turn much of the received wisdom that underlies modern economics and politics upside down as we proceed.

Prior to the advent of double-entry book-keeping and the concept of profit and loss in the Middle Ages, accounting typically involved the use of wooden tally sticks. Notches and marks were made on a stick, with two functions. One was as a memorandum tally or receipt evidencing a sale, and the other was as a record of an obligation – a loan tally. In both cases, the tally stick would be split down the middle with the longer portion (the ‘stock’) being given to the counter-party of a transaction and the shorter portion (counter-stock or foil) kept by the originator.

For over 600 years from the early 12th Century and even before, UK sovereigns were accustomed to raising funds to fight wars and for other sovereign expenditure by obtaining money, goods and services from their subjects as an advance on their tax liabilities. The subject would receive a loan tally in exchange, which represented a pre-payment of tax due.

It could be handed back (hence ‘Tax Return’) in lieu of more conventional money at any point in the future when they came to pay their taxes. This is different from a debt, which normally comes with a date on which it must be paid back. And naturally these Medieval taxpayers did not give the sovereign £10’s worth of value in exchange for a £10 prepayment of tax but received a discount for their trouble.  The phrase ‘rate of return’ literally means the rate over time at which the stock could be returned to the issuer, enabling the initial discount to be realised.

In 1694, the Bank of England stepped in. Originally a private company, it was founded to create money backed by its gold holdings that could be exchanged for Treasury pledges over future taxes. In contrast to the old tally stick system, these pledges, known as ‘gilt-edged’ stock, or gilts, came with redemption dates and paid a fixed rate of interest.

These changed characteristics of a fixed date and rate of return made the pledges resemble debts. However, the difference is that these pledges are ownership claims created by an individual over his own income, whereas a debt claim is created by one individual over another individual’s income. The correct analogy is to think of gilt-edged stock as akin to interest-bearing shares or equity bought by investors in UK Incorporated, with a redemption date.

The position today is quite similar, except that the Bank of England is now State owned and the pound sterling is not backed by gold but by faith alone.

The fiscal myth of tax and spend shared by virtually all schools of economics is that tax is first collected and then spent. This has never been the case: the reality, as we have just seen, has always been that government spending has come first and taxation later. The reality is that taxation acts to remove money from circulation and to prevent inflation: it does not fund and never has funded public spending.

The Treasury does not, as we imagine, bank with the central bank in the same way that we maintain a bank account where our interest-bearing bank deposit asset is the bank’s interest-bearing debt liability and vice versa. The central bank creates credit/money on the Treasury’s behalf which it exchanges with the Treasury for gilts or lends to the clearing banks as necessary for them to balance their interest-bearing lending and deposits.

The clearing banks of course have their own power to create money, for the purposes of lending. They are responsible for most new money in the modern system, accounting for about 97% compared to 3% from the Bank of England.

Incidentally they too are the subject of a well peddled myth, which is that deposits are first collected by banks and then spent or lent into circulation on the basis of requiring a certain reserve level of deposits to be maintained. In fact, there is no constraint on UK credit/money creation of reserves: the constraint on modern money creation by private banks is the capital required to cover losses on loans.  Private banks first lend or spend what are essentially ‘lookalikes’ of central bank money, and then fund their dated interest-bearing loans (assets) with dated interest-bearing deposits (liabilities).

Putting most money creation into the hands of organisations whose raison d’etre is to make money from lending (and more recently, from speculation) is behind much of what has gone wrong with the financial system. As with all historic bubbles, the profit motive drove excessive credit creation. Bank lending departments were abetted by everyone from bank lobbyists persuading the authorities to allow dangerously low capital ratios to trading departments devising increasingly complex instruments for shifting loans off bank balance sheets to make more and more lending possible.

From out of these observations, I reach two conclusions. First, the clearing banks cannot be trusted to freely create the credit which is modern money.  If money is to be created by a middleman or intermediary then it should be the Central Bank or the Treasury: the question is, how and by whom such State credit issuance and allocation should be professionally managed and accountably supervised.

For instance in Hong Kong, there is no central bank. The Hong Kong Monetary Authority supervises the issuance of virtual currency and physical bank notes by three commercial banks including HSBC. The Hong Kong dollar is kept pegged to the US dollar between upper and lower rates which are defended by a currency board mechanism, putting strict limits on the amount of money that the commercial banks can create.

The idea of direct Treasury creation of money should not seem alien, by the way. During the First World War, UK Treasury notes known as Bradburys were temporarily issued as money to surmount a shortage of credit. In the US to this day, there remain a small amount of US Treasury Notes (greenbacks) in circulation which are worth exactly the same as the Federal Reserve Bank dollar notes which replaced them.

My second conclusion is that we must revisit the concept of the National Debt itself and recognise it for the National Equity it is in reality. We have only saddled ourselves with this debt delusion because we have forgotten what the true relationship actually is between public spending and taxation.

All existing UK gilt-edged stock could be consolidated as happened before with Goschen’s Conversion in 1888 which created the single class of undated Consolidated Stock (‘Consols’) which remain to this day.  We could again create a single class of undated stock and the absence of dated ‘debt’ obligations would drastically reduce the UK’s funding costs to the rate of return paid in respect of this ‘National Equity’.

In fact, one could argue that the creation of £375 billion of quantitative easing (QE) reserves – upon which the Bank of England pays interest at 0.5% pa – has partially achieved such a Consolidation by the back door.  These reserves of fiat money created and used by the Bank of England to buy  and hold gilts are assets which are functionally equivalent to gilts, since both are created as claims over future tax income, just like the broken tally sticks from days long forgotten.

Such a centralised re-architecture by the UK government of the national balance sheet is admittedly difficult to foresee at present. But once you dispel the myth of the national debt, it creates a space for discussion of more practical solutions now emerging as a result of technological innovation. With the prospect of a Scottish Treasury emerging in the near future, this is worth serious consideration.


Panel: Open Capital

In Mathematics there is +1, -1 and 0; in Physics, positive, negative and neutral. But in Economics we see only conflicting absolutes of equity and debt; freehold and leasehold; public and private. The long forgotten prepay instrument which enabled UK sovereigns to fund themselves through tax prepayments opens up new neutral asset classes which I refer to as ‘Open Capital’.

Prepay instruments enable not only direct ‘Peer to Peer’ credit, but also direct ‘Peer to Asset’ investment in productive assets without Treasury or banking middlemen.

I’ll illustrate this by outlining a couple of prototypes under development. One involves a housing authority that is building new flats in a project financed by a bank on the basis that their construction loan will be refinanced by the local council once the block is complete. This way the bank gets repaid quickly and the council avoids taking the construction risk.

This model will get the flats built, but means that the money is tied up in the project for years while the housing authority repays the council. The concept of Open Capital ‘rental prepay’, is that once the flats are let, investors will buy (say) 40 or 50 years of rental units at a discount. For the sake of argument, it could be 22 million £1.00 units of index-linked rentals sold at a price of £15m to investors.

Long-term funding for the project becomes equity not debt, albeit not equity as we know it. The refinancing releases what is essentially a revolving pool of public credit to be reinvested in other projects. The Open Capital model is particularly well suited to affordable housing because  the absence of compound interest and debt repayment drastically cuts funding costs and means a more reasonable rental may be charged.  Since an affordable rental is by definition more likely to be paid; the risk of non-payment is lower; and this greater certainty justifies a lower rate of return.

My second example of Peer to Asset investment concerns energy saving schemes. Suppose  investors are concerned about inflation and believe that natural gas will hold or increase its value relative to sterling.  investors may buy units in a fund at the market price of gas in £/therm each of which equates to ownership of a standard number of therms of gas.

This fund would then invest in energy-saving projects and households or communities would take on a ‘gas loan’ obligation to buy back therm units from the fund at the gas market price. Suppose one was a community combined heat and power generator, where instead of heat going up the chimney of a power station, we are going to use it to heat people’s homes. Now suppose this halved the number of therms of gas that each household used per month, from 120 to 60. They would pay the supplier for 60 therms and would buy back the 60 saved therms from the fund thereby reducing their gas loan by 60 therms.

Instead of receiving a sterling loan, the generator is funded by a gas loan based on future consumption, though an electricity loan is equally viable The investor makes money if the price of the power goes up, and loses if it goes down.

Unlike the UK Government’s Green Deal, which is lending money for household energy saving projects, this idea lacks two disadvantages that some believe will make that scheme unworkable. It does not involve compound interest and there is less risk of the savings being undermined by people simply turning up the heating, because unless they save gas, they end up with higher bills during the repayment period.




By Mandeep K Bhandal, on 20 February 2013


ISRS Research Manager, Mandeep Bhandal provides an update to ISRS’ Net Assessment Bulletins on Cyprus (28 January & 11 February 2013):

Cyprus Update

The geo-strategic significance of Cyprus has been overlooked for far too long by many policy and decision makers. It is only now; in recent years that the Eurozone crisis has unveiled the strategic consequence of Cyprus’ debt problems and the triggering of a feared contagion in the Eurozone. In our Net Assessment Bulletins (28 January & 11 February 2013), ISRS highlighted the prevalent strategic issues taking hold in Cyprus from political, economic and energy perspectives. In dealing with the uncertainty and ensuing ‘crisis;’ decision-takers need to identify competitive strategies as well as identifying the competitive advantage of pursuing such options. ISRS indeed recognised Cyprus’ strategic role and purported that it should not be examined in isolation, but rather as part of a dynamic network. A Net Assessment of Strategies (NAS) of the region, including Iran, Israel, Turkey and Syria, should consider Cyprus as a pivotal outcome. Similarly, an FT article published on 19 Feb (Cypriot crisis creates one last chance to reunify the island) recognises these very issues and the important role that Cyprus plays. Given the forthcoming run-off ballot next week, there is pressing urgency to address the island’s divisions. This is vital given we live in a multipolar world.

Update to Cyprus Assessment

By Mandeep K Bhandal, on 11 February 2013


ISRS Senior Researcher, Jas Mahrra provides an update to the Net Assessment Bulletin, posted on the Resiliblog on 28 January 2013.

It has been unveiled today that the EU officials have been working towards finding a way of rescuing Cyprus without triggering a contagion in the Eurozone financial markets. Whatever the bail in/out options being proposed they will have a long term impact on Cyprus as a tax haven for foreign investors and substantially scale down the country’s financial sector. Recognising the challenges in negotiating with Cyprus just around a rescue package, there is the opportunity for the EU to consider leveraging the situation not only in resolving a better settlement for the whole island but within the strategic context of an EU-NATO free-trade area. This could open up advantages on several fronts in the region & beyond.

Reality-based Economics and the Last Big Thing

By Mandeep K Bhandal, on 17 December 2012

In an interview with the Independent on 17 December, 2012, Andy Haldane, director of financial stability at the Bank of England takes a positive view of peer-to-peer lending (P2P). In response, ISRS Senior Research Fellow, Chris Cook says that P2P is only the beginning.


Andy Haldane is in the news again today, this time on the subject of P2P banking which directly connects lenders and borrowers.  He does not say so explicitly, but it is of course in the interests of risk intermediaries such as banks to outsource risk to ‘end-user’ lenders and borrowers, since banking service providers require only sufficient capital to cover operating costs.

Dis-intermediation has been increasingly happening under the radar in relation to market price risk for some time, as investment banks have sold (some might say mis-sold) market risk to ‘inflation hedgers’ but retained credit/counter-party risk. Risk-averse investors in Exchange Traded Funds and Index Funds thereby cause the very inflation they aim to avoid, to the benefit of producers.

In order for banks to facilitate direct P2P connection of lenders and borrowers using interest-bearing debt, another framework of trust must necessarily be found. An existing trust model is that of the ‘Protection and Indemnity (P & I) Clubs’ which have been quietly mutualising shipping and transport-related risk for 140 years, of which135 years has been under the management of the same service provider.

However, in my view, financial and IT connectivity is evolving so fast that such an architecture would be obsolete before it could even be implemented.

Introducing T2T

Since Andy Haldane’s job is to prevent the UK’s financial system from falling over again, he necessarily has acquired a closer grasp of the mechanics of the banking system than either the current or future Governor, but he shares with them a fundamental, and pervasive, mis-understanding as to how the banking system works in practice.

If we look back, as I have been doing, at the historical development of the financial system and financial instruments, then the reality of the relationships, and the nature of the myths which have clouded them, becomes apparent.

Until the foundation of the Bank of England in 1694 the UK’s financing and funding was essentially Treasury to Taxpayer (T2T).  From that point onwards, the national enterprise model has involved banks operating as risk intermediaries between the Treasury and the Taxpayer.

Tax Returns

For many hundreds of years UK sovereigns funded their expenditure through creating IOUs which were returnable in payment for taxes, and exchanging them with tax-payers for value received.

In other words, tax-payers were able to ‘Pre-pay’ their taxes, receiving as a record or token that half of a ‘tally stick’ accounting record known as the ‘stock’. The other part of the tally stick retained by the issuer (which in the case of taxes was the Exchequer) was known as the ‘counter-stock’ or ‘foil’.

Note here that there was also another type of accounting record – the ‘memorandum tally’ – which acted as a transaction record or receipt, and recorded title, rather than obligation.

Of course, no creditor would give £10 of value to the King in exchange for a £10 tax IOU, and stock was issued at a discount which gave rise to a profit upon the return of the stock to the issuer.

The phrase ‘Rate of Return’ therefore refers to the rate over time at which profit arising out of an initial discount was achieved through the return of the stock to the Exchequer for cancellation.

The phrase ‘Tax Return’ for tax-payers’ annual accounting to HMRC has the same origin.

Fiscal Agency

The myth of ‘fiat’ money creation is that the Treasury and the Bank of England have a conventional banking counterparty relationship so that a Treasury credit is reflected by a Bank of England debit and vice versa.

This is not and never has been the case. What happens is that the Bank of England creates – as ‘fiscal agent’ of the Treasury – what are essentially Treasury IOUs, and it records these on behalf of its Principal, the Treasury, on a Memorandum Account.  In other words, a Treasury credit equates in accounting terms to a Bank of England credit.

So the reality is that tax credits created by the Bank of England as fiscal agent of the Treasury are spent or lent into circulation.

The role of private banks is a bit more insidious, since they act opaquely as Treasury fiscal sub-agents, creating ‘look-alikes’ (some might say ‘counterfeits’) of Treasury Credits when they spend or lend ‘fiat’ money into existence.

Only the Central Bank can destroy such ‘fiat’ money, whether it is created openly by the Central Bank or behind smoke and mirrors by private banks.

Orthodox or Reality-Based Economics?

The fundamental misconception which distinguishes orthodox economics from the real world is that it treats as a positive what is in fact a negative, and it bears as much relationship to reality as Physics would do if physicists assumed that anti-matter is matter.

The reality is and always has been that stock is an undated credit/equity instrument – indeed it is the original equity instrument, which pre-dates shares in the entity known as a ‘Joint Stock’ Limited Liability Company.

It follows that the National Debt is in reality better described as a National Equity where Treasury ‘Gilt-Edged’ Stock equates to dated interest bearing shares in UK Incorporated.

By dispelling the myths of the system, and basing Economics upon the reality, we may also blow away some of the ideological cobwebs which are integral with Orthodox Economics.

Blowing Away the Cobwebs

Firstly, the ‘Fractional Reserve Banking’ myth, that deposits are first collected and then lent.

A moment’s reflection indicates that if that were indeed the case, then there could not be any new money.  The reality is that private banks acting as credit intermediaries first create >97% of fiat money into existence and then lend or spend their ‘look-alikes’ of tax credits by crediting the memorandum account maintained by the Bank of England.

Secondly, the ‘Tax and Spend’ myth, that taxes are first collected and then spent.

The reality is that the Central Bank first spends fiat money into existence by creating credits as the Treasury’s fiscal agent, and this is then typically ‘funded’ through being acquired by private banks who create ‘look-alike’ Treasury credits for the purpose.

In other words, Tax-Payers’ Money never goes anywhere near a tax-payer until it’s been spent by the Treasury, and taxation then acts to prevent inflation by taking fiat money out of circulation.

Prepay – the Last Big Thing ?

In my analysis the banking system died in October 2008, and is now in zombie mode, since the imbalance of wealth and purchasing power is now such that only systemic fiscal reform will work. So all Central Bank targeting, whether of GDP, unemployment, or inflation, is completely useless.

Banks have already moved on to an ‘adjacent possible’ of a new generation of quasi-equity funds, and have thereby translated the property bubble into correlated bubbles in equities, precious metals and commodities which have perversely caused the very inflation which risk averse investors aimed to avoid.

When these bubbles collapse, which they must, through the unsustainable transfer of purchasing power to rent-seeking producers, we will then see a transition to the next adjacent possible, which is already quietly in use.  Enron, as ever the smartest kids on the block, was opaquely the ‘first adopter’ of Prepay some 15 years ago but unfortunately it came to be used to defraud creditors and investors.

In other words, we will see a return to Prepay, but this time rather than prepaid T2T taxation we will firstly see direct Peer to Asset prepay investment in revenue streams such as property rentals and energy flows, and secondly, direct Peer to Peer credit, where ‘Real Bill’ IOUs issued by providers of goods and services are accepted directly and are then cleared through a decentralised credit clearing system (VISA is a centralised example) within which there are no deposits.

The next few months, before Andy Haldane’s new boss takes office, but not power – since the steering wheel has come off in the Bank of England’s hands – promise to be interesting.

Chris Cook

ETF’s – Virtues or Vices for Investors?

By Mandeep K Bhandal, on 10 September 2012

ISRS Senior Research Fellow, Chris Cook,  discusses the  virtues and vices of Exchange Traded Funds in the FT on the 10 September 2012.

Dear Sir

I was interested to read John Gapper’s article today re the virtues of ETF’s for investors.

Now, the virtues of ETFs for their originators is quite evident. A stampede of risk averse ‘passive’ investors has, particularly post QE, been convinced by investment banks of the virtues of ‘inflation hedging’. Since market risk is taken by the investor, and not by the banks, excellent returns on minimal capital requirements may be made by banks through strategies such as High Frequency Trading and Delta One proprietary trading incorporating asymmetric information.

Unfortunately, the virtues of ETFs for the originators comes at a price both for the underlying markets and for ETF investors.

Firstly, the presence of generally ‘long only’ passive and risk averse investors in markets –  whose motivation is to avoid loss rather than to make speculative transaction profit – has largely destroyed the price formation mechanism and has thereby financialised those markets where they have become predominant.

The result has been correlated bubbles in equities, energy and commodities and, to use a term coined by the FT’s Izabella Kaminska, a ‘Dark Inventory’ of encumbered shares and commodities. We therefore see a two tier physical market where a privileged few profit from asymmetric knowledge of the encumbered assets.

Secondly, and as a result, we have seen bemused value investors departing equity markets which have lost almost all connection with the underlying reality of assets and dividends, and market participants in commodity markets who are at a loss to understand how market prices are connected to the reality of production and consumption.

In summary, ETFs have killed our present generation of markets and constitute the next great regulatory accident waiting to happen when, not if, the current correlated bubbles collapse and risk averse ‘muppets’ realise that they have been mis-sold market risk on a cosmic scale.

I think that we shall soon find that the unseen vices of ETFs far outweigh any apparent virtues.