This post is based on my new working paper, ‘Bad Money’.

Today, only a small fraction of the money in circulation is made up of physical notes and coins issued by sovereign governments. Instead, the vast majority of our money consists of contractually enforceable promises—demand, time, savings and other deposits—issued by commercial banks. Outsourcing something as important as money creation to private financial institutions is an inherently risky business. Banks combine short-term, highly liquid deposit funding with investments in long-term, risky, and illiquid loans. This heavy reliance on short-term debt makes bank balance sheets extremely fragile and exposes them to destabilizing runs by depositors and other creditors. In theory, this fragility severely undermines the credibility of the contractual promises that banks make to their depositors—especially during periods of institutional or broader systemic distress.

So why do we trust banks with so much of our hard-earned money? What makes deposit contracts more credible than short-term debt issued by other commercial enterprises? The answer is deeply rooted in the unique and highly sophisticated legal frameworks that govern these institutions. In the US, for example, the Federal Reserve System—America’s central bank—is authorized by statute to provide emergency loans and other assistance to banks in financial distress. Banks and their depositors also benefit from a deposit guarantee scheme administered by the FDIC, along with a special resolution regime designed to ensure that banks can continue to honor their contractual commitments to depositors in the event of their failure. In exchange for these special privileges, banks are then subject to prudential regulation and supervision designed to minimize the probability of their failure and its potential impact on creditors and the wider financial system. These regulatory frameworks thus transform otherwise risky deposit contracts into what are often described as ‘safe’ assets. Put somewhat more prosaically, bank regulation is why we think of bank deposits as, fundamentally, good money.

Collectively, these regulatory frameworks give banks an enormous comparative advantage in the issuance of private monetary liabilities. Despite this advantage, recent years have witnessed an explosion in the number and variety of financial institutions seeking to replicate the unique bundle of promises that banks make to their depositors. These institutions include the issuers of so-called ‘stablecoins’: cryptocurrencies backed by everyone from J.P. Morgan, to rap stars, to social media platforms such as Facebook. They also include more established peer-to-peer payment platforms such as PayPal, AliPay, and TransferWise. Importantly, these platforms have evolved to perform many of the same core functions as banks: enabling customers to deposit, hold, transfer, and withdraw funds on demand.

The defining feature of this new breed of monetary institutions is that they issue private monetary liabilities outside the perimeter of conventional bank regulation. As a result, the customers of these institutions do not benefit from the lender of last resort facilities, deposit guarantee schemes, or special resolution regimes available to banks and their depositors. This raises a trillion-dollar question: if this new breed of monetary institutions does not enjoy the unique legal privileges enjoyed by banks, how credible are the contractual promises they make to their customers? Can they really be viewed as issuing not just monetary liabilities—but good money?

Intuitively, we would expect the answer to this question to hinge on the regulatory frameworks that govern these new institutions. In the US, most of these institutions are subject to state-level regulation targeting so-called ‘money services businesses’ (MSBs). Yet despite the rise of institutions such as PayPal—to say nothing of the media frenzy surrounding Facebook’s Libra—scholars and policymakers have thus far paid remarkably little attention to what these regulatory frameworks actually say, how they work, or whether they provide the customers of these institutions with sufficient legal protection.

This paper reports the findings of the first comprehensive survey of the regulatory frameworks governing MSBs across all 50 US states. Between its crosshairs are the core prudential mechanisms that these frameworks employ to reduce the probability of an MSB’s bankruptcy and to protect customers in the event that an MSB is unable to honor its contractual commitments. These mechanisms typically include minimum net worth requirements, security requirements, and restrictions on the permissible use of customer funds. 

The findings of this survey are alarming. First, the minimum net worth and security requirements imposed by these regulatory frameworks are often miniscule when compared with the outstanding monetary liabilities of the largest MSBs. Second, while these regulatory frameworks typically contemplate restrictions on the permissible use of customer funds, these restrictions often explicitly permit investments in a wide range of risky financial instruments including corporate bonds, mortgage-backed securities, publicly traded shares, and even opaque and illiquid intra-group debt. Third, these frameworks often do not require that permissible investments be held in trust for the benefit of customers—thus potentially forcing customers to compete with an MSB’s other creditors in the event that it is forced into bankruptcy. Lastly, these regulatory frameworks vary significantly from state to state: with the result that a customer in Alabama may benefit from fundamentally different legal protections from one in Wyoming. Collectively, the fragmentation, heterogeneity, and permissiveness of these frameworks undermines the credibility of MSBs’ contractual commitments to their customers. Put bluntly: these institutions are issuing bad money.

So, what should policymakers do about the problem of bad money? One option is simply to shut it down: making it illegal to issue money outside the regulated banking system and, thereby, forcing these new institutions to obtain conventional banking licenses. However, while this option may possess some intuitive appeal, it nevertheless presents a host of thorny legal and practical challenges. It would also potentially undermine competition and innovation in an industry already characterized by significant barriers to entry. A second option is to import specific mechanisms from the existing regulatory frameworks governing commercial banks. The Conference of State Banking Supervisors, for example, has recently floated possible amendments to its model state MSB law that borrow heavily from post-crisis reforms to bank capital and liquidity regulation. The challenge presented by this option is ensuring that mechanisms designed to address the risks encountered within a specific legal and institutional environment will perform equally well when placed in a different environment.

This paper proposes a fundamentally different approach based on two key insights. First, this is not the first time in American history that we have encountered the problem of bad money. In fact, the US experienced a similar explosion in the number and variety of monetary institutions—combined with fragmented and heterogeneous regulation—during the so-called ‘free banking’ era between 1836 and 1863. This experience spurred Congress to adopt the National Banking Act, create the National Banking System, and establish the Office of the Comptroller of the Currency to promote the development of a single national currency. Second, from an institutional perspective, PayPal, the Libra Association, and other new monetary institutions typically look far less like banks than poorly regulated money market funds. The regulatory framework governing such funds thus provides a useful starting point for designing a regulatory regime that effectively addresses the risks posed by the new bad money. Combining these two observations, this paper lays out a blueprint for a National Money Act designed to strengthen and harmonize the regulatory frameworks governing these new monetary institutions and promote a more level playing field.

Dan Awrey is Professor of Law at Cornell Law School.