While commercial banking as we know it today, with its unique ability to manufacture money and to profit from that manufacture, will not exist under the Free Money system, there will still be the need for many of the services today provided by the financial services industry.
Open Finance is a financial system infrastructure enabled by Free Money and operating on the same Account infrastructure as Free Money. The goal of Open Finance is to leverage the new capabilities of the Free Money system, including its very low transaction costs, very low latency, and its high transparency to build an infrastructure which will allow us to recreate a financial services industry that really is a service to the economy and not a swallower of wealth and a burden on the economy as our current financial sector has become.
Elimination of Commercial Banking under Free Money
Commercial banks today have three main businesses, all of which will be eliminated by the Free Money system:
Holding Cash Deposits
Since Free Money resides in a central ledger “in the system”, there is no need for checking accounts, checks, nor their associated fees.
Transaction Fees
Since Free Money is transacted “in the system” for a very small fee, the historical business of transaction based fees (ATM fees, debit card fees, check fees, etc) will disappear.
Creating Money to Lend Out
The core business of commercial banks has been the making of loans with money that it manufactured. Since under the Free Money system, new money is created per capita in the accounts of Persons in the system, this means of credit creation will no longer exist.
Free MoneyCredit and Investments Under Free Money
Under Free Money all credit and investment decisions will be made as they should be in a market economy: a Person or Legal Entity will choose to forego consumption in the current period (ie “save”) and will invest or lend those savings to entrepreneurs, businesses, consumers who can demonstrate an acceptable risk adjusted rate of return.
Direct Investments
Today in a world of very limited financial transparency, the majority of investments are made indirectly through mutual funds, pension funds and hedge funds where professionals are supposed to penetrate the veil of opacity on behalf of investors. In the Free Money world of total financial transparency it is likely that more investors will be comfortable investing directly.
Less intermediaries means less cost to investors and therefore, better returns on their investment. It certainly means a smaller proportion of our economy being consumed by the financial sector.
There will also be new market mechanisms (see NuMarkets below) that will enable small businesses to be able to access direct investments, which should also increase the attractiveness of direct investments via mini-IPOs in the Free Money world.
The Free Money world of transparent, low frictional Finance should also really invigorate innovations such as Person-to-Person lending and micro lending.
Financial Intermediaries
While the the unjust power of banks to manufacture money by making loans will be eliminated, there will still be a need for financial intermediaries to concentrate smaller investments into larger amounts needed for larger projects and/or to diversify risk among investors. When they do their jobs well, these financial intermediaries may also have specialized information about an industry or class of borrowers that individual investors standing alone might not have.
While Real Transparency will massively reduce the information asymmetry advantages with respect to financial information, intermediaries will still be able to add value through legitimate information advantages in domain knowledge, quality of management, deep industry knowledge, etc.
Open Finance will specify a special class of Legal Entity: “Financial Aggregation Entity”. Financial Aggregation Entities (“FAE”) will be empowered to take investments of Free Money. An FAE may ONLY serve the role of Investment Aggregators. They may not operate businesses directly nor be part of an operating business entity.
Persons or Legal Entities will deposit Free Money and the FAE will use that pool of Free Money to make loans and/or investments. The profits or losses of the investments and loans will flow back to the FAE and hence be allocated to their investors per the investor’s investment agreement with the FAE. Financial Aggregate Entities will look much like mutual funds or credit unions in that investment returns after costs will flow to those who invest.
Today’s asset management businesses, such as Vanguard or Fidelity should be able to make the transition to Free Money more or less intact as Financial Aggregation Entities.
We would expect that FAEs will arise to fill the credit roles previously provided by Commercial Banks. The difference is that under Open Finance the loaned money would be actual aggregated savings and NOT money “invented out of thin” air. Further it would be without any Government “guarantee” which along with Real Transparency should provide a much more reliable vehicle for sensible non-bubble lending.
There will be complete financial transparency of Financial Aggregation Entities. Like all Legal Entities under Free Money, the Accounts, SubAccounts, and Transactions of Financial Legal Entities will be fully readable by anybody in real-time.
Reducing Arbitrary Complexity with Financial Instrument Templates
Today there is a seemingly insane proliferation in complexity in financial instruments. That complexity works to the advantage of financial insiders as they can be expected to understand the details and nuances and thus the impact of the complexity of investment vehicles better than outsider investors can.
To minimize the unfair advantage to insiders of arbitrary complexity, Open Finance will promote the use of Financial Instruments By Template. All investments and loans with a Legal Entity will have to be in securities defined by Financial Instrument Templates. Persons doing Person-to-Person transactions may also choose to use Financial Industry Templates .
What is a Financial Instrument Template?
A Financial Instrument Template can be thought of as a computer program that generates Financial Instrument Documents after a series of choices are made and blanks filled in.
For instance, a simple example: A Financial Instrument Template for a small loan might have blanks for “amount”, “interest rate”, and “maturity date”; and options among 3 different kinds of amortization: “interest paid monthly, balloon payment of principal at maturity”, ””equal monthly payment amortization of interest and principal”; “interest accrues until maturity”. After filling in the blanks and selecting the options the Financial Instrument Template would then generate the loan document filling in a set of standard terms and conditions of small loans.
Importantly, the language would be the same in all such documents, making them more understandable, and substantially reducing the costs to create and to litigate in the event of default.
While the above example is simple, Financial Instrument Templates could be created to deal with any plausible requirement in the design of financial instruments. There could be hundreds of sets of options and dozens or more of blanks in a document if that is necessary.
To keep financial complexity under control, Financial Instrument Templates, would be issued exclusively by the Open Finance authorities.
At the startup of Open Finance, a set of templates will exist to support all basic securities classes. At a minimum: loans of various seniority (including mortgages), lines of credit of various sorts, loan guarantees, commercial paper, bonds, common stock, convertible preferred stock, preferred stock; and a set of basic derivatives: puts, calls, and futures. There would also be Financial Instrument Templates for financial type transaction typically done between non-financial Legal Entities such as “purchase and sale agreements” used in the acquisition of one company by another.
Representatives of the business and financial communities will work with the Open Finance authority when segments of those communities believes an additional template or templates is in the public interest, or when changes need to be made to existing templates.
The standard to be used by the Open Finance authority on creating new templates or modifying existing templates will be: “is the change in the public interest?”. Thus allowing for change over time, but working against the tendency of financial intermediaries to create complexity in products for their own benefit.
The Open Finance authority will be authorized to approve templates for us on an experimental basis with limitations, such as: “template X may be used for amounts of $F100,000 or less, and no more than $F100,000,000 may be outstanding in the Open Finance system at any one time.”
While Financial Instrument Templates would not be required for transactions between individuals, their use would be encouraged.
Financial Instruments Linked to Entity Accounts
When consummated, all securities created via Financial Industry Templates will become permanently attached to the Accounts of all Entities that are a party to them. A SubAccount will be created for the security, and all disbursements and receipts pursuant to that security will received in or made from that SubAccount.
All securities transaction will be completely transparent with respect to buyer, seller, price, and amount; with a link to the full documents that define the transaction.
Fundamental Credit Regulations
Runaway and unstable debt under fractional reserve banking has time and again caused booms and busts, inflations and depressions. The elimination of fractional reserve banking should mitigate much of the risk of debt and credit.
In order to make it even harder for debt to again become the engine of financial destruction a few basic additional rules will apply to all debt:
No loan may be made with a maturity of less than 30 days.
Very short terms loans such as REPOs (overnight repurchase agreements) are a major source of instability because they cause rapid propagation of shock waves through a financial system. Indeed, the shocks propagate faster than good information can generally flow, leading to panicked reactions without good information.
It was the threatened failure to “roll over” (renew) overnight repurchase agreements that would have collapsed the financial system after the Lehman Brothers failure, if not for heroic intervention by the central bankers.
No collateral for a loan may be “rehypothecated”
Rehypothecation is when a lender has taken custody of collateral for a loan and then uses that collateral to back a loan to itself, from a third party. Rehypothecated collateral can easily function like an unauthorized expansion of the money supply.
There is considerable evidence that explosive growth in rehypothecated collateral was one of the primary sources of funding for Mortgage Backed Securities, the huge growth of which was a major force causing the run up in real estate prices prior to 2007. There is even more clear evidence that the rapid contraction of rehypothecated collateral post Lehman Brothers, in effect reducing the money supply by trillions of dollars almost overnight, was a major factor in the rapid destabilization of the financial sector. (reference: Slapped by the Invisible Hand: The Panic of 2007 )
Debt to Equity Leverage Ratios Not to Exceed 10X
Another major source of instability in the recent financial crisis was the extremely high leverage ratios of the large investment banks. Some of them had leverage ratios on the order of 30X or even more.
To avoid the adverse effects of mandatory leveraging during a crisis, this provision (unlike today’s) will not require Legal Entities to deleverage if they exceed the 10X limit, but rather they may not issue net new debt until they are back under the limit, including the anticipated new debt issue.
Federal Government Credit
Recent history across The West has shown that there is an imbalance in political forces calling for government expenditures versus those calling for taxation sufficient to pay for them. The result has been runaway deficits in almost all Western countries, with much greater deficits still to come to cope with unrealistic social insurance schemes in the face of the demographic transition now underway.
The federal government will be able to issue debt ONLY if the current outstanding debt is less than 25% of the previous year’s GDP. Time to maturity of a Federal debt instrument shall not be less than 6 months nor more than 10 years.
Preferred Stock to Replace Some Debt
Prefered Stock is much like commercial debt in the form of bonds, but it is much superior to bonds with respect to providing robustness to the capital structure of a business. If debt is in the form of bonds (or bank loans) a short term liquidity crises or violation of technical covenant can result in loans being “called” with many potentially dire consequences for a business, including bankruptcy.
Preferred stock is more flexible: if a business can’t make an interest payment this quarter, they can skip it, with the missed payment adding to the amount due. The missed interest payment(s) are then repaid when the company is over the crisis.
Historically preferred stock has been relatively little used because of very adverse tax treatment for preferred stock for most corporations as compared to “straight debt” (bank loans , bonds etc). Interest on straight debt is deductible as a business expense before corporate income tax. Interest (called a “dividend”) on preferred stock is not. With corporate tax rates as high as 35% is this is a MAJOR disincentive to issue preferred stock.
Companies would typically not have all of their debt and debt-like capital in the form of preferred stock because interest rates are typically higher (because of the ability to defer payments, and because preferred stock comes after bonds and loans in the case of a liquidation) but in the absence of the strong tax disincentives in effect today, most companies would make a layer of their capital structure preferred stock rather than straight debt.
Elimination of two level taxation under SmartTax will make preferred stock much more attractive as part of a business’s capital structure which will increase the robustness of the economy as a whole.
Open Finance Markets
The Free Money themes of low transaction costs and transparency will be applied to the operation of securities markets. It is desired that these features will result in an increase in the use of public securities markets instead of private transactions.
Securities Markets
Automated Double Auction
All securities markets will operate as automated continuous double auctions with decimal ticks.
There will be no official market makers, though any trader can choose to act in the role of market maker.
Transparency
All orders will be visible in real time as they are placed and all traders, including for unconsummated “book orders”, will be identified with links to their Account.
All consummated orders will be “published” by the market operator in real time, including buyer, seller, amount, and price.
All securities owned by an Entity will be visible in their Account.
Settlement
Today, securities settlement is a grossly inefficient and surprisingly error-prone process. Currently stock trades settle 3 days after trade and fail at a rate as high as 1%. These long delays result in more collateral needed in the system, and allow for a significant amount of risk to exist with respect to the viability of counter parties over the settlement period.
All Open Finance trades will settle for cash, two hours after execution.
Open Finance will provide “automated settlement agents” which will electronically take custody of the securities and the cash prior to settlement, and will execute the settlement simultaneously on the Free Money book with respect to buyer and seller, updating their Accounts accordingly.
Small Company Securities Markets
Because of the high financial transparency of all businesses in Free Money, it ought to be feasible to give even quite small companies inexpensive access to public markets.
Minimum requirements for a listing for a “small business stock market” public offering might be audited financials yearly and an outside director from a Certified Public Directorships Company.
Perhaps the minimum cost for those services would be on the order of $5000 per year, which could make feasible raising amounts as small as $100,000.
Using a Financial Instrument Template to generate the offering and supporting documents would also make the onetime expenses and lead times much smaller than for today’s securities offerings.
This ecosystem of small public companies could also enable the emergence of small specialized Financial Legal Entities to aggregate investments in local businesses. For example, someone knowledgeable of the local home builders could raise a fund to invest in the better home builders in a community.
Transaction Tax
In the interest of reducing high speed automated trading, which adds little real capital to a market but increases volatility, a small (half of 1 percent) tax will be charged on all securities transactions.
Certified Public Directorships Company (henceforth CPDC)
The concept is analogous to CPAs. There would be a class of well-regulated companies whose purpose would be to provide one or more independent directors to represent minority shareholders in public (or private) companies, for a fee. The CPDC would be selected by the minority investors and could only be fired by them.
While initially envisioned as an enabler of small company public offerings, a cadre of well trained, professional independent directors could also make sense for larger public companies, and for private ones, too.
There will be rules barring “interlocking directorships” in the client base of Certified Public Directorships Company, such that a given CPDC could not provide directors to competitors, suppliers or customers of existing clients.