Over the past couple of weeks, we have explored a couple of concepts that tell us that a revolution in municipal finance is brewing. Demand for good quality government backed assets has grown to the point that $15 trillion in paper is trading at negative yields globally. The Governor of California has signed legislation that will allow up to 10 municipal banks to be established. Cities are looking at models that were tried in the past (local currencies and IOUs amongst others). And the ICO boom of 2017–2018 showed that there were new, efficient ways to issue, trade and hold securities.
For innovation to take place in municipal finance, any new system or asset must meet a few challenges head on.
- It must be easy to issue and maintain under existing regulations
- It must provide efficiencies that are not present in the current system
- It must attract participants with a variety of incentives to hold, trade and use so that a market can develop
- It must have transparent procedures and disclosures
- It shouldn’t introduce new systemic risks
We’d like to propose a solution: The Munidollar. Let’s define the Munidollar::
- A US dollar denominated IOU,
- issued by a qualified municipality,
- redeemable for tax credits and one year zero coupon bonds.
Now if that wording seems somewhat familiar, perhaps you should pull out one of the IOUs issued by the Federal Reserve in your wallet and look in the lower left corner:
The thing that makes a US dollar bill money is the fact that it can be used to settle a tax bill with the Federal Government. Because that utility is worth around $20 in this case, this piece of printed paper can also be used for a wide variety of other exchanges of value.
Since only just over 10% of the money (as measured by M2) is actually in the form of paper bills or metal coins, it should come as no surprise that Munidollars will not be printed on paper or struck in coins. However, it will be able to be held and spent through tap and pay cards.
In effect, a Munidollar project becomes a low cost credit card that the city can use to manage its spending in the same efficient manner that the Federal Government and most households employ.
Ease of Issue and Maintenance
In order for the Munidollar to find its way into public hands, it must first be issued by a qualified municipal issuer. A municipality is not going to embrace Munidollars if it adds too much complexity and work.
Fortunately, many of the steps are part of almost all municipality’s normal routine. A city still needs bonding authority from its voters, must be able to convince a bond counsel that the issue follows all the rules and limits and must continue to disclose key information to the public through EMMA.
The difference in the case of Munidollars is that the city can skip the underwriter. Once the city has authority to issue, it can start spending Munidollars in accordance with its plans. In the early stages, the recipients of that spending will be vendors to the city and projects that the city has chosen to sponsor. If the demand grows in later stages, the city can consider auctioning Munidollars directly to investors and other end users.
Beyond that, there is not much for the municipality to manage and the Munidollar system will yield a dramatic increase in data that could help the city understand and manage its programs.
What about Efficiencies?
In the current setup, Municipal Bond issues are batched to save on the fixed costs of issues. The resulting mismatch between inflows and outflows adds to the administrative burden and is balanced off by using commercial banking facilities. At every step, fees reduce the funds available for the projects.
Munidollars will not totally replace the need for banking facilities but it will have the benefit of allowing the city to spend funds and create the offsetting obligations when needed and in the same action. With the cost and friction of underwriting removed from the picture, more of the proceeds are available to complete the projects.
Attracting a diverse set of participants
The Munidollar is designed to work as a platform for other economic activity. A good market requires participants who have different goals and viewpoints.
At its base level of operations, participants include vendors, brokers and money market fund managers. The municipality’s need to finance the vendors will drive supply of munidollars; the desire for high quality short term paper will drive demand from money market funds. For regulatory reasons, a broker will maintain an orderly market to effect the flow.
The next level of sophistication can be achieved by involving tax and fee payers. By accepting Munidollars to settle tax bills and other fees, the city introduces tax payers and developers as another source of demand who are motivated by the discount opportunity. With an open market making mechanism, tax and fee payers will compete with money market funds to secure Munidollars.
The last bit of local demand could come from the involvement of local businesses using the Munidollar as a local currency. A municipality could offer incentives for local retail shops to accept Munidollars as payment for goods and services. The level of adoption will depend greatly on the float and involvement/incentives of the local government. While there will definitely be a cost savings on a per transaction basis, the upfront cost of training staff and configuring systems may prove to be too great an obstacle for local retail operators.
Once we have developed the local demand, it is time to look for outside sources of demand. As we mentioned, there is no shortage of demand for sovereign debt instruments, even to the point of negative yields. The same institutions and high net worth investors who have shown a preference to pay the Federal Government of Germany to hold onto their funds over depositing the same amount in a Deutsche Bank or Commerzbank are signalling a deep concern about Financial Institution risk. Munidollars represent a US dollar obligation directly backed by the taxing power of a US government entity. It is not quite a Treasury, but it boasts many of the same benefits to investors who want to keep a portion of their assets safe and liquid.
We also don’t want to overlook potential new sources of demand. The Munidollar can easily be held as a token on a blockchain. The Decentralized Finance (DeFi) community is on the prowl for a “stable coin” that can anchor any number of financial products. With its value anchored by the municipality’s un-intermediated liability, the Munidollar can derisk many DeFi products. The market for DeFi is potentially large but it is still early days.
Transparent procedures and disclosures
Unlike most new products that demand a certain level of opacity (think OTC derivatives, for example), the Munidollar is a product that will be launched with strong regulatory oversight and standard disclosures. The ability of a municipality to issue new Munidollars will be an easily knowable fact. The municipality will also serve as the only counterparty to the asset. There will be no ability to inflate the circulation through fractional reserve banking, a practice that even extends to supposed “hard assets” like precious metal certificates.
No new systemic risks
At the ten year mark following the worst financial meltdown for most of us, it is important to ensure that any new product does not increase systemic risks. While financial intermediation, fractional reserve banking and derivatives do have their place in our financial landscape, so too does a direct un-intermediated debt instrument that can be redeemed in a predictable manner from a debtor with a solid property tax base. Munidollars will end up tilting the systemic risk balance in a positive direction as it gains adoption.
The first cities are making their plans now. The financial revolution is brewing in the cities, counties and states. We expect the winners to be those innovative municipalities who are willing to encourage the use of Munidollars as a local medium of exchange in addition to a project funding mechanism. What about the traditional municipal bond market? We think that Munidollars will actually increase the pie. Munidollars are effectively a credit card that allows the city to spend flexibly at a cost of about 1% a year on outstanding balances. But just as a credit card, even one with a low introductory rate, should not be used to buy a house, cities will still rely on the traditional muni market to fund long term projects in order to match expected assets and liabilities.