Means of Exchange in Decentralized Credit Network
Preface
There are currently many means of exchange in national monetary systems. The monetary base includes central bank notes and bank accounts; commercial banks accounts denominated in both national and foreign currencies; and foreign currency in the form of bank notes.
In addition to these traditional means of exchange, at the end of the 20th century, e-money that could be emitted by non-bank financial institutions began to grow in popularity and adoption. Complimentary local currencies based on credit as a means of exchange also became increasingly popular. In the 21st century, the range of exchange instruments expanded due to virtual currencies including cryptocurrencies.
The emergence and expansion of these new private means of exchange raise questions for regulatory authorities as to the best way of regulating their emission and circulation. Choosing an adequate model of regulation demands a full examination of their economic properties and attributes. One of these new means of money circulation that is yet to receive an official interpretation is decentralized credit networks, which allow for the exchange of goods without a bank acting as an intermediary.
Analysis of research and publications in recent years
The credit network model has the form of a weighted graph, where the value of the graph corresponds to economic agents, and the value of the graph’s edges represents the amount of credit an agent is willing to give to their counterparty.
In a centralized credit network, there is only ever one participant to whom all other participants directly provide a loan. In this model, the provision of credit by ordinary network participants to each other is only made possible through the mediation of a person or institution who is at the center of the network.
A decentralized credit network is characterized by the fact that there is no center with which all other participants of the network are connected by direct credit relations. There is no single actor in the decentralized credit network that exclusively holds and processes the database which contains the transaction history between network participants. Instead, the distributed database is stored and processed by all members of the network.
Figure 1. Direct credit relations in centralized and decentralized credit networks
If the model of a centralized credit network is described by a star graph, then the graph of a decentralized credit network has neither restriction on the number of vertices with valence greater than one, nor on the valence of these vertices.
P. Dandekar, A. Goel, R. Govindan, and I. Post studied a model of the decentralized credit network in which nodes exchange goods. This is performed not with the help of a common currency, but through commodity credit instruments that are emitted under bilateral credit lines, with the right of use assigned according to the principle of transitivity of trust..
In this model, according to the authors of the aforementioned study, network nodes, “… act like banks and print their own currency, and trust each other for a certain amount of each other’s currency”. They regard such a system as an alternative to the modern banking system, since the latter, “… is a centralized currency infrastructure”, where the central bank is the sole issuer of the currency, and other nodes trust it for a theoretically unlimited amount of this currency.
Private means of exchange as emitted by participants of the decentralized credit network do not have the status of a legal payment method. They are accepted only by those who directly opened the credit line to the issuer, and only for the amount of the credit line. The national currency emitted by the central bank, as a legal payment method, must accept all subjects of the national market as the payment method, regardless of the degree of confidence in its issuer. However, a look at the modern banking system as a credit network, in which only the central bank issues the means of exchange, does not fully correspond with reality.
As Bank of England researchers, M. McLay, A. Radia and R. Thomas emphasize, in the modern banking system, most of the money is created not by the central bank, but by commercial banks, and not by “multiplying” the money of the central bank, but by issuing loans. Under normal conditions, the central bank does not limit the amount of money generated by commercial banks. It is limited by the ability to compete for commercial banks to profit from loans in which they create money, as well as through prudential regulation that ensures the stability of the financial system.
In the modern two-tier banking system, there is a combination of two mechanisms for the emission of two types of money: commercial banks carry out a competitive issue of private monetary obligations repaid by national currency, while the national currency is issued exclusively by the central bank.
The analysis of the decentralized credit network as an alternative to the modern monetary system and as an analogue of the modern banking system suggests one possible clue as to the debt obligations of the participants in this network exchange of goods. This question has not yet become the subject of a special study.
The first implementation of the decentralized credit network was the Ripple system. Initially, Ripple was positioned as a platform for P2P money transfers, as an alternative to bank transfers, but today it specializes in servicing banks and other financial institutions. The second such network was Stellar, which is also positioned as a decentralized money transfer system, but, in contrast to Ripple, not between financial institutions, but directly between individuals.
The authors of the SilentWhispers decentralized credit network project argue that systems such as Ripple, “… allow for multi-currency transactions (in fiat currencies, cryptocurrencies and user currencies) …”. This statement, however, requires clarification. The only means of exchange that can be transferred within the framework of a decentralized credit network is the debt obligations of its participants. These debt obligations can be denominated in any commodity or currency, including those in the mentioned assets, but they are not identical to these assets. The recipient of such a debt obligation, nominated in cryptocurrency, for example, can repay it from the issuer (or in any other way) and receive cryptocurrency. However, this does not give grounds to assert that the transaction in the credit network was performed through cryptocurrency.
In contrast to the projects mentioned above, the GEO Protocol project is positioned not only as a money transfer system but also as a decentralized credit network, allowing for an exchange of goods without traditional means of exchange. In the documentation of this project, the economic content of debt obligations that network participants use for exchanging goods is not analyzed. The authors of the GEO Protocol are limited to the understanding that in this network the means of exchange are debt obligations.
Identification of previously unresolved parts of a common problem
Means of exchange in decentralized credit networks are by nature debt obligations, but the content of these obligations and their differences from traditional means of exchange is not the subject of this study.
The existing implementations of such networks focus on remittances, therefore, the debt obligations in them represent monetary obligations and their content is no different from traditional electronic money. In studies of decentralized credit networks, where the debt obligations of network participants are considered a means of exchanging goods, rather than as a means of remittances, the analysis of the economic content of these debt obligations is not a part of the research objectives.
Formulation of the problem
The objective of this article is to analyze the economic content of debt obligations that function as a means of exchanging goods within a decentralized credit network, as well as a comparative analysis of these obligations and such traditional means of exchange such as national fiat money, entries in commercial bank accounts, and e-money.
Subject of research
The simplest exchange of goods between participants of a decentralized credit network takes place within the framework of direct credit relations between two participants.
Figure 2. The exchange of goods between the participants of the decentralized credit network (direct credit relations)
Seller B credits buyer A for a certain amount calculated in a given equivalent. Buyer-borrower A has the opportunity to purchase goods on credit for this amount. The instrument of this loan is the debt obligations of participant A, which they provide to participant B in exchange for goods. In turn, the seller-creditor B, who received the debt obligations of buyer-borrower A in exchange for their goods, may subsequently repay these obligations with goods offered by the debtor in the market.
A more complex scheme for the exchange of goods between participants in a decentralized credit network occurs when there is no direct credit relationship between the buyer-borrower and the seller-creditor. If there is no direct credit relationship between participants A and B, then A will not be able to purchase goods from B on credit in exchange for their debt obligations, and B, respectively, will not be able to purchase goods from A.
Purchase by the buyer A of goods on credit from the seller B becomes possible if there is a participant C who has direct credit relations with both A and B.
Figure 3. The exchange of goods between participants of the decentralized credit network (mediated credit relations)
First, buyer A exchanges their debt obligations for the debt obligations of participant C. This allows A to purchase goods on credit from B in exchange for the debt obligations of C. In other words, buyer A transfers to seller B the debt obligations of participant C in exchange for the goods of B.
The repayment of a commodity credit that has arisen, takes place by means of a reverse assignment of debt obligations of C: participant B transfers them to participant A in exchange for their goods, after which A exchanges them from participant C for their own debt obligations.
Figure 3 shows the simplest scheme of mediated credit relations between participants in a decentralized credit network. This scheme becomes more complicated when participant C has no direct credit connection with seller B, but at the same time, for example, can get a loan from participant D, with whom seller B has a direct credit relationship. Then, between buyer A and seller B, there will be not one, but two intermediate links: C and D.
In theory, the number of such intermediate links in the chain of mediated credit connection is limited only by the number of network participants, and the number of direct credit links between them. In some decentralized credit networks, under certain conditions, the assignment of participants’ debts on the basis of the principle of transitivity of trust provides liquidity comparable to a centralized credit network..
Consequently, exchanging goods through their debt obligations, the participants of the decentralized credit network enter into a commodity loan relationship: the object of the loan, like the means of repaying it, is not money, but goods. At the same time, the loan amount is calculated not in goods, but in some equivalent, since the prices of all goods in the market are nominated in some equivalent.
Debt obligations emitted and repaid by participants of a decentralized credit network in the process of exchanging goods are, by their economic content, bonds or, in other words, vouchers. A voucher is an issuer’s obligation to provide some goods for a fixed amount of some equivalent sum. The issuer of such vouchers can be not only a cellular operator or a supermarket, but any seller of any goods.
Vouchers that are used to exchange goods only within the framework of direct credit relations between the buyer-borrower and the seller-creditor serve the exchange of goods only between these two participants. Vouchers that are assigned to third parties in exchange for their goods can be used as a means of exchange for the numerous network participants.
What is the difference between vouchers emitted by participants of a decentralized credit network, from traditional means of exchange such as the national currencies and private credit money, which is issued by commercial banks and other financial institutions? How different are the schemes for exchanging goods using these contrasting means of exchange?
National fiat money
Modern national currencies represent the debt obligations of the central bank — their issue is reflected in the liabilities of the central bank. However, the generic feature of this type of money cannot be that it is emitted by a central bank since state fiat money existed long before the emergence of central banks. Central banks are not a necessary condition for the issue, circulation and repayment of money in this type of exchange.
The reason for the emergence of state fiat money is the need to finance government spending. The government issues its own debt obligations, which are nominated either in some equivalent or in themselves, as in the case of modern national currencies. In exchange for these obligations, the government purchases goods, including labour.
The government does not undertake to repay its obligations with a fixed quantity of any product or money. The only way to pay off these obligations is to use them as legal tender: the holder of these obligations can make any official payment by them. First of all, such payments are taxes and fees paid to the state treasury, but the range of goods that can be used to repay state fiat money from their issuer is not necessarily limited to this.
Figure 4. Exchange of goods through national fiat money.
In the case when there is no direct credit connection between buyer A and seller B, A may receive national fiat money from government C in exchange for their goods. Now A may receive goods from B by assigning them the debt obligations received from C. Further, participant B may, in turn, receive the goods from participant A by assigning them the obligations of C, after which A repays these obligations from their issuer. The issuer can accept its obligations as an official payment, for example, as a means of repaying participant A’s tax obligations or simply exchange them for goods offered on the market.
According to its economic content, the scheme of exchanging goods by means of national fiat money is similar to the scheme of exchanging goods between participants of a decentralized credit network who do not have a direct credit connection: buyer A assigns to seller B the obligations of a third party. At the same time, technically, the operation of assigning the obligations of the third party may differ significantly.
Buyer A assigns national fiat money directly to seller B — this transaction is carried out without the participation and without the knowledge of the issuer of this money. Circulation of national fiat money occurs in a decentralized manner, as bilateral transactions between sellers and buyers. The participation of the issuer of these means of exchange or any other central authority in these transactions as an intermediary is not necessary.
The assignment of a voucher that is being circulated offline in the form of a certain material carrier, for example, a paper voucher, does not require the participation of its issuer. The assignment of a voucher that exists as a record in a database, saved by participants of a decentralized online credit network, cannot take place without the participation of its issuer. The issuer of such a voucher always participates as an intermediary in transactions with their voucher.
The scheme of using a third party voucher to obtain a commodity credit in a decentralized credit network operates online as follows:
Figure 5. Exchange of goods between participants of a decentralized online credit network (mediated credit relations): technical aspect.
Buyer-borrower A does not receive the obligations of participant C, which they then transfer to seller-creditor B in exchange for their goods. Buyer A only transfers to the participant C their obligations, and the transfer of such to the seller B participant C carry out their self. A and B do not exchange the obligations by C directly — participant C carries out transactions with these vouchers.
In contrast to the system of national fiat money, a decentralized online credit network does not carry out a direct transfer of obligations of a third party without the participation and the knowledge of this party.
This feature of a decentralized credit network is compensated by the fact that network members are free to establish direct credit relations. In the system of national fiat money, direct credit relations are possible only with one participant — the issuer of fiat money.
The emission of vouchers in a decentralized credit network, as well as the emission of national fiat money, is carried out in a centralized manner; the network participant exclusively issues their debt obligations. The possibility of a free establishment of direct credit relations between sellers and buyers is what gives rise to the fundamental difference in the mechanism for issuing means of exchange in a decentralized credit network. Importantly, the number of people who can issue a means of exchange is greater than one — each network participant has this ability.
Records on commercial banks accounts
Modern commercial banks issue private credit money in the form of records on the accounts of their clients. The record on the client’s current account reflects the bank’s obligation to this client to provide them with the national currency on demand for the amount fixed in the record. The credit money of commercial banks is denominated in national currency and is repaid by it.
Figure 6. The exchange of goods through records on a commercial bank account.
The emission of bank credit money occurs in exchange for the obligations of the borrower. According to the turnover so often cited in textbooks on the theory of money, banks, “mint money from private obligations, converting them into generally accepted ones”. Buyer-borrower A exchanges from the bank C its obligations for the obligations of this bank. Obligations received from the bank, A transfers to the creditor-seller B in exchange for their goods. B can then purchase goods from A by assigning them obligations of C, which A can exchange from C for their obligations, i.e. pay off their debt to the bank.
Technically, the assignment of liabilities of a commercial bank is similar to the assignment of vouchers in a decentralized credit network operating online, as shown in Figure 5. Buyer A does not directly assign to seller B the obligations of participant C.
A commercial bank is an intermediary in all transactions with its monetary obligations; without the bank’s participation, the assignment of its financial obligations cannot take place. In this system of goods exchange, there is no possibility of establishing direct credit relations between sellers and buyers. Whereas in the system of national fiat money the right to establish direct credit relations is exclusively owned by the government, in the banking system direct credit relations are possible only with banks.
The scheme of centralized emission of credit money by the bank, shown in Figure 6, is not exclusive to the activities of commercial banks. Modern national currencies aren’t emitted directly by governments — the emission of national fiat money in pure form is not practised. Today, the national currency is used in the form of banknotes by central banks, as well as records in central bank accounts. These means of exchange, like the liabilities of commercial banks, are issued in exchange for debt obligations. Emission of bank money may occur in exchange for either private or government debt obligations.
Banknotes of a modern central bank, like classic banknotes or national fiat money, can be assigned without the participation of their issuer. The records on the accounts at the central bank, as well as the records on the accounts at the commercial bank, cannot circulate without the participation of their issuer — the bank always acts as an intermediary in transactions with their debt obligations.
E-money
E-money is “… the monetary value represented by the requirement to the issuer, which: i) is stored on an electronic device; ii) is emitted after receipt of funds in the amount of not less than the emitted monetary value; iii) is accepted as a means of payment not only by the issuer but also by other firms”.
E-money is a monetary obligation, similar to the records on accounts in commercial banks: the issuer undertakes to repay its obligations with a fixed amount of a predetermined national currency. Electronic money nominated and repaid not by national currency, but by noble metals, is much less common practice.
If in the EU e-money issuers can be non-bank financial institutions, then in Ukraine, for example, only commercial banks can issue such means of exchange. If in the EU e-money can be considered as an alternative to private bank money, in Ukraine, e-money is only a banking product.
The schemes for exchanging goods using e-money and using records on accounts in a commercial bank appear interchangeable, as long as the bank does not “mint” its obligations from private obligations, but issues them in exchange for money.
Figure 7. Exchange of goods through e-money.
Buyer A exchanges money for the repayment obligations of participant C. Buyer A assigns to creditor B obtained obligations of participant C. In this scheme, unlike the scheme in Figure 6, A does not receive a loan from C because they acquire obligations from C, not in exchange for their own commitment, but in exchange for money. B then exchanges goods for the obligations of C from A after which A repays obligations by C to their issuer with a fixed amount of money or some commodity, for example, a noble metal.
Similar to the scheme of exchanging goods using records on accounts in a commercial bank, buyer A does not directly assign to seller B the obligations of C. Participant C is an intermediary in all transactions with their obligations and there is no possibility of establishing direct credit relations between the buyer and seller.
A special type of e-money is e-cash. In contrast to the e-money system discussed above, in which monetary obligations exist in the form of records on accounts at the issuing institution, the tangible carrier of e-cash is at the disposal of the holder, not the issuer.
E-cash is a modern analogue of classic banknotes; these are centrally emitted private financial obligations that can circulate without the participation of their issuer. The buyer can make an offline payment, assigning the e-cash to the seller directly. The assignment of these obligations is technically carried out by direct transfer from the buyer’s device to the seller’s device. In this respect, e-cash is not only similar to a classic banknote, but also to paper private vouchers and national fiat money — all these means of exchange allow for P2P-transactions.
Conclusions and prospects for further research
Debt obligations of participants of a decentralized credit network which are used to exchange goods without the mediation of banks are private vouchers. These vouchers are repaid in goods, not in money, and the quantity of goods to which they will be repaid is not fixed in advance: vouchers are nominated in an equivalent other than the goods in which they will be repaid.
Means of exchange in a decentralized credit network have both common features and differences to traditional means of exchange. The common feature present in all the considered means of exchange is a centralized emission. According to such criteria as the emission channel; the means of repayment and its amount; the need for the issuer’s participation in circulation; and the need for commercial banks to participate in the system, private vouchers are not identical either to national fiat money, to records on commercial bank accounts, or e-money.
A private voucher has similarities with national fiat money, with private bank money, and with e-money. Like bank money, vouchers are issued for debt obligations. National fiat money is repaid with goods as well as vouchers, the amount of which isn’t fixed in advance. Vouchers, like e-money, are not homogeneous in terms of the issuer’s participation in their circulation: there are those that can only circulate with the mediation of the issuer, and those that can circulate without it.
The principal difference between the exchange of goods through private vouchers and the traditional exchange systems mentioned above is that sellers and buyers have the freedom to establish direct credit relations.
In the system of national fiat money, direct credit relations between the seller and the buyer arise only when selling goods to the issuer of fiat money. There are no direct credit relations between the seller and the buyer in the systems of bank money and e-money: sellers and buyers enter into credit relations only through an intermediary, in the form of a bank or a non-bank financial institution. In the system of private vouchers, sellers and buyers can freely establish direct credit links and the number of these links is limited only by the number of network participants.
The purpose of this study was to analyze the content of debt obligations of participants in a decentralized credit network issued for the exchange of goods without the mediation of banks, as well as comparing these obligations with national fiat money, and records on accounts in commercial banks and e-money. The question of whether private vouchers are substitutes for traditional means of exchange, a true substitute or alternative, deserves further research.
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The authors:
- Max Demyan, CEO at GEO Protocol.
- Dmitry Bondar, journalist and economist.
