The historical lessons of decentralized banking should guide our approach to Web3 protocol and tokenomics design, but they only help when we properly remember and examine them.
The Tower of Babel is a biblical story about a world where all people speak the same language and therefore can focus all efforts on a single goal. King Nimrod decided to build a tower that would go straight to “Heaven” to unify mankind and demonstrate its greatness. Ironically, we have not given up on our ambition to let a central agency dictate the direction of all humankind.
As the story progresses, God decides to confuse people so that they can no longer understand each other, which forces them to scatter around the world and abandon their towers. More recently, JRR Tolkien wrote about an almighty ring in “Lord of the Rings,” essentially warning of the same dangers. There is a valuable underlying lesson here: excessive centralization is arguably against human nature . It appears that our ancestors may have understood the importance of decentralization before Satoshi Nakamoto’s divine intervention in Bitcoin shook the financial world and opened the first crack in our own tower.
Many civilizations have built their own version of the Tower of Babel, haven’t they? We believe our contribution is greater and more lasting than our predecessors. Our inflated ambition and sense of greatness can become our greatest weakness once a world power has long dominated, bringing civilization into crisis. However, while a crisis may expose weaknesses, it ultimately forces us to be sober, dispassionately analysed, and assess our collective productivity and available resources.
Elliott Wave Theory states that market prices do not move randomly, but move in recurring cyclical patterns
While civilization has recorded the rise and fall of countless generations like the data charts of the financial markets, the goal should be to make progress through effective restructuring, restoring the best from these towers of Babel. Just as cryptocurrency traders use Elliott Waves for technical analysis, we can also look back at history to make comparisons and assess possible future outcomes.
This begs the question: Are we experiencing a Babel event in the global financial markets? Perhaps the scalability of fiat currencies has reached its limit and we are in the midst of a great paradigm shift as we form A new network has been developed and our strength has been enhanced by decentralization embedded in all cores. The world needs a global currency, but it probably doesn’t need to be issued centrally or by a sovereign government. The financial world without a sovereign-issued currency is full of experimentation and opportunity, but is stability important enough to be attached only to our central institutions?
Cryptography and Decentralized Finance: A Trustless Network of Decentralized Towers
What underpins the global reserve currency and assets is the mutual trust of all parties involved. At the macro level, this means central governments and sovereign governments. Furthermore, this wealth permeates every citizen – who wants to preserve the wealth they have acquired – and uses it effectively to bring rewards for their efforts. Ideally, these rewards are based on their efforts to bring value to others, but it is well known that the current financial system is facing structural problems, not to mention the most necessary component – trust.
We trust so many institutions that it’s easy to forget how many layers of trust our financial system relies on. Blockchain and the Web3 protocol make it possible to build financial institutions based on verification and mathematical proofs rather than trust. This is thanks to various advances in cryptography and interoperability, not to mention the composability and modularity of Web3.
By creating a world where assumptions are less trusted, we can reduce systemic risk and ultimately create healthier, more productive economies and societies. However, trust is earned, not given lightly. It will not be a quick and easy transition, but will have to be built from scratch, brick by brick. So, in many senses, learning from the past will be the most effective way forward.
A Brief History of Liberty Banking and Wildcat Bankers
From 1837 to 1864, U.S. banks issued money with little federal oversight. Various schemes have been tried, but perhaps the most controversial is Liberty Bank. The so-called “era of free banking” is a colorful and dynamic era characterized by decentralization and a strong demand for hard money. With proper scrutiny, the past certainly rhymes with the present and may help guide our decisions today.
Liberty Banking was a collection of early local efforts overseen by the states to address the trust problems caused by extreme investor pessimism and subsequent bank runs after the Panic of 1837. After witnessing the failure of the Bank of New York to convert fiat currency into gold, Liberty bankers intended to avoid the corruption they believed to lead to monetary inflation, but witnessed many bank failures in states that tried the Liberty Banking program.
“Although historians have traditionally considered the experiment a failure, the proliferation and continuation of U.S. liberal banking laws before and even during the Civil War shows that they were very popular in many places.”
The term te (liberal bank) refers to the banking system with free entry and issuance of federal bond-backed instruments. Free entry means that a potential bank can start a bank as long as it can raise the minimum capital threshold without needing any special appropriation from the state legislature, a common practice under the older chartered banking system.
Another provision of this new liberal banking system is to allow banks to issue paper money convertible into gold or silver, but as a security measure, they must deposit designated government bonds with national authorities. The bonds would serve as collateral for negotiable notes issued by the Liberty Bank, earning interest as long as the bank remained solvent. However, if it fails to honour its notes, national authorities will sell the defunct bank’s bonds, using the proceeds to repay noteholders.
Although historians have traditionally considered the experiment a failure, the proliferation and continuation of liberal banking laws before and even during the American Civil War showed that they were very popular in many places. In fact, the first Free Banking Act was passed in Michigan in 1837, and in New York and Georgia the following year. By 1861, more than half of the states had enacted free banking laws. Pennsylvania adopted Liberty Banking 23 years after Michigan in 1860, showing that the problems experienced by early adopters did not prevent the adoption of Liberty Banking, but led to tighter oversight and regulatory protections.
When banks ran out of gold and began refusing to redeem the paper money they issued, many bank failures and economic disaster ensued (1837)
The failure of Liberty Bank is often attributed to Wildcat Bank, but it’s actually much more complicated. Broadly speaking, Wildcat Banks issued notes that far exceeded the amount of convertible gold they held in reserve, set up their exchange offices in remote locations, and then disappeared. Of course, it’s not uncommon to encounter predators like lynx, cougar, or “wildcats” in the wild. This is most lucrative when bankers are able to take advantage of interest rate arbitrage, by incentivizing the sell-off of paper money, leaving many with bags of worthless notes and a non-existent bank to redeem it.
Again, the consensus view is that early liberal banking in Michigan was largely a failure, while the New York experience was mostly successful. During 1837-1838, Michigan Liberty Bank investors and paper money holders suffered huge losses due to poor lending practices and insufficient reserves of money at the time of redemption. Of course, note holders have no reason to exchange their notes for gold, as long as Liberty Bank considers the bank healthy.
As a result, banks’ gold and silver reserves are usually small compared to the amount of paper money in circulation, which is often generated by loans such as home mortgages. Since their gold and silver reserves do not pay interest, banks only keep enough currency in their vaults to meet expected redemptions that day.
But if noteholders suddenly suspect that the bank is making bad loans or is at risk of bankruptcy, a mass redemption of money (often called a bank run) could lead to a liquidity crisis, refusal to redeem their notes, and ultimately the bank’s failure. Interestingly, even if the bank is not at risk, if noteholders fear a bank run, it often creates what we now call FOMO, increasing the pressure on banks to redeem more notes than expected.
“The idea that Liberty Bank encouraged risk taking and Wildcat Banking is still prevalent among historians, although it will be debated in the following paragraphs.”
In contrast, New York’s Liberty Banking operation, despite being one of the earliest adopters, rarely failed during its Liberty Banking years. Historical data from other states with liberal banking shows that they have had varying degrees of success in terms of the stability of their banks.
Of course, free banking ended in 1864 when Congress passed the National Bank Act to incentivize banks to obtain state charters. In the debate over the National Banking Act, proponents cite the mass failure of state-licensed banks in liberal banking states and the need for a unified national monetary system. However, is it really necessary – does history have lessons to teach us?
The idea that liberal banking encouraged risk-taking and wildcat banking remains a widely held view among historians, although this will be contested in subsequent paragraphs. Essentially, the main assumption is that the threat of loss of future profit streams and reputational damage often greatly inhibits risk-taking, while excessive competition at the time reduces the value of bank franchises by creating unhealthy short-term incentives.
That said, if the long-term incentives for stability and franchise value become too small due to intense competition, the likelihood of wildcat banking and other risk-taking for short-term gains is greatly increased. Web3 developers and DeFi protocols have carefully calculated the same types of security considerations that need to mitigate the incentive structures of their platforms.
Other evidence points to the long-term decline in the market value of national bonds that are required as collateral for the free issuance of banknotes to be the culprit behind the bank runs. Fortunately, Rolnick and Weber proved this by comparing four states’ Treasury bond price declines, finding that 79% of bank failures and bond price declines are consistent with the hype hypothesis.
“Thus, Liberty’s failure, at least in part, can be attributed to states’ collateral restrictions on Liberty’s holdings of its national debt.”
Further evidence for the researchers was that bank failures in these four states actually did not coincide with the most profitable periods for Wildcat Banking. As a result, falling state bond prices put pressure on Liberty Bank’s Treasury portfolio, triggering panic and subsequent bank runs. Thus, Liberty’s failure can be attributed, at least in part, to states’ collateral restrictions on Liberty’s holding of state bonds.
Essentially, banking regulators treat high-risk Treasuries as essentially risk-free, which remains a problem in modern banking and politics. An important conclusion is that tying the safety of banks to the presumed reckless behavior of a particular asset class is itself quite dangerous, even if those assets are guaranteed by the government. Those investors concerned will adjust their portfolios to protect themselves from counterparty risk without bureaucratic mandates.
It’s hard to ignore the parallels between the past and the present, with many Treasuries and financial institutions required to hold a minimum percentage of certain assets, such as sovereign bonds. This has been a headache for many in recent years, who have witnessed an explosion in sovereign debt, with yields exceeding yields on bonds they are entrusted to hold for clients.
Another key issue to watch out for is the general lack of transparency, coupled with a lack of trust that banks are not just printing money. Of course, this is not unique to the United States, Liberty Bank has appeared and disappeared in several countries around the world, such as Australia, Switzerland, Colombia, France and the United Kingdom.
Global Stateless Currency: A Trustless World Order
The problems experienced in the era of free banking can be more fully solved in modern times with blockchains and oracles, meaning that people can verify rather than trust the issuer of their currency. Likewise, the inflation rate and token burn mechanism are written into the code of the Web3 protocol, giving users a glimpse into the workings of a modern cryptocurrency free bank.
Fiat currencies are fundamentally limited by scale issues, making it difficult to expand trust in financial institutions. This is especially important given how interconnected the global economy has become. Currently, the world has an opportunity to adopt trust-minimized currencies in the form of cryptocurrencies issued by software rather than by sovereign governments. Some have proposed Bitcoin as the next global reserve currency, but as we have learned from the past, authorizing only one underlying collateral asset carries risks.
Running entirely on a cryptographic track, assets can actually be unbounded by physics and then bound by pure mathematics rather than human institutions. In addition, government regulations need to be scrutinized and treated with a healthy dose of skepticism to avoid mistakes made in the past, whether well-intentioned or not. In other words, the mandatory use of one (or designated) reserve asset or underlying collateral asset within the banking system may introduce systemic risk.
This is not to advocate laissez-faire adoption of numbers per se, but it is not entirely clear whether central banks and centralization in general are more stable in the long run. Maybe it’s easier to use a central bank to expand our financial system. However, recent developments should encourage us to unfettered by central banks and to conduct our own free banking experiments for as long as possible. The Bank Negara Act shortened the last experiment, but that doesn’t mean we should give up lightly this time around.
According to Multicoin Capital, the potential market for stateless currencies is between $50-100 trillion, which is now compared to gold’s market cap of just under $12 trillion .
As mentioned above, enforcing the use of one asset class or another as benchmark collateral is unsustainable, but that doesn’t mean that a single asset-collateralized winner won’t be the best reserve asset over time. That is, the free market should decide whether a single reserve asset, or possibly a basket of assets, is needed.
Just as water flows from high to low, hard assets also flow into the portfolios of those looking for liquid markets and preserving their wealth. As such, robustness, liquidity and transparency will play a key role in the race for the most difficult and universally accepted currency and collateral assets.
Of course, political intervention and war are uncertain variables, and even the most carefully planned plans are inevitably disrupted. However, the path ahead is lobbying for the free market, one of the paths to success for many decentralized projects, rather than putting all our eggs in the central bank’s basket with only one chance of success. If we go down this road, we might as well build another tower, as in the biblical story, but we know how it will turn out.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/stateless-money-lessons-from-the-age-of-free-banking-and-wildcat-bankers/
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