Course Textbook

Always and everywhere, monetary systems are hierarchical.

In 1202, a traveling merchant by the name of Leonardo da Pisa, popularly known as Fibonacci, published a book called Liber abaci (Book of Calculation) that enriched the field of mathematics in Europe. Fibonacci grew up in the bazaars of Algeria where he learned of ancient mathematical discoveries, and he later published a book that brought the Hindu- Arabic numeral system to Europe, laying the foundation for the extinction of the limited Roman numeral system. He detailed advancements in arithmetic that were foreign to Europeans at the time, as well as accounting techniques that mirror methods used by merchants from India and universities from Islamic Spain. These accounting techniques were the foundation of what we consider double-entry accounting today, the ubiquitous system of assets, liabilities, equity, and profits. Liber abaci's legacy would be felt right away in Italy as Fibonacci's ideas spawned a new type of merchant class, one with its power derived not from a commodity or a service but from a balance sheet: the banker.

Predating Fibonacci's book of mathematical discoveries was a monetary instrument called the bill of exchange. Bills were a way to send money from one place to another and simultaneously convert it to the recipient's desired currency. They were letters written by bankers promising payment. The bills weren't always paid for up front and therefore were a form of lending and an extension of credit by the issuer, making bills of exchange the world's first widely-used credit instrument. Their origin is difficult for historians to pinpoint, but we know they existed in the Arab world centuries before they arrived in Europe. By the twelfth century, bills became commonplace in northern Italy. By the fourteenth century, bill of exchange issuers denominated at least one side of practically every bill transaction in gold florin. With the florin involved in all major continental transactions, a monetary system started to emerge around this denomination. Even though hundreds of coins were circulating throughout Europe, everybody accounted in florin. It was the international business balance sheet denomination of choice and the world's first world reserve currency. Between the florin and bills of exchange, alongside Fibonacci's crucial innovations, a two-layered money system was starting to emerge.

In the fifteenth century, the international monetary system was finally breaking free from its (precious) metallic chains. Mathematician Luca Pacioli accelerated this process. Pacioli taught mathematics to Leonardo da Vinci and composed a book with him called Divina proportione (Divine proportions) about architectural mathematics, but this was not Pacioli's claim to fame. Before Divina proportione, he published Summa de arithmetica, geometria, proportioni et proportionalita (Summary of arithmetic, geometry, proportions and proportionality) in 1494 which gave Pacioli the nickname "the father of accounting and bookkeeping". Accounting was actually only one of the teachings from his masterful summation of arithmetic, algebra, geometry, trade, and bills of exchange, but it laid the groundwork for the modern balance sheet. He formalized into scripture what had become the "Venetian Way" of double-entry accounting, a system which is still utilized by every major business entity around the world today. Within the double-entry accounting system were the secrets of how bankers could create money not by minting a coin, but from their balance sheet. Ever since Summa, our financial world is viewed through the lens of balance sheets, but this book aims to reframe it with layers.

The Hierarchy of Money

Let's begin to formally defi ne layered money. Keeping in mind the example of a gold coin and a gold certificate from the Preface, let's take a look at an example from Renaissance Florence and the famous Medici banking dynasty. We begin this layered approach by thinking about the difference between a gold coin and a piece of paper that says,"The Medici banking family will pay one gold coin to the bearer on demand". The gold coin is a first-layer money and the form of final settlement. The piece of paper only exists because of the gold it represents; it's a second-layer money, created as a liability on somebody's balance sheet. All second-layer monies are IOUs (I-owe-you) or promises to pay first-layer money. They all have something called counterparty risk, or the risk that comes with holding a promise made by a counterpart. Counterparty risk is an essential concept in the monetary science, especially because all forms of money in today's financial system have some degree of it. Trust in counterparties is required for our financial system to operate, or else we'd all still be using gold and silver coins for every single transaction. Layers of money came to exist because people trusted forms of money that carried counterparty risk of the issuer. They are a way to show how monetary instruments are related to each other based on a relationship between balance sheets of financial institutions. Take a look at Figures 3 and 4, which closely mirror the Preface's example of layered money.

Figure 3

Figure 4

The layers become a way to think about money's natural hierarchy whereupon monetary instruments are ranked in order of superiority from top to bottom, instead of placed next to each other on accounting tables. Each layer represents a side of somebody's balance sheet, and therefore we must also identify the actors that exist in between layers of money. In Figure 4, the Medici Banking Family is the actor between the first and second layers. It issues second-layer money - bills of exchange, which are promises to pay first layer money - gold and silver coins. Key word: promises, with the risk of being broken.

Bills carried default risk by the issuer because they were a form of deferred settlement. Default risk is the risk that the actor between money layers cannot or will not fulfill on the promise to pay. Any bill issuer can default, leaving the holder of second-layer money with a worthless piece of paper. Despite the default risk, bills served as an instrument of monetary exchange and an accelerant to the velocity of money. Bills also greatly increased the elasticity of money; coins can- not be fashioned out of thin air, but bills could. Rubber bands are elastic: they can expand when stretched. Money can also be elastic: it can be expanded but only when it doesn't have to be fully reserved with gold coins in a vault. To merchants and their bankers, elasticity trounced default risk, and bills became the preferred monetary instrument to coins. Those willing to accept bills and other forms of deferred settlement demonstrate to us that money is fundamentally hierarchical. If a merchant demanded gold payment upfront for the delivery of goods, it was his right to do so. But if another merchant accepted a bill that represented a promise to pay gold later, his willingness to defer final settlement is proof alone that the layers of money are not a construct of bankers but immanent in the human tendency to keep tabs with each other. We began to see a system in which different layers of money served in different capacities. First-layer money emerged as a better way to store value over longer periods of time, and second-layer money emerged as a better way to transact because it was more flexible to use than coinage.

Disciplinary Constraint

The most important characteristic of the first layer of money is the disciplinary constraint it applies to layers underneath it. Here's an example. Goldsmiths in fifteenth century England weren't meager craftsmen. They also fulfilled the role of banker because of their ability to securely store precious metals better than anybody else. Let's say that an English gold- smith issues a piece of paper called a deposit for each gold coin he agrees to store. If all deposit holders suddenly ask for their gold coins back, he will easily satisfy the redemption requests because his deposits are fully reserved, meaning there is a one-to-one relationship between gold coins and gold deposits.

Let's take this opportunity to introduce the word cash. Monetary instruments like the gold deposits issued by trusted and reputable goldsmiths often functioned as cash. Cash is defined by anything we use as a form of money that others accept at face value, even if it's a bare piece of paper with counterparty risk and no guarantee of final payment. For something to work as cash, people have to trust the issuer, or whoever has made the promise to pay.

Back to the goldsmith. Let's say his deposits gain credibility and start circulating as cash because people trust that they are redeemable for gold. He gets greedy and decides to capitalize on his newfound trustworthiness. He issues gold deposits to himself without properly reserving the corresponding gold in his vault and spends these deposits as cash into circulation. The goldsmith will then default if ever faced with a full redemption request. This type of activity is called fractional reserve banking, as opposed to full reserve banking when all deposits have corresponding gold in a vault. Gold exists as the goldsmith's disciplinary constraint, serving as motivation not to abuse the power of money creation that comes with the public's confidence in his deposits as a form of cash. Second-layer money is therefore inherently unstable, as the power to create it will always be subject to human abuse, similar to our example of the English goldsmith who abused the public's confidence in his creditworthiness.

The hierarchy of money is dynamic, meaning that it's a set of relationships in constant flux. When credit is expanding, the money pyramid expands as the second layer grows in size. When confidence runs high, a gold coin and a gold deposit have almost no observable difference. People freely accept gold certificates as money because they trust the issuer's ability to satisfy redemption. Certificates result in convenience, as final settlement of coin and bullion can be arduous, cumbersome, and potentially dangerous. This reverses when the money pyramid enters contraction and the objective difference between money and money-like instruments is suddenly pronounced. Instruments that previously had a high degree of perceived trust are no longer desired, and their owners dump them for instruments higher in the hierarchy, such as gold coins. Contractions can result in redemption requests, called bank runs, and eventually financial crises. These crises can be more easily thought of as attempts to climb the pyramid of money, as holders of lower-layer money scramble to secure a superior, higher-layer form of money.

The Clearance Problem

As layered money evolved to solve problems with coin-money, new problems arose. Forms of second-layer money were all different from each other. Yet, what happened during the sixteenth century in Antwerp changed this forever: a market entirely dedicated to trading second-layer money was born. Layered money increased its velocity by bringing a tremendous advancement in the safety of its transfer: funds couldn't be lost or stolen when transferred through a banking network. Fraud and insolvency notwithstanding, the enormous reduction in shipment of coins was a huge victory for international trade. Merchant bankers sent money around the continent effortlessly by using their balance sheets and professional net- work instead of by shipping physical gold and silver coins. The amount of outright risk a business owner took in sending physical metal during this time cannot be underestimated. Piracy was rampant, and maritime insurance apparatuses were in their infancy. Increased usage of deferred settlement increased money velocity, as final settlement could be postponed indefinitely with only the balancing of debits and credits.

A flood of new banking liabilities and second-layer money introduced the issue of clearance, the process of settling transactions. No clearance system for bills of exchange existed yet. Bills weren't treated as cash due to their lack of standardization. They were promises to pay gold and silver, but they weren't fungible with each other. Customized currencies and maturity dates made each bill a static instrument that in no way resembled cash; no two bills looked alike. People weren't willing to swap letters of intent with each other because the letters' terms were all incongruent. A culture of counterparty trust hadn't yet evolved.

Slowly but surely, bill of exchange maturity dates started to gain uniformity in the fifteenth century. Dates that chronologically aligned with the European merchant fair calendar were chosen because bankers followed merchants to provide them financial services. These fairs took place throughout Europe - from France to Flanders. Merchants of cloth and silk, pepper and spices, and coins and bills gathered together seasonally to trade. The fairs were the perfect opportunity for merchant bankers from all around Europe to come and cancel out tabs with each other, or clear (as in clearance) off setting debits and credits. The fairs' seasonal patterns, however, limited bill of exchange clearance to about four sessions per annum. That meant the second layer of money traded approximately four times per year, an objectively infrequent rate of turnover.

In the end, the second layer of money lacked liquidity: it couldn't easily and readily be rendered for cash. During this interval, cash and coins were synonymous, meaning that the only form of money considered to function as cash were precious metal coins themselves. Bills of exchange didn't readily convert to precious metal unless presented to the appropriate underwriters upon their maturity date. A market where bills could change hands at prices determined by buyers and sellers on location didn't exist. Th is would all change when the market for second-layer money left a life of quarterly clearance at traveling fairs for its first year-round home in Antwerp.

A Continuous Fair

The creation of the Antwerp Bourse in 1531 revolutionized money because it birthed the money market. At the time, the money market described the market for second-layer monetary instruments such as bills of exchange, gold deposits, and other promises to pay precious metal. The word bourse came from nearby Bruges, which previously served as the hub of northern European commerce before losing its crown when English cloth merchants decided to center their trade in Antwerp in 1421. The Bruges Bourse was a quiet meeting place for financial clearance, but the Antwerp Bourse was a place for boisterous traders and became the world's first modern financial exchange. Bourse went on to become synony- mous with financial exchanges around the world; the word for "stock exchange" is bourse in French and börse in German.

Financial exchanges, like the original Antwerp Bourse, are places of trade where price discovery happens. Price discovery is exactly what it sounds like: the process by which an asset discovers its price by being bought and sold in a market. The price of an asset emerges, or is discovered, when observing transactions between buyers and sellers. If trade is allowed to freely occur, the price of anything can be discovered. Antwerp prided itself in its regulation-free environment, wherein the trade between first-layer coins and second-layer bills, and between bills themselves, didn't require licenses and wasn't subject to taxes. It was a haven for merchants from every country across Europe and was considered the center of the global economy during the sixteenth century. Merchants from Portugal, Spain, England, and Germany descended upon the hustling and bustling international trade hub. Antwerp's spring and autumn fairs featured English cloth, East Indian pepper peddled by the Portuguese, American silver peddled by the Spanish, and other German, Italian, and French trades. All this trade attracted merchant bankers and a litany of second-layer money issuance. When the Antwerp Bourse opened, it was known as the "Continuous Fair," depicting the evolution of financial clearance from seasonal to real-time.

Within the halls of the Antwerp Bourse the money market was born, a market that transitioned our understanding of cash from metal to paper. Bankers accomplished this by formalizing two major innovations in the evolution of layered money: discounting and note issuance. Bankers in the new Bourse didn't walk around juggling hundreds of coin- currencies all day. Coins were a detriment to money velocity, and only a combination of deferred settlement, accounting, and paper had the potential to bolster it. Initially, money market trading in the Antwerp Bourse occurred almost exclusively in bills of exchange. Money market traders gave bills of exchange liquidity, something they never had previously. Th is drastically increased money velocity. Before the opening of the Bourse, second-layer money was issued in quarterly increments and designed to bridge debts until the next fair. But in Antwerp, second-layer money began to develop cash-like characteristics.

The Time Value of Money

The merchant bankers of Antwerp quickly saw how using money layers, and creatively at that, could improve money as a technology for human progress. What exactly was their secret? The answer lies in one of the foundational concepts of modern finance: discounting. Let's walk through a basic example of discounting in order to illustrate the time value of money and see precisely what the bankers in Antwerp added to our monetary system.

You purchase a bill from a banker today for $98 that can be exchanged for $100 in a month. You do this because the $2 that you accrue during the month is worth the time you have to wait. This is commonly called the time value of money because the time you wait has value associated with it: you're paid to wait. Before the dawn of the money market in sixteenth century Antwerp, you were forced to wait a month before presenting the bill to collect your cash. In the interim, you have a piece of paper with a principal amount and a maturity date. Even though it has a maturity date in the future, this piece of paper still has value associated with it. If, after two weeks, you require liquidity from this bill and must convert it to cash, where do you go? You need a banker willing to purchase the bill for cash before it matures. The banker would split the difference between your purchase price ($98) and the face value ($100) and pay you $99. This process of a banker buying the bill at a price of $99, which is "discounted" from the $100 par value upon maturity, is called discounting. You walk away with cash today, and the banker will collect $100 at the end of the month. This type of discounting by money market traders in Antwerp brought alive the time value of money on a daily basis. Paper money finally had a price for the world to see. In fact, the birth of the financial press occurred in Antwerp during this period, not due to stock or government bond markets, but to detail daily price changes of commodities traded by merchants and second-layer money traded by bankers.

The last piece of the puzzle to Antwerp's success in launching the modern-day money market was the invention of promissory notes. Promissory notes brought full circle the money market's transition from a haphazard and quarterly smorgasbord to a continuous state. At the Bourse, in order to settle any outstanding balances at the end of the day, bankers issued yet another form of credit, a new second-layer money called promissory notes or notes. These notes were promises to pay the bearer, meaning that whoever held the piece of paper was due the promise. These instruments were the direct predecessors to what we consider paper cash today, currency notes. They were groundbreaking in their lack of specificity; previous versions of second-layer money always had people's names on them. Notes, like cash today, were completely free of this construct. They were used as a settlement tool but evolved into their innate role as cash and became extremely useful as mediums of exchange. Figure 5 shows the layers of money in Antwerp during the sixteenth century.

Figure 5

In Antwerp, the interest rate arbitrageur had arrived. Arbitrage is when you buy apples for $1 in one town because you know you can sell them in the next town over for $2. The art of arbitrage is as old as business itself, and medieval money changers that converted one coin into another were themselves engaged in a form of it. But arbitrage opportunities never existed in second-layer money until the Antwerp Bourse. As dealers discounted and traded bills and notes year-round in the Bourse, paper money found liquidity on any occasion, slowly moving the international monetary system away from an over-dependence on metal. The second layer of money itself became an asset class with prices quoted by the world's first financial newspapers. The way to compare all second-layer instruments was not in terms of their individual prices but based on the interest rate one could earn from holding that paper. Interest rates were a complementary way to express the price of money, and one that allowed traders to exploit differences in the value of paper. Every piece of paper in the Bourse had an interest rate, presenting arbitrage opportunities for bankers. This modernization in liquidity ultimately shifted the primary perception of money from metal to paper. Precious metal couldn't fulfill the multitude of properties commanded from a monetary system. Accounting, paper, and a network of bankers could.