An amusing financial instrument for creating a common currency

After my manifesto, I started thinking about the relationship between the new hippy socialist utopia, the EU, and exchange rates.

This got me thinking:

  1. I like common currencies as a way of creating common economic zones, shared trade, etc. They’re not essential but they’re nice
  2. But individual countries and governments need their fiat currencies, otherwise they’re kinda fucked. Witness, recent history
  3. The ideal scenario is that you would be able to use either the local or the common currency in each country. Or at least that certain classes of things would accept either
  4. But how can you create a shared common currency without linking it to governments?

After some (read: 5 minutes) pondering I came up with what I think is a neat solution. You can create a common currency which is naturally linked to the local currencies and has an effectively unlimited supply as a sort of financial instrument. Further, you can do this without requiring a central organisation to administer the currency (although you will probably want to have recognised organisations who are allowed to print paper versions of it).

Suppose we have some collection of countries who want to define a common currency. They each have their own local currencies. We can define a shared unit of currency, which we will call a Credit, as a promise to play a game.

How does this game work? Simple. You pay me one credit. I now pick a country from this set uniformly at random (according to some prescribed and verifiable randomization mechanism). I pay you one unit of that country’s local currency.

A credit is simply a commitment to this contract. Anyone can issue one, and it is subject to local contract law.

However I do not expect that in practice many people would play that game. In reality, the credit has a unique exchange rate defined for it: The worth of one credit in a given currency is the average value of the worth of one unit of currency in each of the countries in the union. If the original set of exchange rates is arbitrage free then so is this new set.

Edit: I’ve just noticed that a much more sensible way to do this is to not have the randomization at all and simply to commit to paying this exchange rate in some subset of the currencies. It’s simpler to just have the contract to be a commitment to pay that average exchange rate for any currency in the union.

Edit 2: On second thoughts, I’ve flip flopped. I think the randomization serves a useful goal after all, because it decouples the contract from the foreign exchange market, which although it roughly follows the simplified model of having a set of consistent exchange rates, that’s not how it really works and pretending that it is ties you to a central exchange. I think in practice you will rarely find you want to employ the randomization, but I think it serves an important theoretical benefit.

It might open interesting options for time based arbitrage – I’m not sure – but I don’t think so. In general you would expect the credit to be more stable than its constituent currencies because the rate of change is averaged, which damps out small fluctuations.

How do you deal with changes to the union?

Well you can do it in two ways. The first is that you can just let it revalue the currency. If your union is large enough this can’t go too badly wrong – e.g. at the 27 member states of the EU, the worst case scenario for adding a new member is that they contribute a 0 value currency, at which point your currency drops 3.6%. Much larger fluctuations in exchange rate are common.

Another solution is that you can version the credit. So rather than committing to a credit for the entire union, you commit to a credit for the union as it was at this date and time. Issuers of physical currency will then have to make sure they create a new distinct currency look for each change to the union and encourage people to sell them old versions of the currency at the exchange rate with the new one. This is not a terrible solution over all.

Note that although it lacks a paper currency, you can use this right now. You might want to get a lawyer to draft up the contracts, but it’s completely workable on a contract basis. Also if you can’t design on a set of countries, just use all of them! Instant global currency.

What would the effects of widespread use of such an instrument based currency be? I don’t know. I like how stable the exchange rate is, and it certainly seems like a more sensible choice than bit coin.

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3 thoughts on “An amusing financial instrument for creating a common currency

  1. daniel royde

    You say the credit is ‘stable’, relative to what? You would still have currency risk between your local currency and a credit. Suppliers would prefer payment in one currency. People might have currency risk when trading domestically :s

    1. david Post author

      It’s stable compared to any of its constituent currencies because it’s basically a diversification strategy.

      Assuming you don’t have a scenario for arbitrage not involving credits, the arbitrage free price of an instrument in credits is the average of its price in all the constituent currencies. This means that a) Any small independent fluctuations in the value of currencies with respect to that instrument are damped out by the averaging and b) You are protected from the crash of any individual economy, because it’s making up at most a few % of the value of the credit (if you have a crash in many countries then the credit will of course devalue, but it will devalue less than the currencies of those countries do, and might be protected by corresponding increase in value of other currencies).

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