By now, everyone has heard the expression “financial innovation” to refer to changes that have taken place in our financial markets. Like all innovation, the goal of financial innovation is to solve problems. To bring our intelligence to bear on the problems that we face. Sometimes those innovations fail completely. At other times they achieve a narrowly defined success while causing new problems to emerge in their wake.
One of the financial innovations that have worked out comparatively well are Exchange Traded Funds (ETFs). ETFs have a lot in common with ordinary stocks. They are listed on a stock exchange and you can buy and sell them just like any stock. Like stocks, ETFs represent fractional ownership in a corporation (the issuer). What distinguishes ETFs from ordinary stocks is the trading strategy of the issuer.
For most public firms, the issuer sells a fixed number of shares to the public in an initial public offering (IPO). After the IPO, the number of shares that trade on the stock exchange is fixed (with a few exceptions like corporate buybacks and secondary offerings). The firm obtains operating capital in the IPO. After that it doesn’t sell any more shares or receive any more liquidity via the equity markets. Its next task is to put that capital to work by building a profitable business that adds value to the real economy. AAPL produces ipads. XOM produces oil and gas. Valuable products.
The way an ETF works is completely different. Its only business is to buy, hold and sell the shares of other firms. The ETF basket is the portfolio of stocks held by the ETF. The basket is a matter of public record, and is completely static with the exception of an occasional rebalance. The ETF doesn’t produce ipads, gas, or anything else that the real economy needs. Its value is purely as a tool for traders and investors. And that value derives from two properties of ETFs; price stability and liquidity.
ETFs achieve price stability when the ETF shares trade close to the value of the underlying basket of stocks that it holds. It does not mean that the market value of the ETF shares is stable. It means that the ETF can be exchanged for a fixed amount of the basket. ETFs achieve liquidity when traders and investors can trade them on demand and at low cost. Generally the cost of trading an ETF is far less than the cost of trading its underlying basket, even for brokers who don’t have to pay commissions. Because ETFs have been so successful at achieving both price stability and liquidity, they are loved by almost all market participants including retirement savers, broker/dealers, high-frequency traders and hedge funds. There are many things wrong with our financial markets, but the price stability and liquidity of ETFs are simply not among them.
It is worth nothing that ETFs do not always produce stable prices and they do not always remain liquid. This is most likely to be the case with more exotic ETF structures that are used to offer leverage, inverse exposure, or exposure to things other than stocks (like commodities). But for this discussion, I would like to focus only on the operations of simple ETFs with equity underliers. These have been the most successful ETF structures.
I mentioned earlier that for an ordinary stock, the quantity of tradable shares is fixed at the IPO. A consequence of this is that the market value of shares can fluctuate wildly depending on the imbalance of supply and demand from traders. The price of the shares can then become completely unhinged from the value of the assets held by the corporation. The result is that investors have to be careful not to overpay when purchasing these shares. This is the opposite of price stability. The lesson is that if the quantity is fixed, the price will float.
So what was the operational innovation behind ETFs that allowed them to achieve stable pricing and high liquidity? They let the total quantity of shares float. That is all there is to it. Unlike stock issuers which no longer participate in the market after their IPO, ETF issuers stick around to create new shares whenever traders prefer to hold the ETF shares over the underlying basket. Likewise, whenever they prefer to hold the basket over the ETF shares, the ETF buys back its own shares in exchange for stock, effectively destroying them. This is known as the create/redeem process. It ensures that the quantity of ETF shares that exist is always in line with the size of the total basket that the ETF holds. This means that if you hold an ETF, you know exactly how much of the underlying basket you could claim via the redemption process, and you know that that amount will never change in the future. The composition of the basket may change due to a rebalance. The result is that the market value of the ETF shares are tightly bound to the market value of the basket. The price of an ETF share is fixed!
If you already know about ETFs you might be wondering why I made you read this explanation of how they operate. After all I am not saying anything new. You might be also be wondering what this has to do with MMT. The answer is that I believe the same innovation behind the ETF create/redeem process can be applied to the operation of a sovereign currency. That is because the same features that have made ETFs popular with traders are also what we want from a currency. Those features are price stability and liquidity.
In the case of currency, price stability means that you can exchange it for equal valued assets over time. If you can buy an apple for a dollar today you should be able to do the same tomorrow, unless there has been a change in the availability of apples relative to other goods. Price stability makes the currency savable. You can hold it over time without losing or gaining purchasing power.
Liquidity means that you have the ability to buy and sell the currency on demand. Buying the currency is called earning. Selling the currency is called spending. So the currency has good liquidity if you can spend it on demand and you can earn it on demand.
Like ETF shares, currencies are intended to serve as a claim over a portion of a basket of underlying assets known as the real economy. Like ETF shares, we want our currency to be liquid; meaning it is earnable/buyable and spendable/sellable on demand. Finally, if the quantity of the assets claimed by a given unit of currency is successfully fixed, the currency will be stable in price and therefore savable. If our currency had all three of those features, the system would be fair to savers, earners, and spenders.
So let’s see if we can derive some guidelines for a currency issuer based on what we already know about successful ETF operations.
- The issuer never creates/sells a share without taking delivery of the corresponding quantity of real assets, company stock in this case. To do otherwise would dilute the value of the shares.
- The issuer never redeems/buys a share without returning the corresponding quantity of real assets to users. To do otherwise would inflate the value of the shares.
- The issuer always stands ready to create and redeem shares upon demand from users. This ensures that the shares are both creatable and redeemable.
- The issuer does not become an active buyer or seller of the shares because it would have to make price concessions in order to do so. This would cause inflation or dilution of the share values.
Now let’s convert these guidelines back into the language of sovereign currency issuance.
- The currency issuer should only spend/create currency for those willing to earn it.
- The currency issuer should only tax/redeem currency while earning it itself.
- The currency issuer should remain responsive to users desire for more or less currency in circulation.
- The currency issuer should not attempt to increase or decrease the supply of currency of its own volition.
The first two guidelines are what provide price stability. They ensure that the currency always trades for a consistent quantity of real assets and is therefore savable. The second two rules ensure liquidity. They make it possible for users to earn or spend the currency on demand.
I have attempted to show that these four rules are consistent with the rules that allow ETFs to serve as liquid and stable trading vehicles. I also believe that these rules are consistent with the existing policy recommendations of MMT. If that is the case, then the success of ETFs carries empirical evidence in support of MMT as a way to create currency offering both high liquidity and price stability. We could carry this same innovation into the monetary sphere in order to create currency that is equally savable, spendable, and earnable.