A gentle introduction to money

This post aims to explain the various common forms of money that exist today, and the words we use to describe them.

Terminology

Confusingly, terminology differs from country to country and words are used to mean different things in different contexts. In this post, as we are discussing the nuances of money, it is important to be pedantic so I try to keep to the following conventions:

Money

There are two important types of money: broad money and narrow money.  There is no standard global definition of these, so below is my effort to explain their common use.

Broad money is what we generally think of as money.  Notes, coins, bank deposits, your Paypal account, stuff that you have access to fairly quickly and use to clear debts. It’s the money of commerce, the money that makes the world go around.

Broad money = Physical notes and coins + instant access bank deposits

Narrow money is more specifically a claim against a central bank. In its physical form, it is banknotes and coins. In its digital form, narrow money is the account balance of those special banks, called clearing banks, who have a (bank) account with the central bank of the country. I cover this in [A gentle introduction to interbank payment systems].

For example, Lloyds bank has a GBP account withthe Bank of England. That balance is a claim against the Central Bank and is considered “narrow money”, and in the UK they are called reserves.  In general, normal people and business don’t have access to digital forms of narrow money.

Narrow money = Physical notes and coins + (digital) reserves at the central bank

In the UK, there is around 10 times more broad money in circulation than narrow money.

Source: Bank of England, 2014

As an aside, if you look at your banknotes they will say something pretty generic about the central bank promising to pay you the value of the note. (Note: No promises to pay back in gold!). In theory you can give a £10 note to the Bank of England, and they have no obligation other than to hand it back to you or give you two fivers.  The obvious next question then is “What backs a central bank” or “What backs a currency?”, but that is a post for another time.

Clearing banks

A clearing bank is a bank that has an account with the central bank of that country. For any currency/country there is a hierarchy of banks:

• The central bank (issues the currency)
• Clearing banks (banks who have an account with the central bank)
• Other banks (banks who have an account with a clearing bank)

Clearing banks have a special status within their ecosystem, because they have an account with the central bank, and therefore can send money to all the other clearing banks electronically, without needing to maintain separate accounts at all the other clearing banks.  See [A gentle introduction to interbank payment systems] for more.

Smaller banks, foreign banks or new banks will make a choice: either to try to become a clearing bank by opening an account with the central bank; or to open an account at a clearing bank, and sit one level lower in the hierarchy, with potentially slower inbound and outbound payments – and more fees!

Currency / Cash

The Bank of England defines currency as physical notes and coins. That’s it.  Money in your bank account isn’t “currency” (it’s deposits… but more on that later).

Sometimes “currency” is used more generically to mean a specific government’s fiat money, eg the GBP currency or SGD or USD.

Bank deposit

A deposit is the balance in your current bank account, which you use to make electronic payments, or instantly withdraw into physical cash from a cash machine.

Deposits are digital, so stashes of notes stored in a locked box in a bank’s vault do not count as deposits.  When you hand over a fistful of dollars to the bank clerk, you are handing over central bank money (or “currency”) and asking the bank to convert them to deposits for you.

It’s important to understand two things:

1. Central bank money (banknotes) is not the same as deposits!
2. A deposit at one bank is not the same as a deposit at another bank
3. Your deposit with a bank is not “Your Money”

If you keep a stash of physical currency banknotes (or jewelry or documents) in a locked box in a bank’s vault, that is “Your Money”, and you are paying the bank a fee to safekeep your assets.  The bank is indifferent to the content of the box and cannot count the items in the box as their property.  If the bank goes bankrupt, you get the contents of your box back.

However, a deposit is different.  A deposit is a legal claim that you have on the bank.  It’s an agreement between you and your bank that they will give you physical cash on demand (up to limits) and you can use your deposit balance to make payments (again, up to limits), unless they decide not to.  Unlike the content of the locked box, the bank cares how much money they owe you in your deposit account.  If your bank goes bankrupt, you don’t automatically get your deposits back, but you’ve got a (fairly senior) claim on a bankrupt entity.

In balance sheet terms (more on this below), stuff in the locked box doesn’t appear on the bank’s balance sheet, but a deposit does, because it is a bank’s liability to you.

Note: In many countries, there are guarantee schemes that guarantee retail account holders will get back a certain amount of money from their current accounts, if the bank fails. This is called “Deposit Insurance“. The schemes are sometimes backed by the central bank of the country.  Here’s an example from the UK’s Financial Services Compensation Scheme (FSCS):

FSCS compensates you if your (UK authorised) financial provider stops trading or is insolvent. FSCS protects a range of products, such as savings/current accounts (from £1 to £85,000) and that protection is free, automatic and usually compensates people within seven days.

So the first £85,000 in your account is kinda a bit closer to real central bank money, in terms of what happens when your bank goes bankrupt, but any more than that is not.  So if you have £90k in a current account, the last £5k is different to the first £85k!

Balance sheets

A balance sheet is a way of thinking and documenting stuff you have and stuff you owe.

• Assets = stuff you have
• Liabilities = stuff you owe

If you have more stuff than you owe, you have a positive net worth. In company-speak, net worth is called shareholder equity.

When you earn money, your assets go up (+cash), and your liabilities stay the same, so your net worth goes up.

When you spend money on food, your assets go down (-cash), and your liabilities stay the same, so your net worth goes down.

If you buy an asset which retains its value, eg a rare vase, your net worth stays the same:

• If you bought it with cash or a deposit, your assets change type but remain the same total value (-cash/+vase) and your liabilities stay the same
• If you used your credit card to buy the rare vase, your assets go up (+vase) and your liabilities also go up (+credit card bill).
  • When you pay off your credit card with cash or a deposit, your net worth remains the same (-cash asset / -credit card bill liability)

Why is this important?  With all forms of money, your asset is someone else’s liability:

• Physical cash is an asset to the holder, and a liability of the central bank (the central bank owes you, the holder of the banknote)
• Deposits are an asset to the account holder, and a liability of the bank (the bank owes you, the account owner)
• Reserves are an asset to the clearing bank, and a liability of the central bank (the central bank owes the clearing bank)
• Your Paypal account balance is an asset to you and a liability to Paypal (Paypal ‘back’ this with a deposit at a bank, which in turn is their asset, and the bank’s liability.)
• Your airline miles are an asset to you and a liability of the airline (they owe you a flight).  Air miles and loyalty points are wonderful for the issuers because the issuers can create and destroy them at will, and change their value!  Superb.  They are like a central bank of those points with more powers than a central bank has over sovereign currency!  (see On loyalty point schemes and blockchains for more)

Note that there is a fundamental difference between money as described above, and something like physical gold or Bitcoin.  These two are assets without a corresponding liability, as there is no entity who ‘owes’ the owner of gold or bitcoin.  They just sit there being assets to the owner.

Digital currency

So what do we mean when we talk about digital currency?  Different people use different words: Digital fiat, crypto fiat, e-Cash, central bank digital currency (CBDC), electronic money… There is no global definition, but in simplest form, it means a direct liability of the central bank, held in digital form.  Something like a digital version of paper banknotes and coins with similar properties.   Reserves, mentioned earlier, are a special form of digital currency that can only be held by an approved list of clearing banks and RTGS participants.

I discuss central bank digital currencies more in the hype around central banks, digital currencies, and blockchains.