Governments and banks love talking about liquidity!
When markets are in crisis, central banks talk about “maintaining liquidity”.
When politicians look to spur growth, they talk about improving small business access to loans (i.e. liquidity).
When main street banks sell us mortgages, that is a way to get liquidity backed by our future stream of earnings.
When businesses/banks/countries are on the brink, there’s often the claim that the fundamentals are ok! They just have have a lack of short term liquidity! It’s not the business/bank/country that’s the problem! It’s the markets! The solution is liquidity!
Liquidity: What if less is more?
Instead of finding ways to get people/businesses/countries more liquidity, what if we focused on ways of improving financial systems so that they need less liquidity!
Obligation Clearing with Jimmy, Paddy and Mary
This is where “obligation clearing” comes in. It’s best explained with a simple example:
Jimmy owes Paddy $100.
Paddy owes Mary $200.
Mary owes Jimmy $300.
If these are the only debts, and neither Jimmy, nor Paddy nor Mary have any money, then the system is stuck. Nobody can pay their loans.
To solve the above problem, banks step in and offer loans to Jimmy, Paddy and Mary. With those loans, they can easy repay what they owe, then get paid for what they are owed, and then pay back the bank loans.
However, bank loans require the payment of interest. Owing to lending risk, bank loans tend to dry up in times of crises, when loans are most needed to keep the economy moving. For these reasons, the banking system sometimes provides less credit than what a benevolent central planner (e.g. government) would provide. This undersupply of credit can be particularly acute in recessions/crises. This undersupply of credit is one justification for a government stepping in as a lender in private markets – particularly during crises.
Obligation Clearing: The underappreciated alternative to bank loans
What if, instead of getting bank loans, Jimmy, Paddy and Mary could coordinate? If so, they can simply agree to wipe $100 of debt from each person to get the following:
Jimmy owes Paddy nothing.
Paddy owes Mary $100.
Mary owes Jimmy $200.
This not just avoids interest on the loans that would have been required, but also reduces the amount of banking credit risk in the system.
A real world example of Obligation Clearing
Obligation clearing happens in Sardinia, where a business called Sardex that allows businesses to coordinate around their obligations to each other and periodically cancel them off each other.
Here’s a diagram that shows each business in the Sardex network as a node:
The image above shows each business as a point. The lines between points represent debts owned by one company to another. A computer program is run by Sardex to find circles of debt that can be cleared off against each other. There is one simple loop (magenta colour) involving just three businesses (think Jimmy, Paddy and Mary)! The red and blue loops are more complicated bigger loops. The green lines are bridges between the red and blue loops that you can think of as a fourth loop.
Just by periodically offsetting debts across the network, the paper shows that about 25% of debt in the network can be eliminated! This means less businesses going under because they are short of liquidity!
Even better – in times of crises – businesses have more trouble getting bank loans, so more businesses tend to register and operate through Sardex. With more businesses registering that allows for more debt cancellation periodically!
Is this a free lunch?
When there is a complicated network of businesses that have credit between each other, there are missed opportunities if they can’t all coordinate. Finding a way to coordinate isn’t completely free (Sardex charges a small fee to offset obligations) but it is a lot cheaper. Obligation clearning also works better in times of recession – as opposed to private bank loans, which tend to dry up in recession.
Where to from here? Why isn’t this being done more?
There is an interesting extension to this approach that allows for even further obligation clearing – I’ll have a post on that upcoming soon.
In the meantime, I’m planning to set up a proof of concept computer program to try this out myself. Maybe I’ll do it as a game first. Let me know if you have ideas or questions.
Recommended listening: Ethan Buchman on The Ownership Economy podcast.