The pawn shop economy: why the financial system is built on sand

Most people have never heard the term collateral explained properly, and I think that is partly by design. The financial system uses language that keeps ordinary people confused and on the outside, because if we really understood what was happening in there, we would ask a lot more uncomfortable questions.

Collateral is a pledged asset. When you borrow money, you put something up as security, cash, property, bonds, whatever the lender will accept. If you default, they take the asset. If the value of that asset falls below the value of the loan, you have a serious problem, and so does the lender.

Liquidity is simply money that is readily available and moving. The analogy I keep coming back to is water. Collateral is the riverbed, the bedrock that allows the river to flow. Liquidity is the river itself. When the riverbed is solid, the water flows freely. When the bedrock is made of something soft and unstable, the whole river is at risk. That is exactly where we are right now.

In the wholesale banking world, institutions borrow cash overnight by temporarily exchanging a liquid asset in what is known as the repo market. They exchange the asset for cash, meet their obligations, and buy the asset back the next day.

When the repo market spikes suddenly, when many banks are all scrambling for short-term cash at once, that is a signal that cracks are appearing in the system. It happened in September 2019, a significant and sudden spike, and then COVID arrived, giving them the perfect cover to do a massive round of money printing while everyone was looking the other way.

I think we are moving towards another situation like that. The losses are building, and at some point there is going to have to be a large injection of new money, blamed on something, a fuel crisis, an energy crisis, something else. So we have got to keep our eyes on the ball.

Not all collateral is equal. The financial system has always preferred what they call HQLAs, high-quality liquid assets: cash, sovereign bonds, government bonds. However those bonds are not looking so stable right now. Nations are selling them off, Turkey being the most recent example, selling its gold and US Treasuries just to cover its oil bill. That is a forced sale, and it tells you something important about where the pressure is building.

The Bank for International Settlements, the BIS, sits at the very top of this entire system, above the central banks, above the commercial banks. They have their own laws, their own sovereignty, and their own army. They have been pushing what they call Basel III endgame revisions, which increase the capital charges on banks, making it more expensive to trade and hold derivatives. The stated aim is to make the system safer. The real effect is pushing smaller banks out of business and concentrating power upward.

What I found extraordinary is a BIS research paper that openly described the system as relying on what it called "opaqueness and symmetric ignorance" to function. Translated: keep it secret, keep it hidden, and make sure nobody outside the system knows what is actually going on. It is a one-way mirror. They are looking in, and we cannot see back.

Here is the thing I found most useful. The oldest form of collateralised lending is the pawn shop, documented as far back as the Tang dynasty in China. You bring something of value, leave it as security, and receive a loan. If you pay back the loan within the agreed time, you get your thing back. If you do not, the shop keeps it.

The beauty of that system, and Tony says this directly, is that the market decides what the collateral is worth, not a central authority. Price discovery happens naturally. Compare that to our current system, where the US dollar and government debt is declared to have a certain value by the very people who create it and benefit from maintaining that value. There is no free market. There is no genuine price discovery. The pawn shop is more honest than the entire global bond market.

This is where it gets interesting for us. Tokenisation is being used to solve the collateral crunch. If Basel III is trapping capital and increasing costs, blockchain is the technology that frees it by dramatically increasing the velocity of money, the speed at which collateral can move across jurisdictions to meet obligations. The DTCC, which processes quadrillions of dollars in securities every year, is tokenising the entire US stock market. They have noted that intraday blockchain-based repos can cut funding costs in half for large banks.

I have to be honest about something here. I have not always been a Bitcoin believer, because I never saw it as a good currency. However I now see what is being engineered. Bitcoin is being positioned as a new form of digital collateral. In times where there is a collateral and liquidity crisis, and I believe that time is coming, Bitcoin could become very valuable indeed.

The darker side of all this is that some are looking to tokenise not just financial assets but nature itself, land, water, minerals in the ground. Carbon credits are tokenisation of air. New Zealand's national parks sit on enormous mineral reserves and the pressure to monetise them is already building. A collision of values is coming.

The system is built on sand. The collateral it relies on is weakening. The instruments of trust are losing their value. The BIS itself admitted in its own research that the whole thing functions on secrecy and deliberate opacity. And now they need new forms of collateral, which is why they need blockchain, and why they need crypto.

Collateral and liquidity are the lifeblood of the financial system, and we have new forms of both coming. Knowing that, and understanding what is driving it, puts you in a completely different position from the vast majority of people still sleepwalking through this transition.

Your stress goes down as your knowledge goes up.

Register today right here