free banking doc

Author: kushti

specs/free_banking.md

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+# Basis and Free Banking
+
+Free banking denotes a monetary system in which private banks issue their own
+redeemable notes under ordinary commercial law, with no monopoly note issuer, no
+central bank, and no lender of last resort; market forces — above all the
+obligation to redeem notes on demand — control the money stock [1]. The
+historical record is dominated by Scotland 1716–1845, whose competitive,
+branching, unlimited-liability system was remarkably stable [2], and by the
+contrasting US "free banking" era (1837–1863), whose "wildcat" failures are now
+attributed by most scholars not to freedom of issue but to legal restrictions —
+unit banking and mandatory bond collateral valued at par [3][4] (for the
+opposing "inherent instability" reading, see [5]). The theory holds that
+convertibility plus interbank note exchange discipline issuers: a bank that
+over-issues sees its notes returned by rivals through the clearing system,
+producing "adverse clearings" that drain its reserves [6], while brand-name
+capital makes over-issue self-destructive [7].
+
+Basis is, in effect, a cryptographic free-banking arrangement. Issuers are
+private competitive note-issuing banks: each locks collateral in an on-chain
+reserve box (the specie reserve) and issues signed IOU notes that circulate
+off-chain and are redeemable against the reserve. Where the literature relies on
+institutional mechanisms, Basis mechanizes them. The tracker server plays the
+role of the Scottish note-exchange system and the clearinghouse: it maintains
+the ledger of who owes what to whom, commits it on-chain via AVL+ tree digests,
+and enforces redemption discipline automatically — a redemption is only signed
+when the reserve can honor it, exactly the "promises to pay that must be met on
+demand" obligation Vera Smith identified as the system's core discipline [8].
+Acceptance policies are the Klein-style reputation gate made explicit [7]:
+instead of relying on brand alone, each note holder declares machine-checkable
+terms (collateralization floors, whitelists, debt ceilings) under which they
+will treat an issuer's notes as "good money" — an approximation of Gorton's
+"no questions asked" par acceptance [9], enforced per-transaction rather than by
+assumption.
+
+The redemption-time policy check added to the tracker maps directly onto the
+literature's treatment of distress. A redemption that would push another
+holder's collateralization below their accepted floor is rejected — the
+mechanized equivalent of adverse clearings stopping an over-extended issuer
+before the loss is socialized across note holders [6]. When a reserve is already
+undercollateralized and every holder's policy is violated, the tracker's FIFO
+fallback (only the oldest outstanding note may redeem) replaces panic with an
+orderly queue: it is the sequential-service constraint of Diamond–Dybvig [10]
+turned from a run incentive into a fair ordering, and a close relative of the
+Scottish "option clause" — a contractual, pre-committed deferral of payment
+that free-banking scholars defend as a circuit-breaker against self-fulfilling
+runs [11][12]. On-chain, where the tracker cannot intervene, the contract falls
+back to the raw historical default: first-come-first-served redemption until the
+reserve is drained.
+
+Two caveats keep the analogy honest. Classical free banking was
+*fractional*-reserve — banks held precautionary reserves against clearing
+variability, not full backing [6] — whereas Basis reserves are
+(over)collateralized by design, placing the system closer to a 100%-reserve or
+currency-board discipline than to Scottish practice; Basis is best described as
+redemption discipline made cryptographic, not as fractional-reserve free
+banking. Second, the historical system's discipline rested on legal
+enforceability of contracts and unlimited liability (the Ayr Bank failure of
+1772 was absorbed by shareholders, not note holders [2]); Basis substitutes
+collateral and cryptographic verification for courts and personal liability,
+which removes those failure modes but also removes the discretionary,
+judgment-based stabilization that clearinghouses historically provided in
+crises [13][14]. For the crypto-side bridge of the literature — stablecoins as
+modern private banknotes, and rule-bound supply as engineered scarcity — see
+[9][15][16], with Hayek's competing-currencies argument [17] as the common
+intellectual root.
+
+## References
+
+1. Selgin, G., & White, L. H. "How Would the Invisible Hand Handle Money?"
+   *Journal of Economic Literature*, 1994.
+2. White, L. H. *Free Banking in Britain: Theory, Experience and Debate,
+   1800–1845*. Cambridge University Press, 1984 (2nd ed., IEA, 1995).
+3. Rockoff, H. "Lessons from the American Experience with Free Banking." In
+   Capie, F., & Wood, G. E. (eds.), *Unregulated Banking*, Macmillan, 1991.
+4. Dwyer, G. P. "Wildcat Banking, Banking Panics, and Free Banking in the
+   United States." *Federal Reserve Bank of Atlanta Economic Review*, 1996.
+5. Rolnick, A. J., & Weber, W. E. "Inherent Instability in Banking: The Free
+   Banking Experience." *Cato Journal*, 1986 (and Minneapolis Fed working
+   papers, 1982–84).
+6. Selgin, G. *The Theory of Free Banking: Money Supply under Competitive Note
+   Issue*. Rowman & Littlefield / Cato Institute, 1988.
+7. Klein, B. "The Competitive Supply of Money." *Journal of Money, Credit and
+   Banking*, 1974.
+8. Smith, V. C. *The Rationale of Central Banking and the Free Banking
+   Alternative*. P. S. King, 1936 (reprinted Liberty Fund, 1990).
+9. Gorton, G. B., & Zhang, J. Y. "Taming Wildcat Stablecoins." *University of
+   Chicago Law Review* 90(3), 2023.
+10. Diamond, D. W., & Dybvig, P. H. "Bank Runs, Deposit Insurance, and
+    Liquidity." *Journal of Political Economy*, 1983.
+11. Selgin, G., & White, L. H. "The Option Clause in Scottish Banking."
+    *Journal of Money, Credit and Banking*, 1997.
+12. Selgin, G. "In Defense of Bank Suspension." *Journal of Financial Services
+    Research*, 1993.
+13. Timberlake, R. H. "The Central Banking Role of Clearinghouse Associations."
+    *Journal of Money, Credit and Banking*, 1984.
+14. Gorton, G. "Clearinghouses and the Origin of Central Banking in the United
+    States." *Journal of Economic History*, 1985.
+15. Selgin, G. "Synthetic Commodity Money." *Journal of Financial Stability*,
+    2015.
+16. White, L. H. "The Market for Cryptocurrencies." *Cato Journal*, 2015.
+17. Hayek, F. A. *The Denationalisation of Money*. Institute of Economic
+    Affairs, 1976 (enlarged 3rd ed., 1990).