Reconstructing the Monetary Stack

The monetary system as we recognize it today is a fairly recent regulatory and financial framework, emerging in the aftermath of the dissolution of the Bretton Woods fixed exchange rate system, and built upon a very closely-knit and mutually advantageous relationship between (permissioned) commercial banks, central banks, and state treasuries.

How does the monetary system work? In the most straightforward terms, commercial banks assess the creditworthiness of the economy and meet its liquidity requirements by offering loans in their own non-branded versions of fiat money. Central banks and regulatory bodies, for their part, establish and oversee the guidelines that commercial banks must adhere to, ensuring in return the interchangeability of the different non-branded forms of fiat money and offering emergency liquidity access in situations of imbalance. Ultimately, state treasuries retain the advantage of accessing a market where they can secure funding at low costs, and in exchange they commit to upholding a stable, politically and fiscally sound system.

The system has proven effective because it has tailored roles and provided incentives for each participant to concentrate on their unique strengths. At the heart of this arrangement, commercial banks have undertaken much of the critical work—deposit storage, credit assessment, risk management, recovery processing, and day-to-day client management. In return, they have benefited from regulatory-induced oligopoly protection and a favorable funding spread compensating for their operational costs and the private capital they put at risk.

How does the monetary system NOT work? Over time, however, the one-size-fits-all established system has begun to exhibit constraints across various dimensions:

• Credit underwriting: with the emergence of structured and sophisticated credit, the capability of commercial banks to effectively assess and manage credit for anything beyond the most standard financing needs is questionable, as demonstrated by the inexorable rise of the shadow banking industry;
• Risk management: the intricacies of today’s financial markets pose significant challenges to managing counterparty risk effectively, often at the expense of the depositors, whose financial security depends on recurrent (yet discretionary) taxpayer-funded government bailouts; 
• Distribution and storage: the necessity of relying on outdated legacy systems, for the distribution and maintenance of private depositors' ledgers is increasingly being questioned—the emergence of Central Bank Digital Currency (CBDC) projects and self-custody solutions are starting to challenge the need for traditional banking infrastructure;
• Returns: the ability of commercial banks to generate sufficient profits to reward their equity capital providers is under scrutiny, given the challenging macroeconomic environment and the burden of heavy regulatory buffers, as reflected in the depressed price-to-book market multiples for most banks;
• Technological integration: the incapacity of commercial banks to facilitate the necessary technological integrations in today's digital age, where commerce and data travel at different speeds and machines increasingly interact with other machines, is obvious.

The undeniable importance of those limitations, unveiled during the global credit meltdown in the Great Financial Crisis of 2007-2009, and masked by fifteen years of zero-interest-rate policies, has reemerged in 2023 due to a sharp rise in interest rates. This shift has put a vast majority of regional financial institutions at risk, leading to multiple failures, notably including Silicon Valley Bank (SVB) as the most affected. Banking as we know it is fundamentally broken, signaling an imminent period of upheaval and reconstruction, and presenting the opportunity to reimagine and rebuild it anew.

The new monetary system. Decentralized Finance (DeFi) has highlighted the possibility of unbundling the fundamental components of banking, such as credit underwriting, deposit storage, and risk management. Although still in its infancy, the insight continues to inspire creativity among financial system designers and software engineers. Envisioning a future where the most efficient sources of leverage can be seamlessly merged with the most secure venues for liquidity storage promises to fundamentally alter the interactions between financial actors and revolutionize the management and allocation of money.

In the wake of any paradigmatic shift, there are inevitably winners and losers, with those feeling a loss of control often resisting the push for innovation. Commercial banks are poised to continue witnessing a significant contraction in their roles, transitioning from the central hubs of the economy to more utility-like entities—a transformation that's already underway. For banks to adapt and become more efficient versions of their former selves, a substantial cultural shift is required, a change many incumbents may be ill-prepared for. State treasuries, the real money printers, will find themselves needing to adapt to a new framework—something that they have been doing over decades of dominance of wholesale markets. Depositors, ultimately, would continue to experience a shift towards digital financial applications underpinned by back-ends capable of native digital value management and distribution.

Given these factors, it would be naive to expect that most traditional financial institutions would embrace genuine monetary innovation. While the creation and distribution of digital money could benefit the most reputable and stable state treasuries, it might pose significant challenges for conventional financial intermediaries. The emergence of these innovations from the libertarian, mathematically intensive domain of cryptocurrency and decentralization, rather than from traditional business-oriented sectors, is no mere coincidence.

‍The emergence of stablecoins. So-called stablecoins emerged as the unequivocal champions among the initial wave of DeFi innovations. Their triumph is rooted in their ability to solve meaningful problems harnessing the strengths of pre-existing systems. Stablecoins established themselves as exceptional digital settlement tools for both individual and institutional users. Yet, in prioritizing settlement functions, many stablecoin issuers have deliberately allowed traditional players to maintain control over the money supply. Their efforts have been directed towards streamlining monetary transactions, effectively adding an additional layer to the existing financial infrastructure rather than replacing it, in line with the stance of frequently unimaginative regulators, who have categorized stablecoins as merely another form of virtual payment instrument or equivalent to a bank deposit.

The remarkable rise of stablecoins, or what some might prefer to call cryptodollars, can largely be attributed to the convergence of innovative technology with a long-standing phenomenon: the use of offshore proxy-dollar instruments for transactions and settlements outside the regulated US financial system. The offshore dollar (so-called eurodollar) phenomenon has seen its volume surge over the years, propelled by emerging market growth and increased cross-border activity in a world where few systems can match the sophistication of the USD network. Today, approximately 70-80% of cryptodollars essentially represent tokenized eurodollars, aligning with the expectations previously outlined.

Money is infrastructure. The development of the M^0 protocol is grounded in the understanding that a good definition of money transcends its basic function as a payment mechanism, and encompasses the complex network of relationships and layers that extend the power of a foundational source of trust to the various instruments utilized daily by individuals and institutions. The distinction between good and bad money, across this spectrum, hinges on the quality of interactions among all those participating entities. Money should not be viewed merely as a product but as a critical piece of infrastructure.

Recognizing the need for innovation across the full spectrum of the monetary stack, we have designed M^0 primarily as a novel framework that transforms the governance of our system by leveraging today’s coordination technology tools, and connects its governors directly to an open-source settlement layer. This foundational layer empowers entities with appropriate connectivity tools to actively participate and contribute to the monetary system's evolution. Consequently, M^0 aims to foster a global, boundless, and transparent digitally-native monetary system. It facilitates the development and application of both soft and hard governance rules, enabling the interaction of a diverse array of participants—the M^0 economy.

‍What is M^0? As described in M^0’s whitepaper, the M^0 core protocol is a coordination layer for permissioned actors to generate M, a crypto asset whose value is designed to be a robust representation of an exogenous collateral basket. The purpose of M is to become a superior building block for value representation, by combining the convenience of digital money with the risk profile of physical cash. While holders may find this construct appropriate as a vehicle for cryptodollar use cases, developers and financial services providers might be interested in it as raw material for the build out of novel products and services—including as collateral for other cryptodollars.

M intends to be credibly neutral by design, by default self-custodial and fungible. Each M is the same as every other M and there is no ability for the core protocol to discriminate against any specific holder. In its current instantiation, M is intended to be generated using short term US T-bills as collateral, representing the lowest level of counterparty risk—exceptions made for physical cash and bank reserves within the US dollar system. The collateral used to generate M must be held exclusively throughout a network of governance-approved, orphaned, bankruptcy-remote entities, which are customized to interact with the M^0 protocol while also meeting the jurisdictional formalities of the existing legal system. M can be sent anywhere in the world instantaneously using the blockchain rails on which it exists. Yield generated by underlying collateral can be partly collected by the protocol and democratized across permissioned issuers and distributors.

We refer to M as raw material for value representation, and not a cryptodollar in its own right, because the system relies on permissioned issuers (known as Minters in the protocol) for generation and disposal. These Minters should be compliant with all applicable regulations and may decide to issue their own product, for example by wrapping M in a cryptodollar contract in a way that best meets their requirements. In this capacity, M becomes a monetary building block on top of which novel products can be built. Moreover, the same governance mechanism native to the M^0 protocol (the Two Token Governor) can support the adaptation of collateral eligibility criteria over time and enables the development of new digital value representations alongside M. This capability effectively transforms M^0 into a comprehensive middleware for value representation.

In summary, the M^0 protocol introduces a superior coordination mechanism that democratizes access to the generation and management of programmable, digital cash instruments—as well as other digital representations of value. It is an infrastructure layer not for the simplistic tokenization of real-world bank deposits or assets, but a much more sophisticated way to provide access to liquidity on high-quality collateral. M^0 intends to progressively redesign the monetary vertical stack, rather than build an additional layer on top of what has ultimately become byzantine infrastructure.

‍Looking ahead. Unsurprisingly, so-called stablecoins have become a pivotal topic in the crypto markets, and while current players thrive, fresh competition has been heating up. We believe that many newcomers are concentrating on short-term, specific solutions aimed at capturing market share from existing players, also influenced by the prevalent market rates in the current economic climate. From the start, M^0 has been dedicated to creating not just another product wrapper but a fungible, modular, and easily integrable infrastructure. We see the cryptocurrency landscape as more than a platform for speculative trading. Beyond yield optimization or risk remedy, we are convinced of M^0’s value proposition as a next generation back-end for global financial technology. This vision requires a revolutionary approach to money generation and intermediation that, while building on the experimentation of DeFi and the standards of institutional finance, rethinks the stack from its origin (governance) all the way to its destination (the users).

The ambitious journey of M^0 towards realizing our vision begins today, with the publication of this post and the accompanying whitepaper, to further unfold with the Mainnet launch of the protocol in the forthcoming months of 2024.

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Luca Prosperi, President of the M^0 Foundation Council