Comments on: More on “Five Down” http://www.stubbornmule.net/2010/05/more-on-five-down/ Obstinately objective Wed, 08 Feb 2012 01:46:02 +0000 hourly 1 http://wordpress.org/?v=3.3.1 By: Stubborn Mule http://www.stubbornmule.net/2010/05/more-on-five-down/comment-page-1/#comment-7601 Stubborn Mule Sun, 09 May 2010 05:05:15 +0000 http://www.stubbornmule.net/?p=2890#comment-7601 <strong>Luis:</strong> credit risk is an important consideration here. In fact, that is a big part of the reason why all the participants should be happy to have multi-lateral netting. While someone owes them something, they have credit risk to their debtor and getting rid of this without any losses is a good outcome for all of them. I'm not sure I'd agree thought that everyone along the change really has credit risk to the banker if he starts circulating the counterfeit $5. If the farmer accepted the note and then realised it was fake, he would have to take it up with the butcher not the banker, whether or not the butcher in turns decides to then follow up the banker. The scenario you propose in which the banker has a choice between paying with a good note and a fake one is a good example of a phenomenon rather like <a href="http://en.wikipedia.org/wiki/Gresham%27s_law" rel="nofollow">Gresham's Law</a>. It reminds me of a common experience for Australians: discovering someone has given you a New Zealand 20 cent coin your change (it is worth somewhat less than an Australian 20 cent coin and no-one is obliged to accept it). Most people in this situation would be inclined to pass that Kiwi coin on as soon as possible (if they can) in preference to using an Australian coin. Luis: credit risk is an important consideration here. In fact, that is a big part of the reason why all the participants should be happy to have multi-lateral netting. While someone owes them something, they have credit risk to their debtor and getting rid of this without any losses is a good outcome for all of them. I’m not sure I’d agree thought that everyone along the change really has credit risk to the banker if he starts circulating the counterfeit $5. If the farmer accepted the note and then realised it was fake, he would have to take it up with the butcher not the banker, whether or not the butcher in turns decides to then follow up the banker.

The scenario you propose in which the banker has a choice between paying with a good note and a fake one is a good example of a phenomenon rather like Gresham’s Law. It reminds me of a common experience for Australians: discovering someone has given you a New Zealand 20 cent coin your change (it is worth somewhat less than an Australian 20 cent coin and no-one is obliged to accept it). Most people in this situation would be inclined to pass that Kiwi coin on as soon as possible (if they can) in preference to using an Australian coin.

]]> By: Luis http://www.stubbornmule.net/2010/05/more-on-five-down/comment-page-1/#comment-7598 Luis Sat, 08 May 2010 11:41:46 +0000 http://www.stubbornmule.net/?p=2890#comment-7598 Credit risk is missing in this solution. The banker, by missing the fact that the note is not real, puts the butcher at risk of discovering the bill is fake. Just because it turned out that nobody noticed until the bill returned to the banker, it does not mean each person in the chain did not carry the credit risk on the banker during the process (whoever discovers the bill is fake would need to trace the chain back to the banker - not necessarily possible, and then the banker would have to agree/admit the bad bill was his, and then the banker would have to come up with a real $5 bill and he may not have one). So the bankers owes everybody along the chain, he benefited by having 'borrowed' $5 from whoever was holding the fake note (the fake note was effectively a very hard to enforce IOU from the banker). Another way to think about this is: If the banker had 2 bills, one fake and one real, and we gave him the choice to use either knowing it will go back to him at the end of the day, should he be indifferent about which bill to use? No, he would be better off using the fake bill EVEN knowing it will come back to him, because he then gets to play with the real bill for the day - a net benefit. Credit risk is missing in this solution. The banker, by missing the fact that the note is not real, puts the butcher at risk of discovering the bill is fake. Just because it turned out that nobody noticed until the bill returned to the banker, it does not mean each person in the chain did not carry the credit risk on the banker during the process (whoever discovers the bill is fake would need to trace the chain back to the banker – not necessarily possible, and then the banker would have to agree/admit the bad bill was his, and then the banker would have to come up with a real $5 bill and he may not have one). So the bankers owes everybody along the chain, he benefited by having ‘borrowed’ $5 from whoever was holding the fake note (the fake note was effectively a very hard to enforce IOU from the banker). Another way to think about this is: If the banker had 2 bills, one fake and one real, and we gave him the choice to use either knowing it will go back to him at the end of the day, should he be indifferent about which bill to use? No, he would be better off using the fake bill EVEN knowing it will come back to him, because he then gets to play with the real bill for the day – a net benefit.

]]>