The Reflux Rate

The maximum rate of redemption (the reflux rate) provides an excellent risk measure what a securities holding institution can absorb during times of stressful withdrawals. The maximum reflux rate expresses how quickly funds can be withdrawn, before the holding institution fails, or must temporarily close its doors to those who want their money back.

This reminds me of the bank run in It’s a Wonderful Life, when the community savings bank experienced a run, and Stuart used his honeymoon money to boost the reflux rate to keep his community bank open.

http://www.youtube.com/watch?v=_Er69b4HMl8

This also reminds me of the great 2008 electronic run on money funds, where ½ trillion dollars worth of redemptions were requested over the space of about 5 hours. Only mad scrambling and explicit new guarantees stopped this epic bank run from collapsing the entire financial universe.

http://boingboing.net/2009/02/09/rep-kanjorski-550-bi.html

According to Greco’s book, ”Understanding and Creating Alternatives to Legal Tender”, page 61, for a community script, such as what was widely used during the 1930s Great Depression:

“One of the fundamental rules of currency issuance is that the issuer be willing to redeem his or her own currency at face value (par), and that she or he be able to generate enough value (sales) in goods and/or services to redeem the currency at the rate of about 1 percent per day, which is equivalent to being able to redeem the entire issue in about three months time.”

His rule of thumb is quite good for small community currencies, with an eye on not creating ponzi-like systems where the late buyers of the currency, or any security, could be left holding the bag.

In regulating new securities markets, regulating bodies try to pay close attention to the expected character of how a reflux rate performs in adverse conditions. This essentially is what the current bank stress tests are all about. It revolves around the question of “how much reserves must be kept on hand to ensure smooth withdrawals, given possible adverse condition scenarios to the supporting inflows”.

For larger asset pools, perhaps lower reflux rates are reasonable to expect, but I wonder how much different the rules should be from smaller pools, given how quickly money funds were evaporating last fall.

But for new currencies and securities, or currencies that are not expected to have a useful life of multiple years (such as Depression style script), this question becomes all the more important. From a strong securities marketplace, to closing out the fund, script, or mortgage market, in a way that is “fair” to the late buyers is something that is reasonable to expect, and a regulatory framework developed for an open currency marketplace should reflect this.