The Layers of Money
Introduction
Though money-ness is usually viewed as binary—as in something either is or is not money—there is actually a hierarchy placing certain forms above others. This hierarchy is often referred to as the layers of money with each subsequent layer being a slightly lesser version of money.
The reason they are slightly lesser versions is that each subsequent layer is a derivative of the layer of money before it. In other words, a lower-layer money is a claim on the layer before it, not the ultimate form of money at the top of the hierarchy.
Normally, using and holding lesser versions of money isn’t a problem, which is why most people don’t need to understand the relevance of all the different layers of money, but the distinction between layers becomes very important in more economically-troubling times, especially when liquidity (money) grows scarce.
If you aren’t holding the purest form of money, you are moving further out onto the risk curve with every deviation from it. This is because all forms of money beyond the first layer are someone else’s liability, meaning that someone has promised you, the holder of non-Layer 1 money, to honor that asset as real money if an exchange is desired.
In discovery of the money-ness of your money, the simple questions you have to ask yourself are why does this money have value and who is responsible for its value. If your answer to either involves a person, business, or government, you don’t have the highest form of money.
So what exactly is Layer 1 money?
Layer 1
Layer 1, the purest form of money, is any bearer asset that isn’t anyone’s liability. Historically, Layer 1 money was gold or other precious metals that were considered to be intrinsically valuable, but bitcoin or a house are also examples of Layer 1 money. Their money-ness or value is an inherent property rather than an attribute granted by a government, promised by a business, or assumed from a claim on future cash flows. Whether its value as money comes from its scarcity, utility, or both, it is seen as an intrinsic quality of the asset.
No matter what happens in the economy, whether markets crash, banks fail, or the government itself collapses, a Layer 1 form of money will retain its money-ness. This is largely because Layer 1 money doesn’t require any other person or entity to honor or repay its value. Layer 1 money is a form of final settlement, not a claim on a future settlement wholly dependent on another party’s promise or solvency.
If a bank fails and all your money is stored with that bank, the value of your account is completely dependent on the bank fulfilling its end of the bargain. If it issued too many risky loans and lost everybody’s money, another party would have to step in to reimburse you, meaning your money isn’t technically in your hands, it’s someone else’s liability.
At this point, I hope the importance of Layer 1 money is becoming more clear. Concerns about different forms of money exchanging at par value for other forms of money may not be relevant the vast majority of the time, but when it does matter, it matters a lot. Breakdowns in the layers of money don’t happen often, but when the stakes are so high, as in you can lose all of your money, it’s worth learning about those rare circumstances to prepare yourself by holding money higher up in the hierarchy.
This idea of trying to hold an asset higher up in the hierarchy of money is actually where the practice of hiding a stack of bills under your mattress comes from. Some people prefer to trust as few people as possible when it comes to their money, and hiding money under your bed or in a hole in the backyard is an effective, albeit outdated, way of climbing up that ladder one more rung. That said, the dollars buried in your backyard are still the liability of the Fed, but I digress.
Before I get into Layer 2 money like the dollar, let me explain some of the shortcomings of Layer 1 money that inspired additional layers. Layer 1 has its advantages, but there are practical reasons societies introduced a Layer 2 and 3, so it’s not as if the risks of holding someone else’s liability aren’t, under most circumstances, worth the benefits.
The Limitations of Layer 1
As trade and economies expanded, the demand for greater liquidity could not be met just by Layer 1. Settling every transaction with physical gold, or any physical asset for that matter, was incredibly inconvenient and impractical, especially with cross-border payments, so Layer 2 money was a way to address these scaling issues.
If every trade was executed with a Layer 1 money like gold, every trade would have to be done in person and settled immediately. There would be no way to borrow or lend and certainly no way to quickly exchange money across large-scale, high-volume economies.
To gain any of these more practical scaling functions of money, you have to create some kind of derivative that acts as a claim to that money, often with interest, at a later date. Whether that’s an IOU for a loan or separate currency redeemable for something like gold, it acts as a placeholder for real payment, which substantially increases the velocity and flexibility of money.
The more trade and transactions within an economy, the more liquidity and flexibility are needed, so Layer 1 money just didn’t cut it as economies evolved beyond the simplicity of one type of money that could only work through final settlement, especially as we moved into the digital world. And this is what brings us to Layer 2 money.
Layer 2
To paint a more complete picture of Layer 2 money, let’s begin with how it first manifested itself.
As previously alluded to, the reason for Layer 2 money emerging was to address the liquidity concerns and scaling limitations of Layer 1 money, but there is a specific mechanism for how this was done. Layer 2 money was first introduced through a two-column ledger system commonly referred to as double-entry bookkeeping.
Double-entry bookkeeping is really just a different way of saying a T chart with assets on one side and liabilities on the other. By creating a record of transactions broken down into assets and liabilities, anyone can easily track which transactions are credits and which are debits.
In other words, double-entry bookkeeping was a way to track the revolving door of assets and liabilities as they shift hands throughout the day, week, or what have you. In doing so, people could delay the headache of payments and focus more on the business side of things. And at the end of the day or after some number of transactions, everyone adds up their books and settles all the claims they have on other people’s money and all the claims other people have on their money.
Perhaps one of the simplest ways to explain double-entry bookkeeping and its usefulness is through the example of bar tabs. Rather than settling each transaction every time you buy a drink, you keep a tab to settle all your transactions at once before you leave. Each drink is a liability of the bar and an asset of the person who drinks it, and each bill is an asset of the bar and a liability of the person who owes it.
This is obviously a very simplified version of how double-entry bookkeeping and Layer 2 and beyond money work, but it hopefully explains the convenience of moving down the hierarchy of money. You may be relying on someone to eventually fulfill any liabilities, but that’s usually not a concern, and delaying settlement is much more efficient.
Because there only has to be one actual settlement at the end of the day or series of transactions rather than multiple or even thousands of settlements for each transaction, postponing final settlement allows businesses and economies to function much more smoothly. A simple tally of everyone’s transactions as seen through a balance sheet just makes more sense and has really become a necessity in the digital world.
If you engage in a trade with someone and they give you $100 worth of food in exchange for a signed agreement, digital or otherwise, to pay a $100 worth of gold tomorrow, that agreement is now their asset and your liability. In fact, that piece of paper is technically worth $100 because it is a claim on $100 worth of gold.
And depending on the circumstances of the economy, that claim could even be exchangeable as money throughout the economy. If that agreement has value because it’s a claim on your real money, the person you gave it to could use it to buy something else, and whoever accepted it would now have a claim on your money.
The fungibility of Layer 2 money isn’t always a guarantee, but as long as the two parties making the exchange agree on its value and the third party guaranteeing its value will honor it regardless of who ends up claiming the final settlement, it can function as any other form of money in the economy.
Note, however, that the first layer of money still plays an essential role in monetary systems as final settlement is eventually necessary, but a second layer offers more convenient and scalable ways of keeping tabs on trade and transactions more broadly.
Layer 2 money, then, was simply a way to accommodate the ever-increasing velocity of money in large-scale economies. In essence, Layer 2 money is just a placeholder for real money until final settlement can take place.
With that out of the way, let’s get into the most important Layer 2 money: the dollar.
The Dollar
Decades ago when the world was on the gold standard, the dollar was established as the premier Layer 2 money. Gold was the pristine asset of the world, but it was a difficult asset to transact with, so people used dollars all throughout the economy with the option to redeem those dollars for gold whenever they wanted to, at which point final settlement from Layer 2 (the dollar) to Layer 1 (gold) would take place.
All throughout the gold standard, there was no disagreement that dollars were a Layer 2 money, but since the dollar-convertibility to gold was suspended, many would argue dollars, and treasuries more specifically, became the de facto Layer 1 money of the world. While this is a reasonable assertion, the dollar remains a liability of the Fed, so it seems more appropriate to continue calling it a Layer 2 money.
The Fed is probably the least risky counterparty, but it still has the potential to default on its promise to fulfill the value of anyone’s dollars. If, for example, the government collapsed and its military fell apart, the dollar’s value as money would be seriously brought into question. Again, highly unlikely, but that small risk technically makes the dollar a Layer 2 money.
Fiat Currencies
What about all the other fiat currencies, you ask? Well, they are more or less in the same camp as the dollar as Layer 2 forms of money. During the gold standard, every other fiat currency was redeemable for dollars, so they were actually Layer 3 money, but now other fiat currencies are just liabilities of each respective government.
There’s a good argument to be made that other fiat currencies are ostensibly still Layer 3s to the dollar, but each currency’s value rests on the solvency of its government and that government’s ability to print or finance its liabilities when necessary.
The notion of money printing might be confusing in the context of the layers of money, so keep in mind the value that is backing the dollar and other fiat currencies is the military or financial stability of each government, not the ability to print currency.
Hypothetically speaking, any person or business could build a money printer to print their own currency, which would be a liability they owe to currency holders just like a government, but nobody would trust it as money without some amount of assets like taxes, land, or military might backing it.
Fiat currencies, then, are just a claim on the economic and military power of their issuers. If the currency issuer’s economy and/or military collapsed, the reality of its fiat currency as Layer 2 money would become abundantly clear.
CBDCs
Now, before I move onto additional Layer 2, 3 and beyond money, let me discuss another form of fiat currency with its own distinct characteristics.
By now most people have probably at least heard of the term CBDC (a central bank digital currency), but I think explaining it in the context of the different layers of money will paint a better picture of its role and significance.
If a government issues a CBDC, a digital dollar if you will, they are essentially giving every currency holder an account with the Fed. In other words, the Fed eliminates the middleman and becomes everyone’s bank.
A CBDC, then, can be thought of as a more streamlined way of implementing FDIC insurance (which I’ll discuss later) by moving Layer 3 bank deposits to a Layer 2 liability of the Fed—only this time, there wouldn’t be an insurance cap or intermediary like a bank to work through.
Much like cash, the value of a CBDC would live and die with the federal government. As long as the federal government is solvent and depositors (currency holders) have confidence in the government, those currency holders can have confidence in their money held as CBDC.
Unlike cash, however, the government has full control over CBDCs. It can increase, decrease, freeze, move, or do anything else it wants to money held as CBDC because it’s all just numbers on a computer screen rather than physical dollars in your wallet or safe.
This could be said of money held with banks as well, but banks are private institutions and don’t have the means or authority to dictate monetary policy, taxes, or other money-related laws the way the government does. Keeping that in mind, storing your money with the bank will avoid certain centralization concerns, but it’s not quite as secure as money stored with the Fed.
Your money might be a little safer held as CBDC when it comes to default risk, but all your transactions can be fully surveilled and managed by the federal government, including taxes. It could sound convenient to eliminate third parties and have the Fed manage your taxes directly, but CBDCs also give the Fed unprecedented powers when it comes to implementing fiscal and monetary policy.
With every citizen having an account at the Fed, the government can instantly send out stimmy checks, but it can also instantly destroy money to combat inflation. QE and QT would no longer be executed through banks and bank reserves as an indirect way to implement monetary policy, they would directly control the entire money supply with a stroke of the keyboard.
The purpose of mentioning all this is to underscore the notion that moving up the hierarchy of money, unless you go directly to Layer 1 money that isn’t anyone’s liability, isn’t necessarily better.
It’s very possible governments will point to the various advantages of having Layer 2 money and an account with the Fed to garner public support and promote CBDC adoption, but the privacy and centralization concerns of a CBDC bring into question the true merit of any such transition away from traditional bank deposits.
A CBDC can increase transaction convenience and instill more confidence in money’s security being that it is solely a liability of the Fed, but it also becomes a dangerous tool for controlling everyone's money, so be sure to maintain a healthy level of skepticism toward CBDCs going forward.
With the various forms of fiat currency now out of the way, let’s discuss some of the non-fait forms.
Lightning Network
Another important Layer 2 network worth mentioning specifically built for scaling bitcoin is the Lightning Network. Although bitcoin is a much more scalable Layer 1 money than gold, especially when it comes to cross-border payments, final settlement still takes until the end of each block, which is roughly every ten minutes.
Ten minutes is an incredible improvement for international settlements, but it isn’t that practical for your everyday purchase. Nobody wants to wait ten minutes for their morning coffee transaction to settle, so creating a Layer 2 system that allowed bitcoin transactions to be approved instantly was essential to its functioning in any practical sense within the modern economy.
To put it simply, the Lightning Network is like an electronic ledger tracking all the little transactions between everyone using it who are connected through various lightning channels, and those transactions are eventually settled through smart contracts and cemented on the Bitcoin blockchain as the final settlement. The technology isn’t that different from Bitcoin itself, it just delays final settlement to alleviate that ten-minute waiting period.
It might be helpful to think of the Lighting Network as analogous to the dollar during the gold standard with the Lightning Network being the dollar and bitcoin being gold. The main difference is settlement is digitally managed through smart contracts, not in person at your local bank.
Other Forms of Layer 2 Money
While fiat currencies and now the Lightning network are the most popular forms of Layer 2 money, they are hardly the only ones. To offer a broad definition, anything that is a direct claim to a Layer 1 money is a Layer 2 money. Even if that claim is just a piece of paper your friend wrote out and signed, if it is a claim on Layer 1 money like gold, bitcoin, or a house, it’s Layer 2 money.
Given such a broad definition, the quality of Layer 2 money to keep in mind is its fungibility or capacity to be broadly accepted in an economy. Under the gold standard, everyone accepted dollars because they trusted it was as good as gold, but everyone probably wouldn’t trust your friend’s signed piece of paper despite it being a claim to the same Layer 1 money, which in this case would be gold.
This is because Layer 2 money requires confidence. Any layer beyond Layer 1 is trusting a counterparty to guarantee final settlement if and when desired. Most people would trust the government is good for the gold, but few people would trust your friend is, and even fewer people would accept your friend’s signed piece of paper as actual money in the economy.
Even if that friend was 100% good for the gold and ready to deliver it at any moment, you almost certainly couldn’t exchange that claim to their gold for an equivalent amount of dollar-denominated value at a bank or with any private business.
The importance of this distinction is to underscore the primacy of confidence as you move down the hierarchy of money. Counterparty risk is arguably the most important consideration for Layer 2 and beyond because the value of your money is derived from that counterparty’s ability to fulfill final settlement.
This means Layer 2 money isn’t necessarily better than Layer 3 money. If the counterparty expected to honor a claim to a Layer 1 money is less reputable or undercapitalized, its Layer 2 money might not be accepted in the economy or even honored at par value to another entity’s Layer 3 money. Anyone can hand out a claim to an asset or write out a ledger to create Layer 2 money, including a business with something like a gift card claim on goods it sells, but that doesn’t mean that money is on quite the same level as a Layer 2 like the dollar.
At this point, I’ve hopefully touched on the most important points about Layer 2, so let’s transition into the next layer: Layer 3.
Layer 3
While the assumption might be that the further down the hierarchy of money you go, the less familiar you would be with that form of money, it’s actually quite the opposite. Layer 3 money is generally how the average person stores the vast majority of their cash with the most well-known form of Layer 3 money being bank deposits.
Bank deposits can cast the illusion of safety and guaranteed money-ness, but money given to banks is not just held in a vault, despite what you might see on TV—it’s almost exclusively digital and used to make more money through various lending activities or the purchase of financial assets.
This is not to say that bank deposits are inherently dangerous, but their value is contingent on each respective bank responsibly managing those deposits and its business operations. Big banks are the next least risky counterparty after the federal government, but they are a counterparty nonetheless.
To better explain the significance of banks and the reality of bank deposits, let’s dive into the circumstances where their counterparty risk becomes very real: bank runs.
Bank Runs
Just about everyone has some amount of money stored with a bank, and most people probably have the majority of their wealth stored with a bank, so the significance of bank deposits and Layer 3 money will hopefully not fall on deaf ears.
Many of the most historic economic events throughout recent history have been powerfully influenced by Layer 3 money’s lack of money-ness, including the Great Depression.
Because Layer 3 money like bank deposits is owed by a counterparty (the bank), confidence in that counterparty is essential to deposits holding par value with the Layer 1 or 2 money from which it is derived, such as gold or dollars.
If economic conditions are leading depositors to become concerned about their deposits held at a bank, they will rush to withdraw those deposits and drain the bank of all its gold or cash reserves.
The problem with this is banks rely on fractional reserve banking and are almost always levered to a T, meaning they issue loans and buy financial assets with money they technically don’t have, as they just create money whenever they issue credit. That might sound crazy, but that is the world we live in.
Banks today only need to maintain a ratio of roughly 1 to 5 of cash reserves to liabilities, so they don’t always have the money to pay every depositor at one time. The assumption is that most people won’t be withdrawing their deposits so banks are able to have the majority of their money tied up in loans and investments.
However, if enough depositors go to withdraw their money all at once, a bank can be forced into default as it will be unable to meet all those liabilities. And even if a bank doesn’t default, large-scale withdrawals could bring it closer to defaulting, which might spark concerns over its future solvency and act as a feedback loop of declining depositor confidence and more withdrawals that eventually lead to a default.
The term for this phenomenon is a bank run because depositors who gave their higher layer money to the bank are concerned the bank may no longer be good for it, so they run to the bank to withdraw all their money before it’s too late.
The irony of this behavior is that it can cause a crisis even if financial conditions are perfectly normal. The nature of fractional reserve banking renders banks ill-equipped to handle large-scale withdrawals, so, even if a bank has a healthy balance sheet and level of risk, it can default solely due to fearful depositors withdrawing their money.
Bank runs have played such a significant role in economic calamities that the Federal government stepped in to essentially move bank deposits up the money hierarchy.
Because confidence in Layer 3 money during economic turbulence is so unreliable, the government decided to insure the value of bank deposits themself, which meant bank deposits became a liability of the Fed and a Layer 2 money, provided they fell within the purview of the FDIC.
FDIC Insurance
Although bank deposits are still technically a Layer 3 money given they are a liability of a bank to pay back dollars, which is a liability of the Fed, up to $250,000 per depositor, per insured bank is guaranteed by the Fed.
This means up to $250,000 held at an insured bank is effectively Layer 2 money fully guaranteed by the federal government in the event a bank defaults. That said, anything beyond $250,000 is still a liability of the bank, and thus, still the lesser Layer 3 money you could lose if the bank defaults.
After a long and troubled history of bank runs and collapses, The Federal Deposit Insurance Corporation stepped in to insure depositors. This agreement is more commonly referred to as FDIC insurance and was implemented for one simple purpose: to avoid bank runs.
As long as depositors know their money held at the bank is guaranteed by the Fed, they have more confidence it won’t disappear. More confidence means less fear of loss and less motivation to withdraw bank deposits, so FDIC insurance helps to keep banks solvent and depositors sleeping well at night.
Speaking of trying to sleep well at night, let’s now dive into where financial assets like stocks and bonds fall in the hierarchy of money.
Stocks & Bonds
Without getting too much into the weeds, a stock is equity ownership of a company, and a bond is a debt obligation owed by a company. Both are claims on some future cash flow and growth, meaning they could be thought of as a type of Layer 3 or even Layer 4 money.
In the case of a government bond where coupons and repayment are a liability of the Fed and the bond is effectively the same type of money as the dollar, a bond would be a Layer 2 money, but corporate bonds are a different story.
When you hold a stock or a bond, it can serve as a claim to future dividends or coupons, which depend on a company’s ability to pay those dividends or coupons via bank deposits it accumulates through business operations. So if bank deposits are Layer 3, a claim on them would be a Layer 4 money.
Even if a company holds its cash reserves in the form of treasuries, the value of the stock and bond is based on a claim to those treasuries, which would make stocks and bonds a Layer 3 money deriving their value from the Layer 2 money (treasuries) the company holds.
However, stocks and bonds can also be a claim on actual assets a company owns, so there is an argument, especially for corporate bonds, that they are a Layer 2 money. It all depends on what type of money is actually backing your stock or bond. If land, valuable machinery, gold, or some other Layer 1 asset is backing your bond or stock value, it’s fair to say it’s a layer 2 money.
Company’s with tons of debt will probably be closer to Layer 3 or beyond because the value depends on a claim to its future cash flow, but other companies with little debt and lots of hard assets on their balance sheet could promise a claim to various Layer 1 forms of money with their stock or bonds.
There is obviously counterparty risk in dealing with an individual company, so it won’t ever be a Layer 1 money, but their asset holdings and circumstances around their debt and cash generation are very important in determining the exact layer of money its stocks or bonds fall into.
With that complicated mess out of the way, let’s get into another one of the complicated layers of money: credit cards.
Credit Cards
Everyone is presumably familiar with credit cards but likely unfamiliar with just how far down they are in the hierarchy of money.
Credit card balances are an asset of credit card companies and a liability of the credit card holder. A credit card balance is a liability because it is a claim on the credit card holder’s money, meaning the credit card company delays settlement when that credit card holder transacts, but then eventually redeems that liability for a higher layer money (the credit card holder’s bank deposits).
Because credit card balances can theoretically be paid off in different ways, I refrained from referring to it as a Layer 4 money, but if they are a claim on the credit card holder’s bank deposits, they would be a derivative of a Layer 3 money, which would technically make them a Layer 4. That said, because of FDIC insurance, it would also be fair to call credit card balances a claim on Layer 2 money, so go with whichever classification suits you.
Regardless of what layer you believe it is, the good news is retail credit card balances are the credit card holder’s liability, meaning the merchant is the one who has more to lose as they run the risk of their borrowers (credit card holders) defaulting.
When someone purchases something with a credit card, a company like Visa or Mastercard promises to pay the seller the specified amount, and then the credit card company, usually on a much later date, settles with the holder when their credit card bill is due. In fact, a lot of people never even fully settle with the credit card companies because they just pay the minimum balance and accumulate interest.
Because dealing with quasi Layer 4 money and counterparties with significant chances of default is such a risky business, credit card merchants make sure to charge more than enough through interest to make up for any lost money. In a sense, then, credit card holders who pay interest on their balances are subsidizing the borrowers who default.
To be clear, though, the real issue here is not the layer of money, it’s the counterparty. The layers of money matter, but they matter because of the various counterparties involved. Going down the hierarchy adds different counterparties to the list, but any one counterparty can be far riskier than a series of counterparties.
Crypto Lending
The last layer of money I wanted to touch on is money stored with crypto lending platforms. It’s very common these days for people to chase yield on their crypto by depositing it with a lending platform like BlockFi or the now infamous Celsius, but that doesn’t mean it’s safe.
Crypto lending platforms, or any platform holding your money for that matter, are effectively banks, which means any deposits they hold are their liabilities to their depositors. Unlike a bank, however, crypto lending platforms are not FDIC insured, so there is no federal government backstop guaranteeing the value of any deposits. This means money held with crypto lending platforms is entirely susceptible to the risks of default and bank runs and an unequivocal Layer 3 or beyond money.
It’s certainly possible many crypto lending platforms are safe and pose no significant risk of losing your money, but it’s important to know you are putting your confidence entirely in that company—not in a reputable bank with a long history of solvency or a government with a money printer.
If you think the potential returns warrant the risk, that is your prerogative, but there is no telling what is going on in the backend of the business, which means there is no telling how safe your money is. Lending money to early-stage companies can be quite lucrative, but always remember that most companies fail and your life savings is probably not worth risking on a company that’s only been around for a few years.
Conclusion
The truth is, most of us need Layer 2 and 3 money to function on a day-to-day basis, so it would be unrealistic to suggest a complete transition to Layer 1 money. Bank deposits are more or less necessary for credit cards to work in any practical sense, and money beyond Layer 1 is crucial for liquidity and large-scale economic activity to function the way modern society needs it to.
For those reasons, the moral of this article is not to rid yourself of all forms of money that are liabilities, it’s to understand the fundamental differences between the different layers of money so you can intelligently distribute your money according to the risks as you see them.
Given the nature of the fiat-centered monetary system today, it will be difficult to completely clear yourself from holding a Fed liability, but that doesn’t mean you can’t meaningfully diversify yourself across the different layers of money.
That could translate to you holding a considerable amount of gold or bitcoin in addition to bank deposits, but it could also mean storing your wealth in other hard assets like a house that won’t be severely affected by a bank run or economic calamity.
The nominal value of Layer 1 money might fluctuate, but your gold will still be gold and your house will still be a house, so their value will never fully disappear. It’s the other layers of money that run the real risk of going to zero.
When it comes to navigating those other layers of money, safely diversifying your risk could mean not storing all your money with one bank, all your stock in one company, or all your crypto with one lending platform. You won’t ever be completely de-risked, but as I’ve mentioned, that’s simply an unrealistic goal.
The real goal is a healthy balance of risk and safety so you’re able to reasonably make and use money in the modern economy, but you’re also prepared to keep your money in the face of economic turmoil and uncertainty.
How exactly to spread your wealth across the different layers of money and various financial assets is a question only you can answer, but having a deeper understanding of the risks and advantages of each form of money will leave you more equipped to tackle each layer and make a thoughtful financial plan.