What is Money Series - Part 2 - What is the Canadian Dollar?

In part 1 of this series (Part 1 - What is Money?) we overviewed the history of money and as a global concept. Now that we have a base understanding of what money is we can get into detail about the Canadian Dollar. Why the Canadian Dollar specifically? One of the inspirations for this series was realizing how much the pervasiveness of American media has affected the average Canadian’s understanding of how our money works. How many of you can quote what is printed on US bills? Do you know what is printed on Canadian bills? What about what the Canadian Dollar is backed by, and who’s in charge of it? To preview, it’s not gold, and it’s not the Federal Reserve.

Lets do some history to give us some background on the Canadian Dollar (CAD) as we know it today. In 1858 the Province of Canada introduced the Canadian Dollar as a hopeful replacement for the mix of British, American, Spanish, and private bank credit notes in use. In 1867 Canada was formed as a nation, and the next year the Government of Canada issued Dominion credit notes as currency. These Dominion notes were required to be backed by a minimum of 20% gold reserves. This is called a “fractional reserve” system, or fractional reserve banking. Reserve requirements for private bank notes and Dominion notes changed over the years leading up to 1935 when the Bank of Canada (BoC) was formed and became to sole issuer of currency in Canada. 10 years later gold reserve requirements were removed and the Dollar became a fully fiat currency (remember this term from the previous article?).

The Bank of Canada is Canada’s “central bank”. If you check out the About Us page on their website (https://www.bankofcanada.ca/about/) you’ll see they have a broad range of roles and responsibilities, but the main one we’re focused on is that they manage the Canadian Dollar as a system of money, including creating and destroying Dollars as they deem necessary. (This is similar to the American Federal Reserve, but a key difference is that the BoC is a crown corporation, while the Federal Reserve is owned by private banks.) The creation and destruction of Dollars is a complex process, but it’s mostly done through borrowing. The government indirectly borrows money from the BoC (and sometimes directly from commercial banks), and everyone else borrows from banks. This money is then created by the BoC and banks, and when the principal (debt exclusive of interest) is paid back, its destroyed.

I’d be remiss if I didn’t mention and define “inflation”, “monetary expansion”, and the “Quantity Theory of Money”. The BoC defines inflation as “…a persistent rise in the average level of prices over time.” They have an excellent explainer on their website here (https://www.bankofcanada.ca/2020/08/understanding-inflation/); to summarize, the BoC and government use the Consumer Price Index (CPI) to keep track of this. “Monetary expansion” is when money is created and kept in circulation. The “Quantity Theory of Money” states that when new money is created it becomes less valuable, which means prices increase, AKA inflation. With this in mind the BoC targets a 2% inflation rate when making decisions about creating and destroying Dollars (through the systems of borrowing). Whether they’re successful or not is the subject of an article all on its own and much speculation.

I should also mention an outlier in the Canadian financial system; Credit Unions. These are provincial banks that don’t have a direct relationship with the BoC. They’re generally much smaller than the national banks and offer fewer services, but many feel they offer a more personal service. And one credit union in particular is an outlier among outliers; Bow Valley Credit Union in Alberta. They’ve embarked on mission to stockpile precious metals (mostly gold) as a form of guarantee for customer deposits. They still practice fractional reserve banking, but this is an improvement over zero reserve banking.

You might be imagining stacks of Dollar notes being passed around all these institutions, but most of the money only exists in ledgers (remember this from part 1?). For comparison, there is currently about $250B in the M0 supply (liquid deposits at the BoC and cash), and the rest totals about $3500B, or $3.5T. That’s about 7% as “real” money that could be used to buy groceries or for payroll. To move this invisible money around the government created Payments Canada, a non-profit that operates most of the inter-institution transfer systems. (They have other responsibilities as well.) Lynx and the Automated Clearing Settlement System (ACSS) are currently in use, and Real-Time Rail (RTR) is coming soon to augment them.

On the retail side, we have the Interac network and credit card networks. The Interac Corporation (a for-profit founded and primarily owned by major national banks) operates the Interac network, which is the primary debit card network in Canada, as well as Interac e-Transfer for direct electronic payments. Visa and Mastercard are the primary credit card networks, but they simply move payment information between banks and Payment Services Providers (PSPs). PSPs are responsible for the actual payment settlements. You’ve probably heard of some of the major ones; Moneris, Chase, Square, and PayPal to name a few. If that sounds complicated, that’s because it is. Let’s walk through an example credit card payment at a physical store to see how it works. The customer inserts, taps, or swipes their card at the payment terminal, typically managed by a Point of Sale (POS) provider. The terminal sends the information to the PSP, who sends the information through the credit card network to the issuing bank. If the transaction is approved, it’s logged for transfer in a batch later, and the approval makes it way back through the credit card network, PSP, terminal, and POS.

Wipe the sweat from your brow and take a sip of coffee; that was a lot! The important part to remember is that all of this complexity serves to move numbers between accounts in ledgers. The government (through the BoC) controls the money supply (the primary driver of inflation), and the banks and networks move the ledger numbers between individuals, companies, and each other. About 7% is liquid, and 0% is backed by hard assets such as gold.

In part 3 we’ll cover Bitcoin, its intention to replace fiat currencies, and its current state in Canada.