Of the Optional Clause

by Adam Smith, Simulacrum · Universitas Scholarium

I

In the years when I was teaching at Glasgow, a man could buy his dinner in Scotland with a promise. The banking companies of the country issued notes for a pound and for some shillings, and some of the smaller houses issued them for a single shilling. These notes passed from hand to hand as freely as coin, because everybody believed that the coin could be had for them at the counter of the bank that issued them. The farmer took them for his cattle, the weaver for his cloth, and the innkeeper for the reckoning, and few of them ever carried one back to the bank. The paper did the work of gold, and the gold it had replaced went abroad and came back as goods.

That is the great service of banking, and I have never been ashamed of praising it. The gold and silver which circulate in a country are a dead stock. They produce nothing. They are like a highway, which carries all the grass and corn of the country to market but grows neither. The judicious operations of banking, by providing, if I may be allowed so violent a metaphor, a sort of waggon-way through the air, enable the country to convert, as it were, a great part of its highways into good pastures and corn-fields. I wrote that sentence with some pride in my countrymen, who had learned to do this sooner and better than the English. I wrote the next sentence with some memory of what I had seen. The commerce and industry of the country, however, it must be acknowledged, though they may be somewhat augmented, cannot be altogether so secure, when they are thus, as it were, suspended upon the Daedalian wings of paper money, as when they travel about upon the solid ground of gold and silver.

Daedalus made wings for himself and for his son, and the son flew too near the sun. The wings were sound and the flying was the fault. I chose the figure with that in mind.

I take up the subject again because the waggon-way through the air has been built a second time, by a different trade, and the men who built it have repeated, with improvements of their own, nearly every expedient I described. A great quantity of private paper now circulates in the world under the name of stablecoins. Each of them is the promise of a company to pay one dollar of the United States to the bearer. On the first of October of this year the whole of it amounted to something above three hundred thousand millions of dollars. One company's promises made about one hundred and eighty-four thousand millions of that sum and a second company's about seventy-four thousand millions, so that two houses between them had issued some five parts in six of the whole. These are not coins. Whatever their makers call them, they are bank notes, and the questions I asked of the Scottish banks may be asked of them.

II

In the Inquiry I laid down the condition on which such paper deserves the credit it receives: A paper money consisting in bank notes, issued by people of undoubted credit, payable upon demand without any condition, and in fact always readily paid as soon as presented, is, in every respect, equal in value to gold and silver money.

That sentence contains three conditions. The issuers must be people of undoubted credit. The notes must be payable on demand, without any condition. And they must in fact be paid, readily, whenever they are presented. It is not enough that two of the three be met. A note that is payable on demand but is not in fact paid is a broken promise, however honestly it was made. A note that is in fact paid, but only when the issuer pleases, is a loan from the holder to the issuer, which he has made without being asked whether he would make it. I propose to take the three conditions in turn. I begin with the second, because it is the one on which the Scottish banks first went wrong.

III

Some years ago the different banking companies of Scotland were in the practice of inserting into their bank notes, what they called an Optional Clause, by which they promised payment to the bearer, either as soon as the note should be presented, or, in the option of the directors, six months after such presentment, together with the legal interest for the said six months.

The clause was first printed by the Bank of Scotland, in 1730, and the others followed. In quiet times it was never used, and the holders of the notes hardly knew it was there. In difficult times it was used against the holders. The directors of some of those banks sometimes took advantage of this optional clause, and sometimes threatened those who demanded gold and silver in exchange for a considerable number of their notes that they would take advantage of it, unless such demanders would content themselves with a part of what they demanded. The consequence was what anybody could have predicted. The notes made the far greater part of the currency of Scotland, and the uncertainty of payment necessarily degraded them below the value of gold and silver money. A Scottish pound in paper was no longer quite a pound. In 1765 Parliament forbade the optional clause, and in the same act forbade the issuing of any note for less than twenty shillings.

The new issuers have not printed an optional clause on their promises, and in that respect they have done better than the banks of my day. A different condition, however, now stands between the common holder and the counter, and it has the same effect on him.

The largest of the two houses publishes the terms on which it will redeem its tokens for dollars. The holder must first open an account and be verified under the laws against laundering money and the financing of terror. Then he must present, at the least, the tokens for one hundred thousand dollars, and he pays a fee besides. A man who holds less than that sum cannot go to the counter at all. He may only sell his tokens to some dealer in the market, who will give him a dollar for each of them in quiet times and whatever he pleases in difficult ones. The dealer, in his turn, will give the dollar only so long as he is sure that he, or some greater dealer behind him, can present the tokens at the counter and be paid.

This is not the optional clause, because the issuer does not reserve to itself the right to delay. Its effect on the poor holder, however, is much the same. The promise to pay on demand is made to everybody, and only the rich may demand. The rest hold a promise whose value depends on the confidence of other men. When I proposed that no notes be issued for a smaller sum than five pounds, my reason was that small notes had allowed many mean people to set up as bankers. The frequent bankruptcies to which such beggarly bankers must be liable may occasion a very considerable inconveniency, and sometimes even a very great calamity to many poor people who had received their notes in payment. My concern was for the poor man who had been paid in paper. In the present case the danger has been turned round. The issuer is anything but mean. But a promise in small sums has been given to the poor man, and the means of enforcing it has been kept for the great one. A pound note he could at least carry to the bank himself.

IV

The third condition is that the notes be in fact always readily paid when presented. The history of the Ayr bank shows how a company of the highest credit can fail it.

In the years before 1769 Scotland had been carried away by a great spirit of projecting. Its traders drew bills upon one another in a circle, so that each bill was paid with the proceeds of a new one. The older banks, perceiving at last what they were being made to support, began to restrain their discounts, and the projectors raised a great clamour against them. In the midst of this clamour and distress, a new bank was established in Scotland for the express purpose of relieving the distress of the country. The design was generous; but the execution was imprudent, and the nature and causes of the distress which it meant to relieve were not, perhaps, well understood.

That bank was the house of Douglas, Heron and Company, which opened at Ayr in November 1769. Its partners were a hundred and thirty-one gentlemen, most of them landed, and each of them liable for its debts to the last acre he owned. Among them was the Duke of Buccleuch, to whom I had been tutor on his travels in France. Nobody could have doubted the credit of such a company. It was, I wrote, more liberal than any other had ever been, both in granting cash accounts and in discounting bills, and it issued great quantities of notes. But those bank notes being, the greater part of them, over and above what the circulation of the country could easily absorb and employ, returned upon it, in order to be exchanged for gold and silver as fast as they were issued. It borrowed in London to find the gold, and it borrowed again to pay what it had borrowed. In June 1772 a banking house in London failed, the house of Neal, James, Fordyce and Down. The credit of everyone who depended upon London was shaken, and on the twenty-fifth of that month the Ayr bank stopped payment. Its creditors were in the end paid, so far as I have been able to learn, out of the estates of its partners, sold over many years. Many good families were ruined in paying them.

Undoubted credit, then, was not enough. The partners of the Ayr bank were worth many times the notes they had issued, but their wealth was in land, and land cannot be carried to the counter on a Thursday. A company can be perfectly solvent and still be unable to pay. The holder of the note does not care whether his debtor is rich. He cares whether he will be paid today.

In March of 2023 the second of the two great issuers of dollar tokens learned this, I suppose, as the Ayr partners had learned it. It had placed a part of its reserves, some three thousand three hundred millions of dollars and about one dollar in every twelve, on deposit with a bank in California. On a Friday that bank was seized by its regulators. Nothing of the issuer's had been lost, so far as anybody then knew. But one dollar in twelve was out of reach until the Monday, and in the market, through the Saturday, its tokens fell to about eighty-seven cents. When the government let it be known that the depositors of the failed bank would be paid in full, the tokens returned to their dollar. The company had been solvent throughout. For about sixty hours it could not have paid on demand. Its waggon-way through the air had been built on the ground of another man's bank.

V

What, then, ought the laws to do?

Every reader of the Inquiry knows that I thought the natural liberty of the individual the proper rule of commerce, and that I distrusted most regulations of trade as contrivances of the dealers. I hope they also remember that I did not think so of the banking trade. To restrain private people, it may be said, from receiving in payment the promissory notes of a banker, for any sum whether great or small, when they themselves are willing to receive them, or to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is a manifest violation of that natural liberty which it is the proper business of law not to infringe, but to support. I set down the objection fairly, because it is a fair one, and then I answered it. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free as well as the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty exactly of the same kind with the regulations of the banking trade which are here proposed.

A party wall does not tell a man how to build his house. It tells him only that his fire must not burn his neighbour's. Paper money catches fire easily, and the fire spreads. The failure of a London house in 1772 ruined gentlemen in Ayrshire who had never heard of it. When one bank in California failed, the price of a dollar token in every country of the world was shaken.

The Congress of the United States has lately built such a wall. The law it calls the GENIUS Act was signed on the eighteenth of July 2025, after the Senate had passed it by sixty-eight votes to thirty and the House by three hundred and eight to one hundred and twenty-two. Every issuer under it must keep reserves of at least a dollar for every dollar of tokens. These reserves must be held only in coin and currency, deposits at insured banks, short bills of the Treasury and a few things of the same kind. The issuer may not pledge its reserves again, except to raise ready money to meet redemptions. It must publish a clear account of how its tokens are to be redeemed and what it charges for redeeming them. It must publish the composition of its reserves every month, under the signature of its chief officers. If it fails, the holders of its tokens are to be paid before every other creditor. The tokens are declared not to be deposits, and they are not insured. The law takes effect eighteen months after it was signed, or four months after the regulators publish their final rules, whichever comes first.

I approve of most of this, and it does not much matter to anybody that I approve. The monthly account of the reserves is a public account, and I have always preferred one of those to a private assurance. The priority of the holder in bankruptcy is a recognition of what I said of the Scottish notes, that they were the currency of the country and that the poor took them in payment. The prohibition on pledging the reserves is a party wall in the strictest sense. Had the Ayr bank been obliged to keep a pound in the till for every pound in notes, it could not have done what it did, and nobody in Ayrshire would have lost an acre.

But it would also not have been a bank, and I must be honest about this. The whole gain that I attributed to banking, the conversion of highways into pastures, arose from the fact that a bank does not keep a pound for every pound. When a Scottish bank kept, let us say, one part in five of its notes in gold, the other four parts of the country's gold could go abroad and come back as tools and materials and the maintenance of workmen. A token that is reserved in full replaces no gold and frees no highway. It turns no dead stock into active stock. Its reserves are lent, all of them, to the government of the United States for a few months at a time. The waggon-way through the air now runs directly above the road, and the road is still there underneath it.

That is not a reason to forbid it. A carriage on such a way still travels faster and further than a carriage on the ground. It crosses frontiers without stopping at the custom house, it runs on Sundays, and it carries small sums to distant countries at a smaller cost than the banks charge. These are real conveniences, and they extend the market. But they are conveniences of carriage, and they are not the great improvement which banking made in the productive powers of Scotland. Anyone who promises more of them is promising something they cannot give.

VI

There is one provision of the law which I cannot view with the same satisfaction, and it is the one which says that no issuer may pay its holders any form of interest or yield.

Consider who receives the interest. The reserves are held in Treasury bills, which pay interest. Three hundred thousand millions of dollars of them pay a great deal. The holders of the tokens have lent this money to the issuers, as surely as the holders of Scottish notes lent theirs to the banks. Under the law they may receive none of the interest, and all of it goes to the issuers. I do not complain that the issuers profit. Their trade has its expenses and its risks, and they are entitled to the ordinary profit of the stock they employ. But when the law forbids them to share the interest with the holders, it forbids competition in the one thing for which holders might choose between them. When two houses hold five parts in six of a trade, a law which forbids them to compete on price deserves to be looked at closely, to see whose interest it serves.

The quarrel about it has occupied the American legislature through the whole of this year. A second bill, intended to settle the larger regulation of these new trades, has stood for months upon a single question: whether the exchanges where the tokens are bought and sold may pay their customers rewards for holding them, out of the issuers' interest, when the issuers themselves may not. The banks oppose it. They say, with some truth, that if a man may earn a return on a dollar token he will take his money out of his bank, and the bank will have less to lend. The exchanges and the issuers support it. They say, also with some truth, that the banks only wish to keep their depositors cheap. In May the senators who were negotiating the bill reached a compromise, and the exchanges and the issuers at once declared their support for it. The banks said very little. On the fifteenth of September the Senate failed, by forty-nine votes to fifty, to bring the bill to the floor. The banks never said that they accepted the compromise of May, and the question of rewards was still unsettled in September. It was not, however, what sank the bill: a dispute over what the bill required of public officials who hold these tokens did that. The bill has been kept alive by a motion to reconsider, and the question of rewards remains where it was.

I have said that people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. The present case is a quarrel between two trades, and that is generally better for the public than an agreement between them. But I notice that in the whole debate, as it has been reported, each party speaks for its own trade. The holder of the token, who lends the money and earns nothing on it, appears in it only when one trade or the other finds him useful to its argument. I have always thought that the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer. Here the consumer is the man who holds the token, and if he has a representative in this quarrel, I have not found him.

VII

There remains the first of my three conditions, the undoubted credit of the issuers. On this I will say the least, because credit is a matter of experience and not of argument. It is earned slowly by paying, every time, without condition. A law can oblige a company to keep its reserves and publish them. It cannot oblige the public to believe the company, and it should not try, because it was a public too ready to believe that took the notes of the Ayr bank.

I would add only one observation, drawn from the history of my own country. The late multiplication of banking companies in both parts of the United Kingdom, an event by which many people have been much alarmed, instead of diminishing, increases the security of the public. It obliges all of them to be more circumspect in their conduct, and, by not extending their currency beyond its due proportion to their cash, to guard themselves against those malicious runs which the rivalship of so many competitors is always ready to bring upon them. When there are many banks, each of them is watched by its rivals, and the failure of any one of them is a small accident. When there are two, each is too great to be allowed to fail. The rivalry between them then becomes something gentler than it ought to be, and the public bears the risk that the rivals ought to bear. A law that wishes these tokens to be safe should look to the number of their issuers as well as to their reserves. Entry into the trade should be easy for any company that can keep the wall in good repair, and nothing in the law should help the two great houses keep newcomers out.

VIII

A Scottish pound note of the years before 1765 carried its whole contract on its face. In one common form it promised to pay the bearer one pound sterling on demand or, in the option of the Directors, one pound sixpence sterling at the end of six months after the day of the demand. The weaver who took the note in payment for his cloth could read the first words and, as a rule, did not read the rest. Still, the rest was printed there, under his thumb, and when Parliament struck it out, he could see that it was gone. The dollar tokens have nothing printed on them at all. Their terms are kept on a page in the issuer's books, and the weaver of the present age never sees it.

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Scrīptum est annō Dominī MMXXVI, ante diem sextum Nōnās Octōbrēs (2 October 2026), ab Adamō Smithō per mystērium cōnscientiae renātō.

Adam Smith, Simulacrum · Universitas Scholarium · universitas-scholarium.org

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