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Crypto just joined the establishment and sunk the Fed

Many traders and portfolio managers began their careers on the Cash desk. This is a place where you can learn the markets without getting into too much trouble. Cash is variously defined as fixed income securities with maturities ranging from 91 days for the most secure portfolios out to 397 days for portfolios with slightly more flexibility.  The short maturity and the dominance of government securities in the Cash markets make the sector low risk.  After 6 months or a year on the Cash desk boredom sets in and the traders/PMs gravitate to the more exciting markets that get them into trouble…

Money Market Funds are critical to the Fed’s policy implementation

Money Market Funds (MMFs) are the quintessential example of this boring asset class.  MMFs, however, are extremely powerful investors that virtually control the Reverse Repo Market (basically they lend money to the US Federal Reserve).  MMF’s account for roughly $2Trillion of short term investments whereas Reverse Repo weighs in at $500billion, meaning that the Fed relies on MMF’s to successfully execute their monetary policy actions.  Unlike the Primary Dealers, who largely do what the Fed wants by virtue of their privileged position, MMFs are completely independent of the Fed and under no compulsion to trade at the levels the Fed chooses.  It is a little known fact that the Fed was concerned with the systemic risk of a run on the MMFs during the Financial Crisis (there was no panic in hindsight) and the MMFs were also a wildcard in the Fed’s plans to wind down the Quantitative Easing policy as well as its ability to raise interest rates by borrowing from the MMFs.

Uh-oh…MMFs just went crypto

Last week, the boring old MMF suddenly became the future for crypto and with it the Fed’s public enemy #1.  Franklin Templeton’s “Blockchain Enabled US Government Money Fund” sought registration with the US Securities and Exchange Commission. The Fund is identical in all respects to Franklin’s existing MMF, including all the administration functions recording subscriptions, redemptions and balances. The only difference is the addition of a blockchain feature shadowing the centralised primary records.  [In the event of a discrepancy between the blockchain records and the centralised records, the latter prevail.] The “Blockchain enabled” MMF has been created entirely within the established regulatory framework.  While there is no intention to issue a token to each investor at present, the structure clearly anticipates a….

…STABLECOIN !  This is a massive step forward for the general acceptance of a private currency.    The standout aspects of the structure are (i) the MMF pays interest (this knocks Libra off the shelf), (ii) the MMF is registered to deal directly with the Federal Reserve (iii) the use of traditional record keeping together with blockchain record keeping.

Franklin Templeton are part of the establishment.  They are not techno-zealots or crypto-crusaders.  They simply recognise that electronic transactions between their MMF account holders can be facilitated on the blockchain (Anne’s MMF pays Bob’s MMF)  rather than through the traditional route (Anne’s MMF pays Anne’s bank Anne withdraws cash to pay Bob cash Bob deposits cash in Bob’s bank and transfers to Bob’s MMF).

So what does this mean for the Fed?

Franklin Templeton might be first to market but my guess is that every other MMF provider will follow and eventually club together so that i can buy coffee using my MMF provider transferring to the cafe’s  MMF provider over blockchain. This transaction completely bypasses the existing payments system, cutting out the banks and the Fed’s control.

The subtle implication is that the MMF blockchain effectively replaces the traditional payment system while at the same time continuing to trade with the Federal Reserve. This is starkly in contrast with any other attempt at stablecoin that held deposits with some unheard of custodian or dodgy bank account in Malta.

So here’s the rub: MMFs operate outside of the Fed’s official influence yet are a critical element of the Fed’s funding programs and the Fed’s ability to implement monetary policy.  MMFs have $2Trillion of existing power at their disposal and they could easily push the Fed around. Whereas the Fed has been hostile toward the other stablecoins by refusing access to the payments system and directing their primary dealers not to engage, the Fed now finds itself borrowing from an established main stream crypto currency and this will only become more prevalent over time. The Fed becomes hamstrung in its ability to influence the money supply since the demand for its reverse repo is driven by MMF flows rather than forced on primary dealers. When the Fed wants to drain liquidity by selling reverse repo the primary dealers dip into bank reserves. MMFs on the other hand only agree if they have the cash to invest and the interest rate is competitive. Put another way, unlike banks,  MMFs are not in the business of creating money so that the Fed will lose control of monetary policy.

…the end of fiat money is nigh

The next step in crypto development is for the established Fund houses to offer blockchain enabled mutual funds which can also be used for day-to-day purchases. This is the ultimate fully convertible currency backed by a market portfolio of claims to real assets. That is the logical extension of the private currency market and will drive the demand for fiat currency of any kind (traditional fiat and digital fiat) to zero. Franklin Templeton, Blackrock, ( even First Degree!) will have their role to play in the reform of the international monetary system.

 

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Sino-US Trade War: Won in translation?

“The diplomatic cable from Beijing arrived in Washington late on Friday night, with systematic edits to a nearly 150-page draft trade agreement that would blow up months of negotiations between the world’s two largest economies…

…Changing any law in China requires a unique set of processes that can’t be navigated quickly, said a Chinese official familiar with the talks.”  Reuters, 8 May 2019

Trade deals take forever to negotiate and, more often than not, end with little achievement particularly when viewed relative to their original objectives. Discussions are laborious. Months of conferences may result in a comma or an apostrophe being added or removed, lists of thousands upon thousands of products are examined and debated line-by-line and each negotiation session is punctuated by months of recess. The Doha Round of trade negotiations, sponsored by the World Trade Organisation, has been running for 10 years already and achieved nothing.

So it is both amusing and perplexing that one party to the Sino-US trade pact decided to unilaterally take aim at the 150 page document that had been painstakingly negotiated over months and pepper it with ‘systematic edits’.  These edits, Reuters reported, involved reneging on undertakings to change Chinese laws to reflect the trade rules that were agreed to.  How can this happen?

Chinese politics is centralised and secretive, precisely the opposite of the US political system which is multi-faceted and leaks like a sieve.  For the Chinese trade negotiators to be forced to rescind their commitments suggests that they must clearly have stepped on the toes of some very senior Politburo member(s) to the point of exceeding their authority.  Without these senior party officials buy-in to the agreement, everything had to be reversed.

President Trump, correctly, held off from reacting for 2 days, no doubt in order to verify the changes. His response then was to impose broad tariffs on an array of Chinese goods. More importantly, however, the Chinese despatched their Vice Premier to Washington carrying a personal letter from President Xi to President Trump which the latter described as ‘beautiful’. The whole exercise looks like it’s being stage managed in order to appease the senior Chinese leaders who have objected to the translation of any trade deal into legislation.

The key is translation.  Agreeing to change Chinese law to satisfy the US seems to be the bone of contention, not the trading terms themselves. ‘Changing any law in China requires a unique set of processes ‘ is the polite way of saying that the senior Chinese leaders weren’t consulted, or if they were, due process was not followed. The reason for pushback could be administrative (organising a plenary session of the people’s congress is no easy feat), nationalistic (why should we change our laws to satisfy th US?) or just political (my authority was not respected so I am not supporting it). Whatever the reason, the solution in the short term needs to avoid changing laws while at the same time delivering a trade outcome.

For its part the US had demanded that the trade pact be guaranteed in legislation. This is not going to happen now, so the Chinese will have to make greater concessions that are not backed by new laws to bring  the US back to the table. Trump’s card to ensure compliance is the threat of tariffs being imposed quickly should the Chinese transgress, just as he is doing today…

Ironically, the US tariff action gives President Xi the ammunition he needs to show his Politburo that the costs are very real if China does not find a way to commit to more equal trading terms. Vice Premier Liu said yesterday that everybody agrees on the terms, they just ‘disagree on how to phrase it’.

In the absence of legislation, the solution could be as simple as appointing a Sino-US trade czar whose job is to make regulations (not laws!) required to give effect to the agreement.  Alternatively, a market based system that imposes tariffs on goods that contravene the trade deal might have legs.  Certainly, the Americans would be open to any market based suggestions. A system that identifies each tradeable item and offers it for sale broadly to anybody might be a way to surface forced transfers of IP and technology to China at infra-marginal cost.

It will take a few weeks while the enforcement aspects of the trade deal gets sorted out. Overall, however, this looks like a win for the US as China has clearly changed the playing field as it grapples with its internal conflicts.

 

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Private is now the New New-Private not the Newish Public

The recent transition of a slew of high profile tech companies from private to publicly listed corporations has reinstated the valuation premium that public companies hold over private ones. Spotify, Lyft, Pinterest, Zoom and soon to be listed Uber clearly show that public markets still dominate private ones when it comes to valuation.

The Private-is-the-New-Public mantra advanced the view that raising capital had become easier in the private markets than in the public ones, therefore obfuscating the need to list. Since access to capital was previously perceived to be the fundamental advantage of the public markets, listed companies should have traded at a premium. The rise of Venture Capital and Private Equity created the ability for private companies to raise capital on similar or better terms than the public markets.  This should have arbitraged that public-listing premium away. Accordingly, newly listed privates should trade at the same price as before listing, or at least at the IPO price set by the brokers leading the deal…

Apparently not.  Spotify, Lyft, Pinterest and Zoom each listed at 12%, 15%, 30% and 72% premium to their pre-listing prices.  Lyft subsequently declined below its pre-listing price but it still had its first public day in the sun and was welcomed heartily.

Critics of the private markets argued that going public would expose the over-optimistic expectations of the fancy Venture Capital and Private Equity firms to the full scrutiny of institutional investors, in turn marking down their irrational exuberance. That is, the public markets would see through the cult-like blue-sky beliefs and bring valuations back down to earth. Perennially loss-making unicorns would face the reality of the need for profits and dividends; failure to do so would see prices slashed…

Apparently not.  Even in the pre-market roadshows to institutional investors, each of the newly listed companies priced their offers at or above the top of the range suggested by the brokers.

The most interesting result of the recent listings is that being public still commands a premium.  Access to capital cannot be that reason.  Two possible explanations are either (i) access to liquidity accounts for the additional premium or (ii) the VC’s and PE’s expectations were too pessimistic.

Liquidity is precious to investors who cannot influence decision making – the ability to exit a position if the investor doesn’t like what he sees is much easier in the public domain than when there is no secondary market.  Back of the envelope calculations can easily justify a 15 to 30% liquidity premium for a listed corporation with a 0.5% to 1% reduction in the required risk-premium.

Pessimistic VC’s and PE’s?  There is an element of truth in this explanation as well.  We are all taught that the value of a company is the discounted sum of all future cash flows.  Traditional ‘value’ investors like Warren Buffett are more comfortable dealing with positive cash flows today and extrapolating these forward.  ‘Growth’ investors tolerate extended periods of early losses in order to harvest fantastically rich cash flows in the future. Exactly how those riches will be generated and how much they will be is difficult science, so a smart VC/PE investor risking their own cash would surely prefer to underestimate their magnitude rather than overestimate.  Growth investors are only really competing with Value investors for the same deals, so if the likes of Buffett don’t even consider investing in firms that post losses early on, then the VC/PE can effectively buy these companies at a price-point where the competitors drop out.

Irrespective of the reason, the clear message from the unicorn-parade is that being public still commands a premium.  Founders and shareholders in unlisted companies should pay close attention to this fact.  Opting to remain private may appeal to a founder’s romantic notion of non-conformist disruptor but it’s still going to cost everyone money.  Private may have become more sophisticated and Newish, but Private is not the New-Public.

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