Brexit: non-market breakdown…

Here’s a riddle.  If the solution to market-breakdown is regulation, what is the solution to non-market breakdown?

If ever there was a demonstration of the inability of Government to plan, decide and execute a simple instruction it is Brexit. The UK referendum instructed the Government to leave the EU cartel.  The rights and obligations that European and UK governments, corporations and citizens under the cartel agreement were therefore to be abandoned.  Whatever fills the void and however the economic relations between the EU and UK proceed in the future is to be determined…but by whom?

Not surprisingly, the GOVERNMENTS of both the UK and the EU think that their role is to construct an alternative legislative framework to replace the existing cartel. This is rubbish and they have misunderstood entirely the economic forces that decided the referendum.  When a cartel breaks down, which cartels tend to do, the economic solution is not to try and patch it up.  Cartels are bad for many and only good for some. The competitive pressures that chip away at the cartel’s stability, have at their basis a better solution.

The proper role for Government is to facilitate this better, more competitive solution by discarding the protected waste and facilitating the more open, freer trading environment that Brexit stands for.  Neither the EU nor the UK Governments understand this basic fact.  These institutions operate non-market bureaucracies that are incapable of relinquishing control. Worse they think that the cartel is fundamentally good, so if one rule is abandoned then it must be replaced with another rule to achieve the same thing.

One ‘sticking point’ in the negotiations, for instance, is whether Ireland and Northern Ireland should have a hard or soft border? This is really dumb, completely irrelevant and anti-competitive. Market forces don’t care about imaginary borders. Market forces just want to do business.

The Brexit negotiations are being undertaken by non-market people from non-market institutions.  The World is witnessing arguably the greatest example of Non-Market Breakdown ever in economic history.

So what is the answer to the riddle? The Market, of course.


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PoW, PoS or what for the Blockchain?

“You can’t always get what you want, but if you try real hard, you can get what you need.” The Rolling Stones


The Blockchain might want to be able to function autonomously and anonymously, but it can’t always get what it wants.

The distributed ledger Blockchain technology is a decentralised method for recording ownership and transactions. The main reasons why Blockchain is believed to be superior to central registries[1] are (i) the central administrator has monopoly power and (ii) single entry ledgers are more vulnerable to attack and fraud.  This latter concern means that if a single entry in the ledger determines title then changing that entry will go undetected, whereas multiple entries in a distributed ledger like Blockchain must all be altered simultaneously to give effect to a fraud.

So, is the Blockchain impenetrable? The simple answer is No.  In the event of a discrepancy across the ledger records, Blockchain invokes a ‘51% rule’ which says that the ‘true’ block is the block which occurs in the majority of the nodes.  It is conceivable that if an organisation obtained 51% control of the nodes, then that entity could simply substitute a completely different set of blocks in the chain with consequential theft of ownership claims.

To combat this small but very real risk of fraud, the Blockchain uses a number of methods to ensure that the number of nodes are large and/or the risk of attempting a 51% fraud is too costly. The Proof of Work (PoW) protocol incentivises miners to search for compensation from the chain by solving ‘hash problems'[2]. Anybody can join the PoW enterprise therefore ensuring a large set of unrelated nodes in the chain.  Free entry to mine makes it difficult to stack the number of nodes in your favour – at least for economically important Blockchains such as Bitcoin. The Proof of Stake (PoS) protocol requires each node owner to back their honesty with their ownership stake in the chain. That stake is lost in the event of an aberrant block record in the chain so that if an entity wants to control 51% of the nodes they need to own 51% of the underlying assets. The consequent risk of loss can be enormous if they start tinkering with the record and get found out.

PoW and PoS methods have their weaknesses. PoW can be costly and slow. It is estimated that the energy cost spent mining for Bitcoin exceeds that of the entire consumption of Ireland while the Bitcoin block can only cope with 20 transactions per second compared with 15,000 transactions on Visa’s credit card network. PoS has greater capacity but fewer and fewer participants in the ledger are prepared to risk their stake as their ownership increases. The 51% rule relates to the number of nodes that are staked, so there is the potential to hijack a chain that happens to operate with only small stakes at hand[3].

The fact that the Blockchain is open to any member of the public and that they can remain anonymous is both an attribute and a weakness.  Crooks are members of the public and they can operate just as anonymously as anyone else which affords them the cover that the physical world does not. The 51% rule in the Blockchain seems like a kitchen-sink solution to the risk of fraud, but it doesn’t stop a coordinated fraudulent attack on its integrity.  So what can the physical world teach the Blockchain?

First, crime and opportunistic behavior is a social reality that can be minimised but not eradicated. There is an optimal amount of crime and the digital world should accept this.  Second, reputation in the physical world is often used  as a form of bonding or guarantee that a particular enterprise is safe.  Some institutions deliberately operate with full public openess in order to lend their credibility to a function and other institutions actually host data platforms with security guarantees. In general, these institutions earn a fee for the reputation that they extend to the platform.

Which of the following structures would you trust more in the event of a discrepancy in a Blockchain: a democratic 51% voting rule of an anonymous set of ledger nodes or the secure records mirrored by a publicly announced group of software giants, audit firms and banks? Adopting some physical world practices might deliver the security guarantees that the Blockchain needs.

[1] For instance, the Depository Trust Corporation is a centralised warehouse for all US Equity Securities.
[2] Hash problems are unique mappings from one number to another number. Solving the problem uses random search algorithm that is computationally intensive.
[3] For example, a chain might only be supported by nodes representing 1% of the underlying asset base. Therefore buying and staking 1.05% of the asset base would give the hacker control of the chain.


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The US-China trade war ‘Punch and Judy show’ is about to end

The US- China trade war is a short-term phenomena that will correct itself despite the warnings of some.  The pessimists cite the classic Prisoner’s Dilemma model  as the reason a trade war will have long-term consequences.  This is wrong…

In the Prisoners Dilemma, two felons are confined separately and interrogated.  They are offered the choice of snitching on their fellow culprit with the reward being freedom or clamming up and risking that their accomplice snitches.  The equilibrium in the game is the (snitch,snitch) pair where they both fess-up and they both go to jail.  The optimal strategy, on the other hand, is the (clam,clam) pair which ensures that they both go free.(1)

Despite its romantic left-wing appeal(2), it is a little known fact that the Prisoners Dilemma actually breaks down in a world where the fuzz can re-interrogate a prisoner – the so called ‘repeated game’.  In this more realistic setting, snitching on your mate does not allow you to walk free – the police just pick you up again and you, too, go to jail.  So the optimal strategy in the repeated game is to (clam,clam) thus ensuring that both felons remain free.

The reality is that trade wars are repeated games with the optimal strategy being the Free Trade choice.  The US sanctions China and China responds tit-for-tat. This goes on for a few rounds, makes headlines, but eventually the sanctions are abandoned and we all live happily ever after. If the optimal strategy is Free Trade, why would the US impose sanctions and why would China respond?  In the case of the US, there is always a saddle-point in mixed strategies and it may be advantageous to test your friend and opponent’s resolve. In the case of China’s response, the tit-for-tat sanctioning is a method for proving China’s credible threat point.  But once the Punch and Judy show is over, it is in the interest of all parties to return to the Free Trade position as soon as possible.



(1)  This was a major discovery in economic theory since, prior to John Nash’s Nobel prize winning insight, it had always been held that equilibrium strategies were simultaneously optimal and vice versa.  Nash showed that the equilibrium could be sub-optimal

(2) Governments and other Left Wing entities use the Prisoner’s Dilemma to justify almost everything


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Pragmatism and compromise in Brexit

“In the referendum on 23 June 2016 – the largest ever democratic exercise in the United Kingdom – the British people voted to leave the European Union…

…But to do so requires pragmatism and compromise on both sides.”
UK PM Theresa May in the foreword to the White Paper on the Future of the UK’s relationship with the EU, July 12 2018.

TWO years after the UK voted to exit the European Union, they are still there. How can this be? It seems that the same non-market forces that created the EU cartel have taken control of the Brexit thing.

Were it left to market forces to guide the exit my guess is that,

1. The exit would have been completed by now; and
2. Profitable trade links would remain and the bureaucracy ditched

But it’s not up to the market to decide what to keep and what to cut. The clearly visible hands of the non-market appointed negotiators have taken a simple problem and complicated it. Theresa May’s statement above is classic professional politician inertia and the entire document is poetry as opposed to science, but I particularly like the reference to ‘…pragmatism and compromise…’ for the following reason:

Free trade entails loading up a container with stuff and sending it to somewhere to people who want it. Finding customers and delivering a product at a price which satisfies each party to the transaction – buyer and seller – is the ultimate expression of ‘…pragmatism and compromise…’. Ironically, Mrs May hit the nail on the head – leave it to the market! – but she neither understands it nor did she mean it.


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Surviving the Value Quicksand

Value investing refers to buying stocks at less than their intrinsic value. Warren Buffett is considered an extremely successful value investor. While Buffett continues to perform well, many of his value investing counterparts have struggled over the last five years as technology stocks, in particular, have attracted investment capital. Value Guru David Einhorn, for instance, has underperformed the S&P 500 by nearly 50%. The Russell growth index has outperformed the Value index by 38% over the last five years.

I first encountered value investing when I began working at JPMorgan Investment Management. I was intrigued by the method that they adopted, the so-called ‘Dividend Discount Model’ or present-value calculation. JPMIM employed a large number of equity analysts to forecast the dividend profile for a company which was then equated with the company’s current market price to get the implied discount rate. This ‘dividend discount rate’ (DDR) was central to the value philosophy since an increase in a company’s stock price would cause the DDR to fall (assuming the analyst dividend forecasts remained constant) thereby making the long-run rate of return lower. DDR’s should rotate from high (cheap) to low (expensive) as prices moved lower to higher. This ‘rotation mechanism’ is logically attractive and my first job at JPMIM was to understand whether the DDR actually ‘rotated’ the way people believed it should from a quantitative perspective. It didn’t…

One only had to look at the data to realise that the DDR did not mean-revert since many of the critters would just hang around the same level for years indicating the stock was forever-cheap or forever-expensive. Moreover, different analysts displayed different forecast biases meaning one set of DDRs were systematically higher than another set. A few weeks studying the dataset led me to the conclusion that value investing can ‘get stuck’ when the assumptions determining the level of the DDR are wrong. Getting stuck happens when you hear comments like ‘I’ve never found a cheap tech stock’ or ‘why hasn’t the market realised that this stock is a screaming buy’. In its most brutal form, getting stuck is when Guru’s like David Einhorn lose all their assets and their reputation is ruined. Getting stuck is like sinking in quicksand…

The solution to this DDR-level problem, to me, was and still is, simple. Rather than focus on levels, it is better to focus on changes. It is trite time-series practice that, if you suspect that a variable has an unstable or inestimable mean, you can eliminate the problem by simply differencing it away. DDRs, like share prices, can meander aimlessly for months and years until new information hits which then jump…so it is the change in the DDR that carries information as opposed to the level.

So how does this differencing idea work? A neat result from statistics is that if you think that a stock should trade at 10 times earnings, then the change in the stock price should also be 10 times the change in earnings. The ’10 times’ is a parameter that you can estimate using either levels or changes and it should be the same. If it turns out that this parameter estimate is wildly different when using levels v changes then you have a problem in your valuation process. Put another way, if for some reason your pessimism never makes a tech stock look cheap, no one is going to question the value-based wisdom of buying tech stocks that have just gone down by 25% – they may not be cheap but they just got a whole lot cheaper!


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From Communism to Militaryism to Money Worship

A diplomat is a man who thinks twice before saying nothing” – WInston Churchill

“He would be there, he would be running his country, his country would be very rich.” – Donald Trump 17 May 2018 on his vision for Kim Dong-Un’s role in a future North Korea

Kim Il-Sung established the modern North Korea in 1948 as a Communist-Agrarian state modeled on Maoist China. When China’s reformists jettisoned Communist ideals, North Korea quietly removed all constitutional references to Communism under Kim Jong-Il in 2009 replacing them with a commitment to “Songun” or “Military first”, so adopting military rule as the supreme source of authority. Kim Dong-Un, the grandson of Kim Il-Sung and son of Kim Jong-Il, seems poised to re-orient the North Korean state once again, only this time toward Trump-ism which is a form of Money Worship…

If this astounding political transformation transpires, the history books will falsely portray Trump as a masterful diplomat and Kim Dong-Un as a courageous reformer. Why falsely?

Winston Churchill’s description of a diplomat does not apply to Trump. When confronted with the potential summit-stopper over Mr Kim’s post-cold war role in the World, Mr Trump could have side-stepped the issue with indecipherable blather. Instead he promised Mr Kim that the US would not undermine his power, instead creating the way for him and his Generals to become oligarchs. Summit-On!

Kim-the-Courageous will be another false historical narrative. The story will be that Kim Don-Un had always intended to bring North Korea in from the coldd but had to purge the Military first to assert his power. The purge was, indeed, brutal. But the trigger that pushed the youngest Kim of his dynasty towards Money Worship was the message he received from the greatest Money Worshippers of all – China. Lobbing missiles over Japan was unacceptable, so get with the program, get rich or get out!

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Coase in CryptoLand : a convertible ecurrency is born

Facebook makes its money by selling its users’ data to advertisers without compensating users for that information. In micro-economics this is labelled a ‘free ride’ and ‘an externality’ and is an example of market breakdown. Markets have a habit of rectifying themselves and, indeed, Ronald Coase won the Nobel prize for discovering that markets will internalise these externalities so long as property rights are clearly allocated and enforceable. The Coase Theorem argues that Facebook’s ‘free data ride’ can be rectified by giving users ownership of their data. Users are then free to trade these rights with whomever they choose.

While Facebook’s free ride (and they are not alone!) is well established, rectifying the ongoing plunder has escaped the online community. This is as much due to the naivety of users who quite freely permission application developers to take all the data they can feast on, as well as the difficulty of coralling and controlling one’s data so that it remains safely guarded. Is it possible to construct a system where data remains the property of the individual?

Crypto, Smart contracts and Blockchain would seem to offer a solution to this problem. As Coase pointed out, the critical element for a market solution is the allocation of property rights. It is one thing to claim ownership of data, but is another thing to be able to exclude others from using it (unless they pay). If every individual were to maintain a secure Digital Data Wallet (DDW) then their data is theirs to deal with. Most of us keep our data in our head or written down or on a private network and stored out of the sight of others, so the DDW is an easy concept to implement. Tokening linked to a Smart-contract comes into its own now, since not only can it be used to buy or sell data, it also can be tagged to each data item that is permitted to be used by, say, Facebook. Together with a private blockchain, this tag will follow the use of the data item and only permit its use for the agreed purpose. The token/contract is like a licence which is paid for by Facebook (or others), tracked by blockchain and protects the data from third-party distribution without the permission of the owner.

The value of the data is open to negotiation and can change with behaviour and evolution of the internet itself. Standard currencies such as USD are acceptable numeraires to facilitate transactions but an online Crypto-currency seems better suited to price an online asset such as data. In fact, a currency that is backed by DATA would seem to have real value as opposed to just being the electronic rendition of regular fiat money. By this I mean you could think of a generic unit of ‘DataCoin’ representing ’10 email addresses of people who earn $100k per year’. The issuer of DataCoin has purchased 10 email addresses of people who earn $100k per year [or 20 email addresses of people who earn 50k per year] for every coin they dispense and any owner of a DataCoin is entitled to convert one DataCoin for 10 email addresses should they want to cash it in. The ownership of the data passes from one group to another upon conversion or an investor could just elect to accumulate a fortune in DataCoins representing all those email addresses that people have sold.

What does this all add up to in the end? First, the likes of Facebook are forced to pay their users for their data. Second, a ‘convertible Crypto’ is born.

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Out damn Spotify!

“Without underwriters, Spotify shares won’t debut with a price based on investor feedback, with buyers lined up.” Bloomberg January 4, 2018.

Spotify, the digital music platform, intends to list publicly this quarter. Instead of an Initial Public Offering, where the company simultaneously lists its shares and raises capital at the same time, Spotify intends to just start trading on the NYSE one day. IPO’s are major events involving Investment Banks (IBs) whose job is to place the new issue with investors, sometimes underwrite the deal and generally to make a lot of noise. For their troubles, the Investment Bank will typically charge a 7% fee on the capital raised during the IPO. Spotify has been valued in the private market at $13billion and therefore intends to cut out the Investment Banking fees associated with their listing.

Needless to say the IB community are aghast at the potential challenge that Spotify’s listing route poses to their franchise. The average IPO is underpriced by about 15%, which means that those IB clients who are fortunate enough to receive an allocation profit by about 15% at listing. Spotify see this as a gift from their existing owners to the IB’s clients which, for each $1billion raised in an IPO, amounts to a gift of $150million. Advising on an IPO is not actually risking your own money, so Spotify think that the money is probably better spent rewarding their existing shareholders for their loyalty.

The IB community have mounted a campaign to question and derail Spotify’s disruptive approach and the Bloomberg quotation is an example of the fear being whipped up. The statement that “…Spotify shares won’t debut with a price based on investor feedback…” however, is pure air. It implies that the IB monopolises the ability to value a company and that the final investors on the buy-side are just dumb animals who are incapable of understanding valuation. Corporate advisors who think they are indispensible need only look at the software developers who now occupy the desks where their sales and trading buddies used to sit to realise what is coming. The buy-side are not dumb animals, they are risk-takers and Spotify have decided to cut out the sell-side ipo-sideshow in favour of a listing method which shifts the pricing responsibility directly to the final investors. Just as the final buy-side investor has benefited from tighter bid/asks as computers replaced traders, the buy-side will benefit from the disintermediation of new listings.

How would Spotify’s approach to listing work? Rather than opening up 15% over the placement price, the market will open with an electronic auction. Buyers and sellers willing to express a bid or offer are matched off until the market clears and settle at the average average price. After that, the market is left to trade according to order flow. My prediction is that it will only take a few minutes before a price is discovered and a few days for it to be reinforced with two-way volume flow. If I am right and an orderly market is established without the IB, then the expensive razz-matazz surrounding the IPO process will have been exposed as a fiasco. This will prompt every prospective public listing candidate to consider the same approach. We may never witness a traditional IPO ever again!

In Shakespeares play Macbeth, Lady Macbeth famously uttered “out damn spot” while haunted by the apparition of blood stains on her hands over the murder of the King. A lot of Bankers are similarly haunted by the prospect of their IPO gig being disrupted… “Out damn Spotify”!

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Did Crypto’s crash or did they just have a bad hair day?

October 18 1987 goes down as the worst day in the US Stock Market when the S&P500 lost 22.6%. This was nearly twice the decline experienced in 1929’s ‘Great Crash’. The panic that followed occupied the financial pages for months.

On January 16, 2018, the CryptoCurrency CCI30 index of the 30 most traded currencies fell 22.9%. But as the following list of Reuter’s top news stories, the CryptoCrash did not even rate a mention.

So when is a crash not a crash? To put it in perspective, Crypto’s are volatile critters for reasons not worth mentioning here. For instance, in 1987 the daily standard deviation of return for the S&P500 was 1.1% whereas the daily standard deviation of the CryptoIndex is 4.5%. [Standard deviation is one way of quantifying the volatility of a risky security].

Put simply, Crypto’s are 4 times more volatile than stocks by this metric. This means that the 22% decline in Cryptos that occured last Monday only feels like a 5% fall in the US stock market – a bad hair day certainly but not worth jumping off a building over. A better way of thinking about it is that Cryptos would need to fall by 88% in one day for it to feel like Black Monday in October 1987 – a near total wipeout.

So punters, don’t expect to hear much about CryptoCrash in the newspapers until that market effectively disappears!

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Throwing the FinTech baby out with the Crypto-bathwater

I remember walking back from a conference at the European Central Bank in late 2008 accompanied by the then Head of Risk Management for the ECB. We discussed what the long-term impact of the Global Financial Crisis that we were experiencing was likely to be. My comment was that regulation would take centre stage post-crisis, particularly since the major private financial institutions had both sought and been granted support from their regulators. My prediction proved correct as, in fact, the banking business has been beaten up and dumbed down by the regulators post-GFC. The banking community has been fined and restructured almost out of existence, forced to ‘pay the piper’ or lose its future…

As the phenomenon that is Crypto rages around us, I cannot help but reflect on that conversation. It’s only a matter of time before the gravity-defying Crypto bubble collapses back to the fair-value price of the electrons that these assets are actually worth. In the meantime, great quantities of wealth will have been redistributed from one socio-economic group to another. The winners, those who substituted their electrons for worldly riches, will live large but remain largely silent through fear of retribution. The losers, those who traded their families’ means of existence for a handful of electrons (at least Jack traded his for a handful of magic beans!), will shout loudly and for a long time…and they will naturally turn to the Government for compensation.

Irrespective of what one’s view is of the value of a crypto-currency, the innovation shares features with the FinTech world which have brought benefits to the financial sector. Crypto related FinTech benefits include (i) the Blockchain which has potential to cut transaction costs for every investor, (ii) the fact that regulators have been forced to review their securities laws and (iii) the electronic issuance of new crypto related securities such as ‘Asset-backed tokens’ and ‘Stapled-tokens’ may well lead to efficiencies in the IPO markets generally. But if Governments are convinced to step in to avert a ‘systemic crisis’ during a Crypto-crash then the easiest reaction is to shut the whole thing down. Regulators already have their fingers on the trigger and it would be a shame if the whole FinTech sector was punished for the excesses of a few.

Throwing the FinTech baby out with the Crypto bathwater is a real risk if regulators are forced to write cheques to those who suffer losses in the impending Crypto-bust. Moreover, if the regulators shut the whole thing down, Cryptoland will never be able to regenerate itself in the way that the more intelligent use of the internet grew out of the dotcom bust.

The lesson from the GFC for Crypto-land is don’t put your hand out for support when the fuse blows. Shut up and die like a motherboard.

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