Speech to Insurance Regulators: Fixing a Fixable Solvency Risk to Insurers

Slides available here:  naic_long_miami_dec2016_vfinal

Thank you to the National Association of Insurance Commissioners (NAIC) for your invitation to speak at your Fall meeting about how blockchain technology can fix a low-probability, but high-severity threat to insurer solvency:  lack of beneficial ownership tracking of securities by the securities industry.

Blockchain is not the only solution to this problem, but it is an exciting and complete one!

I care passionately about restoring title to the true owners of securities–in other words, giving asset owners direct ownership in their assets–and this is a major reason why I jumped to a blockchain start-up after 22 years on Wall Street.  No, you do not actually own the securities you think you own in your brokerage account!

During nearly all of those 22 years on Wall Street, I was fortunate to work in and around the insurance industry and care deeply about its financial health.  In the old days during regulatory exams, insurance regulators used to audit the paper certificates held in insurers’ vaults to verify that securities recorded on Schedule D were actually there.  This is no longer possible to do today, owing to the indirect manner of securities ownership and the use of omnibus accounts by layers upon layers of securities industry intermediaries.  It’s time to go back to the future and restore beneficial ownership tracking–or, better yet, actual ownership of securities by those who think they already own the securities!

With permission from my company, Symbiont, I’ve included my NAIC E Committee presentation slides in this blog post.  This is my second speech to the NAIC on this topic, and the first in a public forum.

As Delaware Chancery Court Judge Travis Laster said in a recent speech to institutional investors, “I want you, the institutional stockholders of America, to take back the voting and stockholding infrastructure of the U.S. securities markets…The current system works poorly and harms stockholders…The plumbing needs to be fixed.  A plunger exists.  The takeover [of securities industry plumbing by institutional investors] doesn’t have to be hostile.  It can be friendly.  But it needs to be done.”

Indeed, it does.

As I’ve said many times, the biggest beneficiaries of blockchain technology are long-only investors:  insurance companies, pension funds, mutual funds, and Mom & Pop investors.  They’re the biggest losers from today’s lack of beneficial ownership tracking in the securities industry.

I stand ready to educate and assist the insurance, pension and mutual fund industries in fixing this problem.  How can regulators measure insurer solvency when securities–especially U.S. Treasuries–may be over-issued?  Even federal securities regulators do not know how leveraged the financial system truly is, because multiple financial institutions report that they own the very same securities at the same time–and securities regulators have no means by which to back out the double- or triple-counting of assets.

Lack of beneficial ownership tracking is a low-probability but high-severity risk to insurer solvency, but it is real.

Blockchain technology is one of many possible solutions to the problem.

Thank you for your interest!

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MUST READ for Corporate/Securities Lawyers Regarding Blockchain

Delaware Chancery Court Judge J. Travis Laster makes the crystal-clear case for why the securities industry should embrace blockchain in this terrific speech. He shares my concern for the securities industry’s plumbing mess that prevents people from actually owning the securities we think we own, and he lays out the gaps between Delaware corporate law and federal securities law that have caused some very expensive balls to drop.

In Judge Laster’s words, “The good news is that you have a plunger that you can use to clean up the plumbing. That plunger is distributed ledger technologies, the technology that underlies bitcoin.”

“The current system works poorly and harms shareholders…These technologies could reunite legal and beneficial ownership of stock and eliminate many of the problems identified [in his speech].”

INDEED, Judge Laster!!!  Well done!!!

http://www.cii.org/files/09_29_16_laster_remarks.pdf


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Caitlin’s Top 10 Blockchain Predictions for the Next 12 Months

 

Below are the welcoming remarks I gave as chairman of IMN’s blockchain conference, which was held on September 28, 2016 in New York City. IMN has kindly given me permission to reprint them here. Enjoy!

 

Good morning and welcome to IMN’s Blockchain Conference!  Julius Hill, CEO of IMN, asked me to chair this conference to bring perspectives from the three different hats I’ve worn in this young ecosystem:  (1) a bank hat (serving on Morgan Stanley’s distributed ledger technology working group beginning in 2014), (2) an independent hat (working over the spring and summer to advance the ecosystem, especially with regulators) and (3) a start-up hat (joining Symbiont as chairman and president a month ago).

Specifically, Julius asked me to speak about where the ecosystem stands and where it’s going.  

 

Where do we stand?  

One word:  deluge.

The deluge is coming from potential customers–if you think about it, it’s quite unusual that customers are beating down the doors of vendors, not the reverse, but that’s what the ecosystem is experiencing. The deluge is also coming from regulators, who want to see demos of the technology in action. And the deluge is also coming from personal networks.  Just for fun, I counted the number of people who sent me direct-messages on social media alone during my first week at Symbiont, not counting emails or calls:  208 people. And it was the week before Labor Day.  And it hasn’t slowed down that much. Others in the ecosystem are experiencing the same, so the deluge is not unique to Symbiont or to me.

Something big is happening.

Duncan Niederhauer shared what I think is the best insight about it. He’s the former CEO of the NYSE, and before that he ran equities at Goldman Sachs. He was early to join the boards of two blockchain start-ups. His insight? Most of the innovation on Wall Street came from the front office during the past couple of decades. Innovation will come from the back office in the coming decades, for myriad reasons.  I think he’s right.

Credit Suisse’s announcement yesterday is a perfect example of why he’s right. Credit Suisse executed a syndicated loans pilot through the R3 consortium, in which 14 major financial institutions participated. This is the most complex proof-of-concept undertaken to date in blockchains. It’s also the first project in which multiple buy-side firms participated. And Credit Suisse announced that the project successfully met milestones, not merely that it kicked off. Yes, big things are really happening.

And that brings us to today’s conference. 300 of you are here today, representing all major banks, exchanges, credit card companies, clearinghouses and buy-side firms. All major financial sector blockchain companies are here, as are 18 corporate sponsors. And an issuer is here too–Overstock.com, whose CEO will give the keynote this afternoon.  

 

And where do we go from here?  

Frankly, it’s easier to talk about the end state for blockchain implementation than it is to see the the near-term steps to get there. So I’ll throw caution to the wind and predict 10 things that will happen in the next 12 months.  All predictions are my own and are not endorsed by IMN or my company, Symbiont. And they’re worth the piece of paper they’re written on, which is not much! These are “educated guesses” based on the breadth of what I’ve seen in the ecosystem, not based on direct knowledge.  

Also, none of these are investment recommendations, so please do not rely on them in your decision making. Caveat emptor!

Here are my predictions for the next 12 months in blockchains:

  1. A well-known private company will kick off preparations for its IPO on a blockchain, thus forcing a fundamental change to the plumbing of securities offerings on Wall Street. I’d bet most people who work in the securities industry don’t even understand that when entrepreneurs take their company public in an IPO, they’re required to sign over title to every single share of the company to the DTC — even shares the entrepreneurs aren’t selling in the IPO. If I’m an entrepreneur, why would I be happy about that? If there’s a viable alternative that allows entrepreneurs to keep title to their own shares, I see the IPO market pivoting to it quickly. Yes, I think that will start to happen within 12 months and a big, important issuer will drive this change. 
  2. Banks will widely adopt blockchain in the syndicated loan market, finally eradicating the fax machine as a prevalent means of communication among parties in this market. 
  3. Insurers and reinsurers will complete a reinsurance syndication on a blockchain. 
  4. A credit card company will deploy a blockchain as its network in mobile payments. 
  5. Bitcoin will generally continue to trend “up and to the right” — in hashpower, transaction volume and price. (But I explicitly do not recommend buying or selling bitcoin!) 
  6. “Failures to deliver” will start happening, as some blockchain start-ups and projects will fail to keep up with their hype. I think a shake-out has already begun, through which a very small number of production-quality blockchain platforms will break out as clear leaders based on what they’ve actually done, not what they might someday possibly maybe do. Folks, it’s hard to deliver blockchain software that meets institutional-level requirements for performance, security and functionality. And let’s face it — players in this ecosystem issue press releases at the drop of a hat, announcing that they’ve started a project or contributed X thousand lines of code, but it seems very few press releases disclose something actually finished, or a milestone met, or software that demonstrably works well. Within the next year, an enterprising reporter will dig into this and write a critical, “big reveal” story. 
  7. More central banks in small countries will follow the lead of the central bank of Barbados, which green-lighted a blockchain start-up called Bitt to create a digital Barbados dollar that uses Bitcoin’s blockchain as an alternative method for settling foreign exchange. Small central banks are searching for alternatives because local banks are losing access to US financial system, owing to the retreat of American correspondent banks from small countries — a trend called “de-risking.” This is choking off trade, which is the lifeblood of most small economies.  Folks, this an unintended consequence of laws requiring U.S. banks to comply with strict anti-money laundering and know-your-customer regulations. These laws are hurting the developing world — and, ironically, boosting Bitcoin as a valuable alternative payment system. Kudos to Barbados for its creative solution! 
  8. Overstock.com will complete the first public securities offering on a blockchain, and skeptics will be surprised at how well the blockchain-settled securities trade relative to Overstock’s existing common stock. 
  9. The Delaware Blockchain Initiative will improve the delivery of all kinds of government services by the State, which will fundamentally boost its relationship with its constituents. Other states will follow Delaware’s lead. 
  10. The Bank of England will issue sterling on a blockchain, causing the pound to become the preferred intermediary currency for cross-border payments and creating a new competitive advantage for London’s financial markets post-Brexit.

OK, I may be too optimistic on a few of these (especially the timing of #10). Caveat emptor! These predictions are worth what you paid for them.  But I believe they’re all directionally correct. It will be a most exciting year ahead!  

Why I Chose to Join Symbiont

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Far and away the best prize that life has to offer is the chance to work hard at work worth doing.”   – Teddy Roosevelt

The blockchain community is hard at work, doing work that’s worth doing.  I’m elated to join it full-time!

Recently I became president of Symbiont and chairman of its board of directors.

I chose to join Symbiont because we have the best technology platform for financial sector uses, and we have a great strategy.  Our software works.  It’s fast.  It’s secure.  It does many things competing platforms cannot do.  Ours is the only smart contracts platform that was purpose-built for institutional financial markets.  We’re ahead of our peers in the race to build production-ready software, because it’s already going into production.

Symbiont’s strategy met my two philosophical criteria for joining:  (1) investors will actually own the assets issued on Symbiont’s blockchain, which is a huge improvement relative to how securities are owned in today’s market structure; and (2) Symbiont’s platform can store all transaction data and documentation in a secure, anonymous manner without sacrificing institutional-level network speed.  (Our speed is multiple orders of magnitude faster than competitors, as we detail below).  Consequently, regulators can gain a tool they do not have today:  a real-time view into how leveraged the financial system is.  This capability of our platform more broadly opens a new “regtech” frontier.  If you follow my blog (here and here), you know how passionate I am regarding these two topics!

My informal collaboration with many different blockchain start-ups began 2½ years ago at Morgan Stanley, where I served on its distributed ledger technology working group.  I’ve been working (unpaid) to advance the ecosystem since leaving in April 2016.  The journey from Morgan Stanley to Symbiont was amazing, partly because it involved digging into multiple projects with blockchain players—from start-ups to consulting firms to software companies to regulators to potential consumers of the technology.  It brought me through Janet Yellen’s office at the Fed, to the floor of the UN as a conference delegate, to a workshop with the 50 state insurance commissioners, and to discussions with Washington regulators about how blockchain technology can help fix deep problems in the financial system.  But it also entailed a difficult decision to step away from my other passion:  fixing the pension problem.

So now begins, for me, the long journey to bring the huge benefits of blockchain technology to fruition, thereby helping our customers do things in simpler, cheaper and faster ways—while making capital markets fairer, safer and more transparent as we go!

Why I Chose Symbiont

  • Symbiont’s competitive advantage is our smart-contracts technology.  

Our architecture is designed specifically for financial services uses.  It’s sophisticated and it’s fast.  It can support substantially more functionality, in spite of its superior performance, relative to competing distributed ledger solutions.

Smart contracts enable our customers to automate operational workflows that today are inefficient, error-prone, sometimes manual, and always require reconciliation across parties.  

Smart contracts are all the rage, but most competitor platforms cannot offer full smart contract functionality because they are developed as extensions to Bitcoin’s payment model, which is fundamentally too restrictive for smart contracts in institutional financial services.  A tiny number of true smart contract platforms exist.  Of those, Symbiont is the only one purpose-built for financial services.  

 Distributed ledgers themselves cannot automate business processes but smart contracts can.  The blockchain industry generally has not distinguished the various components that make up what we call a blockchain, which is why many of our competitors’ platforms have tightly coupled their consensus systems and smart contracts systems.  By contrast, since its earliest days, Symbiont has enforced a clear distinction between these components, making its system significantly more elegant and powerful.  A consequence of this design decision is that Symbiont’s smart contract system can run on any distributed ledger.  (But it runs on our own because it’s the best!  Details below…)

Before moving to the next point, I must share that I’m an Ethereum fan and am involved with the SingularDTV project.  In the institutional financial services arena specifically, I believe Symbiont’s platform will win.  Symbiont’s smart contracts can do things that are mission-critical for financial institutions and that Ethereum-based smart contracts cannot do, mostly due to Ethereum’s language and protocol limitations.  One example is the case of parties agreeing to amend a smart contract after it’s published to the blockchain (i.e., the infamous DAO).  Contract amendments happen all the time in financial services, and Symbiont engineers built our smart contracts to anticipate such real-world financial services functionality.  Symbiont offers protocol-level support for amending contracts.  By contrast, Ethereum has none.  Only Symbiont’s system allows both the code that determines the contract, as well as the contract itself, to be modified at any time by agreement of the parties.  This is just one example that demonstrates why the financial sector needs purpose-built platforms.

 

  • Symbiont’s platform has more functionality, with superior performance and security, relative to competing blockchains.  And it’s already going into production.  

Symbiont’s platform can store data in a private and secure way, without sacrificing institutional-level speed.  The ability to store data on-ledger—including all transaction documents—is huge, and will immeasurably help everyone (the contracting parties, operational staff, auditors and regulators) keep track of what really happened in a business transaction.

Symbiont’s platform is not merely a shared, timestamped log to record that an agreement took place, which is exactly what many competing platforms are.  Rather, on Symbiont’s platform all the terms of the agreement are recorded on-ledger, and that’s why we call our smart contracts “smart securitiesTM.”  A Symbiont colleague put it this way:  a timestamping ledger can guarantee that you won’t lose your trade confirmation, but it doesn’t help with much else—so it’s not very meaningful.

Symbiont’s system is capable of being used as a record-keeping platform, allowing storage of archival data (e.g., Delaware Blockchain Initiative) and maintaining a chronological record of multiparty workflows and signatures (e.g., syndicated loans and reinsurance syndications).  This aids in compliance, regulatory reporting and dispute resolution.  So in addition to being able to automate business processes via smart contracts (by recording inputs, recording and executing business logic, and then recording outputs on-ledger, on a confidential and immutable basis), Symbiont’s platform is a whole new breed of market infrastructure.

Symbiont’s smart contracts platform is modular—built up from multiple software services with distinct functionality—while competitor platforms are monolithic pieces of software, with limited modularity.  This means we can spread smart contract execution across multiple machines—achieving superior scale, performance, resiliency and ease-of-updating relative to our competitors.  It’s harder to build service-oriented software that works, but Symbiont has done it and our clients already appreciate our consequent greater functionality and potential for further innovation.

And here’s what’s amazing:  Symbiont figured out how to store user data anonymously on-ledger while still achieving institutional-level network performance.  Symbiont’s ledger is currently processing 80,000 transactions per second in a single region, and tens of thousands per second globally.  Plus, transaction latency is on the order of milliseconds.  So Symbiont’s software is not just outperforming all competitors whose comparable statistics we know—it’s outperforming them by multiple orders of magnitude.

Symbiont’s ledger is currently processing 80,000 transactions per second in a single region, and tens of thousands per second globally.  Plus, transaction latency is on the order of milliseconds.  So Symbiont’s software is not just outperforming all competitors whose comparable statistics we know—it’s outperforming them by multiple orders of magnitude.

Competing systems are hybrids that store data and business logic somewhere else, requiring disparate systems to communicate over multiple channels, using the ledger just as a timestamping mechanism.  Our system, on the other hand, supports encrypted, point-to-point communication over the ledger itself, allowing us to put all business logic on-ledger while meeting the financial industry’s standards for privacy.  We think storing data and business logic on-ledger is fundamentally necessary to achieve the true promise of blockchain technology, which is the radical simplification of business processes.  It’s hard to create software that achieves this and is fast, but our development team did it.  Symbiont is better!

News that Symbiont is already implementing our platform at a production level may surprise industry watchers because Symbiont has kept a relatively low profile, and intends to continue to do so.  Our publicly disclosed customers include the State of Delaware (Delaware Public Archives project) and a top European insurance company (catastrophe swap pilot project).  Other customers are not yet disclosed.  If you’re not familiar, Symbiont was the first blockchain start-up to eat our own cooking by issuing securities in our own company on our platform, which happened already more than a year ago (on August 4, 2015).

 

  • Symbiont’s platform focuses on newly originated assets, not on tokenizing pre-existing assets.  

A former colleague once wisely observed that existing IT architecture in financial services merely digitized legacy business processes, and that the sector hasn’t yet reaped the true benefits of digitization because its business processes are stuck in the pre-digital age.  What wisdom!

On Symbiont’s platform, financial assets will exist natively on the blockchain during their entire lifecycle, from origination to maturity.  They won’t ever exist in paper form.  This contrasts with competing platforms that tokenize existing assets previously issued in paper form.  I believe tokenization-focused blockchain start-ups will add value too.  But tokenization does not fundamentally change inefficient business processes—actually, it adds extra operational steps to tokenize existing assets.  Maximum efficiencies are achieved by radically simplifying business processes.  That’s what Symbiont’s technology does.

Maximum efficiencies are achieved by radically simplifying business processes.  That’s what Symbiont’s technology does.

 

  • Symbiont has prioritized building our tech to create a first-mover advantage.  

I commend Mark Smith for his strategy to build a lean, developer-heavy team from the beginning.  Surprisingly few of our employees don’t write code!  It’s why Symbiont has a first-mover advantage.  The team’s results speak volumes.  Symbiont is ahead of its peers in delivering a distributed ledger and smart securities platform that already works.

Symbiont’s strategy to prioritize building the software comes from his deep experience as a successful fintech entrepreneur.  Symbiont is the 6th fintech start-up Mark co-founded.  Of his prior five, four had successful exits (The NexTrade ECN, MatchBook FX, Lava Trading and Anderen Bank of Tampa Bay), and the fifth is still operating.  It’s a privilege to work with him, his co-founders, and the terrific team of rocket scientists they’ve built!

 

  • Symbiont is currently focusing on 3 product areas—the Delaware Blockchain Initiative, insurance and syndicated loans—and all of them are ripe for big improvements in business processes.  We are a fintech, insuretech and regtech company!

I’ll just touch the surface here.

It was Mark Smith’s idea to approach Delaware with the proposal to change corporate law to enable corporate registrations on a blockchain, along with counsel Marco Santori of Pillsbury.  Delaware’s governor embraced it.  By giving corporations a choice to register either via traditional stock certificates or on a blockchain, likely by early 2017, Delaware will unlock the potential for fundamentally simpler business processes during a corporate lifecycle—from initial incorporation, to capital raising, to M&A, to investor communication and to winding up.  Delaware’s move will also unlock the potential for radically simpler business processes in the securities industry.  Practically speaking, I expect Delaware’s action to impact markets for private equity, IPOs, asset-backed and mortgage-backed securities, and commercial real estate.  Symbiont is already working with Delaware to record its state archives on Symbiont’s platform by creating a new category of smart assets called smart records.  The State is constructing a roadmap for adding other government data to Symbiont’s platform—potentially including government data such as professional licenses, property deeds, liens and birth/death/marriage records, among others.  (Again, how many other institutional blockchain platforms can handle such data on-ledger, in a confidential manner and with speed??  Only Symbiont can!)

In insurance, Symbiont successfully provided the technology for a top European insurance company’s catastrophe swap pilot with Nephila.  This has opened the floodgates of interest in blockchain technology from the insurance industry, which is now exploring the possibility of blockchain to reduce risk and operational costs.  I’ve worked in and around the insurance industry for 22 years and have seen many ways blockchain can help both insurance companies and insurance regulators alike.

In syndicated loans, Symbiont has a joint venture with Ipreo, a key market infrastructure player.  The syndicated loan market is a classic example of a business line in which front-office growth outpaced back-office investment, and this is true across the industry.  I was fortunate to dig into this product area with key players before leaving Wall Street.  Faxes and spreadsheets are still commonly used, which means incumbents recognize the need for upgrades and are not firmly wedded to legacy systems.

 

Parting Thoughts

To blockchain ecosystem colleagues, I wish all of you well!  Let’s compete vigorously—and in the process create a fairer, safer, more efficient and better financial system!

To pension industry colleagues, you have important work to do!  There’s so much more to be done in pensions, as I expect >$500 billion of corporate pensions ultimately to settle but only about $45 billion have settled to date.  It was an honor and privilege to work with so many talented people in the field.  Fare thee well!

To financial services colleagues, blockchain technology can increase your return on capital by providing a profitable way to transition from capital-intensive principal businesses to fee-based agency businesses. Software will automate inefficient business processes, thereby allowing the industry to realize the true benefits of digitization—finally!

To corporate clients, I’ll still be focused on helping you solve your challenges—not pensions anymore, but different ones now!  Specifically, I look forward to helping you reduce your cost of capital by improving your execution in securities offerings and loan syndications, and to helping you free up working capital by improving your execution in cross-border payments.  As issuers, Symbiont’s smart securitiesTM platform offers you tangible benefits, and you will hear from us soon!

To my new colleagues at Symbiont, I’m all-in!  I’ve personally stepped up with a substantial investment in Symbiont’s Series A round.  Let’s do this!

No, You Don’t Really Own Your Securities

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That’s right. You think you own securities in your brokerage account, but you don’t.

A company you’ve probably never heard of, called Cede & Co., is the official owner of >99% of the securities outstanding in the U.S. What’s in your brokerage account is probably an I.O.U. See the fine print.

This is a feature of U.S. capital markets that arose for historical (not nefarious) reasons. But those reasons long ago faded, and yet this vestige of yesteryear’s market structure remains. Were we to create a new market structure from scratch, it would look nothing like it does today.

Main Street investors lose, folks! This is a consumer protection issue. Winners are the privileged few who are in a position to exploit leakages caused by this market structure, at the expense of Mom & Pop.


Podcast here (20 minutes long). Try here if it doesn’t load.

Slides available here:  no you don’t really own securities_AS PRESENTED


Pension funds, mutual funds, insurance companies and other types of long-only investors unnecessarily bear (1) counterparty risk, (2) operational risk and (3) over-issue risk that can artificially suppress the value of securities. These 3 risks are inherent to today’s crazy market structure. Securities pass through a chain of leveraged intermediaries and are accounted for on an aggregate (not individual) basis—making it impossible to verify that securities accounting is 100% right 100% of the time. In the podcast and slides, I provide real examples of how investors lost because of this market structure.

An example:  based on the IMF’s estimate of the length of collateral chains, only 1 of 3 investors who believe they own a U.S. Treasury security actually does. In the repo market, multiple investors report that they own the same asset at the same time (usually a Treasury security). Fails are a daily occurrence in the repo market.

Hey, here’s hoping the musical chairs never stop! Seriously. Hope!

The good news? Blockchains solve all of these problems!

Coming changes to corporate law will soon permit issuance of securities directly on a blockchain itself, which will give issuers the option to circumvent this risky market structure altogether—thus avoiding its layers of leveraged intermediaries and inherently opaque omnibus accounting. Delaware (the key state for corporate registrations) is leading the charge, and other states are likely to be very fast followers.

Among the winners from blockchain technology are:

  • entrepreneurs, who will no longer be required to cede their ownership of the shares of the companies they built to Cede & Co. when they go public in an IPO. Folks, a better IPO alternative is coming soon!
  • pension funds, mutual funds, insurance companies and other long-only investors, who will no longer bear unnecessary counterparty, operational and over-issue risks. I believe securities chain-of-custody will soon be standard due diligence for ERISA fiduciaries, fund company distribution platforms, independent fiduciaries in pension risk transfer transactions, and insurance company risk officers. Further, I believe long-only investors who have stronger chain-of-custody arrangements will gain a competitive advantage in gathering assets, not to mention absorb fewer costs for TMPG fails, glitches in posting collateral and other operational hiccups.
  • issuers, who will have visibility into who owns their securities at all times, who can be confident of no leakage in close corporate votes, and who can reduce mistakes involved in shareholder records.
  • Main Street, who will re-gain ownership rights in securities and benefit from FAIRER, safer and more transparent markets.

Enjoy!

American Banker wrote a terrific article on the topic here.

Please read important disclaimer here.

 

 

My Interview by Bob Murphy: Financial Markets, Economics, EMH & More!

Republished with permission from the June 2016 edition of the Lara-Murphy Report, a subscription newsletter available here.

Dr. Bob Murphy, who conducted the interview, is a truly gifted teacher and one of my favorite economics professors. During my tour of alternative economic schools of thought after the financial crisis, it was a pleasure to learn about the Austrian School of economics from Dr. Murphy.

In this interview we touch on negative interest rates, whether the efficient markets hypothesis holds true in reality, and what’s happening with Europe’s banks. We cover what I think the Austrian School of economics has gotten right and—importantly—some things it has missed as well. (Note this interview took place in early June so did not cover the impact of Brexit.) 

Again, this blog does not provide investment advice. Caveat emptor! Please read important disclaimers here and here. Thanks for stopping by!

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Lara-Murphy Report: We interviewed you for the inaugural issue of the Lara-Murphy Report! But for the benefit of our new readers, how did you learn about Austrian economics?

Caitlin Long:  Bob, I learned a lot from your online classes! It didn’t take me long to discover you! But Tim Geithner was actually the spark that got me started in Austrian economics. He was Treasury Secretary then. During a 2008 interview after the financial crisis began, he admitted that interest rates were too low before the crisis and insinuated that was a cause of the crisis. Then, a few days later, I heard him argue that interest rates should be even lower. His contradiction got me digging! So I called a friend and former client—one of the best thinkers on the buy-side—to brainstorm. I remember realizing out loud, “I need to learn how the Federal Reserve works. That’s the key to understanding how this happened.” My pal told me to start reading about Austrian economics, and the rest is history. Since then I’ve explored other alternative schools of economic thought, too, but I continue to believe the Austrians have the best assessment of what’s going on. The Austrian School isn’t perfect—for example, I think its misunderstanding of the shadow banking system caused it incorrectly to predict hyperinflation after the financial crisis—but I think its diagnosis of the problem is by far the best among economic schools of thought.

I agree with Austrians that the interest rate is the most important price in any economy, because it’s the traffic signal that directs entrepreneurs where to invest their capital. When interest rates are artificially distorted, capital misallocation happens. Wealth is destroyed. Interest rate distortions can persist for decades as living standards are maintained through borrowing—and that’s we’re living through today. Globally, we’re eating our seed corn by borrowing against the equity on our balance sheets. Eventually, economies run out of balance sheet capacity to keep borrowing, and then a reset happens—but again, this process can take decades.

Another way to phrase this is that Austrians believe balance sheets really do matter. It became clear on my journey of economic exploration that other schools of thought pretty much ignore balance sheets. Their answer is almost always to borrow/stimulate more, without considering the cost of distortions. Austrians believe in preserving capital to grow wealth.

Bob, I’ve heard you say that you became an Austrian because it’s the only school of economic thought that has a capital theory—I fully agree!

                                                                                                                             

LMR: Last time we talked, we asked you about low interest rates. So now we have to ask: What’s the impact of negative interest rates on the financial sector?

CL: Negative interest rates are a symptom of overleveraged balance sheets—a signal that there’s very little borrowing capacity left in an economy (whether in the household, business or government sectors). Since about 2012, I’ve expected that interest rates would turn negative eventually—and I think rates ultimately will go negative in the U.S., too. In fact we have already experienced brief periods of negative T-bill rates in the U.S. I see no reason to believe the 35-year trend of declining yields on 10-year Treasury bonds will break, because the fundamental driver of this trend is higher debt—and I don’t see debt growth stopping anytime soon. That doesn’t mean rates will be a one-way street lower—rates will go up periodically without breaking the larger downward trend. In fact, every time the 10-year Treasury yield has risen since 1981, it dropped again before reaching its prior peak (on a monthly basis). Lower lows and lower highs—for 35 years! Ask a mainstream economist to explain what why that hasn’t mean-reverted yet!

Obviously, negative interest rates aren’t good for the financial sector, whose business model is generally to earn a spread between asset returns and borrowing costs. Banks are being squeezed by higher capital requirements on both sides of that equation, while also bringing down their leverage. That’s painful for banks. An example is Switzerland, which was early to experience negative interest rates and whose government bond yields are negative out to the longest maturities relative to others. For a couple of years now, Swiss banks have quietly turned away corporate depositors and charged all kinds of new fees to avoid losing money. Most banking professionals assume that negative interest rates are temporary and will mean-revert soon, but I don’t agree. They can persist longer than most of us think they can.

 

LMR: Many Austrian-friendly investors—such as Mark Spitznagel—have been warning that a stock market crash is imminent. How should people think about U.S. equities? There’s a popular school of thought that says the market is always valued according to the best information, and so regular Joes have no business second guessing the current level of the Dow.

CL: Well, I’m not in the business of giving investment advice so won’t predict anything here, but I’ll try to educate your readers about what has been happening so readers can make their own predictions. What you’re really asking is whether the “efficient markets hypothesis” (EMH) is valid. I think the answer is yes, it is—BUT ONLY IF interest rates are set on the free market by the voluntary interaction of savers and borrowers. When interest rates are artificially distorted, EMH doesn’t apply. I was 15 years into a Wall St career before I figured out EMH isn’t relevant because interest rates aren’t set by free markets. To this day, most of Wall Street still adheres to EMH because most trading models are still based on it (for example, the Black-Scholes option pricing model presumes efficient markets). The models aren’t wrong—they just don’t reflect today’s reality because markets cannot be efficient when interest rates are artificially distorted.

So what does this mean for the stock market? Is it overvalued? I could easily make arguments both ways—for example, since an asset’s value is the discounted value of the cash flows it generates, I could argue that all assets are overvalued since discount rates are artificially low. Conversely, I could also argue that the way financial markets price credit risk will be turned on its head when governments eventually run out of debt capacity, in which case money will migrate from public to private assets—so stocks may in fact be undervalued. No one knows how markets will play out because no one knows the sequence of events here in the US or overseas. We just know that prices are distorted—but that doesn’t necessarily mean they will revert anytime soon! As a student of economic history, I realize these distortions have existed for much longer I’ve been alive—and longer than my parents were alive, too. Yes, the distortions are bigger than ever today. But some Austrians have been predicting a dollar crash for decades and it hasn’t happened yet.

I think the most interesting question is why these distortions have been able to persist—that’s something about which I’ve done a great deal of thinking. In essence, the US entered its period of inflation (of money and credit) with an incredibly strong balance sheet—and we’ve been drawing down the economy’s equity for decades to support new borrowing. The fact that the US economy’s balance sheet still has equity (i.e., assets > debt) explains why a big correction in the US dollar hasn’t happened yet.

 

LMR: You brought to our attention years ago an analysis that showed even a modest rise in Treasury yields would render the Fed insolvent—meaning its assets would have a lower market value than its liabilities. Do you know what that analysis looks like today? Do people in the markets worry about things like this?

CL:  Yes, that description still holds true. The Fed created what we call a “duration mismatch” by getting into the business of maturity transformation with Operation Twist in 2011, when it started buying long-dated bonds to bring down long-term interest rates. This means the assets on the Fed’s balance sheet are longer-dated than its liabilities. At my last calculation, the duration mismatch on the Fed’s balance sheet was about 5 years—in other words, the duration of its assets was as about 5 years longer than the duration of its liabilities. The Fed’s balance sheet as of June 2, 2016 had $40bn of equity capital supporting assets of $4.46 trillion. In other words, the Fed’s balance sheet is 111.3x levered. The Fed doesn’t mark its assets to market value, so that leverage number appears worse than it actually is on a market-value basis. But still, mathematically, it would not take a large increase in interest rates for the Fed’s equity capital to be consumed by the declining market value of its bond portfolio.

You ask whether people in markets worry about this, and I think the answer is only a handful of people worry about it. The typical response is to point out that the Fed can write checks on itself by doing more QE if it needs to—but that actually exacerbates its leverage. I’d put this in the category of a distortion that can persist for years, with very few caring about it—until someday it matters a lot.

 

LMR: We keep reading doom and gloom reports on Deutsche Bank. Is this a one-off fluke or is there something more fundamental that’s awry?

CL: I can’t opine on a particular bank, but it’s a fact that Europe’s banks have been more leveraged than America’s banks for quite a long time—and I think America’s banks are still too leveraged as well. But, again, this does not mean the situation will correct anytime soon. Notice a theme in my answers—lots of distortions, but they’re not new and Keynes was right when he said markets can stay irrational longer than you can stay solvent. I don’t know what will catalyze a return to rationality, or when! In the meantime, we need to work to feed our families! We can’t hide under a rock, nor should we! The right way to think about these issues is to recognize that they exist, and do your best to adjust for them when putting your hard-earned capital to work.

I’ve always pointed to one simple fact about Deutsche Bank, which has been true for a while—Deutsche’s derivatives portfolio was roughly the same size as JPMorgan’s for several years, but Deutsche had about one-third of the equity capital of JPMorgan (meaning Tier1 + Tier2 capital). Recently, this situation has improved slightly—at year-end 2015, Deutsche’s derivatives notional was EUR 41.94 trillion on total risk-based capital of EUR 60.98 billion, compared to JPMorgan’s at $51.14 trillion and $176.42 billion, respectively. So just on this simple measure you see that Deutsche is a lot more leveraged than JPMorgan. Now I’m not opining about JPMorgan’s leverage—if you look it up in the OCC’s database, you’ll see that JPMorgan’s credit exposure from derivatives alone was 209% of its total risk-based capital at year-end 2015. JPMorgan is one of four US banks whose credit exposure from derivatives alone exceeds its total risk-based capital (the others are Citibank NA, Goldman Sachs Bank USA and HSBC NA). Please don’t make any decisions based on these facts—I expressly disclaim any and all advice on what to do here! Caveat emptor! And again, none of this is new.

cait-chart

Source: OCC Quarterly Report on Bank Derivatives Activities, Q4 2015

It’s clear to me that regulators are working to fix this—they face a delicate balance between clamping down on bank leverage and preventing an economy-wide credit contraction. For example, on June 3rd the Wall Street Journal ran a headline story outlining a “probable” increase in the capital requirement for the biggest 8 banks in the US—on top of the myriad increases they’ve already had. Only time will tell if the regulators’ strategy of steady, consistent increases in banks’ capital requirements will have been the right one, or whether they will have been too slow. Remember that Mises said, “Economics recommends neither inflationary nor deflationary policy.” In other words, deflationary policy is not the right response to a prior inflation. What’s already done is done. The US economy has $61.2 trillion of credit outstanding in non-financial sectors—that’s what’s already done. More of that credit has taken on “moneyness” in the market for collateral than we Austrians like to admit—and I’d argue that most Austrian definitions of money mistreat much of that credit, which has taken on “moneyness” in the shadow banking system (e.g., Treasury/GSE debt functions as base money in these markets). It’s an area of research that’s sorely needed in the Austrian economics field. If you grant my argument, just for this moment, then you see why I believe regulators have so far have executed a successful balance between bank deleveraging and credit deflation. That’s a tough balancing act, indeed!

Interview: Blockchains, Wall St & Economics

Howdy folks!  I recently gave two interviews about the financial system, and here’s the first one to be released publicly.  In this interview, Arthur Falls of the Ether Review asks why I think blockchains are so critical to fixing what’s wrong with the financial system, to ensure its safety and soundness.

It was an honor to chat with Arthur, who is also director of media at ConsenSys!

The interview is available here.

EtherReview logo

Here are some snippets / resources / additional color:

  • Blockchains can bring efficiency, transparency and reduced counterparty risk to the mainstream financial industry.
  • T+3 securities settlement is not a technological problem. It’s a source of substantial and unnecessary counterparty risk in the financial system, and it needs to be fixed.
  • Blockchains can solve a pain point for regulators, which is that no one really knows how leveraged the financial system is today. Even the banks themselves do not know, and banks’ risk departments really do want to know.
  • For the first time, blockchains can give regulators a tool for backing out the repo market’s double-counted assets to know the true solvency, in real-time, of both individual banks and the financial system as a whole.
  • Rehypothecation is conceptually similar to fractional reserve banking because a dollar of base money is responsible for several different dollars of debt issued against that same dollar of base money. In the repo market, collateral (such as U.S Treasury securities) functions as base money. Collateral has taken on a “moneyness” characteristic that’s not captured in the traditional money supply measures like M0, M1 or M2. The fact that collateral has “moneyness” makes it the fulcrum point of so much of the credit creation process in recent years. (Side note:  In my experience the process of credit creation in the shadow banking system is misunderstood by most—Fed proponents and critics alike.)
  • Through rehypothecation, multiple parties report that they own the same asset at the same time when in reality only one of them does—because, after all, only one such asset exists. One of the most important benefits of blockchains for regulators is gaining a tool to see how much double-counting is happening (specifically, how long “collateral chains” really are). This is simply not knowable today because information is too fragmented and can’t be reconciled.
  • 99+% of the time, the financial system works and there are no issues. But when there’s a run on the shadow banking system, as there was in 2008, it’s a big problem.
  • The Fed acts as lender-of-last-resort for the traditional banking system, creating and injecting new money when a bank run happens in the traditional banking sector. Yet, there’s no such lender-of-last-resort for the shadow banking system—it’s not possible for the Fed to create new Treasury bonds out of thin air.
  • Austrian School economists who question why the substantial increase in the Fed’s balance sheet after the financial crisis didn’t cause a big outbreak of price inflation may appreciate Arthur’s question about whether we really want to shine light onto how leveraged the financial system truly is. Speaking about the 2008 crisis, I paint the picture of the run on the shadow banking system—and the substantial credit contraction it caused—which the Fed was able to offset by expanding the monetary base. In other words, to stem the run the Fed offset the amount of credit contraction in the shadow banking system with money expansion, in order to keep the total sum of money + credit outstanding from collapsing. As of today, there’s more than $65 trillion of money + credit outstanding in non-financial sectors in the U.S., compared to just under $4 trillion of base money outstanding.  That’s a lot of leverage—literally a lot of credit created on top of that base money. (Side note: I think the Fed will be able to keep offsetting credit contraction with monetary base expansion without triggering price inflation for longer than most Austrian economists believe—but, unlike other schools of economic thought, I do agree that past credit inflation has been highly damaging by distorting interest rates and causing latent capital misallocation. The effects of distorted interest rates can be masked for long periods by the continued growth of money + credit outstanding, and in the U.S. the growth in the sum of money + credit outstanding has been amazingly steady. You can track these numbers in the Fed’s Z.1 report, which comes out quarterly.)
  • I reiterate my view that the financial system is still too leveraged, applauding regulators’ higher capital requirements for banks (including Basel 3, Dodd-Frank and more apparently coming), but also defending the financial industry by positing that no one wants better visibility into counterparty creditworthiness and the length of collateral chains than the risk departments of the financial institutions themselves.
  • Blockchains would provide a substantial improvement in transparency over today’s reporting infrastructure, even if the blockchains are permissioned and run on closed networks.
  • Regulators should, however, get involved because some of the proposed new blockchain platforms would leave some of the most critical information off the chain and regulators may later regret not having immediate access to that critical information when the new platforms are adopted.
  • Permissionless blockchains, such as Bitcoin and Ethereum, will successfully scale over time, in my view. But today, the financial industry needs technology that offers much higher throughput than Bitcoin and Ethereum were designed to provide. Many commercial blockchain platforms are giving up transparency and immutability in exchange for high throughput. But they’re still such an improvement over the status quo, and I’d encourage even bitcoin maximalists to appreciate the improvement—even if, as I believe, blockchain is an intermediate step toward infrastructure that will ultimately be decentralized. Permissionless ledgers and denationalized money will probably ultimately win out because they’re cheaper and have no counterparty risk, but I believe that’s 20 years away and a lot of intermediate-step blockchain adoption (and resulting improvement) will take place between now and then.
  • When TCP/IP came along, companies at first took baby steps by adopting intranets inside walled gardens before they fully engaged in the Internet. With blockchains, by analogy, companies are taking cautious intermediate steps to adopt centralized, walled-garden versions first. And just as the true power of the Internet came from companies opening those walled gardens to the outside world, I believe the same will happen with blockchains over time. Truly decentralized, permissionless networks will win out because they are superior for so many reasons, but they’re not ready for prime time yet and the adoption process will take years. The end users—people using the payments system or transferring assets—want frictionless networks and they will create incentives for the financial industry to adopt them.
  • Switching costs for the financial industry are very high, because blockchain technology architecture is so different from current IT infrastructure.
  • The blockchain industry should dial back expectations about how fast implementation will take place. It’s analogous to the cable industry, where in 1998 proponents believed that the Internet would challenge cable TV. It took nearly 20 years for the visionaries to be proven right.
  • That said, I see many markets where blockchains will have huge success immediately—markets that still run on fax machines and need IT upgrades anyway, or markets in which most of the securities that will be outstanding in 10 years haven’t been issued yet. I’d expect public equities markets to be the “caboose” for blockchain adoption. It may take ~20 years for a complete switch-over of all financial markets to blockchain technology.
  • Here’s the picture I mentioned of the $10,000 bill issued by the Fed in 1918, which hangs in the Fed’s boardroom and which I photographed during the Fed’s fintech conference on June 1, 2016. Just imagine what that’s worth today!  I suspect it was used for inter-bank settlements rather than circulated on the streets. How fitting that today, some central banks are looking into blockchains for this very task!

    Fed_10kbill

    $10,000 bill, issued by the Federal Reserve in 1918 and hanging on the wall of the FOMC Boardroom

  • Resources I mentioned during the interview:
    • Doug Noland, author of the blog Credit Bubble Bulletin, from whom I learned about the “moneyness” of collateral in the shadow banking system.  Every Saturday morning I read Doug’s weekly commentary. He has chronicled the credit bubble for years, and historians will someday widely cite his work. His website is here.
    • Manmohan Singh, senior IMF economist, who has done tremendous work on rehypothecation and collateral chains. Here,here, here, here and here are among the many insightful writings by Singh on this topic.
    • Pete Rizzo, East Coast editor of Coindesk, whose terrific column I mentioned regarding the 1998 Wired Magazine cover that touted the imminent challenge of cable TV by the Internet. Nearly 20 years later, it’s finally happening. Pete’s column is available here.
  • Thanks for listening!  And thanks again, Arthur, for a fun interview!