Streetwise Professor

January 2, 2018

Buyer Beware: Bart Does Crypto

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 8:08 pm

Back in the day, Bart Chilton was my #2 whipping boy at the CFTC (after Gary Gensler AKA GiGi). Bart took umbrage (via email) at some of my posts, notably this one. Snort.

Bart was the comedian in that dynamic duo. He coined (alert: pun foreshadowing!) such memorable phrases as “cheetah” to criticize high frequency traders (cheetah-fast cheater–get it? Har!) and “massive passives” to snark at index funds and ETFs. Apparently Goldilocks could never find a trading entity whose speed was just right: they were either too fast or too slow. He blamed cheetahs for causing the Flash Crash, among other sins, and knocked the massive passives for speculating excessively and distorting prices.

But then Bart left the CFTC, and proceeded to sell out. He took a job flacking for HFT firms. And now he is lending his name (I won’t say reputation) to an endeavor to create a new massive passive. This gives new meaning to the phrase sell out.

Bart’s massive passive initiative hitches a ride on the crypto craze, which makes it all the more dubious. It is called “OilCoin.” This endeavor will issue said coins, and invest the proceeds in “reserve barrels” of oil. Indeed, the more you examine it, the more dubious it looks.

In some ways this is very much like an ETF. Although OilCoin’s backers say it will be “regulatory compliant,” but even though it resembles an ETF in many ways, it will not have to meet (nor will it meet, based on my reading of its materials) listing requirements for ETFs. Furthermore, one of the main selling points emphasized by the backers is its alleged tax advantages over standard ETFs. So despite the other argle bargle in the OilCon–excuse me, OilCoin–White Paper, it’s primarily a regulatory and tax arb.

Not that there’s necessarily anything wrong with that, just that it’s a bit rich that the former stalwart advocate of harsher regulation of passive commodity investment vehicles is part of the “team” launching this effort.

I should also note some differences that make it worse than a standard ETF, and worse than other pooled investment vehicles like closed end funds. Most notably, ETFs have an issue and redemption mechanism that ensures that the ETF market price tracks the value of the assets it holds. If an ETF’s price exceeds the value of the assets the ETF holds, an “Authorized Participant” can buy a basket of assets that mirrors what the ETF holds, deliver them to the ETF, and receive ETF shares in return. If an ETF’s price is below the market value of the assets, the AP can buy the ETF shares on the market, tender them to the ETF, and receive an equivalent share of the assets that the ETF holds. This mechanism ties the ETF market price to the market prices of its assets.

The OilCoin will not have any such tight tie to the assets its operators invest in. Insofar as investment policy is concerned:

In addition to investing in oil futures, the assets supporting OilCoin will also be invested in physical oil and interests in oil producing properties in various jurisdictions in order to hold a diversified pool of assets and avoid the risk of holding a single, concentrated position in exchange traded futures contracts. As a result, OilCoin’s investment returns will approximate but not precisely track the price movement of a spot barrel of crude oil.

I note the potential illiquidity in “physical oil” and in particular “interests in oil producing properties.” It will almost certainly be very difficult to value this portfolio. And although the White Paper suggests a one barrel of oil to one OilCoin ratio, it is not at all clear how “interests in oil producing properties” will figure into that calculation. A barrel of oil in the ground is a totally different thing, with a totally different value, than a barrel of oil in storage above ground, or an oil futures contract that is a claim on oil in store. This actually has more of a private equity feel than an ETF feel to it. Moreover, even above ground barrels can differ dramatically in price based on quality and location.

Given the illiquidity and heterogeneity of the “oil” that backs OilCoin, it is not surprising that the mechanism to keep the price of the OilCoin in line with “the” price of “oil” is rather, er, elastic, especially in comparison to a standard ETF: the motto of OilCoin should be “Trust Us!” (Pretty funny for crypto, no?) (Hopefully it won’t end up like this, but methinks it might.)

Here’s what the White Paper says about the mechanism (which is a generous way of characterizing it):

OilCoin’s investment returns will approximate but not precisely track the price movement of a spot barrel of crude oil.

. . . .

In order to ensure measurable intrinsic value and price stability, each OilCoin will maintain an approximate one-to-one ratio with a single reserve barrel of oil. [Note that a “reserve barrel of oil” is not a barrel of any particular type of oil at any particular location.] This equilibrium will be achieved through management of the oil reserves and the number of OilCoin in circulation.

As demand for OilCoin causes the price of a single OilCoin to rise above the spot price of a barrel of oil on global markets [what barrel? WTI? Brent? Mayan? Whatever they feel like on a particular day?], additional OilCoin may be issued in private or open market transactions and the proceeds will be invested in additional oil reserves. Similarly, if the price of an OilCoin falls below the price of a barrel of oil, oil reserves may be liquidated with the proceeds used to purchase OilCoin privately or in the open market. This method of issuing or repurchasing OilCoin and the corresponding investment in or liquidation of oil reserves will provide stability to the market price of OilCoin relative to the spot price of a barrel of crude oil and will provide verifiable assurances that the value of oil reserves will approximate the aggregate value of all issued OilCoin.

OilCoin’s price stability program will be managed by the OilCoin management team with a view to supporting the liquidity and functional operation of the OilCoin marketplace and to maintaining an approximate but not precise correlation between the price of a single OilCoin and the spot price of a single barrel of oil [What type of barrel? Where? For delivery when?]. While maintaining price stability of digital currencies through algorithmic purchase and sale may be appropriate in certain circumstances, and while it is possible as a technical matter to link such an algorithm to a programmed purchase and sale of oil assets, such an approach would be likely to result in (i) the decoupling of the number of OilCoin in circulation from an approximately equivalent number of reserve barrels of oil, and (ii) a highly volatile stock of oil reserve assets adding unnecessary and avoidable transaction costs which would reduce the value of OilCoin’s supporting oil reserve assets. Accordingly, it is expected that purchases and sales of OilCoin and oil reserves to support price stability will be made on a periodic basis [Monthly? Annually? When the spirit moves them?] as the price of OilCoin and the price of a single barrel of oil [Again. What type of barrel? Where? For delivery when?] diverge by more than a specified margin [Specified where? Surely not in this White Paper.]

[Emphasis added.]

Note the huge discretion granted the managers. (“May be issued.” “May be liquidated.” Whenever they fell like it, apparently, as long as there is a vague connection between their actions and “the spot price of crude oil “–and remember there is no such thing as “the” spot price) A much less precise mechanism than in the standard ETF. Also note the shell game aspect here. This refers to “the” price of “a barrel of oil,” but then talks about “diversified holdings” of oil. The document goes back and forth between referring about “reserve barrels” and “barrels of oil on the global market.”

Note further that there is no third party mechanism akin to an Authorized Party that can arb the underlying assets against the OilCoin to make sure that it tracks the price of any particular barrel of oil, or even a portfolio of oil holdings. This means that OilCoin is really more like a closed end fund, but one  that is not subject to the same kind of regulation as closed end funds, and which can apparently invest in things other than securities (e.g., interests in oil producing properties), some of which may be quite illiquid and hard to value and trade. One other crucial difference from a closed end fund is that OilCoin states it may issue new coins, whereas closed end funds typically cannot have secondary offerings of common shares.

Closed end funds can trade at substantial premiums and discounts to the underlying NAV, and I would wager that OilCoin will as well. Relating to the secondary issue point, unlike a closed end fund, OilCoin can issue new coins if they are at a premium–or if the managers feel like it. Again, the amount of discretion possessed by OilCoin’s managers is substantially greater than for a closed end fund or ETF (or an open ended fund for that matter). (There is also no indication that the managers will be precluded from investing the funds in their own “oil producing interests.” That potential for self-dealing is very concerning.)

There is also no indication in the White Paper as to just what an OilCoin gives a claim on, or who has the control rights over the assets, and how these control rights can be obtained. My reading of the White Paper does not find any disclosure, implicit or explicit, that OilCoin owners have any claim on the assets, or that someone could buy 50 percent plus one of the OilCoins, boot the existing management, and get control of the operation of the investments, or any mechanism that would allow acquisition of a controlling interest, and liquidation of the thing’s assets. (I say “thing” because what legal form it takes is not stated in the White Paper.)  These are other differences from a closed end fund or ETF–and mean that OilCoin is not subject to the typical mechanisms that protect investors from the depredations of promoters and managers.

A lot of crypto is all about separating fools from their money. OilCoin certainly has that potential. What is even more insidious about it is that the backers state that it is a different kind of crypto currency because it is backed by something: in the words of the White Paper, OilCoin is “supported” by the “substantial intrinsic value of assets” it holds. The only problem is that there is no indication whatsoever that the holder of the cryptocurrency can actually get their hands on what backs it. The “support” is more chimerical than real.

So my basic take away from this is that OilCoin is a venture that allows the managers to use the issue of cryptocurrency to fund totally unconstrained speculations in oil subject to virtually none of the investor protections extended to the purchasers of securities in corporations, investors of closed end funds, or buyers of ETFs. All sickeningly ironic given the very public participation of a guy who inveighed against speculation in oil and the need for strict regulation of those investing other people’s money.

My suggestion is that if you are really hot for an ICO backed by a blonde, buy whatever Paris Hilton is touting these days, and avoid BartCoin like the plague.




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  1. The man is an idiot. Always has been. But, if you work hard, keep your nose to the grindstone, finish high school and your dad knows someone, you can become a congressional coatholder also. Then some other dimwit can reward you with a seat on some commission or other where through effort, chapstick and butt-smooching, you can rise to the top. If your hair is perfectly coiffed of course. You gotta be able to do something on your own after all. Hell, we have an exchange exec. who got put on a very minor federal oversight board by dint of hard work and check writing and now styles himself the “Honorable” something or other. You used to have to put your name on a ballot and get elected to something before you were entitled to an “Honorable.
    But I digress.
    Don’t tell me America isn’t a great country. Good luck Bart. I hope some federal D.A. doesn’t polish his claws on you. You wouldn’t do real good in stir.

    Comment by Fuzznuts — January 3, 2018 @ 2:13 pm

  2. The whole point of blockchain-based ledgers and coins is that it removes the need for some element of trust. Take out Bitcoin’s proof-of-work and you get Fedwire (or E-Gold, which consciously emulated Fedwire). In those, you have a central institution authenticating transactions, and everything rides on that trust. Douglas Jackson had, as far as I can tell, unimpeachable integrity in his operation of E-Gold (and for that he was severely punished), and the Fed has some degree of public accountability. This scheme, not so much.

    The case of Digix, a gold-backed token running on the Ethereum smart-contract system, is instructive here. They raised investment money and bought a bunch of gold held in a custodial vault in Singapore, and then issued crypto-tokens for each gram in storage, which then trade freely on the distributed ledger. So far so good. They don’t however, have a way to bring gold into the system to create new tokens. It isn’t clear to me if having bidirectional convertibility to physical gold was ever intended, or if the coders just underestimated how hard that would be to implement. I suspect that becoming instant millionaires at age 25 eroded the work ethic of the development team. Whatever the reason, the value of this fixed supply of tokens shot up to 60 times the value of the backing gold. I don’t doubt that the prospect of re-selling oil for 60x its market value would bring in hucksters like flies on sh*t.

    By contrast, E-Gold would accept an LBA-compliant gold bar delivered to the appropriate custodian and the system would issue corresponding credit, or an account holder with enough credit could claim delivery of a gold bar, though I don’t know if the latter ever actually ever happened, until, of course, the Feds came and took all the gold. So E-Gold’s units always tracked the price of gold.

    Comment by M. Rad. — January 5, 2018 @ 11:22 am

  3. @M. Rad. E-Gold, and the current joint effort of the Royal Mint and CME, RMG, were/are essentially just digital warehouse receipts that represent ownership of physical gold. And like warehouse receipts, they can be traded, used as collateral, etc. The two-way convertibility ensures convergence of the digital price to the prices of other ownership documents. And as you note, this requires a trusted intermediary to validate the holdings. Departures from this basic formula are usually scams.

    The ProfessorComment by The Professor — January 5, 2018 @ 9:41 pm

  4. If you can’t beat them, join them!

    Comment by Zoe — January 10, 2018 @ 12:54 am

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