Streetwise Professor

Gary Gensler has long lusted to get his regulatory hooks into cryptocurrency. To do so as head of the SEC, he has to find a way to transform crypto (e.g., Bitcoin, Ether, various tokens) into securities, as defined under laws dating from the 1930s. Although Gensler has stated that crypto regulation is a long way off–presumably because it is no mean feat to jam an innovation of the 2010s into a regulatory framework of the 1930s–he thinks that he may have found a way to get at the second largest crypto, Ether.

Gensler pictured here:

Sorry! Sorry! Understandable mistake! Here’s his actual image:

Ether just switched from a “proof of work” model–the model employed by Bitcoin–to a “proof of stake” model. Gensler recently said that Ether may therefore qualify as a security under the Howey test, established in a 1946 Supreme Court decision–handed down when computers filled large rooms, had no memory, and caused the lights to dim in entire cities when they were powered up.

Per Gensler:

Securities and Exchange Commission Chairman Gary Gensler said Thursday that cryptocurrencies and intermediaries that allow holders to “stake” their coins might pass a key test used by courts to determine whether an asset is a security. Known as the Howey test, it examines whether investors expect to earn a return from the work of third parties. 

“From the coin’s perspective…that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler told reporters after a congressional hearing. He said he wasn’t referring to any specific cryptocurrency. 

To call that a stretch is an understatement. A huge one. Because the function of proof of stake is entirely different than the function of a security.

Proof of work and proof of stake are alternative ways of operating an anonymous, trustless crypto currency. As I’ve written in several pieces here and elsewhere, eliminating the need for trusted institutions to guarantee transactions does not come for free. Those tempted to defraud must incur a cost if they do in order to be deterred. A performance bond sacrificed on non-performance or deceit is a common way to do that. Proofs of stake and work both are effectively performance bonds. With proof of work, a “miner” incurs a cost (electricity, computing resources) to get the right to add blocks to the blockchain: if a majority of other miners don’t concur with the proposal, the block is not validated, the proposing miner gets no reward, and sacrifices the expenditure required to make the proposal. Proof of stake is a more traditional sort of bond: you lose your stake if your proposal is rejected.

A security is something totally different, and serves a completely different function. (NB. I favor the “functional model of regulation” proposed by Merton many years ago. Regulation should be based on function, not institution.). The function of a security is to raise capital with a marketable instrument that can be bought and sold by third parties at mutually agreed upon prices.

So with a lot of squinting, you can say that both securities and staking mechanism involve “the efforts of others,” but to effect completely different purposes and functions. The fundamental difference in function/purpose means that even if they have something in common, they are totally different and the regulatory framework for one is totally inappropriate to the regulation of the other.

This illustrates an issue that I often come across in my work on commodities, securities, and antitrust litigation: the common confusion of sufficient and necessary conditions. Arguably profiting from the efforts of others could be a necessary condition to be considered a security. It is not, however, a sufficient condition–as Gensler is essentially advocating.

But what’s logic when there’s a regulatory empire to build, right?

I’m also at a loss to explain how Gensler could think that proof of stake involves the “efforts” (i.e., work) of others, but proof of, you know, work doesn’t.

Gensler’s “logic” would probably even embarrass Sir Bedevere:

“What also floats in water?” “A security!”

Gensler might have more of a leg to stand on when it comes to tokens. But with Bitcoin, Ether, and other similar things, hammering the crypto peg into the securities law hole is idiotic.

But never let logic stand in the way of Gary’s pursuit of his precious:

GiGi is not solely focused on crypto of course. He has many preciouses. This week the SEC released a proposed rule to mandate clearing of many cash Treasury trades.

Clearing of course has always been a mania of Gary’s. His deep affection for me no doubt dates from my extensive writing on his Ahab-like pursuit of clearing mandates in derivatives more than a decade ago. Clearing is Gensler’s hammer, and he sees in every financial problem a nail to be driven.

The problem at issue here is the periodic episodes of large price moves and illiquidity in the Treasury market in recent years, most notably in March 2020 (the subject of a JACF article by me).

Clearing is a mechanism to mitigate counterparty credit risk. There is no evidence, nor reasonable basis to believe, that counterparty credit risk precipitated these episodes, or that these episodes (whatever their cause) raised the risk of a chain reaction via a counterparty credit risk channel in cash Treasuries.

Moreover, as I have said ad nauseum, clearing and the associated margining mechanism is a major potential source of financial instability.

Indeed, as I point out in the JACF article, clearing and margin in Treasury futures and other fixed income securities markets is what threatened to turn the price (and basis) movement sparked by Covid (and policy responses to Covid) into a systemic event that required Fed intervention to prevent.

I note that as I discussed at the time, margining also contributed greatly to the instability surrounding the GameStop fiasco.

Meaning that in the name of promoting financial market stability Gensler and the SEC (the vote on the proposal was unanimous) are in fact expanding the use of the very mechanism that exacerbated the problem they are allegedly addressing.

Like the Bourbons, Gensler has learned nothing, and forgotten nothing. He has not forgotten his misbegotten notions of the consequences of clearing, and hasn’t learned what the real consequences are.

Of course these two issues do not exhaust the catalog of Gensler’s regulatory imperium. Another big one is his climate change reporting initiative. I’ll turn to that another day, but in the meantime definitely check out John Cochrane’s dismantling of that piece of GiGi’s handiwork.

As Gideon John Tucker said famously 156 years ago: “No man’s life, liberty or property are safe while the Legislature is in session.” Nor are they when Gary Gensler heads a regulatory agency.

ICE is on the verge of launching Bitcoin futures. The official start date is 23 September.

The ICE contract is distinctive in a couple of ways.

First, it is a delivery settled contract. Indeed, this feature is what made the ICE product so long in coming. The exchange had to set up a depository, the Bakkt Warehouse. This required careful infrastructure design and jumping through regulatory hoops to establish the Bakkt Trust Company, and get approval from the NY Department of Financial Services.

Second, the structure of the contracts offered is similar to that of the London Metal Exchange. There are daily contracts extending 70 days into the future, as well as more conventional monthly contracts. (LME offers daily contracts going out three months, then 3-, 15-, and 27-month contracts). The daily contracts settle two days after expiration, again similar to LME.

The whole initiative is quite fascinating, as it represents a dual competitive strategy: Bakkt is simultaneously competing in the futures space (against CME in particular), and against spot crypto exchanges.

What are its prospects? I would have to say that Bakkt is a better mousetrap.

It certainly offers many advantages as a spot platform over the plethora of existing Bitcoin/crypto exchanges. These advantages include ICE’s reputation, the creation of a warehouse with substantial capital backing, and regulatory protections. Here is a case in which regulation can be a feature, not a bug.

Furthermore, for decades–over a quarter-century, in fact–I have argued that physical delivery is a far superior mechanism for price discovery and ensuring convergence than cash settlement. The myriad issues that were uncovered in natural gas when rocks were overturned in the post-Enron era, the chronic controversies over Platts windows, and the IBORs have demonstrated the frailty, and vulnerability to manipulation of cash settlement mechanisms.

Crypto is somewhat different–or at least, has the potential to be–because the CME’s cash settlement mechanism is based off prices determined on several BTC exchanges, in much the same way as the S&P500 settlement mechanism is based on prices determined at centralized auction markets.

But the crypto exchanges are not the NYSE or Nasdaq. They are a rather dodgy lot, and there is some evidence of manipulation and inflated volumes on these exchanges.

It’s also something of a puzzle that so many crypto exchanges survive. The centripetal forces of liquidity tend to cause trading in a particular instrument to gravitate to a single platform. The fact that this hasn’t happened in crypto is anomalous, and suggests that normal economic forces are not operating in this market. This raises some concerns.

Bakkt potentially represents a double-barrel threat to CME. Not only is it competing in futures, if it attracts a considerable amount of spot trading activity (due to a superior trading, clearing, settlement and custodial platform, reputational capital, and regulatory safeguards) this will undermine the reliability of CME’s cash settlement mechanism by attracting volume away from the markets CME uses to determine final settlement prices. This could make these market prices less reliable, and more subject to manipulation. Indeed, some–and maybe all–of these exchanges could disappear if ICE’s cash market dominates. CME would be up a creek then.

That said, one of the lessons of inter-exchange competition is that the best mousetrap doesn’t always win. In particular, CME has already established liquidity in the futures market, and as even as formidable competitor as Eurex found out in Treasuries in the early-oughties, it is difficult to induce a shift of liquidity to a competitor.

There are differences between crypto and other more traditional financial products (cash and derivatives) that may make that liquidity-based first mover advantage less decisive. For one thing, as I noted earlier, heretofore cash crypto has proved an exception to the winner-takes-all rule. Maybe the same will hold true for crypto futures: since I don’t understand why cash has been an exception to the rule, I’d be reluctant to say that futures won’t be (although CBOE’s exit suggests it might). For another, the complementarity between cash and futures in this case (which ICE is cleverly exploiting in its LME-like contract structure) could prove decisive. If ICE can get traction in the fragmented cash market, that would bode well for its prospects in futures.

Entry into a derivatives or cash market in competition with an incumbent is always a highly leveraged bet. Odds are that you fail, but if you win it can prove enormously lucrative. That’s essentially the bet that ICE is taking in BTC.

The ICE/Bakkt initiative will prove to be a fascinating case study in inter-exchange competition. Crypto is sufficiently distinctive, and the double-barrel ICE initiative sufficiently innovative, that the traditional betting form (go with the incumbent) could well fail. I will watch with interest.

To huge fanfare, Facebook announced the impending release of a new cryptocurrency, “Libra.” Except it isn’t–a crypto, that is. Whereas real cryptocurrencies are decentralized, anonymous, unpermissioned, and lack trusted intermediaries, Libra is centralized, permissioned, non-anomymous and chock-full o’ intermediaries in addition to Facebook. It doesn’t really utilize a blockchain either.

Other than that . . .

For the best (IMO) take on the “Zuck Buck”, I heartily recommend FT Alphaville’s extended take–and takedown. I’ll just add a few comments.

First, when it comes to finance, there is little (if anything) new under the sun, and that is clearly true of Libra. The Alphaville stories provide several historical precedents, to which I’ll just add another. It is basically like pre-National Bank Act banking system in which banks issued bank notes that circulated as hand-to-hand media of exchange, and which were theoretically convertible into currency (gold prior to the Civil War) on demand. Libra is functionally equivalent to such bank notes, with the main distinction that it is represented by bytes rather than pieces of paper.

Facebook attempts to allay concerns about such a system by requiring 100 percent backing by bank deposits or low-default-risk government bonds, but as historical experience (some as recent as 2008) demonstrates, although such systems are less subject to runs than liabilities issued by entities that invest the proceeds in illiquid assets, they are not necessarily run-proof.

Furthermore, the economic model here isn’t that different from the 19th century bank model because the issuer can profit by investing the proceeds from the issue of the currency in interest bearing assets, and pocketing the interest. Those buying the currency forego interest income, and presumably are willing to do so because of it reduces the costs of engaging in various kinds of transactions.

This type of system faces different kinds of difficulties in low and high interest rate environments. In high rate environments, the opportunity cost of holding the currency is high, which leads to lower quantity demanded. In low rate environments, the revenue stream may be insufficient to cover the costs incurred by the intermediaries. This creates an incentive for asset substitution, i.e., to allow backing the currency with higher risk assets (with higher yields) thereby increasing insolvency and run risks.

I note in passing that low interest rates destroyed the traditional FCM model which relied on interest income from customer margins as a major revenue stream (as Facebook is proposing here). Ask John Corzine about that, and look to the experience of MF Global.

Why introduce this in a low interest rate environment? Maybe this is a kind of loss-leader strategy. The opportunity cost of holding Libra is low now (given low rates), so maybe a lot of people will buy in now. Even though the benefits to the issuers/intermediaries may be low now (because the interest income is low), they may be counting on customer stickiness once there is widespread adoption. That is, those who hold Libra when the cost of doing so is low may stick around even when the cost goes up substantially. That is, Facebook and its partners in this endeavor may be counting on some sort of switching cost or some behavioral irrationality to reduce the interest-rate sensitivity of demand for Libra.

Good luck with that. (For another example of nothing new under the sun, read up on disintermediation of traditional banks when interest bearing money market mutual funds came on the scene.)

I would also suggest that Libra has some disadvantages as a medium of exchange. For one thing, since assets will be held in multiple currencies, it creates currency risk for virtually everyone who uses it. For another, it involves additional cost to move from fiat into Libra and from Libra into fiat. This reduces the value of the Libra as a medium of exchange because of the resulting difference in cost in using it for within-network and off-network uses.

This last point relates to something else in the Libra white paper, namely, the claims that the currency will be a boon to the “unbanked.” This makes zero sense.

The reason that some people don’t have bank accounts is that the cost of servicing them (reflected in fees that banks charge) is above the willingness/ability of those people to pay for those services. There is no reason to believe that Libra reduces the cost of servicing the currently unbanked. Furthermore, the value of the services provided is likely to be lower, and substantially so because inter alia (a) the lack of brick an mortar facilities that low income people need for check cashing/depositing and cash depositing, (b) the restricted network of people with whom they can transact, and (c) currency risk.  Relatedly, it’s hard to see how one can move funds into our out of Libra without having access to banking services. I see the unbanked rhetoric as mere SJW eyewash attempting to make this look like some progressive social project.

The arrogance of Facebook is also rather astounding. Again, this is not crypto–it is banking. Yet Facebook presumes that it can do this without the panoply of licenses that banks must have, and without being subject to the same kinds of regulation as banks.

Because why? Trust me? Suuuurrreee, Mark.

Along these lines, note that the most benign interpretation behind Libra is that it is a narrow bank (100 percent reserve banking). But remember the Fed recently denied approval to TNB (“The Narrow Bank”) USA NA even though it was only going to offer deposits to “the most financially secure institutions” and explicitly eschewed providing retail banking services. Yet Marky et al expect the Fed (not to mention banking regulators in every other jurisdiction on the planet) to stand aside and let Facebook offer maybe (but maybe not) narrow banking services (with added currency risk!) to the great unwashed?

On what planet?

Note the furious government reactions to this, not just in the US but in Europe. Zuckerberg et al were totally delusional if they expected anything different, especially in light of Facebooks serial privacy, free-speech, and antitrust controversies.

In sum, in my opinion Libra faces serious economic and political/regulatory obstacles. Having politicians and regulators hate you isn’t bad per se in my book–it can actually represent an endorsement! But the economics of this are incredibly dodgy. My skepticism is only increased by the misleading packaging (crypto! a boon to the unbanked!) and the congenitally misleading packager.

In my derivatives classes, here and abroad, I always start out by saying that another phrase for “derivative” is contingent claim. Derivatives have payoffs that are contingent on something. For most contracts–a garden variety futures or option, for example–the contingency is a price. The payoff on WTI futures is contingent on the price of WTI at contract expiration. Other contracts have contingencies related to events. A weather derivative, for instance, which pays off based on heating or cooling degree days, or snowfall, or some other weather variable. Or a contract that has a payoff contingent on an official government statistic, like natural gas or crude inventories.

Credit default swaps–CDS–are a hybrid. They have payoffs that are contingent on both an event (e.g., bankruptcy) and a price (the price of defaulted debt). Both contingencies have proved very problematic in practice, which is one reason why CDS have long been in such disrepute.

The price contingency has proved problematic in part for the same reason that CDS exist. If there were liquid, transparent markets for corporate debt, who would need CDS?: just short the debt if you want to short the credit (and hedge out the non-credit related interest rate risk). CDS were a way to trade credit without trading the (illiquid) underlying debt. But that means that determining the price of defaulted debt, and hence the payoff to a CDS, is not trivial.

To determine a price, market participants resorted to auctions. But the auctions were potentially prone to manipulation, a problem exacerbated by the illiquidity of bonds and the fact that many of them were locked up in portfolios: deliverable supply is therefore likely to be limited, exacerbating the manipulation problem.

ISDA, the industry organization that largely governs OTC derivatives, introduced some reforms to the auction process to mitigate these problems. But I emphasize “mitigate” is not the same as “solve.”

The event issue has been a bane of the CDS markets since their birth. For instance, the collapse of Russian bond prices and the devaluation of the Ruble in 1998 didn’t trigger CDS payments, because the technical default terms weren’t met. More recently, the big issue has been engineering technical defaults (e.g., “failure to pay events”) to trigger payoffs on CDS, even though the name is not in financial distress and is able to service its debt.

ISDA has again stepped in, and implemented some changes:

Specifically, International Swaps and Derivatives Association is proposing that failing to make a bond payment wouldn’t trigger a CDS payout if the reason for default wasn’t tied to some kind of financial stress. The plan earned initial backing from titans including Goldman Sachs Group Inc., JPMorgan Chase & Co., Apollo Global Management and Ares Management Corp.

“There must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity,” ISDA said in its document.

Well that sure clears things up, doesn’t it?

ISDA has been criticized because it has addressed just one problem, and left other potential ways of manipulating events unaddressed. But this just points out an inherent challenge in CDS. In the case Cargill v. Hardin, the 7th Circuit stated that “the techniques of manipulation are limited only by the ingenuity of man.” And that goes triple for CDS. Ingenious traders with ingenious lawyers will find new techniques to manipulate CDS, because of the inherently imprecise and varied nature of “credit events.”

CDS should be a cautionary tale for something else that has been the subject of much fascination–so called “smart contracts.” The CDS experience shows that many contracts are inherently incomplete. That is, it is impossible in advance to specify all the relevant contingencies, or do so with sufficient specificity and precision to make the contracts self-executing and free from ambiguity and interpretation.

Take the “must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity” language. Every one of those words is subject to interpretation, and most of the interpretations will be highly contingent on the specific factual circumstances, which are likely unique to every reference entity and every potential default.

This is not a process that can be automated, on a blockchain, or anywhere else. Such contracts require a governance structure and governance mechanisms that can interpret the contractual terms in light of the factual circumstances. Sometimes those can be provided by private parties, such as ISDA. But as ISDA shows with CDS, and as financial exchanges (e.g., the Chicago Board of Trade) have shown over the years in simpler contracts such as futures, those private governance systems can be fragile, and themselves subject to manipulation, pressure, and rent seeking. (Re exchanges, see my 1994 JLE paper on exchange self-regulation of manipulation, and my 1993 JLS paper on the successes and failures of commodity exchanges.)

Sometimes the courts govern how contracts are interpreted and implemented. But that’s an expensive process, and itself subject to Type I and Type II errors.

Meaning that it can be desirable to create contracts that have payoffs that are contingent on rather complex events–as a way of allocating the risk of such events more efficiently–but such contracts inherently involve higher transactions costs.

This is not to say that this is a justification for banning them, or sharply circumscribing their use. The parties to the contracts internalize many of the transactions costs (though arguably not all, given that there are collective action issues that I discussed 10 years ago). To the extent that they internalize the costs, the higher costs limit utility and constrain adoption.

But the basic point remains. Specifying precisely and interpreting accurately the contingencies in some contingent claims contracts is more expensive than in others. There are many types of contracts that offer potential benefits in terms of improved allocation of risk, but which cannot be automated. Trying to make such contracts smart is actually pretty dumb.

There are many silly things written about commodity traders, and alas many of the purveyors of this silliness get paid large amounts of money for it. Case in point, this just-released Oliver Wyman study, “Commodity Trading Goes Back to the Future.”

The piece begins with a well-recognized fact (that I’ve written about frequently in the past): commodity trading firm margins are down, relative to 2014-15, and especially 2008-9. It goes off the rails in totally misdiagnosing the cause:

Signs of the coming dramatic shakeout that will result from the commodity trading margin squeeze are already at hand. Trading margins have fallen by more than 20 percent from their recent peak in 2015.

This trading margin meltdown will continue as commodity markets become more mature, stable, and liquid. Over the past decade, the volume of commodity contracts traded nearly tripled and the value of contracts traded on standard electronic platforms doubled. Commodity market data is also increasingly readily available and widely socialized, as a greater number of players sell information and provide services to commodity traders. These new sources of data allow commodity traders to estimate much more precisely events that impact their trading strategies, such as when commodities will arrive at a specific destination and when local stockpiles will be high or low.

The combination of increased transparency and gluts in almost every commodity should keep volatility in the relatively tight band it has been confined to since 2012.

Where to begin? For starters, the electronic trading volumes of futures and futures option contracts has jack-you-know-what to do with the margins on physical commodity trading. Ditto the market data from these transactions. To throw these topics into a discussion of physical commodity trading profitability is to shoot your credibility in the head on page 2.

Further, as I’ve written extensively, particularly with regards to the ABCDs, “gluts in almost every commodity” do not necessarily imply compressed physical trading margins–in fact, they usually do the reverse. What has happened is that commodity transformation capacity has outstripped commodity transformation demand.

So that’s a self-inflicted double tap. Quite a trick!

Relatedly, low flat price volatility is a complete red herring. What matters to physical traders–who transform commodities in space, time, and form–is the volatility of relative prices, specifically the spreads between transformed and untransformed commodity prices.

Triple tap. Even more impressive!

Indeed, the irrelevance of gluts is readily evident from Exhibit 1, a graph of margins by year. When were the biggest margins in oil and oil products? Glut years–2009, and 2014-2015. The traders made easy money on simple storage plays. As Trafigura illustrated in its half-year report last September, it is the disappearance of the contango (i.e., the disappearance of the oil glut) that crushed margins.

Amazingly, the word “contango” does not appear in the OW report. That just screams credibility, I tells ya.

The report also discusses increased price transparency as a source of pressure on margins, but I am unpersuaded that there has been any meaningful increase in cash market transparency, at least not enough to make a difference. Take the grain markets. Yes, you can go online and see what local elevators are bidding in the US. But bids and transactions are very different things, and in these markets there can be huge differences between offers and bids. Having studied the US grain markets for almost 30 years, I don’t see a material increase in cash price transparency in that time. And I can say pretty much the same about cotton and oil.

This is moderately intelligent, at least as a forecast rather than as a diagnosis:

Major commodity producers and consumers like national oil companies and miners will charge higher premiums and claim more margin as they expand their global reach and become more sophisticated market participants. Simultaneously, physical infrastructure service providers and new online platforms will impinge on traders’ traditional roles. These players are making traders less essential by removing bottlenecks in order to correct supply imbalances and connecting more commodity producers and consumers directly

But that has everything to do with increased transformation capacity chasing a limited supply of transformation opportunities, and nothing to do with gluts or increased price transparency.

But every moderately sensible statement is undone by silly ones, like this:

As commodity markets become more liquid and accessible, commodity traders are relying more and more on algorithmic trading, coupling predictive analytics with robotic trade execution. Traders are improving their ability to hedge and speculate by developing codes that more nimbly identify trades and execute them across a broader set of
tradable instruments

Yeah. Robotic execution of physical trades. Right. These statements have some applicability to paper spec/prop trading. Virtually none to trading of physical barrels and bushels.

After completely misdiagnosing the disease, Dr. Wyman has a cure–BIG DATA!

Well, I guess that’s something: they could have prescribed blockchain.

Yes, improved data analytics may permit those who employ them to pick up a few more pennies in front of the steamrollers, but its beyond a stretch to claim that this will affect industry profitability overall.

The report in fact hedges its bets, acknowledging that there is no proof that BD is not just more BS:

It is often unclear if anticipated relationships between data feeds and commodity prices actually exist, and even if they do it is not certain the volume of data is sufficient to make meaningful predictions. For example, it is incredibly difficult to analyze global satellite imagery
to identify precisely the daily flow of commodities given the frequency at which images are being taken. Depending on the specific market, these signals are often also relatively limited compared to just market sentiment when forecasting in the horizon of interest

Who knew?

Nonetheless, OW boldy recommends that traders “completely revamp” their operating models, and closes with:

Traders need to make maximizing the potential of information
advantages their top priority. Previously unthinkable digital
capabilities will determine who will be the industry’s leaders
in the long term.

And no doubt, big fat consulting contracts with Oliver Wyman are ESSENTIAL!!!! to make this leap.

Yes, data analytics will no doubt prove of use, and they will become a necessary tool in traders’ kits. But they are unlikely to be transformative–because the big determinants of trader margins are the demand for transformations in space, time, and form, and the capacity available to perform them. Further, the industry is a very competitive one, with relatively free entry and exit, meaning that any persistent increases in margins will be eroded by new entry, and persistent decreases by exit.

The pool of entrants has plausibly increased, as the one sensible part of the OW piece says. That will tend to lead the traditional players to contract (or at least lose share). Some of the entrants are not mentioned by Wyman, such as the farmers in North and South American who are integrating into traditional merchant niches.

These are the first order drivers of past, current and future commodity trading profitability. Big data is an attention grabbing subject, but at the end of the day, it will be a second order (if that) driver of physical commodity trading profits.

But I guess consultants gotta eat too, right? But that’s no excuse for anyone to pay them, especially for drivel like this report.

Imagine my great surprise at reading a Bloomberg piece titled: “Blockchain, Once Seen as a Corporate Cure-All, Suffers Slowdown.”

That was sarcasm, by the way.  I’ve long and publicly expressed my skepticism that blockchain will have revolutionary effects, at least in the near to medium term.  In my public speaking on the topic, I’ve explored the implications of three basic observations.  First, that blockchain is basically a way of sharing/communicating information, which can in turn be put to various uses.  Second, there alternative ways of sharing/communicating information, with different costs and benefits.  And third, it is necessary to distinguish between sharing information within an organization and between organizations.

Much of the hype about blockchain relates to the potential benefits of more efficient sharing and validation of information.  But this does not address the issue of whether blockchain does this more efficiently than alternative means of sharing/communicating/validating.  As in all institutional/technology issues, a comparison of alternatives is necessary.  This comparison has been sadly lacking in public discussions of the potential for blockchain, beyond incantations about blockchain eliminating the need for trusted third parties which is (a) often untrue (in part because trusted parties may be required to enter information into a blockchain, and (b) is not necessarily a feature, because trusted third parties may be able to operate more efficiently than consensus based systems employed on a blockchain.

The most developed implementation of blockchain (Bitcoin) involves very large cost to solve a particular problem that (a) is unique to cryptocurrency, and (b) is not necessarily important in other contexts–namely, the double spend problem in crypto.  Maybe blockchain is the best way to solve that particular problem (which itself begs the question of whether cryptocurrency`is an efficient solution to any economic problem), but that doesn’t mean that it will be a more efficient way of solving the myriad types of opportunism, fraud, and deceit that plague other kinds of transactions.  Double spend is not the alpha and omega of transactional challenges.  Indeed, it might be one of the most trivial.

Thinking in Williamsonian transaction cost terms, where the transaction is the unit of analysis, transactions are highly diverse.  Different kinds of transactions are vulnerable to different kinds of information and opportunism problems, meaning that customized blockchain approaches are likely necessary.  One likely cause for the waning enthusiasm mentioned in the Bloomberg article is that people are coming to the recognition that customization is not easy, and it may not be worth the candle, compared to other ways of addressing the same issues.  Relatedly, customization makes it harder to exploit scale economies, and recognition of this is likely to be making initially enthusiastic commercial users less keen on the idea: that is, it may be possible to use blockchain in many settings, but it may not be cost-effective to do so.

The siloed vs. cooperative divide is also likely to be extremely important, and the Bloomberg article mentions that issue a couple of times.  The blockchain initiatives that do seem to have been implemented, at least to some degree, as with Maersk in container shipping or Cargill with turkeys, are intra-firm endeavors that do not require coordination and cooperation across firms, and can exploit the governance structure that a firm has in place.  Many of the other proposed uses–for instance, in trade finance, or in commodity trading, both of which require myriad parties in a single transaction to communicate information among one another–are inherently multilateral.

This creates all sorts of challenges.  How can commercial rivals cooperate?  How are the gains from cooperation divided?–this is a problem even when participants supply complementary services, such as a trading firm, banks providing trade finance, and the buyer and seller of a commodity.  As oil unitization has shown, battles over dividing the gains from cooperation can dissipate much of those gains.  Who gets to see what information?  Who makes the rules?  How?  How are they enforced? What is the governance structure?  How is free riding prevented?  Who pays?

Ironically, where the gains from cooperation are seemingly biggest–where there are large numbers of potential participants–is exactly where the problems of coordination, negotiation, and agreement are likely to be most daunting.

I’ve drawn the analogy between these cooperative blockchain endeavors and commodity exchanges, which (as I showed in a 1995 JLS paper) were formed primarily as ways to reduce transactions costs via cooperative rule making and enforcement.  The old paper shows that exchanges faced serious obstacles in achieving the gains from cooperation, and often failed to do so.  Don’t expect blockchain to be any different, especially given the greater complexity of the transactional problems that it is being proposed as a fix.

Thus, I am not surprised to read things like this:

“The expectation was we’d quickly find use cases,” Magnus Haglind, Nasdaq’s senior vice president and head of product management for market technology, said in an interview. “But introducing new technologies requires broad collaboration with industry participants, and it all takes time.”

or this:

Most blockchains also can’t yet handle a large volume of transactions — a must-have for major corporations. And they only shine in certain types of use cases, typically where companies collaborate on projects. But because different businesses have to share the same blockchain, it can be a challenge to agree on technology and how to adopt it.

One of my favorite illustrations of the hype outstripping the reality is the endeavor launched with much fanfare in the cotton market, where IBM and The Seam announced an endeavor to use the blockchain to revolutionize the cotton supply chain.   It’s been almost two years, and after the initial press releases, it’s devilish hard to find any mention of the project, let alone any indication that it will go into operation anytime soon.

Read the Bloomberg article and you’ll have a better understanding of R3’s announcement of an IPO–and that they might have missed their opportunity.

In 2017 and a little before, Blockchain was a brand new shiny hammer.  People have been looking everywhere for nails to pound with it, and spending a lot of money in the effort.  But they’re finding that many transactional problems aren’t nails, that there are other hammers that might do the job better, and there are other problems that require many parties to agree on just how the hammer is to be used and by whom.  Given this, it is not surprising that the euphoria is fading fast.  The main question that remains is in what shrunken domain will blockchain actually be employed, and when.  My guess is that the domain will be relatively small, and the time until employment will be pretty long.

Ethereum wunderkind Vitalik Buterin delivered a rant against centralized crypto exchanges:

“I definitely personally hope centralized exchanges burn in hell as much as possible,” Buterin said speaking to TechCrunch.

When bitcoin, the original cryptocurrency, was founded in 2008 by the anonymous Satoshi Nakomoto, the point was to create a decentralized financial future that renders middlemen useless. Nearly 10 years later, the centralized exchanges — those folks sitting in the middle of buyers and sellers — are among the most powerful players in the market for digital currencies such as ethereum and bitcoin.

Bloomberg News estimates they brought in $3 million a day last year. And exchanges such as Gemini and Coinbase are expanding at a clip, bringing on talent from Wall Street.

“It’s hard to ignore the irony that an asset created to allow decentralization is currently almost completely traded on centralized exchanges,” Peter Johnson, a vice president at Jump Ventures, said in an interview. Buterin, however, wants the crypto community to focus more on decentralization so that cryptos can more frequently trade peer-to-peer. Buterin’s remarks come as so-called decentralized exchange gain more attention.

Like many of his arrogant ilk, Buterin ignores the lesson of Chesterton’s fence: why does this thing you do not like and do not understand exist?

Yes, blockchain and cryptocurrencies allow peer-to-peer transactions.  They were largely designed to facilitate such transactions.  For some, the motivation is ideological: an anarchic belief in radical decentralization, and a deep distrust of centralized institutions.

But just because blockchain and related technologies reduce the costs of peer-to-peer transactions, doesn’t mean that such transactions are cheaper than centralized trading on exchanges.  Transacting requires finding a counterparty.  It requires negotiating a price (for a standardized thing, like a Bitcoin–negotiations of other terms for more complex things).  Negotiating a price is costly when information about value is diffuse, so in a decentralized setting not only is it necessary to search for counterparties, it is advantageous to search for information about prices to (a) find the best price, and (b) to be able to negotiate with better information about value .

Centralization reduces the cost of finding a counterparty.  It enhances competition, which tends to reduce bargaining costs.  It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs.  Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs.  This is clearly what is happening in crypto world.  Indeed, the main puzzle at present is why there are so many exchanges.  The centripetal forces of liquidity will likely result in a huge consolidation in this space.

Buterin and others are attempting to find ways of mitigating some of the disadvantages of bilateral trading (bilateral just being another, more conventional, way of saying “peer-to-peer”).  Reducing the ways of finding people who want to take the other side of a transaction, for example.  But I am highly skeptical that these measures will overcome the inherent advantages of centralizing trading of homogeneous things that large numbers of people want to buy and sell pretty much 24/7, to the point that peer-to-peer will supplant centralized trading.  Buterin can rant all he wants, but centralization is here to stay, and if anything, this segment of the market will become more centralized.

Buterin’s error is seemingly the opposite of those who bewail the lack of centralization in some markets, e.g., those who want to make swaps trading more centralized and who rail against bilateral OTC transactions, but it is really the same mistake. Those who see too much centralization in some markets, and those who see too little in others, fail to recognize that trading mechanisms are emergent orders that develop diverse niches to accommodate the fact that transactors and transactions are heterogeneous.  Centralization is efficient for some transactors and transactions: bilateral/OTC for others.  That’s why we see both.

(This is a point I made at a Platts blockchain conference in November, BTW.  The theme of my talk was where decentralization can work, and where it is likely inefficient.  Trading of standardized instruments was one of the main cases I discussed.)

Alas, the ignorance of techno-geniuses is not limited to trading mechanisms.  One of the supposed benefits of blockchain that is that it allows the ownership of anything–a painting, a house, you name it–to be divided into shares, with the fractional interests recorded in an immutable register, and traded peer-to-peer.  That is, block chain facilitates equitization of assets.  A breakthrough!

Uhm, not really. The benefits of equitizing assets and risks has been long, long understood by economists.  In particular, it has long been understood that equitization facilitates more efficient risk sharing.

But long ago, economists also recognized that despite these apparent benefits, in fact very few assets and risks are equitized.  A vast literature has come up with explanations why.  Information and incentive problems–moral hazard and adverse selection–are notable among these.  A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft?  Who pays for maintenance? Who decides on what maintenance is needed?  When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?  There are other transactions cost problems associated with measurement (who verifies exactly what the asset is?) and opportunism and governance and control.   Related to the centralized trading point, if an asset is highly idiosyncratic/unstandardized, the desire to trade fractional shares will be small.

A potentially slightly cheaper way of recording and transferring fractional ownership does not address these far, far, far more fundamental impediments to equitizing (or should I say, “tokenizing”?) assets and risks.  But the coder geniuses miss the forest for the trees.  They see the issue that their technology can address, and think that it will be revolutionary, only because they do not understand the broader economic issues in play, and therefore think everyone born before them or who does not code must be an idiot.

No, not really.  They are looking at the capillaries, and missing the heart, veins, and arteries.

It reminds me of the Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years.”  Except seven years haven’t passed for the Buterins of the world, and frankly, I seriously doubt that they will.  Instead, they inhabit a techno-Groundhog Day.

All of this is symptomatic of blockchain hype and froth.  There is an indication that we have reached peak hype.  R3, a bank-led blockchain consortium, is contemplating an IPO.  To me this is a signal that those on the inside of blockchain development, especially in the area where its benefits have been particularly hyped (finance/payments/settlement/fintech) understand that the reality will never match the hyperbole, so it’s best to sell out while hyperbole reigns supreme.  (Yes, they claim that they are being approached by those looking to buy the whole thing, but take that with a big grain of salt–I view it merely as part of the sales pitch.  “This is a hot little property right now.  Better get in before someone snatches it away.”)

In brief: don’t be the greater fool.

I think that blockchain and DLT will have some viable commercial applications.  But I am highly confident that they will not be nearly as revolutionary as the True Believers claim.  This is in large part due to the fact that it is clear that the True Believers have an extremely narrow, blinkered understanding of the broader economic issues associated with transacting, ownership, risk transfer, incentives, and governance.  Blockchain may address some issues, but many–if not most–of these issues are secondary or tertiary, not fundamental.  Some things are done more efficiently in a centralized fashion–the trading of standardized instruments being one.  Some things are not equitized/tokenized not because it is technically infeasible/prohibitively costly to issue and record fractional interests, but because fractional ownership entails substantial incentive and information problems.

So don’t believe the hype.  And take a pass on those R3 shares, if they do come to market.

Addendum: the dominance of crypto exchanges is even more remarkable, given how they, well, pretty much suck.  They are hardly comparable to modern futures or equities trading exchanges.  Yet people still strongly prefer to trade on rather clunky platforms with major potential security issues where you can’t easily convert digital into fiat currency and which are likely rife with manipulation than peer-to-peer.  That tells you something.

This article isn’t explicitly about blockchain, but in a way it is. It describes the halting progress of the LME’s LMEShield digital warehouse receipt system, and ascribes its problems to the Alphonse-Gaston problem:

“It’s all about liquidity and a tipping point,” said an executive with a warehouse company.

“If Party A is using the system, they can’t trade if Party B is not using the system. It’s a redundant system until market masses are using it.”

After you, Alphonse. No! After you, Gaston! I insist! (Warning! Francophobia and Mexaphobia at the link!)

In essence, LMEshield is attempting to perform one of the same functions as blockchain–providing a secure, digital record of ownership. LMEshield’s technological implementation is not blockchain or distributed ledger, per se. It is a permissioned network operated by a trusted party, and does not employ a distributed ledger, rather than being an unpermissioned network not involving a trusted party, run on a DL.

But it is not that technological difference that is causing the problem: it is the challenge of coordinating the adoption of the use of the system. This coordination problem exists here even though there is an entity–the LME–that has an incentive to promote adoption and build a critical mass so that tipping takes over. Despite a promoter, the virtuous cycle has not taken hold. The adoption problem is even more challenging without a promoter.

This problem will be present in all attempts to create a secure digital record of ownership, regardless of the technology used to achieve this goal.* There is more than one technology to skin this cat, and it is not the technology that will in the end determine whether the cat gets skinned: it is the ability to overcome the coordination problem.**

And as I’ve noted before, if tipping does occur, that just creates another conundrum: tipping effectively creates a natural monopoly (or at best a small numbers natural oligopoly), which raises questions of market power, rent seeking, and governance.

Bitcoin world is providing an illustration of the challenges of governance (as well as raising questions about the scalability of blockchain). Block size has become a big constraint on the capacity to process transactions, leading to a spike in transactions charges and long lags in processing transactions. There are basically two proposals to address this issue: expand the size of blocks, or allow some processing to occur off the blockchain. This has divided Bitcoin world into camps, and raises the possibility that if the dispute is not resolved Bitcoin could experience a hard fork (i.e., split into two or more incompatible networks). Miners (mainly Chinese) want to expand block size: Core (the developers who maintain the software) want to externalize some processing. Both sides are talking their book–go figure–which illustrates that distributive considerations and politicking, rather than efficiency, will have an outsized effect on the outcome.

Keep both LMEshield and the Bitcoin block size debate in mind when somebody offers you pie-in-the-sky, techno-evangalist predictions of how blockchain/DLT Is Going to Change the World. It’s not the technology alone that matters. Indeed, that may be one of the least challenging issues.

Also keep in mind that there is nothing new under the sun. The functions that blockchain/DLT are intended to–or dreamed to–perform are inherent in all transactional settings, including in particular financial and commodity transactions. Blockchain/DLT is a different way of skinning the cat, but the cat has been skinned one way or ‘tother since the dawn of these markets. Maybe in some cases, blockchain/DLT will do it more efficiently. Maybe elements of blockchain/DLT will be blended into more traditional ways of performing these functions. Maybe some applications will prove resistant to blockchain/DLT.

But the crucial thing to keep in mind is that blockchain/DLT will not banish the fundamental challenges of coordinated adoption and governance of a system that scales. And note that if it doesn’t scale, it won’t replace existing systems (which do), and if it does scale, it will pose the same organization, governance, and market power issues that legacy systems do.

*There is no guarantee that DLT is even a technological advance on existing technology. As I discuss further on, some implementations (notably Bitcoin) have exhibited severe problems in scaling. If it don’t scale, it will fail.

**I own a cat. I like my cat. I like cats generally. If colloquialisms offend, this is not the place for you. Particularly colorful if somewhat archaic American colloquialisms that I learned at my grandfather’s knee. Alphonse and Gaston is also something I picked up from my grandfather. Today it would cause an outbreak of fainting, shrieking, and pearl clutching (though maybe not–after all, the characters are Europeans), but if you can’t separate the basic comedic idea from what was acceptable in 1903 (the year of my grandfather’s birth, as well as the date of that clip) but isn’t acceptable today, you’re the one with the issues.