Bitcoin Bail-Ins and Yuan Bets

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Bitcoin bail-in.

Bitfinex is a bitcoin exchange that suffered a $71 million hacking attack. It is not, to put it gently, the first bitcoin exchange to get hacked. Historically, the way bitcoin-exchange hacks work is that the exchange keeps all of its customers' bitcoins in a single commingled bitcoin wallet, the hackers steal bitcoins from the wallet, and the exchange then passes those losses on to its customers with a mumbled apology. Bitfinex, however, had a separate bitcoin wallet for each customer. ("The era of commingling customer bitcoin and all of the associated security exposures is over," it said, in happier times.) So when hackers stole about 36 percent of the bitcoins at Bitfinex, they didn't just steal 36 percent of each customer's bitcoins: They stole, basically, all of the bitcoins owned by 36 percent of the customers, and none of the bitcoins held by 64 percent of the customers. (Weighting customers by account size; you know what I mean.)

But Bitfinex decided to socialize the losses:

Due to the indiscriminate nature of the attack, we have decided to generalize losses across all accounts. Upon logging into the platform, customers will see that they have experienced a generalized loss percentage of 36.067%. In a later announcement we will explain in full detail the methodology used to compute these losses.

Customers will also get "a new token on the Omni protocol" that will be transferable and "remain outstanding until repaid in full by Bitfinex or exchanged for shares of iFinex Inc.," Bitfinex's parent company. "Raising capital is one strategy we are considering for making our customers whole," says Bitfinex, optimistically.

This is bitcoin, so obviously some people are uncomfortable with the idea of socializing losses even within an exchange. There are other issues. Here's Izabella Kaminska on the victims of the hack:

They are still going to be entitled to track the funds across the blockchain to seek recourse from whomsoever receives the bitcoins in their accounts. That’s good news for victims, but mostly likely very bad news for bitcoin’s fungible state and thus its status as a medium of exchange. 

It is all a mess, and yet it is a charming, hopeful mess. It is easy to make fun -- and I do make fun -- of bitcoin/blockchain enthusiasts for naively re-creating everything that has existed for decades or centuries in the traditional financial system. Modifying contract rights, spreading losses among creditors of an insolvent firm, giving them equity to make up for it: That's how bankruptcy works. There is not quite a blockchain concept of bankruptcy yet, but Bitfinex is sort of groping toward it. The rest of the world has already arrived.

But this stuff is hard! Not the keeping-out-hackers stuff, though obviously that is hard too, but the stuff about how to spread losses and deal with moral hazard and weigh the inviolability of contract rights against fairness and other goals. The regular financial system had a massive crisis of legitimacy eight years ago, where very basic questions about how to allocate losses were fought over bitterly; today, Italy and Puerto Rico and lots of other places are dealing with similar issues. In a sense, the regular human financial system has over the centuries evolved a lot of pretty good and flexible systems -- of contract law and bank regulation and bankruptcy and so forth -- for dealing with unexpected financial problems. In another sense, we still seem to be at a loss every time they come up.

The bitcoin/blockchain people come to all of this very late, and many of them come to it with a sort of naive libertarian idealism that can make practical rule-making difficult. But they generally come to it pretty smart, and they can build on what the financial system has learned over the centuries without being bound to all of its mistakes. The responses to bitcoin hacks provide a fascinating laboratory for the future of finance. It's a good thing that there will be so many more of them!

Elsewhere, here is a post on "The emergence of blockchains as Activity Registers" that I found helpful.

The market can remain irrational etc.

Here is a profile of Mark Hart, who runs a hedge fund called Corriente Capital that has been betting against the Chinese yuan for seven years. There's a photograph of Hart in his Fort Worth office under "a chalk-on-blackboard copy of The Raft of the Medusa, that icon of 19th century French Romanticism," which, in black and white, is even more unsettling than the original. But far more horrifying is this chart, of the yuan/dollar exchange rate, which just goes up and up and up and up for six years until his fund expires. Then it goes down. Then he starts a new fund

I mean, it's been going down since then, so I guess it's fine. (And to be fair, "even if he’d still had his wager in place" in summer 2015, "'it’s not like it would have really made me money,' Hart says.") And he made a ton of money on the housing crash and so forth. Still, that chart ought to give you nightmares. They ought to put that chart up on the screen on the first day of Hedge Fund 101. "Look to your left. Now look to your right. One of the three of you will end up closing your fund a couple of months before your big bet would have paid off."

Last week Michael Mauboussin of Credit Suisse published some "Reflections on the Ten Attributes of Great Investors" to mark his 30 years in the business. It's good. I feel like these lists always include something like this:

Great investors do two things that most of us do not. They seek information or views that are different than their own and they update their beliefs when the evidence suggests they should. Neither task is easy.

And something like this:

Great investors don’t get sucked into the vortex of influence. This requires the trait of not caring what others think of you, which is not natural for humans. Indeed, many successful investors have a skill that is very valuable in investing but not so valuable in life: a blatant disregard for the views of others.

There's other stuff -- about accounting literacy and position sizing and so forth -- but just from those two things, doesn't investing sound impossible? Like, the two key skills are:

  1. Seeking out different views that will force you to revise your own views.
  2. Ignoring what everyone else thinks so you can go against the grain.

Those are opposites. How do you know which one to do when? 

"The battle of six and 16."

There is a sort of long arc of modern financial history in which markets replace banks in various activities, because markets are coldly efficient and price everything rationally, while banks suffer from all the inefficiency of, like, meeting with customers and expecting a high return on equity. There is something similar going on in the reinsurance industry, where pensions are happy to buy catastrophe bonds that effectively protect insurance companies against disasters at much cheaper prices than traditional reinsurers charge. The reinsurers are not happy:

Mr. Ehrhart, the Aon executive, says he used to call the profit squeeze “the battle of six and 16.” Reinsurers historically aimed for returns of 16% a year. The pension funds snapping up cat bonds are happy with just 6%.

By last year, though, the overall return of reinsurers tracked by Fitch Ratings had fallen to 9.9%.

Yes right six is less than 16. If someone charges six, and someone else charges 16, probably go with the six. It is such an inevitable process, though. Here is the story of the guy who invented catastrophe bonds in 1993:

Mr. Müller and a colleague at Hannover Re, Dirk Lohmann, were working on ways to build up the reinsurer’s capital base so that the German company could take advantage of rising rates. Some of their bosses worried about opening up the lucrative business to Wall Street and asked: “Are we opening Pandora’s box?”

Mr. Lohmann replied: “If we don’t do this, somebody else will.”

So off they went on a dismal roadshow that just barely sold any bonds but that ultimately paved the way for the declining profitability of their industry. And while cat bonds are good for insurance companies, which can get cheap protection by selling cat bonds instead of going to reinsurers, the insurers are next:

Some companies are starting to obtain insurance by issuing notes directly to bond investors. Last year, Amtrak sponsored $275 million of cat bonds that will pay out if specified storm surges, winds or earthquakes hit the Northeast during a three-year period.

The general trend is that underwriting anything -- a mortgage or a consumer loan or an insurance policy -- was once done through some combination of data analysis and look-'em-in-the-eyes personal relationships. Over time, the data got better, while the relationships were hard to scale. At some point, if the underwriting and pricing of risk is a purely depersonalized data-driven affair, an open market may be the most efficient way to do it. And so the old banks and insurers get disintermediated.

Market structure.

One critique that you sometimes hear about high-frequency trading is that it is a socially wasteful arms race in which firms constantly compete to build faster communications technology just so they can get a tiny edge on each other. It has never been all that obvious to me that competing to build faster communications technology is socially wasteful. That aside, the arms race can only go so far, as there are physical limits on how fast you can communicate, and these sorts of complaints have tapered off in recent years. There are only so many towers you can build, only so many technologies you can use. I assumed we had approached the limit and everyone had given up. But nope, here you go:

A handful of financial-technology startups are arming many of the world’s most powerful trading firms and exchanges with devices that promise to handle stock-market transactions at rates rivaling the speed of light, as the race for speed in financial markets remains alive.

Engineers at Sydney-based Metamako LP and Exablaze Pty. Ltd., and Chicago-based xCelor LLC are rolling out switches that take around four nanoseconds—four billionths of a second—for messages to transit from one side to the other, sending data from exchanges to electronic traders.

Congrats to everyone on your new four-nanosecond switches. I assume they are expensive.

Libor is weird.

I guess this could be "People are worried about short-term unsecured dollar funding." The particular worry is the October 14 deadline for money-market fund reform, when money-market funds that lend money to banks will have to convert to floating net asset values. Some investors won't like this, and will withdraw their money. The funds are preparing for this by basically hoarding liquidity, which means that when their longer-term (3- or 6-month) loans of U.S. dollars to banks expire, they are not rolling them over but are replacing them with very short-term paper. This makes it more and more expensive for banks to borrow unsecured for longer than a month. But bank regulation -- the liquidity coverage ratio -- essentially requires banks to borrow unsecured for more than a month: Regulators require banks to have unencumbered high-quality liquid assets to meet all short-term outflows; loans that mature in less than a month count as short-term outflows, and secured borrowing encumbers assets, so the only way to keep your ratio up is to borrow unsecured for more than a month. So the supply of unsecured loans to banks is going down, and the demand is staying stable, so the price is going up. Which means that "the dollar London Interbank Offered Rate, or Libor, has risen to the highest level in seven years while the cost of converting Japanese yen into greenbacks has surged." That's from Bloomberg's Tracy Alloway. And here is the Financial Times's Robin Wigglesworth with more.

We used to talk sometimes around here about how people were worried about swap spreads. They talk about them less now, but long-end swap spreads remain negative. I see (at around 8 a.m.) the 10-year Libor swap at about 1.48 percent, about 11 basis points tighter than the 10-year Treasury at 1.59 percent. Meanwhile the short end is the opposite: 3-month Libor is about 0.79 percent, versus about 0.26 percent for the 3-month Treasury bill. One-year Libor is about 1.48 percent, roughly equal to the 10-year swap rate. Back in my day, Libor was sort of the risk-free rate for most practical purposes, swap rates were the unproblematic extension of Libor over more than a year, and they were all sensible interest rates with a basically upward-sloping term premium. Now everything is weird technicals, and short-term rates are higher than long-term ones.

Elsewhere: The yield on 10-year Treasuries is already negative, swapped to yen. 

Rolling thunder.

Look, finance is fun and interesting and exciting, but it is unavoidably true that the core activities of finance are, like, sitting at a desk, typing on a computer, talking on the phone and going to meetings. There's just not a lot of parachuting behind enemy lines or seducing beautiful strangers at the baccarat table. Any "swashbuckling" is, with one glorious exception, metaphorical. That's fine! But here is the story of how Dell raised the money to finance its acquisition of EMC. On the one hand, it is an interesting story of tweaking the capital structure to put a surprising amount of investment-grade debt on what was ultimately a non-investment-grade company; also there is a tracking stock. On the other hand, the way they raised the money is, you know, they got on the phone and went to meetings and asked people to buy bonds, and those people did some calculations on their computers and were like, sure, we'll take some bonds. But this is a good effort from Egon Durban, the Silver Lake partner who helped lead the 2013 leveraged buyout of Dell:

“We had a rolling thunder campaign, where we followed one step after another,” Mr. Durban said.

It's true, it's so true; first they sold bank loans, then they sold investment-grade bonds ("The Dell and Silver Lake teams held some 40 calls for the offering"), then they sold a Term Loan B, then they sold junk bonds, then they sold off some assets. One thing happened, and then another thing happened. I hope some Silver Lake associate rattled a copper sheet to make a thunder sound effect each time they closed a tranche of the financing. 

People are worried about unicorns.

Here is some worrying about the effects of the unicorn economy on San Francisco's restaurant scene, if you're into that sort of thing:

The tech-boom economy also infects everyone inside and outside of it with both dreams of striking it rich and fears of getting priced out of town. That’s why chefs don’t just open that one restaurant they’ve always dreamed about. They invent catchy new restaurant “concepts” and borrow mountains of money to create dining rooms that end up with no human touch and food that looks remarkably similar to Instagram photographs of dishes created by trendsetters like Mr. Kinch and Mr. Patterson.

And: "These days every company is a tech company."

People are worried about bond market liquidity.

Here's a report from the International Organization of Securities Commissions, which says the same thing as every other official report: "IOSCO did not find substantial evidence showing that liquidity in the secondary corporate bond markets has deteriorated markedly from historic norms for non-crisis periods."

These conclusions are always a little unsatisfying. The basic narrative of bond-market-liquidity worrying is that big banks have cut way back on using their balance sheets to conduct principal market-making transactions in bonds, and are instead acting as agents, working orders to try to match up buyers and sellers rather than taking the risk themselves. ("Buy-side market participants point to evidence that in the U.S. trades in approximately 30%-40% of investment-grade corporate bonds and as much as 70% of high-yield corporate bonds are executed following the receipt of an order," says IOSCO.) Pointing to evidence that, say, volumes are stable and spreads are tight does not really answer this worry, which is not so much about a lack of liquidity now as it is about the possibility that, if buyers do disappear, dealers won't be able to pick up the slack. IOSCO is aware of the issue:

Some dealer representatives expressed the view that regulatory requirements, e.g., higher capital and leverage requirements, have reduced dealer ability and willingness to allocate capital to proprietary and market making activities, hold positions (particularly large inventories) in corporate bonds over time, and actively trade corporate bonds. As a result, they believe that the resulting decline in the breadth of participation on the dealer-side is likely a contributor to the sense of illiquidity perceived by some buy-side market participants today. In addition, a few industry representatives opined at a roundtable that when economic conditions (particularly interest rates) change and are more favorable, dealers may be more willing than today to increase the portion of their balance sheet allocated to making markets in corporate bonds.

Things happen.

Goldman warns of Brexit restructuring. Worst banks in EU stress tests have paid €20bn in dividends since 2011. Wal-Mart to Acquire Jet.com for $3.3 Billion in Cash, Stock. Trump to Propose Moratorium on New Financial Regulations. Installment loans. Fake gold! A Critique of the ValueAct Settlement. U.S. Seeks New Hearing in Countrywide ‘Hustle’ Appeals Case. Ronald Barusch on Viacom. Gretchen Morgenson on Diamond Resorts International. "In the chase for funds, think tanks are pushing agendas important to corporate donors, at times blurring the line between researchers and lobbyists." Silvio Berlusconi sells AC Milan to Chinese group. Bank boss Mark Carney glitters as he models an eye tattoo at the Wilderness music festival. Is fire bad? Have Two Drinks at a Party. It's Now OK to Take Your Dog Out to Dinner. "We have to gamify sex."

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Brooke Sample at bsample1@bloomberg.net