Fintech, Governance and Data Feeds
Programming note: Money Stuff will be off on vacation tomorrow and Monday. I'll see you back here on Tuesday.
Here is a blog post from Carlypso about Beepi. What? I don't know what those things are either. But the post is about market structure in online used-car trading, and it is a fun read if you are interested in market structure and trading more generally. There are some useful aphorisms. ("Used car managers at traditional dealerships will tell you that 'you make all of your money when you buy the car'"; "the longer a car stays in dealer inventory the higher the risk of it becoming a money-loser.") But the important insight is that not every market works as a peer-to-peer market:
Bridging a seemingly obvious inefficiency in the market, i.e. paying private sellers more than trade-in value and selling the cars to customers for less than traditional retailers while still capturing a margin for $1,000 – $1,500 per car sounds like a compelling proposition.
But -- says Carlypso -- it's not as simple as that. "Traditional dealers get up to 50% of their inventory as trade-ins and the rest from wholesalers and vehicle auctions," because private sellers are too expensive: You need to pay for marketing to find them, and when you do, they "always think their cars are special and worth more." It's hard to replace the used-car market with a peer-to-peer internet structure because it is not a peer-to-peer market. Used car dealers add value by intermediating between one kind of seller and a different kind of buyer; they don't just match up similar buyers and sellers and take a cut. They move supply from one market to another. Making the market flatter and more transparent isn't sufficient to make it work.
Here is an article from Nathaniel Popper on the disappointments of fintech:
The venture capitalists who have invested billions of dollars in this wave of new financial technology — think Venmo and Bitcoin — have been left waiting for a breakout star that actually looks like a threat to even a part of the big banks’ business.
“A lot of people set out saying, ‘We are going to displace the banks,’” said Sheel Mohnot, a venture capitalist at 500 Startups who focuses on financial technology. “We realized along the way that you really have no choice but to work with the banks.”
Part of the banks' moat is regulatory, of course. But there is also the fact that banking is not as simple as it seems, because banks match different universes of buyers and sellers. The promise of "peer-to-peer lending" was, originally, that some regular people would want to lend money, and others would want to borrow money, and a smart platform could match them up and cut out the legacy costs of banks. That solution might be right, but the description of the market seems mostly wrong. Lots of people want to borrow money, but fewer want to lend it. They want to put their money somewhere safe; the magic of banking is that it issues safe deposits and uses them to make risky loans. "At a more fundamental level, online lenders realized how hard it was to fund the new loans they wanted to give out without having access to cheap deposits, as the banks do," writes Popper. Borrowing from depositors and lending to borrowers creates value. Borrowing from lenders and lending to borrowers seems like it would be easy, but there's a reason it's not much of a thing.
Or take bond market liquidity. Investors want to buy bonds, and investors want to sell bonds, and an all-to-all electronic platform can match them up more efficiently than any bank can. Maybe! Except that investors, in the aggregate, don't want to sell bonds. U.S. corporate debt outstanding constantly increases. Companies want to sell bonds; investors want to buy them. A neutral platform that matches investors with investors will miss the most important source of supply, new issuance. Banks, which underwrite new bonds, match companies who are selling bonds with investors who are buying them. This new-issue allocation process helps to ensure that they also dominate investor-to-investor trading. If your view of the problem is limited to investor-to-investor trading, you might build a cool electronic system to solve it, but that's not quite the right problem.
My basic theory of corporate governance, stock buybacks, long-termism versus short-termism, etc. is:
- These are essentially debates about who should make decisions at companies, managers or shareholders; and
- It depends on the managers and the shareholders.
I guess it is not much of a theory -- it is obvious, for one thing, and has no particular predictive power, for another -- but I nonetheless find it clarifying. It helps you avoid extremes. For instance: Are stock buybacks bad? Well, a stock buyback is a transfer of the investing decision from managers to shareholders. The company has money. The managers can decide what to spend it on. (Research or factories or corporate jets or whatever.) If they instead give it to the shareholders in a stock buyback, the shareholders can decide what to spend it on. (Investing in new startups or personal consumption or whatever.) The buyback is bad if the managers would have spent the money on something better, and good if the shareholders spend it on something better. Some managers have lots of good opportunities and are good at picking which ones to invest in. They should invest money and not do stock buybacks. Some managers have fewer opportunities and are bad at picking them. They should do stock buybacks.
And so in fact when you see activists agitating for buybacks, the thesis is rarely that buybacks are always and everywhere good: It's that the managers have more cash than they have opportunities, or are bad at identifying opportunities, and so should give the cash back to the shareholders to find something better to invest in. Here's an article by Alessio Pacces on "Hedge Fund Activism as a Conflict of Entrepreneurship":
Not knowing the proper length of time in which to assess corporate performance (call it the “right term”), whether management errs towards the long term (“long-termism”) or hedge funds err towards the short term (“short-termism”) is hard to say when the conflict occurs. This conflict is rather about how the company should be managed, that is, a conflict of entrepreneurship.
Or: Is it bad for a company to have a dual-class share structure that concentrates power in its chief executive officer? Yes, if that CEO makes worse decisions than an empowered group of public shareholders. And no, if the CEO makes better decisions. I suppose it is hard to know in advance, but it is hard to know lots of things in advance, and the whole job of investing is making predictions about what a company will do in the future. If you are an investor in a public company, one central question that you always have to ask is: How much do I trust this management team? If the answer is "not at all," you shouldn't invest, no matter how good the company's governance provisions. (Well, or you should invest and launch a proxy fight to oust the management team, but that is an advanced move.) If the answer is "the regular amount," you should invest in the company if it has good governance provisions that allow you to monitor managers the regular amount. If the answer is "so much, they're the best," then the fact that the company concentrates power in management and limits shareholders' voting rights shouldn't be that big a deal. (Until the managers retire, I mean.)
Anyway here's John Plender on "Snap and the 21st century governance vacuum":
By any standard Snap’s governance arrangements are flawed and its directors minimally accountable. Anne Simpson, a leading governance expert at the California pension fund Calpers, dubs this “a banana republic approach” to corporate governance.
Snap Inc. has of course taken the dual-class stock concept to its logical extreme, and is planning to sell non-voting stock to public shareholders in its initial public offering. That is a choice about decision-making! If you trust the founders a whole lot -- and figure you'll retire before they do -- then it seems fine.
Plender is most interesting on the historical context of governance:
Today’s governance codes are rooted in a 19th century concept of the corporation, where the shareholder-capitalist is seen as the key stakeholder and risk-taker in the system. The implicit assumption is that the shareholder is entitled to the residual profits and net assets of the company after the claims of labour and all the other creditors have been met.
This view of the limited liability company made sense in the 19th century, when capital was scarce and labour cheap and plentiful.
But now that "the world is awash with savings and finance capital is abundant, and "the real driver of high growth in the economy is increasingly human capital," things have changed. And "in the technology sector the issue of fairness between the different stakeholders in the corporation has been unilaterally resolved by founding entrepreneurs who have retained voting control despite bringing in outside capital."
That is: Snap and other tech companies don't represent a governance vacuum. They'll be governed. They just represent a shift in governance: They'll be run by entrepreneurs rather than shareholders, because the bargaining power has shifted in the entrepreneurs' favor, and because the entrepreneurs' contributions to the company are relatively more important than the shareholders'. That seems like a perfectly reasonable way to run a company. It's just not the traditional way.
The impact of IEX’s announcement may be largely symbolic. Only about 2% of U.S. equities trading takes place on the startup exchange, and much of the time, the prices displayed on other exchanges are better than those being quoted on IEX. That limits the value of IEX’s new web tool for someone seeking the best prices available in the marketplace—not least because investors can already find such prices on websites such as Yahoo! Finance.
In addition, the sophisticated brokers and trading firms that use stock exchanges’ market-data feeds are unlikely to use a relatively slow web-based interface to track activity on IEX.
A central insight of IEX is that there is such a thing as public relations for stock exchanges. You can become a well-known institution, get books and articles written about you, earn a groundswell of support from retail investors, all by setting yourself up as the champion of the little guy in market structure. You can understand why other stock exchanges missed this. (Mostly: The little guy's trading is normally internalized by brokers, meaning that no U.S. stock exchange really has much of substance to say to retail investors.) But they did miss it. We talked recently about a delightfully tone-deaf comment letter from the New York Stock Exchange to the Securities and Exchange Commission, defending some of NYSE's fees and responding bitterly to its own customers' criticism. Market data and technology setups are well-known cash cows for the major exchanges, and the exchanges defend them. The public-relations value of being nice about them never really comes up.
Meanwhile IEX gives away its (web-based, top-of-book, not-always-on-the-national-best-bid-or-offer) feeds for free. It also gives its actual, useful, high-speed data feeds away for free to the sophisticated firms who trade on IEX. But the web API isn't for high-speed trading. It's potentially helpful for app developers: "IEX API 1.0 provides any individual or academic, public or private institution looking to develop applications that require stock market data to access near real-time quote and trade data for all stocks trading on IEX." It's good public relations. It makes IEX seem nice and helpful and a good citizen.
It also draws attention to other exchanges' expensive data, which makes those exchanges seem less nice. The press release includes a dig at them from IEX co-founder Brad Katsuyama, who says: "Legacy stock exchanges obstruct transparency and create an uneven playing field by overcharging for market data on orders they did not create." It turns out there's some value to be captured by seeming nice, even as a stock exchange. No one else seems to want it.
White-collar crime investigations are weird. Here's a story about a Justice Department investigation of potential tax evasion at Credit Suisse AG, in which a cooperating witness secretly recorded Credit Suisse managers starting in 2015:
Yet it wasn’t until late 2015 that the Justice Department informed Credit Suisse’s general counsel, Romeo Cerutti, that investigators had flagged an unspecified issue at the bank’s desk serving Israeli clients, according to people familiar with the discussions. They instructed him to do nothing about it to avoid interfering with their examination, the people said.
That put Mr. Cerutti in the awkward position of having to stand by as a fresh probe into a painful issue from the bank’s past unfolded, people said.
Why tell him then? It seems strange for the Justice Department to tell a company "you are committing a crime, but please don't do anything to stop it, because we want to catch you in the act." This is not how murder investigations work.
Lynn Tilton, the founder of Patriarch Partners, who is in legal disputes with the Securities Exchange Commission and MBIA Inc., has a podcast about her fight that you should listen to. The first episode -- "7 years a target prologue" -- is six minutes long and features Tilton discussing her situation in purple prose delivered in a gray monotone:
So I realized that I could best tell my story, best teach others, best inspire those who want to follow, and to show people that most don't lose because they're in a position to lose but because they give up, and the powerful and the ugly win because they know how to create campaigns of lies and destruction, and most decide it's not worth it. And I understand that feeling. But why do I continue on, why do I fight on, why do I journey forward? And it's the same reason I built this business: for others. And in the end one has to believe that justice prevails and that truth wins and that light ignites itself and that darkness fades.
The effect is equal parts terrifying and soothing. It will put you to sleep, but your sleep will be full of nightmares. I kind of want to play it for my baby.
Math and legal realism.
Here is a story about a math professor, Moon Duchin of Tufts, who trains mathematicians to work as expert witnesses in gerrymandering cases, which seems like a small niche but an interesting one. (Basically: Electoral districts are supposed to be compact. Mathematicians study compactness. Etc.) But I particularly liked this anecdote:
Recently there was a big media sensation in Wisconsin around something called the "efficiency gap." It was a new metric of partisan gerrymandering that, for the first time, a court said they liked. The way it was devised was that the people who created it, they went back and they read all of Justice Anthony Kennedy’s written decisions about measuring gerrymandering. By reading his words and by reading what he said he found convincing and less convincing, they designed a statistic to appeal to him. He’s that vaunted median justice. If you can come up with something that will be convincing to Anthony Kennedy, then you’ve probably just changed the outcome.
It's ... like ... mathematical legal realism. They proved a fixed-point theorem about Supreme Court majorities and then optimized their process to make the majority the one they wanted. It is exactly my preferred combination of cynicism and elegance.
People are worried about unicorns.
If nothing else, you have to be impressed by the persistence of Theranos, the Blood Unicorn (Elasmotherium haimatos), which keeps getting its labs shut down months after they've already been shut down. "An Arizona lab run by blood-testing firm Theranos Inc. put patients at risk and failed to quickly fix its deficiencies, the main U.S. lab regulator found, triggering a new round of sanctions last month against the company," even though Theranos shut down that lab in October. I don't really know what Theranos does any more. One answer might be "get in trouble with regulators," which doesn't sound like it would be a business model, but a lot of banks have been running that way for years and they seem to be fine. Perhaps that is Theranos's pivot? In any case, I look forward to regulators continuing to shut down labs that Theranos wasn't operating anyway.
Elsewhere, Uber has an "aggressive, unrestrained workplace culture":
Between bouts of drinking and gambling, Uber employees used cocaine in the bathrooms at private parties, said three attendees, and a manager groped several female employees. (The manager was terminated within 12 hours.) One employee hijacked a private shuttle bus, filled it with friends and took it for a joy ride, the attendees said.
And: MIDI unicorn.
People are worried about bond market liquidity.
Here you go:
We present a model of market makers subject to recent banking regulations: liquidity and capital constraints in the style of Basel III and a position limit in the style of the Volcker Rule. Regulation causes market makers to reduce their intermediation by refusing principal positions. However, it can improve the bid-ask spread because it induces new market makers to enter. Since market makers intermediate less, asset prices exhibit a liquidity premium. Costs of regulation can be assessed by measuring principal positions and asset prices but not by measuring bid-ask spreads.
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