Money Stuff

Tokens, Vaults, Ties and Taxes

Also the VIX, the Mayo Unicorn, and an agent-based model of bond market liquidity.

Tokens and securities.

A couple of years ago, a startup called the Sand Hill Exchange launched a website that allowed people to trade futures on the values of well-known private companies. This is the sort of thing that is normally regulated by the Commodity Futures Trading Commission or the Securities and Exchange Commission, but Sand Hill had found a way around that regulation: Their trades would occur on the blockchain, where the rules do not apply. No, just kidding, the rules totally apply! "Just because you mumble the word 'blockchain' doesn't make otherwise illegal things legal," I wrote at the time, and a few months later the SEC shut down and fined Sand Hill. (Sand Hill co-founder Elaine Ou went on to become my Bloomberg View colleague.)

But the basic lesson of Sand Hill -- that the blockchain is not a magic amulet to ward off governmental regulation -- never really sunk in. So the DAO, the "Decentralized Autonomous Organization," was "a new breed of human organization never before attempted," launched last year on the Ethereum blockchain (and promptly hacked). When corporations or partnerships or other old breeds of human organization raise money for investing projects from investors in the U.S., they have to comply with SEC rules about disclosure and investor protection. But the DAO was a new breed of human organization, on the blockchain, whose investors were protected by smart contracts and immutable code. Surely the old rules did not apply to it?

They did. Yesterday the SEC released an investigative report that "found that tokens offered and sold by a 'virtual' organization known as 'The DAO' were securities and therefore subject to the federal securities law." This is the most obvious imaginable conclusion. "Securities," for regulatory purposes, include any "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others," as the SEC explains in its investigative report. Investors in the DAO invested money: Technically they invested ether, but that still counts; "cash is not the only form of contribution or investment that will create an investment contract." They expected profits: The whole point of the DAO was that it would go and fund projects that would make money. And those profits were derived from the efforts of others: The DAO advertised itself as an "autonomous organization" that would be run by investors voting on projects to be run by smart contracts, but in practice DAO investors were relying on humans -- the developers of the DAO, the "curators" who would help choose projects, and the managers of the smart-contract projects -- to make their investments profitable.

So the DAO offering was a securities offering, was subject to the antifraud provisions of the securities laws, and should have been registered with the SEC (or conducted under an exemption from registration, for instance by limiting purchasers to rich "accredited investors"). It didn't do that, but the SEC decided to let this one go:

In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants:  the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.

That was nice of them.

Meanwhile there are approximately eight billion initial coin offerings going on right now. Here is a story about how "accomplished financiers are abandoning lucrative careers to plunge into the murky world of ICOs," in which the financiers say things like this:

“Unlike the traditional financial sector, there are no ceilings or barriers. There’s so much to imagine,” he said.

Or this:

“It’s a Cambrian explosion of ideas. But that means you have to put in your work to figure out which one is even likely to work,” he said.

There is a theory that ICOs are not, or don't have to be, securities offerings. The theory goes something like this: An ICO is an offering of tokens to be used on some existing or future blockchain platform to purchase goods or services. The tokens aren't shares in a common enterprise or profit-seeking investments; the sale of the tokens is just a pre-sale of a product. You start a cloud-storage company, and people buy tokens, and you use their money to build your cloud-storage service, and then the tokens can be used to acquire cloud storage. Cloud storage is not a security, it is a product, and so is not covered by SEC regulation.

In practice, though, it seems like most people are not investing in ICOs because they have a burning need for cloud storage at some indeterminate point in the future. They are investing in ICOs because they think that the particular project they're investing in -- or the "ICO sector" generally -- will take off and the tokens will become more valuable. That is, while the tokens are not stock in the traditional sense -- they usually don't have the voting or ownership rights of stock -- they look, financially, quite a bit like equity securities. They can be bought and sold, and their value is proportional to the value of the underlying project, which depends on the managerial efforts of the founders. Along with the DAO report, the SEC released an Investor Bulletin about ICOs, saying that "depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities." I am going to whisper in your ear something that is very much not legal advice, but that I nonetheless suspect is true: They're securities.

Blockchain blockchain blockchain

Ahahaha sure, sure, sure:

BitBounce, an anti-spam e-mail provider, is planning to raise as much as $20 million through an initial coin offering of digital tokens on the ethereum network. Founder Stewart Dennis says he may have millions of dollars worth of tokens left over from the ICO, which will need safekeeping. Recent hacks have revealed the risks of storing digital money online. Given those concerns, Dennis said he’s considering offline options, such as safe deposit boxes and theft insurance.

The new cutting edge in bitcoin security is writing your private key down on a piece of paper and putting it in a safe deposit box at a bank. It's a great way to disintermediate the banks!

The conventional wisdom is that cryptocurrency is about re-learning all of the lessons of modern finance in a sped-up way. (The SEC was formed in reaction to decades of shady behavior in U.S. stock markets; it started regulating ICOs months into their boom.) But what if it's the opposite? What if the story arc of cryptocurrency is about traveling back in time? First bitcoin was a way to make electronic payments without using banks; now it is a way to keep money in a safe deposit box at a bank without being able to use it to make payments; at this rate, in a decade, it will be a face-to-face barter system. By 2050, bitcoin users will undiscover fire. 

Elsewhere, here's Izabella Kaminska: "In ICO utopia, there is no division of labour." And: "Some Bitcoin Backers Are Defecting to Create a Rival Currency."

Where do the tech children want to work?

Here is a story about the difficulties that financial firms like Goldman Sachs Group Inc. and Quicken Loans Inc. have in competing with tech firms in trying to recruit young computer engineers at Internapalooza and hey wait a minute what:

But one high school senior on a day off from from his internship at a venture capital firm wasn’t sold.

"They’re looking pretty desperate," said Shreyas Parab, wearing a mustache-print necktie made by a company he founded. "They’re not super attractive for people who are entrepreneurial."

There are ... so many ... things ... there. His company is Novel Tie. "When he enrolled at Archmere in 2014, he realized his male classmates had an unmet need: creative ties, for 'when you want to look sly but also serious,'" says his website. "'So I created ties for kids just like me.'" Don't miss his Chick Magnet tie, only $24.99. I hope he does intern at Goldman, and goes around the trading floor trying to sell his ties to the partners.

A tax trade.

Here is a story about a man who bought a collection of Annie Leibovitz photographs for $4.75 million, donated them to a museum, and then claimed on his tax return that they were worth $20 million. That's fine, that happens all the time: You buy art cheap, it appreciates, you donate it to a museum, and you take a deduction for its appreciated value rather than its original purchase price. If there's enough appreciation, the value of your tax deduction can be bigger than the original price you paid, and the government essentially pays for your philanthropy and throws in a bonus for yourself.

But what's so goofy here is that there was no appreciation, and this was all one integrated transaction. The buyer paid $4.75 million with plans to donate at $20 million immediately; in fact, he is withholding part of the purchase price until authorities sign off on the tax valuation. The photographs were worth $20 million, his theory goes, at the exact moment that he was paying $4.75 million for them. That's ... possible! (They were appraised at $20 million, and there's a story about how he was effectively buying them in a fire sale, fine.) But it sure does look odd.

Obviously if it works it is a perpetual-motion money machine. I produce a signed print of this issue of Money Stuff. I sell it to you for $1 million. You get it appraised at $5 million. You donate it to the Money Museum. You deduct $5 million from your taxes, saving you about $2 million. (I assume that you, like so many of my readers, have a lot of taxable income.) Now you have $1 million more than you had before the trade. And so do I. Philanthropy is great.

People are worried that people aren't worried enough.

"The CBOE Volatility Index, known as Wall Street’s 'fear gauge,' declined to 9.04 at one point in the day, marking a new intraday low for the index," so for a time yesterday people were less worried than they've been at any other time in almost a quarter-century. (The VIX closed at 9.43, above the record closing low of 9.31 in 1993.) Obviously this worries people. "I think less and less it is reflecting the risks in the market," says one strategist.

People are worried about unicorns.

This article is titled "Inside Hampton Creek's Empty Boardroom," and while it is amazing, it is possible that it does not quite live up to its headline. What I really wanted, after that headline, was fly-on-the-wall reporting from inside the board meetings at mayo unicorn Hampton Creek Inc., now that its board of directors consists solely of Joshua Tetrick, its co-founder and chief executive officer. Do you think he holds the meetings? Out loud? "The chair recognizes Mr. Tetrick. Yes, Mr. Tetrick, I would like to move to approve the minutes of last month's board meeting. Thank you, Mr. Tetrick, do I have a second? I see Mr. Tetrick seconds. All right, all in favor? Aye. The vote is unanimous." I bet it goes on for hours.

But the article is actually about how Hampton Creek got into this situation, which is also pretty nuts. It "began in 2015 after Tetrick revised the startup’s governance documents to strip away the board’s authority," and then proceeded to do things like fire his chief financial officer, chief operations officer and head of human resources without telling the board. The board tried to buy back power from Tetrick:

Running out of cash, the board members made an offer they hoped Tetrick couldn’t refuse, said two of the people. Existing shareholders would provide Hampton Creek up to $60 million of fresh capital on the understanding that Tetrick return power to Hampton Creek’s board, said one of the people. It would also allow the board to move Tetrick to a diminished role and place a more experienced executive in charge of operations, three of the people said. Tetrick declined the offer, which was never formalized in a term sheet, they said.

Instead, he agreed not to "make major decisions without consulting his directors," but then he used an elaborate ruse (a fake venture capitalist meeting in Majorca!) to fire some more people without telling the board, and the board members sort of slunk away one by one.

One nice thing about this story is that it shows that there is, at some limit, a tradeoff between capital raising and governance rights. You rarely see companies confronted directly with the choice of raising more money or keeping more control: Snap Inc. sold nonvoting shares in its initial public offering, and investors complained, but they never credibly argued that they'd have paid more for voting shares. Here, though, Tetrick was very directly given the choice of more money or more control. He chose control.

Elsewhere, Lyft is introducing "Taco Mode." And:

Giant venture-capital funds are piling up in Silicon Valley, a sign that foundations, pension funds and endowments are still willing to rush money into the risky startup sector despite lingering concerns about overheated valuations.

People are worried about bond market liquidity.

Here is a paper by Donald Berndt, Saurav Chakraborty and James McCart of the University of South Florida and David Boogers of FinaMetrics.com on "Using Agent-Based Modeling to Assess Liquidity Mismatch in Open-End Bond Funds." They run agent-based simulations for a bond-market shock with various levels of mutual-fund ownership, in which mutual-fund investors have a tendency to redeem out of their funds -- and force more bond sales -- when bond prices drop due to some external event. When mutual funds own 15 percent of bonds in their model, everything is great: The shock lowers the price of the bonds, the market accommodates the mutual-fund redemptions, and the bonds quickly settle at the new correct price.

At 25 percent mutual-fund ownership, everything is fine, just fine: The bonds overshoot the correct price, but not by too much, and it's a buying opportunity for value investors.

At 35 percent, it is chaos and death:

They write:

In fact the concave curve means that the price drops accelerate with correspondingly dramatic wealth destruction. The price drops are more pronounced from the outset, but reach an inflection point followed by precipitous price drops until all the dealer capacity is consumed (and the market flatlines). In these simulations, the redemption-driven price drops dwarf the initial interest rate shock effects. The feedback loop causes price drops in the 35% to 44% range, as compared to the shock-induced drops of roughly 1% to 14%.

You shouldn't take those numbers too literally -- these are simplified agents, not real mutual funds and dealers -- but I guess if you want to worry, or not worry, about bond market liquidity and mutual-fund withdrawals, you can find a model to suit either preference.

Begging Stuff.

Ah yes, here is a story about economists who "think panhandlers could benefit from being certified, similar to the way personal trainers are":

O’Flaherty and his co-authors say an app could be one solution. Panhandlers who have been vetted by nonprofits would be assigned identification numbers that they would display on their signs. Potential donors could look up the panhandler on the app to see a photo of them and verify that they’re credentialed, then tap to make a donation. Most panhandlers carry phones, O’Flaherty and his co-authors found, so the app could inform the panhandler of the donation. The organizations doing the certifying would decide what criteria a panhandler would have to meet to get credentialed.

You could call the app Panhandlr. I would read a study of what motivates economists to write papers like this. Like it is not a bad idea, really, certifying panhandlers. It is not a realistic idea, but neither are lots of economic ideas. It does not exactly help that much, but what are you doing to help? And yet the paper so clearly invites negative reactions that you have to kind of think that's what the authors wanted?

Law 5B of Insider Trading.

Yesterday I mused that it's sort of inspiring that short sellers (almost?) never poison the products of the companies they are short, and about a thousand of you pointed out that it happened on "Billions." So, yes, okay, fine, fictional short sellers really are icky and un-American. Meanwhile in the real world, "Chipotle Mexican Grill on Tuesday said the $1 billion in value the chain lost over five days was caused by a single employee coming to work sick" with norovirus.

Things happen.

Greece Raises EU3 Billion in Bond Market Return After 3 Years. Starboard Value Hedge Fund Wants to Force ComScore to Hold an Annual Meeting. HNA Mystery Man Gives Away a Fortune and Raises Fresh Questions. Ex-Wives and Kids’ Schools: Digging for Dirt on Chinese Stocks Gets Personal. IPO Backed by Morgan Stanley and One of Asia’s Richest Men Gets Denied. Fed Balance Sheet Shifts Into Limelight Absent Rate Hike Urgency. Happy five-year anniversary, "whatever it takes"! ‘Super firms’ claim record share of euro bond sales. The gold trick. HUD Ignored Procedures in Selling Distressed Mortgages, Report Says. Finance jobs are moving to Denver. Why Can’t Americans Ditch Checks? CFA Says Pass Rate for Level 2 Climbs to 47%, Highest Since 2006. "People have long tagged pets. And businesses regularly use chips to track shipments. Implanting employees, however, still sounds like an idea out of science fiction." Don't make company songs. Bear blamed for cliff-jumping deaths of 209 sheep in France. L.A. man accused of smuggling king cobras in potato chip cans. Pablo Escobar's hippos.

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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:
    James Greiff at jgreiff@bloomberg.net

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