Bitcoin Forks and Unicorn Fakes
Yesterday afternoon I wrote about how bitcoin exchanges dealt with the Bitcoin Cash hard fork and short sellers, which is a surprisingly weird story. I mentioned an analogy between a bitcoin fork and a corporate spinoff, but there is an important difference between those two events. In a spinoff, you own stock of ParentCo, and the board of directors votes to give you shares of SubCo, and then ParentCo hands you those shares of SubCo. There is a very direct link between ParentCo and SubCo. In a fork, on the other hand, you own some bitcoins (BTC), but bitcoin doesn't have a board of directors, and The Bitcoin Blockchain Itself doesn't go and hand you some forked bitcoins (BCH, "Bitcoin Cash," in this case). It's just, like, some bitcoin people like the old blockchain, and some people want a new blockchain, and so they create a new separate blockchain that starts with everyone on the new blockchain owning whatever they owned on the old blockchain.
So tomorrow I could just download the bitcoin blockchain and say "everyone who owns bitcoins as of now also owns one Mattcoin." And no one would care, because Mattcoin is not a thing. And because every dumb joke about cryptocurrency has also actually happened, this has actually happened: CLAMcoins were distributed to bitcoin holders (also to Dogecoin holders because, remember: every dumb joke) in 2014, unasked for, and are actually worth a little bit of money.
This is all fine and funny and dumb, but it creates an issue for an exchange that allows short-selling of bitcoins. The basic idea of short selling is that you borrow a thing -- a share of stock, a bitcoin -- and then you have to return the thing at some point. Traditionally, if there are distributions on the thing -- if a stock pays a dividend or has a spinoff -- then you have to return the distribution as well as the original thing. (The person you borrowed the thing from should get back whatever she would have gotten if she had just held the thing without lending it to you.) But you can't expect a bitcoin borrower to return every dumb thing that any person distributes to bitcoin holders.
But on the other hand, what if the fork is really a big deal? What if lots of people abandon the original blockchain for a new one? This kind of happened with Ethereum, where most users chose the forked version rather than the original "Ethereum Classic," whose price is now a fraction of Ethereum's. An ether holder who loaned out ether before the fork and got only Classic ether back would reasonably feel aggrieved.
So basically if you run a cryptocurrency exchange, you should try to enforce "real" forks (by making short sellers go out and deliver the forked currency to lenders) while ignoring "dumb" forks. But that is not an easy distinction to draw! Bloomberg's Joe Weisenthal tweeted that "we need the word 'forkiness' to express the concept that these forks exist on a validity spectrum." In a very forky fork, a big part of the value of the blockchain is going with the new fork, and exchanges should deal with it. In a not-so-forky fork, the "fork" is more of a random interloper lobbing coins at you, and exchanges could reasonably ignore it. Bitcoin Cash had some significant indicia of forkiness, both in terms of support for its backers, and in terms of price: It was worth a couple of hundred dollars at the time of the fork. And the basic controversy over how the exchanges treated it is that a lot of holders thought it was pretty forky, while a lot of exchanges did not. (So for instance Coinbase ignored the fork and said it would not distribute BCH to its customers; its customers threatened to sue.) And obviously doing all of this subjectively and after the fact is terrible, and you'll want to write contracts (smart contracts?!) to cover it, but it can be a bit squishy to describe in advance.
By the way, a perfect market would have a perfect solution to this. As always, the perfect solution is: price! If I download the bitcoin blockchain in my basement, declare that every bitcoin now also comes with a Mattcoin, and get no support for my "fork," then Mattcoins should trade at $0, and bitcoin short sellers can just acquire Mattcoins for free and deliver them to close out their shorts. If my fork is a huge success, though, the Mattcoins will be worth a lot, and the short sellers will have to pay a lot to acquire them, but that's fine, because the high price demonstrates that they have a lot of forkiness and the short sellers should have to deliver them. In practice, though, this seems fraught with friction and peril: If short sellers need to buy Mattcoins, and the Mattcoins are otherwise worthless, then they probably won't trade that liquidly, and the short sellers will have to overpay to buy them from the few Mattcoin holders who are even aware of the issue. Even Bitcoin Cash, which was fairly forky, had very volatile trading, and its early price was perhaps not an efficient indicator of its forkiness. Pure markets may not be a perfect solution to this issue; human judgment may still be required.
People are worried about fake unicorns.
There is a study by Will Gornall of the University of British Columbia and Ilya Strebulaev of Stanford called "Squaring Venture Capital Valuations with Reality" that has been getting some attention recently. The basic idea is that a lot of headline valuations of private tech companies are higher than their actual valuations: If someone buys $100 million of Series G preferred stock at a $20 billion valuation with a $150 million liquidation preference, that doesn't mean that the company is "worth" $20 billion. Those Series G shares are clearly worth more than the common stock that they can convert into, because they have a liquidation preference: If the company ends up selling for $10 billion, the Series G holders will get back $150 million, while the holders of an equivalent amount of common will get back less than $50 million. But the headline $20 billion valuation treats the common stock as being worth $100 million, the same amount as the plainly more valuable Series G. So it overstates the valuation. Other structural features of preferred shares -- ratchet rights, cumulative dividends, IPO blocking rights, etc. -- can also make them more valuable than common stock, and further inflate the headline valuations of tech unicorns.
Using data from legal filings, we show that the average highly-valued venture capital-backed company reports a valuation 49% above its fair value, with common shares overvalued by 59%. In our sample of unicorns – companies with reported valuation above $1 billion – almost one half (53 out of 116) lose their unicorn status when their valuation is recalculated and 11 companies are overvalued by more than 100%.
Their model is essentially an option pricing model: The liquidation preferences, ratchets, etc. look like options, and so they use option-valuation methods to see how much they're worth. Subtracting those values from the preferred-stock price, roughly speaking, then gives you a valuation for the common stock, and so you can figure out how much the whole company is worth.
There is a glorious -- Nobel-Prize-winning! -- mathematical edifice of option valuation constructed around the insight that you can "manufacture" options by trading the underlying securities. This allows you to value an option without knowing whether the underlying stock will go up or down. This is called "risk-neutral" valuation, and it is most tightly linked to the real world when you can freely trade the underlying securities to hedge the options. When you can't ... I don't know, man. Back when I was a derivatives guy at a bank, I would occasionally be asked to use options math to value securities issued by private companies, and I would very slowly put the phone down and roll my chair away from my desk and off the floor and into the elevator and out of the building and across the street and generally as far away from that conversation as I could get. Sometimes they would catch me on my way out the door, and I'd have to do it, but I'd throw in a disclaimer like "Here's some math! Enjoy your math! It's just math! Not a valuation!" This, too, might be more math than valuation. The basic point -- that headline unicorn valuations are too high -- is surely true, but I'm not sure we have the science to quantify it.
Here is Alexandra Scaggs on the effort to get rid of Libor, which won't necessarily be finished when the U.K. Financial Conduct Authority phases out sterling Libor in 2021:
Libor’s administrator, the US’s Intercontinental Exchange, will still be able to publish the dollar rate after that point, and analysts and trading executives say it may still be necessary. Five years is not long enough for banks to overhaul the $350tn of outstanding derivatives, loans and mortgages tied to the key reference rate, they say.
I always tend to think that the right way to get rid of Libor is to keep calling it "Libor" but change what it is. So if the derivatives contracts say "Libor means the London Interbank Offered Rate as reported by ICE or its successor and displayed on Bloomberg page LR <go>" or whatever, and you want to change the benchmark from a self-reported Libor to, say, the market-determined broad repo rate, then the trick is to just get ICE to stop reporting the Libor survey results as "Libor," and start reporting the broad repo rate as "Libor." The derivatives contracts just call an external function, "Libor," to produce a number; they don't determine how that function operates. The keepers of that function are Libor's administrator, and the regulators and banks and customers who influence it; they could change the internal workings of the function without changing how it is called in the $350 trillion of contracts.
Still it's not as easy as that; any new number -- like the broad repo rate -- will be economically different from Libor, too high or too low, and just dumbly swapping it in will create havoc. You'd need to modify the new number to make it more Libor-y, and that is a challenge:
Regulators, banks and investors could agree on a fixed spread over their region’s chosen short-term reference rate, and work out a term structure.
But as Mr Cabana notes, the option “obviously would raise some concerns around what spread to be chosen, the term structure of the fixed spread . . . but these, in our view, would be easier challenges to address than renegotiating and re-hedging existing contracts”.
There is a widespread perception that, in the run-up to the financial crisis, bank employees were too focused on short-term profits, with effects that were disastrous in the long run. So they'd build and sell terrible mortgage-backed securities for a quick profit, without worrying too much that those securities would collapse in a couple of years and bring ruin and liability, because a couple of years is an eternity if you work on a trading desk. There is also a widespread perception that one way to fix this problem is to give bank employees longer-term compensation, tying their fortunes to those of the bank for years after they do whatever it is that earned them their bonuses.
This always feels to me like a grimly mechanistic view of how bankers and traders work: Surely ethical and risk-management decisions are not made in such a mercenary way; surely a whole range of things -- cultural expectations, pride in a job well done, legal consequences -- matter more than the vesting schedule of your compensation. But haha no the vesting schedule really matters:
Sure enough, our empirical analysis reveals that that firms with shorter CEO equity durations as of 2006 had significantly more subprime exposure during the 2007-2009 crisis. In addition, shorter durations are associated with larger firm payouts in subprime fraud-related lawsuits settled over the 2010-2016 period. Finally, firms with short CEO equity durations had better risk-adjusted stock returns during 2006, when subprime activities were at their most profitable, but significantly worse returns during the crisis. Financial firms with short CEO durations were also more likely to fail during the crisis. We conclude CEO incentives to trade short-term gain for long-term pain were indeed at the root of the crisis.
That's from a blog post about a forthcoming paper, "Managerial Myopia and the Mortgage Meltdown," by Adam Kolasinski of Texas A&M and Nan Yang of Hong Kong Polytechnic.
I try to keep the Anthony Scaramucci news to a minimum around here, because it is always so distasteful, but I am only human and could not resist this quote, from a former colleague, in Linette Lopez's profile of Scaramucci:
"This is the way you're brought up when you're middle class from Long Island. You go to Harvard, and those are still your roots. It's part of your story. You go to Wall Street and there's a mutual respect for people who pulled themselves up by their bootstraps."
Ah yes, the rarely-trodden path from Long Island to Harvard to Wall Street. Certainly when I worked on Wall Street, and I met fellow Harvard graduates from Long Island, I would give them a quiet fist-bump to acknowledge our mutual respect, and my knuckles were raw and bleeding each day from all the fist-bumping.
"Is Gary Cohn a Good Pick to Head the Fed?"
Some of Cohn’s old friends and colleagues think he could inject real-world experience into the Fed. Yet even when a few of them try to be complimentary, they describe an aggressive personality who might not enjoy the calm, scholarly halls of the Fed’s Eccles Building. “I can’t see why he would want to spend all his hours in those meetings dealing with material that’s as dry as a bone,” says Jay Dweck, a former Goldman partner. “He has no patience for that kind of stuff.” Another former colleague tried to imagine how a Chairman Cohn would handle silly questions from members of Congress or reporters, then started laughing. Christopher Pia, a friend and hedge fund veteran, is optimistic. “What he lacks in economic policy and political know-how,” he says, “he makes up for in tenacity and loyalty.”
"Tenacity and loyalty" are probably the least important imaginable characteristics in a Fed chair, other than, like, vertical leap or 40-yard dash time.
People are worried that people aren't worried enough.
Here is "Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles."
We examine forty well-known bubbles and, using creative graphical representations to capture robustly the transient dynamics of the volatility, find that the dynamics of the volatility would not have been a useful predictor of the subsequent crashes. In approximately two-third of the studied bubbles, the crash follows a period of lower volatility, reminiscent of the idiom of a “lull before the storm”.
In Money Stuff yesterday I wrote about a hedge fund named for the Egyptian goddess of accounting, which is pretty on the nose. "Next you will tell me about a Homeric epic whose hero charges a performance fee for managing investments, or a Norse god who wears fleece vests," I wrote. But I somehow forgot that there is a Greek epic whose hero wears fleece vests. Well, I mean, Jason and the Argonauts go on a quest for the Golden Fleece, rather than wearing a zip-up fleece while on a quest for uncorrelated returns, but still, that is pretty close. "Golden Fleece Capital" would be a perfectly reasonable name for a hedge fund. And "Argonaut Capital," also perfectly reasonable, actually is the name of a European asset manager. Thanks to Tom Morgan and other readers who pointed out this embarrassing oversight.
Also there were some defenses of the name "Cerberus," which I guess is fair. In some areas of finance -- distressed investing, for instance -- you want to seem mean! If you're the three-headed hound who guards the gates of hell, people will be afraid of you. If you are a mythological accountant, I mean, meh. Just as long as you don't get confused yourself and start barking instead of reading financial statements.
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