Money Stuff

Swap Prices and Awkward Meetings

Also early education, yacht taxation, and people who are worried about bitcoin liquidity.

Swap pricing.

If you buy a share of stock, the instant after you buy it, it is probably worth a bit less than what you paid. If the stock traded at $99.99 bid and $100.01 offered, and you bought at the offer and paid three cents of commission, then you paid $100.04 for a share that is "worth" -- at mid-market prices -- $100.00. In some sense you instantly lost 0.04 percent of the value of your investment. But no one really thinks of it that way, because that is a small number, and also because it goes to things -- commission, bid-ask spread -- that are reasonably transparent and that everyone recognizes as transaction expenses. Those things are related: The transaction costs are small in part because they are transparent.

If you buy a complex enough derivative, the second after you buy it, it is probably worth less than what you paid. This makes sense: The person selling you the derivative, the bank or dealer, has to put a lot of work into building and hedging it, and runs real risk in taking the other side, so it needs to make a profit on the trade. But, unlike with stock, it may not be immediately obvious to you how much a complex derivative is worth. If it's worth $90, and the dealer charges you $100, it's not like you can just go look at the market -- or even your Black-Scholes calculator -- and see that $90 value. Part of what you are paying the dealer for is its ability to structure and price complex derivatives, an ability that you lack. The dealer knows this. 

Regulators also know this, and dislike it, and post-financial-crisis regulatory reforms include a provision requiring swaps dealers to tell customers how much their swaps are worth, both before they enter into the trade and also daily during the life of the trade. This value is supposed to be "the mid-market mark," that is, roughly speaking, the fair value of the trade without any profit markup. This should make it fairly easy for clients to know how much they are paying dealers: If the price of a swap is $100, and its mid-market mark is $90, then the dealer's markup is $10. If $10 is too much, the client can insist on a lower markup.

A lot of derivatives dealers find this extremely uncongenial. Really the point of getting into the complex derivatives business is to build things that you can sell for much more than your cost of goods. Everyone knows what a basic vanilla swap is worth, so you can't make all that much money selling them. But if you build something weird and bespoke that only you can price, then you can sell it for whatever you can persuade people it's worth. It is no longer a commodity business; it is a business that rewards creativity in structuring and brio in salesmanship. 

This is not just about money. It is about money, of course: If you can conceal your markups, then they can be bigger, and you can be richer. But it is also about the very nature of the business, the thing that you are rewarded for. If creativity and complexity can be rewarded with outsized profits, then the business rewards creativity and complex thought. But if you build a clever complication and then have to immediately disclose its markup, then everything is immediately commoditized. In some ways this makes your life nicer: If you're being open and transparent with your customers, then you can have better and more trusting relationships with them, and feel better about what you do. But some of the fun is gone when the rewards to creativity are reduced.

Anyway Cargill, Inc., the big commodities company, is a swap dealer, and sold complex swaps (which "could contain features to embed volatility or optionality into the transaction, such as caps, collars, floors, knock-in or knock-out rights, or various accrual or accumulation features") to customers through its Cargill Risk Management business, and hated the new rules:

The leadership group of Cargill’s swaps business, which included a senior member of the compliance team and business executives, held at least one meeting to discuss “the implications” to Hedging Products, if Cargill had to register as a swap dealer, “of the requirement that they provide a mid-market mark price along with the execution price on each trade.” In relation to that meeting, a senior member of the compliance team went on to say “Providing the mid-market mark price is concerning to HP and the impact it could have on earnings.” In another email, this senior member of the compliance team described concern that “the transparency of the mid-market mark . . . could result in lower margins” for Hedging Products.

So it came up with a solution to continue hiding the value:

Ultimately, Cargill decided to continue to use its prior practice of amortizing its expected revenue over sixty days for certain complex swaps, including complex swaps offered by Hedging Products, and providing an “unwind” or “termination” value as the mid-market mark. As a result, instead of showing the entire mark up on day one, after registration as a swap dealer Cargill reported a mid-market mark that did not reveal the unamortized revenue, both pre-trade and during the first sixty days of the swap.

There is a non-trivial argument for this position, at least if Cargill would really unwind at the "unwind" value. If Cargill sells you a swap for $100, and it's "really" worth $90 (according to the mid-market marks on Cargill's internal models), but Cargill would be willing to buy the swap back from you at $99 (its amortized price on the second day of the trade), then who's to say that its real value isn't in fact $99? (Cargill will sell you more at $100 or buy it back at $99, so why would the fair price be $90?) You can think of the amortizing unwind value as a sort of 60-day money-back guarantee: If you do a swap with Cargill and aren't happy with it in the first 60 days, then you can get out of it without paying Cargill its full markup. 

But that is probably not quite the way Cargill thought about it. More likely they thought about it as a way to gently ease their profit margin into the marks, so that customers couldn't notice. You can tell because: 

Cargill, however, made one modification to its previous practice. Rather than amortizing all of its expected revenue over the first sixty days – which resulted in a “market value” of the swap on the date of the transaction that closely matched the price the customer had paid for the swap – Cargill decided to “recognize” ten percent of its expected revenue on the day of the swap and amortize the remaining ninety percent over the next sixty calendar days. One consideration in recognizing ten percent of expected revenue on the day of the swap was to create a midmarket mark that, pre-trade and shortly after the trade, was sufficiently different than the price the counterparty had paid that it would be believable to counterparties as Cargill’s mark up. Multiple Cargill employees, including the Cargill Executive, discussed whether ten percent would be a believable number to counterparties, and concluded that it would be.

If you sell a swap at $100, and then immediately mark it at $100, then the customer will realize that your mark doesn't account for your profit margin (because your profit margin isn't zero). If you sell a swap at $100, and then immediately mark it at $99, then the customer will assume that your profit margin is $1. That can be a nice assumption to encourage, if your profit margin is actually $10.

As you probably gathered, all those quotes are from the Commodity Futures Trading Commission's order against Cargill, which was fined $10 million for this stuff. You are not supposed to do this; it is against the spirit (and letter) of the CFTC's swap dealer transparency rules. But you can see why Cargill did it: Those rules are themselves kind of against the spirit of being a dealer of complex derivatives. If you have to tell customers exactly what your markup is, why build the complex derivatives in the first place?


Here is a story about how Bridgewater Associates' then co-chief executive officer, and now co-chief investment officer, Greg Jensen, allegedly had a "monthslong personal relationship with a female employee who was his junior and in his line of supervision." Bridgewater founder Ray Dalio found out about the relationship, and as part of the firm's commitment to radical transparency, they all sat down and had a comfy chat about it:

Mr. Dalio questioned Mr. Jensen and the woman together in front of a panel of top Bridgewater executives, people familiar said. Bridgewater’s human-resources department wasn’t immediately involved, the people said.

We have talked before about an accusation of sexual harassment at Bridgewater, in which the accuser "said he remained silent for many months about the harassment out of fear the incident would not remain private and would impede his chances for promotion." And he had reason to worry: At Bridgewater, "radical transparency" and a rule against talking against people behind their backs ("If you do, you are a slimy weasel") might discourage people from reporting harassment confidentially. "It would be awkward to talk to HR about sexual harassment with your harasser present," I said. It would probably also be awkward to talk about your months-long personal relationship with your married boss, to his boss, with him present. But I suppose that if you worry about awkwardness then Bridgewater may not be the place for you.


Later, Mr. Dalio told some at Bridgewater that he couldn’t determine whether Mr. Jensen or the female employee were telling the truth about the relationship, people familiar with the matter said. Mr. Dalio noted that Mr. Jensen’s overall believability had long been ranked particularly highly in Bridgewater’s rating metrics, meaning that his description of some details of the relationship carried extra credibility over hers, people familiar with the matter said.

Look, that is not exactly the same as saying "he gets the benefit of the doubt because he is more senior and has been here longer," but there are perhaps correlations. Anyway Bridgewater kept him, got rid of her, paid her "a settlement of more than $1 million," and had her sign a nondisclosure agreement. The radical transparency does not extend outside the firm.

Entrepreneurial children.

You know, I am tempted to make fun of this story about how WeWork Cos. co-founders Adam and Rebekah Neumann are starting a school that enrolls one of their children and uses their farm as class space and teaches children to be "disruptive" and "entrepreneurial" and generally terrifying, but the thing is, I have a young child, and finding a school in New York seems like quite an ordeal, and I worry that if I make fun of WeGrow (that's the name) then I will inevitably be sending my child there in a couple of years and my interactions with the Neumanns at parent-teacher composting night will be super awkward. So, you know, sure, entrepreneur school for toddlers, sounds great, may they get all the funding their little hearts desire. Still I am only human and cannot resist quoting the best lines. Like:

“In my book, there’s no reason why children in elementary schools can’t be launching their own businesses,” Rebekah Neumann said in an interview. 


Neumann argues it’s conventional education that is “squashing out the entrepreneurial spirit and creativity that’s intrinsic to all young children.” Then, after college, she said, “somehow we’re asking them to be disruptive and recover that spirit.”

Are we? Asking them to be disruptive? Is that what we're asking?

Paradise Papers.

Did you know that fancy lawyers can help you avoid sales taxes when you buy a yacht? I did not know that specifically -- it is not something that has ever come up as a practical concern, for me -- but if I thought about it I probably would have guessed that. It just seems safe to assume that you can avoid sales taxes on a yacht. Avoiding taxes often involves doing stuff "offshore," and there's nothing more offshore than a yacht. It is literally a boat. "I hide my money offshore to avoid taxes," you say, and then when people ask "oh you mean you have a Swiss bank account in the name of a Cayman Islands trust?" you can be like "no I mean I have a stack of cash in a safe on my boat." Also if you are in the market for a yacht you were probably also previously in the market for sophisticated tax and legal advice. There probably aren't a lot of people who both (1) own a yacht and (2) use TurboTax. Paying sales tax on a yacht just seems like an amateur move. 

Anyway here is a story about how Appleby, the Bermuda law firm named in the leaked "Paradise Papers," helps clients buy yachts and private jets without paying value-added tax. Seems right!

Otherwise, the Paradise Papers seem to be "dull reading," and they describe plans that are "mostly, if not totally, legal" -- "Some are not even questionable from a legitimacy point of view."

Blockchain blockchain blockchain.

Institutional investors are buying more bitcoins, which, weirdly, is leading to a sort of people-are-worried-about-bitcoin-liquidity set of concerns:

Kevin Zhou, a longtime trader in the space, said that hedge funds were more likely than small investors to pull out a lot of money at once, and that Bitcoin was still small enough that a single fund’s cashing out could cause the price to drop sharply.

“You could get a possible run on the bank if one large investor withdraws and that causes the price to tank,” said Mr. Zhou, a co-founder of the trading firm Galois Capital. “That could cause a cascade of withdrawals.”

That's not a run on the bank? That's just ... if people want to sell an asset, its price will go down? It continues to be fun watching cryptocurrency enthusiasts rediscover how financial markets work, and a bitcoin crash driven by institutional investors might be interesting.

Meanwhile in initial coin offerings: "In a recent analysis of 65 of the biggest digital tokens from ICOs as measured by market value, almost 75 percent were found to have a medium to high probability of being regulated as a security, according to database operator and researcher Token Report." Seems low! I look forward to a wave of rescission lawsuits as investors in ICOs lose money, realize that their tokens are securities, and sue the creators for their money back.

And: "‘Buy Bitcoin’ Overtakes ‘Buy Gold’ as Online Search Phrase."

Oh and finally I am going to quote extensively from a Dentacoin press release. Dentacoin has the sort of public relations effort where they email me press releases every day and say things like "Please find below interesting information for your audience and publish it at your media upon your convenience." Normally this is quite rude -- please, if you work in PR for anything but Dentacoin, do not do this -- but in their case I always ... feel like I ... should ... publish it? Here's a recent one:

Title: This Mobile App Pays You to Brush and Floss

How long does it take you to brush and floss your teeth? 2-3 minutes? 4 maybe?

This app tells you exactly how long you should brush your teeth, helping you with tutorials and voice navigation, all while listening to music of your choice.

Yes, it’s super fun.

And yes, you get paid for this.

DentaCare is the second tool of Dentacoin – the new Blockchain solution for the global dental industry.

It goes on like that, though with diminishing returns. "The blockchain will tell you how to brush your teeth," is apparently the future we are living in. Okay.

People are worried about non-GAAP accounting.

"Companies are using ‘ghost revenue’ to calculate executive bonuses" is the headline here. It's possible that corporate pay-for-performance should just be purely subjective: If the board thinks the CEO is good at her job, it should pay her a lot; if it thinks she's bad, it should pay her a little; and it should use whatever metrics it wants however it wants and not have to explain or justify them to shareholders. If the shareholders don't like it, they can vote for an activist. I realize that this is not how anything works -- there are extensive Securities and Exchange Commission rules about disclosure of pay metrics and shareholder say-on-pay -- but the result of the current system seems to be similarly subjective, except with a lot of contortions to justify how pay fits within the published metrics. 

Things happen.

The Drug Kingpin Running Venezuela's Bond Negotiations. Venezuela’s debt struggle poses more questions for investors. The New York Fed Chief Is Stepping Down — but Not Quietly. Tricky Balancing Act Faces New York Fed Search Committee. U.S. Treasury’s First Director of Office of Financial Research to Leave Post. Equifax Board Continues to Probe Legal Officer’s Share-Sales Role. Multinationals Scurry to Defuse House Tax Bill’s ‘Atomic Bomb’. The numbers are in, and the House Republican tax bill raises taxes on nearly a third of Americans. Saudi Crackdown Widens as More Bank Accounts Said Frozen. For Investors, Saudi Crackdown Sparks Hope, Risks Uncertainty. 21st Century Fox has been holding talks to sell most of the company to Disney. Dick Fuld's Matrix Expands Into Private Equity, Short-Selling. Getting Along with BlackRock. Trade, Merchants, and the Lost Cities of the Bronze Age (via Alex Tabarrok). "Costello said the open house guest didn't make an offer on the home because 'he wasn't Koalified to make one.'"

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