Matt Levine’s Money Stuff: Crypto Finance Meets Regular Finance

LAGOS (Capital Markets in Africa) – Yesterday I casually suggested that the ideal thing to turn into a smart contract on the blockchain is an interest-rate swap: It’s just a series of exchanges of money, with no need to do anything in the real world, so it is easy to encode in  computer instructions. But one reader correctly objected that the real meat of an interest-rate swap as a contract is its credit terms. An interest-rate swap is an unfunded way to get interest-rate exposure. Instead of putting up $1,000 to buy a bond and getting back 2.5 percent interest every year, I sort of pretend that I did that: You give me 2.5 percent of $1,000 every year, and in exchange, I give you whatever Libor is that year. But neither of us ever puts up the $1,000.

That means that if interest rates move sharply against me — if Libor goes to 10 percent — then I have to come up with $100 each year, and you have to trust that I’m good for it. And that trust usually comes in the form of credit support annexes and collateral posting and the possibility of suing me and so forth, a whole apparatus that lets market participants trust that their counterparties will pay them in the future. Turning that into a smart contract is harder: The smart contract could theoretically be required to pull any arbitrary amount of money from my computer and send it to your computer, and the only way to guarantee that it will be able to do that is to lock up a lot of my money for the whole length of the contract. Everything has to be fully collateralized in order to automate it with perfect reliability. And so unfunded exposures — bets where I may have to pay you later and you may have to pay me later but neither of us pays now — are harder to put into smart contracts on the blockchain.

This is in some sense not a bug but a feature; many cryptocurrency enthusiasts like Bitcoin precisely because it limits fractional-reserve banking and excessive leverage and other evils of the traditional financial system. But outside of crypto, much of the work of finance is about finding new ways to take on leverage. And so when you introduce finance people to cryptocurrencies, their first reaction is often “well this is neat, lots of volatility, computers, I can work with this,” but their second reaction is often “wait but we need to find a way to borrow this thing.”

Anyway here’s a story about a former Goldman Sachs and Merrill Lynch structurer who “plans to launch a platform for digital currencies later in 2018 that will allow private or institutional investors to strike so-called repurchase agreements or repos with one another”:

Holders of a cryptocurrency—institutions or private individuals—will earn money from lending it out via the Oxygen platform. In return they get another cryptocurrency, which they agree to take as collateral until their original currency is returned. Borrowers get access to a cryptocurrency they want to use or trade short-term. That could allow them to trade it or use it for transactions.

Of course some Bitcoin exchanges already allow for lending and shorting. The point is that this is a feature that people want; it is also a feature that is not built into the Bitcoin blockchain. The core feature of Bitcoin — the technological problem that Satoshi Nakamoto set out to solve — is that you can’t spend Bitcoins that you don’t have. The core feature of finance — the technological problem that bankers have set out to solve for millennia — is that you can spend money that you don’t have. That’s what finance is; it’s the business of moving money from the people with the money to the people with productive uses for other people’s money. There is an obvious tension.

Elsewhere in tensions between blockchains and finance, here’s a story about the Lightning Network, a bid to ease congestion on the Bitcoin blockchain by basically deferring settlement of Bitcoin transactions:

In this system, two parties open a channel and commit funds to it. The opening of a channel gets broadcast to the blockchain and incurs the normal bitcoin transaction fee. The channel can stay open for however long—say, a month—during which time the two users can exchange as many payments as they like for free. When the time expires, the channel closes and broadcasts the final state of the pair’s transactions to the blockchain, incurring another transaction fee.

A lot of what I read about the blockchain for finance involves speeding up settlement time. If you trade stocks or syndicated loans or whatever on the blockchain, people argue, you can have instantaneous settlement instead of waiting days or weeks for your transactions to clear. Meanwhile a lot of people who actually trade stocks or loans or whatever are skeptical of that goal: Gaps between trade and settlement are not just technological failures; you need that time to line up funding or stock borrow or permissions or whatever. It turns out that even trading Bitcoin on the Bitcoin blockchain might work better with a one-month settlement delay. Again and again, the messy reality of the traditional financial system keeps intruding on the crystalline purity of the blockchain.

Elsewhere, here is a headline saying “Davos: Blockchain can no longer be ignored,” and imagine ignoring blockchain. I am imagining it right now and it is a lovely feeling. I should point out that the World Economic Forum was writing breathless love letters to the blockchain back in 2016; “let’s not ignore blockchain” is among the most Davos-y sentiments I can think of. 

And last week Venezuela sort of released the white paper for its cryptocurrency? It is called the “petro,” and we have made fun of itbefore, but even by the standards of joke-cryptocurrency white papers Venezuela’s is a poor effort. Tonally it is is more of a “manifesto” than a “white paper,” though I suppose that is true of a lot of cryptocurrencies. Monica de Bolle and Martin Chorzempa of the Peterson Institute are unimpressed: “It combines serious misunderstandings with wishful thinking about the benefits of blockchain technology, along with evidence that the government is either trying to fool its populace or that it does not understand the basics of cryptocurrencies, or both.”

The U.S. Treasury is also unimpressed: Its sanctions FAQ (item 551) notes that the petro “would appear to be an extension of credit to the Venezuelan government,” and that people who buy it “may be exposed to U.S. sanctions risk.” 

And here’s a good reason for banks to be wary of Bitcoin:

UBS Group AG Chairman Axel Weber said the Swiss bank won’t trade Bitcoin or offer it to retail clients as increased regulation could lead to a “massive” drop in value. 

“This is something where the price is really unclear,” Weber said in an interview Wednesday with Bloomberg TV at the World Economic Forum in Davos, Switzerland. “We fear that in the future if these investments implode and the market corrects, then investors will be looking at ‘who sold us this?’”

If some dude on the internet sells you a hugely volatile asset with no intrinsic value and it immediately loses 50 percent of its value, you’re like “well played, dude on the internet.” If a bank does it, though, you sue.

And 50 Cent is a bitcoin millionaire. 

Corporate governance.

There is an extensive literature in finance about how companies should motivate their managers to act in shareholders’ best interests, minimize conflicts, discourage shirking, and so forth. Often this literature assumes a sort of idealized homo economicus chief executive officer, one who has a certain set of recognizable human characteristics (some desire for money, power and/or leisure) but who is not necessarily a fully fleshed out person. For instance, the literature rarely considers the CEO’s blood pressure or cholesterol levels or family medical history. And yet, as a public company, having a CEO who is alive is perhaps even more important than having one with properly aligned incentives. As CSX has concluded:

CSX Corp. will require the railroad’s chief executive to submit to an annual physical exam that will be reviewed by the board, adopting an unusually aggressive approach to a delicate issue just weeks after the death of its previous CEO.

The railroad’s board was under fire last year after it agreed to hire Hunter Harrison even though he declined to get a physical exam or provide access to his medical records— despite concerns about the then 72-year-old railroad veteran’s health.

It is an unusually stark case of barn-door-closing; really the time to give your CEO a physical is before you hire one who dies in office. But this is not the sort of thing you think about until you have to.

Elsewhere in governance, Bloomberg News reports that Elon “Musk’s New Pay Deal Could Make Him the World’s Richest Man—If Tesla Succeeds”:

If the award fully vests, Musk would own a 28 percent stake in the company worth about $184 billion, vaulting him to the top of the Bloomberg Billionaires Index. Amazon’s Jeff Bezos currently sits atop the index with a $111.5 billion net worth as of Monday’s close in New York. Musk’s stake in SpaceX constitutes about half of his current net worth of $21.5 billion.

Sure yes but look. We talked about this yesterday. If the award just didn’t exist — if Tesla Inc.’s board was just like “you know what, this guy is rich and motivated enough,” and decided that his compensation for being CEO would be zero forever — then Musk would also be the world’s richest person at a $650 billion valuation. He currently owns 21.9 percent of Tesla. If Tesla were worth $650 billion — it’s currently worth about $60 billion — then that 21.9 percent stake would be worth about $142 billion. If Tesla’s market cap grows tenfold while Amazon’s doesn’t move, then Elon Musk will be the richest person in the world, because that is a lot of growth and he owns a lot of Tesla stock. This has very little to do with his compensation plan and very much to do with the fact that if you own billions of dollars of stock and it goes up by 1,000 percent then you will be super duper rich.

Still elsewhere in corporate governance, Twitter Inc. CEO Jack Dorsey and departing Chief Operating Officer Anthony Noto have different management styles:

During Twitter’s frequent company-wide discussions called “Tea Time,” Noto rallied employees around pep talks that explained the strategies the company was pursuing, like live video, and often punctuated his company memos with the two-exclamation-point emoji. Dorsey tended to give more abstract speeches that were sometimes personal stories about the founding of Twitter, his own reflections or his vision for the product, according to one of the people. 

I guess Dorsey’s approach sounds more like “Tea Time,” though maybe Noto’s is more like management. Anyway Noto is leaving Twitter to become CEO of Social Finance, the online lender whose mission just a couple of years ago was to “kill banks.” Now it will be run by a former Goldman Sachs Group Inc. banker. The banks do not want to be killed, and they play a long game.

Never trust the water-skiing instructor.

I am sure that Jimmy Levin is really good at making investment decisions but I giggle every time I am reminded of how he got his start at Daniel Och’s hedge fund:

In the late 1990s, Mr. Levin was working at a summer camp in Wisconsin, teaching Mr. Och’s son how to water ski. By last year, the younger man was in line to succeed Mr. Och as chief executive of Och-Ziff Capital Management LLC, the largest publicly traded hedge fund in the U.S. with $33 billion in assets under management. To entice him to stick around, Mr. Och handed Mr. Levin, who is 34 years old and goes by Jimmy, nearly $300 million in cash and Och-Ziff stock.

There is a popular notion that hedge funds are for brilliant iconoclasts who don’t fit in with the politics at investment banks, but that is not the whole story. The other side of it is that you have to get along personally with the brilliant iconoclast running your hedge fund if you want to do well there. At a small place without an institutionalized human resources function, the politics can be more important than they are at a big corporate place. They’re just weirder and more idiosyncratic politics. Instructing the right kid in the right water-skiing moves at the right time could make your career.

Anyway Levin is now out of favor, Och has “reasserted control,” and the knives are out:

Interviews with more than a dozen people close to the situation at Och-Ziff suggest that many inside the firm, including board members and Mr. Levin, were shocked by the shift. People familiar with Mr. Och’s thinking say he felt Mr. Levin pushed too far, too fast, asking for more money and control than he was due.

Being the protege of a big hedge-fund manager can take you a long way, but you run the risk that he will change his mind.

Leaks.

Recently Snap Inc. sent a somewhat ill-tempered memo to employees telling them not to leak Snap’s secrets:

If you leak Snap Inc. information, you will lose your job and we will pursue any and all legal remedies against you. And that’s just the start. You can face personal financial liability even if you yourself did not benefit from the leaked information. The government, our investors, and other third parties can also seek their own remedies against you for what you disclosed. The government can even put you in jail.

A lot of tech and business reporters — whose job, after all, is to get corporate employees to leak their companies’ secrets — found this objectionable, and objected. “Snap Threatens Jail Time for Leakers,” wasCheddar’s headline reporting the memo. “Leaked Snap Memo Says Employees Could Go to Jail If They . . . Leak Memos,” pointed out Yahoo Finance.

Can you really go to jail for leaking corporate secrets? Yes, of course, come on. We talk about it all the time. It is called “insider trading”: If you have some Snap secrets, and you tell them to your golf buddy, and you expect him to trade on that information, and he does trade on that information, then you are at least probably guilty of insider trading. (That is not legal advice, and if we had more time we could talk a lot about the “personal benefit test,” but it’s good enough.) That seems to be what Snap’s general counsel is getting at, with the “even if you yourself did not benefit” stuff. Even beyond insider trading there are other ways to go to jail for leaking secret corporate information. Poor former Sergey

Aleynikovwas arrested twice for giving Goldman Sachs Group Inc.’s secret computer code to a new employer, and there is apparently an active criminal investigation into the apparent leak of Waymo’s self-driving-car trade secrets to Uber Technologies Inc. People definitely get arrested for leaking corporate secrets, what a silly question.

On the other hand, can you really go to jail for leaking corporate secrets to journalists? I am going to say no, though this is especially not legal advice, and you should consider my conflicts of interest. (Go ahead, leak corporate secrets to me, whatever.) To be fair I do not read Snap’s memo to say otherwise: It says that some sorts of leaks could land you in jail, but it doesn’t come out and say that leaks to reporters are in that category. Perhaps it does subtly conflate the issues as a tactical choice. Some journalists, who have even more guild loyalty than I do, got very up in arms about the Snap memo, arguing that it is illegal for companies even to fire employees for leaking to the media. This seems … untrue? There is some authority that broad prohibitions on talking to the media violate the National Labor Relations Act because they might chill employees “from discussing labor disputes, wages, or other terms and conditions of their employment,” but Snap’s policy prohibits only leaking confidential information, and it seems bizarre to imagine that there’s a magical provision of federal law that prohibits companies from keeping their secret financial and operating information secret.

Suing Wall Street.

If you are a service provider — a law firm, say — then big banks are attractive clients. They are big, their affairs are complex, they provide steady work, they pay their bills on time. If they want to hire you, you say yes. But here is a Bloomberg Big Law Business profile of Quinn Emmanuel, a big — and very profitable — law firm that said no to the banks:

The decision arose after client conflicts prevented the firm from handling some work in the Parmalat matter because it represented banks, which prompted a review of Quinn Emanuel’s business, Carlinsky said.

“The epiphany was: we’ve got this backwards,” he said. “We need to get rid of our bank clients.”

The banks provide steady legal work, sure, but the epiphany was that they provide steady work to both sides. And suing them can be even more lucrative than defending them.

Me yesterday.

I wrote about accountants and the regulatory revolving door.

Things happen.

Men Only: Inside the charity fundraiser where hostesses are put on show. A Wall Street Ally Is Leading the Charge to Roll Back the Volcker Rule. Senate Confirms Jerome Powell as Federal Reserve Chairman. Mnuchin EndorsesWeaker Dollar, Sharpening Trade War Rhetoric. State Tax WorkaroundsCould Mean $154 Billion Lost to Treasury. Qualcomm Gets $1.2 Billion EU Fine for Apple Chip Payments. CFPB Chief Mulvaney Says Days of ‘Pushing the Envelope’ Are Over. Comparability of Basel risk weights in the EU banking sector is questionable. Matt Hurd reminisces about HFT (“A good thing about my prior firm is they did fire people for making money.”). Elie Mystal reminisces about his law-school loans. Claw machine cat.

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

Source: Bloomberg Business News