Sunday, April 28, 2013

What equity markets can learn from bitcoin and ripple

Stock trading on the New York Curb Association market, 1916

This isn't a bitcoin post. But it cribs some ideas from bitcoin and applies them to equity markets. Specifically, I'm going to play around with the idea that if equity markets were to adopt a bitcoin-style distributed ledger system, then some of the destabilizing effects of the so-called latency wars might be mitigated.

Historically, most databases and ledgers have been maintained at a central hub. In order to get access to this information, users have had to walk into the building that houses the records, or sign into a server that stores them. Bitcoin, litecoin, Ripple, and other cryptocurrencies all demonstrate the possibility of distributing a database away from its center. Rather than a hub doing all the work, networks of independent nodes can store, maintain, and update the database. Bitcoin's ledger, the blockchain, is probably one of the best examples of a real living distributed database.

A few weeks ago I had some fun speculating that one of the worlds most important centralized ledgers, the Federal Reserve's Fedwire system housed in East Rutherford, New Jersey, might one day be converted into a bitcoin-style distributed ledger. The advantage would be redundancy. Take out a hub and the entire database disappears. Take out a node, and the database lives for another day. Here's some more speculative financial fiction: taking inspiration from cryptocurrencies like Ripple and Bitcoin, might all equity trading one day move from a central order book to a distributed order book?

A market's order book is made up of a list of buyers and sellers, the amounts that each are willing to transact in, and their desired price. It amounts to a supply and demand curve for a given equity.

When early financiers congregated on a curb or under a buttonwood tree to buy and sell stock, the demand and supply curves were visible to anyone who was close enough to see the action. Get too far from the buttonwood tree and the order book was no longer visible. Later on, trading migrated into caf├ęs and special rooms. Only those directly on the floor could "see" the current demand and supply curves. Anyone on the edge of the action could get an indication of the order book by communicating with their floor trader via an odd array of hand gestures and signals. An investor outside the building, say Jesse Livermore, had to phone his floor broker for a quote, who in turn had to quickly sign to his trader and then relay the response back to Jesse Livermore. By the time Livermore had the data, the quote on the floor would already be different.

This is one of the defining features of a centralized order book. Access to the information contained therein is tiered. Those closest to the geographical centre have the most current information. Quality steadily deteriorates as one moves away from the hub. Having faster lines of connection into the hub—say a broker and trader who can gesture incredibly quick—can give one trader an informational edge over another.

The order books of modern electronic markets are centralized on powerful computers in suburban data centres. The NYSE's order book, for instance, no longer exists in New York. It can be found in a datacentre in Mahwah, New Jersey, about 30 kilometres from Wall Street. (See map below) One wonders if we shouldn't rename the exchange the NJSE.

View Larger Map

In fact, most of the US's major equity exchanges are run out of datacentres in New Jersey, including the Nasdaq in Carteret, BATS in Weehawken, and Direct Edge out of Secaucus. [See Google Map]

As in times past, it's still very important to be close to the geographic center of a centralized database. Evidence of this is that a large part of the NYSE's Mahwah datacentre is currently rented out to trading firms keen to install their hardware as close as possible to the exchange's own computers. When a new quote is added to the NYSE's order book for a given stock, say JPM, the first tier to receive this information will be those who are co-located next to NYSE's machines. The information will ripple outward from there through T1 fibre optic cables to successive tiers, beginning with those who have set up shop just across the street from the Mahwah datacenter and ending with those who are furthest away, typically retail clients and small institutions.

By the time retail clients and small institutions get to see the order book for JPM, the true order book back at Mahwah will have already been updated with new quotes. Despite not knowing the true book, those on the informational periphery will nevertheless base their trading on the stale quotes they see in their version of the order book. Colocated traders, already apprised of the changes to Mahwah's order book, can take advantage of their superior knowledge and put themselves in a position to profit from relatively uninformed trades flowing back to Mahwah. By virtue of being right next to the central ledger, colocated traders get to "see" the market a few milliseconds ahead of everyone else. Latency wars — the modern competition to decrease time delay over a digital network  — is only the most recent chapter in a centuries' long battle to get as close to the central order book as possible.

A centralized order book is hardly democratic since those closest to the hub can consistently use their informational advantage to game those who are furthest away. But no one ever said markets were fair. Nevertheless, too much unfairness in a stock market can be destabilizing. Unlike say a grocery market, a stock market is only as good as its liquidity. If too many investors feel they are being pickpocketed they'll walk away from the market and liquidity will dry up. This hurts all actors in the market, including those at the center. It also hurts equity issuers, since reduced liquidity inhibits their ability to raise capital.

Which brings us back to bitcoin and the idea of a distributed ledger. Here we have a solution to the tiered nature of information reception from a central hub. Why not have a network of independent nodes store a stock's order book, listen for new quotes and trades, verify the identities of traders, and update the distributed order book? The neat thing about storing data in a distributed fashion as opposed to a hub is that information is freed from geography. Rather than sitting on a computer in Mahwah, New Jersey, the order book is everywhere. This would help to mitigate the unfairness issue that plagues central order book markets.

Exchanges like NYSE Euronext, NASDAQ, and BATS would suffer. These businesses make plenty of money by charging people to get as close to the order book as possible. Think fees for membership, seats, data access, and colacation.  Put a stock's order book in a distributed database and the premium people are willing to pay for access no longer exists.

Distributed order books are not science fiction. If you do want to see one in action, head over to Ripple. The ripple client lets anyone see a distributed order book for claims denominated in multiple currencies including bitcoin, USD, and euros.

On inequalities caused by latency, read Latency Arbitrage: The Real Power Behind Predatory High Frequency Trading by Arnuk and Saluzzi and Latency Arbitrage, Market Fragmentation, and Efficiency by Wah and Wellman.

Here's an 2005 paper on Peer to Peer Securities Trading by Gehrke, Daldrup, and Seidenfaden

Tuesday, April 23, 2013

Beyond bond bubbles: Liquidity-adjusted bond valuation

Real t-bill and bond yields have been falling for decades and are incredibly low right now, even negative (see chart below). With an eye to historical real returns of 2%, folks like Martin Feldstein think that bonds are currently mis-priced and warn that a bond bubble is ready to burst.

Investors need to be careful about comparing real interest rates over different time periods. Today's bond is a sleek electronic entry that trades at lightning speed. Your grandfather's bond was a clunky piece of paper transferred by foot. It's very possible that a modern bond doesn't need to provide investors with the same 2% real coupon that it provided in times past because it provides a compensating return in the form of a higher liquidity yield.

[By now, faithful readers of this blog will know that I'm just repeating the same argument I made about equity yields.]

Here's a way to think about a bond's liquidity yield. Bonds are not merely impassive stores-of-value, they also yield a stream of useful services that investors can "consume" over time. In finance, these consumption streams are referred to as an asset's convenience yield. (HT Mike Sproul)

For instance, the convenience yield of a house is made up of the shelter that the house owner can expect to consume. A Porsche's convenience yield amounts to travel services. What about a bond's convenience yield? I'd argue that a large part of a bond's convenience yield is comprised of the liquidity services that investors can expect to consume over the life time of the bond. Let's call this a monetary convenience yield.

In an uncertain world, it pays to hold a portfolio of goods and financial assets that can be reliably mobilized come some unforeseen event. A fire alarm, a cache of canned beans, and a bible all come to mind. Liquid financial instruments, say cash or marketable bonds, are also useful since they can be sold off quickly in order to procure more appropriate items. This ability to easily liquidate bonds and cash is a meaure of their monetary convenience.

Even if the unforeseen event for which someone has stockpiled canned beans or bonds never materializes, their holder nevertheless will enjoy the convenience of knowing that in all scenarios they will be secure. The stream of uncertainty-shielding services provided by both a bond and a can of beans are "consumed" by their holder as they pass through time.

This monetary convenience yield is an important part of pricing bonds. Prior to purchasing a bond, investors will appraise not only the real return the bond provides (the nominal interest rate minus expected inflation) but will also tally up the stream of future consumption claims that they expect the bond to provide, discounting these claims into the present. The more liquid a bond, the greater the stream of consumption claims it will yield, and the higher its monetary convenience yield. The greater the stream of consumption claims, the smaller the real-return the bond need provide to tempt an investor into buying. (HT once again to Mike Sproul on consumption claims)

Which brings us back to the initial hypothesis. If the liquidity of government debt has increased since the early 1980s, then we need to consider the possibility that bonds are providing an ever larger proportion of their return in the form of a monetary convenience yield, or streams of future consumption claims. If so, the observed fall in real rates isn't a bond bubble. Rather, negative real rates on treasuries may reflect technological advances in market microstructure and improvements in bond market governance that together facilitate the increased moneyness of bonds. Put differently, investors aren't buying bonds at negative real interest rates because they're stupid. It's possible that investors are willing to accept negative real interest rates because they are being sufficiently compensated by improving monetary convenience yields on bonds.

I find this story interesting because we usually think that in the long term, real interest rates are determined primarily by nonmonetary factors, including the expected return to capital investments and the time preferences of consumers. The story here is a bit different. In the long term, real interest rates on bonds are determined (in part) by monetary forces. The higher a bond's monetary convenience yield, the lower its real interest rate. Oddly, bonds may be bought not by consumers who are willing to delay gratification, but by impatient consumers who want to immediately begin consuming a bond's convenience yield (ie. using up future consumption claims). The line between consumption and saving is blurred and fuzzy.

In my previous post on equities, I gave some numbers as evidence for the increased liquidity of stocks. Bonds aren't my shtick, so I won't try to prove my hypothesis. All I'll say is that the rise of repo markets would have contributed dramatically to bond market liquidity since repo increases the ability to use immobilized bonds as transactions media. Give Scott Skyrm a read, for instance.

There is a case of missing markets here. If we could properly prices a bond's monetary convenience yield, then we could get a better understanding of the various components driving bond market prices over time.

Imagine a market that allowed bond investors to auction off their bond's monetary convenience yield while keeping the real interest component. Thus a bond investor could buy a bond in the market, sell (or lease) the entire chain of consumption claims related to a bond's liquidity, invest the proceeds, and be left holding an illiquid bond whose sole function is to pay real interest. By stripping out and pricing whatever portion of a bond's value is related to its monetary nature, investors might now precisely appraise the real price of a bond relative to its real interest payments. Excessively high real prices relative to real interest would indicate overvaluation and a bubble, the opposite would indicate undervaluation and a buying opportunity.

But until we have these sorts of markets, we simply can't say if bond prices are in a bubble. Sure, real rates could be unjustly low because bonds prices have been irrationally bid up. But they could also be justly low if bonds are simply providing alternative returns in the form of monetary convenience. Without a moneyness market, or a convenience yield market, we simply lack the requisite information to be sure.

Friday, April 19, 2013

A rush for US paper dollars: the rejuvenation of the world's most popular brand

Here are Paul Krugman and James Hamilton on the renewed demand for dollar bills.

So what's behind the soaring demand for US paper dollars? A simple strategy for getting a grasp on US data is to compare it to the equivalent in Canada. Comparisons between Canada and the US serve as ideal natural experiments since both of us have similar customs and geographies. By controlling for a whole range of possible factors we can tease out the defining ones.

The chart below shows the demand for Canadian paper dollars and US paper dollars over time. To make visual comparison easier, I've normalized the two series so we start at 10 in 1984. On top of each series I've overlayed an exponential trendline based on the 1984-2006 period. I've zoomed in on 1997 for no other reason than to provide a higher resolution image of the typical shape of cash demand over a year.

Some interesting observations:

1. Not a huge surprise, but the demand for US paper has been accelerating far faster than the demand for Canadian paper. As James Hamilton points out, this is no doubt due to the huge transactional demand for US dollars overseas. The emerging countries in which US paper is demanded often have high growth rates, and their requirement for transaction media is correspondingly elevated. Unlike greenbacks, Canadian loonies are only demanded in Canada. As a slow-growth country, we don't require rapidly expanding amounts of physical transactions media.

2. Zooming in on any given year (I've chosen 1997) the demand for Canadian paper is far more jagged than the demand for US paper. Why is this? My guess is that the demand for US paper is diffused across multiple nations with diverging business practices and cultures. The demand for Canadian paper, on the other hand, is tightly linked to specific Canadian customs, holiday seasons, and payroll scheduling practices. The overseas demand that smooths out and counterbalance the peculiarities of domestic US paper demand don't exist for loonies.

3. There are some neat patterns in the chart. No, not all cash is demanded by criminals. There's always a cash spike at Christmas/New Years, and if you look carefully you can see jumps in Canadian cash demand coincide with major holidays, including Thanksgiving and the September long weekend. As Lenin once said, give me data on your nation's money supply and I can tell you when its holidays are. And note the huge Y2K-inspired rush to hold paper. Cash is still the ultimate medium for coping with raw uncertainty.

4. US paper demand started to slacken relative to trend in the early 2000s. One might be tempted to blame technological advances or changes in US preferences over payment media for slowing demand. Cash is a dinosaur, right? But this can't be the case. Canadians benefit from the same technologies as the US, nor do payment preferences change when one moves from 50 miles south of the 49th parallel to 50 kilometres north of it. If technology or preferences had changes, then Canadian cash demand would have deteriorated too, but as the chart shows, it continued to rise on trend. The best explanation for the US dollar's divergence from its long term growth just as Canada hewed to its trend is that foreign demand for US paper began to decline.

It's a reasonable explanation. Around 2002, the value of the US dollar begin a long and steady deterioration against most of the world's currencies, in particular the euro. It's very probable that consumers of the US$ brand punished the brand owner, the Federal Reserve, by returning dollars enmasse to their source, thus reducing the supply of paper dollars (or at least reducing its rate of increase). As incontrovertible proof, I submit exhibit A—a 2007 video of Jay-Z flashing euros instead of dollars (skip to 0:51).

5. So it seems to me that from 2003-2008 there was a mini run on the Fed by overseas cash holders. What Jaz-Z doesn't show is the process by which US dollars would have refluxed back to the US. Euroization, or de-dollarization, goes like this. A foreigner goes to their local bank to trade US dollars for euros. The local bank, flush with dollars, puts this paper on a plane for redeposit at their US correspondent bank in New York. The New York bank, which now has too much vault cash, loads these dollars into a Brinks truck and sends them to the New York Fed. And the FRBNY shreds the notes up.

This mini run would have put downward pressure on the federal funds rate. Here's how. Having accumulated excess cash from overseas, US banks would have sent this cash to the Fed in return for reserves. But now these banks have excess reserves. Desperate to get rid of them, they all try to lend their reserves at once, driving the federal funds rate down. To ensure that the federal funds rate doesn't fall below target, the Fed would has to sell treasuries in order to suck in reserves, thereby reducing the oversupply in the federal funds market and keeping the fed funds fixed.

The lesson being, when folks like Jambo in Zimbabwe and Julio in Panama get distraught about the quality of their Ben Franklins, the effects of their unhappiness will be felt, with some delay, all the way back at the Fed's open market desk.

6. US paper demand has since rebounded. Paul Krugman posts a chart that shows a massive accumulation of US cash holdings relative to GDP beginning in 2008. But Krugman's chart overstates the effect by constricting his time frame. As my chart shows, the rate of growth in US paper has only returned to the trend it demonstrated in previous decades.

Krugman attributes this increase in dollar holdings to the fact that the US is in a liquidity trap. When rates are near zero, people have no problems holding zero-yielding cash. I'm not so sure about his explanation. Canada had incredibly low rates for a few years, yet as our chart shows, Canadian paper never budged from its trendline growth. The same goes for the Euro. Rates have been low there, but we haven't seen a flight into paper money. Because cash is inconvenient and bulky, rates have to go pretty far below zero before people flee to paper.

No, the more likely explanation for the rebound in the US paper outstanding is the rejuvenation of the US dollar brand. The ECB has had to deal with waves of negative publicity for the last few years. Given the alternatives, the world wants to hold Benjamins again. This seems to be borne out in the chart below, which shows the ratio of ECB-to-Fed banknotes in circulation.

The US dollar, it would seem, is back. Cash holdings are only one sign off a currency's hegemony. It would be telling if there's also been a rebound in the use of the dollar to denominate bonds and other debt instruments, as well as increased holdings of US dollar-denominated assets in the reserves of major central banks. The US's "exorbitant privilege", as Barry Eichengreen calls it, continues apace.

Note: As I was writing this, I stumbled on a paper by Ruth Judson via James Hamilton called Crisis and Calm: Demand for U.S. Currency at Home and Abroad from the Fall of the Berlin Wall to 2011. And what do you know. She uses Canada as a foil for determining US cash demand, just like I did. I haven't read it yet, but am quite looking forward to doing so and am willing to yack about it in the comments.

On Lenin, read White & Schuler.

Tuesday, April 16, 2013


The price of gold has fallen over $200 in the last two days. This sounds like 1983 all over again.

Not only did Star Wars Episode VI come out in 1983, but gold experienced its largest one-day fall in recorded market history. On February 28, 1983 the metal fell $56, a whopping 11.5%. The context in which this collapse happened is worth revisiting since it might help explain some of what we are seeing now. I'll take a short diversion through 1983 oil markets before getting back to gold.

There were plenty of worries of an oil glut leading up to the metal's 1983 collapse. OPEC, which had kept an iron grip on oil prices by adjusting production, had been steadily losing its dominant position as oil producer. In the 1970s the cartel controlled over 60% of world production. Small adjustments to the rate at which it extracted crude were sufficient to set a floor in the oil market. But increased supply in the UK, Norway, USSR, and Mexico had eroded this share to under 40% by the early 1980s. As a result, OPEC nations were required to remove ever larger amounts of oil from the market to support prices.

The coordination necessary to motivate these adjustments was lacking. Beginning in June 1982, OPEC tried and failed three times within seven months to set quotas. As a result, spot prices had begun to trade well below OPEC's benchmark Saudi light price of $34, a gap that started to expand quite dramatically in winter and early 1983, as the chart below shows.

Because of the glut, the cartel was breaking at the seams. On February 17, 1983, the British National Oil Company (a government marketing board that bought 51% of North Sea output) dropped its North Sea price by $3 to $30.50, quickly followed by Norway. Nigeria, an OPEC member, reacted on February 19 by ignoring OPEC and reducing the price of Bonny light, a crude stream similar to Brent, from $35 to $30.

A week later the gold price collapsed. And on March 14, 1983, OPEC announced the first ever decrease in its benchmark price, with Saudi light now being priced at $29, down $5 from $34. We know what happened next. The glut continued and oil prices steadily declined until all-out collapse to $12 in early 1986 when Saudi Arabia, tired of OPEC squabbling, decided to open the taps and let all their partners suffer.

Zoom forward thirty years and we also have an oil glut:

The tight-oil revolution, the realization that the drill bit can liberate oil from reservoirs once-considered insufficiently porous to yield sufficient oil flows, is coursing through North America and will inevitably spread to the rest of the world. There's so much oil collecting in the US that the price at Cushing, Oklahoma trades 10% below European Brent.

What are we to make of these twin episodes of crude glut/gold collapse? When returns on non-crude related capital projects are low, negative, or falling, there's little incentive to invest. Investors may as well hold some durable asset that costs only a few bucks to store, like gold. After all, in a zero return world a project will likely be a dud, but at least an ounce of gold will still be an ounce of gold a few years hence. As a result, gold prices get bid up, just like they did in the 1970s and 2000s. Gold bull markets are less about inflation than they are a reflection of poor returns on capital projects.

A glut-induced reduction in the price of oil suddenly improves the return on all non-oil related capital projects. The world now looks rosier to everyone who isn't an oil extractor. There's no point in storing gold when the return on most capital projects has perked up. Investors quickly reallocate portfolio space to productive projects, gold prices get ratcheted down, and equity valuations get bid up.

What about equities? In early 1983, the Dow Jones Industrial Average broke convincingly through the famous 1000 level, a line it had knocked up against repeatedly through the 1970s. In similar fashion, it was only a few weeks ago that the S&P500 broke through 1500, a ceiling that has contained it for all of the 2000s. There has been a disturbance in the force, it would seem, and just like 1983, we're watching the Return of the Equity.

PS. If you're interested in the history of gold, do check out my wallchart: A Recent History of Gold, 1954-2010.

For more perspectives on the gold collapse, read David Glasner, Tyler Cowen, Izabella Kaminska, Washington's Blog, and Menzie Chinn.

Sunday, April 14, 2013

Why the Fed is more likely to adopt bitcoin technology than kill it off

Paul Krugman has a recent post in which he casts bitcoin as a retrogression from our current fiat system. He's wrong about this. In the next few years, I put decent odds on the guardian of our fiat system, the Federal Reserve, adopting the very bitcoin technology that Krugman finds so dubious. Here is Krugman:
One thing I haven’t seen emphasized, however, is the extent to which the whole concept of having to “mine” Bitcoins by expending real resources amounts to a drastic retrogression — a retrogression that Adam Smith would have scorned.
Krugman has taken bitcoin's colourful jargon a bit too literally. It's best to think of "bitcoin" as a distributed ledger, or a record, and not as physical coin. And while Bitcoin miners do "mine", they're not performing a function that is analogous to gold mining. Rather, they're contributing to the tending and maintenance of the information that makes up the bitcoin ledger. The mining community listens for ledger transfer announcements, processes and verifies them, and then updates the distributed record. The reward for being the first to successfully add to the ledger is new bitcoin. Distracted by this reward, Krugman misses the underlying verification process it represents, thus drawing an incorrect analogy between bitcoin miners and gold miners.

It's better to think of a bitcoin miner as a gold assayer who verifies that a circulating gold coin isn't a fake, or, in our fiat world, as part of the verification process in a credit card payment. A bitcoin miner listens, processes, double checks, and polices the distributed ledger. Protecting a ledger is a valuable use of resources.

Rather than being retrograde, let's see how bitcoin technology could be adopted by the Fed.

The Federal Reserve owns one of the world's most important ledgers. The Fed's 3,000 or so member banks maintain accounts at the Fed. Put differently, they own allocations in the Fed's ledger. Every business day banks trade Fed ledger space amongst each other. The name for the system that facilitates these transfers is Fedwire and the name for the ledger space being transferred is "reserves".

The quantity and size of Fedwire transactions is breathtaking. In the fourth quarter of 2012, 33.8 million transfers were made with an average transfer value of $4.45 million. A total of $150 trillion in ledger space, or reserves, was exchanged.* Many types of transaction are carried out over Fedwire. When company A buys out company B for a billion dollars, the payment will probably be made over Fedwire. If the Fed conducts an open market purchase of $5 billion, it'll pay for that purchase by transferring ledger space over Fedwire. (The size of a single Fedwire transactions is currently limited to $9.99 billion). When John Doe wires a college $80,000 to pay for his daughters tuition bill, ledger space is being moved from John Doe's bank to the college's bank via Fedwire. The lifeblood of the US commerce pumps through Fedwire.

The Fedwire infrastructure is currently hosted at the Fed's East Rutherford Operations Center (EROC) at 100 Orchard Street, East Rutherford, New Jersey (see map below). While most of the world's attention is usually focused on the Fed's Washington headquarters at 20th Street & Constitution Avenue, the importance of Bernanke's office pales in comparison to 100 Orchard Street. All vital information pertaining to the Fed's ledger is maintained on computers at EROC. If a bank wants to transfer ledger space to another bank, the payment is routed to EROC where it is processed and the Fedwire database updated. This system is a hub and spoke system, with EROC serving as hub for its member bank spokes. In the picture at top, it is the system on the left, a centralized network.

View Larger Map

Because Fedwire is so important, it needs to be resilient. Should disaster strike at the East Rutherford hub, a secondary back up data center at the Federal Reserve Bank of Richmond is designed to resume Fedwire operationality 60 - 90 minutes later. A third backup center exists at the Federal Reserve Bank of Dallas.** The weakness of the system is that if the hub is destroyed (and the second and third backups) then the entire payments infrastructure disintegrates.

An alternative (and perhaps cheaper) way to build a resilient payments system would be for the Federal Reserve to adopt a bitcoin-style distributed ledger. The Fed's ledger would no longer be stored at EROC. Rather, all member banks would hold a copy. Much like a bitcoin miner "mines", a member bank would be an independent node responsible for helping to maintain the ledger's integrity. Should a bank want to exchange ledger space, the transaction would be announced to the network of member bank nodes who would in turn poll each other to verify the legitimacy of the transaction. Once a consensus has been arrived at, the payment would be processed and the Fed's ledger updated. As a condition of membership in the Federal Reserve System, banks would be required to act as verification nodes.

What would be accomplished is a decentralization of the information contained in the Fed's ledger. The ledger would be everywhere rather than at one spot. Transfers of ledger space would no longer be patched through the central processor at EROC but would be handled by a distributed network of cooperating nodes. Whereas the current hub and spoke system has two levels of redundancy, Richmond and Dallas, a distributed system has no central hub and therefore much more layers of redundancy. It would be very difficult to destroy it. Such a system is represented in our top chart by the network on the right, in which no entity is more important than the other.

All of this is an exercise in speculative economics, of course. But I like to think there's a grain of truth in it. Whether you agree with me or not on the possibility or likelihood of the Fed adopting a bitcoin-style distributed ledger as the basis for Fedwire, at least you'll see why Krugman has been too hasty in writing off bitcoin as a retrogression. Distributed ledgers are cutting-edge and will have many applications in the future.

PS. In the burst of attention over the last few weeks, the press and pundits have all become a bitcoin experts, just like they were Cyprus experts in the previous news cycle. There are three blogs worth reading that offer more stable and permanent bitcoin fare. Peter Surda wrote his thesis on bitcoin, so do go by and check his blog The Economics of Bitcoin. Jon Matonis has payments industry experience and has been following bitcoin for far longer than myself or any journalist. He blogs at The Monetary Future. Finally, Mircea Popescu owns and operates MPEX, the largest bitcoin stock and options exchange, and knows all the excruciating detail of the system's inner functioning. He blogs at Trilema.

* Fedwire statistics
**Payments, Clearance, and Settlement: A Guide to the Systems, Risks, and Issues by the General Accounting Office (1997) PDF

Friday, April 12, 2013

Consumption isn't a fleeting burst of pleasure, it's a long-lived asset

I've learnt enough about the terms income, savings, consumption, investment, capital, and other major macroeconomic categorizations to pass a basic economics exam. But I've never been a big fan of the style of thinking these terms force on me. Am I just being lazy? I'll lay out my points and give an alternative.

Squarely Rooted recently commented on the somewhat arbitrary nature of the boundary economists set between consumption and saving, opining that travel should be thought of as investment, not consumption. On twinkies as savings, here is Squarely Rooted from an earlier post:
Think of a Twinkie. Twinkies are an odd product; on the one hand, they are a cheap, delicious, unhealthy snack; on the other hand, they are (at least according to legend) practically immortal. So is buying a Twinkie consumption or saving? Does it depend when you eat it? And for those who will say “but Twinkies aren’t an investment, they bear no interest, they just sit there” – so does money under the mattress, and nobody thinks that isn’t saving.
As Squarely Rooted notes, dividing the world into categories allows for discussion, but it also "pre-digests" the world for us. This is what Nick Rowe once called the Borges Problem:
We get very different results depending on how we categorise the world. And sometimes the categories we use are chosen by someone long ago who had a totally different purpose and/or a totally different theory to ours. Our way of seeing the world gets distorted by the dead hand of historical ways of seeing.
This cuts both ways. While the dominant technique of linguistically dividing up the world may distort our way of seeing things, having multiple languages can be equally problematic. Here is Steve Randy Waldman:
Our various allegiances — to schools or tribes or policy ideas — exploit the ambiguity of language to manufacture conflicts, through which we reassure ourselves that we are right and they are wrong. (And no, math doesn’t help much, because we must map it arbitrarily to the same ambiguous language for it to be of any use.) Now I will reassure myself that I am right and they are wrong.
It seems to me that looking at the world through a set of different categorical lenses can give us some great insights, as long as those lenses are coherent. But we need to be aware that there are many different taxonomies. Learning how to recognize each and being able to translate between them will probably save us eons in lost time arguing about semantics.

Back to the basic set of categories under discussion. The typical view is that income is a flow, part of which gets apportioned to consumption. Consumption spending is immediately used up, providing a sudden burst of consumptive joy before disappearing for eternity. The unspent income that remains is defined as savings, and this in turn will be invested with an eye to the future, primarily to fund consumption down the road. Most savings will go into capital, though some of it might leak into money hoardings.  Equipped with these categorizations, economists can go out into the real world and determine what falls in one basket and what falls in the other.

The line being drawn between consumption and savings is based on the distinctions between now vs. later and durable vs. nondurable. Let's try a different way of splitting up the world. Suppose that all consumption goods and experiences are long-lived durable assets. They are forms of income-yielding capital in which one invests. Canned beans bought for my pantry will provide a burst of consumptive joy several months from now. Until then, just having them in a pantry provides a stream of useful services, much like a fire alarm provides utility even though it is never used. These are what Steve Horwitz calls availability services. Both the food we keep in our larders and our fire alarm quell uncertainty and soothe us.

If I take out my employees to the bowling alley, I'm investing in organizational capital. But when I go out to bowl by myself, I'm drawing down my wealth on a one-time shot of consumptive joy, at least according to way the lines are currently drawn. Why not consider both to be long term investments?

Take travel spending. As Squarely Rooted points out, travel is a perpetuity. The travel asset that you might be considering purchasing provides an immediate burst of raw travel experience (not all of it fun), followed by a perpetual flow of memories, experiences, and knowledge that continues till death. Any one who swaps out a security, say Microsoft, from their portfolio for a travel asset has determined that on the margin, the present value of the flow of dividends provided by a voyage exceeds the present value of a flow of Microsoft dividends.

I recently splurged on an expensive meal and did so not only to enjoy the near-term burst of flavours, but also for the long-term flow of returns that my investment would produce, namely the opportunity to remember my experience and talk about it with others. Until I forget my experience a few years from now, it'll have provided me with repeating chain of returns. On the other hand, I'll probably sell out of the gold futures contract I just bought in a month or two. Which of these two swaps is the future-oriented durable one and which is about the here & now?

When someone spends their income on so-called consumption they aren't drawing down their stock of savings. Rather, they're swapping asset x in their portfolio for asset z.  The choice to buy food, travel, and get a haircut isn't a depletion or exhaustion of wealth—it's a portfolio adjustment. Consumption is a stock, not a flow. We can calculate the discounted value of all yields thrown off by a consumption good or experience over time and sum these flows up into a stock value.

We are always conducting asset swaps in order to grope towards portfolios with the highest net present value. Our personal capital is probably our greatest asset. When we earn income, all we've really done is swapped personal capital, time & effort, for a bank-issued liability. We commit to this swap because we estimate that the NPV of additional bank-issued liabilities will more than offset the lost NPV of personal capital.

In equilibrium, the returns on all assets are equilibrated through arbitrage. Investing $10 in cigarettes should provide the same prospective flow of services as investing $10 in a trip to somewhere, $10 on a massage, or $10 in Microsoft. If the yield on some consumptive asset, say a massage, exceeds the economy wide rate of return, individuals will sell their Microsoft shares and go off to the masseuse. This process continues until the price of massages has increased to the point that it no longer makes sense to conduct this arbitrage.

What about the classical bias against so-called consumption? Say that rather than swapping out bank-issued liabilities for Microsoft shares we swap them for a long-lived travel asset. Economists would say that we have high time preference and are sacrificing future consumption for present. Society says we've splurged on silly consumption. It seems to me that as long as we've made this decision by appraising each asset's future earnings stream, who cares if we've chosen Microsoft or travel? All we've done is clocked the two NPVs against each other and purchased the one with the best yield relative to its cost.

Microsoft shares have one advantage over a travel asset. They are liquid. Travel experience can't be resold. In committing your entire portfolio to travel, the problem isn't that you've sacrificed future consumption for present consumption, nor that you've sent money down a black hole. Rather, you've rendered your portfolio less liquid. People who reallocate their portfolios towards travel are asset rich, but liquidity-poor.

While we can't directly remonetize our travel asset, we can indirectly remonetize it. If travel and good food improve our spirits and productivity, then we can recombine these benefits with our labour and resell the total product at a higher price than before. So investing in consumption assets can be a great idea. But in general, it's probably not a good idea to invest everything one owns in illiquid consumption assets. Liquid assets will always be good in a bind.

Getting back to the Borges problem, how does reconceptualizing things this way lead to different results? The old lines between capital, land, and labour aren't so important, nor is the axis between the household and firm. Nor does the distinction between durable and non-durable goods concern us. All we have are millions of yield-generating assets that are constantly moving in or out of individual's portfolios. The main difference between these assets is their swappability, or their liquidity. It's a good platform on which to start thinking about moneyness.

Even if you don't agree with me on any of this, I hope you see how the Borges problem operates. How we choose to linguistically parcel up the world influences the way we take in and sort data, and the data we generate is the base for our actions, policies, and institutions. We've built up an incredibly large edifice based on our initial categorizations. Hopefully we've gotten them right.

Monday, April 8, 2013

If your favorite holding period is forever...

[This is a continuation of my post on liquidity adjusted equity valuation.]

If your favorite holding period is forever, then today's stock markets just aren't meant for you.

As I pointed out in my previous post on stocks and liquidity, stocks can do more money-ish and cashlike things than in times past. For most people, the ability of stock (or any other good or asset) to be easily-exchanged is desirable since it ensures that come some unforeseen event, that stock can quickly be swapped for more suitable items. We can think of easily-exchangeable stock as insurance against uncertainty. Investors estimate the stream of 'expected comfort' or 'uncertainty alleviation' that a stock's degree of exchangeability will provide, discount these streams into the present, and arrive at some value for the liquidity return provided by a stock. The more moneylike or liquid a stock, the higher its liquidity return.

A stock's liquidity return makes up but one bit of a stock's total expected return. The other bit is the risk-adjusted real return, or the stream of dividends and price appreciation that a stock provides. When an investor buys a stock, they're getting a 2-in-1 deal. They're buying a real return and a liquidity return. The all-in price paid for a stock is a sum of the prices investors put on the value of these two different return streams.

It's for this reason that modern stocks are not an ideal investment for value investors, the species of investor whose favorite holding period is forever. While most people appreciate the 2-in-1 deal provided by equities, the ability to easily resell a stock is pretty much worthless to a value investor.  In order to enjoy a stock's real return stream (dividends plus price appreciation), a value investor must endure having that stock's liquidity return, which to them isn't worth a dime, forced down their throat.

Here's an analogy. Imagine that you're shopping around for a bare bones car. Unfortunately, the only models available have leather upholstery, oak trim, and a rear seat champagne cooler. Either you pay up for what you see as useless options or you walk away from the lot without a car. This is the same world that Warren Buffet type value investors face every day. Like it or not, they've got to buy stock with all the bells and whistles, even though they put zero value on these extras.

In the real world, a car dealer will let our car buyer strip out the oak trim, the champagne cooler, and the rest of the options they don't need until they arrive at a pared down car package that suits their needs and falls within their budget. Why not do the same in the stock market? Why not allow Buffet-style value investors to strip out the liquidity return of a stock so that they can own a pure real stream of returns?

The way to do this is to establish 'moneyness markets' for equities. In moneyness markets, the liquidity return of a stock is severed from the stock's real return and put up for auction. A value investor would be able to simultaneously buy a stock, sell off the stock's moneyness, or the right to enjoy that stock's liquidity, and be left holding a perpetually non-tradeable chunk of equity.

In doing so our investor has now effectively committed herself to an indefinite holding period. She will continue to earn dividends and enjoy price appreciation (or not), but she has limited her exits to either a cash takeover, the unwinding of the company, or a repurchase and cancellation of shares by company management. Gone is the traditional avenue for exit, the secondary markets.

In constricting her exits, our value investor is no worse off than before since her preferred holding time, moneyness market or not, was always forever. Indeed, moneyness markets have allowed her to improve her position. She has achieved the same final allocation that she would have without such markets, a perpetual long position in a stock, but she has succeeded in reducing the purchase price of her stock by auctioning off an option on which she placed no value whatsoever.

Let's say our value investor has a change of mind. Perhaps the circumstances surrounding a company in her portfolio have worsened and she no longer considers its shares worthy of an eternal holding period. Or maybe her personal situation is less stable and she wants to improve her ability to sell out should some unforeseen event occur. To return to a more liquid state our value investor would have to wade back into the moneyness market and repurchase the option to sell her stock. Put differently, she'd have to pay a fee to recapture her stock's old liquidity return.

How much would she pay to have these restrictions lifted? To restore her ability to freely trade in shares she'd have to pay others an amount sufficient to compensate them for being indefinitely deprived of that very same ability. This is the moneyness market.

This stock market story could be an allegory for all markets. Anyone with an indefinite holding period will usually overpay for things because most active markets are 2-in-1 markets. The asset being sold provides a real return and a liquidity return, whereas so-called "value" buyers typically only want the real return. Moneyness markets in everything would be a way to sell off the liquidity return so as to ensure people achieve the allocation they desire, at the right price.

Over the next few weeks I hope to sketch out a few related posts dealing with the following rough ideas:

1. When a stock trades at a high multiple to earnings, is this because the stock has an excellent liquidity return or because it is genuinely overvalued relative to its earnings power? Without equity moneyness markets, it's difficult to be sure. With these markets, value investors would be provided with the full range of liquidity price information necessary to decompose real returns from liquidity returns. Liquidity-adjusted earnings metrics would lead to greater accuracy in the pricing of equities, and along with more accurate prices would come a greater degree of precision in capital allocation.

Because they like to buy when everyone is selling, value investors are some of the market's best natural stabilizers. Without moneyness markets, the ability of value investors to efficiently price assets is limited as as their wherewithal to participate. Introduce these markets and value investor's capacity to contribute to market stability expands.

2. While fundamental investors would be sellers of moneyness, I've been a bit circumspect who the buyers would be. Intertwined with this is the question of how to construct an equity moneyness market. Over-the- counter or a central clearing house? Would the terms of a moneyness contract be perpetual or would we see 1, 2, 5, 10, and 30 year moneyness contracts? How well would such a structure port over to housing, fixed income, commodity, and goods markets?

Thursday, April 4, 2013

Bitcoin's plunge protection team

I see that the mainstream bloggers are starting to flog the bitcoin story, which means I'll be moving on to greener blogging pastures for the time being. I've had some great discussions in my last few posts with my commenters. As always, this blog is meant to be learning tool, both for me to absorb things from others and hopefully vice versa. In this post I'm going to discuss the idea of a plunge protection team made up of avid bitcoin collectors that could potentially anchors bitcoin's price and provide a degree of automatic stabilization.

In all my bitcoin posts I've been emphasizing that bitcoin lacks a fundamental, or intrinsic, value. Regular commenter Peter Surda disagrees, pointing out that despite their intangibility, virtual goods should not be seen as inferior to so-called real assets. I completely agree with him. 0s and 1s can be valuable. When I bandy around the term fundamental value, I'm not talking about physicality or solidity. What I'm referring to is an asset's non-monetary value.

The best way to think about non-monetary value is by reference its counterpart—monetary value. A good or asset has monetary value when a subset of the people who hold it do so solely for its moneyness, or its ability to be exchanged in the future. Perhaps these people are driven by a transactions motive. They plan to hold the asset for a day or a month before exchanging it on for another good. Alternatively they may be driven by the speculative motive. They intend to temporarily hold the asset, always with the goal of passing it on at a higher price. Transactors and speculators alike value their inventory of gold, cash, bitcoin, or whatever, for its ability to be exchanged, and not for any other reason.

Strip out an asset's monetary value, and you're left with the remainder: pure non-monetary value. This is the fundamental core of an asset, or its intrinsic value. One way to think about this is to imagine what would happen to an asset upon the sudden flight of all transactors and speculators from the market. The remaining holders of the asset will be those who value it on a purely fundamental basis. They have no intention of ever selling out of their position and are perfectly content to sit on their holdings and "consume" them.

I've made the claim that a bitcoin has no fundamental value because it's mere ledger space. If all the bitcoin speculators were to suddenly split, no one would be left to holding the bag. But doesn't this apply to other assets? Jon Matonis brings up the idea that central bank instruments could also be viewed as blank ledger space. Adam Love points to gold as a potential analogy.

Let's run through how other assets evolve when speculators and exchangers panic and bolt.

Stocks: When all speculators try to sell, a stock's price quickly plunges. Because the firm's earnings power hasn't changed, at some lower price the CFO realizes that capital should be directed to retiring the firm's own shares from the secondary market rather than investing in projects. At this price, the firm will buy up every share offered till all speculative selling is exhausted.

Central bank cash and reserves: If all transactors and speculators try to flee a currency then inflation emerges. To meet its inflation targets, a central bank will start to conduct massive open market sales. Blowfish-like, it sucks in all unwanted currency and reserves until panic-selling by transactors and speculators has subsided.

Gold: If all transactors and speculators try to sell their gold then its price collapses. Jewelers, dentists, and manufacturers begin to withdraw gold from the market at these advantageous prices because they can use the metal to displace more expensive alternative materials. All unwanted monetary gold will be removed into the inventories of jewelers, dentists, and manufactures, or into their finished product.

My incessant concern with a speculator-driven collapse in monetary value isn't just me being ornery. Any given asset faces a daily threat of liquidity flight. These sorts of runs can quickly become self fulfilling phenomena. If one speculator causes an asset's price to fall by selling it off, more speculators might bolt, thereby causing yet another fall in price, causing more speculator flight, ad infinitum. Similarly, as transactors make less use of an asset, that asset loses liquidity, causing transactors to use it even less, causing it to lose liquidity, and so on and so forth. The moneyness of an asset can quickly implode, blackhole-like.

Gold, stocks, and central bank reserves/cash all have fundamental mechanisms for ensuring that this sort of flight is dampened. In the case of bitcoin though, if transactors and speculators get spooked there is no central bank to suck bitcoin back in, nor a CFO to conduct buy backs, nor dentists or jewelers to re-purpose it for alternative uses. Bitcoin is 100% moneyness. Whenever a liquidity crisis hits, the only way for the bitcoin market to accommodate everyone's demand to sell is for the price of bitcoin to hit zero—all out implosion.

Commenter Arvicco points out that there is a non-monetary core at the heart of bitcoin. People value bitcoin as a collectible. Mike Sproul has also brought up this possibility, comparing bitcoin to baseball cards. In my first bitcoin post, I hypothesized that bitcoin might be an indicator of geek cred, a badge of sorts. Does bitcoin actually have a fundamental value? Let's assume for the moment that this view is right. This means that come the next liquidity crisis, bitcoin won't collapse to zero but will bottom out at whatever price so-called bitcoin collectors are willing (and able) to set. Just like jewelers and dentists act as safety valves in the gold market, cushioning panic-driven speculative declines in the gold price through their purchases, the bitcoin collector community will step in as buyer of last resort to ensure that BTC never falls to 0.

Who might these collectors be? They are bitcoin's true believers, the ones who have been there from the start (or wish they had). Out of pure admiration for bitcoin, they'd willingly buy it at any positive value, even though the rest of the world couldn't care less about bitcoin's unique properties. Collectors hold bitcoin  not because they plan to exchange it on for a better price, but as a permanent consumption good. These folks joins other rare birds like stamp collectors and crocheted doily collectors in setting the fundamental value of an item that the rest of the world neither understands nor values for its own sake.

This is different from the gold market. Jewelers, manufacturers, and dentists take gold out of the market during panics not because they collect the metal, nor because they're loyal to it. They do so because their profit and loss calculation tells them that it makes sense to do so.

I'm not able to appraise how big the core collector community is and how determined its member are, but I am skeptical of their ability to absorb a mass exodus of bitcoin speculators and transactors. After all, there's a tremendous amount of speculation in the market, surely far more speculators than transactors. So for now I'll remain a seller of bitcoin, since I'm worried about instability. But let's ignore my outlook. Here are some thoughts about bitcoin true believers as a potential plunge protection team.

First, there needs to be a lot of collectors if they're going to successfully anchor bitcoin's price against massive and inevitable monetary panics. They should be firm in their commitment to bitcoin. There needs to be a steady recruitment of new people to the collecting cause. A mythology is a great tool for inspiring collectors and potential collectors. The story of bitcoin founder Satoshi Nakamoto or the techno-anarchist narratives of bitcoin-as-destroyer-of-government-money and liberator-of-society are powerful coordination devices. When bitcoin crashes $40 in ten minutes, it'll take waves of devoted believers to put in plunge protection buy orders. If Bitcoin's cultural motifs are sufficient to motivate the requisite desire to hold and consume bitcoin as collector's items, then perhaps a future liquidity panic won't cause bitcoin to implode.

Secondly, the bitcoin collector community should be selling into every bitcoin price rise so that they have the ammunition to reinforce plunge protection efforts when the market inevitably experiences a speculative run. By selling high, bitcoin collectors will have sufficient reserves of USD, pounds, yen etc to repurchase bitcoin from speculators when the latter eventually flee. Just as buying into falls should help halt plunges, the process of selling into a rise will have the side benefit of softening the rise, thereby reducing speculative excess.

There are a lot of interesting catch-22s here. Too much speculation is dangerous since a speculative buyer represents a future panic-seller for whom collectors will have to budget resources to purchase unwanted coin. But at the same time, as more collectors are drawn to the bitcoin mythology, they push prices up, attracting the very same speculative elements that threaten to destabilize bitcoin. Speculators, after all, love fast-moving unidirectional markets. Here's another irony. Even as the plunge protection team anchors bitcoin's price to the downside, in doing so it creates a Greenspan put of sorts, insuring speculators that they'll never lose more than a fixed amount of their capital. This only inspires more speculation. The last catch-22 is this. A plunge protection team of loyal collectors needs to keep a store of central bank media-of- exchange to repurchase bitcoin from fleeing speculators and prevent the zero value problem—but owning fiat instruments clashes with the whole anti-fiat mythology of bitcoin.

I'm skeptical of the ability of collectors to act as the necessary automatic stabilizer to counterbalance mass speculative exit. I'm not convinced that they can ensure that bitcoin will be around 10 years from now. I still think some sort of blockchain-style ledger will be in use 10 years from now, but it won't be the bitcoin ledger. But who knows, odder things have happened.

PS: Notice that I haven't used the word "money" once. I challenge commenters to avoid the word too. Trying to define something as money or not causes all sorts of distractions.

Monday, April 1, 2013

The growing demand for larger and smaller monetary units

A thousand years ago we never needed to measure lengths of more than a few hundred leagues nor less than a few hairs. Now we measure the diameter of our local galactic supercluster in yotameters and the length of neutrinos in yoctometers.

A similar dynamic exists in the measurement of prices. When I was doing research last week for this post, I ran into my first instance of something measuring in the quadrillion dollar range. Apparently the Depository Trust & Clearing Corporation (DTCC) settled some $1.669 quadrillion in securities transactions in 2011. I'm still having problems getting a grasp on the size of that number. I doubt a banker in 1500s London would have ever had to conceive of anything more than a few hundred thousand shillings.

When the Fed's balance sheet exploded in 2009, we all had to get used to thinking in terms of trillions of dollars. But anyone analyzing the Fed in, say, the 1960s never had to worry about a balance sheet worth more than a mere $80 billion. I suppose that we all need to start getting used to quadrillions now, and whatever unit comes after that.

This goes the other direction, too. In financial markets, we're starting to see stock quotes in sub-penny amounts. This is a massive change from a few decades ago when stock was typically quoted in eighths of a dollar.

Cryptocurrencies like bitcoin are particularly interesting in this respect because they are divisible to 8 decimal places. I found myself in a novel place last week when I was offering to sell a bitcoin-denominated stock for 2.99999, and someone undercut me by offering 2.99998. Consider the cryptocurrency used by the Ripple system, the XRP. One millionth of an XRP is called a "drop". The default transaction fee on a Ripple trade is 10 drops. Given that an XRP is worth around 1/50,000th of one US dollar, it becomes very difficult to comprehend the tiny value of the 10 drop transaction fee.

One wonders how much larger and smaller our monetary units will be a thousand years from now.