Bits and stuff: cathedrals and more… December 10, 2017

If any of you have ever taken a mooc (massive open online course), you’ll know the compelling power of having good quality teaching of a vast range of subjects at just a couple of clicks away. Access to that kind of wealth is intoxicating, and can be the black hole of time management. A couple of years ago I was a total addict, at one point enrolled in about 15, from institutions such as Harvard, Princeton, University of Edinburgh…

Needless to say, I didn’t complete them all, but I did get through a fair number. Most of my choices were in programming, economics and finance, but, surprisingly, the ones I enjoyed the most (and most remember) were the ones from “left field”, nothing to do with my training or profession. I especially recommend “How to Change the World” from Wesleyan, and “Digital Education” from the University of Edinburgh, if they ever put them on again.

I bring this up because today I started a new one, the first mooc I’ve felt brave enough to sign up for since I started work at CoinDesk. By “brave”, I mean willing to struggle with the time management issues – there are only so many hours in the day, and many things take priority over scratching a curiosity itch, however enlightening it may be. In so doing, I realized how much I missed scratching that curiosity itch, and how much more interesting the world is when we have the luxury of doing so. Also, how intertwined different disciplines are, and how big pictures emerge through seemingly unrelated connections.

The course I’ve started is “Cathedrals”, from Yale University, available on Coursera. I’m not religious, I’ve never been particularly fascinated with cathedrals before, but I’m married to someone who is and I’ve wandered around more than I can count.

So why did I sign up? I didn’t know at the time – it just felt like something that I needed to do. But now that I’ve started, I realize why: it’s the desire for context. Just two chapters in, it’s already about engineering, history, religion and philosophy. And already it’s tying in to reading I’ve been doing about economic development and how money evolved.

I’ve also realized that it’s one thing to gape in awe at the beauty and splendour of gothic structures. It’s another to understand how they came to be, what purpose they served and why so many are still standing today, centuries later.

So, while a course on cathedrals may sound fusty, it’s not. It’s modern and eye-opening, and I’m loving it.

notre dame

— x —

The course also taught me a new word: cephalophore. It means “saint carrying his own head”. I challenge you to use that in a sentence.

— x —

Angela Walch (@angela_walch) is serialising an update of The Christmas Carol, faithful to the original style but with modern characters and a moral that is disconcertingly not too different from the original.

Parts 1 & 2 here.

— x —

Sticking with the cathedrals theme, take a look at this installation of stained glass “ribbons” in a San Francisco cathedral… Magical.

stained glass ribbons

(Installation by Anne Patterson, image by Fiestaban Photography, via MyModernMet)

 

Bitcoin futures and the meaning of finance – how did we get here?

Photo by Brandon Morgan on Unsplash
Photo by Brandon Morgan on Unsplash

One outstanding note in the cacophony of the bitcoin futures debate is an intriguing claim that I confess I didn’t understand at first: that bitcoin has no “natural sellers”. What’s unnatural, I thought, about people wanting to sell to realize profits? It turns out that’s not what the phrase means.

It means that nobody needs bitcoin. So why hedge it?

To go deeper, let’s look at why capital markets exist. They were developed to enable firms to raise money outside of bank loans. Bonds and equities pair those that need funds with investors who want a return.

Derivative markets emerged to protect cash flows. This both gives producers more security, and helps to raise funds – investors are more likely to “lend” to a company with protected income than to one subject to the vagaries of nature.

In essence, capital markets exist to help businesses flourish. Old-school capitalism.

Here’s where the “natural seller” part becomes important.

Farmers need to sell wheat. It’s what they do. Oil producers need to sell oil. Steel manufacturers need to sell steel. Gold miners need to sell gold. So, they all should protect those sales in the derivative markets.

No-one needs to sell bitcoin.

So what income flows are the derivatives protecting? Mutual fund redemptions, maybe. Pension plan payouts. But do we really think that mutual funds and pension plans should have significant exposure to bitcoin?

This question is important for whatever side of the bitcoin debate you’re on. If you’re a sceptic and think that it’s all a ponzi scheme, surely you don’t want institutional funds heavily invested in an asset that will no doubt crash. If you’re a bitcoin believer, do you really want the “money of the future” stuck in funds? Where’s the decentralizing potential in that?

So, it could be that the constructive purpose of bitcoin derivatives is to protect flows for funds that are either taking irrational risks or hijacking the finance of tomorrow. This is a far cry from ensuring that farmers can make a living and oil producers don’t go bust.

We could argue that all this started to go awry back in the ‘80s with the creation of synthetic derivatives that had as their sole aim to make a profit at the expense of others (trading being a zero-sum game). We could also argue that back then we got ahead of ourselves by letting markets run far ahead of the infrastructure. We know what happened next. (Ok, I’m simplifying, but the point still holds.)

And we could ask ourselves what good bitcoin futures will do the economy as a whole. To what productive use will their markets contribute? Are they adding stability, as per the original intent of derivatives? Or could they be adding yet another layer of complexity that masks a deepening fragility?

Of course, playing the long game, this could be what true bitcoin believers have known would happen all along. That the world will see (again) how unstable the current financial system is. And to what will people turn when widening cracks send central banks scrambling?

True, the bitcoin price would also likely tumble. But the technology would still work. People would still be able to independently transfer funds. And the advantage to having an alternative to an interconnected and unstable system would become more apparent than ever.

The threat of bitcoin futures

photo by Jesse Bowser on Unsplash
photo by Jesse Bowser on Unsplash

The financial press has been in a flutter of excitement over the launch of bitcoin futures trading on not one but two reputable, regulated and liquid exchanges: CME and Cboe.

CME Group (Chicago Mercantile Exchange) is the largest derivatives exchange in the world, as well as one of the oldest, with roots going back to the 19th century. It will launch bitcoin futures trading on December 18th.

Cboe Global Markets owns the Chicago Board Options Exchange (the largest US options exchange) and BATS Global Markets (the platform on which the Gemini-backed bitcoin ETF would have been listed had it been approved). It plans to beat CME to the punch by launching bitcoin futures trading on December 10th.

In theory this opens the doors to institutional and retail investors who want exposure to bitcoin but for some reason (such as internal rules, or an aversion to risky and complicated bitcoin exchanges and wallets) can’t trade actual bitcoin.

And that expected flood of interest is, from what I hear, part of the reason that bitcoin’s price recently shot past $11,000 (which, considering it started the year at $1,000, is phenomenal).

I’m missing something. I don’t understand why the market thinks there will be a huge demand for bitcoin itself as a result of futures trading.

First, a brief primer on how futures work: let’s say that I think that the price of xyz, which is currently trading at $50, will go up to $100 in two months. Someone offers me the chance to commit to paying $80 for xyz in two months’ time. I accept, which means that I’ve just “bought” a futures contract. If I’m right, I’ll be paying $80 for something that’s worth $100. If I’m wrong, and the price is lower, then I’ll be paying more than it’s worth in the market, and I will not be happy.

Alternatively, if I think that xyz is going to go down in price, I can “sell” a futures contract: I commit to delivering an xyz in two months’ time for a set price, say $80. When the contract is up, I buy an xyz at the market price, and deliver it to the contract holder in return for the promised amount. If I’m right and the market price is lower than $80, I’ve made a profit.

Beyond this basic premise there are all sorts of hybrid strategies that involve holding the underlying asset and hedging: for instance, I hold xyz and sell a futures contract (I commit to selling) at a higher price. If the price goes up, I make money on the underlying asset but lose on the futures contract, and if it goes down the situation is reversed. Another common strategy involves simultaneously buying and selling futures contracts to “lock in” a price.

Futures contracts currently exist for a vast range of commodities and financial instruments, with different terms and conditions. It’s a complex field that moves a lot of money. The futures market for gold is almost 10x the size (measuring the underlying asset of the contracts) of the physical gold market.

How can this be? How can you have more futures contracts for gold than actual gold? Because you don’t have to deliver an actual bar of gold when the contract matures. Many futures contracts settle on a “cash” basis – instead of physical delivery for the sale, the buyer receives the difference between the futures price (= the agreed-upon price) and the spot (= market) price. If the aforementioned xyz contract were on a cash settlement basis and the market price was $100 at the end of two months (as I had predicted), instead of an xyz, I would receive $20 (the difference between the $100 market price and the $80 that I committed to pay).

Both the CME and the Cboe futures settle in cash, not in actual bitcoin. Just imagine the legal and logistical hassle if two reputable and regulated exchanges had to set up custodial wallets, with all the security that would entail.

So, it’s likely that the bitcoin futures market will end up being even larger than the actual bitcoin market. That’s important.

Why? Because institutional investors will like that. Size and liquidity make fund managers feel less stressed than usual.

The bitcoin market seems to be excited at all the institutional money that will come pouring into bitcoin as a result of futures trading. That’s the part I don’t understand.

It’s true that the possibility of getting exposure to this mysterious asset that is producing outstanding returns on a regulated and liquid exchange will no doubt entice serious money to take a bitcoin punt. Many funds that are by charter prohibited from dealing in “alternative assets” on unregulated exchanges will now be able to participate. And the opportunity to leverage positions (get even more exposure than the money you’re putting in would normally warrant) to magnify the already outrageous returns will almost certainly attract funds that need the extra edge.

But here’s the thing: the money will not be pouring into the bitcoin market. It will be buying synthetic derivatives, that don’t directly impact bitcoin at all. For every $100 million (or whatever) that supermegahedgefundX puts into bitcoin futures, no extra money goes into bitcoin itself. These futures do not require ownership of actual bitcoins, not even on contract maturity.

Sure, many will argue that more funds will be interested in holding actual bitcoins now that they can hedge those positions. If supermegahedgefundX can offset any potential losses with futures trading, then maybe it will be more willing to buy bitcoin – although why it would allow its potential gains to be reduced with the same futures trade is beyond me. And, why hold the bitcoin when you can get similar profits with less initial outlay just by trading the synthetic derivatives?

That’s the part that most worries me. Why buy bitcoin when you can go long a futures contract? Or a combination of futures contracts that either exaggerates your potential gains or limits your potential loss? In other words, I’m concerned that institutional investors that would have purchased bitcoin for its potential gains will now just head to the futures market. Cleaner, cheaper, safer and more regulated.

So, if the market is discounting an inflow of institutional funds into actual bitcoins, it’s likely to be disappointed.

What worries me even more is the possibility that the institutional funds that have already bought bitcoin (and pushed the price up to current levels) will decide that the official futures market is safer. And they will sell.

Now, it’s possible that the demand for bitcoin futures and the general optimism that seems prevalent in the sector will push up futures prices (in other words, there will be more demand for contracts that commit to buying bitcoin at $20,000 in a year’s time than those that commit to buying at $12,000 – I know, but the market is strange). This will most likely influence the actual market price (“hey, the futures market knows something we don’t, right?”).

And the launch of liquid futures exchanges increases the likelihood of a bitcoin ETF being approved by the SEC in the near future. That would bring a lot of money into an already crowded space.

Buuuut… it’s also possible that the institutional investors that are negative on bitcoin’s prospects (and there’s no shortage of those) may use the futures markets to put money behind their conviction. It’s much easier to sell a futures contract with a lower-than-market price than it is to actually short bitcoin. These investors may well send signals to the actual bitcoin market that sends prices tumbling.

And the leverage inherent in futures contracts, especially those that settle for cash, could increase the volatility in a downturn.

That’s pretty scary.

Let’s not even go into the paradigm shift that this development implies. The growth of a bitcoin futures market positions it even more as a commodity than a currency (in the US, the Commodity Futures Trading Commission regulates futures markets). And even more as an investment asset than a technology that has the potential to change the plumbing of finance.

So, while the market appears to be greeting the launch of not one but two bitcoin futures exchanges in the next two weeks (with two more potentially important ones on the near horizon) with ebullience, we really should be regarding this development as the end of the beginning.

And the beginning of a new path.

Bits and stuff: panels, politics and pastry – December 4, 2017

And so a whirlwind November draws to a close. As predicted, Web Summit was intense – the best part for me was catching up with some great people, making new friends and having many memorable conversations. I thoroughly enjoyed the panels I was on, and hats off to the organizers for coordinating such a massive event.

websummit

Last week I was on a panel (there are soooo many blockchain conferences these days) at The Blockchain Summit in London. Although I lived in London for a few years, I’d never been to the Olympia center before. Big. Packed. I especially enjoyed the round tables, and recommend to all conference organizers that you set some up – small, intimate groups discussing predetermined topics.

blockchain summit panel

As I mentioned before, I no longer do the newsletters for CoinDesk – the Daily has been taken over by editor Pete Rizzo, and the weekly is in the capable hands of managing editor Marc Hochstein. He’s doing a brilliant job, and the takeaway essay in yesterday’s email is excellent – if you don’t get the weekly newsletters (what????), look out for it on the CoinDesk website.

I’m embarking on a month-long sabbatical to finish a research project, focus on reading and catch up on some learning. Already the month is going by too quickly.

In January I re-join CoinDesk to work on new products. It’ll be interesting…

— x —

The Financial Times is upping its blockchain coverage, both in quantity and quality. It used to be just the Alphaville team (specifically Izabella Kaminska) that produced insightful and original comment – but now a slew of sections are casting their gaze on the concept. Unsurprisingly, the focus is on bitcoin, the ingenuous darling of the investment market. And while they lack Izabella’s caustic aspersions on the blockchain hype, they are (in general) doing a fairly good job of conveying the surreal protagonism of cryptoassets.

Gary Silverman, Hannah Murphy and John Authers gave a good overview of bitcoin as an investment, conveying that even professionals don’t seem to understand it.

And capital markets editor Miles Johnson attempted to extract some political meaning from the tea leaves of bitcoin mania.

“Financial professionals who fail to comprehend why someone would risk their wealth investing in bitcoin when it appears to them so obviously to be a bubble can be compared with the political analysts who believed it was impossible the UK would vote to leave the EU.”

— x —

The South China Morning Post, however, misses the point completely by contrasting bitcoin’s “lack of residual value” with the utility inherent in copper, silver and gold.

True, metals can be used for things. But so can bitcoin: it’s a secure means of transferring information without relying on a central authority. That is useful, arguably more so than pretty jewellery (and most industrial uses are being innovated away by new synthetic materials).

— x —

When I head outside for some exercise these days, I’m listening to the audiobook of “Sapiens”, by Yuvah Noah Harari. It’s surprising how different the listening experience is from reading – I’m noticing totally different points. That could, however, just be down to my erratic attention span…

Anyway, last night the following jumped out at me – the conquistadors have just invaded Mexico, and the Aztec natives are perplexed as to why they keep jabbering on about a certain yellow metal:

“What was so important about a metal that could not be eaten, drunk or woven, and was too soft to use for tools or weapons? When the natives questioned Cortés as to why the Spaniards had such a passion for gold, the conquistador answered, ‘Because I and my companions suffer from a disease of the heart which can be cured only with gold.’”

This ties in with my previous point about intrinsic value. Metals have some utility, yes. But most of their market value comes from the fiction (by that I mean “invented reality”) that they’re pretty.

I think gold is pretty. But I think clear water is prettier. A sunset, a butterfly, an orange maple leaf… they’re prettier, also – in my opinion. Beauty is in the eye of the beholder, no?

It could be argued that metals are more durable, therefore they are a much better store of “prettiness”. And that’s a fair point, assuming that durability of “prettiness” warrants such a premium over utility.

But it’s not much different from the rationale that bitcoin’s premium is due to perceived value, not residual usefulness. So, why is one totally rational but the other is “market madness”?

As Harari explains, the Aztecs – who did not see gold as scarce – were puzzled by the aliens’ lust for it. So, while I don’t pretend to be able to justify bitcoin’s current market value, I would like us to stop holding gold up as an asset/safe haven/store of value that “makes sense”.

— x —

Bloomberg is also upping their crypto game, and that’s from an already high level.

As well as an argument for central bank cryptocurrencies and a summary of the positions of the warring bitcoin factions, the Gadfly column gave a good explanation of why the emergence of liquid bitcoin futures markets could explain the price buoyancy.

— x —

From the stratospheric to the sublime, Bloomberg also shows us how a renowned Parisian pastry chef is creating sweet delicacies that look like apples, and taste like apples, too.

image by Céline Clane for Bloomberg (click for link)
image by Céline Clane for Bloomberg (click for link)

I’m all for culinary experimentation, but I can’t help but wonder why, if what we want is something that looks and tastes like an apple, we don’t just eat an apple.

That said, they are gorgeous. I do love the spectacle. And I wouldn’t say no to trying one.

Confusion over faster payments, and what it could mean for bitcoin

The Spanish press has been reporting today on the rollout of TIPS, a payment system that allows instant reconciliation, even across borders within the European Union.

Only they’re wrong.

why pass up an opportunity to insert a Ryan Gosling gif?
(why pass up an opportunity to insert a Ryan Gosling gif?)

TIPS, which stands for TARGET Interbank Payment Settlement, launches in November of 2018. Seriously, the European Central Bank bringing forward the launch of a new payments system by a whole year would be pretty big news. Only, it didn’t happen.

email from ECB

Did a careless journalist just get the year mixed up?

Possibly, but it’s more likely to be a case of alphabet soup.

What does launch today is SCT Inst, which stands for SEPA Credit Transfer Instant, a different faster payments system.

Why the confusion? Because they’re similar, but not the same thing at all. And the difference may seem trivial, but it’s not.

Both promise almost instant payment finality within the Eurozone. Up until now, payments generally settled at the end of the day as totals were added up and net amounts were transferred. With the new, faster systems, settlement occurs on a transaction-by-transaction basis, generally within 10 seconds or so. Even across borders. I live in Madrid – if I make a transfer using this system to a friend in Paris, for example, it will get to her account almost immediately.

One drawback is that you can’t “change your mind” during the day, as you can with the current batch settlement system. But the benefits are many, and go beyond more immediate access to funds, a better service for clients and the possibility of new business models (more on this in a later post).

The main difference between the two systems is the promoting organization.

SCT Inst (the one that launches today) is organized by the European Payments Council (EPC), a not-for-profit group representing payment service providers (PSPs). It is not an EU institution. It was created by the banking industry in 2002 to develop harmonized electronic payments. In other words, it works for private companies, and it is these private companies that execute the payment settlement.

TIPS is organized by the European Central Bank (ECB), which represents central banks.

Private companies… central banks… not the same thing.

With SCT Inst, the private payment service providers settle the transactions, for a fee. With TIPS, the payments settle in central bank money – at 0.2 cents for the first two years, and a maximum of 1 cent thereafter. SCT Inst will have a hard time competing with that.

Plus, it’s fair to assume that the reach of TIPS will be greater, not just geographically, but also sectorially through the possible roping in of automated clearing houses (currently left out of SCT Inst).

However, SCT Inst is here today, and TIPS isn’t. Although the launch is relatively modest – almost 600 PSPs have signed up (about 15% of the possible pool), and it’s available in a limited list of countries: Austria, Estonia, Germany, Italy, Latvia, Lithuania, the Netherlands and Spain (so you’d think they’d report on it correctly?). Others are expected to follow in the next two years.

For participating institutions, it means an opportunity to offer a better service to clients. The focus is likely to be on consumer payments, at least to start with – the transfer limit is currently set at €15,000, which rules out most B2B payments.

TIPS and SCT Inst will co-exist. The TIPS documentation insists that messaging will be compliant with the standards adopted by SCT Inst. But it will be interesting to see how the launch and take-up affect the movement of funds, and which system ends up impacting the market more.

I confess that I have some more digging to do to unravel the relationship map (it looks like spaghetti), after which I hope to uncover more differences.

Meanwhile, we should focus on the big step forward that SCT Inst represents, and the bigger push that its colleague/competitor TIPS will give the payments sector. And on the removal of one of bitcoin’s supposed advantages: that cryptocurrency will replace fiat transfers because of speed.

The envelope, please… Blockchain and shareholder voting

Who knew that shareholder voting could be so… suspenseful?

If you missed the news, Proctor & Gamble has been locked in a bitter battle with shareholder activist Nelson Peltz, who wants a seat on the board. This led to the biggest shareholder battle to date, with over 2.5 billion votes (for 2.5 billion issued shares) in play. Robocalls, social media ads and a flood of mailings… the tactics got fierce.

suspense

At stake is the structure of the consumer goods conglomerate. Peltz – CEO of asset management firm Trian Partners – wants a seat on the board, and to break P&G up into three distinct units, to streamline operations and add flexibility. P&G says that the recent restructuring is already showing positive results, and changing the composition of the board would bring unnecessary disruption.

At the annual general shareholders’ meeting, P&G announced that Peltz’ bid had been defeated. Shareholders had voted to not give him a seat on the board, by a margin of 6.15 million votes, which sounds like a lot but when taken in context of the overall number of outstanding shares, was only 0.2%. A statistician would argue that is well within the margin of error.

And she would be right. Yesterday the FT reported that a recount by an independent expert found that the margin was only 43,000, in favour of Mr. Peltz. Effectively, a dead heat. The final, definitive results are not yet in. But Mr. Peltz could well get his board seat.

Why the lack of clarity in the outcome?

As you have most likely seen with national elections, counting votes is cumbersome, and largely manual. Even today, there is no definitive way to ensure that votes are not double-counted or falsely filed. One of the main problems is collecting all the votes, which are still mainly submitted on paper, either at a company’s annual general meeting, or sent in via physical mail (although some firms allow online voting). Another is making sure that the count is not manipulated. This requires rigorous identity verification, and a decentralized process of tally.

A separate issue is identifying who has the right to vote – with shares held at central depositories and “ownership” represented by a type of cession of rights, this is often not as clear as it should be.

Could blockchain technology, with its security and automation, help? Several large proxy voting managers believe so.

Last year, Russia’s National Settlement Depository announced that it has tested a blockchain-based voting system. The Abu Dhabi Stock Exchange unveiled a blockchain-based voting service that allows shareholders to both participate in and observe the process. And Nasdaq ran an e-voting trial, which recorded stock ownership on a blockchain platform, and issued digital voting right assets and tokens.

Earlier this year, Broadridge – the world’s largest provider of proxy voting infrastructure – revealed that it is building a blockchain platform on ethereum to streamline the sharing of information between custodians. A pilot run was successfully executed (in parallel with voting using traditional software) with JP Morgan, Northern Trust and Banco Santander.

Around the same time, financial services company TMX group (operator of the Toronto and Montreal stock exchanges, among others) revealed that it had completed a proxy shareholder voting prototype built on Hyperledger

And just last week, a group of central securities depositories (CSDs) announced progress on a distributed ledger proxy voting platform. Swift is among the institutions participating, to assist in ensuring compliance with international financial messaging standards (which would open up the platform to uses other than voting).

Timelines on any of the above projects going into the production are at the moment vague. Will any of them even happen? With shareholder voting generally an in-network activity (with limited, if any, need for participation from outside organizations), why use blockchain at all? Why not just go for a robust, efficient database?

Because of the vulnerabilities of centralization, which in many cases doesn’t matter – but when it comes to voting, that’s a different story. First of all, even a distributed database can be hacked and manipulated. Second, shareholders need to be certain that the vote was fair, and that the company in question has not tried to influence the tally. If they are granted real-time transparency into the voting process are more likely to trust the system, and therefore more likely to vote.

Plus, as shareholder voting becomes even more important, propelled by improvements in the technology (reduction of friction) and increased activism, audits of processes by external parties are going to become even more of a regular feature. An access node would facilitate that, as well as reduce the costs.

And finally, proxy polls are not cheap. According to FactSet Research Systems Inc., a “typical” proxy battle costs about $1 million, mainly from printing, mailing and legal fees. For context, the P&G battle is expected to cost the company over $35 million (small change compared to its Q2 income of $2.2 billion, but still…).

And even with that expenditure, it might not win. Final results are yet to come, so the battle isn’t over yet.

But the drama and nail-biting suspense sheds light on the urgent need to reform shareholder voting technology. Current platforms are, in general, inefficient. And electronic voting systems run by any one organization, even audited ones, will always have a cloud of doubt over the controlling interests. The transparency and security of distributed ledger systems could offer a more robust, lasting and scalable solution. Widespread use is still a long way off, though, and they’re unlikely to be practical until the murky issue of stock registration is solved.

While perhaps not the decentralize-the-organizations disruption that blockchain technology originally promised, it would be a step towards a more democratic governance, enabling shareholders to participate in corporate decisions more frequently and with less upheaval. It could end up giving shareholder activists more firepower and motivation, even perhaps going as far as to change what we understand by “shareholder capitalism”. Or capitalism overall, for that matter.

And when it comes to letting the market decide, it must be galling for the P&G board to see the positive price reaction to the news that they might not get their way. If the close outcome of the voting doesn’t send the board a strong message (in other words, when almost half of your shareholders side with your most vocal critic, you’re doing something wrong), perhaps the voice of the market will.

FX trading fines and regulation catch-up

Photo by Ben Rosett on Unsplash
Photo by Ben Rosett on Unsplash

In my last post I mentioned some hefty fines incurred by foreign exchange dealers for trading infractions. The amount keeps climbing.

Yesterday the Financial Times reported that Credit Suisse has just been fined $135m by New York state’s financial regulator for “unsound” conduct between 2008 and 2015. Apparently the traders shared client information with other global banks to manipulate foreign exchange (FX) prices and maximize Credit Suisse profits.

What’s more, the bank was found guilty of front-running (putting your order in just ahead of clients’ orders to take advantage of resulting price movements) between 2010 and 2013.

And (this ties in to my previous post) between 2012 and 2015, traders took advantage of the “last look” feature of their electronic trading platform, which allows dealers to back out of a trade before execution, by applying it to all client trades. To make matters worse, it lied to clients about why trades were rejected.

It’s one thing to use the system to profit your own book over your clients’. It’s quite another to lie about it.

This is one of the reasons for the increasing volume of calls to reform the last look practice. Many traders think it should be banned. Others believe that it should be allowed, but that traders should be honest and upfront with the conditions in which a previously agreed trade would be rejected.

Going back to the Credit Suisse infringements, what blows my mind is that they openly talked about frontrunning and using proprietary information in electronic chat rooms. And get this: one of chat rooms was known as “The Cartel”. It’s not the stupidity that surprises me, it’s the arrogance. If everyone’s doing it, it’s fine, right? Why even try to hide it?

The sentences are coming thick and fast. In September, HSBC was fined $175m by the Federal Reserve for “unsafe and unsound” FX trading practices. In July, the Fed ordered BNP Paribas to pay $246m for charges relating to its FX conduct between 2007 and 2013. These fines follow others of more than $5.7bn levied on a handful of major banks in 2015 by the US Department of Justice, and over $3bn handed down by the US Commodity Futures Trading Commission and the UK’s Financial Conduct Authority in 2014.

While we may be blinded by the volume of fines, we need to put them in context of the overall size of the FX market. The largest market in the world, it trades over $5tn per day. Apart from the massive profits the rogue traders earned for their banks (no doubt largely reflected in handsome bonuses), the fines also reflect the gravity of the infringements. Damage to its reputation and a loss of trust would pose a risk to global commerce and trade.

The high profile of these cases could add momentum to the move towards trading platforms that offer greater transparency to clients and to the regulators.

The FX market, already of systemic importance, is likely to expand as world trade continues to grow. Until recently, large clients didn’t have much of a choice – to get big deals done, you went to the big dealers. Now, however, newcomers with shinier platforms are nibbling away at market share. Increasing compliance adds to costs, and the advantages of largely manual, opaque and relationship-based execution are becoming less apparent. Especially with increasing scrutiny.

The embarrassment for the regulators at the revelations that this was going on for as long as 10 years before anyone noticed will surely give them a good incentive to push for better reporting and greater access to trading records.

So, distributed ledger-based trading platforms in which the regulators have a node that allows them to see in real time what’s going on? Confidentiality issues aside (because they can be solved), it is likely to happen in some form.

Regulators monitoring electronic chat rooms? That’s a different story.

FX trading and last look doubts

photo by Veri Ivanova for Unsplash
photo by Veri Ivanova for Unsplash

The murky world of foreign exchange trading could be about to get a bit more transparent.

A few days ago, the sovereign fund of Norway (NBIM) – the largest in the world, with over $1tn under management – published a report calling for improvements in the foreign exchange (FX) market. It feels that the market’s friction and opacity tilts profits unfairly towards the dealers, and that the lack of transparency is weakening trust in the system.

It points to three particular aspects of FX trading, specifically: last look, algorithms, request for quote feeds and their relationship with interdealer prices.

While each is intriguing and worthy of further digging, I want to take a closer peek at “last look”, since it exemplifies how new technologies can both improve and complicate trading, and how evolving infrastructure requires a regular re-think of established processes.

Looking back

What is “last look”? It’s a “way out” for the dealer, who can renege on an agreed trade if certain conditions are not met. It could be that the client doesn’t pass the credit check. Or it could be that the price moves against the dealer.

This last aspect gives last look the whiff of unfair advantage. Critics claim that it can be used to “cherry pick” trades, only following through on the profitable ones, which would negatively impact market confidence and liquidity. It could also lead to “front running” of trades, whereby information from client orders is used for the dealer’s own profit.

Others argue that its use as a latency buffer – protecting against price moves between order agreement and order execution – is no longer necessary given technology improvements that make that time gap almost negligible. And the lack of information – often clients are not told why their trades fell through – weakens confidence, which could impact order size and even willingness to operate in the market.

Proponents claim that the practice allows dealers to quote better prices – with less risk in a trade, the spread can be narrower, which implies a better deal for the clients.

What’s more, the option of backing out of a trade enables dealers to post their price on several exchanges at once. Without that option, the dealers run a higher risk that the market will move against them. With posts on several exchanges, changing all of them takes time (seconds, but that’s a long time in FX). So, last look encourages a wider spread of trading venues, which in theory enhances liquidity.

Wait a second

Norway’s sovereign fund is not alone in its concerns about the practice, which has been coming under increasing scrutiny.

Vanguard (the world’s largest mutual fund manager), Citadel (one of the world’s largest alternative asset managers) and others have called for its elimination. Several exchanges have echoed that sentiment. XTX Markets Limited, one of the world’s biggest spot currency traders, officially stepped back from the practice in August. The Bank of England has been publicly questioning the practice since 2015.

Global regulators are also taking a closer look. In 2015, Barclays was fined $150m for what was deemed abuse of the practice – not only did the bank filter all trades in which the market moved against it (as opposed to using last look as a sporadic protective measure), but it denied doing so. (2015 was a ripe year for FX manipulation – Barclays was fined a further $2.3bn for other FX infractions, and penalties levied on Citigroup, JP Morgan, UBS, Bank of America and the Royal Bank of Scotland brought the total to almost $6bn.)

However, removing the practice will leave end users vulnerable to predatory manoeuvres, especially given the prevalence of high-speed trading. It could also constrict liquidity as dealers protect themselves against risk.

Rules, please

Why can’t the regulators step in and establish certain rules? Because the FX market is notoriously difficult to regulate, largely due to its cross-border nature. Which jurisdiction would apply?

In an enlightening example of self-regulation, the Global Foreign Exchange Committee (GFXC) was created in May 2017 as a forum for FX market participants (including central banks). Its first act was to issue an updated FX Global Code, a set of “best practices” for the foreign exchange community.

It does not rule out last look, but does ask practitioners to disclose the criteria, in order to allow end clients to make the appropriate adjustments. The GFXC simultaneously issued a request for feedback on the practice, demonstrating a willingness to contemplate adjustments.

So why are the Norwegian sovereign fund and others protesting now? Just two years ago, NBIM publicly came to the practice’s defense, citing its potential to improve available liquidity for investors.

It turns out that their positions are not inconsistent. Even now, it is not advocating the removal of last look. What it wants is more transparency.

Furthermore, it is no doubt aware of the deteriorating levels of trust in FX trading. The previously mentioned scandals and fines are probably the tip of the iceberg when it comes to abuse, especially since the rules have been vague and the FX market is opaque to begin with.

And, the protests could be influenced by fund managers’ need to increase revenue and lower costs through narrower spreads and more transparent pricing. Quoted in the Financial Times, the co-author of the report said:

“We want to be more explicit about the risk sharing between us and the dealer. The client is providing optionality for the dealer. We would like to be rewarded for this option.”

Large market participants no doubt understand that the system is changing, and so are expectations. Calls for market reform are both timely and self-serving, contributing to a cleaner image and hopefully a more robust system.

Looking forward

So, what would a solution look like?

While blockchain technology is by no means the solution to all things financial, it could offer a useful tool for a platform that allows transparency, immutability and decentralized (but permissioned) participation. A major drawback would be the latency – it’s not the fastest way to share data, and the FX market is used to split-second speed.

It is clear that enhanced disclosure is a stop-gap remedy. Once the goal posts start moving, it’s impossible to see where they will stop. What’s more, temporary solutions are not conducive to a lasting realignment of trust. And with self-interest up against community fairness, and a huge economic sector in play, a more durable solution is urgent.

Will blockchain technology end up playing a part? It’s possible, perhaps even probable, especially as new features emerge and work-arounds gain strength. It’s unlikely to be the only solution, though, as database technology and communications infrastructure also continue to evolve. And as long as speed remains a competitive advantage, decentralized resilience and transparency are unlikely to be the main priority.

What’s more, the FX sector is unlikely to see a sweeping change in the near future – it’s just too big and important for that. However, the processes that keep the system running need revision and updating, to continuously improve efficiency and trust.

And eventually, the patchwork of solutions to specific problems will point to a deeper evolution, one that favours interoperability over universality, reliability over speed and trust over profit.

Bits and stuff: talks, takes and transparency – November 1, 2017

You’ll have noticed that there hasn’t been much activity here in October – too much overwhelm from other areas. Priorities are being juggled.

I chaired The Blockchain Summit in London yesterday. The organizers Marketforce did a great job – an excellent event, stimulating and knowledgeable speakers from a wide range of experiences. We had executives, technologists and entrepreneurs talking both big picture and small applications.

blockchain summit

There were a lot of fresh faces up on stage, too, people who know a lot but who I hadn’t heard speak before. I confess that I wasn’t paying full attention to the talks, since the next panel’s questions needed formulating, but there are some presentations that I will be going over again. Vinay Gupta’s opening keynote did not disappoint, and the LSE Group’s David Harris revealed a lot of stuff I didn’t know (and am particularly interested in) – he’s a fun speaker, too. Peter Stephens from UBS gave a thought-provoking talk on identity – I would have like to pay more attention to that. There were many other highlights, too many to mention them all.

The audience seemed to be knowledgeable and focused, and I met some fascinating people from several countries. That’s one of the aspects I most love about these gatherings – meeting smart individuals with smart questions, everyone coming at this from a different angle.

Claudia Coppenolle gave an eye-opening talk on diversity
Claudia Coppenolle gave an eye-opening talk on diversity

— x —

Now I’m off Stockholm for a brief break, then Lisbon for WebSummit (which should be intense).

There’ll be lots to talk about when I get back, that’s for sure. Assuming my brain still works.

— x —

My article on CoinDesk this week, on why banks don’t want to give accounts to cryptocurrency startups:

It’s my last weekly opinion column. And Sunday’s newsletter was my last for CoinDesk. I handed over the daily newsletters to our Editor in Chief Pete Rizzo a while ago. Next week our Managing Editor Marc Hochstein takes over the weekly. It’s in good hands.

My last day at CoinDesk is the end of November. As for what I’m going to do afterwards, I’m not sure yet – plenty of ideas, some interesting options, but no firm decisions yet. I’ve always believed that the big decisions sort of make themselves, so we’ll see where inspiration strikes.

— x —

An interesting take on bitcoin and ethereum from investor Albert Wenger.

“In summary then: for the time being I am cautiously bullish on Bitcoin and at best neutral on Ethereum.”

Obviously, Albert knows much, much more than I do about investments – but why hold on to something when you are “at best” neutral? It doesn’t sound like optimal allocation – even if neutral, shouldn’t the funds be put to better use in an investment with more conviction?

Perhaps ideology is in play…

— x —

… perhaps something along these lines:

“People who are angry and cynical about venture capitalists and the Silicon Valley ecosystem — and I know many — often don’t appreciate the extent to which VCs genuinely believe, in good faith, that what they do makes the world an enormously better place, by nurturing green shoots of innovation into a mighty forest of progress, and are genuinely baffled by the counter-narrative that they reinforce pre-existing social stratification while mostly just helping the rich get richer.”

This is from Jon Evans’ brilliant article “Ether fever dreams” on TechCrunch, about hype and winnowing.

— x —

Venture capitalist Fred Wilson also poked the hype:

“If you read Carlota Perez, you will understand that most important technological revolutions have been fueled by rampant speculation that almost always comes undone right as the sector is moving from the installation phase to the deployment phase.”

Although he takes a more emotional tone:

“So this ugly speculative phase comes with the territory and always has. But that doesn’t mean I have to like it. I hate it.”

So, it seems that the hype-bashing is increasing in volume. Relief, bring it on. And I agree that when we get through to the other side, we’ll realize that some valuable work has been going on amongst the razzle-dazzle.

The next phase is going to be the most interesting.

— x —

This just doesn’t seem right:

photo by Grant Achatz
photo by Grant Achatz, via MyModernMet

A transparent pumpkin pie???? Very pretty, but… Although I work in a sector based on innovation, so of course I would try it. But… (I need to reexamine my open-mindedness.)

By chef Simon Davies, via MyModernMet.

Enough with the bitcoin images

You want to know the one thing about cryptocurrency reporting that drives me mad? It’s not just from the mainstream press either – the specialised press is even more guilty, if that’s possible.

It’s this:

bitcoin cnbc

If I counted on my fingers the number of articles a week that use an image with a physical bitcoin, I would need more hands.

Why do so many articles insist on representing bitcoin as a physical thing? It’s not.

And insisting on presenting it that way – as if us humble humans are incapable of grasping the concept unless we can see it – is condescending.

It speaks to our comfort with the visual.

Most of our development as humans has been building on what we can see. The realm of ideas has traditionally been left to the philosophers, while money and power typically went to the engineers. It’s one of the many reasons art has had such a pull on us over the centuries. Ideas that we can’t see are hard to wrap our heads around.

And everyone knows that money means coins, right? (It doesn’t.)

To be fair, understanding finance is not for everyone – ledgers and compound returns are not straightforward. And if seeing a bitcoin helps us accept that it is real (or, as real as anything gets in the money world), then, sure, let’s use images.

No.

As long as we hang on to the notion that money has to be physical, we won’t fully understand the underlying implications. And, it puts physical boundaries around an abstract concept while anchoring us in the limitations of the past.

The very press that strives to help us understand how this new technology will impact the way we see the world, is perpetuating the old paradigm. It needs to stop.