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

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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.

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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.

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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…

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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.”

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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).

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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”.

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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.

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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.