Too Clever By Half


The smartest animals on my farm aren’t my bees (although they possess the genius of the algorithm). It’s not the horses or the goats or even the dogs. The barn cat is pretty smart, but only in fairly limited circumstances, and the house cats are useless. Obviously it’s not the sheep or the chickens. Nope, the smartest animals on my farm aren’t really on my farm at all. They’re the coyotes who live in the woods.

My favorite example? We have a really big invisible fence for the dogs … covers about five acres. Yes, my farm is a great place to be a dog. For those of you who aren’t familiar with the technology of the invisible fence, it’s a buried wire that transmits a signal to a receiver placed on your dog’s collar. When the dog gets close to the wire, the receiver starts to beep, and when the dog gets all the way to the “fence” boundary, the receiver generates a small electric zap. I know, I know … it’s negative reinforcement and it’s a shock collar and all that. Don’t care. It’s fantastic for us and our dogs. But whether it’s a smart dog like Maggie the German Shepherd or a … shall we say … “special” dog like Sam the Sheltie, after a few weeks (Maggie) or a few hours (Sam) they will forget where the fence exists if they stop wearing the collar.

Not so the coyotes.

The coyotes know *exactly* where the invisible fence begins and ends, without the benefit of *ever* wearing a shock collar. How do I know? Because they intentionally leave their scat on their side of the invisible fence, creating a demilitarized zone as precise and as well-observed as anything on the Korean peninsula. Occasionally a coyote will try to test our dogs by leaving its scat juuusst over the line on our side of the DMZ. Our dogs, of course, just blithely ignore the provocation, not even knowing that they’re being challenged. My dogs are the Roadrunner in some real-life Looney Tunes competition with Wile E. Coyote, super-genius. The coyotes are scheming; my dogs have no idea what scheming is.

I feel bad for the real-life coyotes in exactly the same way that 7-year-old me felt bad for Wile E. Coyote and 30-year-old me felt bad for The Brain (not a coyote, of course, but still). They put SO MUCH EFFORT into their plans and machinations for taking over the world, and it all comes to naught in a world of Roadrunners, Pinkys, and dogs like my Sam the Sheltie.
I see myself in the coyotes. So do most people reading this note, I bet.

For the canonical compilation of all Pinky and the Brain “pondering” quotes, see Richard Watanabe’s magisterial site.

The truth is that domestication makes any animal dumb. You name the species — dogs, cats, cows, horses, sheep, pigs — human selection on “tameness” for thousands of years accumulates a wide array of traits, including floppier ears, shorter snouts, hair color variability and the like, most likely based on more basic inherited alterations in certain stem cell and stress hormone production patterns (see Domesticated: Evolution in a Man-Made World, by Richard Francis, for a great read on all this). Different species show these external traits to different degrees. But the trait that ALL domesticated species demonstrate relative to their wild species is a smaller brain. I’d bet it’s happening with humans, too, but that’s just an observation for another day.

Unfortunately, coyotes are too smart for their own good. They are, to use the wonderful Brit phrase, too clever by half. They are, to use a post-modern, TV reality show lingo, not good in the meta-game. And the meta-game has turned against the coyotes with a vengeance.

Case in point — in our pre-farm life, where we had a yard like any other yard and were part of a neighborhood like any other neighborhood, we still had run-ins with coyotes. There were three or four of them roaming around one fall, coming in from the local nature preserve, and it became something of an issue in our small town. Warnings went out on mom chat groups not to let your small children play outside alone, much less your small dog or cat (yes, this was back in the day when it was not a blatant act of animal cruelty in Fairfield County, Connecticut to let your house cat go outside when it wished). Fortunately, clear instructions were provided through various channels as to how to protect your family.

Don’t yell at the coyotes. Half fill an empty coffee can with loose change and shake it at them. This will frighten them and they will run off.

Again, this is Fairfield County, Connecticut, where even owning a BB gun is enough to earn a lifetime ban from any play dates for your kids. It’s a far cry from growing up in Alabama like me or Texas like my wife, but when in Rome …

A few afternoons later the coyotes came wandering around our yard. We had (very) small kids at the time. So my wife dutifully brought out the coffee can she had prepared, and rushed out into the yard to confront the coyotes, shaking the coffee can like a madwoman. At which point the lead coyote, a female we think, sloooowly looked up and just stared at my wife. It wasn’t scared. It wasn’t frightened. It recognized immediately that there was absolutely zero danger posed by this human female gesticulating wildly and making a bizarre clanking sound with her hands. The message from that coyote’s stare was clear — is that all you got? Really? Almost derisively, the lead coyote sloooowly turned around and sauntered back towards the woods, leading the others away.

It was an alpha move. Smart, cool, totally in command. I’m leaving because I want to, at my own speed, and only because you’re annoying me with that ridiculous noise, not because I’m scared.

It was also a really dumb move for the meta-game.

What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.

The smartest play for coyotes in the meta-game is never to Skirmish with humans. Never. And if you find yourself in a Skirmish-with-Humans game, then the smart play is to act scared, to run away at top speed from a jangling coffee can. But no, coyotes are too clever by half, plenty smart enough to understand and master the reality of their immediate situation, but nowhere near smart enough to understand or withstand the reality of their larger situation. It’s their nature to play the scheming mini-game. They can’t help themselves. And that’s why the coyotes always lose. It’s always the meta-game that gets you.

Okay, Ben, entertaining as ever, but where are you going with all this?

Almost there. Before I pull this charming discussion of too clever by half coyotes back into the real world of markets, there’s one other (supposedly) clever, non-domesticated animal I need to introduce into this story. That’s the raccoon.

Coyotes have a roguish charm and bring something interesting to the world with their independence and scheming. Raccoons are simply criminals. And they’re not that smart. I’d put our barn cat up against a raccoon any day on any sort of cognitive test. We think raccoons are clever because they have those anthropomorphic paws and those cute little masks and even a Marvel superhero with its own toy line, but please. Raccoons are takers, not schemers. They’re killers, often for the sheer hell of it. Raccoons steal and kill way beyond what they need, and they do so in a totally wanton, non-clever way. I hate raccoons.

When they push their scheming and stealing too far, coyotes and raccoons ALWAYS end up getting killed by the farmer — regretfully in the case of coyotes, remorselessly in the case of raccoons. It’s not a cute Looney Tunes death, either. There’s no little puff of smoke and immediate reincarnation for these Wile E. Coyotes and Rocket Raccoons. Just blood and sadness.

That’s true on the farm and it’s true in the real world, too. And that’s how we pull this allegory together.

Every truly disruptive discovery or innovation in history is the work of coyotes. It’s always the non-domesticated schemers who come up with the Idea That Changes Things. We all know the type. Many of the readers of this note ARE the type.

Financial innovation is no exception. And this is Reason #1 why financial innovation ALWAYS ends in tears, because coyotes are too clever by half. They figure out a brilliant way to win at the mini-game that they’re immersed in, and they ignore the meta-game. Eventually the meta-game blows up on them, and they’re toast.

Reason #2? Financial innovation, more than any other sort of innovation, attracts the raccoons — con men and hucksters at best, outright thieves at worst. They infest financial innovation. And they can’t control themselves, so they always push it too far. They’re never content with stealing a little. Or even a lot. No, raccoons want it ALL.

Example, please.

Financial innovation is always and in all ways one of two things — a new way of securitizing something or a new way of leveraging something.

Securitization is a ten-dollar word that means associating something in the real world (a cash flow from a debt, an ownership interest in a company, a deed on a property, a distributed ledger mathematical calculation, etc.) with a piece of paper that can be bought and sold separately from that real world thing.

Leverage is a ten-dollar word that means borrowed money.

That’s it. There’s nothing new under the sun. Finding new ways to trade things (securitization) or new ways to borrow money on things (leverage) is what financial innovation is all about, and there are vast riches awaiting the clever coyotes who can come up with a useful scheme on either.

The biggest market disasters happen when both leverage and securitization get mixed up with the same clever scheme, as when new ways of leveraging and securitizing U.S. residential mortgages were developed in 2001, resulting in the creation of a $10 trillion asset class that utterly collapsed during the Great Financial Crisis. There were a lot of coyotes involved in so gargantuan an Idea That Changes Things, but most illustrative for these purposes is the Gaussian Copula formula published by David Li in 2000, the “technology” which allowed the securitization of pretty much any mortgage portfolio (prior to this most securitization was limited to “conforming” mortgages securitized by Fannie Mae and other government-sponsored mortgage agencies) and also the leveraging of those securities through tranching (splitting up the security into still more securities, each of which can be used as collateral for more borrowing, particularly those tranches with higher credit ratings). I wrote a bit about the Gaussian Copula in “Magical Thinking”, and if you want to learn more you can’t do better than  Felix Salmon’s 2009 Wired magazine article — “The Formula That Broke Wall Street” — still my all-time favorite piece of financial market journalism.

The formula doesn’t look like much, does it? But this little equation made billions of dollars in profits for Wall Street through hundreds of clever coyote schemes. More than a few raccoons got involved along the way. And then it broke the world in 2008.

It’s what I’ll call “coyote-math”. The math behind blockchain and Bitcoin the Gaussian Copula and non-agency residential mortgage-backed securities (RMBS) is undeniable. It is a mathematical certainty that these securities “work”. Unless, of course, you have a government-led chilling effect on exchanges and network transactions a nationwide decline in U.S. home prices, in which case Bitcoin non-agency RMBS doesn’t work at all.

So what will does the aftermath of this classic example of financial innovation gone awry look like?

Blockchain The Gaussian Copula is still around. These things don’t get un-invented, and it’s still a very useful piece of code for certain applications. The truth about blockchain the Gaussian Copula is that it’s an Idea That Changes Things In a Modest Way, not an Idea That Changes Everything. It’s a modern algorithmic twist on letters of credit portfolio risk, and there are a few interesting uses for that. Just a few, but that’s okay. That’s still important. Just not as important as HODLers Wall Street thought it was.

As for the primary financial application that blockchain the Gaussian Copula spawned, Bitcoin non-agency RMBS is still around, too. The securitization of distributed ledger calculations non-conforming mortgages is something that market participants still want and still trade. It will NEVER be a $10 trillion asset class again, because the inherent flaws of this security have been well revealed. Turns out that Bitcoin a AAA-rated tranche of Alt-A mortgages wasn’t the store of value that coyote-math “proved” it was, to the detriment of individual institutional investors who put a significant portion of their portfolio into these securities, and to the ruin of those who used leverage to acquire these securities.

Many of the coyotes involved with this classic example of financial innovation gone awry are (professionally) dead. At the very least careers were permanently derailed, and entire coyote institutions, like Bear Stearns, were taken out into the street and shot in the head by animal control officers were merged into healthier financial institutions by government regulators as an example to other coyote institutions as a necessary measure for systemic stability. I miss Bear Stearns. The world is a poorer place for Bear Stearns not being in it.

Surprisingly few of the raccoons involved are (professionally) dead. In fact, more than a few of the financial hucksters involved with the run-up to the Great Financial Crisis are back to their old tricks with cryptocurrencies whatever the latest coyote innovation might be. This makes me VERY angry, and probably colors my view on blockchain financial innovation more generally. I wouldn’t miss the raccoons for a second if the animal control officers took them out, but somehow they never do.

And that brings me to what is personally the most frustrating aspect of all this. The inevitable result of financial innovation gone awry, which it ALWAYS does, is that it ALWAYS ends up empowering the State. And not just empowering the State, but empowering the State in a specific way, where it becomes harder and harder to be a non-domesticated, clever coyote, even as the non-clever, criminal raccoons flourish.

That’s not an accident. The State doesn’t really care about the raccoons, precisely because they’re NOT clever. The State — particularly the Nudging State — cares very much about co-opting an Idea That Changes Things, whether it changes things in a modest way or massively. It cares very much about coyote population control.

When coyotes play the Skirmish game, that’s all the excuse the State needs to come swooping in. And that’s exactly what is happening with Bitcoin what happened with non-agency RMBS.

What’s the alternative to playing Skirmish in the meta-game?

It’s this: to be an arborist.

It’s this: to be as wise as serpents and as harmless as doves.

Coyotes can change the world. Coyotes WILL change the world. But not if they misplay the meta-game. Not if they hang out with raccoons. Not if they fetishize ANY financial instrument as an intrinsic aspect of a commitment to liberty and justice for all. Because it’s not.

Render unto Caesar the things that are Caesar’s. Wise words 2,000 years ago. Wise words today.

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Wall Street’s Merry Pranks: Things that Matter #4

Lisa Simpson: Get out! Get out!
Bart Simpson: OK! But on my way, I’m going to be doing this. And if you get hit, it’s your own fault!
Lisa: OK, then I’m gonna start kicking air like this. And if any part of you should fill that air, it’s your own fault.
Marge Simpson: Hmm. I better go check that out. Now Homer…don’t. You. Eat. This. Pie!
Homer Simpson: Okaaaay. Alright pie, I’m just going to do this. And if you get eaten, it’s your own fault!
 The Simpsons, Season 6, Episode 8 “Lisa on Ice”

So much of the nudging from our smiley-faced authoritarian overlords on Wall Street sounds like it is coming from a mid-windmill Bart Simpson. I’m going to give you low-cost tools. I’m going to create ways to encourage you to trade them (frequently) at close to no cost (that you can see, anyway). And if you happen to trade so much that you create short-term gains everywhere, if you end up with an underdiversified portfolio that blows up, if you end up selling at the bottom and holding cash through half of the recovery…well… it’s your own fault.

Verbal: Who is Keyzer Söze?

He is supposed to be Turkish. Some say his father was German. Nobody believed he was real. Nobody ever saw him or knew anybody that ever worked directly for him, but to hear Kobayashi tell it, anybody could have worked for Soze. You never knew. That was his power. The greatest trick the Devil ever pulled was convincing the world he didn’t exist. One story the guys told me — the story I believe — was from his days in Turkey. There was a petty gang of Hungarians that wanted their own mob. They realized that to be in power you didn’t need guns or money or even numbers. You just needed the will to do what the other guy wouldn’t. After a while they come to power.

 The Usual Suspects (1995)

I originally intended to include nothing but Spacey quotes that feel much creepier and weirder than they did six months ago. I decided against it but had to keep the classic Söze line.

Why? Because the greatest trick any nudger, any libertarian paternalist ever pulls is always to convince the world they don’t exist. Their new business model, their new sales pitch, is all about the customer. They are just conveying it to you, and it’s really your decision whether you’re going to take advantage of it. But don’t mistake value for virtue — the magic of free markets is that they empower value-seeking behaviors to generate societally virtuous outcomes. The low-cost investing revolution and its sister — the movement to empower individual investors — has been a generational boon for investors. They created immense value. But never forget that this is a business and that these products are created by profit maximizers, not virtue maximizers. When we see branding and advertising that convey psychic or moral value from do-it-yourself and low-cost investing, we must know that we’re being nudged toward other less virtuous, riskier behaviors. 

Well, when all the people arrived in church, Eulenspiegel mounted the pulpit, said something from the Old Testament, tossed in the New as well, with Noah’s Ark and the Golden Bucket, in which the bread of Heaven Lay — and said, moreover, that all this stuff was the greatest holiness. Then at the same time he began to speak of the head of Saint Brendan, who had been a holy man. He had Brendan’s head right there — and it had been commanded of him that he use it to collect for the building of a new church, and to do so with purest goodness, never (on pain of death) accepting any offerings from any woman who might be an adulteress.

“And whoever here may be such women, let them stand back. For if they offer me something — those who are guilty of adultery — I won’t take it, and they will be revealed in shame unto me! So — know yourselves!”

Till Eulenspiegel: His Adventures, No. 31, Paul Oppenheimer (Editor/Translator)

The Söze-style penchant for creating havoc and disappearing into the background — and avoiding responsibility — is hardly new. It’s straight out of the playbook for the Trickster that exists within every major mythology. Till Eulenspiegel, a late middle ages version, is well known to Germans but almost completely unknown in America, which is a shame. This story is the best example I know of a trickster’s need to adapt his schemes to be more palatable when the world gets wise to him. Sound like any industries you know?


Some people always knew they wanted to be investors. They read Barron’s as a teenager and had their parents create an account for them to buy and sell stocks when they were 13.

Not me.

I wanted to be a composer. I would have settled for being an operatic tenor. If I couldn’t do that, I’d be willing to try my hand at being a musician in an orchestra. Short of that, I’d settle for being a drummer in a rock band. I supposed, if I couldn’t do any of those things, finance might be interesting enough. When I started the process of looking at universities, I considered pursuing each of these five things. I ultimately concluded that, if I were good enough at any of the first four, it wouldn’t matter if I had a degree saying that I was. So I studied finance. It’s a good thing, too, because it turns out I wasn’t nearly good enough at any of the others. I auditioned with some regional orchestras and opera companies, and got enough alternate work to pay for food and rent in college. It never would have gone any further than that.

Now, orchestral auditions are especially funny. These days, you’re called into the room and you sit in front of a screen. You are asked to play excerpts from the standard repertoire. I was a hornist. The horn is among the most versatile instruments, and so the point of the audition is to demonstrate your ability to perform all the things the horn is called upon to do. You need to display technical prowess, and so they ask you to play the famous horn call from Richard Wagner’s “Siegfried”. You need to display facility throughout the range of the instrument, so you are called to play the opening from “Ein Heldenleben”, by Richard Strauss. You must have a capacity for lyricism, for which you are asked to play the solo theme from the Poco Allegretto movement of Brahms’ Third Symphony, which has been shamelessly stolen by everyone from Sinatra to a weird and creepy Santana-Dave Matthews duo. Then they ask you to show you can do all of those things at once by playing the corno obbligato solo from Mahler’s Symphony No. 5.

But there’s one piece that shows up every time, even though it doesn’t get played by orchestras too terribly often: “Till Eulenspiegel’s Merry Pranks”. It’s another Strauss tone poem, and it is the Tower of Babel to every richly scored Merrie Melodies and Looney Tunes cartoon. Seriously, listen to the whole piece with your eyes closed, and your mind will fill in just where Bugs Bunny tricks Elmer Fudd into shooting his shotgun into a rabbit hole that sends it back through a funnel into Fudd’s face. The piece itself is a musical imagining of Germany’s version of the classic trickster character. Of course, it’s Germany, so the pranks are pretty dark, and most are scatological. As with many such stories, however, they also effectively highlight some of the absurdities of language and human behavior.

My favorite Till Eulenspiegel tale is the 31st of those that may have been assembled by Hermann Bote in the late 15th century. Paul Oppenheimer at CCNY did a lovely and sadly underbought translation, if you’re looking for an off-the-beaten-path and entirely inappropriate bedtime storybook. In this story, Eulenspiegel has become a bit too well-known to play his usual characters. A sort of Sacha Baron Cohen of the German late middle ages, if you will. He needs to find a new way to make money, and so he decides to pass himself off as a dealer in religious relics. He takes on a priest’s cassock and goes from town to town in Pomerania with a certain scam in mind. After procuring a skull from a graveyard, he inlays it with silver and asks the local priests — who are, naturally, universally corrupt and drunk — to allow him to raise money to build a new church in honor of the saint whose skull he carried. Which is, of course, just the remains of some dead blacksmith, but no matter. There is, however, a catch: our heroic church-building protector of holy relics is sworn never to accept donations from any woman who has ever committed adultery, and he will know if they are lying.

So who comes up to kiss the skull and drop some money in the pan?

Every woman in the church, of course. As soon as the first pious busybody makes her way up to demonstrate her faithfulness and purity (and to wait for the fireworks from her more libidinous sisters), all the other faithful wives don’t really have a choice. If she is going to go up there, then it’s not like they can avoid giving to the cause and proclaiming their virtue. Now, the guilty ones, their decision is a bit more complicated. Their bet is either that Eulenspiegel is a fraud or that he’s not. The alternative, not going up, results in the same outcome for them: being outed as an adulteress. So, for them, too, the best strategy is to kiss the skull and drop a coin or two in the basket. They were doomed to this roll of the dice as soon as the first woman walked to the front.

With every adulteress who comes to this conclusion, it’s easier for all the rest, because it’s more likely they’ve seen someone they know or suspect to be guilty come away blameless. At a certain point, despite Eulenspiegel’s bold words celebrating the holiness of their parish, most people have gotten wise. But who cares? We like the eggs. It’s a useful exercise for everyone. Eulenspiegel and the priest get paid. The pious confirm their piety. The guilty get a bit of public absolution, and even more license to continue their sin.

OK, great, so what does this have to do with finance, markets and politics? Well, “Till Eulenspiegel’s” is a story of those who would deceive us by exploiting our need to appear virtuous and good. It’s a story of the good among us proclaiming virtue and forcing the hands of others to proclaim it as well (whether they are virtuous or not). And when the non-virtuous join in the proclamations, it is a story of how they lean on their newly-found virtue to get themselves into some real trouble. Of course, by that time, Till Eulenspiegel has already gone full Keyzer Söze. He never even existed.

What virtue are we called upon to signal in finance, then? Well, is there any investing behavior more widely pursued, more universally lauded than low-cost, passive investing? Is there any trait more prized than empowerment of the individual investor to use those tools to take his investments into his own hands? When the industry comes to us, silver skull in hand and asking us to pledge ourselves to these virtues, most of us do so willingly. After all, we recognize that stock-picking is usually a waste of time. We recognize that spending a bunch of time fussing about which fund manager to pick is usually a waste of time.  And we don’t like to pay fees that don’t buy us anything.

This pound-the-table religion about active vs. passive management is all well and good for those of us in the business, who mostly live and breathe the Things that Matter. But for a universe of individual investors (and rather distressingly, probably some institutional investors, too), the message of empowerment is anything but. It’s a nudge into terrible portfolios, terrible costs and terrible outcomes. But hey, at least they got religion and implemented those terrible, far-too-actively-traded portfolios with ETFs!

I recognize that this is an odd way to start a note that’s going to be about the importance of costs in investing. And that really is what this note is about. It’s an especially odd way to start a note that’s going to characterize those costs as one of the big Things that Matter in investing. But while we walk through just how indispensable low-cost investment tools must be to any modern portfolio, what I really want to emphasize is that the order of this Code was not an accident. By and large, the decisions you make about risk, diversification and behavior are all going to impact your portfolio more than the expenses you are paying on funds or to your financial advisor.

Perhaps more controversially, I also want to observe that even among costs, those direct expenses will often fall short of other costs that get short shrift in most solutions offered: especially taxes, transaction and market impact costs, and the indirect costs imposed by buy/sell behaviors.

More to the point, I fear the empowerment of low-cost investing tools is making adulteresses of many of us.  Given license by a perception that buying a bunch of index funds makes us passive (it doesn’t), we actively trade those positions in ways that impose far more costs than we ever would have borne directly. We build portfolios that are excessively risky (or too defensive), underdiversified or dependent on single factors that produce long-term risk and return impacts that dwarf the costs of advice on portfolio construction. We trade portfolios for no cost without recognizing the terrible execution we are getting. We fire the only people holding us accountable for our behavior as investors — our financial advisors — to chart out our own course.

And the Pranksters and Priests of Wall Street love every minute of it.

The Most Important Development in Finance Since 1952

So now that I’m done negging on low-cost investing, let me give you a slightly more positive take: the availability of low-cost indexed vehicles to access the world’s financial markets is the single most important development in finance since at least the development of the 401(k) in 1978, and probably since Markowitz in 1952. It’s difficult to really measure the impact that indexing has had, because it has taken a variety of forms. Most people think of the direct impact of funds flowing from expensive actively managed mutual funds to indexed mutual funds and ETFs with a lower cost. This alone has had a multi-hundred-billion-dollar impact, retaining wealth in the hands of individuals that would otherwise have gone to fill the coffers of fund management companies. There has also been a direct shift from ownership of individual securities to index funds, which has had the effect of reducing commissions paid to brokers by an amount that is probably somewhat less. I haven’t seen a detailed study on the matter, but my back-of-the-envelope math says investors have accumulated something on the lower end of hundreds of billions here as well.

Indirect benefits have been significant, too. Because of prevalence of low-cost index fund options, active funds and other strategies have been under pressure to lower their costs in response. This kind of thing is hard to quantify, but as the guy running a fund management business, trust me… it’s a lot. And while all this was going on in retail land, we’ve observed financial futures contracts becoming more common, more liquid and among the most cost-effective means of accessing global financial markets for institutions. We have also seen hedge fund fees drop steadily, incentive fees shift toward a recognition of underlying market betas, and private equity managers begin to move away from fees on uncalled commitments. In a 2016 article, Bloomberg estimated the cumulative impact for asset owners at a cool trillion, give or take. I think this number is probably a bit light once the indirect impact is considered fully.

I argued in “You Still Have Made a Choice” that investors should think constantly about opportunity costs and the implicit bets they make in their portfolios. There, my focus was on the implicit bets we make on one asset class or investment to outperform another when we under diversify. One could just as easily apply that kind of thinking to the explicit expenses we pay. And they set a very high bar. If you think that you have a good chance of selecting a manager in a major asset class that is likely to consistently outperform the 70-80bps per year you typically save these days by selecting a comparable passive option, you are suffering from hubris, delusion or both.

The “Other” Direct Costs of Investing

OK, so the amount of ink spilled on saving the 70-80bps previously paid to financial advisors and fund managers is justifiably voluminous. But here’s where Eulenspiegel takes us for a ride — and where those of us jumping up to kiss the skull act as their accomplices: In celebrating this victory, we seem to assume that everyone else is using their newfound freedom from a financial advisor and an infinite array of index funds the same way that we are. We assume that they are long-term, diversified, generally buy-and-hold investors in command of their behaviors that are reveling in the synergy of that approach with an arsenal of low-cost solutions.

It is a pleasant fiction, isn’t it?

In a prior piece about the Things that Don’t Matter — “And They Did Live by Watchfires” — I referenced some of the data showing just how fictional that is, at least as it pertains to ETFs. Most of the data on average holding periods you can find pretty easily, something I encourage everyone to do. The data and reports you’ll find split the world into two pieces. On the one hand, you’ll find a lot of studies showing that average holding periods for ETFs are somewhat less than for other vehicles — usually around 1 ½ to 2 years — but still on the longish side. On the other hand, mean holding periods of the instruments themselves end up being shorter. Much shorter. In some cases, these periods can be measured in weeks. So what gives?

What gives is that you’ve got a very bipolar universe of users. Most of the world — especially people with financial advisors — see low-cost index strategies, whether they come in mutual funds, ETFs or futures contracts, as tools to develop an efficient portfolio. All hail us, the faithful wives. But you’ve also got a smaller universe of (mostly individual) investors who have rallied around the message of low-cost investing to execute strategies that are anything but. Witness the march of the adulteress army to the altar. How do I know these people exist, other than the fact that the data show that they exist?

Because I meet them every day. Because financial advisors tell me about them and ask me what to do about them every day. The amount of bitcoin day-trading, TVIX-flipping, SPY-to-QQQ-to-IWD swapping that goes on in some individual investor accounts is shocking. And to a one, these investors are painfully cost-conscious. They wouldn’t dream of paying a management fee to a fund manager. And paying a financial advisor? Forget about it!

And yet.

The Petajisto paper referenced in “Watchfires” covers trading costs reasonably well, although increases in size and volume of the market have almost certainly narrowed some of the spreads since it was originally published. Still, trading costs of any actively traded strategy have the potential to be as large as the average difference between a passive and active fund. All investors should be thinking about trading costs as a Thing that Matters every bit as much as direct advisory costs, and based on my conversations with advisors and individual investors, I don’t think most investors give it much of a thought at all.

Separately, and potentially far more importantly, the kind of activity implied by the increased turnover of this special class of investors in low-cost vehicles can have a massive impact on taxes. In the chart below, I show the equivalent advisory fee you would pay in order to equal the impact of different levels of annual short-term taxable turnover.

Source: Salient 2017. For illustrative purposes only.

Let’s unpack that. Assume, for example, that you had a 20-year horizon. Now assume that every year you turned over 40% of your portfolio, and that you did so with positions that produced short-term gains. This is fairly typical of the activity I see even from goody two-shoes virtue-signaling investors and advisors like me, whose average holding periods are in the 18-to-24-month range. Even in this case, the impact from taxes is the same as paying a 75bp advisory fee to a fund manager or financial advisor. Now imagine (or just look above to see) what a more actively traded approach is going to look like. It’s not pretty.

Now, I’ve made a lot of fuss about how some misguided investors are misusing index funds and ETFs, but this isn’t really about that. Frankly, this is a point that needs to be heard by investors in any commingled vehicle, mutual funds and hedge funds perhaps more than any, so I want to say this as clearly as I can: if you are a taxable investor, taxes matter more than fees, and you’re not paying enough attention to them.

No, Virginia, You’re Not a Passive Investor

The “vehicle-centric” view of investing guides investors toward do-it-yourself solutions where the only important consideration is whether you’re paying an explicit fee. The resultant behaviors for a portion of those investors lead to disproportionate tax impacts, and they lead to transaction costs. There’s a reason why I’ve written that Investor Behavior Matters. But those behaviors matter most when they impact the two biggest decisions that investors must make: how much risk to take and where to take it (diversification).  So, unsurprisingly, I do want to take another opportunity to remind everyone that they aren’t passive investors just because they bought a bunch of index funds. In “I am Spartacus”, I put this in context of a global portfolio of financial assets. Here, I want to take a different tack.

Let’s assume that the world of index funds (here, I use ETFs, but could just as easily be mutual funds) consisted of the 100 largest such vehicles as they exist today. Now consider an exercise in which we decided we wanted to buy 10 of those funds at random, assigning them 10 different portfolio weights (also at random). If we did this random selection, say, 100,000 times, how often would we have gotten different risk and return outcomes[1]? How much would they really differ from one another? Basically, what I’m trying to answer is, “If I had absolutely no insight into asset allocation, but was being told I needed to keep costs down and do the investing myself, what is the range and likelihood of different portfolios I could end up with using those instruments.” The table below shows the answer.

Source: Salient 2017. For illustrative purposes only.

First, how do we interpret this? In short, the difference between good and bad asset allocation decisions is big. It’s bigger than taxes. It’s bigger than transaction costs. It’s bigger than advisory fees. And if you are assuming that you don’t really have a lot of ex ante insights, that’s kind of a big deal.

A nice portion of the portfolios cluster around a 6-8% return with 12-14% volatility, but they’re only about 17% of the total. More than 43% of the portfolios have returns that differ materially (by 2-4%). And if you’re comparing the best 20% to the worst 20% of portfolios we could have selected, you’re talking as much as a 6% annualized difference in returns, with correspondingly large differences in the amount of risk you were taking to achieve it. And this is just including the Top 100 ETFs, which are largely confined to large, liquid, broad market instruments, and not the more esoteric options that begin to fill up the portfolios of many practitioners.

To many readers this is certainly intuitive, and so I don’t pretend I’m making a novel point here by saying that asset allocation matters. Other readers might criticize this by saying, “Surely we should expect more from folks than just a random allocation to funds.” This is the point in the conversation where I would stare at you intently, but quietly, until you amended your statement to something less stupid so that we could continue our erstwhile cordial discussion.

More novel, however, is the observation that — in rough numbers — a better than random approach to asset allocation can matter to the tune of 2-6x the impact of a typical active fund’s fees.

In Defense of the Financial Advisor

So yes, Costs Matter. And if you asked me how much each of these direct and indirect costs matter, my very generalized, not-at-all-personalized for you list would look something like this:

  1. Indirect Behavioral Costs on Asset Allocation Decisions
  2. Taxes
  3. Advisory Fees (Tie) / Transaction Costs (Tie)

One of the responses Ben and I invariably get from readers is, “Include more actionable ideas!”, so I’m ready for the chorus of, “OK, I get it. What do I do?” Here’s what you do:

Hire and pay a financial advisor.

Before anyone jumps in, I’m not telling you to pay a bunch of high fees for actively managed strategies in markets where they don’t have a prayer of producing sustained outperformance after those fees. God knows homo marketus can find just as many perfectly good ways to create taxable gains and transaction costs in actively managed solutions as well.

What I AM telling you is that you should find someone who you trust. Find someone who is looking out for you on taxes. Find someone who is looking out for you on transaction costs. Find someone who tells you the truth about how much you’re paying them. Find someone who is going to save you from your fear when you want to sell low, and who will protect you from your greed when you want to buy high. Find someone who will keep you diversified when you want to take stupid risks in markets and securities where you don’t have an edge (which is all of them — sorry). Find someone who isn’t trying to get you to trade in and out of new ideas all the time. Find someone who doesn’t sell to you with Eulenspiegel-style virtue signals. Find someone who doesn’t disappear like Keyzer Söze when things go wrong.

Find someone who will treat you like a partner, and pay them.

But not too much.

[1] Here, we present this as a historical analysis. No resampling, etc.

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Epsilon Theory Mailbag: Bitcoin and Big Data

One of the best parts of authoring Epsilon Theory is the correspondence I get from readers. For the past few months, however, I’ve been frustrated by my inability to respond to every writer with the same attention and thoughtfulness evidenced by their emails. Between my day job and the effort each Epsilon Theory note requires, I’ve run out of hours in the day to respond to the geometrically increasing volume of emails I receive. Having a public comments page on the website isn’t a solution for a number of reasons – some of my correspondents don’t want to be public, I still wouldn’t have time to respond to the comments, an anonymous comments page tends to become a cesspool, and the regulatory burden this would place on Salient is not insignificant – so I’ve decided to start an irregular mailbag column. For the most part I’ll be aggregating common comments and questions with a few recent news articles, and I won’t reprint anyone’s private email communication without asking permission first. Along the way I’ll try to work in some of the more insulting comments published on the public/anonymous comments pages of ZeroHedge, Seeking Alpha, and Forbes Online, as well as some lovely Tweets … it’s important to keep a sense of humor about this stuff!

For this initial effort I’ll focus on reader comments to “The Effete Rebellion of Bitcoin” and “First Known When Lost”, two recent notes that sparked more than their fair share of responses. 

You, sir, are using glib, provocative, and insulting descriptions to pull in readers, then doing a bait & switch.

Elizabeth VH

Well…yeah.

If bitcion is just a fad, what do you consider the Internet?

@PerianneDC

Not very smart. Surprised Forbes published him. Spouting bs before enlightenment is a common trait of effete snobs.

@jmwnuk

These were fairly typical comments from the Twitterverse. As someone who has been called the a-word, the b-word, the c-word (yes, the c-word), the d-word, the f-word, and the s-word on the mean streets of ZeroHedge, I find Twitter haters to be almost charming in their child-like Peewee Herman-ish insults. For the record, I suspect the Interwebs are here to stay. And, dude … I know you are, but what am I?

You’re an idiot. Ever heard of 2-factor authentication?
many anonymous comments, surprisingly few emails

I love 2-factor authentication. I love anything that allows me to keep the same password for more than a few months and avoid the “security theatre” that so many enterprises portray by requiring me to change a password for absolutely no reason other than that it looks like they’re actively defending my security.

Banks love 2-factor authentication, too. Why? Because it provides a significant security upgrade for the online account transfers that federally regulated banks are required to offer per the Electronic Fund Transfer Act of 1978. Yes, 1978. The same year that TCP/IP was invented. Jimmy Carter vintage legislation for an Internet that wasn’t even a twinkle in Al Gore’s eye and a retail banking world where ATM’s were novelties. Banks aren’t rolling out 2-factor authentication protocols in 2015 because it’s a convenience for you. They’re rolling it out because it’s good for them, because it helps limit (but by no means eliminate) the losses they suffer from the online transaction liabilities imposed by Reg E of the 1978 Act. It’s exactly like a credit card issuer shutting down your card when you go on vacation. In no way is this “for your protection”; it’s all about limiting their liability for charges made on a stolen card. And even with the enhanced security of 2-factor authentication, notice how the transaction size of all online transfers is limited to an amount that the federally mandated blanket bond will cover. Take away that federally mandated insurance backstop and federally mandated online transaction liability and you’ve got Bitcoin – a Hobbesian environment where security and risk management is entirely on you, and where in a very real way life is “a war of all against all”. Yes, it’s invigorating and refreshing to be occasionally free of Leviathan and its mandates on this and mandates on that. But only in small doses, thank you very much. Sorry, but I’ve read Thomas Hobbes and seen “Jeremiah Johnson” too many times to be more than a tourist when it comes to modern crypto-anarchy.

Speaking of Leviathan … one-time 2-factor authentication requires a delivery device or token, and on a mass scale that means text messages over smart phones. Does anyone in his or her right mind believe that a cryptography system that generates a second key and texts it to you on your registered cellphone is unhackable or untraceable by any number of national security services? Really? Read this if you do.

You’re an idiot. Ever heard of multiple private key systems?
– many anonymous comments, surprisingly few emails

I love multiple private key systems. I appreciate them in the same way that I appreciate an intricate clock. I appreciate them in the same way that I appreciate the medieval voting system to elect a Venetian Doge. Wait … what? For more than 500 years, from 1268 – 1797, the Supreme Leader of The Most Serene Republic of Venice was elected for a life-time term by means of a highly complex ten-step process, where groups of electors were alternately randomly selected by lot and then directly selected by the votes of those selected by lot, over and over again for 5 of these dual rounds. The process was designed to prevent any single faction from corrupting the election through bribery or by “packing the court”, and … it worked. Venice maintained a stable oligarchy for hundreds of years, an unbelievably difficult feat in any age (for a fascinating analysis of the Doge electoral system and its implications for security protocols, see this paper by two HP scientists).

But it worked at a cost. Direct costs, opportunity costs, complexity costs … you name it, stability and elegance do not come cheap. There is an unavoidable and linear (or worse) relationship between security and cost. Or rather, the cost of breaking the security of a system does not increase faster than the cost of advancing the security of that system, whether you’re talking about multiple keys or longer passwords or extra voting/lottery election rounds. There is no such thing as a free lunch, particularly when it comes to information entropy, which is what we’re really talking about here.

The problem is that the cost of complexity in Bitcoin’s case is only manageable in a commercial sense if you inject third party service providers into the mix. Now there’s a long history of successfully injecting such third parties into financial transactions. In fact, no large property or securities cash transaction occurs today without a government-regulated escrow agent playing the central role of validating the underlying transaction. If I buy a house or 100 shares of Apple, my money isn’t released to the seller until a government-certified and insured intermediary makes sure that I have clear possession of that property or block of securities. Why is this a good thing? Because if something goes wrong with the underlying transaction … if all is not as advertised with the property or securities I am purchasing … I have recourse. Ultimately, I have a government and a government’s self-interest and a government’s guns on my side. None of this exists in the Bitcoin ecosystem, and any entity that holds itself out as an escrow agent or transaction validator does so without a smidgen of government support beyond what’s available to the local laundromat. Would I take a non-regulated escrow agent at their word if I’m buying a skim latte or a snappy new suit of clothes? Sure, why not. No biggie if the deal falls through, and at least I’ll have an interesting story to tell. Would I take a non-regulated escrow agent at their word if I’m buying a house? No way.

I know that no one in Bitcoin-world likes to think about Mt. Gox, and I know it was a flawed animal … a complete outlier from all of the brilliantly conceptualized and elegantly implemented Bitcoin and blockchain service providers that got their VC money and set up shop over the past 18 months. I’m not arguing otherwise. My point is simply this: once a Bitcoin service provider gets big enough … once there are a couple of hundred million dollars sloshing through your system … you’re going to be robbed. I don’t care how smart you are or how much you trust your employees and your systems, you’re going to be robbed. Now maybe you can find private insurance against the small stuff. But public insurance – which is the only thing that works in a big crack-up and has been part and parcel of the mainstream banking world for 80 years – is not available to you. There’s not a government in the world that really cares whether a Bitcoin service provider in its jurisdiction lives or dies, and that’s a problem. I want my bank and, by extension, my bank account backstopped by infinite lawyers, guns, and money (to quote the late, great Warren Zevon). And that’s what modern governments provide – infinite lawyers, guns, and money. The Venetian electoral system worked for 500 years not only because it was elegant and smart, but also because Venice had the largest navy and the biggest Treasury in the Western world over that span. That’s systemic security, and that’s what I want underpinning my elegant and smart financial service applications.

Bitcoin might have its flaws, but banks worldwide already allow direct trade – directly from bank account to bank account: http://cointelegraph.com/news/113537/german-bank-unveils-insured-express-bitcoin-buying-moves-into-us-market
– Monic DG

Am I surprised that an online-only German micro-bank (200m euros in deposits as of 12/31/13) is trying to gain publicity by claiming that Bitcoin transactions and deposits are now linked to insured accounts in euros or dollars? Of course not. But even here dig just one inch below the surface claims and you see that Fidor Bank is linking Bitcoins to an ordinary cash account in the same way that Bank of America might link your insured cash account with a personal check you want to deposit or a registered security you want to sell. I mean … if you give a bank 3+ days for the transaction to clear, you can get pretty much anything deposited to a cash account, but that’s a far cry from saying that depositing a personal check is the same thing as depositing cash, particularly if the personal check is for anything more than a trivial amount.

You mention Silk Road in passing. Have you read the Wired transcripts of the Dread Pirate Roberts trial?
– Bill E.

Wow. Everyone who doubts that Bitcoin is inextricably entwined with illegal activity, and not always of the victimless sort, should read the transcripts of the phone conversations between Silk Road founder Ross Ulbricht (aka Dread Pirate Roberts) and a senior manager for a regional Hell’s Angels franchise (aka Redandwhite), presented at Ulbricht’s federal trial. My conclusions:

  1. If there aren’t 20 screenplays making the rounds in Hollywood based on this transcript, I will eat the accumulated print outs of every Epsilon Theory note to date.
  2. Every company is a technology company today. Even the Hell’s Angels.
  3. Redandwhite would be a successful businessman in any century and any profession.
  4. As always, life imitates art. Hyman Roth: “I’m going in to take a nap. When I wake, if the money’s on the table, I’ll know I have a partner. If it isn’t, I’ll know I don’t.” Redandwhite: “I will check the computer in about 10 hours, and if I see that you want to go ahead with this and the payment has been sent, we’ll do it today.” [hat-tip to Todd C.]
  5. The murders-for-hire here are made possible by Bitcoin. Period. You think Ulbricht would be wiring cash or taking suitcases full of small bills to Vancouver? Please.

Bitcoin (or, if Bitcoin fails, some replacement cryptocurrency) represents a reversal in the rule/permission cycle, applied to ownership, in a similar way that the Internet as a whole represented a reversal in the rule/permission cycle applied to communication.

What I mean is: Neither the Internet (or any application of it, like email) fundamentally challenges the existence of certain legal rules. It *does* however fundamentally change the order in which you can proceed to do certain things: before the Internet, you needed to ask for permission more often than not (for example, to publish something), at which point a “rule check” took place.

The Internet reversed this process: the rules still exist, and you can still be prosecuted for breaking them, but the *first* step is your decision if you want to do something that could potentially break those rules or not: you can post whatever you want, on a number of places. Whether it’s legal or not is a different thing, but that check occurs *after the fact* of you posting it.

This is where Bitcoin comes in. A distributed, tamper-proof (by our best knowledge on the matter) way to register and transfer ownership rights nearly instantaneously, over arbitrary distances *without* the need to ask any authority for permission to do so, is a major step.

– Wouter D.

This is a very smart observation. Wish I had thought of it. The Internet is indeed a Great Leveler, a force for disintermediation that rivals the printing press, and no social practice – including the social practice of Money – is immune to that force. Thanks, Wouter.

Moving on to Big Data …

Big data is like teenage sex: everyone talks about it, nobody really knows how to do it, everyone thinks everyone else is doing it, so everyone claims they are doing it.
Speedy W.

Me and my team at work use big data all the time and I can tell you first hand it’s almost useless. SaaS and Cloud Computing were wearing thin so big data was needed to continue Silicon Valley’s only real talent: separating fools from their money.
“TS”

There’s no doubt that “Big Data” has become a marketing catchphrase, much like “The Cloud”. But my guess is that TS “and his team” are using Big Data in approximately the same way that free online speed-up-my-PC services are using advanced network security algorithms. Look … we kill people with drones every day on the basis of Big Data. You think we’ve got handsome NCIS agents prowling the outskirts of Sana’a calling in air strikes on the bad guys? No, we’ve got terrestrial and low-orbit devices picking up a cell phone signal that our NSA Big Data Machine tells us is highly likely to be associated with a high value target, and then we send in a drone to go blow up whoever is holding the cellphone. Now say what you will about the morality of all this (my view: the NSA gives new meaning to what Hannah Arendt once called, in reference to Adolf Eichmann, “the banality of evil”), but don’t tell me that the NSA is incompetent or doesn’t know what it’s doing. Big Data works.

Not sure I understand. “to identify the unique individual purchasing patterns of 90% of the people involved”… it doesn’t say it identifies the people involved. It’s a collection of purchasing patterns that belong to who knows.
“AF”

Sigh! Yet another article that starts with point A and leaps to point Doom. That algorithm doesn’t identify the individual, all it does is look at the data and posit which transactions are likely to have been carried out by the same individual.
“R”

These comments illustrate a very common misconception about Big Data and the collection of “anonymous data”, a misconception that is (surprise!) intentionally spread by the collectors of that data. For most Big Data purposes, nothing is gained by going the last mile to connect a specific name to a specific set of behaviors. To continue with the NSA example above, if I want to kill everyone in Yemen who has placed a cellphone call to a set of people who, in their aggregate behaviors, score high on some security threat matrix, then it would just slow me down to learn individual names. I’m going to kill whoever is holding that cellphone, regardless of what his name is. Or if you prefer a feel-good example, if I want to advertise my new movie to everyone who tweeted to a set of people who, in their aggregate behaviors, score high on some movie affinity matrix, then it would similarly just slow me down to learn individual names. But just because it’s usually inefficient to infer a specific identity from the data doesn’t mean it’s not possible. Actually, it’s child’s play, and for those rare applications that require specific identities you don’t stand a chance.

Ray Dalio’s $165 billion Bridgewater Associates will start a new, artificial-intelligence unit next month with about half a dozen people, according to a person with knowledge of the matter. The team will report to David Ferrucci, who joined Bridgewater at the end of 2012 after leading the International Business Machines Corp. engineers that developed Watson, the computer that beat human players on the television quiz show “Jeopardy!” 

The unit will create trading algorithms that make predictions based on historical data and statistical probabilities, said the person, who asked not to be identified because the information is private. The programs will learn as markets change and adapt to new information, as opposed to those that follow static instructions. 

Quantitative investment firms including $24 billion Two Sigma Investments and $25 billion Renaissance Technologies are increasingly hiring programmers and engineers to expand their artificial-intelligence staffs.
Kelly Bit, “Bridgewater Is Said to Start Artificial-Intelligence Team“, Bloomberg, Feb. 26, 2015

First, calling this “artificial intelligence” is a misnomer. There’s nothing artificial about it. It’s a non-human intelligence, but no less natural than our own. I dislike the term “artificial intelligence” because it implies that these systems are some sort of mimicry of the human brain, just on a larger, faster, more god-like scale. If you get nothing else out of what I’ve written on this subject (here and here), it’s this: the inductive simultaneity of a powerful non-human intelligence is sui generis. It sees the world in an entirely different way than a human intelligence can, and in the right hands it is magic.

Second, everything I said above about “don’t tell me that the NSA is incompetent or doesn’t know what it’s doing” … well, multiply that sentiment 10x when it comes to Bridgewater, Two Sigma, and Renaissance (and Citadel, and Fortress, and a dozen other firms I could name). What’s possible here is not only an accurate crystal ball for short-term market forecasts, but – even more profitably – the knowledge of what small market actions can trigger much larger market moves. Think of Ray Dalio standing on top of a giant mountain and rolling tiny snowballs down at you that get larger and larger as they pick up more snow. All completely legal. All completely above board. And all completely devastating. It’s something that I’ve been working on for the past 4+ years, and I’m absolutely convinced it’s possible. Within 20 years I don’t think we will recognize public capital markets. They’re going to be transformed by this technology into something else … a casino? a utility? … I have no idea where this goes. But it’s going somewhere that will disrupt the current investment patterns and portfolios of trillions of dollars of capital. Good times.

And on that happy note I’ll close this mailbag. Keep those cards and letters coming!

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The Effete Rebellion of Bitcoin

epsilon-theory-the-effete-rebellion-of-bitcoin-february-17-2015-heat

Neil McCauley: We want to hurt no one! We’re here for the bank’s money, not your money. Your money is insured by the federal government, you’re not gonna lose a dime. Think of your families, don’t risk your life. Don’t try and be a hero!

“Heat” (1995)

epsilon-theory-the-effete-rebellion-of-bitcoin-february-17-2015-butch-cassidy

Butch Cassidy: What happened to the old bank? It was beautiful.
Guard: People kept robbing it.
Butch Cassidy: Small price to pay for beauty.

“Butch Cassidy and the Sundance Kid” (1969)

epsilon-theory-the-effete-rebellion-of-bitcoin-february-17-2015-hans-gruber

John McClane: Why’d you have to nuke the whole building, Hans?
Hans Gruber: Well, when you steal $600, you can just disappear. When you steal $600 million, they will find you, unless they think you’re already dead.

“Die Hard” (1988)

epsilon-theory-the-effete-rebellion-of-bitcoin-february-17-2015-the-town

“The Town” (2010)

epsilon-theory-the-effete-rebellion-of-bitcoin-february-17-2015-point-break

“Point Break” (1991)

epsilon-theory-the-effete-rebellion-of-bitcoin-february-17-2015-dark-knight

“The Dark Knight” (2008)

Cobb: What is the most resilient parasite? Bacteria? A virus? An intestinal worm? An idea. Resilient…highly contagious. Once an idea has taken hold of the brain it’s almost impossible to eradicate.

– “Inception” (2010)

Jimmy Dell: I think you’ll find that if what you’ve done for them is as valuable as you say it is, if they are indebted to you morally but not legally, my experience is that they will give you nothing, and they will begin to act cruelly toward you.
Joe Ross: Why?
Jimmy Dell: To suppress their guilt.

“The Spanish Prisoner” (1997)

“Is it true that you shouted at Professor Umbridge?”

“Yes.”

“You called her a liar?”

“Yes.”

“You told her He Who Must Not Be Named is back?”

“Yes.”

“Have a biscuit, Potter.”

J.K. Rowling, “Harry Potter and the Order of the Phoenix” (2003)

I hold it that a little rebellion now and then is a good thing, and as necessary in the political world as storms in the physical.

Thomas Jefferson (1743 – 1826)

I really can’t think about kissing when I’ve got a rebellion to incite.

Suzanne Collins, “Catching Fire” (2009)

In the day we sweat it out on the streets of a runway American dream.

At night we ride through the mansions of glory in suicide machines.

Sprung from cages out on Highway 9,

Chrome wheeled, fuel injected, and steppin’ out over the line.

Bruce Springsteen, “Born To Run” (1975)

So few want to be rebels anymore. And out of those few, most, like myself, scare easily. 

Ray Bradbury (1920 – 2012)

Every act of rebellion expresses a nostalgia for innocence and an appeal to the essence of being.

Albert Camus, “The Rebel: An Essay on Man in Revolt” (1951)

I used rebellion as a way to hide out. We use criticism as fake participation.

Chuck Palahniuk, “Choke” (2001)

One of the first Epsilon Theory notes I wrote, and the one that really put this effort on the map, was about the modern meaning of gold. “How Gold Lost Its Luster” argued that gold today is not a currency or some sort of store of value; instead, it is an effective insurance policy against central bank error. That’s an Important Thing, just not as important as it used to be or as its more ardent proponents would have you believe. Today’s note is about the meaning of Bitcoin. Not its technical construction or its formal market interactions, but the behavioral WHY that gives Bitcoin its ultimate value. I caught a lot of flak for “How Gold Lost Its Luster”, and I expect some multiple of that for this note. So be it. The core tenet of Epsilon Theory is to call things by their proper names, even if that’s not the best way to make friends here in the Golden Age of the Central Banker.

Like gold, Bitcoin is neither a currency nor a store of value. Bitcoin is the cautious expression of a rebellious identity. Using Bitcoin is an effete act of rebellion, a weak signifier of resistance like wearing a hoodie or getting a tattoo that’s well covered by your work clothes. Bitcoin is fashion, more than a fad but less than lasting. Now fashion can be lucrative and fashion can be fun. Fashion is one of those intersections of art and commerce that I personally find fascinating (go ahead, quiz me on “Project Runway”). But fashion is not an Important Thing. Sorry, but it’s not.

As for the blockchain technology that underpins Bitcoin and is trumpeted as both an Important Thing and the Next Big Thing in every venture capital conference of the past two years, it’s a modern twist on the “technology” of the letter of credit. Color me unimpressed.

Strong words. Let’s dig in.

Bitcoin’s greatest attribute – its independence from every manner of organized social control – is also its fatal flaw. Bitcoin is a bearer bond. We all know what a bearer bond is, because we’ve all watched heist movies like “Heat” and “Die Hard”. Bearer bonds are the MacGuffin of choice for so many screenwriters because they side step all of those annoying plot questions when it comes to the logistics of stealing cash ($600 million in $100 dollar bills weighs more than 6 tons) or fencing stolen goods. By definition, there’s no registered owner of a bearer bond. If you possess it, you can trade it for value without your trading partner worrying about whether or not you are the “rightful” owner.

Bearer bonds have a very similar legal foundation to a bank letter of credit, where the bank will release the contracted funds to anyone who presents the documents required by the letter of credit, regardless of whether or not there was fraud or theft associated with the underlying real-world transaction or sales contract. This so-called “abstraction principle”, where the bank is only responsible for validating the documents defined in the letter itself and has no responsibility for validating the underlying transaction, is what makes a letter of credit work. The abstraction principle limits the liability of the letter issuer when faced with an unscrupulous beneficiary (the person receiving cash from the issuer) and places that liability squarely on the applicant (the person giving cash to the issuer in exchange for the letter). For those who are interested in such things, the abstraction principle is a fundamental concept in German common law and has lots of interesting twists and implications. I can just imagine some clever merchant guild master of the Hanseatic League coming up with this idea in the 13th century and transforming international commerce for the next 1,000 years.

The abstraction principle is Bitcoin’s fatal flaw. If I possess the private key associated with a Bitcoin address, then I can trade that Bitcoin with any counterparty for value without the counterparty worrying about whether or not I am the “rightful” owner of the Bitcoin. The private key is the only “document” required to satisfy the abstraction principle at the legal heart of Bitcoin, and so long as that document is not forged (which is what blockchain is very good at preventing) then the Bitcoin issuer has absolutely zero liability to any party in a Bitcoin transaction, including the “rightful” owner of the Bitcoin. ALL of the liability associated with unscrupulous presentation of the documents associated with a beneficiary claim on a Bitcoin credit rests with me, the rightful owner of that Bitcoin. I have absolutely zero recourse if my private key is lost or stolen. I am, to use the technical texting acronym, SOL.

As you might imagine, banks don’t go out of their way to inform you of the liability assignments associated with the abstraction principle, and neither do Bitcoin service providers. It’s not that they hide any of this, but they also know full well that the legal principles surrounding letters of credit and Bitcoin are entirely foreign to our common experience. They know full well that our behavioral expectations in this regard are almost entirely determined by our experience with credit cards and cash accounts – two bank-issued products underpinned by radically different legal principles.

Credit card issuers have made a simple deal with the US government. Bank issuers can charge outrageous fees and rates of interest on their revolving loans, but they do NOT enjoy the protection of the abstraction principle on the underlying transactions made with these loans. If someone steals my credit card, then my maximum liability is $50. Period. The bank will undoubtedly try to shift a portion of the liability onto the merchant accepting the stolen “document”, particularly with a card-not-present transaction, but it is illegal for the bank to push more than $50 of the liability onto me, no matter how careless or stupid I was in losing the keys to my revolving credit account. This is why credit card issuers are so quick to freeze your account when you go on vacation and start charging in person (card present) in a new locale. They couldn’t care less about “looking out for you”. It’s entirely an effort to limit their liability at the expense of your convenience.

It’s a little more complicated when it comes to your cash accounts, because any nation’s currency is, in effect, a form of bearer bond. Neither the cash in my wallet nor the cash in my checking account is registered to me, and whoever possesses those physical cash bills can trade them for value without the transaction counterparty worrying about whether or not the possessor was the rightful owner of those bills. That’s not to say there are no limitations or liabilities associated with cash acceptance by a transaction counterparty – this is the entire purpose of anti-money laundering (AML) regulations and other capital controls – but on a fundamental level the abstraction principle is in effect here, as the currency issuer bears zero liability if my “documents” (the cash bills) are lost or stolen.

Or at least that’s the way it was back when Butch Cassidy and the Sundance Kid were out robbing banks. Whether Butch and Sundance stole cash or gold nuggets from the vault made absolutely no difference to the owners of that cash or gold. Whatever you had on deposit with the local bank was almost always uninsured, recoverable only if you put together a posse and got your money back from Butch and Sundance directly. Some banks maintained “blanket bonds” that would insure accounts from fraud and theft, but far more often these provisions were honored only in the breach.

That all changed with the Banking Act of 1933 (establishment of the FDIC and deposit insurance), the Banking Act of 1935 (essentially all banks under FDIC jurisdiction), and the Federal Deposit Insurance Act of 1950 (codification of our current system). Now obviously these laws and the entire notion of deposit insurance came out of the massive spate of bank failures associated with the Great Depression, not because we were overrun with bank robbers, and even today the FDIC does not directly insure deposits against theft and fraud. But with the FDI Act of 1950, the FDIC was empowered to require regulated banks (which means essentially all US banks) to maintain sufficient blanket bond coverage to make cash account holders whole (up to FDIC limits) for almost any source of loss. More importantly, for the past 60+ years the FDIC and every other organ of government has promoted the idea that, without exception, no one can lose a dime in an FDIC-insured account. Our government has well and truly become an insurance company with an army attached, to use the phrase popularized by Paul Krugman, and nowhere is this set of behavioral expectations more solidly ensconced than in the cash deposits of US banks. It’s no wonder we all have a soft spot in our hearts for the plucky thieves in bank heist movies. Whatever they’re stealing, it’s no skin off our collective noses.

There’s one more piece of legislation relevant to our story, and that’s the Tax Equity and Fiscal Responsibility Act of 1982.  This was the final nail in the coffin for the issuance of corporate and municipal bearer bonds in the US, as it eliminated the corporate issuer’s tax deduction for interest payments and the muni purchaser’s federal tax exemption for interest received. Both tax advantages were preserved for registered bonds, of course. I say of course because the US government, regardless of political party (the 1982 Act was in Reagan’s first term), has been trying to eliminate bearer bonds for a looooong time. Why? Because the US government believes that bearer bonds are at best a gift for criminal enterprises and at worst actively subversive. Whether this belief is right or wrong (and I think it’s mostly right), the notion that the US government will do anything to help a modern twist on the bearer bond under ANY circumstances is absolutely ludicrous.

So where does that leave us? It leaves us with an extremely elegant credit instrument that is almost immune to forgery or government registration, but because of this immunity it is permanently trapped by the abstraction principle within the world of bearer bonds and letters of credit. As such, Bitcoin is the apple of every criminal’s eye. Every modern day Butch and Sundance, every Neil McCauley, every Hans Gruber is trying to steal your private key. Some will succeed through violence and intimidation. More will succeed with words rather than guns, using what cybersecurity experts call social engineering. If you’ve never seen David Mamet’s “The Spanish Prisoner”, now would be a good time.

And because Bitcoin is hated by governments, it’s all on you to maintain the security of your private key. There is no insurance here, either directly through deposit insurance or indirectly through a blanket bond required of federally regulated banks. There is no “forgot your password?” button to push here, no regulatory or enforcement agency that will vouchsafe a service provider.

For some, the constant liability risk generated by the abstraction principle is – as Butch Cassidy said – a small price to pay for beauty. But for anyone with a serious amount of money who’s not in a criminal enterprise, this is an intolerably risky legal no-man’s land. Look … there are good reasons why bearer bonds have gone the way of the dodo. Are they illegal? No. Do they have an insanely poor risk/reward profile as a central part of any investment portfolio? Yes.

So why is Bitcoin popular, at least on its appropriately small scale? Because it IS beautiful in its technological conception and execution. Because it IS independent from and mildly threatening to the Powers That Be. Because it IS associated (albeit indirectly and at a safe distance) with criminal venues like Silk Road. Bitcoin projects an identity of technological sophistication, bad boy savvy, and a healthy suspicion of Big Government in a safe, palatable manner. That’s an identity that many people (including me) find attractive and would like to take on. It’s an identity that mainstream corporations that sell to those people, like Dell and Microsoft, would like to take on. Bitcoin is a fashion statement. I don’t say that to be pejorative. I say that as high praise. It’s a brilliant marriage of art and commerce, and that’s a lot. Unfortunately that’s not enough for some.

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