Let’s abolish the Bundesbank!

There is a bit of brouhaha about the Bundesbank’s deposition before the German constitutional court, arguing that the ECB goes beyond its mandate with policies like the OMT, in the direction of monetary financing of governments, which is explicitly banned under the treaties that establish the ECB.

The debate is generally spurious: the fluidity of money is such that you cannot devise an enforceable mandate in the common sense of the word. Whatever the rule book says, you could devise a transaction or set of transactions that respect the letter of the rule but not the spirit. Defining what is monetary financing itself is similarly virtually impossible: if the central bank makes policy that results in a vibrant economy, this increases taxation receipts and decreases fiscal expenses (or conversely), is that monetary financing? It does certainly achieve the same effect! It both always and never is, and it doesn’t matter once you have accepted that a central bank is an agency of government and that in any case it cannot not have a monetary policy (the central bank always sets the quantity and flows of money in a fiat currency system, by definition). What the ECB does is really what is politically acceptable, both within it (the governing body must come to an agreement) and without it (what the member state politicians, who can change the law if they really mean it, allow it to do). Like many institutions, it is better understood through its governance structure rather than its notional mandate.

Beyond the pointlessness of the debate, there’s been an argument whether the Bundesbank is going in the direction of arguing for Germany leaving the euro, given that the ECB’s measures are pretty much essential to euro survival, and have been extremely conservative so far. It could be. It could also be playing the role of the “useful idiot” by showing that there’s multiple forces pulling in different directions, so as to guarantee that wherever it goes some intransigence will prevent the ECB from going totally wild. This is actually quite positive for the euro’s stability, as it makes it hard to argue it is completely controlled by crazy inflationists, thus killing most opposition before it can even start.

Is Jens Weidmann under an explicit brief of being a useful idiot? I doubt that, but it is convenient for everybody. I would be more inclined to think that whoever ends up head of the Bundesbank is going to face institutional existential angst. The current clunky setup where the national central banks are notionally members of a network but operationally branch offices is doomed to normalise into more centralisation — unless the euro doesn’t survive. Most branch office functions should sooner or later (if you think decades) be subsumed into the central core. The direction of travel is clear. Banking union takes away one of the few remaining relatively independent responsibilities national central banks still have. The Target-2 non-problem, if it at some point it was to surface as a political issue, can quickly be resolved by consolidating the accounts centrally once and for all, and taking the NCBs out of the equation.

So what is the future of the Bundesbank once stripped from its ECB branch office functions? Hard to see apart from being the custodian of (pointless) German gold. Maybe that’s why they’re repatriating some of which was stored elsewhere: to have something to do.

So going forward, the Bundesbank will probably not be notionally abolished, but will functionally disappear in all but name. That might explain slightly queasy management.

How could Bitcoin fail?

Bitcoin has gone mainstream, boomed and crashed, in just a few short weeks. If you want to understand how it works, the self-evident blog has a brilliant introductory series which goes in just enough depth to be interesting and yet capture the subtleties of the technology.

What interests me however is to try and think of ways in which it could fail. It’s based on a clever technology, but like computer security it’s very hard to design software systems or algorithms that correctly anticipate every possible misuse. It’s been surprisingly resilient so far and a remarkable success story. It’s nowhere near becoming a real alternative currency for what existing mainstream currencies are used for, but just getting considered for that role is a remarkable achievement for something created by one lonesome and anonymous hacker.

There’s probably a myriad of ways in which it could fail, so I’ll just throw a few random ideas. It is also worth noting that currently most people involved in Bitcoin seem to genuinely want it to succeed, for various ideological or aesthetic reasons. It feels like the naive Usenet of the 80s and early 90s before wilful spam was introduced into it by unrepentant green card lawyers.

The blockchain as a data store

The core of Bitcoin is a distributed ledger of all transactions ever conducted, which may “metastasise”. The obvious risk is what happens if it becomes too big, although it’s also hard to overwhelm modern computers with mere transaction information (a modern smartphone has more computing power and storage than a major bank had when bank accounting moved to electronic processing), but it may face tangential attacks or misuses.

Through steganography any data store can be used to store anything else. People may start to use the Bitcoin blockchain as a store for information they want to publicise anonymously or hold for a a long time, by generating sequences of special dummy transactions. This might cost transaction fees (to get included in the blockchain) but for that you get perpetual public distributed storage, which is a good deal! It doesn’t need cost actual Bitcoins beyond transaction costs, because the encoding transactions can be conducted between Bitcoin addresses all belonging to the entity writing the data.

Here are some applications I can think of:

• Way to publish illegal content like child porn
• Way to publish secret information, like wikileaks
• Back up device for small data as a substitute for a paid for data store
• Underground social network using the blockchain as the transport and storage mechanism for status updates
• Anything you can do with a public more or less anonymous data store…

This is a bit limited in size, if people start backing up their HD porn collection encoded as Bitcoin transactions the network would probably be overwhelmed fast enough to require remedial action.

For small controversial content though it might attract the ire of authorities which are used to be able to take such content down… the obvious answer would be for a way to “delete” the offending “transaction” but this is totally at odds with the core design principles of Bitcoin…

Jamming the network with a penny auction

Another idea is that an hostile force which has managed to acquire some Bitcoins could try and jam the network. For instance they could offer a prize to the Bitcoin address which posts the most transactions in a given block, which would push third parties to devise inventive ways to maximise pointless transactions. The logic is that of a penny auction, which leverages greatly the impact of the prize — a lot of people may compete for a single prize, collectively loosing more in effort and transaction cost than the nominal prize is worth. If it worked well the price of transaction may go up with increased competition to be included in the blockchain, perhaps making some genuine transactions uneconomic.

Becoming an ordinary currency

Bitcoin is effectively a software monoculture — nearly every actual node in the network uses the reference implementation — so there’s some scope for the people managing this code to act, de facto, like central bankers for regular fiat currencies. As long as they can get the community to upgrade and not fork the code — arguably a protection — they control all the rules that are encoded in the algorithm as code. This can also be seen in the highly concentrated mining syndicates, who intermediate the mining process, although again the members could switch if they disagree and manage to overcome institutional inertia. One could make a parallel between them and how the network of regional Federal Reserve banks compose the Fed…

Reinventing the existing would not be a particularly unusual phenomenon. Some institutional forces are so strong that alternatives tend to gravitate back to something close to what was originally rejected, if you let them marinate long enough.

Scarcity is not scarce

This would not be a technical failure, but it could also fall into disuse because of being drowned by competitors doing the same thing — Bitcoin is a form of synthetic scarcity which is itself not scarce: anyone can start a new Bitcoin clone, either as a new root with the same code, or by creating something similar based on a different protocol. Seen as synthetic gold, the problem is shared with actual precious metals. Gold supplies may be limited, but people who see it as a store of value could move on en masse to platinum or any other rare material, or alternative sources of scarcity, and thus whatever value it has depends on ebb and flow of fashion.

London portfolio update: Iberdrola in, Reckitt reduced

I’ve updated the Obliquity London portfolio page, trying to follow an approximately quarterly cycle. The performance since December has been below that of the benchmark — at last, it was supposed to happen! — presumably mostly explained by the Japanese market re-rating. It’s still 3 percentage points or so above the benchmark since inception.

No rising sun when the sun is rising

I considered having a handful of Japanese large caps in the portfolio during the construction phase, even shortlisted a handful, but the intention lapsed due to not resolving the hurdle of finding if and how they are tradable at a decent cost with my UK broker. Also there’s a risk of stretching my competence too thin by including a still to this day exotic culture — some aspects of understanding the companies may be lost in translation. Thankfully the broad and international exposure of existing portfolio companies should provide some connection to what happens in Japan, though with a lag compared to direct market exposure. It seems also quite likely that most of the Japan news will have more a global impact than directly domestic, if monetary policy is as interconnected as I believe it is — that is Japanese monetary easing seen as part of global easing of the worldwide convertible currency space.

Rebalancing: Reckitt reduced, Iberdrola in

Portfolio rebalance activity during the quarter was modest: Easyjet was top sliced due to price gains as per the guidelines, which I’m adjusting to include a whole of portfolio effect, that is a company should be 1/3 cut when it grows 50% more than the portfolio as a whole. The last bit is what’s new, and it’s just a reformulation of the rule in terms of weights rather than absolute size. This was necessary sooner than expected as the exuberant bull market saw the portfolio nearly reach +25% in barely more than six month which I didn’t quite plan for (at that speed) when starting last summer.

Apart from that two investment decisions: Reckitt Benckiser was downsized to a lower “mid cap” allocation, for risk mitigation because while it still passes the portfolio criterion I’m having increasing doubts about the management’s attitude — although it’s one of those companies that’s hard to sink and thus to an extent resistant to executive ineptitude.

This and dividends freed a large cap allocation to invest, which went to Iberdrola the Bilbao-based utility. While having some debt hangover from previous times, it seems well managed, well diversified in having operations in multiple countries so as to smooth the regulatory risk all utilities face, as well as benefiting from the peripheral eurozone discount. The spread across generation methods (from nuclear to renewables) contributes to diversification. It’s also on a high free float with no dominant shareholder, a rare feature in southern European stock markets.

Communists saving the rich and other oddities

I wanted to avoid jumping on the Cyprus bandwagon, but OK, I can’t help. As the most obvious things have already been said many times, let’s try to think about some interesting side angles:

The euro went (mildly) down instead of up

In general this is very good for the Eurozone that the euro goes down, as it creates inflationary pressure from import costs, and compensates for the ECB otherwise stern monetary policy relative to major currency peers, with all the positive impact a modicum of inflation has. So as such that’s good news, more of it please, but that’s not my main point. What we have here is the ECB not bailing out the Cypriot banks, that is not printing (more) euros to fill the hole in their balance sheet, which would make euros more plentiful and therefore cheaper. Things should go up on the news of a supply shock!

Communists against wealth tax!

It seems the “communists” in the Cypriot parliament are against what is effectively a wealth tax. I don’t know for sure if their position applies only to low deposits or to the whole thing but in general true proletarians are not long currency. They should at the very minimum support the >100K portion very enthusiastically (the higher the rate the better) and even for below 100K, I doubt that the median cash savings of ordinary people in Cyprus (or anywhere else outside Monaco) is much above 5K. So they should be fully supportive of the current proposals where the tax starts at 20K (last number I read for the draft law, probably obsolete by the time I post) which should cover the vast majority of their constituency.

Bank run on monday!

The weekend anglophone financial blogosphere was predicting a bank run in all of southern Europe on Monday. Hasn’t happened. It’s not surprising, rationally it’s been years since it has made sense for any resident of peripheral countries to keep any surplus cash (or their entire credit banking) in a Northern Eurozone bank, to avoid both local banking failures and hedge the euro exit risk. Electronic transfers (SEPA) work well and your euro payment card works everywhere at the same price as domestically — and sometimes better, SEPA can be faster than legacy domestic transfers, and you escape domestic out-of-network cash machine levies! So, whatever the reason that made southerners not run so far (or very slowly, which is not a run) is persisting. It could always change but again hasn’t.

A stimulus measure?

If your savings are at risk, then one of the best way to diminish that risk is to spend them. Perhaps frightening everyone will take some away from (excess) savings, which could actually be positively helpful in the current circumstances. In general I think a positive of this is to show that bank deposits are not sacrosanct (esp above >100K or wherever petty cash limit is set) and that could have some positive aspects. Fully guaranteed deposits are in effect synthetic government bonds, with the benefits of the guarantee in private hands, and that cannot sustainably work out fairly.  Now the art is in not blowing up the remaining useful bits of the financial system in the process.

Cash is an underrated long term investment

Tadas Viskanta of Abnormal Returns makes the following, rather outlandish, claim:

Treating cash as a long-term investment has been historically a money-losing proposition.

This is fascinating because, while it strikes me as an obvious fallacy, it is presented as self evident, and he was sure enough to commit it to print (it’s quoted from his otherwise surely excellent book). It is common: I’ve more than once failed to convince people during a casual conversation that cash might be a fair long term investment.

But what happens if we look at the data? It’s not as if it’s hard to obtain, historical interest and inflation rates are some of most easily available economic data around, and many people have seen the times series many times and have a feel for where the nominal numbers have been in the past few decades.

So, here we have the real rate of return on cash from 1955 for the US dollar, sourced from Fred, as the Fed funds rates less CPI for inflation:

So we can see it’s been positive most of the time, it spikes down on occasion but usually hasn’t stayed negative very long. This can’t really produce negative long term returns very often, which we see below by showing the trailing 10 year returns, which is the return obtained from holding cash in an instrument that pays the Fed fund rates for 10 years and letting the interest compound. The numbers are shown annualised:

So we can see that apart from the immediate past, there’s only one instance in the past half century where holding cash for 10 years has had a — very slightly! — negative real return, circa 1980, at the worse time of the inflation period. For an instrument that is nominal-based, to work well even in a strongly inflationary period is quite an achievement. Not that it is particularly surprising either, interest rates do tend to be high, of course, during inflation periods, as economically it takes special circumstances to allow negative real returns to go far or last a long time.

The mean of all these periods is 1.8% which is not half bad and commensurate with typical historical returns on index linked bonds. This is consistent with long term efficient markets: if cash didn’t return something close to the long term risk free rate, few people would stay in cash for more than their petty cash and transaction requirements, which we know empirically is not the case.

I expect the result to hold for most other currencies, I just picked the dollar because it is familiar and the data was easy to find.

It may not remain the case in the future, but the claim was for history. If cash starts reliably losing money in the long (real) term from now on, which I guess is possible, it will be a fundamental regime change, a break with history.

It may be a “money losing proposition”, some of the time, relative to more racy investments, but rarely absolutely. In addition to the limited downside, in both real and nominal terms, you get no intermediary fees to pay, infinite liquidity, a somewhat pointless but still nice to have nominal capital  guarantee, and historically small but steady real returns.

Is it a bad long term investment? It depends on circumstances of course, but it’s not easy to find an instrument that returns well above 2% real, and it’s even harder in risk adjusted terms.

For retail investors, the headwinds are even stronger, because there are so many pitfalls to non-cash investing (layers of fees, transaction costs, psychological biases, etc) and a retail saver can often beat the central bank rate while staying in cash: savings products are often available at loss leader rates from banks to entice new custom, and the simple strategy of moving your money every year or so to follow these offers is likely to achieve 1-2 percentage points above cash. When the consensus estimate for the equity premium is 3-4%, doing better than that is hard, and the sorry truth is that many individual savers would be better off if the only financial investment available to them was cash, even in the long term.

It is, however, extremely boring.

Disclosure: long cash.

Venture Shorting, or how to finance a business from the anticipated failure of its incumbent competitors

It is not uncommon to find companies with a sleepy quasi-monopoly: the product has become overpriced for what it is, but is has remained dominant on the market, or benefits from network effects.

In theory, if there’s no essential intellectual property in the way, someone should pop up with a fair priced competitor, and arbitrage the overpricing away. But often the barrier to entry, while not insurmountable, is sufficiently high that nobody bothers entering. Public companies with such “moats” tend to trade at a premium.

A dried up moat that may be difficult to defend (credit: user quinet on flickr)

Fund startups by shorting incumbents

If financed the old school way, the payback of launching a competitor may take a lot of time, because the large costs of building the product are incurred upfront, and building market share may be loss-making for a number of years before reaching critical mass, and then become only slightly positive requiring more years to get up to full speed, and eventually recover the initial investment.

One could imagine a model where the launch costs for the competitor are funded by the anticipated failure of the incumbent: that is before starting the product, the funding entity shorts (directly or via derivatives) the incumbent. They still need to finance the development, and provision for failure of the short (if the prices goes up for unrelated reasons), but if the product’s potential is recognised by the market soon after it becomes available, the payback will come much faster, because not only will the new company be on the slow road to profitability, but the upside from the short will come much sooner if the market is any good at discounting the disappearance of the moat and possibly losses due to the sleepy incumbent being run with high costs.

This is almost “free”, because the upside risk of the short is in theory neutral to this — the failure of a previously unpriced attempt at introducing a competitor should not change the valuation of the incumbent.

Ideal for open source…

This could work particularly well in the case of creating an open source replacement for proprietary software. Once a project is bootstrapped and used by enough entities, the benefits of open source come in full swing, and an ecosystem of support organisations can easily be sustained, at a much reduced costs to users of the software. The hard bit is to bootstrap the project, especially if it doesn’t scratch a programmer’s itch so as to spontaneously appear through community efforts. There is no obvious way to recoup the significant bootstrapping cost of the initial development, as anyone can start a support organisation once the product is available on an open source basis and so support should end up being priced based on costs that do not include the initial development.

But if you short the incumbent, the very appearance of the open source solution, which can be cheaper by an order of magnitude and thus see relatively quick adoption, may sink the incumbent sufficiently to recoup the project bootstrap costs by closing the short position relatively early in the process.

… or free internet services

It could even work for things like creating a competitor to a dominant social network. Let’s imagine a social network that has 500 million users and a market cap of 50 billions, that is a valuation of $100 per user. The service is free but it harvests monopoly profits on advertising and the commercialisation of user data, but nobody knows how to lure users from the incumbent to a more tightly run ship. The cost of reproducing the service (hosting and software) could be relatively small, because the value of the incumbent lies in the network effect, not the product itself.

Less advertising and less data resale (back to normal profits) is a soft proposition that is not enough to get everyone to move en masse, unless the incumbent really grossly abuses their position. One way to work around this would be to short the incumbent, estimate the reduction in value that would result from a loss of dominant position, deduct the set up costs for the service, and use the rest as bribes to break the network effect, that is pay the users, once, to switch services (e.g. by paying switching users a bonus after a few months of regular usage).

If we imagine a social network valued at 50 billions, with say 500 million active users and that an exodus of 20% of them would be enough to bootstrap their loss of dominant position and take their valuation to say 10 billions. If we short 20% of the stock we basically can pay each user something close to (or commensurate with) the valuation per user of the incumbent. The bribes can be targeted at the most active users who will bring their less active friend with them and for free. It may not take that much of a bribe to break the quasi-monopoly of the incumbent.

Where’s the catch?

The idea seems a bit too good to be true. Of the problems I can think of, there might be issues that a manageable short position would rarely produce enough profits, even in a realistic success scenario, so as to remain too risky to be worth attempting.

There might be legal problems with shorting a company while building a competitor, though probably not insurmountable with good lawyers and early disclosure, assuming a disclosure ordering that doesn’t kill the proposition can be devised. Besides it’s generally in the public interest for new entrants to be able to challenge incumbents, so regulators could possibly be convinced to welcome such practices.

The curious stability of historical net fertility

This Slate article about demographics is a relatively good take on the topic, apart from perhaps excess pessimism about a possible population shrinkage.

It eschews a common mistake, where people think that modern societies have dramatically lower birth rates than in the pre-technological era, sometimes arguing some moral implications out of that. While it is trivially true if you look at gross numbers, it is also misleading, and ceases to be true when looking at birth rates in net terms, the number of children who reach childbearing age per women, which is a much more useful metric to understand demographic trends.

In net terms, we have merely moved, as noted in the article “from high death rates and high birthrates to low death rates and low birthrates”, that is pretty similar net rates. Without knowing the exact numbers, it can trivially be inferred from the fact that humanity grew pretty slowly for millenia, if at all during some periods and geographies, that the net rate has been between 1 and 3, and rarely much above 2 during humanity’s almost entire existence. Net rate bumps where healthcare was improved rather suddenly and before the rest of a developed economy’s features arrived, as happened in the late twentieth century in some developing countries, are a short lived historical anomaly.

It does seem that people adapt to the available technology to get to a rate within sustainable boundaries (there is evidence, for instance in medieval and renaissance Europe, that people were already actively operating below the then available capacity). Given that it seems pretty universal and not dependent much on local culture, historical time, or on the degree of technological development, one can ponder why is it so? Do resources constraint or some other perennial equilibrium forces play a role, or is it just a curiously persistent coincidence?