Reverse tax lotteries — taxes where a basic parameter (the amount, the taxpayer) is chosen randomly — are an interesting concept which may have a wealth of applications. Maybe there’s a series coming here.

Today’s instalment is about using taxes as a regulatory device to control for financial concentration and increase risk awareness and management among market players.

Financial products are not aircrafts

One problem with the mainline approach to financial regulation is that it’s aimed at trying to find fragile features of the financial system, and then regulate around the fragility to make it impossible to happen. This is basically the aircraft industry’s approach to safety. This may not be such a good idea in finance because financial failure are as such not as catastrophic as a plane crash. Finance is about bookkeeping units of future resource allocation power, where failure causes more subtle problems — sometimes not even system-level negative — than a plane crash. Secondly in finance players are often trying to work around the safety procedures instead of consenting to the safety imperative as pilots and maintenance technicians generally do.

Regular failure

What best to teach people to cope with failure than having it happen frequently enough for it to become a manageable habit? Incandescent light bulbs fail frequently, so cars have two headlights, so they can keep operating at night should the predictable failure of one light bulb occur. The statistical chance of both lights failing is small enough, that one can take the small residual risk of having a complete failure between the failure of one lamp and its replacement.

In finance the solution to such issues is diversification. If one’s savings are split between 100 issuers, the failure of one of them is a non-event. Unfortunately, some classes of financial instruments, e.g. the quality end of fixed income, fail so rarely that people often forget they can fail, which in itself is a contributory factor to them failing en masse during systemic crisis.

Probabilistic bankruptcy

So, a way to remind people of that failure risk is to have forced bankruptcies: have the regulator pick some random issuers every so often, and simulate a bankruptcy, by taking all their assets and closing them down. Applied to equity for instance, this could be done by expropriating current shareholders of the randomly chosen company, and redistributing new shares via an IPO whose proceeds are tax revenue.

It’s a nice way to add some tax revenue as well, which could substitute some of the existing non-probabilistic taxation, of fund new public goods as desired. Alternatively this can be do in a tax neutral way, by redistributing the proceeds of the levy to the remaining players.

This tax could be applied to all asset classes, e.g. just pick 1% of all available financial products every year and fail them. For risky investments with an intrinsically high failure rate it will just be barely noticeable noise, and it spares the regulator the arduous and hazardous task of having to classify instruments.

In addition to reminding people of bankruptcy risk, by effectively introducing a floor to the level of total loss risk, it is a strong disincentive against having large single points of failure as nobody will want to put too much in any single basket.

Downsides

Some potential problems with the measure I can think of: this can’t be applied to brokerage-level institutions unless end consumers of financial service are required to diversify brokerages or bank accounts — although maybe that is desirable! Exempt brokerages  could help my making it easy to split savings or investement into diversified portfolios (e.g. replacing single-point of failure ETFs with auto-rebalanced direct holdings of the underlyings).

It does not remove the risk of systemic misinvestment into asset classes represented by many instruments, e.g. if wouldn’t prevent sector bubbles. Still the higher background level of failure may have a slight moderating effect on the psychology of exuberance.

As with any new tax, the argument would be made in any jurisdiction introducing it first that all the money would leave. I see no reason why it should be the case at a reasonable level, the tax load is not in essence that different from say stamp duty style taxes. Indeed in the UK it could replace stamp duty and be levied at the same rate of 0.5% (but here of instruments’ market cap rather than trading volumes).

London holdings up to date

I’ve belatedly updated the Obliquity London portfolio page in the same style as the other (holdings, reweightings, disposals tables) with up to date data, which shows the full history of the portfiolio. Most of the slow movements have been reported in blog posts but the page wasn’t up to date pending an ever procrastinated automation. No automated process yet but this is backed by a little toolset I’ve been building in numeric Python (pandas) which should make future reporting easier.

IRR benchmark units reporting

The concept I’m playing with at the moment is using IRR (Internal Rate of Return) on cash flows expressed in benchmark units. That is for any given position I extract all the cash flows (trades, dividends and corporate actions), which I get from my broker in sterling, and then convert them in accumulating units of a benchmark ETF, as if it was a currency — remember that in essence any tradable paper is a currency. So each sterling flow is translated to an ETF units flow at the price (“exchange rate”) on the day of the cash flow. This shows the balance someone doing nominal accounting in benchmark units, or equivalently using the benchmark as their “cash” asset, would see.

This makes relative performance very clear: the sign of the nominal PNL (portfolio value change) tellls you if you have out- or underperformed the index. Basically if you had funded every buy by selling units of the benchmark, and bought them back on sales, it tells you if you’d have more or less units following trading than passively sitting on the benchmark units.

The use of the IRR also implies a normalisation of time effects, to capture that a N% change over 2 years is not the same as N% over 2 months, which is hard to see in classical nominal PnL reporting.

Stamps IRR charts

So here are a few of the result for the small cap London Stamps portfolio, valued as of 2015-05-08. This is early software so subject to errors and bugs, the numbers have merely passed a plausibility test.

The benchmark is iShares MSCI UK Small caps (CUKS) which is a good substitute economically (I’d happily buy it as a replacement allocation if I stopped playing stock picker in this segment) though a relatively poor short term benchmark technically. The reasons for that is that it uses a worldwide definition of small caps, which basically in the UK market captures the bottom of the FTSE250 — which are traditionally viewed as midcaps in the UK markets — and the top end of the local small caps section. So the average market capitalisation is significantly higher than my mostly AIM oddballs stock picks. A pure AIM index index wouldn’t be a good benchmark either as it would have a would bunch of junior resources stocks and overseas scams that I don’t touch, and I would never buy an AIM index as an economic substitute. The MSCI methodology is pretty good at excluding the darker corners of the market, so it is a valid benchmark in sector and industry terms.

Predictably the portfolio as a whole has underperformed by almost 10% since inception in money weighted terms. We’ll blame midcaps doing well while really small caps had a lacklustre year and say the jury is still out on my stamp collector skills or lack thereof.

Now, let’s do some digging down. Here is the IRR of each stock since inception, including closed positions, as a monthly return in benchmark units.

London Stamps IRR Ranks 2015-05-08

This is not very precise chart because the more recent positions produce outlier IRRs — the computation makes less sense in the very short terms. This excludes positions younger than 100 days (only AMD at the moment).

Other than that no surprises really, and apart from the GW Pharma pot bubble the next winners are tech companies that got taken over (indeed I held them for relatively short periods).

Now let’s watch our underperformance by plotting an histogram of these same returns (with AMD back in).

London Stamps IRR histogram 2015-05-08

So we’ve got the reasonable level of symmetry, as predicted by theory, the problem is only that zero is on the wrong side of the chart for the time being. It’ll shift if the performance reverses.

A thing to note in these charts is that the average monthly moves are not big, mostly within the -5/+5% range, which implies that with the typical spreads in small and micro-caps, long holding periods are essential. This is well known but nice to have another confirmation. Anyone flipping their portfolio every couple of months, in addition to having trouble to find alpha, would get trounced by transaction costs. It should also mean that long term returns should be better, so let’s do a little trend check by plotting our returns against holding period (remember this includes closed positions):

London Stamps IRR Age plot 2015-05-08

That one looks good. Patience pays so far.

That’s all for IRR analysis for today. Let’s finish with a little check we don’t have any undue overweight, with a simple visual check of portfolio weights for current holdings:

London Stamps weights 2015-05-08

So far so good.

One thing I think Bitcoin, or a similar blockchain-based token system, may be useful for is to replace centralised social networks, or more broadly messaging systems.

A core if oft forgotten feature of a social network is how it manages spam and other forms of network abuse. One solution may be to exploit altruistic punishment, a tendency people have to want to correct bad actions even if it’s not in their direct private interest to do so. In familiar terms, people seem to enjoy pushing the “dislike” button even if they get no personal benefit.

How could one devise a cryptocurrency transaction type that cab be used to harness this effect?

One possible way is what I’ll call “altruistic destruction”. The basic idea is to have a transaction that can cancel some of the recipients’ funds, that is enriching everybody else, through the reduction of the monetary base. If this is free to the sender, this is open to abuse — though whether such abuse would be common could be a subject to interesting experiments — so a compromise might be simply that both the sender and recipient destroy some tokens. As a base case a simple matched ratio may do. The altruistic destruction transaction semantic would be as follows.

When Alice sends to Bob an altruistic destroy for N tokens,

  • Alice’s account value decreases by M tokens.
  • Bob’s account value decreases by M tokens.
  • where M = min(N, Bob’s balance)

M copes for the case where Bob’s has fewer token than N, assuming the token system does not allow debit balances.

In paper terms, this would be equivalent to burning a bank note with the name of a miscreant on it, where through some magic burning the named banknote would also make a banknote of the same value vanish from the miscreant’s wallet. Economically this reduces the total amount of banknotes in the system thus making holders of the remaining banknotes richer (like simply burning one without magic does) everything else being equal.

For practical use in a spam control system, this would have to be implemented with policies that uses minimum balances as condition of message transmission — a distributed deposit system of sorts.

There may also be other application of that transaction type. The ratio of destroyed tokens between sender and recipient may also be toyed with, but 1:1 may be special in that the cost of inflicting damage is equal to the damage individually, while the social benefit is leveraged: destroying 1 of one’s tokens produces 2 tokens’ worth for the community, and the punishment’s social value is free on top of that.

After years of dodging the bullet I’ve finally got a total loss in my portfolio: Ceramic Fuel Cells (from the Stamp Collection) has gone into administration. It’s a pity given that the technology seemed at a turning point, finally getting to a point where efficiency and production are seemingly close to a sustainable product, and if it ever becomes competitive with other technologies the market for fuel cell is large.

A BlueGen machine

CFU’s BlueGen heat and power unit

Let’s hope someone takes over the product. The company could certainly do with some simplification, such a small outfit with listings on 3 markets, HQ in Australia, main operations in Germany, and an AIM listing — could hardly be worse! I presume the plan is to sell the German operation as a going concern — they’ve still announced going to a trade show in Hanover after the administration announcement — and lean down on the multi-listing and Australian and UK operations. At this stage it probably doesn’t deserve to be a listed entity, it’s small enough to be part of a large group or supported by private investors directly. Looking at the accounts, it did burn AUD 300M (negative retained earnings) on the way there which is financially a spectacular failure. Thankfully I got in a few months ago when the market cap was a small fraction of that. Will there be any value left for remaining shareholders? I presume not, the only case where it would is if there’s a tight competitive bid for the German operation or the technology. Though given my entry point it wouldn’t take much for getting some money back.

Was it an error? So far I don’t think it was a particularly bad decision: it was a gamble on the technology taking off, and the outcome of this is undecided. While it ran out of working capital, it also has no debt, and has some active customers, so it wasn’t an obvious train crash as some blue-sky shares who are just burning all the cash they can raise with little to show for it. The risk sizing was appropriate, and indeed the loss is less than my portfolio’s daily move on a somewhat active day — indeed I wouldn’t have noticed for it showing as delisted on the FT’s portfolio tracking tool. Funnily enough, it’s still psychologically more irritating to lose an entire holding than the same nominal loss in a price move on a large position. I had a look at recent UK listing CeresPower, to replace it with more of the same. The technology is plausible and backed by blue-chip scientists, but much further away from production so I find it’s too early. It’s also generally pretty hard to bet on the right horse in such a new technology area — in the solar industry, basically none of the horses got to the finish line, and the mainstream solar tech today is an incrementally improved silicon cell, an improved pony. So no more fuel cells in the portfolios for the time being, but perhaps worth keeping an eye as the sector seems quite unfashionable these days.

The general assumption in the Greek crisis is that, in so far as there is one, plan B — Grexit — is the introduction of a new currency. I think that actually Greece using the euro outside of the Eurozone is more likely as plan B. It’s still very unlikely because it doesn’t make sense at all from the point of view of the Eurozone, but it’s fun to play with as a thought experiment, and discussing it may help understand why it won’t happen.

There are well known advantages to having your own currency, but in this case a new currency would have big problems,:

  • Risk of non-adoption by people on the street because they don’t trust it
  • Inflationary spiral caused by the economic situation, the sudden introduction and the above
  • Logistic issues (printing new banknotes, converting contracts) which is essentially impossible to do over the weekend, and impossible to announce in advance

The alternative is just to keep using the euro while being outside of the Eurozone. Like Kosovo does, or like Ecuador does with the US dollar.

Map of euro adoption

Going lilac? (source: Wikipedia)

How would it work out?

Paper money

According to the Greek central bank there are about €2000 of paper euros in ciculation for each person in Greece (the actual number may be more or less depending on net flows of notes and coins from other Eurozone countries, but you’d expect this to be a conservative estimate because of net incoming tourists presumably arriving with more euros banknotes than they leave with). These are not going anywhere in case of Greek exit from the Eurosystem, so Greeks have more than enough paper banknotes to go round for a long time, even if they can’t print their own new ones.

(Note that this abundance of paper euros also makes the risk that nobody is interested in new drachmas higher than it would otherwise be.)

No central bank

Grexit would happen through the suspension of the ELA, which would in turn push all Greek banks into bankruptcy (as a liquidity problem at the very minimum) which in turn would exclude them from the electronic payment systems (SEPA, etc). This would also make the Greek central bank insolvent. They could just close it down, which would allow them to default on €50-100 billion worth of Eurosystem liabilities. If you’re a unilateral adopter of the euro you don’t need a central bank, the ECB remains your central bank, at arm’s length.

Look ma, no debt!

While we’re defaulting, given a primary surplus the Greek government can operate with no debt at all, and will be better off than the status quo, even if they can’t borrow for the foreseeable future. So they can default on the whole debt stock from the Troika lenders, and why not the private sector as well given under a balanced budget they don’t need borrowing at all, so maintaining a good credit rating on the markets is pointless.

Having no central bank, the Greek treasury can operate their payments by opening commercial bank accounts (with no overdraft needed!) like any business, with Remnant Eurozone banks, e.g. Deutsche Bank. They can use online banking to manage it, no need for the banks to have branches in Greece. They can also use new Greek banks (see below).

Capital flight is good for you

With no central bank, the Greek banks would have no access to clearing accounts in the Eurosystem. But there are several options here. First, we can assume they would lose all their Eurozone assets (most being owned by the ECB as collateral, and Remnant Eurozone governments could enact special confiscation legislation for local law assets owned by Greek banks, fair game), as well as their liabilities (ECB funding, etc). What is left is basically the local Greek-law loan book, and local Greek euro deposits. As of late December this was approximately balanced. With capital flight it actually improves every day: the loan book can’t walk away, but the deposits (liabilities for banks!) shrink, and capital = loans – deposits, which gets more positive with every euro leaving. Assuming the impairments on the loans are not too far off fair value, and the Eurosystem exit doesn’t create too much new defaults (arguably a risk, but much less so in the Kosovo scenario than in the own currency one), we have solvent banks. If all else fail, a haircut on remaining large deposits should help rebalance.

Liquidity for non-Eurosystem euro banks

These Greek banks are illiquid outside the Eurosystem though, with no access to clearing accounts, but there are solutions:

  • Sell the solvent domestic loan books + domestic deposits to Remnant Eurozone bank(s) for €1. E.g. National Bank of Greece could become part of, say, Santander, who can get liquidity for their new Greek subsidiary operations from the Spanish central bank, still a Eurosystem member, and they have spare borrowing power there given their large balance sheet. Problem sorted. And Greek depositors get their €100k guarantee backed by Remnant Eurozone taxpayers as their deposits are fungible with domestic Eurozone deposits!
  • With the same solvent loans + deposits as above, perhaps less crap stuff sent into a bad bank type entity, reopen the (New) Greek banks as corporate entities which use Remnant Eurozone corporate accounts in lieu of central bank accounts for clearing. This needs a stop gap for liquidity, by either converting the deposits to term deposits (a soft form of capital controls arguably) or possibly finding bridge loans from external private entities. Given the entire deposit base is below €150 billion and may be much less by the time this scenario would unfold, and not all of it will move after an exit (too late), it should not be that hard to find hedgies to provide the financing.

The first variant brings a more generally interesting question: in a currency union, should financially weak regions have their own banks, or should they bank using the institutions from financially strong regions within the union? The answer is probably the latter, as happens in most centralised countries (e.g. most people in Cornwall do not bank with Cornish banks, but freeload on London banks, and quite rightly so; at an (ex-)country level the ex-GDR part of Germany has a weak indigenous banking sector and banks with West German banks, and quite rightly so).

What are the risks of Kosovoisation?

I may have missed something, but I don’t see many problems with this scenario, from Greece’s viewpoint. Long term, Greece would have no indigenous monetary policy, but they were never particularly good at it and monetary policy is of limited use anyway for a small country. They would loose access to EU structural funds, but then they save €400 billion of debt so net positive here surely. The main short term problem is if the Remnant Eurozone tries to cut private Greeks and private entities from their (non-overdraft) mainland Eurozone bank accounts. Possible but pretty hard, and mean. And hard to justify given all this would be triggered by the ECB pulling the plug in the first place.

Why this won’t happen

It should be obvious now that this won’t happen, precisely because it would probably be an okay deal for Greece, while costing the Eurosystem dearly both in nominal terms of treasury + ECB write-offs, in possibly collateral damage, and a very high risk of an associated cataclysm for the European project. The ECB will just not pull the plug unless Greeks do something really stupid (like printing their own unauthorised euros, they do have a print works I think).

One of collateral damage effects of the oil price crash of recent weeks has been that airlines who have aggressively hedged their jet fuel requirements face a loss on the hedge. Normally this is not a problem, as the point of hedging is to match anticipated revenues with anticipated costs, but here it may backfire if unsold inventory becomes uncompetitive (at the hedged price) compared to competitors who have not hedged (or hedged less).

This brings the question, how much should ideally an airline hedge its fuel costs?

Hedgie or airline operator?

The first thing is that the airline should resist the temptation to branch out as a macro hedge fund and hedge based on predictions of future oil prices, beyond its current need, e.g. for future flights it hasn’t irreversibly committed to fly yet.

Making macro predictions and running an airline are two very different problems and it is unlikely a single management would be equally good at both. If they’re good at macro prediction, they should close the distracting airline and become an oil trader on a much larger scale, and conversely. Arguably an airline operator will have some idea on the general dynamic of the airline sector, and its fuel requirements, in their geography, but that’s unlikely to be enough to justify making active bets on the broader markets.

Asset liabilities match

So a reasonable fuel is to match the hedge as close as possible to committed fuel liabilities.

The maximum hedge is thus all the fuel required for all the scheduled flights the airlines has to fly, that would be something like all flights with at least 1 passenger booked.

But, in an era of dynamic pricing, the price of seats unsold can be varied in response to supply and demand, and costs. So why hedge unsold tickets at all? This gives the minimum hedge: only hedge the fuel share corresponding to tickets already sold.

This inconveniently would be an exact match only if demand and supply don’t react to fuel costs being pushed to ticket prices, and are not variable for non-fuel factors. So the ideal match is somewhere between those 2 possibilities, without an exact answer being easily attainable.

The simplest for a shrewd airline may be safety in numbers: to hedge as much as (and no more than) their competitors (on comparable routes, etc). Then success remains a result of operational excellence or lack thereof.

Economic intelligence test

For investors in airline shares, there may be more to read in how management justifies their hedging policy — do they get the economics? — rather than how much. And run away from closet hedgies.

It’s now a commonly held view to say that Greece would have been better off exiting the euro, returning to their own currency in 2009, let it devalue and restart from scratch.

picture of Greek Europa face watermark on a euro 10 banknote

Greek Europa watermark on new series euro banknotes (credit: ECB website)

Devaluation is no panacea

GDP and real incomes are down about 30% since the beginning of the crisis. It’s a lot, but how much it would have been down in real terms (in hard currency) with an exit? Even if we assume no redenomination costs (untangling contracts denominated in euros, etc) and no adoption issues (Greeks keeping using the euro for some of their daily usage because they didn’t trust the new currency, see below) the typical fall in such cases would be likely at least 50%. Then you would get a bounce in nominal drachmas but where would they be now in real terms? -30% maybe? The historical experience of other countries doing devaluations, say Argentina, does not show it as a certain path to unbridled prosperity.

It is likely that the numbers would have looked better at PPP (purchasing power parity) as all local services and goods go down in price in a devaluation. Greece is though a small country which is far from self-sufficiency and imports many goods, including energy, that are not produced locally, thus ensuring the impact of a devaluation would be felt by all.

So, while it’s not impossible that real GDP would have done a bit better with a devaluation, it’s certainly not a given.

Distributional impact of devaluation and Kosovo-isation risk

Perhaps the one advantage of the devaluation route is that it makes everyone with nominal incomes in the national currency poorer. This is sort of good for social equality — we’re all down together — although in the case of Greece it wouldn’t apply to shipping magnates or owners of tourist-oriented businesses (whose products are world-priced in competition with alternative destinations) so the one percent (or a section thereof) would have done okay either way.

For recipients of social transfers, it’s also not obvious which way is best. A pension halved but still in hard currency may buy more than a devalued one. The distribution is different (cheaper haircuts, higher cost energy) so who knows which is better.

One case where it would be worse for the poorest is the “Kosovo-isation” scenario, where people in employment or with any form of foreign income keep using the euro despite the introduction of a new currency, so the currency is only used by state employees and benefit recipients, who spend or exchange it as soon as they can to avoid it losing value. Some say the state collecting taxes in its own currency gives it value, but not necessarily: people can just convert from euros, or whatever the street currency is, to the tax currency the day before a tax payment is due. In this case the new currency may just go into a death spiral which is combining the disadvantage of a hard currency with those of a local one.

Tsipras is the Troika’s child

Creative destruction has a bad name, but it does, to an extent, work. A problem with everybody getting poorer together in a devaluation is that there are fewer reasons to change bad habits and people can just plod along in their mediocrity until the next round.

Greece had and may still have a dysfunctional state with poor tax collection and poor value for money when delivering services, that is not providing a well working framework for a modern economy. For example, clientelism is central to Greek politics which means people are given jobs they may not be qualified for or productive in as a reward for political support. This is not only a direct net cost to the Greek taxpayer (compared to employing productive people at market rates), but also an opportunity cost as these people may have otherwise found more productive use for their time. Even for the beneficiaries of state largesse, being stuck in dead end careers in comfy but meaningless jobs may not be that fulfilling.

The crisis has allowed Greece to make some progress on this, no doubt with some collateral damage. To know if the devaluation solution would have been better, we would need to know whether there are net benefits to the shock therapy, and how they compare with reforms possible, or not, under a devaluation scenario.

There may be more progress to come as Tspiras, being an outsider can break lots of allegiances that were untouchable for the incumbent. It is quite plausible that his government makes some progress that would have been impossible, or taken decades more, in a sleepy repeated devaluation cycle where a newcomer like Tsipras would have remained permanently unelectable. If Tsipras is the Greek Lula, and the euro crisis made him possible, it may not be a bad thing for Greece.

What now?

In any case, whether the benefits of devaluation then would have been real or imaginary, it’s a bit too late. Exit at this stage would probably be the worst of both worlds, by creating a real term depression at a moment where there are not many benefits left from it. Both Tsipras and the Greek electorate seem to be wise to that.

The main remaining open question is whether they obtain a satisfactory compromise on the large debt stock. Tsipras has new reforming powers to bring to the table. Many of his proposed reforms are compatible with fiscal responsibility (anything that attacks clientelism, or the economic privileges of the Orthodox church, or effective tax collection from the rich). Besides it seems they understand they need to keep the nominal debt untouched, which allows Northern governments to sell a deal to their own electorate more easily. What they need is lower outgoing cash flow for the next couple of years, which any combination of rescheduling, lower interest, or interest capitalisation can do. The situation further ahead can be dealt with later on. A partial (or total) conversion to GDP bonds would also be a good compromise: Greece pays if it does well (as it would with the current setup) and doesn’t if it doesn’t manage (in which case the current setup produces sooner or later a hard default).

The tricky point for the negotiation is perhaps whether they manage to isolate Greek banks from the Greek treasury. If Greek banks were either self standing, or taken over by a eurozone body (EFSB or whatever) then the Greek treasury could suspend, or threaten to suspend, official sector repayments without as such causing a disaster. They could be kicked out from the eurozone for that reason, though that would probably, ironically, require a treaty change and unanimity, that is it would be practically impossible unless they behave really really badly. And if everyone knows that, they’ll do a deal before we get there.

Maybe in 20 years time historians will see that the euro, somewhat inadvertently — or perhaps by design if we consider the euro as a federalist pre-commitment device — helped Greece extricate itself from its own failings. And perhaps save the EU from it own failings in the process too.

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