CRYPTO: The Manifest Absurdity and Danger of Proposed "Regulation"

 

Some Problems Can be Avoided at the Outset

This is the follow-on to my previous post today on crypto “assets”.

A look at the second and more absurd manifestation of advocating the wrong sort of regulation.

Why is regulation a “bad” idea?

First, the regulation advocated will give the appearance that “crypto” is an “asset”.

Second, it is major step in entangling our financial system in risks it would be better off avoiding. It may also be the first step on the slippery slope of governmental support/insurance for crypto.

Conveying the Appearance of Approval and thus Value

A very simple analogy.

Crypto is like patent “medicines” or illegal drugs.

Just as these are not medicines, crypto is not an asset.

An asset has inherent value. A medicine generally helps improve health.

No responsible physician nor government agency/regulator would give the appearance that patent “medicines”, miracle cures, or narcotic drugs are “good” for one’s health.

Similarly, no responsible finance professional or government agency/regulator should do the same with crypto.

Regulation can of course be of two types:

• Prohibition 
• Establishing standards

In the case of dangerous substances, only the first type is good.

That is the prohibition of their sale.

This will not eliminate their sale, but will limit the potential damage.

Banks and other financial institutions are not permitted to provide banking services to drug dealers. 

Investment advisors and exchanges do not list or trade in securities for these companies

Similarly, they should not be allowed to do so for crypto.

The second type of regulation advocated by some pundits is not good, because it gives an appearance of official sanction of a product.

“To the best of my understanding” neither HMG or the US Government prescribe purity standards for street heroin, cocaine or crystal meth. Nor do they establish requirements for manufacturing, packaging, etc.

To do so would imply some sort of approval.

So would setting similar regulatory requirements on crypto exchanges and stablecoins.

Entangling the Financial System and Government

This is potentially the most dangerous outcome

If these imaginary assets are “validated” through regulations, then it is highly likely that our and other countries’ banks and investment companies will throw open the doors to crypto intermediaries and transactions. 

Other service providers – audit and accounting firms, law firms-- as well. 

Adding to the appearance of value.

When the gullible who have brought crypto find that their “assets” are worthless or worth less than they paid for them, it’s likely they will turn to our banks and investment companies for recompense and perhaps even to the government for failure to regulate. A potential backdoor to government support.

But there is more.

The world financial system is already freighted with enough risks.  

We don't need to pile on any more.

This is one that we can take a pass on.

CRYPTO: Keep the Faith, Baby

All Colander, No Spaghetti Monster

 

One might have thought that recent unraveling of the crypto-con space might have shaken faith in this imaginary “asset” class.

But alas, it has not.

Aside from the diehard crypto believers whose faith cannot be shaken, there has been what is an interesting and troubling—at least to AA—reaction among financial commentators.

Sadly even from the august salmon coloured pages of The Financial Times!!

Now pundits—even those of the financial persuasion—must “pun” on a regular basis to justify their employment.

On topics of current concern, even when they don’t really understand the basic issues involved.  

As usual, there are others--financial types, politicians, etc.--who add their voices to the mix.

Two central failures:

• Clinging to the “sacraments” of crypto after abandoning the faith. 
• A naive belief that imposition of certain standards on the industry via greater regulation will solve the problem.

A look at the first manifestation of this syndrome in this post.

Like the Pastafarian who loses faith in the FSM but still sports his/her colander, these pundits cling to Blockchain. And to DeFi.

Taking these in order.

Blockchain

The assumption is that Blockchain will allow the quicker and nearly frictionless completion of transactions.   

That is no doubt true for certain transactions conducted at certain volumes.  

But the overall utility may be modest like super yachts for oligarchs and the like.

However, if we are looking to process payments, a system's capacity is paramount.

• How many transactions the system can process per unit of time. 
• The cost of processing a transaction.

Parties interested in system economics can explore this further by looking at volume comparisons between the old and therefore presumably “bad” Visa card and the new and therefore “good” Blockchain.

Similar for average transaction costs and their variance. 

The latter of particular importance if speed is of the essence.  

And if one of the key goals is providing financial services to the "unbanked".

DeFi

According to crypto dogma, the current financial system is centralized and therefore “bad”. 

DeFi will eliminate centralization and is therefore “good”.

But like crypto, DeFi has proven to be a lot less than claimed.

It has merely replaced one set of intermediaries with another. 

And in doing so it has reduced the number of intermediaries.  

There are a lot more banks than crypto exchanges.

But some may argue that true DeFi –peer to peer transactions--can be implemented.

Let’s look at that a bit closer.

Practically how does one connect with someone to find a counterparty for one’s ”transaction”?  Generally via the internet as opposed to "in person".

I can’t think of any example of that sort of contact which does not take place through an intermediary.

Whether that’s sharing your wisdom with the rest of the world via tweets or blogposts, searching for information, looking for a rental, etc.

If you were to attempt a direct peer to peer contact without using an intermediary platform, it would be theoretically possible.  It would also be costly and time consuming.  

And you would probably not reach all the potential “peers” you wanted to reach.

That is important because you want to go where there is sufficient supply or demand to accommodate your “transactional” need as well as an infrastructure to facilitate your transaction quickly at the lowest cost. 

If you're selling 1,000 Bitcoin, Joe might buy a couple, but that would require finding a lot of other Tom's, Richard's, Harry's.  

In the next post I'll look at the second manifestation which is more dangerous and pernicious.

Twitter: Unanswered Questions & Logical Conclusions (?)

SAM's Consultant Logician Philip Francis Queeg

 

 

The press has reported that someone who is in an excellent position to know has stated that a replacement CEO for Twitter would have to be "foolish".  

I believe the exact words were "foolish enough to take the position" or some variant.

However, there was no reported assessment about the state of mind of the recent purchaser of Twitter who it would seem to me--and perhaps to you--would have a lot more at stake than a "hired hand".

Does logic, perhaps geometric logic, enable us to draw a reasonable conclusion?

As a side note, most successful businessmen and their bankers report that rigorous up front due diligence generally--but not always--leads to better decisions than that conducted after the closing.

 

One Call You Don't Want to Miss

 

Hommage a Hubert Germain -- dernier Compagnon de la Libération 11 November 2021

 

Remembrance Day 11 November 2021 Menin Gate

 

Remember to remember.

Tag der Deutschen Einheit

 

Much accomplished, much yet to be done.

“Wir denken selten an das, was wir haben, aber immer an das, was uns fehlt.”

 

Don't it always seem to go that you don't know what you've got till it's gone.

... beispielsweise

Vielen Dank, Mutti

The Sporting Equivalent of Brexit

20 years.  Finished out of the top four twice.

Dramatic Irony? The FT “Nods”

Those oft are stratagems which errors seem,

Nor is it Homer nods, but we that dream

 

If you read this blog, you generally detect a strong admiration for the FT.

But like Homer sometimes the FT nods.

Today’s (17 September) Lex had this bon mot to lead off its column.

China’s recent push to regulate the country’s fastest growing sectors begs the question of whether the market is still investable.

“Still investable”????

Given the legal and political issues with investments in the PRC—e.g., Peking University Founder Group bonds, Evergrande Group, and stock investments via VIEs-- I’d argue there is a strong case that the PRC market was never “investable” if that term is used in a normative rather than descriptive sense.

September 13 the FT ran an article today about the crackdown of South Korea’s Financial Services Commission on digital currency exchanges in the RoK. Some US$2.6 billion in losses were expected for wise investors in this imagined asset class.

Industry data showed that digital coins other than bitcoin made up about 90 per cent of South Korean crypto trading, highlighting the market’s highly speculative nature.

Isn’t investing in sh*tcoins highly speculative regardless of their provenance?

Or in other words is jumping from the top floor of the Lotte World Tower more deadly than jumping from the top floor of the Parc 1?

I hold that statistically the results are likely to be the same.

Happy Qi Xi Festival!

 

Nach all dem Weg, nach all der Zeit

Bist du die Frau in meinen Träumen

Und meine Heldin in der Wirklichkeit

The “Big Boys’ Market” VIEs—The “Myth” of Foreign “Ownership” of PRC Stocks

"Choose Your Investment Wisely
Not All Chips are Blue"

 

If I'm not mistaken (and as Madame Arqala could tell you, I often am), in his seminal work, Benjamin Graham made the observation above.  Along with the advice to carefully analyze a proposed investment before you commit funds. 

If you’ve been following recent financial news about the PRC government’s clampdown on private educational companies, you’ve probably seen comments about the Variable Interest Entity (VIE) structure which is typically used by companies in the PRC to access equity from foreign investors.

The VIE is used because under PRC law foreigners may NOT own stock in some sectors within the PRC.  Lots to be exact.

How does the VIE work or more accurately claim to work?

1. A PRC company wishing to access foreign equity markets establishes an offshore company with the same name as its own. The Cayman Islands is a “favorite” location.

2. The offshore company and the PRC-based company sign contracts that ostensibly (note that word) grant the offshore company legally enforceable rights to a share of profits of and a measure of control over the PRC company. These are portrayed as providing “the equivalent to ownership”. If you’re interested you’ll find a detailed discussion of the structure and the agreements in the two “warning” articles cited below.

3. The offshore company then issues shares to investors. Note these are shares in the offshore company not in the PRC company.

4. Net proceeds from the issue are upstreamed to the PRC company typically as loans in consideration for the contracts and agreements in point #2 above.

What are the issues with the structure?

1. As with other structures based on complex legal agreements that attempt to “work around” (or perhaps more accurately circumvent) law, they are inherently fragile.

2. The investors’ ownership rights are in the assets of the offshore company – those are solely the contracts and agreements with the PRC company—not in the assets of the PRC company. That is, the investors have no direct claim against the assets of the PRC company.

3. To enforce their constructive (or more accurately imaginary) ownership rights in the PRC company, the investors have to enforce the underlying contracts against the assets of the PRC company.

4. That legal action has to take place in the courts and under the laws of the jurisdiction where the PRC company holds assets. In both cases that is in the PRC.

5. “Small” problem with that. Under PRC law, foreign ownership of PRC companies is illegal.

6. Therefore, mechanisms that attempt to “get around” PRC law—the VIE and the various contracts and agreements that purport to give the rights of ownership-- are illegal.

7. And, thus, are not enforceable in the PRC.

This legal situation is analogous to the Peking University Founders Group offshore bonds debacle, chronicled here for Part 1 and here for Part 2

While for some time, the PRC authorities have turned a “blind” eye to the use of VIEs, that does not change the fact that these structures are illegal.

Whenever the authorities choose, they can enforce the law.

This month the PRC turned its “good” eye toward education companies. They will no longer be able to use VIEs.

That lead to a substantial drop in PRC “equities” listed on non Chinese markets.

As well as much angst among investors, some of them charter members of the “big boys” club that frankly should have known better.

The 31 July FT article Equities Watchdogs Bite. Investors Rethink China Stocks Strategy After Regulatory Shock (Harriet Agnew, Tabby Kinder and Hudson Lockett) contains a rather chilling quote.

“The VIE structure, which allows global investors to get around controls on foreign ownership in some Chinese sectors, has never been legally recognised in China, despite underpinning about $2tn of investments in companies like Alibaba and Pinduoduo on US markets.” 

First, you will note that there are some US$ 2 trillion in stock investments on US markets that use the VIE structure.

Second, that suggests that the FT journalists’ reference to a “rethink” is wrong because clearly there was no “thinking” at the time of investment.

Rather it was “faith-based” investment.

To be fair, some of this amount is via passive investing by funds seeking to track various global indexes that include these companies.

I’ve always thought it was a good idea for an index to only include investable stocks.

What is distressing about all of this is the simple fact that neither the FT article nor this post constitute an “overdue wake-up call” nor a “sobering fact”.

There have been many warnings about VIEs.

Here are just two:

• 2012 King and Wood Mallesons – A PRC/Australian law firm which described the structure as a “Sword of Damocles over their [foreign investors’] heads”.

• 2017 Council of Institutional Investors – a “buyer beware” alert.

If you look within these two articles, you will see further warnings in the form of prior actions taken by PRC authorities against VIE structures as well as some rogue activities, e.g., T2CN and GigaMedia. Or perhaps (?) more benign – Alipay and Alibaba.

All of these “wake-up calls” and “sobering facts” were clearly ignored.

• Over a prolonged period.

• To the tune of US $2 trillion.

Remind me again about the efficient market theory.

Don’t forget to also mention the role of the “sophisticated” investor in the markets.

I do really love a good laugh