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.

The Absolute Wrong Way to Stop Ransomware and Hacking

 

Just when I thought the idiocy on this topic had reached its pinnacle, I was proven wrong yet again.

See today’s FT “White House implores businesses to strengthen ransomware defence”

The word “implores” particularly set me off.

Then I thought a bit more and remembered—or at least I think I do—how this sort of decisive approach has been successful in the past.

Here are just two examples:

1. Following an appeal from the SEC a few years back, the incidence of financial fraud and market manipulation in the USA has dropped dramatically. As has insider trading.
2. After both my wife and I implored the little ones who live with us to eat healthy for their own good, we’re no longer asked for cookies or ice cream. Both grandmothers have reskilled and are now bringing vegetables when they visit.

While there has been no reaction yet, I’m confident that my letter to the President Biden and Senator McConnell is about to usher in an era of bipartisanship not seen since “peace guided the planets and love steered the stars”.

Naysayers out there might comment that business with few exceptions has been asleep at the switch so long now, that it’s almost certain that they don’t have a clue where the switch is. Or what it does. Or how to operate it.

Or that imploring the habitually somnolent and negligent to “take action”--particularly when the action involves spending money—has not proven to be particularly efficacious.

They’re wrong as demonstrated above.

Though I will admit that it seems strange to call the addressees on the memo business “leaders”.

One final note.

If you’ve been inspired by this blogpost and want to establish peace in the Middle East, on the Korean Peninsula, or in the Gulf, please feel free to direct your own memo imploring the parties to take action.

I won’t mind.

I had intended to do all those things myself.

But currently I am focused on learning Romulan to write the memo that will "fix” any dangers to our way of life from UFOs. I think we’re not far enough into the season that it would be the Borg.

Kumbaya!

Bonus Gratuitous Snark

Some further thoughts that occurred to me after I first posted the above.

Additional rather sad conclusions that have to be drawn from this episode.

First, the memo contains 5 recommendations for action that might charitably be described as the blindingly obvious.  Things equivalent to lock your doors, don't run with scissors.

Hardly, the sort of advice that captains of industry should need to receive for two reasons.

• The advice given isn't rocket or computer science.  Just common sense steps. 
• The warning should not be necessary, they should know this already.

If they missed either or both of these points, it's pretty clear that they need to step aside for those with the aptitude and attitude required to do the job.

The memo is a damning assessment of the calibre of our business tycoons. 

Though to be fair that assessment is supported by successful ransomware attacks on companies who did not lock their doors, etc. and the woeful lack of preparation at other firms as noted in my earlier post.

Second, but it's not just the captains of industry who are in for criticism.  

What does it say about the US Government? 

As my mentor used to say "you can tell you're in a third world country, when problems are addressed through rhetoric rather than concrete action".  

CryptoCurrencies – The Manifest Absurdity of the Stablecoin

 

Just the other day, there was an article in the FT about "stablecoins" describing them as a "link" between traditional curriencies and cryptocurrencies.

There is quite a lot of manifest absurdity in the world these days, economics, politics, and matters financial.

To set the stage for today's exploration, a review of the "logic" for cryptocurrencies.

Proponents argue that:

1. Government-issued currencies are not "backed" by real assets. e.g., gold.

2. Governments can therefore issue as many "fiat" currency notes as they wish. Thus eroding value via inflation.

3. Electronic payments made with "fiat" currencies are subject to (a) surveillance and (b) seizure by pressumably intrusive and untrustworthy governments.

Cryptocurrencies are the "answer" because:

1. They are created by private sector entities and thus free from the "malign" behaviour of governments.

2. A key assumption (delusion) here is that private sector entities' honesty is beyond question.

3. While like fiat currencies cryptocurrencies are not backed by real assets, their value depends on and is obtained through the operation of the market.

4. A key assumtion (delusion) here is that the "market" never misvalues an asset either because of irrational exuberance, manipulation, market failure, etc.

5. Electronic payments made with cryptocurrencies are immune to (a) surveillance and (b) seizure by those presumably malign and untrustworthy governments.

6. A key assumption (delusion) is that movement via a trading platform from "fiat" currencies to "cryptocurrencies" and vice versa is not subject to (a) surveillance and (b) seizure by untrustworthy and malign governments.

7. Elliptic a blockchain/crypto security company claims to have traced Colonial Pipeline's ransom payment to a BTC wallet to which apparently other such payments were directed. And then payments out of that wallet.  Another delusion hits the wall.

So now to the "stablecoin"

1. Having trashed "fiat" currencies as unreliable and potential unstable, some stablecoins offer the investor the proposition of indirectly holding "fiat" currencies, e.g. tether.

2. In such cases, the stablecoin claims to hold one unit of fiat currency for each unit of cryptocurrency. So let's get that straight. It's backing its "currency" with the "real" asset of a "fiat" currency. But with the holder of the stablecoin assuming the risk of the intermediary between the Central Bank issuer of the fiat currency.  

3. Some stablecoins are tied to bitcoin or other sh*tccoins. Exactly how the underlying volatility of those "assets" is managed is no doubt a combination of "naive belief", "magic", and derivatives. The latter being the last (valuation) refuge of scoundrels and conmen.

4. Some stablecoins can in the words of Celsius pay interest 100X what one can earn in the bank market for fiat currencies. As of August 2020, capable of earning up to 16% per annum!

5. A key assumption (delusion) is that such returns make economic sense from investing in a non-productive asset. At least Tesla has a "real" business selling emission credits to third parties, even though that market appears to be shrinking!

So let's look a bit closer at the first class of stablecoins – those "tethered" to a fiat currency.

As background, here's a link to the settlement agreemen effective 18 February 2021 between the NY State Attorney General and iFINEX INC., BFXNA INC., BFXWW INC.,TETHER HOLDINGS LIMITED, TETHER OPERATIONS LIMITED, TETHER LIMITED, TETHER INTERNATIONAL LIMITED.

The pattern of behaviour recorded in the settlement agreement should demonstrate the fallacy of several of the assumptions (delusions) cited above.

It should also demonstrate the additional risk that such entities face in obtaining the services of creditworthy financial institutions.

When one is forced to deal in the “odd and out of the way corners” of financial markets, with undercapitalized institutions in less than ideal jurisdictions, including non banks, one’s business is subject to greater risks.

And those risks ultimately flow to the “wise” investors who have placed their funds with “one”.

Bitfinex is a cryptocurrency trading platform that allows its clients to trade between fiat and cryptocurrencies.

Tether is a stablecoin which claims to hold one US dollar in reserves for each “tether” issued.

It is by most accounts the “largest stablecoin in the cryptospace”!!!!

The companies are related parties.

Initially, Bitfinex and Tether worked through banks in Taiwan that had correspondent relationships with Wells Fargo Bank. In early 2017 WFB stopped processing transactions for Bitfinex and Tether.

In June 2017 Bitfinex opened an account with Noble Bank International Puerto Rico.

NBI was formed under Act 273 of Puerto Rico which provides for the creation of offshore financial entities. Such entities enjoy tax benefits and may not offer services to residents of Puerto Rico. They must have a minimum capital of US $5 million of which US $250 thousand must be paid in, and four employees.

Just the sort of financial “institution” one might think a good place to plunk down US $500 million of one’s “spare” change. Or more precisely one's customers' hard earned money.

Tether for its part kept its US dollar reserves at the Bank of Montreal but the account was in the name of its attorney.

Presumably, that was because BoM didn’t want to “entertain” an account from Tether.

Until September 2017, Tether (or more precisely its attorney) held some USD 61 million in that account. At that point some 442 million tethers (worth US $442 million) were in circulation. 

Even without a calculator you should be able to determine that the "collateral" coverage was less than 1 to 1.

During that time Bitfinex held US $382 million of Tether’s funds in its account.

After 15 September Tether opened an account at NBI and Bitfinex transferred the funds to Tether’s account.

Between 2018 and 2019, Bitfinex had problems finding an FI willing to handle its transactions.

So it turned to Crypto Capital in Panama to hold its funds.

By 2018 CC held some US $ 1 billion of Bitfinex's funds or more accurately its customers' funds.

No doubt it sounded like a great idea to plunk down US $1 billion in a non bank.

What could possibly go wrong?

Bitfinex's contact there was "Oz Yousef" or just "Oz".

I'd hasten to add that it's not clear from the settlement agreement whether Oz was a wizard or not.

Oz responded to Bitfinex's subsequent requests for its funds with a variety of excuses as to why the funds couldn't be moved.

Bitfinex nevertheless continued to direct new clients to remit funds to CC!

Apparently when you've got a guy like Oz handling your money, you can't let a few bumps in the road disturb the relationship.

During the summer of 2018, Bitfinex "borrowed" US $ 400 million from Tether.

Oz still was holdiing on to CC's money.

The two entities relationship with NBI was terminated and funds shifted to Deltec Bank Bahamas.

Bitfinex repaid Tether's initial US $400 million "loan" by redeeming an equal amount of Tethers.

Oz still wasn’t releasing Bitfinex’s funds.

2 November 2018 Tether remitted US $475 million from its account at Deltec Bank to Bitfinex’s account at Deltec bringing the total “loan” to some US $ 625 million.

In February 2019 Tether updated its website to state that “[e]very tether is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities (collectively, ‘reserves’).”

Tether did not announce that it had changed its disclosure, and indeed there were no media reports about the change until several weeks later on March 14, 2019.  

It also did not provide a breakdown of its "reserve" holdings which would have shown that the bulk of these were in the form of loans to Bitfinex.

Subsequently, Bitfinex and Tether agreed a “credit” agreement under which Bitfinex could “borrow” up to US 900 million of Tethers funds (the supposed reserves for Tether). This appears to be part of a “regularization” on an existing US $625 million existing loan.

As of the date of the settlement agreement, Oz still hadn’t released any of Bitfinex’s cash or as noted above more precisely Bitfinex’s customers’ cash.

Market Commentary: Manifest Absurdity

 

Greensill

Today’s FT reported on Lex Greensill’s testimony to Parliament’s “Treasury Committee” as follows:

He insisted that his company’s lending was supported by real assets, although he admitted that up to 20 per cent of the group’s lending last year was based on “future receivables”.

If you’re like me, you probably had to stifle a guffaw on the conflation of “future receivables” with “real assets”.

But if you think a bit more, perhaps in the current environment it’s not so far fetched.

Even sober financial analysts and commentators, including some at the FT, have identified crypto currencies as a new “investable asset class”.

In terms of “real assets” are future receivables any less real than Bitcoin, Dogecoin, or their like? 

I think not.

If that isn’t a sign of irrational exuberance, I’m not sure if there is any sign.

Fairness impels me--note the choice of that verb—to mention that today Jemima Kelly did opine in those very same salmon-colored pages that crypto currencies were a “joke” and shouldn’t be taken “seriously”.

Ark Innovation – Springs a Leak

The FT reported that Ark had lost one-third of its value since its February “high”.

I’d make the same comment I did regarding Tesla’s loss of value.

More accurately, the price is down by one-third.

Value is intrinsic. Price is a market phenomenon.

Also a shout out to Lex, for noting that:

Data from Morningstar illustrate the pitfalls. More than two-thirds of thematic funds outperformed the broad MSCI ACWI index in the year to end March. But go back five years and that drops to below a third. One-fifth of thematic funds did not even survive. Over a decade, just 4 per cent outperformed. As themes go, this one does not inspire much confidence.

Middle Eastern Democracy – Kurdistan Style

Today’s FT “Long Read”--as its actual length discloses it is apparently designed for those with ADD--discussed authoritarianism in Kurdistan.

Not only was I was surprised and deeply shocked to learn that Jeffersonian democracy was not flourishing in Kurdistan. 

But also that corruption was rampant indeed.

Who would ever have thought?

As pointed out in the article, much of the silence on these two topics has to do with geopolitical “considerations”.

So much for making the world safe for democracy or fighting corruption.

At least I suppose one can take comfort that no one has proposed Kuridstan for NATO membership. 

 At least not yet!

AA Providential Warning – US Way of Life and Future Under Attack -- End of Civilization As We Imagine It

Another Public Service from AA

Who monitors the news so you don’t have to?  And reports serious stories you need to know?  

AA of course.  

What follows is clearly a three tinfoil hat level threat. And that's why I'm using both digital and old media to sound the alarm tocsin. 

Despite the title, this post is not about TISVP, though there’s no reason that it wouldn’t be him in the background.  Or that it would be him in the background.  

As reported in The Guardian, Larry Fedora, head coach of the University of North Carolina football team, sounded the warning:  

“Our game is under attack,” Fedora said on Wednesday at the ACC’s preseason media day in Greensboro. “I fear that the game will get pushed so far to one extreme that you won’t recognize the game 10 years from now. And I do believe that if it gets to that point, that our country goes down, too.” 

Fedora illustrated the point by recalling a conversation he’d had several years ago with a three-star Army general who attributed the success of the US military to football.  

“I had a question for him: What is it that makes our country, our military, superior to every other military in the world?” Fedora said. 

“He was like: ‘That’s easy, we’re the only football-playing nation in the world. And most of our troops have played the game at some point in their life at some level and the lessons that they learned from that game makes us who we are.’”  

That's football, not soccer!  You can call you game "football" but you'll never have a military superior to ours as the picture below demonstrates.

The story may also explain the peculiar features of American “thinking” to those confused by what they see happening in the former colonies.

 

 Strong Virile Football Playing American General Comforts Weak Soccer Playing European Officer

The “Art” of the Deal – How to Have a Successful Negotiation Each and Every Time

Gradually It's Getting Clearer What All the Mirth Is About

Asian analysts seem to have reached consensus that the above picture definitely dates from July and not May of this year.  Debate still continues whether the date of the photo is 12 July, 16 July, or 17 July.  

Did you ever wonder how the dealmeisters are able to have a “fantastic” record of successful negotiations? 

Side comment:  “fantastic” in the previous sentence is used in the first two senses of this definition.  

AA has for some time. Just recently his eyes were opened when America’s #1 DealMeister successfully negotiated a comprehensive precedent-shattering agreement with the formerly bad leader of the formerly bad Democratic Peoples’ Republic of Korea.  

Uniformed critics and other purveyors of “fake news” criticized the agreement as lacking real detail and commitment.  With what appeared recently to be push back by the North Koreans, these critics were emboldened further stating that “Kim will never give up his nukes”.  

In a masterstroke that saved the deal and no doubt silenced critics, according to press reports, the US President announced to what was no doubt an appreciative and rapt audience:  

“We have no time limit. We have no speed limit,” Trump said at a meeting with members of Congress on Tuesday.” 

Appreciate the pure genius of this.  

Strike a deal that doesn’t contain specific required actions but merely states some platitudes.   Then have no deadline for implementation.   It’s hard to imagine even a serial breaker of previous deals, like the DPRK, walking away from a deal like this.  

Please no snide comments that a deal without specific performance or time frame isn’t a contract.  

You may be wondering why an ostensibly financial blog like SAM is commenting on a political agreement.  Well, the simple answer is that this principle could be applied to finance.  

Worried about Abraaj or some other duff borrower repaying a loan to you?  Buy their zero coupon perpetual bond.  You’ll sleep as sound as the folks in South Korea or Japan do these days after the NK nuclear threat was eliminated!

Dana Gas: Three Additional "Things" to Watch Plus "Bonus" Features

The Underwriting Phase is the Best Time for Scrutiny 

Given the company’s weak financial condition and the behavior of management, those with a financial interest in the firm—creditors and equity investors— need all the help they can get in monitoring DG’s performance.  

As always AA has your back.

In addition to keeping an eye on macro financial performance, here are a few relatively quick things that sukuk holders and equity investors can do to make sure they don’t miss problems organized around three topics:  

• Current performance
• Receivables collection
• Financial liabilities 

These aren’t the only indicators. 

They certainly are not replacements for looking at the financials carefully particularly aggregate cashflow, but can be helpful in identifying performance problems.  At times information in the consolidated income statement or statement of condition can be used to trigger a deeper look.  For example, declines in overall net revenue, a sudden large write-off of exploration costs, etc. should send you looking for more information.  You’d expect to find explanations in the various management reviews in annual and interim financial reports. These tools will hopefully help you look deeper.  If management omits to highlight a problem, these tools may help you discover incipient problems as well. 

Current Performance

DG operates in three separate locations.  Looking at aggregate performance obscures what’s happening on the individual level. That could be quite important if the level is a critical "bit" in the overall business.

DG does provide some information on individual operations in its “segment reporting” note (typically note 4).  Here you'll find total assets and liabilities.  Not enough to go on.

Starting in 2013 DG began providing more information on Pearl's balance sheet in the note Interest in Joint Operations (note 15 in 2016 and 13 in 2014) than in note 4.  One can create a rudimentary balance sheet from this information back to 2012.  That still leaves a significant information gap on the balance sheets of Egypt and the UAE.  

But there is another more important problem with DG's segment disclosure.

The Company does not disclose net income and net comprehensive income for the UAE, Egypt, and Iraq.  It only discloses net revenues and gross profit (net revenue – depreciation and operating expenses) with some additional limited disclosure about elements of the income statement.  Sadly this falls short of what would be ideally useful to users of its financial statements.

With this limited additional information, one can try to construct a rudimentary income statement. But more than some assembly is required. Unlike IKEA not all the parts are in the box, so it’s generally hard to determine whether these entities are profitable before allocation of expenses at the holding company (DG) level or the nature of at least two of the three main operating entities' balance sheets.  

In some cases where there is an extraordinary expense, e.g., a substantial write-off of exploration expenses, it’s a bit easier.  For example, in 2009 it’s pretty clear Egypt had a net loss.  As did Zora in 2016.  One doesn’t even need a calculator to see this.   

What’s a quick but not complete fix to this lack of information?  

Tracking the top line for an indication of ability to generate earnings and cashflow and looking at the disclosed expenses is the easiest.  It's also not a bad starting point. But this is an imperfect "fix".

Revenue declines or increases can reflect changes in prices or volumes.  One would expect prices to be largely out of DG’s control.  Volume declines could reflect operating or reserve problems. 

One can also scan the disclosed expenses for surprises.  These should be visible in the consolidated income statement but looking at the segment information note (note 4) will identify which of the three businesses took the "hit". 

Here’s a starting point for the investors out there who hold DG paper.   

DG Top Line Revenues Millions of USD
	UAE	Egypt	KRG	Total
2016	23	154	78	255
2015	4	125	142	271
2014	4	225	247	476
2013	5	225	230	460
2012	5	237	258	500
2011	5	290	226	521
2010	4	264	82	350
2009	4	192	42	238

 Source:  Note 4 DG Annual Reports

Trade Receivables (“TR”)

As discussed in earlier posts, collecting TR is key to repayment of the Sukuk and to eventual cash returns to shareholders. (AA is indulging in extremely optimistic fantasies today).  The TR are “whisker-growing” stale.  Cash conversion is glacially slow.  On a present value basis, the value of TR is being eroded when one considers the appropriate risk-adjusted discount rate. 

Those with a financial interest in DG’s financial performance should be watching trends in collection or further accumulation of the TR. 

Note to DG’s auditor: Transparent disclosure of just how past due the TR would be helpful. 

Provisions for Surplus Over Entitlements

But there’s something new to watch. 

That is the above mentioned provision which is money that DG owes the KRG.

Why is this important? 

AA suggests you read Note 28 in full, but here is a sentence that caught AA’s eye and summarizes the issue: 

“Furthermore, Pearl has a right under the terms of the Authorisation to offset this Surplus, when payable, against any other outstanding payments due from the KRG.” 

Given its current cashflow generation problems, it’s likely that if the TR are settled, the amounts owed to the KRG will be offset against the TR. The KRG may have a similar right to offset.  But we don't have confirmation of that.

AA would expect that those who depend on collection of the TR for their repayment or dividends would want to track whether this offset is growing and just how fast.  Is this liability threatening to seriously diminish their source of repayment?  

Side comment:  Though none is really needed in AA’s view, perhaps this is another compelling argument that sukuk holders should reject a five-year bullet structure and insist on amortization of the sukuk in the rescheduling negotiations.  As you will recall and if you don’t, AA will repeat his earlier advice.  Principal payment should be in the form of both scheduled repayments and a cash sweep structure to hoover up prepayments if there is excess cash. 

Bonus Indicators

In addition to the operational indicators mentioned above, some "bonus" tips. 

If you missed the reference in DG’s Annual Report 2016 CEO Review, there seems to be a problem of some sort at Zora.

“In the UAE, despite full year average production of 2,744 boepd, total production from the Zora Gas Field has declined throughout the year from production start-up in February.”

This may be a technically solvable problem or it may not. 

Those with a financial interest are likely to have an interest in knowing, though Zora is a rather small fish in DG’s operations.  It clearly is not showing a profit based on DG’s Annual Reports Note 4.

This information may also temper optimism about Zora as additional collateral until the cause of the decline is known. 

For Pearl there are other sources of information (more on that point in a post to come) in the financial reports of three of DG’s partners in the joint operations. 

Here are some examples from MOL Hungary’s 2016 annual report.

• MOL took provisions equal to its share of 2016 net income in Pearl Petroleum (note 6).
  

  “Given the current economic situation impacting the Group’s associate in the Kurdistan Region of Iraq a provision has been made in 2016 against the Group’s share of profit.”

• MOL also announced that it has changed its revenue recognition for sales in the KRG from an accrual to a cash basis.  That’s generally not a sign of robust credit standing of the buyers.  (AA’s first understatement of the post). And may be related to the 2016 provisioning against MOL's profit in Pearl.

Note 3:  “Having assessed the probability of receiving economic benefits from sales activities in Group’s operations in Kurdistan the management decided to recognise revenue on a cash basis on sales in Kurdistan Region of Iraq.”

• MOL has also taken some additional steps in the KRG which appear to reflect a serious concern about economic conditions.  You can easily find them by searching MOL’s 2016 annual report using the search term “Iraq”.  Pearl isn’t MOL’s only KRG asset so some of these steps relate to other companies. But the message seems pretty clear.  MOL is concerned about KRG ability to repay. 

AA Rant

If you read this blog on a semi-regular basis, you’re familiar—perhaps more than you’d like—with AA’s frequent complaints about "shortcomings" financial reporting. 

This rant is about the quality of DG’s segmental information. I’ve noted the deficiencies above. In short DG isn't providing enough information to understand it's underlying business.

Why isn’t DG providing more detailed information?

Others do.  The nearest I can find to an “explanation” is in DG’s 2016 annual report notes 2 and 4.  The below quotes basically repeat what they’ve said in previous years.

“Note 2: Operating segments are reported in a manner consistent with the internal reporting provided to the Chief Operating decision-maker.  The Chief Operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as the Chief Executive Officer who makes strategic decisions.”  

“Note 4:  Management has determined the operating segments based on the reports reviewed by the Chief Executive Officer (CEO) that are used to make strategic decisions. The CEO considers the business from a geographic perspective which is divided into three geographical units.  The Group’s financing and investments are managed on a Group basis and not allocated to segment.” 

This might be charitably described as manifest garbage.   

DG’s segments are independent companies that prepare their own financials.

What this means is that DG has this information.

Preparation of the segmental information would be a simple matter of reproducing summaries of the income statement and balance sheet.

AA wonders if the CEO really does not look at these reports or condensed versions of them to make decisions. How can he run the business and make investment decisions if he isn't tracking the profitability of major lines of business based on an allocation--imperfect as it is likely to be--of all expenses?  How does one track risks?

If indeed the CEO is not using a methodology similar to this, then perhaps DG needs a new CEO. 

AA also wonders DG’s auditor’s apparent acceptance of this explanation. Some uncharitable souls might say questions about auditor credulity have already been conclusively answered: the auditor has accepted DG’s decision to carry the Trade Receivables as “current assets”.

When important information is missing from financials or other statements by a firm's management, one should wonder why.  Is it that they don't have the information (which is a troubling question in its own right)?  Or that they don't want to release the information (an  even more troubling question)?  That leads to AA's golden rule of providing capital.  If the firm doesn't trust you with information, why should you trust them with your money?