The “Big Boys” Market – Ransomware Insurance

 

The Underwriter's New Suit

In the 3 June FT, Ian Smith had an article Cyber Premiums Jump in Face of Acute Threats.

Two quotes from the article and my reactions.

Surge in attacks prompts vigilant insurers to question clients closely about culture, attitude to security and training.

And 

Nor are insurers simply jacking up prices. They are also becoming more vigilant about controls at the companies to which they sell cover.

A big “shout out” for the use of “vigilant”.

The clear implication is that many, perhaps most, have been asleep at the switch.

If you’ve been following my “Big Boy” series of posts, you know I like to puncture the unwarranted myth of the imaginary “sophisticated” investor.

In that vein let’s reflect on Ian’s article using my own personal experience.

When I went to take out an insurance policy on Chez Arqala, my insurance company asked a raft of questions.

• About smoke detectors, their locations, and presence of fire extinguishers and other such equipment.

• I was also asked if we have a home security system, whether in addition to intrusion detection it also had a fire detection capability. Was it set to ring up the authorities? Who were the providers of the home security system?

• Did it have a back-up battery in case of power disruption?

• How far we were from the nearest fire station?

• Whether we stored any flammable or dangerous materials in the house.

• Other than the little people who live with Madame Arqala and me we were clean on that score.

No questions about culture, though. 

I guess he could tell just by looking at me. Or perhaps at Madame Arqala.

The decision to “write” the policy and the premium depended on our answers to those questions as well as our post code.

It boggles the mind that insurance companies writing cover multiples of that provided our house wouldn’t be asking similar questions for cyber cover.

And come to think of it, quite a lot more.

Apparently, they were not doing this.

Now to be fair, the general “take” on insurance underwriting standards is that only life insurance consistently makes a profit.

With other “lines” irrational exuberance and shoddy standards lead to highly cyclical swings in profits.

So much for the “big boys” of insurance. 

At least they are not an outlier among the "big boys"

Tether Reserves - Verify Then Trust

As Argued Below, Verification Should Come Before Trust

First post in this series here.

If you’re old enough or have access to the internet, you may recall a US politician who announced a major international agreement by quoting a Russian proverb “Trust, but Verify”.

If you think about it carefully, you might come to the contrary conclusion that one should verify first then trust.

Or as in the hadith relayed by al-Tirmidhi (2517) “ اعْقِلْهَا وَتَوَكَّلْ “ or “Tie your camel first and then trust in God”. 

The point of that hadith being that one has to take responsibility for one's affairs.

Wise words in all facets of life, including investments.

Even more so when the prior behaviour of the counterparty was less than would instill confidence.

As paragraphs 14-54 of the February 2021 settlement agreement between Tether et al and the NY State Attorney General revealed Tether had been less than candid in disclosing the fact the status of its reserves and that they were not always backed 1 to 1 with US dollars on deposit. 

In fact at times “reserves” were “held” in the form of loans to an affiliated company Bitfinex, whose own funds were frozen.

That’s not very comforting.

Nor is the fact that as per paragraph 57 of the settlement agreement, Tether was compelled to provide quarterly disclosure on its “reserves” for two years.

Shouldn’t a responsible fiduciary (and that’s the role that Tether assumed in issuing stablecoins) have been more (a) careful and (b) candid about the reserves?

That was as they say the “past”.

So how are Tether doing now?

Risk Disclosure

On Tether’s website here under the tab labeled “Risk Disclosure” you will find a set of risks outlined.

Missing is the fact that Tether’s reserves are subject to market risk. Why this isn’t mentioned is surprising. Well maybe not so surprising given their past behaviour.

Reserves Disclosure

Here is the link to Tether’s “disclosure” of its reserves as of 31 March 2021.

Some observations.

Some 75.85% of the “reserves” are grouped under the heading “cash & cash equivalents & other short term deposits & commercial paper”.

Now if we wanted to evaluate the reserves in terms of backing for tethers, we would want to know the amounts of each of these three components.

Why?

Because each of these three categories is likely to have differing liquidity.

Liquidity being the ability to sell a financial instrument quickly at face value or with a minimum deviation from face value. 

Why is liquidity important?  

Because if holders of tether want to exit and can't find buyers, if the reserves are insufficient, they won't get US$1 for each tether.  

Imagine a scenario in which a Techo-King or perhaps just a Techo-Prince tweets that CatCoin is the new investment meme of the day.

Also if the "market" thinks the reserves are inadequate, then the price of a tether should go below US$ 1. 

This could arise from liquidity or credit concerns about the "reserves".

Cash and cash equivalents are highly liquid, not subject to penalty or delay on withdrawal and typically maturities of three months from date of acquisition. Note that word – acquisition not date of the report.

This category would be likely to be realized at face value or very close.

You will note that roughly one-half of total reserves is in commercial paper (75.85% x 65.39%).

This amount is not included in “cash and cash equivalents” That means it does not have the characteristics described above.

As a consequence it is likely to be redeemed at less than face value prior to maturity.

The CP also bears the credit risk of the obligor/issuer on the CP.

And we have its amount.  It's almost 50% of reserves.

Some 18.36% is in “fiduciary” deposits. (Same calculation as above)

Since short-term deposits are listed as a separate category from cash and cash equivalents we can assume that some of the "fiduciary deposits" are not “cash and cash equivalents”. So less liquid.   

And likely to be redeemed for less than face value prior to maturity. That may reflect the penalty for early withdrawal on the deposit.  

But we don't know the amount that might be "cash equivalents".

You may derive “comfort” from seeing that these are “fiduciary” not “regular” deposits.

But all that means is that when placing the deposits, Tether acknowledged that it was acting on behalf of the owners of the deposits, presumably the owners of outstanding tether. 

However, these do not appear to be “trust” deposits, though we don’t know based on Tether’s incomplete disclosure.

Thus, the deposits are subject to the credit risk of the institution holding the deposits.  That is, they would be claims against the depository institution's estate in bankruptcy.

If they were trust assets, they would not.

And we don’t have any details on the depository institutions to get a sense of their credit risk. 

Are they IFIs in Puerto Rico, Oz Bank and Trust, Panama, or HSBC?

Some 4.96% in Treasury Bills and Reverse Repo Notes (same calculation as above).

We don’t know if all these qualify as cash equivalents, but since they are a relatively small amount, let’s ignore them.

Let’s also assume that all “fiduciary deposits” qualify as cash equivalents, though this is unlikely to be the case.

On that basis the CP (49.6%) and the other categories (secured loans, bonds commodities, and other) equal almost 74% of total reserves.

The stability of Tether therefore rests on what are very likely to be less liquid assets. And some of which, e.g., CP and secured loans may not be susceptible to early redemption.

Discounted sales of these instruments might be possible depending on the identity of the obligors/issuers. 

But a wise investor wouldn’t count on it.

Attestation Report

Moore Cayman an accounting firm issued an “attestation report” on Tether management’s “assertions” about the reserves (the CRR).

Two things to note about this report.

First, Tether has not issued a financial statement for Tether “stablecoins”. 

Rather what we have are their “assertions”.

Note that many fund managers do issue financial statements on their funds.

If you’re following my advice to “verify”, you may well wonder why Tether didn’t issue a financial statement or its equivalent.

Cost control? Or some other motive?

Second, an ISAE 3000 Revised Assurance Engagement is not an audit.

Here is an AICPA paper which asserts that the typical “assurance” engagement under ISAE 3000 (Revised) is less rigorous than that required under AICPA Standards. Though you’d expect “exceptional” folks to hold that they are “exceptional”.

It is less than an audit.

Given the problems with audits, that ought to send a chill up the spine of the sentient.

We don’t even have the imperfect work of an audit to hang our “investment hat” on.

Luckily for Tether, the sentient segment appears to be highly underrepresented in their “investor” base.

It is very important for investors to understand the nature of MC’s work and report, particularly in terms of the valuation of the “reserves” that “back up” outstanding Tether “coins”.

So what do we have from MC?

It is almost certainly less than a “review” of financial statements in both scope and rigour.

Why?

Because Tether hasn’t issued a financial statement. Rather it has made what MC describes as “assertions”. 

If you're like me, you might find the use of the term "assertions" to inspire less than confidence in their contents.

I didn’t see enough detail to find “comfort” in MC's report because I don’t know what standards and principles the “assertions” were based on and what work MC did as part of its engagement.

In describing its conclusion on the financial information in the CRR. MC states that it is “based on our investigation of the balances stated herein”.

That’s rather short on detail.

• Did MC rely on Tether’s accounting records for the values?

• Or on account statements from third parties holding the assets?

• Did it send balance confirmations to which those third parties responded?

• On the US$ 5.3 billion in secured loans, did it review documentation on the nature and value of collateral? Did it check Tether’s procedures for determining credit impairment and needed loan loss provisions?

I suspect that it did not go much beyond the first step – accounting records and internal controls. I also hope that I am wrong.

All that being said, in their report MC did express an “emphasis of matter”.

This is typical accountant-speak for relatively important matters that do not change the accountant’s opinion or in this case “attestation”, but are significant enough that the accountant feels the need to bring them t to the attention of interested parties.

In my view the following is the key point from that section. Italics are mine.

Management’s accounting policy is to value assets and liabilities at historic cost plus any accrued interest and less any expected credit losses, or otherwise the redemption value where applicable. The realisable value of these assets and liabilities could be materially different if any key custodian or counterparty incurs credit losses or substantial illiquidity.

First the use of historic cost. One sells assets at market price if they are not held to maturity. 

Changes in interest rates can affect the value of financial instruments which is why the "cash equivalent" definition has 3 month maturity limit.

Second credit and liquidity risk. Note the comment about “realisable value” being potentially "materially different" that than shown on the report.

MC is waving a redflag here.

In the next post I’ll offer some unsolicited advice on what should be done. 

( الفاضي يعمل قاضي.  )

Tether: How Stable Are This Stablecoin’s “Reserves” ?

If You're Buying "Stable"coins, You Should Be
Reasonably Certain the Reserves are "Stable"

The 3 June FT Lex Column had a call-out box on Tether “Stablecoins/bitcoin: unTethered to reality”.

Citing information published by Tether, Lex noted that only 2.94% of the value of outstanding Tethers is backed by pure cash.

The remainder is “backed” by a variety of instruments:

• commercial paper (49.6%),

• short term deposits (18.36%),

• Treasury Bills and reverse repo notes (4.96%)

• secured loans (12.55%),

• corporate bonds, funds, and precious metals (9.96%), and

• other investments (1.64%), which include “digital tokens”

No real disclosure on the other items, except that “secured” loans weren’t to affiliates.

The lack of disclosure is troubling as will be discussed in the next post.

Lex dryly noted that not all of Tether’s reserves were held in risk free assets.

Indeed!

That directly impacts stability.

If the reserves are subject to volatility, then so is the value of the “stablecoin”.

So much for the “stable” in “stablecoin”.

But there’s a bit more here to think about.

This is quite a diverse set of assets.

1. What is Tether’s overall investment objective and strategy? It sure doesn’t look like “preservation of capital”.

2. How does this collection of assets achieve the objective and strategy?

3. What are the required criteria for investments, e.g., asset class, industry, individual investor or counterparty characteristics (credit grade, etc), tenor, etc?

4. Is Tether’s management capable of designing, executing, monitoring, and adjusting the strategy and portfolio as needed? They are by all accounts either certified tech geniuses or perhaps self-certified tech geniuses. But are they really financial geniuses as well?

5. If not, is Tether using third parties? If so, how are these selected?

6. Who are they? Goldman Sachs or Oz at Crypto Capital in Panama? What additional risk do these third parties pose in addition to obligor and counterparty risks?

7. Given the “diversity” of assets in the reserves, it might also be worthwhile to ask if any of these were used to purchase Tether. That is, has a customer or have customers bought Tether with any of the “reserve” assets rather than with cash.

8. If you’ve read paragraph 38 of the settlement agreement with the NYS AG, you’ll notice that in October 2018 Bitfinex “repaid” US$ 400 million in loans from Tether via the “redemption of 400 million tethers”. That is, via a non cash transation. It doesn’t seem likely that these were clients’ Tethers, assuming no sketchy dealing by Bitfinex. So were they Bitfinex’s own Tethers? And, if so, how did it obtain them?

It the next post we’ll look a bit more into other issues surrounding the valuation of the reserves.