It's time to get rid of "crypto"

Call me a pedant, but I'm not a fan of the word "crypto". It may have been a serviceable category back in 2011 when there was only one type of crypto thingy – bitcoin. But it's ceased to be a meaningful term and, if anything, it causes a regression in understanding.

Source: Fidelity

Case in point is the above diagram from Fidelity, which suggests that clients should conservatively invest 40% of their wealth in "equity," 59% in "fixed income", and the other 1% in "crypto."

These categories are nonsensical because in many cases, crypto *is* equity. (And in other cases, crypto *is* fixed income.) Fidelity's buckets are not mutually exclusive.

For instance, take MKR tokens, which are inscribed on the Ethereum blockchain and are a top-100 asset listed on CoinGecko. MKR may sound like it deserves to fall in the crypto bucket, but hold on a sec. As a MKR holder, you enjoy a right to the earnings of MakerDAO, which is effectively an offshore bank. You enjoy buybacks, voting control, and a residual claim on assets after creditors in case of windup or bankruptcy. Guess what, folks. That's equity! Yep, buying MKR shares is economically equivalent to buying shares in Bank of America.

Likewise with Dai tokens, the payments instrument – aka stablecoin – that MakerDAO issues to customers on the Ethereum blockchain and the 25th largest asset on CoinGecko. Sounds like crypto, no? But along with being pegged to the U.S. dollar, Dai pays interest of 5%. That puts it firmly into the fixed income bucket, very much like an uninsured interest-yielding account at the Bank of America.

What exactly is crypto, then?

The word "crypto" describes a database technology, not an asset class. Various asset classes – equity, bonds, options, and savings accounts (or various combinations of these) – can be recorded and stored on crypto databases, much like how MKR shares are served up on Ethereum, one of the most popular crypto database. These crypto databases fall in the same bucket as an Azure SQL database or an Oracle databases, both of which record assets but neither of which belongs itself to an asset class.

So now you can see why Fidelity counseling its customers to invest 99% in equity + fixed income and 1% in crypto is absurd. It's a category mistake, like if Fidelity advised folks to hold 99% in equity + fixed income and 1% in assets stored on Oracle databases.  

Telling customers to invest 1% of their wealth in generic assets stored in Oracle databases isn't just a category mistake; it's downright reckless. All sorts of wild financial stuff appears on Oracle databases, including sports bets and zero day options. Conservative investors have no business touching these. As for crypto databases, they are particularly notorious for holding financial fluff like ponzis and digital chain letters (i.e. litecoin, dogecoin, floki inu and their various ancestors and cousins); none of which Fidelity should be hocking to serious customers.

Crypto doesn't refer to an asset class, it describes the database technology on which assets appear. Better yet, let's just get rid of the word altogether. It's beyond repair.

Comparative cross-border payments: Wise vs USDC

image via Guy J. Abel and Stuart Gietel-Basten

 A popular response to my recent tweet about remittance company Wise went like this: "but JP, stablecoins are better for remittances; they're instant and cheap!" In this post I want to talk about comparative remittance costs. The problem with most of the responses to my tweet is that they incorrectly compare the cost of making a plain-vanilla stablecoin transfer to a traditional cross-border payment.

Can't do that folks! That's an apples-to-oranges comparison.

A traditional remittance, say like those offered by banks or transfer companies such as Wise, is made up of a bundle of four services. By contrast, a stablecoin transfer (I'll use USDC as my example) offers just one service. To accurately compare USDC to a remittance platform like Wise, you've got to add back the three missing services, and their associated costs.

Here are the four bundled services that Wise offers when you make a cross-border transfer:

1) verification and on-ramping: first, a sender must pass a series of Wise checks so that they can use Wise's platform. Think of this as Wise justifying your money to regulators. Next, Wise pulls your funds from your bank and onto its platform.
2) the transfer itself: once your funds have arrived at Wise, a lattice of databases moves your funds across Wise's platform towards their final destination.
3) a foreign exchange conversion: along the way, Wise converts the sender's currency to the recipient's currency.
4) off-ramping: Wise takes the funds off its platform and deposits them to the recipient's bank account.

By contrast, USDC offers just one of these services; the transfer itself (#2). In order to be verified and onramp into USDC (#1), convert from U.S. dollars to local currency (#3), and offramp back into spendable fiat (#4), both the sender of USDC and the recipient will need to use a third-party, most likely a cryptocurrency exchange. Alas, crypto exchanges extract their pound of flesh.

As an example of how to do an apples-to-apples comparison, I recently looked into the economics of a USDC remittance to see if that option made sense for me. I often sell stuff in U.S. dollars and need to repatriate my funds and convert them into Canadian dollars to pay for living expenses.

Here's what my own personal USDC calculation looks like:

Say someone in the United States owes me US$2,000 for services rendered. As payment, they offer to transfer me 2,000 USDC. I provide them with an address at my crypto exchange, BitBuy, and they send the payment. 

Next, I'll have to do a foreign exchange swap on BitBuy, trading out of USDC and into Canadian dollars. Alas, BitBuy's USDC-to-Canadian dollars market isn't very liquid, and the best rate I could get when I checked yesterday was 1.3569 (compared to the institutional rate of 1.3598). The loss from a loose bid-ask spread is called slippage, and it represents an implicit but very real C$6 fee.

On top of that I'd have to pay a 2% trading fee to BitBuy, or C$54. (If I was a high-volume trader, the fee would be much lower, but I'm not.) Next, I have to move my Canadian dollars off the exchange and into my bank account. Alas, BitBuy charges a 1.5% withdrawal fee, so that adds another C$40.

All those fees works out to C$100. That's not cheap, basically eating up 3.7% of the entire transfer. My current remittance route, which uses a U.S. dollar bank wire and a uniquely Canadian kludge called Norbert's Gambit (buying a ETF with US dollars and selling it for Canadian dollars) is significantly cheaper.

Some Canadian crypto exchanges offer better rates. With NDAX, for instance, I'd be paying around $10 on USDC-to-Canadian dollar slippage, $5.60 on trading fees, and $5 to withdraw to my bank, for a total of $20.60. That's an improvement.

However, keep in mind that what I'm describing (i.e. using BitBuy or NDAX to convert USDC to Canadian dollars) represents just the second leg of the entire remittance route. I haven't even included the fees that my U.S. sender must incur to onboard into USDC, nor have I accounted for any on-chain fees. By contrast, Wise will do both legs of this transfer for just US$14. That's tough to beat.

Your own personal estimation for whether to go with a traditional remittance or stablecoins will differ from mine, of course, depending on how cheap your local cryptocurrency exchange is (as well as that of your counterparty), and the availability and price of options like Wise or Western Union. Just make sure you include all stablecoin-related fees so that you're not mistakenly comparing apples to oranges. Stablecoins don't work for me, but they might for you.

Where are the customers' rate increases?

U.S. banks are at it again. Inflation is at its highest level in decades. At the same time, interest rates on deposits at the Fed, Treasury bills, bonds and mortgages are rising rapidly to compensate. Yet banks are still in a holding pattern when it comes to the interest rates they pay to customers on savings accounts, certificates of deposit (CDs), and interest-checking accounts.

Here's the chart, which uses FDIC data from FRED. Note how customer deposit rates (in red) have hardly budged, despite the Fed beginning to raise rates last summer. This same sluggishness also occurred in 2015, the last time the Fed began to hike rates. Banks didn't boost savings accounts rates till two years later, in 2017!

 

Historically, rates on CDs seem a little more responsive. But they're still sluggish. The average 6-month CD still only yields a scrawny 0.09%, whereas the yield on a 6-month Treasury bill is now at 1.4%.

This stickiness wouldn't be such a big deal if banks were also slow to reduce interest rates on customers' accounts – win some, lose some, right? But take a look at what happened when the Fed began to cut rates in mid-2019. Banks didn't hold off. They immediately started to pass lower rates on to their customers, and only became more aggressive when COVID hit in March 2020.

So for bank depositors, it's all lose. U.S. banks are slow to increase rates on checking accounts, CDs, and savings accounts, but quick to reduce them. I wrote about this sad lack of symmetry back in 2020. Do go back and read it.

This observation isn't something that economists have ignored. In a paper entitled "Sticky Deposits", Federal Reserve economists John Driscoll & Ruth Judson found that rates are "downwards-flexible and upwards-sticky." This stickiness has consequences for regular Americans. If rate stickiness didn't exist, the authors estimate that U.S. depositors would have received as much as $100 billion more in interest per year!

Banks are slow to increase rates on savings accounts, but quick to reduce them

Chase Sunset & Vine, 2012. Painting by Alex Schaefer

There is a fundamental asymmetry to banking. Banks don't like to share higher interest rates with their customers who have checking and savings accounts. But they are quick to pass off lower interest rates to us.

This asymmetry is good for bank shareholders, but bad for customers.

To illustrate this asymmetry, I'll start by showing how banks modified interest rates on savings and checking accounts as the Federal Reserve, the U.S.'s central bank, went through a long period of hiking interest rates from 2015 to 2019.

The Federal Reserve's first rate increase (from 0.25% to 0.5%) was in December 2015. It increased rates once more in 2016 and three times in 2017. But the interest rate on the average U.S. savings account and interest checking account didn't start to rise till spring 2018, two and a half years after the Fed's first rate hike.

This irked me and I tweeted about it over a year ago:

Any day now, banks.

I understand why the rate that banks pay to savers is below the rate that the Fed pays banks (they need to cover costs). But I find it kind of shocking that banks don't match the pace of Fed rate increases. Shouldn't savings accounts by yielding ~1% by now? pic.twitter.com/ctK35xkvmc

— John Paul Koning (@jp_koning) May 17, 2019

If you're like me, you'd assume some sort of direct linkage between: 1) the interest rate that the Federal Reserve pays its customers (i.e. banks) and 2) the rate that these same banks pay their customers, you and me. Just like we have a checking account at a bank, banks maintain checking accounts at the Federal Reserve. They earn interest on balances held in those accounts. This rate is known as the Fed's interest rate on reserves, or IOR. As the Fed increases the interest rate that it pays on these checking accounts, the banks earn more from the Fed. But for some reason the banks are slow in passing these earnings on to the public.

Although the delay in pass-through irked me, I didn't take it too seriously, figuring it was due to some sort of institutional inertia. Banks are slow monolithic beasts. If they're slow to increase rates, at least they're slow to chop them, too, right? So on net, we customers aren't any worse off over the full economic cycle.
 
But if banks are slow to increase rates, is it indeed the case that they are also slow to reduce rates? Well, the results are in. The Fed began to cut rates in mid-2019, just around the time of my initial tweet. There were another few cuts in the latter half of 2019. Then COVID-19 hit in March, and the Fed rapidly ratcheted the rate it pay banks down from 1.6% to 0.1%. Banks went from earning around $38 billion in interest on their checking accounts at the Fed (in fiscal year 2018) to almost nothing.

If banks are generally lethargically about passing on rate changes to their customers, it should have taken them three or four years to reduce rates on savings and checking accounts back to where they had started. Nope. In just a month or two, the banks obliterated all the interest rate gains that customers with savings account had enjoyed since 2018:

Thanks for nothing, banks.

From 2016 to 2019, U.S. banks slowly passed on Fed rate increases to their customers. Look how fast they passed on Fed rate reductions in 2020! pic.twitter.com/jt8hHgvL7F

— John Paul Koning (@jp_koning) June 3, 2020

So no, banks aren't lethargic beasts that are universally slow to change interest rates enjoyed by savers. They seem to have a strategy of increasing rates slowly, and then reducing them rapidly. Assholes.

Note that the savings rate I am using is from the Federal Deposit Insurance Corporation's website. FDIC takes the simple average of rates paid by all insured depository institutions and branches for which data are available.

By the way, this data probably doesn't represent the experience of the minority of financial sticklers who make an effort to locate high-interest rate savings accounts at online-only banks. JP Morgan's Goldman Sachs's Marcus currently offers 1.03%, much higher than the 0.10% that the Fed pays to Goldman JP Morgan. Ally offers 1.10%. But the average savings account holder doesn't bank at these institutions. They stick to Bank of America or Wells Fargo, which both offer a measly 0.01%.

This asymmetry is not a new phenomenon. In "Sticky Deposits", Federal Reserve economists John Driscoll & Ruth Judson found that rates are "downwards-flexible and upwards-sticky."

More specifically, the authors used proprietary data from 1997 to 2007 to show that interest rates on bank accounts and other retail deposits adjust about twice as frequently during periods of falling Fed interest rates as they do in rising ones. They estimate that this sluggish pass-through from rising Fed rates to customer rates costs American consumers around $100 billion per year!

My favorite chart from Driscoll & Judson is below:

Source: Judson & Driscoll

At left, we see the number of weeks it takes for banks to decrease the rate on interest checking accounts in response to a cut in the Fed's interest rate. At right we see the converse, how long it takes increase rates in response to higher Fed rates. Decreases tend to happen quickly (the purple bars in the left chart congregate closer to zero weeks) whereas increases are slow (the purple bars in the right chart congregate close to 100 weeks).

More specifically, during Fed easing cycles, checking deposit rates are updated on average every 22 weeks, but during tightening cycles it takes an average of 50 weeks.

So what explains this asymmetry? A lack of competition perhaps? If I had to guess, I'd say low financial education and dearth of customer attention. Banks can afford to be assholes because most customers either don't understand what is happening, or don't notice.

If the banks are taking advantage of their customers' ignorance and inattention to the tune of $100 billion per year, should something be done?

One option would be to provide a government savings option that 'corrects' for this asymmetry. Like digital savings bonds. Or maybe a government prepaid debit card with a built-in savings account. These cards would offer an interest rate that is linked to the Federal Reserve's interest rate, but only available to those below a certain income ceiling.

Or what about setting statutory minimum interest rates on savings accounts? In Brazil, for instance, banks are obligated to link the rate they pay on savings accounts to the central bank's interest rate:

In the US, interest rates on savings accounts are minuscule. This would be illegal in Brazil, where banks must set rates using a formula linked to SELIC, the central bank's policy rate: https://t.co/3bupDm4L8f

SELIC is 6.5%. Savings accounts must yield 70% of that, or 4.55%. pic.twitter.com/EPkkbROQvY

— John Paul Koning (@jp_koning) May 17, 2019

Or maybe it starts with education. As part of its new financial literacy drive, Ontario will teach children how to identify Canadian coins and bills and compare their values in Grade 1, saving and spending from Grade 4, how to budget starting in Grade 5, and financial planning starting in Grade 6. If the result is a more savvy population, banks may face more pressure to pass on higher interest rates.

Or maybe nothing. In which case one hopes that over time the combination of better financial technology, branchless banking, and competition from Silicon Valley will eventually result in better pass-through and more symmetry in interest rates.

The best investment in the world

I've blogged about strange trades before. There's Kyle Bass's bet on 5-cent coins. The great Japanese gold trade of 1859. And the epic bull market in shares of the Swiss National Bank, Switzerland's central bank.

This post is about the best investment in the world. I won't leave you hanging. It's the U.S. "Series EE" savings bond.

The coronavirus pandemic has led to a huge collapse in U.S. interest rates. As of April 21, the 30-year U.S. government bond rate was at 1.17%, down from 2.33% at the beginning of the year. The 20-year rate was at 0.98%, down from 2.19%.

But there's one corner of the U.S. government debt market where a a juicy 3.5% interest rate is still to be had: grandpa's savings bond. Snap it up quick, because it may not last.

Savings bonds have been around since 1935, when Franklin D. Roosevelt came up with the idea of getting regular folks to help fund new Depression-era programs. Savings bonds have always had low face values; investors don't need much money to get started. Each savings bond is part of a series, and each series has different features. This post is about one of those, the EE series.

1935 advertisement for US Savings Bonds

On the face of it, the Series EE savings bond seems like an awful investment.

The government pays EE savings bond investors a paltry interest rate of 0.1% a year. Instead of getting interest payments in hand as you would a regular bond, the Series EE payments gets re-added to the bond every month. So no regular flows of income over time--you've got to wait years to get any return. (In bond-speak, it's a zero-coupon bond). To make matters even worse, the bond is non-marketable, meaning that it can't be resold. Once you own it, you're stuck with it.

But there's a odd feature that turns this bond from dud into stud. Here it is:

What this fine-print says is that the government guarantees that the Series EE will double in value in 20 years.

If you do the math, this works out to an incredible 3.5% yield. As I pointed out earlier, the regular 20-year government bond only yields 0.98%. So anyone who buys an EE savings bond is making over three times the market rate! It's not often you get a gift like this. Check out the chart below:

There are some catches. To earn this 3.5% return, you have to hold the thing for twenty years. No backing out! This sort of commitment isn't for everyone. Who might these terms appeal to? If you're 30 or 40 and planning to retire by holding a government bond ETF for 20 to 30 years anyways, you might want to switch into savings bonds. Or, if you're a grandparent or parent and want to gift a baby some funds for college, an EE savings bond is a great option. (They can earn interest tax-free for  education purposes.)

The other catch? The limit is $10,000 per year per social insurance number. So unlike most fancy arbitrage trades, this isn't meant for all of you fat cats out there. It's for regular Americans. Which is why I like it.

(I suppose a hedge fund manager could rig up system that evades these rules. This would involve gifting $10,000 to hundreds of straw men, using their identities to invest in savings bonds and harvest the 3.5% rate. But this seems like it might not be worth the cost.)

Hurry up. You have till April 30, 2020 to buy the current crop of  EE savings bonds. There's a chance that after April 30 the U.S. government will reduce the 3.5% interest rate on subsequent versions of the EE bond. The government would do so by replacing the guarantee to double the bond's value after 20-years with a 25-year, or 30-year, guarantee.

It's made this change to the doubling period before. Up until 2003, the government guaranteed that an EE bond would double in 17 years. But that year it changed the terms so that subsequent issues would require 20 years to double. (It doesn't make changes retroactively. So if you already own a bond, you needn't worry).

Given such a sweet deal, you'd think that EE savings bonds would be flying off the shelves. Not so. Below is a chart of showing the dollar value of EE bonds issued going back to 1999.

In March 2020, the U.S. government issued just $5.2 million in Series EE savings bonds. That's hardly anything! Back in 1998, it was issuing a cool half a billion dollars worth of EEs each month. (The big drop in 2011 is when the government stopped printing paper savings bonds. Conveniently, they could be bought at the post office. The government now only issues them in electronic format.)

The chart below shows the total quantity of EE savings bonds outstanding. Given the slow rate of issuance (and quick rate of redemption), the total quantity of EEs in existence clocks in at $80 billion and falling, far below its $130 billion peak.

The tiny trickle of new EE bonds being issued could be good news for today's investor. It might mean that an alteration to the crazy high interest rates (i.e. the 20-year doubling period)  is not on the government's radar screen. So if you buy $10,000 before April 30, you could be able to reload and get another $10,000 next year.

Why is no one interested in buying EE Savings bonds?

I'm only speculating here, but I feel that the population's general understanding of bonds is on the decline. Today's bond investor buys government bonds packaged up in the form of an exchange traded fund, or ETF. These are available on the stock market. Not so in the old days. People had to purchase bonds individually through their broker. And this process encouraged them to be somewhat attuned to the principals of a bond. Or they had to open an account at Treasury Direct, the government's investor portal, and make the purchase themselves. That's a very hands-on way to invest in bonds, and obliges people to learn about bond fundamentals. Or they could buy a paper savings bond at the post office, a route that has been closed.

Bond ETFs provide a relatively hands-off way to buy and sell government bonds. No need to understand how a bond actually works. And so today's investor has mostly forgotten what a savings bonds is. "It's that strange thing grandpa buys." Or "RobinHood doesn't offer it."

Compounding matters is the fact the the EE's magic 20-year doubling number (which is what gives it its kick) is buried under a miserable advertised interest rate of just 0.1%. You've got to be one of those folks who enjoys combing through the fine print to catch it.

So if you're already a committed government bond holder, consider making the switch to Series EE savings bonds, folks!

Bitcoin and the bubble theory of money

A few months ago Vijay Boyapati asked me to "steel-man" the bubble theory of money. The bubble theory of money, which can originally be found in a few old Moldbug posts, has been used by Vijay and others to explain the emergence of bitcoin and make predictions about its future.

So here is my attempt. I am using not only an article by Vijay as my source text, but also one by Koen Swinkels, a regular commenter on this blog. Both are interesting and smart posts, it's worth checking them out if you have the time.

Steel-manning the bubble theory of money and bitcoin

1. Unlike a stock or a bond, which is backed by productive assets, bitcoin cannot be valued using standard discounted cash flow analysis. And since it has no intrinsic uses, it can't be valued for its contribution to various manufacturing processes, nor for its consumption value. Rather, bitcoin is a bubble. Its price is driven by a speculative process whereby people buy bitcoins because they think that other people can be found who will pay an even higher price.

2. There is no reason why bitcoin must pop. At first, bitcoin will be bought by those on the fringe. As more people get in, the price of bitcoin will rise further. It will continue to be incredibly volatile along the way. But once bitcoin is widely held (and very valuable), the flow rate of incoming buyers will fall, and so will its volatility. At this point it has become a stable low-risk store of value. The eventual stabilization of bitcoin's price is a commonly held view among the bitcoin cognoscenti. For instance, bitcoin encyclopedia Andreas Antonopoulos has often said the same thing (i.e. "volatility really is an expression of size").

3. Once its price has stabilized, bitcoin can transition into being a widely used money, since people prefer stable money, not volatile money.

So having steel-manned the bubble theory of money as applied to bitcoin, where do I stand?

I agree with points 1 and 3. My beef is with the middle point.

Will a Keynesian beauty contest ever stabilize?

First off, let me point out that there are elements of the second argument that I agree with. Yes, bitcoin needn't pop, although my reasons for believing so are probably different from Koen and Vijay.  In the past, I used to think that a popping of the bitcoin bubble was inevitable. After all, as a faithful Warren Buffett disciple, I believed that the price of any asset eventually returns to its fundamental value, and bitcoin's is 0.

But the eternal popularity of zero-sum financial games, or gambles, has disabused me of this view. People are lured by the promise of winning big and changing their lives without having to do any work. Heck, even though a Las Vegas slot machine will take on average 8 cents from every $1 wager, people still flock to insert $1 bills into slots. And so they will play bitcoin too, which like a slot machine is also a zero-sum game.

But I digress. The key point I want to push back on is Vijay and Koen's assumption that bitcoin volatility will inevitably decline as it gets more mature. I'm going to accuse them of making a logical leap here.

If bitcoin is fundamentally a bubble, or—as Vijay describes it—if bitcoin's price is determined game-theoretically, then why would its price dynamics change if more people are playing? Almost a century ago, John Maynard Keynes described this sort of game as a beauty contest. Presented with a row of faces, a competitor has to choose the prettiest face as estimated by all other participants in the contest:

"...each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."

Whether 100 people are participating in Keynes's beauty contest, or 10,000, the nature of the game has not changed—it is still an nth degree mind-game with no single solution. Since the game's underlying nature remains constant as the number of participants grows, its pricing dynamics—in particular its volatility—should not be affected.

The stabilization of Amazon

We can think about this differently by using actual examples. I know of an asset that has become less volatile as it has gotten bigger: Amazon. See a chart below of its share price and volatility over time:

Why has Amazon stabilized, and will bitcoin do the same? When Amazon shares debuted back in 1997, earnings were non-existent. Jeff Bezos had little more than a hazy business plan. Since then the stock price has steadily moved higher while median volatility has declined. Amazon shareholders used to experience day-to-day price changes on the order of 2.5-4.5% in the early 2000s. By the early 2010s, this had fallen to 1-2% or so. Over the past several years, volatility has typically registered between 0.5-1%.

I'd argue that the stabilization of Amazon hasn't been driven by a larger market cap and/or growing trading volumes. Under the hood, something fundamental has changed. The company's business has matured and earnings have become much more stable and predictable. And so has its stock price, which is just a reflection of these fundamentals.

I've just told a reasonable story about why a particular asset has become less volatile over time. But it involves earnings and fundamentals, two things that bitcoin doesn't have. I'm not aware why a Keynesian beauty contest, which lacks these features, necessarily gets less volatile as more people join the guessing game.

Vijay and Koen draw an analogy between gold and bitcoin. Their claim is that if gold once transitioned from being a volatile collectible into a low-risk store of value, then so can bitcoin. But we really don't have a good dataset for the price of the yellow metal, so we really have no idea how its volatility changed over time. Going back to 1969—admittedly far too short a time-frame—gold has certainly increased in size (i.e. the total market value of above-ground gold has increased), but unlike Amazon there is no evidence of a general decline in price volatility:

I'd argue that in gold's case a lack of a correlation between size and volatility makes sense. A large portion of gold's daily price changes can be explained by speculators engaging in a Keynesian beauty contest, not changes in industrial demand or earnings (unlike Amazon shares, gold doesn't generate income). There's no good reason to expect that the volatility generated by gold speculators' beliefs should level off as participation in the "gold game" grows. Any game in which speculators base their bets on what they expect tomorrow's speculator to do, who in turn are guessing about potential bets made by next week's speculators, who in turn form expectations about the choices made by next month's players, is unlikely to converge to a stable answer for very long.

Will Proof of Weak Hands 3D tokens ever become money?

As a third example, let's take Proof of Weak Hands 3D (PoWH3D), an Ethereum dapp that I've blogged about a few times. PoWH3D is a self-proclaimed ponzi game. Basically, a player purchases game tokens, or P3D tokens, with ether. Each player's ether contribution goes into the pot, or the PoWH3D smart contract, less a 10% entrance fee which is distributed pro-rata to all existing P3D token holders. When a player wants to exit the game, their tokens are sold for an appropriate amount of ether held in the pot, less another 10% that is distributed to all remaining players.

So if a new player spends one ether (ETH) on some P3D tokens only to sell those tokens an instant later, they'll end up with just 0.81 ETH, the first 0.1 ETH having been paid to everyone else upon the new player's entrance, the other 0.09 being deducted upon their exit. Why would a new player take such a bad bet? Only if they believe that a sufficient number of latecomers will join the game such that they'll get enough entrance and exit income to compensate them for the 0.19 ETH they have already given up.

PoWH3D is a pure Keynesian beauty contest. A new entrant's expectations are a function of whether they believe latecomers will join, but latecomers' expectations are in turn a function of whether they believe yet another wave of even greater fools will pile in, etc, etc.

Applying Koen and Vijay's assumption that volatility decreases with adoption, then the return on P3D tokens should become less volatile as more people join. It might even transition into a stable investment, say like a blue chip utility stock. Who knows, it could even become a medium of exchange to rival the dollar. But surely Koen and Vijay don't want to walk out on a limb and argue that a pure ponzi game like PoWH3D will ever stabilize. Or that it might become a form of money. I think the most reasonable thing we can say about PoWH3D is that once a ponzi game, always a ponzi game. The volatility of its returns will not decline as the game grows, and that's because the game's fundamentals, its ponzi nature, doesn't vary with size. (If you are interested in PoWH3D, here are some great charts and stats).

At this point, it may be useful to map out a chart of bitcoin's 200-day median volatility. As in the case of Amazon and gold, I use the median rather than the average to screen for outliers:

new Bitcoin volatility chart from @jp_koning

based on the 200-day rolling median daily price change: pic.twitter.com/U3zfHPQsVd

— Tim Swanson (@ofnumbers) August 20, 2018

I haven't updated the chart for two months, but volatility has declined since then. Vijay and Koen will probably say that as of October 2018 bitcoin is less volatile than it was in 2011. That's certainly true. But eyeballing the chart, we certainly don't get the same clean relationship between size and volatility as we do with the Amazon chart.

Here's the biggest oddity. By December 2017 bitcoin had reached a market cap of $300 billion, its highest value to date. If Vijay and Koen are right, peak size should have corresponded with trough volatility. But this wasn't the case. In late 2017, bitcoin volatility was actually quite high. In fact, it exceeded levels set in late 2013, back when bitcoin was still a tiny $3 billion pup! The lesson here is that with bitcoin, bigger is just as likely to correspond with more volatility as it is with less volatility. More broadly, when it comes to Keynesian beauty contests there seems to be no fixed relationship between volatility and size. It's chaos all the way down.

This leads into Koen and Vijay's final point, that once bitcoin's price has stabilized, it can transition into a widely used money. I agree with the underlying premise that only stable instruments will become accepted by the public as media of exchange. But since I don't see any reason for bitcoin to stabilize, I don't see how it will make the leap from a speculative instrument to a popular means of paying people.

Bitcoin isn't on the verge of going mainstream. It's already there.

Vijay's message (Koen's not so much) can be taken as investment advice. Because if he is right, and bitcoin has yet to progress to a popular store of value and finally a medium of exchange, then we are still in the first innings of bitcoin's development. Vijay points to what he thinks are the features that will make bitcoin win out against other popular stable assets, including portability, verifiability, and divisibility.  Given that only the “early majority” has adopted bitcoin (the late majority and laggards still being far behind), Vijay thinks it would be reasonable for the price of bitcoin to hit $20,000 to $50,000 on its next cycle, and hints at an eventual price of $380,000, the same market value of all gold ever mined. So buying bitcoin now at $6,000 could provide incredible returns.

I have different views. Whereas Vijay thinks bitcoin has yet to go mainstream, I think that bitcoin went mainstream a long time ago, probably by late 2013. Bitcoin is often portrayed (wrongly) as a payments system-in-the-waiting, and thus gets unfairly compared to Visa and other successful payments systems. Given this setup, cryptocurrencies seems to be perpetually on the cusp of breaking out as a mainstream payments option. But bitcoin's true role has already emerged. Bitcoin is a successful decentralized gambling machine, an incredibly fun censorship-resistant Keynesian beauty contest.

Viewed this way, bitcoin's main competitors were never the credit card networks, Citigroup, Western Union, or Federal Reserve banknotes, but online gambling sites like Poker Stars, sports betting venues like Betfair, bricks & mortar casinos in Vegas, and lotteries like Powerball. By late 2013, bitcoin was at least as popular as some of the most popular casino games, say baccarat or roulette. It had hit the big leagues.

Whereas Vijay hints at a much higher price, where do I see the price of bitcoin going? I haven't a clue. But if I had to give some advice to readers, I suppose it would be this. Like poker or slots, remember that bitcoin is a zero-sum financial game (For more, see my Breaker article here). You wouldn't bet a large part of your wealth in a slot machine, would you? You probably shouldn't bet too much with bitcoin either. Vijay could be right about bitcoin hitting $380,000. It could hit $3.80 too. But if it does go to the moon, it will do so for the same reason that a slot machine pays off big.

It's worth keeping in mind that when it comes to gambling, the house always wins. Searching around for the lowest gambling fees probably makes sense. As I said earlier, Las Vegas slots will extract as much as 8 cents per dollar. Lotteries are even worse.

In bitcoin's case, the "house" is made up of the collection of miners that maintain the bitcoin system. All bitcoin owners must collectively pay these miners 12.5 bitcoins every 10 minutes to keep things up and running. So if you hold one bitcoin and its market value is $6000, you will be paying around 62 cents per day in fees, or $230 per year. That works out to a yearly management expense ratio of 3.8%. Beware, this number doesn't include the commissions that the exchanges charge you for buying and selling.

So before you start gambling, consider first whether the benefits of decentralization are worth 3.8% per year. If not, find a centralized gambling alternative. If the costs of decentralization are worth it, then buy some bitcoin, and good luck! But play responsibly, please.

Norbert's gambit

I executed one of the oddest financial transactions of my life earlier this week. I did Norbert's Gambit.

These days a big chunk of my income is in U.S. dollars. But since I live in Quebec, my expenses are all in Canadian dollars. To pay my bills, I need to convert this flow of U.S. dollars accumulating in my account to Canadian dollars.

Outsiders may not realize how dollarized Canada is. Many of us Canadians maintain U.S. dollar bank accounts or carry around U.S. dollar credit cards. There are special ATMs that dispense greenbacks. Canadian firms will often quote prices in U.S. dollars or keep their accounting books in it. I suppose this is one of the day-to-day quirks of living next to the world's reigning monetary superpower: one must have some degree of fluency with their money.

Anyways, the first time I swapped my U.S. dollar income for loonies I did it at my bank. Big mistake. Later, when I reconciled the exchange rate that the bank teller had given me with the actual market rate, I realized that she had charged me the standard, but massive, 3-4% fee. In an age where the equivalent fee on a retail financial transaction like buying stocks amounts to a minuscule $20, maybe 0.3%, a 3-4% fee is just astounding. But Canadian banks are an oligopoly, so no surprise that they can successfully fleece their customers.

So this time I did some research on how to pull off Norbert's gambit, one of the most popular work-a rounds for Canadians who need to buy or sell U.S. dollars. From a moneyness perspective, Norbert's gambit is a fascinating transaction because it shows how instruments that we don't traditionally conceive as money can be recruited to that cause. The gambit involves using securities listed on the stock market as a bridging asset, or a medium of exchange. More specifically, since the direct circuit (M-M) between U.S. money and Canadian money is so fraught with fees, a new medium--a stock--is introduced into the circuit (like so: M-S-M) to reduce the financial damage.

To execute Norbert's gambit, you need to move your U.S. dollars into your discount brokerage account and buy the American-listed shares of a company that also happens to be listed in Canada. For instance, Royal Bank is listed on both the Toronto Stock Exchange and the New York Stock Exchange. After you've bought Royal Bank's New York-listed shares, have your broker immediately transfer those shares over to the Canadian side of your account and sell them in Toronto for Canadian dollars. Voila, you've used Royal Bank shares as a bridging medium between U.S. dollar balances and Canadian ones.

These days, Norbert's gambit no longer requires a New York leg. Because the Toronto Stock Exchange conveniently lists a wide variety of U.S dollar-denominated securities, one can execute the gambit while staying entirely within the Canadian market. In my case, I used a fairly liquid Toronto-listed ETF as my temporary medium of exchange, the Horizon's U.S. dollar ETF, or DLR. I bought the ETF units with my excess U.S. dollars and sold them the very next moment for Canadian dollars.

Below I compare how much Norbert's gambit saved me relative to using my bank:

Using the ETF as a bridging asset, I converted US$5005 into C$6465, paid $19.90 in commissions, for a net inflow of $6,445.10 Canadian dollars into my account. Had I used my bank, I would have ended up with just $6265, a full $180 less than Norbert's gambit. That's a big chunk of change!

What is occurring under the hood? Norbert's gambit is providing a retail customer like myself with the same exchange rate that large institutions and corporations typically get i.e. the wholesale rate. Because there is a market for the DLR ETF in both U.S. dollar and Canadian dollar terms, an implicit exchange rate between the two currencies has been established. Call it the "Norbert rate". Large traders with access to wholesale foreign exchange rates set the Norbert rate by buying and selling the DLR ETF on both the U.S. and Canadian dollar side. If any deviation between the Norbert rate and the wholesale exchange rate emerges, they will arbitrage it away. Small fish like myself are thus able to swim with the big fish and avoid the awful retail exchange rate offered by Canadian banks.

This workaround is called Norbert's gambit after Norbert Schlenker, a B.C-based investment advisor who it to help his clients cut costs. Says Schlenker in a Globe & Mail profile:

"In 1986 I moved down to the States, and while I was there I needed to be able to change funds from U.S. dollars to Canadian and vice-versa, and I had a brokerage account in Canada. It came to me that I could use interlisted stocks to do this."

Thanks, Norbert!

But using stock as money isn't just a strange Canadianism. Back in 2014, I wrote about other instances of stocks serving as a useful medium-of-exchange. During the hyperinflation, Zimbabweans used the interlisted shares of Old Mutual to evade exchange controls, lifting them from the Zimbabwe Stock Exchange to London. Earlier, Argentineans used stocks (specifically American Depository Receipts) in 2001 to dodge the "corralito". But I never imagined I'd use this technique myself to skirt around Canada's banking oligopoly!

ETFs as money?

Blair Ferguson. Source: Bank of Canada

Passive investing is eating Wall Street. According to 2015 Morningstar data, while actively managed mutual funds charge clients 1.08% of each dollar invested per year, passively managed funds levy just a third of that, 0.37%. As the public continues to rebalance out of mutual funds and into index ETFs, Wall Street firms simply won't be able to generate sufficient revenues to support the same number of analysts, salespeople, lawyers, journalists, and other assorted hangers-on. It could be a bloodbath.

Here is the very readable Eric Balchunas on the topic:

Because when an inv switches from active to passive, it basically means a 70% drop in revenue for industry. #DOLrule https://t.co/HntHyDi3rJ

— Eric Balchunas (@EricBalchunas) April 7, 2016

Any firm that faces declining profits due to narrowing margins can restore a degree of profitability by driving more business through its platform. In the case of Wall Street, that means arm-twisting investors into holding even more investment products. If Gordon Gecko can get Joe to hold $3000 worth of low margin ETFs then he'll be able to make just as much off Joe as he did when Joe held just $1000 in high margin mutual funds.

How to get Joe to hold more investments? One way would be to increase demand for ETFs by making them more money-like. Imagine it was possible to pay for a $2.00 coffee with $2.00 worth of SPDR S&P 500 ETF units. Say that this payment could occur instantaneously, just like a credit card transaction, and at very low cost. The coffee shop could either keep the ETF units as an investment, pass the units off as small change to the next customer, use them to buy coffee beans from a supplier, or exchange them for a less risky asset.

In this scenario, ETF units would look similar to shares of a money market mutual fund (MMMF). An MMMF invests client money in corporate and government debt instruments and provides clients with debit and cheque payments services. When someone pays using an MMMF cheque or debit card, actual MMMF shares are not being exchanged. Rather, the shares are first liquidated and then the payment is routed through the regular payments system.

Rather than copying MMMFs and integrating ETFs into the existing payment system, one idea would be to embed an ETF in a blockchain, a distributed digital ledger. Each ETF unit would be divisible into thousandths and capable of being transferred to anyone with the appropriate wallet in just a few moments. One interesting model is BitShares, provider of the world's first distributed fully-backed tracking funds (bitUSD tracks the U.S. dollar, bitGold tracks gold, BitCNY the yuan, and more). I wrote about bitUSD here. Efforts to put conventional securities on permissioned blockchains for the purpose of clearing and settlement are also a step in this direction.

Were ETFs were to become a decent medium of exchange, people like Joe would be willing to skimp on competing liquid instruments like cash and bank deposits and hold more ETFs. If so, investment managers would be invading the turf of bankers who have, until now, succeeded in monopolizing the business of converting illiquid assets into money (apart from money market mutual fund managers, who have tried but are flagging).

Taken to the extreme, the complete displacement of deposits as money by ETFs would get us to something called narrow banking. Right now, bankers lend new deposits into existence. Should ETFs become the only means of payment, there would be no demand for deposits and bankers would have to raise money in the form of ETFs prior to making a loan. Bank runs would no longer exist. Unlike deposits, which provide fixed convertibility, ETF prices float, thus accommodating sudden drops in demand. In other words, an ETF manager will always have just enough assets to back each ETF unit.

Two problems might emerge. Money is very much like an insurance policy—we want to know that it will be there when we run into problems. While stocks and bonds are attractive relative to cash and deposits because they provide superior returns over the long term, in the short term they are volatile and thus do not make for trustworthy money. If we need to patch a leaky roof, and the market just crashed, we may not have ETF units enough on hand. Cash, however, is usually an economy's most stable asset. So while liquid ETFs might reduce the demand for deposits, its hard to imagine them displacing traditional banking products entirely.

A fungibility problem would also arise. Bank deposits are homogeneous. Because all banks accept each others deposits at par and these deposits are all backed by government deposit insurance, we can be sure that one deposit is as good as another. And that homogeneity, or fungibility, means that deposits are a great way to do business. ETFs, on the other hand, are heterogeneous. They trade at different prices and follow different indexes. Shopkeepers will have to pause and evaluate each ETF unit that customers offer them. And that slows down monetary exchange—not a good thing.

Somewhat mitigating ETF's fungibility problem is the fact that the biggest ETFs track the same indexes. On the equity side, three of the six largest ETFs track the S&P 500 while on the bond side, the two largest ETFs track the Barclays Capital U.S. Aggregate Bond Index. Rather than just any ETF becoming generally accepted media of exchange, the market might select those that track the two or three most popular indexes.

In writing this post, I risk being accused of blockchain magical thinking—distributed ledgers haven't yet proven themselves in the real world. All sorts of traditions and laws would have to be upended to bring the world of securities onto a distributed ledger. Nevertheless, it'll be interesting to see how the fund management industry manages to squirm out of what will only become an increasingly tighter spot. Making ETFs more liquid is an option, though surely not the only one.

---

PS. Here is the blogosphere's own Tyler Cowen (along with Randall Kroszner) on "mutual fund banking" in 1990:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

With the rise of ETFs and blockchain technology, the modern version of mutual fund banking would be something like distributed ETF banking described in the above post,

Finance's Battle of the Somme

When I think of senseless waste, I think of the Battle of the Somme. Whole generations lost in
order to move a trench line forward by a metre or two. Zoom forward in time to the modern finance industry which, for many decades, has been marshaling starry-eyed recruits in search of excess returns. I worry that all their effort has been wasted because, like the Somme's trenches, the integrity of prices can't be advanced any further once large amounts of effort are already being expended in beating the market.

Fund managers who want to beat the market must find unique information in order to get a leg up on their competitors. But the supply of such information is limited so that at some point, prices include pretty much everything there is to know about a company. Any additional effort to hunt down information is wasteful from a society-wide perspective.

The recent-ish phenomena of indexing gives us a feel for how far beyond the 'waste point' we've gone. Rather than trying to beat the market, indexers randomly throw darts at stocks in order to harvest the average market return. Throwing darts is far cheaper than hiring Harvard grads to hunt down information. An indexer is betting that information has already had most of its value wrung out of it, so any effort to search for more doesn't justify the cost.

Say that the finance industry had only progressed a step beyond the waste point. If so, then as investors begin to adopt indexing, the bits of information they stop analyzing become unique again. The marginal return to hunting for information will rise above zero and those engaged in the activity should perform better. The popularity of indexing would quickly stall as money moves back into the beat-the-market game, pushing the value of information back to down to nil. We'd expect the size of the information hunting and indexing ecosystems to stay steady over time as shifts in the marginal value of information are quickly ironed out by movement from one group to the other.

The numbers show the opposite. Index investing has been growing for three decades and shows no sign of slowing. Managed funds have been shrinking since the mid-2000s. And rather than benefiting from the unparsed information that these indexers have left on the table, fund managers continue to lag the average market return. This suggests that we went FAR beyond the 'waste point.' After all, if the brain power that indexing is releasing from the information hunting process has not made information hunting more profitable, then there was way too many people engaged in the activity to begin with.

If markets are supposed to efficiently allocate resources, why did we go so far past the waste point? I suppose we can chalk it up to a combination of greed, hubris, cynicism, and naivete. Whatever the reason, the long trek beyond the waste point has been the financial equivalent of the Somme. For decades, all those investors who thought they could beat the market would have been better off allocating their resources elsewhere. And generations of young Wall Street whizzes could have been making useful things for the rest of us rather than engaging in the equivalent of converting a scorched desert into a scorched desert.

The good news is that the rise of indexed investing is steadily undoing this misallocation. Fund managers, traders, analysts, and advisers are currently being let go so that they can move into different sectors of finance or entirely different industries, a trend that could continue given the fact that non-indexers continue to underperform the market. And this will proceed down the line to financial journalists, financial economists, and all other workers who provide support to the information hunters. These people are alert, ambitious, mobile, and intelligent so the real world should become a more productive place.

---

As I was writing this, I thought of this post from David Glasner.

Slow money

Would it make sense for firms to try to slow down their equity structure?

Equity markets are made of two classes of participants. The minority consists of long-term investors who, like Ulysses, have 'tied themselves to the mast' and would rather fix things when a company runs into problems than sell out. The majority is made of up rootless speculators and nihilistic indexers who cut and run the moment the necessity arises.

Because their holding period is forever, the long-term investor class does all the hard work of monitoring a company and agitating for change. Keeping management honest is the only recourse they have to protecting their wealth. Speculators and indexers are free loaders, enjoying the same upside as investors without having to contribute to any of the costs of stewardship.

How might long-term investors be compensated for the extra expenses they incur in tending the garden?

One method would be for a firm's management to institute a slow/fast share structure. The equity world is currently dominated by the fast stuff, shares that can be bought and sold in a few milliseconds. A slow share is a regular share that, after having been acquired, must be "deposited" for, say, two years. During the lock down period the shareholder enjoys the same cash dividends as a fast share but they cannot sell. Only when the term is up can the slow share be converted back into a fast share and be got rid of. The illiquidity of slow shares is counterbalanced by a carrot; management makes a promise that anyone who converts into slow shares gets to enjoy the benefit of an extra share down the road i.e. a stock dividend. So a shareholder with 100 fast shares who pledges to lock them in for two years will end up with 101 fast shares once the lock-up period is over.

The investor class, which until now has received no compensation for their hard work, will quickly choose to slow down all their shares and enjoy the biennial stock dividend. Feckless speculators and indexers, unwilling to stay tied down for two years, will keep their fast shares and forgo the dividend. After all, the S&P's constituents could change at any moment, so an ETF/index fund needs to be able to cut and run. And a speculator's trend of choice could reverse at any moment.

By the way, ETFs and index funds aren't the only asset type that I include in the fast money category. Also qualifying are the huge population of funds that claim to be "active" but are actually "closet" indexers, as well as all those funds that say they are engaging in 'investing' but are really just speculators. Given the possibility of sudden redemption requests, they need the flexibility that liquid fast shares provide.

As the slow/fast share structure goes mainstream, the benchmark to which market participants are compared, the S&P 500 Index, will evolve into two flavours, the Fast S&P 500 and the Slow S&P 500, the former including the fast shares of the 500 index members while the latter includes only the slow. The Slow S&P will, by definition, show better returns than the Fast S&P, since slow shares enjoy stock dividends at the expense of fast shares. Nihilistic indexers and rootless speculators will choose to benchmark themselves to the lagging Fast S&P. Active investors with a genuine long-term bias, most of whom will choose to own slow shares, will compare themselves to the better-performing Slow S&P.

Mass adoption of fast/slow share structure could change the complexion of the very combative active vs passive investing debate. Passive investors have typically outperformed active investors after fees, largely because they have been able to freeload off of the stewardship of long-term investors. With a new structure in place, buyers of passive indexed products would—by definition—begin to underperform the average long-term active investor. This is because the dual share structure obliges the passive class to compensate long-term investors for their efforts.

I suspect that the adoption of a fast/slow share structure would increase the size of the investor class. After all, with a long-term investing mentality now being rewarded, those on the margin between the investing class and the mass of speculators/indexers will elect to slow down their shares. Once they have lost the ability to cut & run, the only way to protect their wealth will be through constant surveillance of management and a more activist stance. This is a good thing since long-term shareholders are better stewards of capital than short-term ones. In general, share prices should rise.

On the other hand, as more shares are locked down, market liquidity will suffer. Will the increase in stock prices due to improved stewardship outweigh the drop in prices due to a much narrower liquidity premium? If I had to guess, I'd say yes. Which means that even feckless indexers and speculators should support the subsidization of long-term investors.

---

Addendum: This isn't a new idea. Read all about loyalty-driven securities here.
Disclaimer: I consider myself to be 50% speculator, 25% indexer, 25% investor. But I'm trying my best to boost the last category.

The social function of equity deposits

One more post on equity deposits.

My last post described a dirt cheap (and hypothetical) way for long-term investors to get exposure to equities. Briefly, an investor commits a certain amount of money to a one-year term deposit that promises an equity index-linked return. The manager of this equity deposit (ED) invests that money in an appropriate number of shares in the companies that make up the index, then lends these shares out to borrowers for one year at a fixed rate. At the end of the year the stocks on loan are recalled, sold, and the investor's deposit is repaid. The interest earned on stock loans is shared with the depositor, boosting their returns.

It's worth pointing out that ETFs already lend out shares, but unlike an ED they can only do so on an overnight basis. So an ETF can't harvest the extra term premium on long-term loans.

EDs have a broader social purpose than just saving a few bucks. Here's a quick list:

1. Equity deposits would reduce the dead weight loss currently being incurred by long-term investors.

The investing world currently discriminates against long-term investors by requiring them to invest in securities that are tailor-made for short-term traders. Stocks, ETFs, and mutual funds enjoy a permanent trading window--the ability to cash out of the stock market in a millisecond. Long-term investors who have precommitted to the stock market for ten or twenty years simply don't need this feature. Unfortunately, not only do they not have a choice (all securities have these windows), but they must pay the fees involved in the maintenance of said window. This is an an efficient allocation of resources, or what economists call a dead weight loss.

Equity deposits are tailor-made for the long-term investor. By removing the trading window, long-term investors no longer have to pay for a feature that caters to traders, thus lowering investors' costs and improving their returns. The world is made more efficient.

2. Borrowers of stock are missing a market. Equity deposits would fill this gap.

Anyone who wants to borrow dollars from a bank can do so overnight or on a long-term basis. It's not the same when it comes to other financial instruments. Anyone who wants to borrow stock can only do so overnight. An equity deposit provides the missing market.

The reason for this gap is that institutional owners of stock like ETFs and mutual funds face the possibility that they might be besieged at any moment by redemption requests. This means that they can only lend out stock on a short term basis to borrowers, usually overnight. Because owners of equity deposits have committed to a fixed holding period, the manager of an ED is free to lend underlying stock out on a long-term fixed rate basis. Borrowers should be willing to pay an ED manager a premium rate of interest for the certainty its fixed products provide.

Which leads into points 3, 4, and 5...

3. Equity deposits would improve market liquidity and reduce price volatility.

The job of a market maker is to facilitate trading in a security by maintaining tight spreads between the bid and ask price. Market makers need an inventory of securities to do their job, and they will often borrow to ensure that supply. Because most shares are lent out on an overnight basis, this source of liquidity is flighty. Stock can be recalled without warning and lending rates can get ratcheted up suddenly. A manager of an ED can offer market makers a guaranteed supply at a fixed price, thus reducing the uncertainty involved in market making. Hopefully this will help make for a thicker and tighter market.

4. Equity deposits would improve price discovery.

Arbitrageurs need to borrow stock to put on the short leg of their strategies. Because most equity loans can be recalled at any moment and lending rates can change daily, it can be difficult to know ahead of time the return of a certain strategy. Equity deposits provide a stable long-term supply of stock for arbitrageurs at a fixed lending rate, thus helping to ensure that the arbitrage process keeps prices in line.

5. Equity deposits provide a useful risk management tool.

Hedgers may need to borrow stock and sell it to hedge some other position they hold, thus offsetting risk. Long-term fixed interest rate loans may offer the hedger more peace of mind than a series of overnight loans that might be reset at higher interest rates without warning.

In closing, ETFs and index mutual funds have become more than just vehicles for retail investors to get passive market exposure. They have also become intermediaries between overnight lenders and borrowers of stock, even if most retail investors in ETFs do not actually realize that they have become lenders. An equity deposit mimics the passive market exposure provided by an ETF while extending the lending business from an overnight basis to what should be a more profitable long-term basis.

It is generally accepted that stock lending brings stability to the marketplace. But as we know from the financial crisis, overnight markets are run-prone. Long-term stock lending via an ED solves the run problem; it seems like an incremental way to create a more robust system.

Even cheaper than an ETF

John Bogle, father of passive investing

With fees as low as 0.10%, passively managed ETFs are one of the cheapest ways to get exposure to equities. Not bad, but here's a financial product that would be even cheaper for investors: an equity deposit. I figure that equity deposits would be so cost efficient that rather than charging a management fee, investors would be paid to own them.

To understand how equity deposits would work, I want to make an analogy to bank deposits. Think of an equity ETF as a chequing account and an equity deposit, or ED, as a term deposit. In the same way that chequing deposits can be offloaded on demand, an ETF can be sold whenever the owner wants, say on the New York Stock Exchange or NASDAQ. Equity deposits, like term deposits, would be locked in until their term was up up. Issued in 1-month, 3-month, 1-year, 3-year, and 5-year terms, EDs would replicate a popular equity index like the S&P 500.

Given that both ETFs and EDs track the same index, and both provide the same dividends, the sole difference between the ETF and the ED is their liquidity. A commitment by an investor to an ED is irrevocable (at least until the term is up) whereas an ETF allows one to change one's mind.  ETFs represent liquid equity exposure; EDs are illiquid equity exposure.

An investor might buy an ED rather than an ETF for the same reason that they might prefer term deposits to a chequing account; they are willing to sacrifice liquidity for a yield. For a trader with a holding period of a few minutes or hours, an ED would be an atrocious instrument. On the other end of the spectrum, long-term buy-and-hold investor would be perfect candidates for substitution from ETFs into EDs. Come hell or high water, investors following a buy and hold strategy have pre-committed themselves to owning equities till they retire. As such, they don't need the permanent liquidity window that ETFs provide. Now if that window were provided free of charge, then investors may as well buy ETFs. But liquidity doesn't come without a cost, as I'll show below. Which means that long-term investors who own ETFs are paying for a worthless feature.

Better for a buy and hold investor to slide a portion of the portfolio that has already been dedicated to ETFs into higher yielding 5-year EDs, rolling these over four or five times until they retire. In doing so, investors get a higher return while forfeiting liquidity, a property they put no value on anyways.

How is it that an ED can provide a higher return than an ETF? Here's how. Once investors' funds have been irrevocably deposited into a 5-year vehicle, the manager buys the stocks underlying the S&P 500. Next, the manager offers to lend this stock to various market participants, either short sellers looking to make a quick buck or market makers who want to replenish inventories. These loans, which are quite safe due to the fact that the borrower provides collateral, earn a recurring stream of interest income which the ED manager shares with the ED investor. This return should be high enough to more-than counterbalance management expenses such that on net, ED investors end up earning an extra 0.25% or so each year rather than paying 0.10-0.50%.

But wait a minute, why don't ETFs do the same thing? Why don't they lend stock and share the income with ETF investors? Actually, they already do. And in some cases, ETF managers are already providing investors with more in lending income than they are docking them to manage the ETF. See the screenshot below from an iShares quarterly report:

The iShares Russell 2000 ETF, which has a net asset value of around $25 billion, provided investors with $34.58 million in stock lending income in the six months ended September 30, 2015, well in excess of advisory fees of $27.85 million.

So yes, ETFs can and do earn stock lending income, but my claim is that an ED manager following an equivalent index would be able to earn even more from lending out stock. To understand why, we need to think about how stock lending works. Stock loans are usually callable, meaning that the lender, in this case the ETF, can ask for a return of lent stock whenever they want. Callability is terribly disadvantageous to the borrower, especially a short seller, as they may have to buy back and return  said stock when they least want to, say during a short squeeze. In order to protect themselves, a short seller will always prefer a non-callable stock loan, say for 1-year, then a callable one, and will be willing to pay a higher interest rate to enjoy that protection.

ETFs and mutual funds are not in the position to provide non-callable stock loans because ETF and mutual fund units can be redeemed on demand by investors. For instance, if performance lags a mutual fund manager may start to experience large redemption requests. To meet those demands, the manager needs the flexibility to recall lent stock and quickly sell it. As for ETFs, units can be redeemed when authorized participants submit them to the ETF manager in return for underlying stock. So an ETF manager is limited in their ability to lend out stock on a long term basis lest they are unable to fulfill requests from authorized participants. Because ETFs and mutual funds can only lend on a callable/short-term basis they must content themselves with a correspondingly low return on lent stock.

As one of the only actors in the equity ecosystem with a long-term pool of pre-committed stock-denominated capital, an ED manager is in the unique position of being able to make non-callable term stock loans. Put differently, redemption of EDs is distant and certain, so only an ED structure allows for the perfect matching of long term assets with long-term liabilities. This means EDs should enjoy superior stock lending revenues, more than offsetting the costs of running the ED.

Say that an ED can beat an ETF by around 0.5% a year thanks to its superior stock lending returns. That doesn't sound like much, but compounded over a long period of time it grows into a large chunk. For instance,  If you invest $2000 each year for 25 years in an ETF that earns 8%, you end up with $157,900. Place those funds in an ED that returns 8.5% and you end up with $170,700. That's a pretty big difference.

EDs don't exist. But if they did I'd probably sell a significant number of my ETFs and buy EDs. I could imagine putting 20% of my savings in a 5-year S&P 500 ED, for instance. What about you?

---

PS: Feel free to torture test this idea in the comments
PPS: It is very possible that this product already exists.
PPPS: The devil is in the legal details.

Related posts:

An ode to illiquid stocks for the retail investor 
A description of the moneyness market 
If your favorite holding period is forever 
Beyond Buffett: Liquidity-adjusted equity valuation 
Liquidity as static 
No eureka moment when it comes to measuring liquidity