Category: Original Thoughts

The Infamous Black Swan

the-black-swan

By Marcie D Terman – Communications Director
September 6, 2016
    London

No not the character in that painful ballet movie played by Natalie Portman, but the meme that drifts by just beyond our next trade. Everyone is convinced they can see her coming. But in actual fact, no one can.

Notice that almost all of the brokers offering mainstream stock trading into the bitcoin market support only a dozen or so markets. The reason for this is that they do not place trades into the market on behalf of their customers and charge a commission. Instead, to make a profit they make a bid / offer spread on the market being traded that is roughly around the live price in the market at that point in time. And that spread is much wider than the actual market.

For instance, I’m looking at the S&P future which you can trade on our platform. Right now it has a bid / offer spread of 25 ticks. That’s the live market. Having a peek at one of the bitcoin CFD brokers at the same time I can see a bid / offer spread was 80 ticks. First Global charges a fixed commission. They change their spread based on market volatility.

But if you bear with me for a moment I will point out something even more off putting at play.

Let’s say their trading customers have 5,000 shares of the S&P that are long and 10,000 shares of the S&P that are short. The 5000 longs and 5000 shorts cancel each other out. If the market goes up, the longs make the money the shorts lose. Well, what happens to the extra 5000 shorts? They’re losing money right? But there is no actual trade in the live market, so when the shorts close their positions at a loss the broker pockets that money.

What happens in the same situation if the market goes the other way? There are 5000 extra longs making money. From where does that money come from? It comes from the broker’s proprietary account. And that’s ok. It mostly works out because they work on the premise that most traders lose money. (Sucks doesn’t it?) They only hedge in the market when they perceive that volatility is rising and therefore there is something to worry about. This makes their business very cost efficient because they have practically no cost of service delivery…

Because there are no real trades out there.

And that’s why they can only offer a limited number of contracts. They need to aggregate trading around a limited number of markets, so their customers are trading against one another.

And that works most of the time, but…

This is what happens when THE BLACK SWAN swims by…

And just to be clear, let me provide a hypothetical scenario that might help you understand the point I am making which clearly shows that market prediction is not possible.

Let’s say everyone is bearish of Tesla and Elon Musk secretly plans a trip to the moon and tragically dies during the launch of his personal mooncraft. (Do these brokers even offer Tesla? Not sure, but it is just as possible with any company where an unexpected event pushes the market beyond what people expect.) But let’s say there are 10,000 Tesla shorts and everyone buys back their shares at once to cash in on the big win concerning Mr. Musk’s untimely demise. And each one makes 10,000 USD on their trade. That’s a loss of 100,000,000 dollars or 172,413 bitcoins (at Friday’s prices.) Do you think the bitcoin CFD broker is sitting on that kind of war chest? Even at 500 times leverage, that represents a loss of 200,000, Would they be able to cough that sum up and continue to meet their other market obligations? Who knows?

Over time they have put some protections in around this issue. But there is a reason mainstream brokerages do NOT do this and this practice is illegal in many jurisdictions.  Ultimately I believe this is the real reason that most brokers in the bitcoin space do not say who they are. If something goes terribly wrong, they will slip away and their customers will pay for it.

I know my customers and my customers know me…

Common sense kicks in following the Bitfinex hack

By Marcie Terman, Communications Director, First Global Credit and XBT Corp Geneva

Those of us involved in the cryptocurrency space right now are all certified early adopters and we wear that badge with great pride. We are individualists, a bit edgy and a bit libertarian.  Because of this, companies like First Global Credit that take a hard line on the Know Your Customer rules withstand a lot of criticism. Cryptocurrency aficionados do not like the fact that we are legally compelled by international convention to understand who we do business with. But I will tell you from a life-long responsible relationship with my money (crypto or otherwise), it makes sense knowing who is on the other side of monetary transactions.

That is why when First Global Credit was founded in 2014 we published the identity of everyone on our management team. It seemed only fair if we demanded transparency from our customers that we in turn would be equally transparent with them. It would seem that in the aftermath of the Bitfinex hack the sentiment of the rest of the bitcoin market are suddenly in step with our own as the numbers of customers signing up and immediately KYC’ing their live trading accounts on our bitcoin backed, stock, futures and FX trading platform have increased four times the usual level over the past 7 days.

At a cursory inspection it may seem eminently fair that Bitfinex’s founders have taken the view to spread losses over their entire pool of customers. But if you think about this critically, it wasn’t the customer’s fault that permitted an automated, unchecked process at BitGo to release funds to points unknown. And given that the identity of Bitfinex’s management is not generally known, it makes it much easier for the culpable to hide until the heat dies down. Perhaps giving the go ahead on ill-conceived policies like this would have been deliberated on with greater care if the decision makers knew they would be identified as responsible?

My thinking is that these issues with Bitfinex have raised the question of what kind of accountability you can expect from vendors that use their customers’ penchant for anonymity as a cloak that they themselves can hide behind? (Doubly bizarre since Bitfinex follows the KYC conventions for their customers to reveal their identities.) This kind of thinking is logically followed by the realization that platforms offering anonymity or exchanges that automate withdrawals (a thing you NEVER see in conventional online brokerages) are perhaps not the most trustworthy place to store capital. With anonymity not only is it very easy for a financial service business, its website and its founders to disappear if things suddenly go wrong, it also makes it much harder to make a bid to reclaim capital yourself after a hack if you have no way of proving that it was your money stolen in the first place!

We cryptocurrency advocates consider the sanctity of personal information inviolable but the standard for company founders is and should be different. If you choose to do business with companies that hide the identities of their founders creating an opportunity to avoid responsibility, you, yourself are equally as culpable. I believe strongly, as many in crypto do in the principle of personal responsibility which is why I know that people who do not stand behind what they are selling are looking to avoid the consequences of poor decisions.

Having recognised that anonymity is not desirable in a business where client assets are involved I would suggest substituting the goal of anonymity with the selection of business partners that show a high regard for the personal privacy of clients as we do at First Global Credit. Choose business partners domiciled in jurisdictions that share your values. Make sure that the jurisdiction follows rule of law and the concept of search and seizure as it existed before the panics of the last decade. A blanket request for all customer data is simply not acceptable. If a government feels that there is criminal activity associated with an account, the proper course of action is to obtain a warrant through an objective legal system only after due process has been exercised.

Customers have a responsibility as well where the security of their assets are involved. Do not complain if your financial service company uses manual processes for withdrawal.  Consider multiple layers of validation for transactions over a certain level simply a cost of doing business that is there to protect you as well as your service partner. Restrict your financial dealings to companies that you have vetted to make sure that they have a serious approach to not only maintaining security but validating processes regularly to make sure your service partner stays as far ahead of thieves as humanly possible. But at the core of all these measures lies transparency which should do much to facilitate trust between customer and service provider.

Those of us involved in the world altering cryptocurrency markets are absolutely ahead of the curve. We are doing exciting things, making the fiscal world more equitable, creating opportunities that will remove money from the hands of bankers and put it back in the hands of people who worked for the assets in the first place. Bringing opportunity to populations that have been abused by their governments for far too long. That’s pretty exciting stuff! But these paradigm changes do not mean that the sensible precautions that are part of the conventional financial markets should be ignored.

DAO you see it, DAO you don’t

Looking critically at the aftermath of the great DAO heist of 2016

Dao heist artJune 23, 2016    Geneva / London / Hong Kong

By Gavin Smith, Chief Executive, First Global Credit

Anyone interested in cryptocurrency and innovative use of the Blockchain cannot help having heard about the most egalitarian expression of this technology, Ethereum. And anyone interested in the progress of Ether as a DIY cryptocurrency must be familiar with how Ethercoin is being used as the basis of DAOs or decentralized autonomous organizations. DAO is a method for making investment decisions where choices are made by collective agreement not by fund directors.

There already have been a few DAOs but the first one with any traction has been created by German startup, slock.it. Slock.it has members of the Ethereum project team Simon Jentzsch and Stephan Tual on its board. The DAO concept is based on a set of smart contracts that represent investment opportunities presented to the DAO ‘collective’ of investors. Along with buying tokens to the DAO comes the right to vote on which opportunities the DAO takes a position in. The view being that decisions made by consensus will be more profitable as the intelligence of all the investors is behind the selection. Investment utopic dream?

That dream turned into a nightmare last Thursday with news that of the $150m invested in the slock.it DAO at least $60m has been withdrawn by a “hacker” who exploited a vulnerability in the script that governed distributions from the DAO.

The flaw that is at the root of the DAO security problem is based on what first appears to be the strength of the Ether model with its embedded scripting language. Ether permits individuals or organizations to develop powerful smart contracts with complex behaviours. Unfortunately, this flexibility goes hand in hand with the risk that the implementation of a particular solution is not well thought through. This leaves customers of the smart contract (or in this case DAO) at risk of faulty contract implementation with weak security.

This risk has always been played down by the prime movers of the Ethereum project but the fact that the management of Slock.it is also made up of some of the core development talent of the Ether project proves that this risk is not only valid but also not easily overcome – after all, if these developers can’t get the security model right how are others supposed to?

This issue, however, pales into insignificance when compared to the much larger concern … what happens now that the hack has been discovered?

One proposed response to the hack is to roll back the Ether Blockchain – while appearing attractive at first, this route, if taken, has far reaching consequences for Etherium’s future.

Nobody condones the siphoning of funds from the DAO but it should be remembered that this project was highly experimental and participants took part in something that was largely untested with significant risks.

The strength of a public blockchain, which Ether claims to be, has always been the irreversible characteristic of any transaction. Once a transaction has been confirmed it cannot be unwound by any individual or group – this is the very strength of Bitcoin and why attempts to replicate Bitcoins’ benefit structure using private blockchains is a flawed premise – while private blockchains provide benefits of efficiency for member organisations to transact business together without holding counterparty risk, they are by nature limited in their scope, not designed to ‘include’ but exclude participants. In other words they are designed to benefit the “elite few” who run the private blockchain, for instance a select number of banks who wish to extend their cartel with greater efficiency but no benefit to the greater public.

If the Ethereum Project decides to roll back the Ethereum blockchain they simply confirm the charge that is often levelled at Ethereum – it is not a public blockchain at all but a private blockchain developed to move control of the financial industry from one set of hands into another, benefiting Vitalik Butterin and his buddies.

While many would argue that there is no harm in rolling back transactions that were a deliberate exploitation of a weakness in Slock.It’s implementation of the scripting language. You don’t have to dig too deeply to recognise the flaw in this logic.

Is the Ethereum Project going to roll back all future hacks – or just those involving members of the inner circle? What constitutes a hack? One of the proposed uses of Ether smart contracts is an exchange (say for Bitcoin) – If the smart contract incorrectly makes multiple sales at a low price which people identify and exploit – will those transactions be rolled back as well?

Perhaps a smart contract takes place between 2 organisations, one of which is inside the favoured circle of the Ethereum Project – let’s say they decide they don’t like the terms and want it rolled back – does their request get actioned while the other organization foots the bill?

What quickly becomes apparent is that once you lose the irreversible characteristic of the transaction; When it is no longer an independent network that confirms transactions you no longer have a trustless P2P network – you have crony capitalism and you are  simply perpetrating the worst characteristics of the old world financial industry order.

This event represents a critical decision point in Ethereum’s evolution. Do they go down the route of a distributed P2P network with irreversible transactions (which probably means abandoning proof of stake in favour of proof of work) or do they go down the route of a private blockchain with control retained by the select few?

For our part the First Global Credit company will continue to allow holders of Ethereum to use it as collateral for stock and futures trading but, for the time being, our Smart Contract work will remain focussed on Bitcoins’ capabilities. Ethereum, for us, is still a work in progress which we will continue to monitor with interest.

Bitcoin and “The Big Short”

Can the blockchain avert the next financial meltdown?

By Gavin Smith, CEO First Global Credit

February 29, 2016    Geneva / London / Hong Kong

As this year’s Academy Awards celebration draws to a close, it seemed an opportune time to take a closer look at the dysfunction on display in one of the nominees for Best Picture, “The Big Short,” which was based on Michael Lewis’ book of the same name.  Lewis’ book, and the movie it inspired, related the story of the subprime mortgage crisis in the United States.  Essentially, a series of opaque and illiquid financial instruments were sliced and diced into a series of increasingly complex derivatives, the notional value of which ended up being many times greater than the size of the underlying mortgages.  When homeowners, who were the people responsible for paying the underlying mortgages, defaulted on those mortgages, investors in these derivatives (collateralized debt obligations (CDOs), CDOs-squared, synthetic CDOs, credit default swaps, etc.) lost a lot of money.  Those who sold these derivatives short (Michael Burry et al) made a lot of money.

To understand this at a very high level, consider a pivotal scene in the movie: Steve Carrell’s character goes to see a contact at S&P (played by Melissa Leo).  In the course of speaking with her, he learns that S&P basically gives an investment bank whatever rating it wants for a CDO issue, because if S&P did not cooperate with the bank, the bankers would simply go down the street to one of S&Ps competitors.  The system was rotten to the core, and was intermediated by humans doing very human things.

So what could have prevented this?  One theory is that had blockchain-enabled smart contracts been used in the financial system, there would have been fewer opportunities for misbehavior by market participants.  Now, this is a fairly bold claim, and a robust analysis of why this might be the case is beyond the scope of this brief article.  Nonetheless, let’s review what smart contracts are:

  • Smart contracts are pieces of computer code, the logic of which replicates the logic of contractual clauses. If I sign a contract with you in which I agree to sell you 10 apples at $1 per apple, and you refuse to pay me, then I have to seek redress through the courts.  A smart contract, on the other hand, could contain code which, should the payment terms not be complied with, would automatically penalize you.
  • This kind of self-enforcement reduces transaction costs. In the example above, the transaction costs include the cost of litigating through civil courts to seek redress and compensation in the event of a contract breach.
  • Smart contracts reside on a blockchain, which if correctly implemented, would allow a real-time auditing of who owns what side of a given trade.
  • Smart contracts would allow for real time pricing of even illiquid securities, since all of the transactions (including those transactions that create derivatives from underlying assets) would be fully auditable: you would know who owned what tranche of a CDO, who issued which mortgages that made up the AAA, AA, A, etc., tranches of the CDO, and, even, if the system were designed well, which homeowner signed which mortgage documents.

Perhaps most importantly, since all of this would be software-based, you would have no middlemen (or women) looking to create ever more complex derivatives.  Creating derivatives of derivatives (so-called CDOs-squared or –cubed, etc.) does two things: (1) it makes the financial system more complex and opaque, and (2) it creates more income potential for bankers and traders.  Since people aren’t good at policing themselves, in the absence of any system which prohibits people from making more money, complexity, opacity, and illiquidity are the result.

As long as people keep paying their mortgages, this system works more or less OK.  But, as Burry and others suspected, just because housing prices went up for a while, didn’t mean that they would go up forever.  Borrowers got overextended, lost their jobs, and defaulted on their mortgages.  Because those mortgages were then packaged into CDOs, which themselves were packaged into other derivatives, no one knew what anything was worth and banks couldn’t unload their positions in these derivatives very easily.

So smart contracts seem to be one possible solution to the problem of misaligned incentives and opaque financial instruments.  By removing much of the human element, and replacing people with code, we are presented with an opportunity to create a clear, objective framework for the pricing of financial assets and enforcement of contractual obligations.

In fact, in January 2016, American Banker, which is a trade paper for the financial services industry, published a short article[1] discussing this very issue.  Quoting from the article:

…what if you could program [bitcoin] transactions to occur at preordained times, under set circumstances, and even involving a preregistered group of multiple counterparties?

And what if you could use similar technology to preprogram transactions such as the payout of a derivative or other security, all done through a public ledger system such as blockchain without the risk of intervention or the inefficiency created by the involvement of an intermediary counterparty agent?

To make this a bit more concrete, here’s an article from CoinDesk[2], which demonstrates how a smart contract would work.  Essentially, the contract is a series of IF-THEN-ELSE statements, which are familiar to anyone with a rudimentary knowledge of programming.  In the example given in this article, we have the following logic rendered into computer code:

IF payment of 1000 USD in bitcoin is made to BobbyRick by Term 1’s expiration date, THEN Term 1 is completed AND is recorded as completed in the blockchain. If those clauses are met, then the counterparty’s (walkerdavefun) escrow is released. OTHERWISE, Term 1 FAILED, AND is recorded as failed in the blockchain.  THEN the escrow is released to BobbyRick.

All of this is obviously much more efficient than standard contract breaches, which, as discussed earlier, need to be remediated through human-controlled and –operated civil or criminal courts.  Thus, software-based smart contracts provide a compelling and exciting opportunity for those interested in making a fairer and less opaque financial system.

[1] http://www.americanbanker.com/bankthink/smart-contracts-are-the-future-of-blockchain-1078705-1.html

[2] http://www.coindesk.com/new-blockchain-startup-brings-contracts-digital-age/