"Every bad thing that a public company does is securities fraud" is not quite the rule: You also need some statement by the company that is made false by the bad thing. When Wells Fargo said that it interviewed diverse candidates for its jobs, and it turned out it was fake-interviewing them, that was arguably fraud, but it did need to say it. Here, though, the judge ruled that a lot of what SolarWinds said was not really misleading, so could not be fraud, even though the company really did do bad things.

But the case was not entirely dismissed, and bad passwords are still securities fraud. From the judge's ruling:

The [SEC's complaint] also adequately alleges that the Security Statement [published on SolarWinds' website before the hack] materially misrepresented to the public that SolarWinds enforced a strong password policy. …

In essence, the Statement held out SolarWinds as having sophisticated cybersecurity controls in place and as heeding industry best practices. In reality, based on the pleadings, the company fell way short of even basic requirements of corporate cyber health. Its passwords — including for key products — were demonstrably weak and the company gave far too many employees unfettered administrative access and privileges, leaving the door wide open to hackers and threat actors. …

A reasonable person contemplating investing in Solar Winds would have viewed the alleged gap between SolarWinds' words and on-the-ground reality as highly consequential-as "significant in making investment decisions." … Indeed, the business risks presented by such penetrable cybersecurity might well have been material for a company that sold old-fashioned products (e.g., furniture or cars). But the specific risks were magnified for SolarWinds, whose products (software) had cybersecurity as a key attribute and whose key clients (government agencies and Fortune 500 companies) expected the software they purchased to be and remain uncompromised.

If you say you have good passwords and you have bad passwords, that's securities fraud.

This is an ever-so-slightly live possibility, because the CFTC is authorized by law to regulate "event contracts," meaning roughly "prediction markets," so if you want to run a public exchange for bets on election outcomes, you have to go to the CFTC for approval. Exchanges occasionally do ask the CFTC for approval to list election contracts, [4] and then the CFTC says no.

But it could theoretically say yes. And then there'd be an election, and one candidate would win, and the other candidate would say "no this election was stolen from me," and the outcome for the financial purpose of settling the contracts would be disputed. And either the losing candidate would be wrong, and lying about the election being stolen, in which case there would be arguable commodities fraud inflating the price of his contracts. Or he'd be right about the election being stolen, in which case there would be arguable commodities fraud depressing the price of his contracts. And people with money on the line would go to court. And the thesis of "everything is securities fraud" is that US law is somehow more responsive to financial-market claims than it is to other, substantive claims, and so the courts and the CFTC would feel more compelled to address the claim "this election was stolen, which is commodities fraud," than they would to address the claim "this election was stolen, which is bad on its own."

I realize that all of this sounds incredibly dumb and far-fetched, but in my defense last week the CFTC proposed new rules to ban election contracts. This is in part, as Scott Alexander points out, so it can save time [5] : Right now, people ask the CFTC to approve election contracts, and it says no; if it's always going to say no, it's simpler to have a blanket rule against the contracts so people stop asking. But it is also in part because the CFTC does not want to meddle in elections. Here is the statement of CFTC Chairman Rostin Behnam proposing the rules:

To be clear, that means that event contracts on the outcome of a political contest such as an election could not be listed for trading or accepted for clearing under the proposed rule. Such contracts not only fail to serve the economic purpose of the futures markets—they are illegal in several states and could potentially and impermissibly preempt State responsibilities for overseeing federal elections. …

Allowing these contracts would push the CFTC, a financial market regulator, into a position far beyond its Congressional mandate and expertise. To be blunt, such contracts would put the CFTC in the role of an election cop.

The CFTC's jurisdiction as mandated by Congress and solidified in our statute, the Commodity Exchange Act, recognizes our expertise in markets for goods, services, rights, and interests—which can include events associated with financial, commercial, or economic consequences. We are tasked with upholding the public interest by ensuring that America's derivatives markets provide a means for managing and assuming price risks and providing for price discovery through liquid, fair, open, transparent, and financially secure trading facilities. Market integrity is featured so prominently within that mandate that the CFTC has civil enforcement authority when it comes to the potential for fraud, manipulation, and other abuses such as the dissemination of false information in the underlying or commodity cash markets. Political control contracts on CFTC-regulated exchanges would push the CFTC far beyond this historical expertise and jurisdiction, and potentially place the CFTC in the position of monitoring such markets for fraud and manipulation in elections themselves.

"Everything is securities fraud," I like to say around here, meaning:

1. Sometimes a public company does a bad thing, or has a bad thing happen to it. 2. News of the bad thing comes out and the stock drops. 3. Shareholders sue, saying "you didn't tell us about the bad thing in advance, so we bought the stock thinking there was no bad thing, but then we found out that there was a bad thing. We were defrauded; we overpaid for the stock because of your lies."

Occasionally I add a technical clarification: Simply not mentioning a bad thing is not fraud under US securities law. The law (Rule 10b-5) says that it's fraud "to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." So lying — saying something that isn't true — is securities fraud. And many omissions are securities fraud, if the company omits information that is "necessary in order to make the statements made … not misleading." (So for instance if a company's public statements say "we have an ethics policy and try to be ethical," and omit to mention "our executives did an unethical thing," somebody will sue over that, claiming that the description of the ethics policy was misleadingly positive.)

But it is not securities fraud simply not to mention a bad thing. If a bad thing happens, and the company doesn't say anything about it, and it doesn't say anything that might be misleading, that's not securities fraud. This does not come up that often, because companies are always going around saying generic things that might be contradicted by their bad news. If a company has a sexual harassment scandal, its statements about its ethics policy might be misleading; if it has a computer hack, its statements about its information security policy might be misleading; etc. But in theory pure silence is not securities fraud.

Still, you could imagine pure silence being misleading. For instance, you could imagine things that the market would expect to be disclosed if they happened, so that not disclosing them sort of implies that they didn't happen. If a company's chief executive officer died suddenly, and the company didn't tell anyone for a few weeks, that would be weird! The company hasn't lied , but everyone kind of went around assuming that the CEO was alive, and the company didn't bother to correct their mistaken impression.

Or: There are a lot of US Securities and Exchange Commission rules requiring companies to disclose certain things. Regulation S-K, for instance, requires companies to disclose certain specific types of information about their business in their quarterly filings: Companies are supposed to "describe any known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations," "describe briefly any material pending legal proceedings," discuss "material factors that make an investment in the registrant or offering speculative or risky," etc.

If the law says that you have to disclose any material lawsuits in your quarterly report on Form 10-Q, and there is some material lawsuit against you, and you file a 10-Q and don't mention the lawsuit, then that is arguably misleading. "If there was a lawsuit, they would be required to mention it, and they didn't mention a lawsuit, so there must not be one," investors could reasonably conclude. The omission, combined with the reporting requirement , is misleading. If Form 10-Q consisted of a literal form with a box saying "Are there any material lawsuits against you," and you wrote "no," the "no" would be a false statement. Arguably just leaving out the required disclosure has the same effect.

Anyway that is the view of the US Securities and Exchange Commission:

An MD&A [management's discussion and analysis] that makes certain statements but omits information that [Regulation S-K] Item 303 requires to be included is a misleading half-truth.

Where regulatory disclosure requirements apply, reasonable investors will infer from an issuer's silence that the types of events for which disclosure is required have not occurred.

Macquarie Infrastructure Corp. operated terminals for No. 6 fuel oil. In 2016, the United Nations essentially banned No. 6 fuel oil by 2020. But:

In the ensuing years, Macquarie did not discuss IMO 2020 [the UN ban] in its public offering documents. In February 2018, however, Macquarie announced a drop in the amount of storage contracted for use by its subsidiary due in part to the decline in the No. 6 fuel oil market. Macquarie's stock price fell 41%.

Shareholders naturally sued, arguing that (1) Regulation S-K required Macquarie to "describe any known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations," (2) this was a known trend or uncertainty that was likely to be bad for sales, (3) Macquarie did not disclose it and (4) that was misleading. Macquarie argued that it couldn't be securities fraud just to not mention the new UN rule. The district court agreed and dismissed the lawsuit, but an appeals court disagreed, finding that, when there's a rule requiring disclosure of something, it can be fraud not to disclose the thing.

Macquarie appealed to the Supreme Court, and last Friday it won. The unanimous Supreme Court said:

The question in this case is whether the failure to disclose information required by Item 303 can support a private action under Rule 10b–5(b), even if the failure does not render any "statements made" misleading. The Court holds that it cannot. Pure omissions are not actionable under Rule 10b–5(b).

I guess that is the better reading of the actual words of the rule, though it is a weird reading of its intent. Omitting things that you're required to disclose really does seem misleading. In any case, there you go, some things are not securities fraud.

One thing that I think about from time to time is that the notion of "material nonpublic information" is outdated and incoherent. In the olden days, you could have some simple intuitions about what constituted insider trading. Some news would obviously be material to a company's stock price: If you knew that the company was about to announce a merger, or earnings that were much higher than analysts' expectations, then you could expect that the stock would trade up a lot. So you could buy the stock before the announcement, wait a few days, and then sell the stock at a big profit right after the announcement.

Insider trading — trading on this sort of material nonpublic information — is generally illegal, and regulators policed it in intuitive ways: They look at stocks that move a lot on earnings or merger announcements and see if there's any suspicious trading by anyone who might have inside information.

Meanwhile investors were regularly meeting with corporate managers and talking about their business. Of course they were! The investors wanted to make informed investment decisions, and the managers had a fiduciary duty to their shareholders to help them understand the business. It was good for the companies, and for the investors, to have these meetings.

Of course the managers were not supposed to give the investors any material nonpublic information in these meetings. You couldn't have an investor meeting and say, like, "good news, we're in talks to be acquired by Alphabet next week." You couldn't say "good news, we're going to announce blowout earnings next week." But the investors could try to get a more nuanced and detailed understanding of the public information; they could ask questions to sharpen their models and their sense of how the company made money. The managers could give the investors "color," people used to say. Sometimes this was called the "mosaic theory": Management couldn't just hand the investors big material news, but they could give the investors little pieces of information, and the investors could combine those pieces with other bits of information (public data, what they heard from other companies, etc.) to make informed investment decisions.

This whole structure rested on the idea that some information is "material" and therefore has to be disclosed to everyone equally, while other information is not material and yet sophisticated investors want to know it. That makes some crude intuitive sense: Merger news that will move the stock by 20% is material; nuanced news about earnings line items that will move the stock by 0.5% is not. News that would cause any retail investor to say "oh boy I'd better buy that stock" is material; news that only a sophisticated expert analyst would find interesting is not.

But that divide seems unstable right now. For one thing, prosecutors and judges seem skeptical. Here is a 2018 law firm memo asking "Is the mosaic theory as a defense to insider trading dead," and I occasionally quote the time US Supreme Court Justice Sonia Sotomayor told a lawyer that there are "regulations to stop" companies "talking to analysts."

But for another thing, modern markets really are more professional and efficient and competitive than they used to be, and the bar for what is material to investors probably is lower. If you are an analyst at a hedge fund, and you spend all your time thinking about a couple of dozen companies, and you buy lots of alternative data and talk to lots of experts and do lots of investigating of those companies, and you generally wring every possible insight out of public information to inform your trading decisions, well, analysts at a dozen other hedge funds are doing the same thing.

And if somebody at a company came to you and said "hey here's a little piece of news that will move our stock by 0.5% next week," that's huge! Your portfolio manager runs a highly levered, factor-neutral, short-term investing strategy; if you can regularly bring her 0.5% idiosyncratic weekly profits, that translates into vast riches for all of you. Algorithmic trading firms mint billionaires by being right 51% of the time; a little bit of reliable edge, in modern markets, is hugely valuable. It makes no sense to say that it's not material.

The simplest form of fraud is that you lie to someone and they give you money. Perhaps you give them something in exchange for their money, but you lie about its attributes. (They pay you for magic beans, but the beans are not magic.) Or perhaps you lie about giving them something and give them nothing. (They pay you for the Brooklyn Bridge, but you do not give them the Brooklyn Bridge.) Fraud is often illegal, though exactly how it is illegal will depend on how you do the fraud, and to whom, and what you are lying about.

For instance, doing fraud about securities is illegal under US federal law; this is called securities fraud. Securities fraud often takes the simple form: You lie to someone (about securities) and they give you money (for the securities). You tell people that you have started a company that has discovered cold fusion, you offer them a 1% stake in the company (stock, a security) for $1 million, they pay you, you deliver the stock, but you were lying about the cold fusion. This is fairly standard; Elizabeth Holmes and Sam Bankman-Fried are recent high-profile cases of people convicted of fraud for lying about their companies to sell stock to investors.

But securities fraud often does not work that way. In modern public stock markets, it is possible to lie to people in a way that costs them money, and gets you money, without them giving you the money. Schematically:

1. You have some stock. 2. You lie about it. 3. The people who believe your lies buy the stock, anonymously, on the stock exchange, so it goes up. 4. You sell the stock at a profit, anonymously, on the stock exchange. 5. Eventually your lies are discovered and the stock goes back down again.

You made money (Step 4), and your victims lost money (Step 5), and your lies caused their losses and your gains. But you didn't necessarily sell the stock to the victims: You sold the stock on the stock exchange, they bought it on the stock exchange, and you have no idea who was on the other side of any of those trades. Quite likely the victims bought the stock from some sophisticated electronic market maker, and you sold the stock to some sophisticated electronic market maker, and the market makers didn't believe or even see your lies.

This is quite a common form of securities fraud. Companies, for instance, are regularly accused of doing securities fraud for lying about their business in a way that keeps their stock price up, even if they are not selling the stock themselves and lying directly to the purchasers. ("Everything is securities fraud," I often say.)

But this sort of securities fraud doesn't have to be done by the company. We have talked a few times about fake takeovers, where someone buys stock, puts out a fake press release saying that the company will be bought, and then sells the stock at a profit. More broadly, a "pump and dump" is a classic form of securities fraud in which someone — perhaps a promoter affiliated with the company, perhaps just a guy online — buys a stock (often a small, illiquid penny stock) and then tells lies about it. "This company discovered cold fusion," he says, to his email newsletter subscriber list, or on X or Reddit or whatever. People believe him, they buy the stock, the stock goes up (the pump), and he sells his shares (the dump) before the price crashes again. He doesn't necessarily sell the shares to his email subscribers or X followers, but their buying is what makes his sales profitable.

This is, if you think too hard about it, actually a bit of a puzzle. If you are charged with fraud, you might say: "Oh sure I lied about this stock, and it went up, and then I sold the stock. But nobody can prove that I sold the stock to the people I lied to. So how can I have committed fraud? As far as you know, the people I lied to never gave me money, and in fact I never even wanted them to. I just wanted them to buy the stock, so it would go up, so somebody else — some anonymous person on the stock exchange who never even heard my lies — would give me money."

I think most people think this is too cute. It sure looks like fraud: You lied, someone believed you, they paid money, a fairly mechanical process (the workings of the stock market) occurred, the money came to you. Surely that's fraud. In US securities law, this is called the "fraud on the market theory." In 1988, the Supreme Court endorsed the theory:

The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations. …

The modern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases, and our understanding of Rule 10b-5's reliance requirement must encompass these differences.

In face-to-face transactions, the inquiry into an investor's reliance upon information is into the subjective pricing of that information by that investor. With the presence of a market, the market is interposed between seller and buyer and, ideally, transmits information to the investor in the processed form of a market price. Thus, the market is performing a substantial part of the valuation process performed by the investor in a face-to-face transaction. The market is acting as the unpaid agent of the investor, informing him that given all the information available to it, the value of the stock is worth the market price.

If you lie to the market, and the market believes you and gives you money, then that is fraud, even if the particular people who believe you are different from the people who give you money.

I sometimes write "everything is securities fraud" as a shorthand for a particular weird argument about how modern US legal dynamics transmute every bad action taken by a public company into securities fraud, but never mind that. A simpler story is that if the board of directors of a company (public or private) puts out a public statement saying "turns out our chief executive officer is a big liar," somebody is going to think that's securities fraud. Whatever the CEO was lying about was probably material to the company — otherwise why would the board care? — and you've got to at least look into it.

This isn't quite that, but the Wall Street Journal reports:

The Securities and Exchange Commission is scrutinizing internal communications by OpenAI Chief Executive Sam Altman as part of an investigation into whether the company's investors were misled.

The regulator, whose probe hasn't previously been reported, has been seeking internal records from current and former OpenAI officials and directors, and sent a subpoena to OpenAI in December, according to people familiar with the matter. That followed the OpenAI board's decision in November to fire Altman as CEO and oust him from the board. At the time, directors said Altman hadn't been "consistently candid in his communications," but didn't elaborate. …

Some of the people familiar with the investigation described it as a predictable response to the former OpenAI board's claim in its November statement. One of the people said that the SEC hasn't pointed to any specific statement or communication by Altman that it has deemed misleading.

Right, maybe they'll find a "specific statement or communication" to investors that was misleading, and he'll get in trouble; probably they won't. [8] But if the board of directors of a giant company fires the CEO for the stated reason that he was not candid, the SEC really does have to look into it.

"A giant company," I said; not necessarily a public one. "The SEC enforces laws that forbid people from misleading investors, regardless of whether fundraisers seek capital in public or private markets," notes the Journal, correctly. Still there are some relevant differences between OpenAI and most companies:

1. OpenAI's stock does not continuously trade in public markets, so its CEO could go around lying about lots of stuff without tricking investors into buying stock. If you are the CEO of a public company and you go on television and say "we have built a superintelligent robot that can cure cancer," people will buy your stock, the stock will go up, and if it turns out you were lying, they will sue you for fraud. If you are the CEO of a private company and you do that, nobody will trade the stock, because they can't. If you then try to raise money by selling stock to investors two weeks later, and you send them a private placement memo saying "we have not built a superintelligent robot, we're not even working on cancer, our CEO was just letting off steam on TV," and then they buy the stock, they weren't misled, were they? This is very much not legal advice, don't do it, but the point is that every public statement by a public-company CEO is risky, while private companies have more limited investment-related communications. 2. In a typical private company, and particularly in a typical tech startup, if the CEO is lying to the board of directors, he is also lying to his investors, because ordinarily the board will include several representatives of the venture capital firms that invest in the business. So if the board feels misled, the investors probably feel misled, because they're the same people. That's not the case here. In fact, it is exactly the opposite here: OpenAI's description of its corporate structure says "the board remains majority independent," and "independent directors do not hold equity in OpenAI." (Microsoft Corp., OpenAI's biggest investor, is represented by an observer on the board, but has no voting rights, and even the observer seat came after Altman's firing and unfiring.) So in some sense the board of directors was a good group for Altman to mislead: They weren't investors! 3. I continue to find it funny and relevant that, at the top of OpenAI's operating agreement, it warns investors: "It would be wise to view any investment in OpenAI Global, LLC in the spirit of a donation, with the understanding that it may be difficult to know what role money will play in a post-[artificial general intelligence] world." I still don't know what Altman was supposedly not candid about, but whatever it was, how material can it possibly have been to investors, given what they signed up for? "Ooh he said it cost $50 million to train this model but it was really $53 million" or whatever, come on, the investors were donating money, they're not sweating the details.

On the other hand, the general idea of "everything is securities fraud" is that if investors care about a thing, and the company says misleading stuff about the thing, then that's securities fraud. Traditionally , investors cared about things like profits, and companies sometimes cooked their books to show misleading profit numbers, and that was traditional securities fraud. But the modern theory understands that investors care about lots of things that could impact the company's business — its policies for securing customer data, its treatment of its employees, its treatment of its whales — and misleading investors about any of those things could be fraud.

In the modern world of environmental, social and governance (ESG) investing, it seems pretty uncontroversial to say that at least some investors care about a company's environmental record. And thus lying about your environmental record gives investors — or regulators — a securities-fraud hook to sue you.

You could imagine some sort of world in which governments directly regulated companies' environmental behavior, in which people made collective judgments about climate trade-offs through a democratic process, governments made rules enacting those judgments, companies followed those rules, and people got the level of emissions that they wanted. It's one approach.

But I think that the US approach is, roughly, that people make rough collective judgments about climate trade-offs through their ownership of ESG investment vehicles , investment managers pressure companies to enact those judgments, companies respond to those pressures by making environmental promises, and US regulators regulate those promises and punish the companies when they are false. Environmental regulation through securities fraud.

I say this a lot but it keeps being true: Every bad thing that a public company does, and every bad thing that happens to a public company, is also securities fraud.

The general form of this is something bad happens and the company does not immediately disclose it, or has not adequately warned shareholders of the risk of it happening, or both. Later, when the bad news comes out, the company's stock drops. Shareholders who bought the stock before the news came out sue, saying that they were deceived about the bad thing and lost money. The US Securities and Exchange Commission also takes an interest in fraud and might bring an enforcement action.

Take computer hacking, for instance. If a company gets hacked, that is bad: The hack might disrupt its business, it might have to pay a ransom to unlock its files, its customers might stop trusting it, it might get in trouble with regulators for losing customer data, etc. If a company gets hacked and does not immediately disclose it, and then later discloses it and the stock drops, it will get sued for securities fraud. (Even if it does immediately disclose it, it might get sued for not previously warning shareholders about the risk of being hacked, or for saying things like "we use strong passwords" if, in fact, it did not.)

Actually hacking is a special case, because getting hacked is so securities fraud that the SEC recently wrote new rules about hacking disclosure. These rules, which go into effect next month, require public companies to disclose "any cybersecurity incident they determine to be material" within four days after they decide that it is material.

One corollary of "everything is securities fraud" — and this is the farthest possible thing from legal advice but here we are — one corollary of this is that, if you do a bad thing to a public company, once you have finished doing the bad thing, there is a fascinating window in which:

1. You know about the bad thing, because you did it. 2. The company knows about the bad thing, because it experienced it, and/or because you sent it an email like "nyah nyah I just hacked your computers." 3. The public does not know about the bad thing, because the company has not yet disclosed it.

By the theory of "everything is securities fraud," the company is committing securities fraud during this window. (Particularly if the bad thing was a hack and the window has been more than four days.) And you know it. How can you take advantage?

One thing that you could do is short the company's stock, hoping to profit when the bad thing is disclosed. This is a well-established approach, but has the problem of being illegal. It is (probably) insider trading: You have material nonpublic information about the company, and are trading on it. [1] You might not care: If you did an illegal bad thing to the company (like hacking), also doing insider trading might not bother you. Still it adds some risk. My Fifth Law of Insider Trading is "don't insider trade by planting bombs at a company and buying put options on its stock."

Another thing you could do is sue the company for securities fraud, but that takes a lot of time and effort. Also you won't get that much money for it unless you owned a lot of the company's stock, and presumably you didn't. (If you did, why did you do the bad thing to the company?)

A third thing you could do is file a whistleblower complaint with the US Securities and Exchange Commission saying "hey FYI this company is doing securities fraud." And then maybe the SEC will investigate and agree and fine the company a pile of money and give you a cut of the money as a whistleblower reward. The SEC does the work for you and just hands you the money at the end. Efficient!

One thing that I think about sometimes is the similarity between journalism and insider trading. Consider: You are in the business of finding out things about companies that nobody else knows, so you spend your time developing sources at those companies who will tell you things. If their company has a new product coming out, or is about to announce a merger, or has been doing fraud, they call you to tell you before anyone else knows.

Sometimes they tell you things just because you ask, and they are indiscreet. Sometimes they tell you things out of a sense of public-spiritedness: They think that what they know should be known more broadly. Sometimes they tell you things out of a sense of grievance: They are mad at their bosses and want to leak information. Sometimes they tell you things because you are friends: You have done such a good job of developing relationships that your sources think of you as a personal friend, not just a transactional counterparty. Sometimes there is some amount of favor-trading involved: You get information from them, and in exchange you give them something that they want. Perhaps that is also information: You give them news or gossip about their firm or industry that you got from other sources. Or perhaps you can give them career advice. Or maybe you just buy them lunch, or drinks. Maybe you pay them cash! Often, of course, their motives are mixed; they tell you stuff out of public-spiritedness and grievance and friendship and favor-trading and carelessness all at once.

What do you do with this information? Here are three possibilities:

1. You work at a newspaper, you write up a story containing your sources' secret information, and you publish it on your website and in your print newspaper. 2. You work at a hedge fund, and you trade on your sources' information: You buy ahead of the merger announcement, sell ahead of the accounting fraud, whatever. 3. You work at a very small and odd newspaper, one that charges $1 million a year for a subscription and that has only five subscribers, all of them hedge funds.

Option 1 is called "journalism." It is generally considered a good thing — the public has a right to know secret stuff, etc. — and in the US it is protected by the First Amendment. Of course some of the readers of your newspaper will trade on what you publish, but that's fine; journalism can move markets.

Option 2 is usually called "insider trading," and in most cases, in the US, it is illegal.

Option 3 is a gray area! It seems clear to me that if you have one subscriber and a million-dollar subscription, that's insider trading: You work for a hedge fund, but you have an obfuscatory job title. Probably at five subscribers it is still insider trading. On the other hand, at a million subscribers and a $200 subscription, you are clearly a journalist : Publishing a story behind a paywall, to paying customers who get it before everyone else, still counts as journalism.

I think that probably the dividing line between "journalism" and "insider trading" is, like, some number of subscribers? The number is not that high. I think that sending a newsletter to 50 subscribers, 95% of them hedge funds, for $50,000 each per year, probably looks more like journalism than like insider trading. Whereas five subscribers is insider trading. But I am just making that up and oh boy is it not legal advice.

If you run a business, you will always feel pressure to tell some people that it's going well and other people that it's going poorly. You will always want to tell investors that the business is going well, because then they will reward you by giving you more capital. You will generally want to tell the tax collectors that the business is going poorly, because then they will collect less money in taxes. (Thus, tax accounting and financial accounting are sometimes different, and people sometimes get mad about it.) Other categories are more ambiguous: You might want to tell suppliers that business is going well (so they are comfortable increasing the relationship and selling you more stuff on credit), or that it is going poorly (so that they feel sorry for you and give you a discount). You might want to tell employees that business is going well (so they don't quit for a more stable job), or that it is going poorly (so they don't demand a raise).

Ideally you would not lie to any of them, but there is a range of ways to characterize your business, and to make conditional predictions about an uncertain future. And everything is on the internet these days, so it is often possible for one audience to find what you are telling another audience and say "hey, you are telling us two different things." And if you are a public company and one of the audiences is your shareholders, someone — not necessarily the shareholders! — might say "hey, is this securities fraud?" Because everything is securities fraud.

A few years ago, the US Department of Labor proposed some new rules for investment advisers, and some companies that would be subject to the rules wrote comment letters to the DOL about how bad the rules would be for their business, because "this is a catastrophe for investment advice" is a good argument against the rules. But they also did investor calls where they told investors that the rules would be fine for their business, because "this is a catastrophe for investment advice" is a bad thing to tell your shareholders. And then Senator Elizabeth Warren — who supported the rule and didn't like the investment industry — just wrote down all the things they told the DOL, and all the things they told their investors, and put them in a letter to the US Securities and Exchange Commission asking "hey is this securities fraud or what?" She wrote:

Both sets of industry claims - that the proposed rule will harm them and their business model, and that the proposed rule will not harm them and their business model - cannot possibly be true. And if one these public statements is materially false, it would appear to violate long-standing interpretations of our securities laws.

We talked about it at the time. It was a very fun rhetorical move. Was it fraud? I wrote:

I mean, the comments to the regulators and the comments to the shareholders are both contingent predictions about the unknowable future, so you can't really hold anyone responsible if they turn out to be wrong. And nobody actually makes different unconditional quantified falsifiable predictions to the two different audiences -- no one says to the regulators "this rule will definitely cost us $100 million a year no matter what we do in response," while also telling the shareholders "this rule won't affect our bottom line at all no matter what." They make vague, conditional predictions; they stress the problems to the regulators and the solutions to the shareholders.

Still, awkward. Anyway here is a Wall Street Journal podcast with television writer Michael Schur about the Hollywood writers' strike:

Ryan Knutson: A lot of studios say this is a bad time to be making major changes to writers pay. Most streaming services are losing money, and many studios are under pressure from Wall Street to cut costs. Warner Brothers, Discovery, and Paramount have all canceled projects lately, and companies like Disney have been laying people off. How do you respond to that?

Michael Schur: It's very funny, they say one thing on their investor calls and then a very different thing to us when we're in the negotiating room. On their investor calls, it's all rosy. We're going to make so much money. We're going to be profitable very soon. We're going to make X billions of dollars over the next Y years. And then when they get in a room with us, they're like, "Guys, you've picked a really bad time to ask for a raise." We are like, we read the notes of your call. We know how much money you're projecting.

Yes right when you are negotiating a union contract you turn your pockets inside out and say "we're broke, you gotta take a pay cut," and then when you have an investor day you pull sacks of gold out of your pockets and say "we're so rich it's great." It's just that the union can hear you, and the shareholders are litigious.

I like to say around here that everything is securities fraud: If a public company does a bad thing and the stock price drops, someone will sue, claiming that the company did not adequately disclose that it was going to do the bad thing. What "everything is securities fraud" means is that securities fraud is not confined to the financial statements: If a company gets hacked, or if its chief executive officer commits sexual harassment, someone will sue for that too, because you can always find something that the company said that looks false in light of the bad news. If the bad news has to do with environmental, social or governance issues, you can say that "public companies can and should be held accountable for material misrepresentations in their ESG-related disclosures," but there's really no need to bring ESG into it: The broad rule is that public companies are accountable for absolutely everything they say if it turns out to be wrong and the stock price drops.

My general theory is that every bad thing that a public company does is securities fraud. The public company does a bad thing and does not immediately disclose it to shareholders (because it is bad). Eventually the bad thing comes out. The stock drops on the news (which is bad). Shareholders who bought the stock sue, saying that they were defrauded: The company lied to them by not telling them about the bad thing, so they bought the stock at inflated prices; when the bad thing came out, the stock dropped to its true value, exposing the fraud.

That is the basic theory. But there is a more advanced part of the theory. Technically the previous paragraph is not quite right, because technically it is not lying — it is not always securities fraud — if a company simply doesn't mention a bad thing. Technically the rule is that it is fraud "to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." Just omitting a material fact — without saying anything else misleading — doesn't count.

What this means for the class-action lawyers bringing "everything is securities fraud" cases is that you have to find some other statement that looks misleading in light of the bad things that the company failed to mention. We have talked about a couple of classic methods:

1. If the company makes public statements about its policies or values or code of ethics, you can say "aha, these statements were misleading, because you were doing bad things, and that isn't very ethical is it?" 2. If a company discloses risk factors like "we might get hacked, which would be bad," or "we rely on the services of our chief executive officer, so we hope he doesn't do anything terrible," then you can say "aha, those statements were misleading, because you didn't say that you had already been hacked, or that your CEO was already doing terrible stuff that would force you to fire him.

But what this means for the US Securities and Exchange Commission is a bit different. For the SEC, the way to turn everything into securities fraud is to require more disclosure : If you require companies to make extensive disclosures about their carbon emissions and environmental policies, then you have sort of de facto turned pollution into securities fraud, since a company that does a lot of terrible pollution probably won't have great disclosure about it. [3]

Similarly, if the SEC had a rule that was like "each company must disclose, each quarter, the number of sexual harassment incidents that happened that quarter," then some companies would say zero when the answer was not zero, and they'd get sued. The SEC's rule would more or less automatically turn sexual harassment into securities fraud.

The SEC does not have a rule like that, but it can … sort of … make one up? Here is a fascinating SEC enforcement action against Activision Blizzard Inc. from last week [4] :

The Securities and Exchange Commission [Friday] announced that Activision Blizzard Inc., a video game development and publishing company, agreed to pay $35 million to settle charges that it failed to maintain disclosure controls and procedures to ensure that the company could assess whether its disclosures pertaining to its workforce were adequate. ...

According to the SEC's order, between 2018 and 2021, Activision Blizzard was aware that its ability to attract, retain, and motivate employees was a particularly important risk in its business, but it lacked controls and procedures among its separate business units to collect and analyze employee complaints of workplace misconduct. As a result, the company's management lacked sufficient information to understand the volume and substance of employee complaints about workplace misconduct and did not assess whether any material issues existed that would have required public disclosure. ...

"The SEC's order finds that Activision Blizzard failed to implement necessary controls to collect and review employee complaints about workplace misconduct, which left it without the means to determine whether larger issues existed that needed to be disclosed to investors," said Jason Burt, Director of the SEC's Denver Regional Office.

Activision has a history of serious workplace sexual misconduct. The SEC's order quotes Activision's risk factors in its public filings, saying things like "we may have difficulties in attracting and retaining skilled personnel or may incur significant costs to do so." And it argues that Activision did not do a good enough job elaborating on that risk factor:

Though Activision Blizzard disclosed the risk factors described above related to its workforce and how its ability to attract, retain, and motivate skilled personnel might materially impact its business, Activision Blizzard lacked controls and procedures designed to ensure that it captured and assessed – from a disclosure perspective – certain information related to these risk factors. This included lacking controls and procedures among its separate business units designed to collect or analyze employee complaints of workplace misconduct.

As a result, complaints related to workplace misconduct were not collected and analyzed for disclosure purposes.

Additionally, during the relevant period, Activision Blizzard required that individual business unit leaders report certain categories of potentially material information to Activision Blizzard's Disclosure Committee. However, these categories did not include information relevant to Activision Blizzard's ability to retain employees, such as employee complaints or incidents of workplace misconduct.

As a result, such information often was not accessible to Activision Blizzard's management and disclosure personnel, and was not assessed from a disclosure perspective. By lacking sufficient information to understand the volume and substance of employee complaints of workplace misconduct, Activision Blizzard's management was unable to assess related risks to the company's business, whether material issues existed that warranted disclosure to investors, or whether the disclosures it made to investors in connection with these risks were fulsome and accurate.

There is no actual argument that the disclosures were not accurate. (I guess they were not "fulsome," but that doesn't make them misleading.) The SEC's position seems to be something like: Public companies are obligated to collect information about workplace sexual misconduct and to disclose it if it seems material. If they don't disclose it, that is a violation of "Exchange Act Rule 13a-15(a), which requires issuers … to maintain disclosure controls and procedures designed to ensure that information required to be disclosed by an issuer in reports it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Commission's rules and forms." If they do disclose it, and it's wrong, that's securities fraud.

We talked last month about environmental, social and governance investing and securities fraud. I wrote that "there are some areas of corporate behavior where a company can be good or bad , but these areas are not relevant to shareholders. " But I added that the modern "everything is securities fraud" project is about limiting those categories, about expanding what is relevant to shareholders:

One rough way to think about the "everything is securities fraud" theory is that, once upon a time, most sorts of corporate behavior fell into these categories — investors were presumed not to care about them, they weren't discussed in filings, etc. — and the only area that mattered was, like, financial results. "Securities fraud" meant lying about earnings. And then over time various areas of corporate behavior — executive ethics, cybersecurity, et

Around here I like to say that every bad thing that a public company does is also securities fraud. It does the bad thing, it does not immediately tell shareholders about the bad thing, later the shareholders find out about the bad thing, the stock drops, and the shareholders sue, saying "we were tricked into buying your stock because you lied to us about not doing the bad thing."

This is I think a broadly correct description of how US securities class actions work in practice, but it is not a technically accurate description of the law, and it is missing some nuance. For one thing, simply not mentioning a bad thing might not be enough to create securities-fraud liability: To sue and win, shareholders will need to point to some misleading statement that the company did make. (So sexual harassment might be securities fraud if a company has a stated policy forbidding sexual harassment, or a risk factor in its annual report saying "we rely on the services of our chief executive officer and would have problems if he was a sexual harasser" but not mentioning that he is.)

For another thing, there will be arguments about whether the misstatements or omissions were material to investors. If shareholders say "we bought your stock because you lied to us and told us you were ethical, and we believed you," a plausible answer would be: "No you didn't, you didn't care about our ethics, they don't matter to our stock price and you were not actually defrauded." (This was roughly the issue in a 2021 Supreme Court case about Goldman Sachs Group Inc. and the "everything is securities fraud" theory.)

One way to synthesize these points is that there are some areas of corporate behavior where a company can be good or bad , but these areas are not relevant to shareholders. That is:

1. The shareholders do not care about these areas of behavior; they do not evaluate whether a company behaves well or badly in these areas, and those questions do not inform their buying and selling decisions. 2. Companies do not talk about these areas of behavior in their public filings. 3. If it turns out that a company is bad in these areas, the stock doesn't usually drop.

Like one bad thing that a public company could do is that its executives could have really bad fashion sense and dress really badly. (Not a high fashion company I mean, just like a software company or whatever.) That would be bad , in some aesthetic sense, but it would not be securities fraud. Investors would not make investing decisions based on executive fashion, the company would not make any claims about it in its filings, and if a photo emerged of a badly dressed executive the stock would not drop.

These categories are fuzzy, though; there are some categories that investors once did not care about but now do, some sorts of behavior that sometimes cause stock drops and sometimes don't, some things that are obliquely hinted at in securities filings. Sexual harassment scandals, for instance, seem more likely to cause business consequences and stock drops now than they did 10 years ago, financial decision-makers ask about them more frequently, and they are probably covered by companies' disclosed ethics policies. You could argue that 10 years ago executive sexual harassment was bad but not securities fraud, but now it is also securities fraud.

One rough way to think about the "everything is securities fraud" theory is that, once upon a time, most sorts of corporate behavior fell into these categories — investors were presumed not to care about them, they weren't discussed in filings, etc. — and the only area that mattered was, like, financial results. "Securities fraud" meant lying about earnings. And then over time various areas of corporate behavior — executive ethics, cybersecurity, etc. — became things that companies disclosed and investors were presumed to care about, and so now shareholders can sue companies if bad things happen in those areas.

Surely the biggest and most important example of this shift is ESG. Stereotyping very crudely, once upon a time investors did not care about the environmental, social and governance behavior of public companies, and now they care very much. For many investors, these are the most important factors; many investors have "ESG" (or "sustainable," etc.) right in their fund names. And companies produce increasing amounts of disclosure about ESG, in part because that's what investors want but in large part because it's what regulators demand.

And so you could imagine 20 years ago thinking "companies produce financial statements, investors read the financial statements and use them to make investing decisions, and if the financial statements are wrong that is securities fraud." And now you could imagine thinking "companies produce ESG statements, investors read the ESG statements and use them to make investing decisions, and if the ESG statements are wrong that is securities fraud." The ESG statements haven't replaced the financial statements, but they exist parallel to them, and they are … perhaps not equally important, but certainly important enough to produce lots and lots of lawsuits:

Lawyers are bracing for an increase in ESG-related cases as corporate disclosure requirements stiffen around the world.

A survey by the law firm Norton Rose Fulbright found that 28% of more than 430 general counsel and in-house litigation leaders said their so-called ESG dispute exposure increased in 2022, and 24% expect it to deepen over the next 12 months. The key reasons are the absence of clear environmental, social and governance metrics and requirements, and the heightened regulatory scrutiny on the importance of ESG.

The issue has joined employment and labor disputes, cybersecurity and data protection in what Norton Rose refers to as "class-action areas of future concern."

The growing attention of corporate litigators in industries ranging from financial services to technology corresponds with the growing tide of class actions tied to greenwashing. This is partly due to the California's plaintiffs' bar having "figured out the blueprint for how to bring these cases," according to Norton Rose. In a nutshell, this means companies that put out generalized ESG statements will sometimes find themselves as targets in product-specific cases.

If you make a product that is bad for the environment, that didn't use to be securities fraud, but it sure is now.

You know my theory: Every bad thing that a public company does is also securities fraud. If there is a data breach or sexual harassment or animal mistreatment or pollution at a company, and the public finds out about it and the stock goes down, then someone will sue the company, arguing that it defrauded shareholders by leading them to believe that it wouldn't be a data breach or sexual harassment or whatever. And this theory is weird, and people sometimes say "wait shouldn't securities fraud be for, like, accounting misstatements, not sexual harassment?" But it is a little hard to articulate a limiting principle. If a company convinces investors that it is good, but it is in fact bad, then it has defrauded them, and badness is not limited to accounting.

Once you have mastered this basic idea, you can apply it to other laws. For instance, every bad thing that a company does is also bank fraud, if the company has ever borrowed money from a bank. The Wall Street Journal reports:

The U.S. government is looking into whether Amazon.com Inc. might have misled lenders about its workplace safety record to obtain credit, using a law stemming from the savings-and-loan crisis in a legal move a lawyer for the company called "unprecedented."

The Manhattan U.S. Attorney's Office is conducting an investigation into Amazon under the Financial Institutions Reform, Recovery and Enforcement Act, a law that allows civil cases to be brought over wrongdoing that impacts banks. The office has deployed the 1989 law at the same time the Labor Department presses a workplace safety investigation of Amazon that has already led to several citations. …

The U.S. Attorney's Office in Manhattan issued a subpoena in August to Amazon for information the company might have shared with financial institutions involved in at least $90 million in contracts or agreements with the online retailer in the previous five years, specifically information it shared on its injury rates and labor law compliance. …

"It is difficult to understand how a safety inquiry could plausibly be shoehorned into a Firrea investigation," Zainab Ahmad, a partner at outside counsel Gibson, Dunn & Crutcher LLP, wrote in a letter to government lawyers that is included with court papers.

"Firrea addresses financial fraud, not employee safety," Ms. Ahmad added, calling the U.S. Attorney's Office's legal theory "extremely tenuous" and "unprecedented."

It is very easy to understand how a safety inquiry could plausibly be shoehorned into a Firrea investigation! Ahmad doesn't like it, and really neither do I, but I understand it.

Amazon has an equity market capitalization just shy of $1 trillion, tens of billions of dollars per year of cash flow from operations, A1/AA credit ratings and 5-year credit default swaps that trade inside of 50 basis points. If you are a bank and you loaned Amazon $90 million (!?) in the last five years, you are just fine with that decision. No bank has become insolvent because it loaned money to Amazon and now Amazon is facing "several citations" from the Labor Department.

But, sure! In its credit agreement, Amazon says that it complies with the law, so if it did not comply with labor law then its credit agreement was not strictly true. And perhaps in the due diligence for a loan, a bank sent over a questionnaire asking things like "are your workplaces safe," and probably Amazon answered "yes" in some sort of qualified and lawyered way, and if the answer should have been "no" then, right, fraud. Of course no one at a bank made a credit decision based on that questionnaire. It's not like Jamie Dimon was called in to decide whether JPMorgan Chase & Co. should lend to Amazon, and he said "hmm, I don't know, how's their safety record," and the analyst who sent the due diligence questionnaire was like "well they say here that it's good," and Dimon said "well okay, if you think we can trust them about that, then let's lend them the money," and JPMorgan went ahead on that basis and was shocked to find out that Amazon's safety record was not so good. Presumably what happened is that some credit committee made the credit decision by asking "wait this is Amazon?" and the relationship banker was like "yep" and the credit committee was like "sure wave it in" and nobody discussed worker safety at all. And if they did, it was probably along the lines of "well, Amazon is a huge company and a great credit, shame about its spotty worker safety record but we gotta make this loan."

Oh, I am being a little glib. Sometimes banks consider not only the actual credit risk of a financing but also the reputational risk: Even if you think some major oil company is huge and stable and a great credit, you'll probably have a contentious committee meeting about lending it money, because there is activist pressure on banks not to lend to oil companies. (And, of course, pressure the other way.) My impression is that lending money to Amazon is not really in this category, but is it possible that the deal memo had a paragraph like "Reputational risk: A lot of people don't like how Amazon treats its workers"? Is it possible that the deal memo went on to say "Mitigating factor: Amazon says its workplace safety is good"? I mean, sure. Would its banks have loaned it the money on the same terms no matter what Amazon said about its workplace safety? Yes, I think so. But you can understand how the prosecutors might be doing the shoehorning.

Elsewhere, and related, here is Patrick McKenzie on "KYC and AML: beyond the acronyms":

Many, many crimes involve lies, but most lies told are not crimes and most lies told are not recorded for forever. We did, however, make a special rule for lies told to banks: they're potentially very serious crimes and they will be recorded with exacting precision, for years, by one of the institutions in society most capable of keeping accurate records and most findable by agents of the state.

This means that if your crime touches money, and much crime is financially motivated, and you get beyond the threshold of crime which can be done purely offline and in cash, you will at some point attempt to interface with the banking system. And you will lie to the banks, because you need bank accounts, and you could not get accounts if you told the whole truth.

The government wants you to do this. Their first choice would be you not committing crimes, but contingent on you choosing to break the law, they prefer you also lie to a bank.

Same idea with workplace safety violations.

The general form of "everything is securities fraud" is:

The company, or one of its executives, does a bad thing; The company does not simultaneously disclose the bad thing to shareholders (because it is shameful, etc.); Eventually the bad thing comes out and the stock drops; The shareholders can say they were defrauded: They paid more for the stock than they would have if they had known about the bad thing.

When I write about this, sometimes I get complaints from securities lawyers who say "no, securities fraud doesn't work that way: You are not required to disclose everything immediately , and it is only securities fraud if the company puts out some misleading disclosure. Just not mentioning a bad thing is not fraud." [6] And so in fact the technical game of "everything is securities fraud" is that you have to find something that the company did say that turns out not to be true in light of the bad thing. A classic that we have discussed a few times is that, if a company has a public code of ethics saying "our executives are not allowed to do bad stuff," and they do bad stuff, then you sue the company because its code of ethics is misleading. Or if the company has a risk factor that says "bad stuff might happen and that would be bad," and the bad stuff has already happened, then that risk factor is misleading.

Or, here, if the company fires an executive for having an intra-office affair, and it puts out a press release saying that he "separated from the Company following the Board's determination that he violated company policy and demonstrated poor judgment involving a recent consensual relationship with an employee," but it doesn't say that he had several consensual relationships with employees, well, I guess that use of the singular is misleading?

If a Danish bank acquires a Finnish bank with a branch in Estonia that serves Russian customers and does not do sufficient anti-money-laundering checks, and some of those Russian customers at the Estonian branch of the Finnish bank owned by the Danish bank "were engaged in highly suspicious and potentially criminal transactions," is that securities fraud in the US? You know the answer! It's right in the section header:

The Securities and Exchange Commission [yesterday] announced fraud charges against Danske Bank, a multinational financial services corporation headquartered in Denmark, for misleading investors about its anti-money laundering (AML) compliance program in its Estonian branch and failing to disclose the risks posed by the program's significant deficiencies. Danske Bank agreed to pay $413 million to settle the SEC's charges.

According to the SEC's complaint, when Danske Bank acquired its Estonian branch in 2007, it knew or should have known that a substantial portion of the branch's customers were engaging in transactions that had a high risk of involving money laundering; that its internal risk management procedures were inadequate to prevent such activity; and that its AML and Know-Your-Customer procedures were not being followed and did not comply with applicable laws and rules. The SEC alleges that, from 2009 to 2016, these high-risk customers, none of whom were residents of Estonia, utilized Danske Bank's services to transact billions of dollars in suspicious transactions through the U.S. and other countries, generating as much as 99 percent of the Estonian branch's profits. The complaint further alleges that, although Danske Bank knew of these high-risk transactions, it made materially misleading statements and omissions in its publicly available reports stating that it complied with its AML obligations and that it had effectively managed its AML risks. As the full extent of Danske Bank's AML failures became apparent, its share price dropped precipitously.

There is a parallel US Department of Justice guilty plea and $2 billion penalty, and that makes sense. If Russians are doing crimes at their Estonian bank, the odds are good that somehow they will end up with some dollars, and giving criminals access to the US dollar banking system is of great interest to US prosecutors:

U.S. Attorney Damian Williams said: "For years, Danske Bank lied and deceived U.S. banks to pump billions of dollars of suspicious and criminal funds through the U.S. financial system. In doing so, Danske Bank, the largest bank in Denmark, deliberately disregarded U.S. law, of which it is well aware, facilitated the laundering of criminal and suspicious proceeds through the United States, and placed the U.S. financial network at risk, all in the name of its bottom line. The Bank is now being held to account. For its years-long criminal conduct, today Danske Bank pled guilty to conspiring to commit bank fraud, will forfeit over $2 billion, and will implement and maintain a revamped compliance program and AML controls. Banks and other financial institutions around the world should heed this message: If you want to use the U.S. financial system, you must play by the rules. If you don't, we will hold you accountable."

From the Justice Department's perspective, Danske defrauded US banks by tricking them into facilitating dollar transactions for Danske as Danske was opening accounts for possible criminals. From the SEC's perspective, though, Danske defrauded US shareholders by tricking them into thinking that it was a good bank, but then it turned out to be a bad bank (with the money laundering), so its stock went down. When a US public company does a bad thing and its stock goes down, that's securities fraud.

The fact that Danske Bank is not actually a US public company is a minor detail:

Danske is a Danish multinational banking and financial services corporation headquartered in Copenhagen, Denmark. At all relevant times, Danske was the largest bank in Denmark and a major retail bank in Northern Europe, with offices in countries outside Denmark. Danske's shares traded in Denmark on the OMX Copenhagen and in the United States over-thecounter ("OTC") as American Depositary Receipts ("ADRs") listed in U.S. dollars, and U.S. investors constituted a significant portion of Danske's shareholders. Between 2009 and 2018, U.S. shareholders held as much as 18% of Danske's stock.

Pursuant to Exchange Act Rule 12g3-2, 17 C.F.R. § 240.12g3-2, Danske was exempt from registering its equity securities under Section 12(g) of the Exchange Act and filing periodic reports under Sections 13(a) and 15(d) of the Exchange Act, provided that, among other things, Danske publish in English, on its website, information and reports in the form required by the laws of its country of incorporation (Denmark).

Accordingly, between 2009 and 2016, Danske periodically published a variety of reports, including annual, interim, corporate governance, and risk management reports, in English on its corporate website for the benefit of and made available to, inter alia, actual and prospective U.S. investors. Certain of these reports contained representations to investors about Danske's risk management processes and disciplines related to the banks systems and controls. Such systems and controls would include Danske's policies and procedures to detect, prevent and mitigate risks to the bank from financial crime, including money laundering. …

From at least 2009 through early 2016, Danske knew or was reckless in not knowing that its statements to investors in its periodic reports … were false and misleading.

If a public company anywhere in the world does a bad thing and its stock goes down, the SEC will take interest.

This is the theory that we talk about all the time around here, that "everything is securities fraud." If a company does a bad thing, and it didn't tell its shareholders about it, then it deceived the shareholders and that's fraud. Ordinarily this theory applies only to public companies, but if you're a high-profile enough private company and you raised a lot of money from outside investors while doing bad stuff and not telling them about it, then I guess that's good enough.

We talked last year about an everything-is-securities-fraud case against Goldman Sachs Group Inc.; there, the allegations were that (1) Goldman did some fraud while selling mortgage collateralized debt obligations, (2) it didn't tell shareholders that it was doing fraud while selling CDOs, so (3) it was doing fraud on the shareholders too. I wrote:

As I often write, this theory can turn anything bad that a public company does into securities fraud: A company will put out some generic statements saying that it is good, follows the law, has a code of ethics, etc.; then it will turn out that the company secretly does bad things, breaks the law, has unethical executives, etc.; the stock will drop (because the bad things are bad for the company); the shareholders will sue, saying "you said you were good, we believed you, we bought the stock, but you were bad and we lost money." And so climate change and sexual harassment and lax customer data protections and mistreatment of orcas can all be transmuted into securities fraud.

Here the underlying bad deed that was transmuted into securities fraud was also securities fraud —Goldman said it put customers first, then it did a fraud on the Abacus CDO buyers, then it got caught, then its stock dropped—but that is just a coincidence. If instead of defrauding the Abacus CDO buyers Goldman had murdered them, that would not have been securities fraud with respect to the Abacus CDO buyers (it would have been murder), but it would still have been securities fraud with respect to Goldman's shareholders (if the stock dropped after Goldman was charged with murder).

Similarly, here, the underlying bad deed was (allegedly) running a fraud at a crypto exchange, which certainly looks like securities fraud, but might not actually be. But it doesn't matter; if you have shareholders, any sort of fraud is also securities fraud.

In so much of business, there are different ways to describe the same conduct, and the different descriptions have different legal implications. "I paid a bribe to a politician to get this government contract": no, bad, don't say that. "We do not have extensive contacts in that region, so I paid a consulting fee to a firm with deep local knowledge, and they were able to advise us on how to tailor our proposal effectively to the right decisionmakers": Isn't that so calm and boring and business-y? Don't your eyes glaze over as you think "sure, yes, business, whatever"? Does it mean the same thing? Quite possibly!

Or: "He blackmailed me, so I handed him a sack of cash": bad. "He gave me a copy of his allegations as part of a confidential offer of settlement, and, without admitting or denying them, I decided to put the matter behind me by entering into a monetary settlement, which of course included a non-disclosure agreement": Isn't that so calm and boring and lawyer-y? Don't you think "sure, yes, settlement, whatever"? Does it mean the same thing? Quite possibly!

This is extremely extremely extremely not legal advice, do not try it at home, and often we find ourselves talking about these issues around here because someone thought they used the right words and prosecutors disagreed.

Here's another important one. "They hacked into our system and stole our user data, so we paid them ransom to give it back": bad! Bad for them (they did a crime), and also bad for you: You have to disclose — to the users, perhaps to the government, perhaps to shareholders — that you got hacked, and you might get in trouble for your carelessness. "We have a bug bounty program in which we pay rewards to outside security researchers who spot holes in our security, and that program worked as designed to catch this problem before it could be used by evil hackers": much nicer. Your bug bounty program working effectively is not a security failing , it is a security success , and you don't have to report it to anyone.

You know the drill. A public company does a bad thing. When the bad thing becomes public, the company's stock goes down. Shareholders sue the company for securities fraud. The lawsuits are always the same: "You told us in your public filings that you were not doing a bad thing, so we bought your stock. But you were lying, and when the world found out you were doing the bad thing, the stock went down and we lost money. We were defrauded out of our money by your lies." Everything bad — polluting, sexual harassment, animal abuse, making a buggy video game, social media companies failing to safeguard user privacy, social media companies having a negative effect on society, lax information security practices leading to data breaches — can also be characterized as securities fraud, if a public company does it.

Now. The theory of everything-is-securities-fraud is something like: If a company does a bad thing, that will be bad for its business in some way. It will lose customers or lose employees or pay fines or whatever. This will reduce the profits available to shareholders, which will reduce the value of the stock. If shareholders had known about the bad thing, they could have properly valued the company; the fact that the bad thing was hidden prevented that and inflated the stock price. When it came out, the stock fell to its true value, and the deceived shareholders lost money. Byrne Hobart once wrote:

This is … partly a result of how efficiently markets aggregate and share information: it's hard to directly measure the effect of corporate malfeasance on sales or employee retention, especially over long periods. But stock prices react fast, and they represent a guess about the long term. So if you want to know exactly how bad some piece of news was, the only way to rephrase that is "how bad was it for shareholders?"

If a Brazilian iron mining company builds a dam, and the dam collapses, kills 270 people and causes "immeasurable environmental and social harm," is that securities fraud? Of course it is:

The Securities and Exchange Commission [Thurssday] charged Vale S.A., a publicly traded Brazilian mining company and one of the world's largest iron ore producers, with making false and misleading claims about the safety of its dams prior to the January 2019 collapse of its Brumadinho dam. The collapse killed 270 people, caused immeasurable environmental and social harm, and led to a loss of more than $4 billion in Vale's market capitalization.

According to the SEC's complaint, beginning in 2016, Vale manipulated multiple dam safety audits; obtained numerous fraudulent stability certificates; and regularly misled local governments, communities, and investors about the safety of the Brumadinho dam through its environmental, social, and governance (ESG) disclosures. The SEC's complaint also alleges that, for years, Vale knew that the Brumadinho dam, which was built to contain potentially toxic byproducts from mining operations, did not meet internationally-recognized standards for dam safety. However, Vale's public Sustainability Reports and other public filings fraudulently assured investors that the company adhered to the "strictest international practices" in evaluating dam safety and that 100 percent of its dams were certified to be in stable condition.

This is all pretty normal stuff. As I often say around here, every bad thing that a public company does, or that happens to a public company, can be recharacterized as securities fraud: (1) you said your dams were safe, (2) I bought the stock, (3) a dam collapsed, (4) the stock went down.

But there are two somewhat unusual points here. One is that Vale is a Brazilian company and the dam was in Brazil, so it's a bit odd for the U.S. SEC to regulate it. But Vale has American depository receipts that trade on the New York Stock Exchange, and also sold bonds in the U.S., and that's more than good enough for the SEC. When a Brazilian company's dam in Brazil collapses and kills 270 Brazilians, the SEC will step in to protect American shareholders.

Every bad thing that a U.S. public company does can be transmuted into securities fraud: When the news about the bad thing comes out, the stock will drop, and investors will say "you didn't promptly tell us about the bad thing, or you didn't adequately warn us about the risk of the bad thing, so we were deceived into buying your stock and have now lost money." We talk about this a lot. It has some international applications, but in general, not everything that public companies do outside of the U.S. is securities fraud. The U.S. is very advanced in this matter.

But this would be quite a shareholder lawsuit:

Geoff Bainbridge, the chief executive of [Australian] listed whisky maker Lark Distilling, sensationally quit the company on Wednesday "to enable him to manage a personal matter" that was brought to the board's attention on Tuesday night.

That "personal matter" is an alleged case of international extortion that stemmed from a visit to South East Asia well before his appointment as Lark CEO.

"I attended a gathering with people I didn't know and don't remember much more about that night. However, the next morning I was played footage which made it clear I had been set up as part of a shakedown," Bainbridge said in a statement.

"Following the incident, due to this captured content I have been the subject of a sophisticated, continuing and recently escalated extortion." ...

The stock, which had gained 170 per cent in a year before Wednesday's announcement, fell as much as 21 per cent in a few hours.

Imagine trying to write that risk factor.

The point here is that "everything is securities fraud" is a way to punish political speech. In general, in the U.S., people — and also corporations — are allowed to express their opinions about controversial political topics, and it is viewed as unseemly for the government to punish them for doing so. And this is true even if they are factually mistaken, or outright lying: It is bad for people to lie about political matters, but the punishment for that is pretty much "journalists might call you a liar"; the government is not in the business of punishing even dishonest political speech.

On the other hand it is illegal — it is securities fraud — for a company to lie to its shareholders to get them to buy stock, and that rule is generally interpreted broadly enough that essentially any untrue statement that a public company makes can be called securities fraud.

So you just combine those two things and you can turn any sort of political speech or position-taking by a public corporation (or its executives, or its subsidiaries) into securities fraud. Find some debatable premise in what they say: fraud. Or, failing that, you can accuse them of fraud for failing to include a risk factor about how their political position is actually bad, will cost them customers, etc.

The point is that the law of fraud — here securities fraud, but more generally "wire fraud" or just "fraud" — creates a sort of backup to contract law, corporate law, partnership law, etc. If you go around telling people "hey, sign this contract and you'll get a pony," and they sign the contract and it actually says "you will never get a pony," they will not have much ability to sue you under the contract, but someone will probably go after you for fraud, depending on things like how many people you marketed it to and how unsophisticated they were and how high-pressure your marketing was and and how complicated the contract was and how much money you got out of them.

People complain about this from time to time; in particular, it is common for fraud defendants to say "this is not a case of fraud, but a simple contract dispute in which we disagree with our counterparties about what our obligations were under the contract." There is a lot of overlap between those things.

I think this is an interesting situation — related to but distinct from "everything is securities fraud" — for, like, corporate governance and Elon Musk and executives on Twitter. I think that corporations and their executives are, in broad terms, obligated to do not only what their contracts and corporate documents say they have to do, but also what they have said publicly they are going to do (and particularly what they have said to investors they are going to do), because if they do something else they'll get sued for securities fraud.

One thing that I like to say around here is that every bad thing that a public company does is also securities fraud. Traditionally, when a public company lies about its financial results, that's securities fraud, but modern securities-fraud litigation has expanded until, you know, making teenagers feel bad about their bodies is securities fraud. But lying about financial results, yes, also definitely still securities fraud.

The word "public" is important there. Every bad thing a public company does is securities fraud, is the theory. Most bad things that private companies do are not securities fraud. Even lying about their finances , as long as they are not lying to investors to get them to invest. I once wrote:

One main reason for this is that public companies make their statements publicly, to everyone, and everyone can buy their stock. If a public company executive says "we had a good quarter" in a magazine interview, people will go buy the stock on the stock exchange; if it turns out she was lying, they will all have been deceived about a material fact in connection with a securities trade.

If a private company executive says "we had a good quarter" in a magazine interview, readers might say "oh interesting, nice to hear good news out of a startup," but they will not go buy the stock, because there's no stock for sale and nowhere to buy it. Investors can only buy the stock from the private company itself, in occasional, carefully controlled and lawyered fundraising rounds. When the company is raising a round, it will put together disclosure documents and send them to potential investors, and when it sells stock to those investors it will make them sign a contract saying in effect that they've done their due diligence, that they're only relying on the company's official disclosure, and that they can't sue the company for lying in a random magazine interview.

The approximate result is that every untrue public statement made by a public company has securities-fraud victims, while almost no untrue public statements by private companies have securities-fraud victims.

Again, to be clear, if you are a private company and you tell investors "we made $100 million last quarter" and they invest and you were lying, that's still securities fraud, they can sue, the Securities and Exchange Commission can still come after you, there are no exceptions for private companies. But if you are a private company and you tell a magazine "we made $100 million last quarter" and you are lying, that might be fine, as long as you tell the truth to investors before they invest. (Not legal advice!) This can be awkward when a private company goes public. Last month Dan Primack wrote a funny article about Sweetgreen Inc.'s filings for its initial public offering:

Restaurant chain Sweetgreen on Monday filed to go public, and revealed that it lost money in each year since 2014.

Why it matters: The company lied when it repeatedly told reporters it was profitable.

In a 2018 podcast with Recode's Kara Swisher, Sweetgreen co-founder and CEO Jonathan Neman replied "We are," when asked if the company was profitable. …

The company also told the NY Times last year that its 2019 revenue "topped $300 million," even though it was actually $274 million.

If you lie to reporters about being profitable, and then print the truth in your IPO filing, reporters will notice and be mad at you! That is probably the only consequence! They will write articles saying that you lied, which will hurt your feelings a bit, but whatever. As long as you gave your private investors accurate financial statements, and include accurate financial statements in your IPO filings, you're fine.

Still I suppose your lawyers might overthink it a bit and say: Well, the old articles are still out there on the internet, the ones where you lied about your financial results. Any rational investor will of course ignore those old articles and look at your IPO filings to see your financial results. But there are a lot of irrational investors in the world, and more to the point there are a lot of clever securities plaintiffs' lawyers. If you go public and then your stock goes down, someone is going to sue you, saying "you said in a New York Times article that your 2019 revenue was over $300 million, but it was really $274 million, and we read the article and were deceived and bought your stock." This is very stupid stuff but just to be safe you might as well disclaim those articles now.

And so today Sweetgreen filed an amended prospectus for its IPO that includes this paragraph in the risk factors:

Additionally, any public statements, including social media posts, from any members of our senior management team or board of directors that are perceived negatively or other than as intended by the media or our customers could have a material and adverse impact on our brand. For example, in a December 2018 podcast, our Co-Founder and Chief Executive Officer, Jonathan Neman, stated, in response to a question of whether the company was profitable, that "we are." As noted in this prospectus, for the fiscal year ended December 30, 2018, we had a net loss of $31.1 million. Although Mr. Neman was referring in this response to operating profitability for the third quarter of fiscal year 2018 rather than net income profitability under GAAP requirements, listeners of the podcast, or readers of subsequent articles that reprinted this statement, including potential investors in our prior private financings or this offering, may have construed this statement to be referring to GAAP profitability. In addition, in January of 2020, we were quoted in an article by the New York Times that revenue for fiscal year 2019 "topped $300 million." As noted in this prospectus, for the fiscal year ended December 29, 2019, we had revenue of $274.2 million. Accordingly, this quote did not precisely reflect our revenues for fiscal year 2019. While we believe all investors in our private financings since the date of these public communications had complete and accurate information in which to make an investment decision, some investors may have given undue reliance on these public communications. Although we would vigorously contest any claim that a violation of the Securities Act occurred as a result of these public communications, we cannot assure you that such investors, or regulatory authorities, could not make such claims and/or that such sales of securities around the time of these communications could not subject the company to rescission claims. Any such claims could have an adverse effect on the company. Similarly, potential investors in this offering should not rely on these prior public statements. You should make your investment decision only after reading this entire prospectus carefully.

That should do it! Of course the problem persists: If you read the old news articles but not the prospectus, then you won't read this risk factor , and you won't know that Sweetgreen lied about its 2018 and 2019 results or that it now disclaims those statements. Still, probably good enough.

Note the other point here is that, while Sweetgreen believes (correctly, I think) that those public statements were not securities fraud on the private investors who previously bought its stock , because they "had complete and accurate information in which to make an investment decision," there's still some risk that those investors will give it a go and sue claiming that they relied on the inaccurate public statements. That seems a bit much to me, but I see why Sweetgreen would want to be careful; the frontiers of securities fraud are always expanding.

Everything, I like to say, is securities fraud. If a public company does a bad thing, or a bad thing happens to it, some creative lawyer will be able to argue that the company's disclosure was misleading and that it defrauded its investors. Specifically, if you bought the stock before the bad thing was disclosed, and then the stock price went down after the bad thing was disclosed, you have a securities fraud claim.

Bad things do happen, so there are lots of securities fraud class actions, lawsuits on behalf of everyone who bought or owned stock in Company X between Date Y and Date Z. And these cases often settle for millions of dollars, and then the lawyers send out notices to investors saying if you qualify — if you bought stock in Company X between Date Y and Date Z — you can send in a claim and you'll get some of the settlement money. In our modern system of stock ownership, it shouldn't be that hard to figure out who qualifies. But it can sometimes be a little complicated:

While many claims are submitted by individual shareholders, traders that are involved in a large number of trades, such as high frequency trading firms, hedge funds, or family offices, sometimes use claim aggregators, which, for a fee, compile large amounts of trades for a client and manage the claims process in dealing with distribution fund administrators.

In evaluating claims, the distribution fund administrator typically performs audits and data integrity checks to confirm that a purported injured investor is entitled to receive compensation from the distribution fund. For example, distribution fund administrators typically confirm that the submitted documents reflect transactions in the relevant security during the relevant time period, and that the reported transactions reflect a price at which the security traded on the relevant date.

As part of the claims evaluation process, distribution fund administrators may request documentation and information to further evaluate a claimed securities transaction. The trading dates and holdings of the security must conform to the period of the alleged misconduct.

And because everything is securities fraud — because it is a growing business, because there is a whole industry of enterprising lawyers trying to turn more things into securities fraud — there are a lot of settlements, a lot of chances to submit claims, a lot of overworked claims administrators, and, you know, a certain amount of opportunity to do fraud. These guys allegedly did some fraud:

The Securities and Exchange Commission [last week] announced it charged a New Jersey "claims aggregator" - a firm that submits claims on behalf of its clients to administrators tasked with returning settlement funds to harmed investors - and its three principals with defrauding distribution funds established to return money to securities fraud victims in a multi-year scheme that yielded millions of dollars.

The SEC's complaint, filed in the United States District Court for the Eastern District of Pennsylvania, alleges that Joseph Cammarata, Erik Cohen, and David Punturieri, and two entities that they control, AlphaPlus Portfolio Recovery Corp. and Alpha Plus Recovery, LLC (collectively "AlphaPlus"), stole at least $40 million from approximately 400 distribution funds, including more than $3 million from settlement funds arising from SEC enforcement actions. The complaint alleges that, starting in 2014, AlphaPlus engaged in a serial scheme to fraudulently obtain money by submitting false claims to settlement fund administrators - purporting to represent clients who had traded the securities that were the subjects of the underlying settlements. The complaint further alleges that defendants used false trading data and broker-dealer letterhead they misappropriated from other companies to "document" the purported trades and provide an air of legitimacy to their fake claims. According to the complaint, Cammarata, Cohen, and Punturieri funneled the fraudulently obtained distributions through a web of accounts they controlled and used the stolen money to pay for numerous personal expenses, such as jewelry, home renovations, luxury automobiles, watercraft, and real estate.

One question is: If you disguise your voice in order to impersonate a customer executive on a due diligence call in order to trick a potential investor into giving your company money, is that securities fraud? I am not really a lawyer and nothing in this column is ever legal advice but … yes? Yes, that does seem very much like the core of securities fraud? Lying to people about your business in order to trick them into investing money in your securities? So I'm going to go with yes.

Another question is: If you do that, and it doesn't work, and then you don't disclose to a different potential investor that you tried that on the first investor, is that securities fraud? That is, once you've done the fake diligence call, is every subsequent stock sale also fraud unless you say "hey guys, just so you know, we tried a little fraud before but now we have stopped"?

It is a little harsh but I think the answer is also yes? I am talking of course about Ozy Media, whose co-founder Samir Rao allegedly impersonated a YouTube executive on a due diligence call with potential investors from Goldman Sachs Group Inc. about how Ozy's videos do on YouTube. Goldman quickly figured it out and passed on the investment so, no harm no foul I guess? Goldman did not sue anyway, though apparently Google (which owns YouTube) found out about the impersonation and reported it to the FBI. But then Ozy kept going around trying to raise money, and it succeeded, and one of its later investors has now sued:

Ozy Media Inc. was sued by an investor over its co-founder's impersonation of a YouTube executive during a conference call with Goldman Sachs Group Inc. executives about a potential investment.

LifeLine Legacy Holdings LLC said in a securities fraud suit filed late Monday that it invested around $2.25 million in Ozy in February and May partly because co-founders Carlos Watson and Samir Rao claimed Goldman was about to put money in the company.

"Watson and Rao expressly represented to LifeLine that Goldman Sachs was positioning itself to make a substantial investment in the company," Beverly Hills-based LifeLine said in its complaint filed in federal court in San Jose. …

Ozy never disclosed that "Rao attempted to impersonate an executive of YouTube in an effort to obtain a substantial investment from Goldman Sachs, or that, as a result of Rao's fraudulent conduct, Goldman Sachs declined to invest in Ozy Media and that Ozy Media was under investigation by government agencies," LifeLine said in its suit.

Did it have to disclose that? Ozy is a private company, and when it sold stock to LifeLine it did so under a stock purchase agreement, and a stock purchase agreement will generally contain a representation saying something like "the company complies with all applicable laws," and if you are currently doing a fraud, or recently got finished doing a fraud, that rep is probably not true. Which makes the new sale, arguably, also a fraud. From LifeLine's complaint:

Based, in part, upon the foregoing representations, on or about February 24, 2021, LifeLine entered into a Series C Stock Purchase Agreement ("Series C SPA") pursuant to which it agreed to purchase approximately $2 million of Series C Preferred Shares in Ozy Media.

Among other things, the Series C SPA provided that "to the Company's knowledge, the Company is not in violation of any federal or state statute, rule or regulation applicable to the Company".

In hindsight the proper approach would have been for Ozy's lawyers to edit that rep to say "to the Company's knowledge, the Company is not in violation of any federal or state statute, rule or regulation applicable to the Company; provided, however, that an executive of the Company did disguise his voice on a call with another potential investor to impersonate a YouTube executive, which ended up getting reported to the FBI, but that investor never actually invested and the executive was having a tough time so we think it's not really a big deal, but just FYI." That would have been fine I think. Though of course then LifeLine probably wouldn't have invested? Which is the point? The point is that this would have been material to LifeLine's investment decision, had Ozy told them about it?

There is a classic view that the interests of shareholders and the interests of society sometimes diverge, that sometimes companies put the financial interests of their shareholders (profit) above the good of society, and that an important job of government is to find and regulate those cases of market failure. It's cheaper to dump your industrial waste in a river than to pay for safe disposal, so companies do that to maximize profits, so governments write laws to prevent them from doing that, etc. The shareholders say "focus on profit above all else" and society says "well not above all else." And then companies have an optimization problem: They have to maximize profit, constrained only by staying within the rules.

This is such a standard view that a couple of years ago the chief executive officers of a bunch of big companies said, in effect, "we are going to stop caring only about shareholders and start caring about society." This was viewed as a big change. You have shareholders, you have society, they are adverse to each other, you have to pick. The CEOs were like "usually we have picked shareholders but now sometimes we will pick society."[1]

But I think this model is wrong. I mean, perhaps it was once right, but now it isn't. Now shareholders increasingly come to the companies they own and say "don't maximize profits for us, do what is best for society."

The basic theory is about long-term sustainability and internalization of externalities. The theory is that if a company chooses profit over some other legitimate stakeholder interest (being nice to customers, treating workers fairly, not polluting, not undermining democracy, etc.), then its profits will not be sustainable. Eventually the customers will take their business elsewhere, the workers won't produce good work, or governments will pass laws about pollution and democracy-undermining that will destroy the company's business. In the long run, externalities are internalized: If you make a profit by harming society, eventually society is going to send you a bill for that harm, with interest. Long-term shareholders want you to profit without harming society, so that you can keep profiting in the future.

This theory has gotten a ton of traction and attention in the last decade. In particular it is at the core of ESG investing, investing that takes into account environmental, social and governance factors. We talked last month about a presentation from ESG-ish activist fund Engine No. 1 LLC, which focused explicitly on this internalization-of-externalities argument.[2] And I say "the last decade" because of this article by Bloomberg's Kate Mackenzie from last Friday about "How the Finance World Started Turning Against Fossil Fuels":

A quiet celebration took place in London last month. It marked the 10th anniversary of the "Carbon Bubble" report, published by the think tank Carbon Tracker Initiative, that's become one of the most influential arguments against burning fossil fuels. …

Carbon Tracker concluded that only a fifth of the 2.3 trillion tons of hydrocarbons could be extracted and used. The rest would have to be left in the ground. It was a completely counterintuitive proposal to the corporate world. All that coal, oil and gas contributed to the value of companies and assets that sat in portfolios from New York to Hong Kong. Even if the goal was only partly realized, those holdings would plummet.

"Investors are thus left exposed to the risk of unburnable carbon," the report said. They would be "stranded assets" ...

The Carbon Bubble report introduced a completely new way of looking at the problem. Its authors pointed out another truth: the fossil fuel business had to go away if the planet were to survive, and being the last one out the door would be a colossal financial mistake.

That is an argument of the form "sure you can make a lot of money for shareholders now by pumping out oil, but in the long run you won't be allowed to, so as shareholders we want you to stop doing so much of that." That argument was in some sense invented 10 years ago, and now it is close to a consensus among bi

One topic in finance that fascinates me is "body language." Here is the problem:

1. Big institutional investors often meet one-on-one with the executives of the public companies whose shares they own. 2. These meetings appear to be desirable and informative, to the point that investors will pay banks for setting them up, and investors seem to make market-beating trades after these meetings. 3. However, it is illegal for companies to give the investors "material nonpublic information" in these meetings. 4. So what do they talk about? 5. One theory is that the company tells investors information that is found in its public filings, and they chat about the weather and stuff, but the investors observe the executives' "body language" during these meetings and use it to inform their investing decisions. 6. Like, the executives say "as we said in our earnings release, we had 14% gross margins this quarter," and that is in fact in the earnings release so it's not news. But if they say it confidently in a power pose the investors buy more, and if they say it nervously while looking to the side the investors sell everything. Body language. 7. One assumes (why?) that this "body language" is not itself material nonpublic information, so there is no legal problem with the company giving the investors access to it.

I don't want to discount this theory entirely; I wrote once about a big investor that dumped all its stock of a public company because its chairman was too tan, which makes sense and was in fact a good call. (The company went bankrupt.) Still I do wonder about it sometimes. I assume "body language" is often a polite way to say "well sure they say a few things that aren't in the public filings, but not important things." It is easier to draw a bright line of "telling us earnings in advance is bad, but seeing body language is fine" than it is to say "telling us earnings in advance is bad, but helping us with some technical questions about how we should think about drivers of margin in our earnings model is fine." And no one's in the meeting with you, so for all anyone knows it's just body language.

"Everything is securities fraud," I like to say, and sexual harassment is particularly securities fraud. If an executive at a public company sexually harasses colleagues, and the news gets out and the stock drops, shareholders will sue the company, saying something like "you said that you had a code of ethics and policies against harassment, but you didn't say that your executive was harassing people, so we were misled into buying your stock, and when the truth came out we lost money." And then the company will settle and pay the shareholders something for the harassment. We have talked about this a few times. Sexual harassment, very much a core form of securities fraud.

When I write about "everything is securities fraud," mainly I am writing about plaintiffs' lawyers. "Everything is securities fraud" is essentially a theory of the incentives facing plaintiffs' lawyers, a way to transmute lots of problems at public companies into securities-fraud claims that are (1) easier to pursue and (2) more lucrative. If the stock drops when bad news comes out, it's easy to bring a class action on behalf of every shareholder who bought the stock before the news came out, and easy to calculate their damages (how much the stock dropped), which are large. Whereas just suing for sexual harassment is more difficult: Each case is unique, damages might be hard to prove and litigating might be painful for the victims.

Still, everything is securities fraud. I said the other day that the SEC is "the U.S.'s most general-purpose regulatory agency": Securities disclosure touches everything, from financial stability to climate change to Chinese-American relations to presidential war powers. Everything bad that happens, also happens to shareholders, and the SEC is there to protect them.

The basic rule is that when there is a devastating plane crash, the shareholders of the company that makes the plane will sue the company for securities fraud. "You built planes that would crash, but you lied and told everyone that you built planes that wouldn't crash, and we bought your stock thinking your planes wouldn't crash, and then they did so the stock went down." I don't make the rules, and I realize that this is both bizarre and ghoulish, but it is the rule. "Everything is securities fraud," I call it. And in fact Boeing Co. makes planes, including the 737 Max, and in 2019 and 2020 two 737 Max planes crashed, and Boeing's stock went down, and shareholders brought securities fraud lawsuits against it. Standard stuff.

But there are other, related but slightly different theories. For instance instead of suing the company for failing to disclose that its planes would crash, you could sue the executives and directors for failing to stop the planes from crashing. "The directors and officers had a fiduciary duty to build safe planes, not planes that crashed, and they failed in their fiduciary duties so they should pay damages." This sort of lawsuit is called a "shareholder derivative claim,"[1] and it is in many ways more complicated than the everything-is-securities-fraud theory. It is hard, generally, to get a court to second-guess directors' and officers' business decisions; it is hard to hold them personally liable for business failures.

But the derivative lawsuit has some advantages. For one thing, it doesn't rely on finding misstatements in the disclosure. If Boeing's public statements were along the lines of "we try to make safe planes, but there is a risk that they might crash due to design flaws, and if they did that would be very bad for our business,"[2] and then some planes crashed, it is a little hard to argue that it deceived anyone. You can, of course — "you said you had a culture of safety and you had a culture of not-safety," etc. — but it's hard. It seems somehow more straightforward to argue "look, your job was to make safe planes, and you didn't, so now you have to pay."

For another thing, if you are a shareholder and you sue the company for securities fraud, and you win, the company pays you, which is sort of pointless? It just moves money from the corporation (whose shares you own) to your bank account, but it was your money anyway. And now the lawyers get a chunk of it. But if you sue the directors and win, the money goes from the directors' personal accounts to you; money that was not yours becomes yours (and the lawyers get a chunk). In practice directors are generally indemnified and insurance is paying for all of this, but it does make a little bit more intuitive sense for shareholders to sue the people who (allegedly) messed up the corporation than it does to sue the corporation itself.

Anyway some shareholders brought a derivative action against Boeing's directors and officers, and the directors and officers asked a Delaware court to dismiss the case, and last week Delaware Vice Chancellor Morgan Zurn ruled that the case against the directors (though not the officers[3]) can go forward:

The narrow question before this Court today is whether Boeing's stockholders have alleged that a majority of the Company's directors face a substantial likelihood of liability for Boeing's losses. This may be based on the directors' complete failure to establish a reporting system for airplane safety, or on their turning a blind eye to a red flag representing airplane safety problems. I conclude the stockholders have pled both sources of board liability. The stockholders may pursue the Company's oversight claim against the board.

It is hard to sue directors for breaching their fiduciary duties. In general, the "business judgment rule" insulates directors' business decisions from judicial review. But a 1996 Delaware court decision called Caremark allows directors to be held liable for some kinds of failure to oversee the company. Vice Chancellor Zurn explains:

As Chancellor Allen first observed in Caremark , and as since emphasized by this Court many times, perhaps to redundance, the claim that corporate fiduciaries have breached their duties to stockholders by failing to monitor corporate affairs is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." A decade after Caremark , our Supreme Court affirmed the doctrine Chancellor Allen announced there and clarified that our law will hold directors personally liable only where, in failing to oversee the operations of the company, "the directors knew that they were not discharging their fiduciary obligations." At the pleading stage, a plaintiff must allege particularized facts that satisfy one of the necessary conditions for director oversight liability articulated in Caremark : either that (1) "the directors utterly failed to implement any reporting or information system or controls"; or (2) "having implemented such a system or controls, [the directors] consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention." I respectfully refer to these conditions as Caremark "prong one" and "prong two." …

As our Supreme Court explained in In re Walt Disney Co. Derivative Litigation , the "intentional dereliction of duty" or "conscious disregard for one's responsibilities," which "is more culpable than simple inattention or failure to be informed of all facts material to the decision," reflects that directors have acted in bad faith and cannot avail themselves of defenses grounded in a presumption of good faith. In order to plead a derivative claim under Caremark , therefore, a plaintiff must plead particularized facts that allow a reasonable inference the directors acted with scienter which in turn "requires [not only] proof that a director acted inconsistent[ly] with his fiduciary duties," but also "most importantly, that the director knew he was so acting."

This is a somewhat strange standard. The words make it sound like the directors can only be liable if there is proof that they sat around cackling and saying "we don't care about safety, let it all burn." But in practice it rarely works like that; instead, mainly the rule is that if the board just didn't pay enough attention to safety, it will get in trouble. Here, Boeing's board "had no committee charged with direct responsibility to monitor airplane safety," and "did not regularly allocate meeting time or devote discussion to airplane safety and quality control until after the second crash":

The period after the Lion Air Crash is emblematic of these deficiencies. The Board's first call on November 23 was explicitly optional. The crash did not appear on the Board's formal agenda until the Board's regularly scheduled December meeting; those board materials reflect discussion of restoration of profitability and efficiency, but not product safety, MCAS, or the AOA sensor. The Audit Committee devoted slices of five-minute blocks to the crash, through the lens of supply chain, factory disruption, and legal issues—not safety.

The next board meeting, in February 2019, addressed factory production recovery and a rate increase, but not product safety or MCAS. At that meeting, the Board affirmatively decided to delay its investigation into the 737 MAX, notwithstanding publicly reported concerns about the airplane's safety. Weeks later, after the Ethiopian Airlines Crash, the Board still did not consider the 737 MAX's safety. It was not until April 2019—after the FAA grounded the 737 MAX fleet—that the Board built in time to address airplane safety.

The obvious lessons here are that if you are the board of directors of a public company, you should:

1. Make a list of the things that can plausibly go horribly wrong at your company. 2. Set up a board

Everything, I like to say, is securities fraud: If a public company does a bad thing, or a bad thing happens to it, and it becomes public and the stock goes down, investors will sue. "You didn't tell us about the bad thing," they will say, "so we bought the stock thinking it was very valuable, but then when we learned of the bad thing the stock went down and we lost money due to your deception."

Now, technically, this is not always securities fraud. Companies don't actually have an obligation to disclose everything that happens as soon as it happens. If a moderately bad thing happens, and the company doesn't say anything for a while, and then the news comes out, that is not technically securities fraud.

But this is a small technicality that doesn't matter much, because companies will generally have said something that the bad thing renders untrue, or untrue-ish, or somewhat misleading. For instance, the company will say "we have a code of ethics and tell our executives to behave well." Then if the executives behave poorly, someone will sue the company, saying "you told us that you have a code of ethics, so we believed your executives behaved well, but you neglected to tell us that they actually behave poorly." (This is the Goldman Sachs Group Inc. case that went to the Supreme Court.)

Or the company will have risk factors in its public filings, saying things like "if we get hacked that would be bad" or "if our chief executive officer is a sexual harasser that would be bad" or "if we violate the law that would be bad" or whatever. And then if it turns out the company had been hacked, or the CEO is a harasser, or the company did violate the law, then investors could object: "You lied to us! You used words like 'if we get hacked,' which implied that you had not been hacked, but in fact you had been hacked already! Your use of the word 'if' was fraud."

That's really the law I guess; here is a U.S. Securities and Exchange Commission enforcement action from last week:

The Securities and Exchange Commission today announced that Pearson plc, a London-based public company that provides educational publishing and other services to schools and universities, agreed to pay $1 million to settle charges that it misled investors about a 2018 cyber intrusion involving the theft of millions of student records, including dates of births and email addresses, and had inadequate disclosure controls and procedures.

The SEC's order finds that Pearson made misleading statements and omissions about the 2018 data breach involving the theft of student data and administrator log-in credentials of 13,000 school, district and university customer accounts. In its semi-annual report, filed in July 2019, Pearson referred to a data privacy incident as a hypothetical risk, when, in fact, the 2018 cyber intrusion had already occurred. And in a July 2019 media statement, Pearson stated that the breach may include dates of births and email addresses, when, in fact, it knew that such records were stolen, and that Pearson had "strict protections" in place, when, in fact, it failed to patch the critical vulnerability for six months after it was notified. The media statement also omitted that millions of rows of student data and usernames and hashed passwords were stolen. The order also finds that Pearson's disclosure controls and procedures were not designed to ensure that those responsible for making disclosure determinations were informed of certain information about the circumstances surrounding the breach.

From the SEC's order:

On July 25, 2019, Pearson's management met to discuss the incident and again decided that it was not necessary to issue a public statement regarding it. On July 26, 2019, Pearson furnished on Form 6-K its report of interim results for the six months from January 1, 2019 through to June 30, 2019. In the "Principal risks and uncertainties" section of that report, Pearson stated that a "[r]isk of a data privacy incident or other failure to comply with data privacy regulations and standards and/or a weakness in information security, including a failure to prevent or detect a malicious attack on our systems, could result in a major data privacy or confidentiality breach causing damage to the customer experience and our reputational damage, a breach of regulations and financial loss." This statement, which remained unchanged from prior Forms 6-K, implied that no "major data privacy or confidentiality breach" had occurred when Pearson knew months earlier about the AIMSweb 1.0 breach. Pearson failed to consider how certain information about that breach should have informed this risk disclosure.

Let's assume that Pearson's management was right and that "it was not necessary to issue a public statement regarding it." (The SEC seems skeptical, but does not quite come out and say that Pearson was obligated to disclose it immediately.) It could have just burbled along keeping the breach quiet, until its next interim financial report was due. Then, if it just left in the usual risk factor — "if we get hacked it'd be bad" — that would become securities fraud; the hypothetical phrasing would imply that a hack had not happened, but in fact it had. I suppose Pearson could have just taken out the risk factor, but that seems like much worse disclosure. (Certainly their risk of being hacked hadn't gone down?) The advanced move would be to tinker with it a bit: "if we get hacked it would be bad, and when we say that we don't mean to imply that we have not been hacked, perhaps we have been hacked, we're not telling you." (For instance: "Risk of a data privacy incident or other failure to comply with data privacy regulations and standards and/or a weakness in information security, including a failure to prevent or detect a malicious attack on our systems, which may have already happened , could result in a major data privacy or confidentiality breach causing damage to the customer experience and our reputational damage, a breach of regulations and financial loss.") Even that might be too hypothetical for the SEC though. Really the only move is to come clean. Your existing disclosure boxes you in.

Anyway this went to the Supreme Court and there were some arguments about the theory — which I talk about a lot around here — that "everything is securities fraud." If companies say vague nice things about themselves — "we have a code of ethics," "the client comes first," "we have a culture of risk management," etc. — and then a bad thing happens, a shareholder will sue, arguing that the vague nice statements were lies that deceived investors and pumped up the stock, and that when the bad thing happened the truth was revealed and the stock dropped. When we talked about it in February, I quoted some amicus curiae briefs like this one:

Frequently, event-driven claims allege that generic or aspirational statements, similar to ones made by virtually every public company, maintained inflation in a company's stock price. Allegations of wrongdoing nearly always conflict, at some level of generality, with a company's code of conduct or other statements of corporate policy. So it is not difficult for plaintiffs to allege that negative reporting or disclosures "corrected" a prior, generic policy statement (e.g., "We strive to comply with all applicable laws."). The result is that just about any corporate controversy that coincides with a drop in stock price can be re-characterized as a securities fraud. Examples abound. COVID-19 exposure on cruise ships, wildfires, data breaches, and sexual-harassment allegations have all served as grounds for event-driven claims of securities fraud supposedly tied to generalized statements.

Like those briefs, I suggested that this case might be a chance for the Supreme Court to reconsider the growing idea that everything is securities fraud.Well, never mind. The Supreme Court decided the case yesterday and it is the most boring imaginable decision. If you were looking for the Supreme Court to say "you know what, not everything should be securities fraud," or "you know what, actually everything should be securities fraud," you will be disappointed. The decision is about a minor technicality, sending the case back to an appeals court to think a bit harder about whether Goldman's generic statements of honesty and integrity inflated its stock price before the crisis.The rule (from previous Supreme Court cases) is basically that Goldman can defeat the lawsuit by showing that its statements "did not actually affect the market price of the stock." The court of appeals concluded that Goldman did not do that, but the Supreme Court wants that court to try again. The court "'should be open to all probative evidence on that question—qualitative as well as quantitative—aided by a good dose of common sense,'" says the Supreme Court, helpfully. Goldman had argued to the Supreme Court that the statements at issue here — about integrity, etc. — are so generic that they could not possibly have affected the price; the Supreme Court basically said, well, no, it depends. "As a rule of thumb, 'a more-general statement will affect a security's price less than a more-specific statement on the same question.'" Ah.Here's a good passage (citations omitted):

The generic nature of a misrepresentation often will be important evidence of a lack of price impact, particularly in cases proceeding under the inflation-maintenance theory. Under that theory, price impact is the amount of price inflation maintained by an alleged misrepresentation—in other words, the amount that the stock's price would have fallen "without the false statement." Plaintiffs typically try to prove the amount of inflation indirectly: They point to a negative disclosure about a company and an associated drop in its stock price; allege that the disclosure corrected an earlier misrepresentation; and then claim that the price drop is equal to the amount of inflation maintained by the earlier misrepresentation.

But that final inference—that the back-end price drop equals front-end inflation—starts to break down when there is a mismatch between the contents of the misrepresentation and the corrective disclosure. That may occur when the earlier misrepresentation is generic (e.g., "we have faith in our business model") and the later corrective disclosure is specific (e.g., "our fourth quarter earnings did not meet expectations"). Under those circumstances, it is less likely that the specific disclosure actually corrected the generic misrepresentation, which means that there is less reason to infer front-end price inflation—that is, price impact—from the back-end price drop.

Public and private companies are subject to different rules about what they have to disclose to their shareholders, but the basic rule of securities fraud is the same. You are not allowed to knowingly make an untrue statement about a material fact to investors to try to get them to buy stock.[1] You can't lie about your company to get people to give you money. Reasonable enough.

In practice, this basic rule is vastly more likely to be enforced against public companies than it is against private, venture-backed startups. One main reason for this is that public companies make their statements publicly, to everyone, and everyone can buy their stock. If a public company executive says "we had a good quarter" in a magazine interview, people will go buy the stock on the stock exchange; if it turns out she was lying, they will all have been deceived about a material fact in connection with a securities trade.

If a private company executive says "we had a good quarter" in a magazine interview, readers might say "oh interesting, nice to hear good news out of a startup," but they will not go buy the stock, because there's no stock for sale and nowhere to buy it. Investors can only buy the stock from the private company itself, in occasional, carefully controlled and lawyered fundraising rounds. When the company is raising a round, it will put together disclosure documents and send them to potential investors, and when it sells stock to those investors it will make them sign a contract saying in effect that they've done their due diligence, that they're only relying on the company's official disclosure, and that they can't sue the company for lying in a random magazine interview.

The approximate result is that every untrue public statement made by a public company has securities-fraud victims,[2] while almost no untrue public statements by private companies have securities-fraud victims.

A related reason is that, when public companies sell stock, their disclosure documents are public; when private companies sell stock, their disclosure documents are private, sent only to potential investors with "CONFIDENTIAL" stamped on the cover. If a regulator or journalist or plaintiffs' lawyer or concerned citizen wants to spend an hour checking out a public company's disclosure to see if it has any lies, the disclosure is easily available on the internet. You cannot idly check out the disclosure documents that startups send to potential investors, so they just get a lot less scrutiny from outside enforcers.

A third reason is that the audiences are different. When a public company says something untrue, there are lots of victims (who buy stock). Some of them will be recruited by plaintiffs' lawyers (who monitor public companies' disclosures, looking for lies) to sue. Others will just be sympathetic victims; the Securities and Exchange Commission or federal prosecutors will bring a fraud case and talk about how the company has deceived ordinary investors.

When a private startup says something untrue, even in connection with a sale of stock, the victims will often be sophisticated venture capital firms.[3] These firms are less likely to sue, for a couple of reasons. For one thing, they want to invest in other startups, so they want to cultivate a reputation for being founder-friendly, and suing founders for fraud is not friendly. For another thing, they want to raise money from pensions and endowments and allocators, so they want to cultivate a reputation for being smart and doing good due diligence; calling attention to how they got tricked is not helpful. For a third thing, they are looking, in their venture capital investments, for high-risk, high-reward bets. The ideal founder, for them, is someone who promises the impossible and then delivers it. If a founder promises the impossible and then does not deliver it, well, you know, that's okay, most startups fail.

Similarly, prosecutors and regulators are less likely to bring a case in those circumstances: If the victims have no real complaints, it is harder to get a jury to punish the fraud.

The result of all of this is that there is, I think, a norm that a bit more … stretching of the truth … is tolerated in venture-backed startups than in public companies. Tolerated by the SEC, by prosecutors, by venture investors, by startup founders themselves. I wrote in February:

That is, like, startups, man. What you want, when you invest in a startup, is a founder who combines (1) an insanely ambitious vision with (2) a clear-eyed plan to make it come true and (3) the ability to make people believe in the vision now. "We'll tinker with hydrogen for a while and maybe in a decade or so a fuel-cell-powered truck will come out of it": True, yes, but a bad pitch. The pitch is, like, you put your arm around the shoulder of an investor, you gesture sweepingly into the distance, you close your eyes, she closes her eyes, and you say in mellifluous tones: "Can't you see the trucks rolling off the assembly line right now? Aren't they beautiful? So clean and efficient, look at how nicely they drive, look at all those components, all built in-house, aren't they amazing? Here, hold out your hand, you can touch the truck right now. Let's go for a drive." That's not true, but it's a nice metaphor; the goal is to get the investor to see the future, so she'll give you money today, so that you can build the future tomorrow.

But this norm is not written in the law anywhere, and it doesn't entirely correspond to legal concepts. (Perhaps you could express it in terms of "materiality" or "reliance"; like, private investors don't believe or care about startups' lies, so they don't count as fraud?[4]) It's just, if a public company lies a little bit, it will certainly be called on it; if a venture-backed startup lies a medium amount, it probably won't.

Everything, I like to say, is securities fraud, but … this? My first thought was, well, they sold these vehicles through a company, Pioneer Auto Finance. Perhaps they raised money for the company without telling investors that they were doing odometer fraud. On the theory of "everything is securities fraud," doing odometer fraud to your customers can also be securities fraud on your shareholders. It is a stretch, though, and in any case more the sort of thing a plaintiffs' lawyer would argue against a public company than what a federal prosecutor would argue against a private company.

But, nah, there is a simpler explanation. From the charges against them:

Defendant DEVON LUNA … did knowingly make, utter, and possess, and cause to be made, uttered and possessed, forged and counterfeited securities of the State of Texas, with the intent to deceive other persons, organizations, and governments; specifically, Defendant DEVON LUNA altered and caused to be altered the existing Texas titles of the vehicles listed below, by writing the false mileages listed below, to deceive automobile dealerships and individuals regarding the vehicles' true mileages … In violation of Title 18, United States Code, Section 513(a).

That's not the regular securities fraud law, which forbids "any manipulative or deceptive device" in connection with the purchase or sale of any security. That's a special one, which prohibits deceiving people with a forged or counterfeited "security of a State or a political subdivision thereof or of an organization." Apparently an automobile title counts as a security of a state. So if you mess with a car title document, that's securities fraud. Good to know.

Weird that they were arrested? To be clear, this is not a case of police in "Ukraine, Russia, North Macedonia, Moldova, Latvia, Uzbekistan and Azerbaijan" noticing the crimes, identifying the perpetrators, tracking them to Brooklyn and asking U.S. authorities to arrest and extradite them. This is the U.S. Attorney for the Eastern District of New York arresting them on his own initiative, not to ship them off to Ukraine etc. to be prosecuted for bank robbery, but to prosecute them in Brooklyn for … money … laundering?

The defendants and their co-conspirators agreed to use the United States financial system in furtherance of these crimes. For example, a co-conspirator … used a credit card issued in the United States … to make multiple purchases to promote the bank thefts, including, among other things (i) to purchase airline tickets to fly from, among other places, the Eastern District of New York to the locations of the thefts; and (ii) to rent hotel rooms for COOPER and the defendant GARRI SMITH, among others. The defendant ALEX LEVIN used bank accounts in the United States, including accounts located in the Eastern District of New York, among other things, to purchase sophisticated camera equipment used in the thefts, some of which was shipped to LEVIN's residence in the Eastern District of New York, and to launder the proceeds of those crimes.

The U.S. financial system is amazing. If you use a U.S. credit card to buy a plane ticket to a foreign country, and then you do a crime in that country, that's also a crime in the U.S. (It violates the Travel Act.) And if you rob a bank abroad, deposit the proceeds of the heist into a U.S. checking account, and use the money to pay your rent or whatever, that's a big U.S. crime; that's (allegedly) "money laundering." Everything is money laundering.

Everything, I frequently say, is securities fraud: If a public company does a bad thing, or a bad thing happens to it, shareholders will sue it alleging that it didn't sufficiently warn them about the bad thing. Credit Suisse had two high-profile errors more or less back to back, so that is, like, double securities fraud. Here is the complaint:

During the Class Period, defendants issued materially false and misleading statements regarding the Company's business metrics and financial prospects. Specifically, defendants concealed material defects in the Company's risk policies and procedures and compliance oversight functions and efforts to allow high-risk clients to take on excessive leverage, including Greensill Capital ("Greensill") and Archegos Capital Management ("Archegos"), exposing the Company to billions of dollars in losses. Not only did defendants conceal these operational landmines from Credit Suisse investors, which caused the price of Credit Suisse securities to be artificially inflated, but they also undertook actions indicating that Credit Suisse securities were substantially undervalued, such as a massive stock buy-back program worth 1.5 billion Swiss francs worth (equivalent to $1.6 billion).As a result of defendants' false statements, Credit Suisse ADRs traded at artificially inflated prices, reaching a high of $14.95 per ADR by February 2021. Following a series of corporate scandals which have revealed grave deficiencies in Credit Suisse's risk and compliance activities, the price of Credit Suisse ADRs plummeted, reaching a low of just $10.60 per ADR by March 31, 2021.

Blech. Yes, absolutely, Credit Suisse did two bad things. It ran some funds that invested in Greensill Capital notes and lost money when Greensill blew up, and it wrote some swaps to Archegos Capital Management that lost money when Archegos blew up. Credit Suisse's shareholders wish it hadn't done that, and Credit Suisse's managers wish it hadn't done that. Still it is strange to characterize this as primarily securities fraud against the shareholders, to think that the problem here was lying. The problem is not that Credit Suisse went around telling shareholders "we try not to lose money on dumb stuff" but had a secret undisclosed nefarious plan to lose money on dumb stuff. The problem is that Credit Suisse tried not to lose money on dumb stuff and failed. On the other hand, if I invested in one of those Credit Suisse Greensill funds, thinking that I was financing short-dated secured loans against accounts receivable, and then found out that I was financing long-term unsecured loans against " prospective receivables," I'd be annoyed. I might even feel defrauded, depending on what exactly the disclosure for those funds looked like. I don't know how I'd get Archegos into my complaint though.

Imagine two public companies, Company A and Company B. They both sell widgets. Their widgets are bad. Nobody should buy them; terrible widgets, over there at Company A and Company B.

Company A addresses this problem by lying to its customers. "Our widgets are great," it says, falsely. "They meet all the latest safety standards," it says, again falsely. "They're the widget of choice for the U.S. Department of Defense and the Queen of England. Nine out of ten doctors recommend Company A widgets." Etc. This campaign of lying works, and people buy a lot of Company A's widgets. It — accurately — reports high and growing revenue and net income quarter after quarter; it tells analysts and investors "we are doing great, we sold a million widgets this quarter because our widgets are so good." Executives get big bonuses and sell a lot of stock. This lasts for a year or two. Eventually customers notice that the widgets are bad, they stop buying, the company goes bankrupt and the investors lose everything.

Company B addresses the problem by lying to its shareholders. "Buy some widgets," it says to customers, and the customers look at the widgets and say "these widgets are bad," and Company B shrugs and walks away. No widgets are sold. When the quarter ends without any widgets being sold, Company B puts out an earnings report saying "we are doing great, we sold a million widgets this quarter because our widgets are so good." It just pretends. It publishes securities filings with financial statements reflecting millions of widgets that it never sold.[2] Executives get big bonuses and sell a lot of stock. This lasts for a year or two. Eventually someone — auditors? the SEC? a short seller? — notices that Company B never has any actual money despite supposedly selling millions of widgets, the scam is exposed, the company goes bankrupt and the investors lose everything.

Classically, Company B is committing "securities fraud." Faking your accounts, saying you sold products you didn't sell and earned money you didn't earn, these things are the core of securities fraud. You are lying to your shareholders about your business so that they will buy your stock. Very much securities fraud.

Company A … I would say that Company A is committing what I like to call "everything is securities fraud." Company A is primarily conducting a fraud on its customers. This is, in some rough sense, good for its shareholders; at least in the short term, Company A really is getting more money from this strategy (lying to customers) than it would from a non-fraud strategy (admitting that its widgets are bad and not selling any). Company A's securities filings and financial disclosures are more or less accurate: All the financials reflect real money that really came in.

Still there are some arguable inaccuracies. Company A probably uses some loose verbiage, "we sold a million widgets this quarter" (true) "because our widgets are so good" (subjective, but basically false). In any case, Company A's disclosures probably "omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading": If you say "we sold a million widgets" but neglect to say "by doing lots of fraud," you are giving your shareholders an incomplete understanding of your business. (For instance, a lot of that money will probably go out again, once the customers discover the fraud.) It's a little fraudy. For your shareholders. For your customers, it's a lot fraudy; for your shareholders, a little.

We talk about this a lot around here. In recent years, securities plaintiffs' lawyers have discovered that any fraud any company does to anyone is also a fraud on its shareholders; in fact, any bad thing that a company does is a fraud on its shareholders, at least if the stock goes down after the bad thing is discovered. The fraud on the actual victims can be complicated to prove; it might be hard to get a lot of victims together for a class action; the damages caused by the fraud might be small or uncertain. But the shareholder fraud is easy: Lying to shareholders (even by omission!) is sort of an obvious fraud, it's easy to define a class of victims (everyone who bought stock during the lies, etc.), and the damages are easy to prove (if the stock dropped) and potentially enormous (if it dropped a lot). If you are a product-liability lawyer or a sexual-harassment lawyer or a defective-widget lawyer, you will be fairly specialized and do a narrow range of complicated lawsuits. If you are a securities class action lawyer, you can sue anyone for anything; every fraud is, also, securities fraud.

The U.S. Securities and Exchange Commission also sometimes gets into this business, for related reasons. The SEC can be a meta-regulator; it can regulate companies' environmental and product-market and social behavior. Other regulators regulate one aspect of business, but the SEC can regulate whatever it wants through the lens of securities law.

You know their theory. We talk about it all the time. It is "everything is securities fraud." Here:

1. Goldman said publicly that it followed the law, put customers first, managed conflicts of interest, and generally was good. 2. Investors bought Goldman's stock, relying on Goldman's representations that it followed the law, put customers first, managed conflicts of interest, etc. 3. In fact Goldman was lying: It did not follow the law, put customers first, manage conflicts of interest, etc. 4. When the investors found out about this—after the global financial crisis and the SEC lawsuit over Abacus—the stock went down and the investors lost money.

As I often write, this theory can turn anything bad that a public company does into securities fraud: A company will put out some generic statements saying that it is good, follows the law, has a code of ethics, etc.; then it will turn out that the company secretly does bad things, breaks the law, has unethical executives, etc.; the stock will drop (because the bad things are bad for the company); the shareholders will sue, saying "you said you were good, we believed you, we bought the stock, but you were bad and we lost money." And so climate change and sexual harassment and lax customer data protections and mistreatment of orcas can all be transmuted into securities fraud. Here the underlying bad deed that was transmuted into securities fraud was also securities fraud —Goldman said it put customers first, then it did a fraud on the Abacus CDO buyers, then it got caught, then its stock dropped—but that is just a coincidence. If instead of defrauding the Abacus CDO buyers Goldman had murdered them, that would not have been securities fraud with respect to the Abacus CDO buyers (it would have been murder), but it would still have been securities fraud with respect to Goldman's shareholders (if the stock dropped after Goldman was charged with murder).

Now, two things I will say about this theory are:

1. I don't like it, it feels weird, and 2. It's not really the law.

It's kind of the law? It's not the law in the sense that they teach you this in law school, but it is law-like in that lots of plaintiffs' securities lawyers have been hard at work developing new theories about what bad things could be securities fraud, and have gotten good at it. And so if a company does a bad thing and the stock drops, someone will bring a class-action lawsuit against it alleging securities fraud, and that will be expensive and risky to defend and likely to lead to a big settlement, even if it is not exactly securities fraud in the strict legal sense.

There are two main things that are illegal. One is "securities fraud." This basically means lying about a stock. The other is "market manipulation." Nobody knows what this means. Legally, it means something like:

To effect, alone or with 1 or more other persons, a series of transactions in any security … creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.

So if you buy stock with the purpose of pushing the price up so that other people will buy it, that's market manipulation. If you buy stock hoping that the price will go up because other people buy it, that's not market manipulation; that's just normal. Those things are not so different. There is a "traditional four-part test for manipulation that has developed in case law":

(1) That the accused had the ability to influence market prices; (2) that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand; (3) that artificial prices existed; and (4) that the accused caused the artificial prices.

So consider the general concept of a "pump-and-dump" scheme. The most classic pump-and-dump goes like this:

1. I buy some GameStop stock. 2. I put out rumors—in my subscription newsletter, on Reddit, in fake press releases, whatever—about some catalyst for the stock to go up. "Hey I hear from an inside source that GameStop just got an exclusive contract to supply downloadable video games in Tesla cars," etc. 3. People see these rumors, believe them and buy GameStop stock, pushing the price up. 4. I sell the stock to them at the higher prices.

This is very straightforwardly illegal and the SEC goes after this stuff all the time, alleging securities fraud. Lying about stocks. Here is the SEC's "Investor Alert: Social Media and Investing -- Stock Rumors," which pretty much defines a pump-and-dump this way:

For example, in a "pump-and-dump" scheme, promoters "pump" up the stock price by spreading positive rumors that incite a buying frenzy and they quickly "dump" their own shares before the hype ends. Typically, after the promoters profit from their sales, the stock price drops and the remaining investors lose money.

There are variations. The SEC has gone after forms of dishonesty that aren't quite lying about the stock. For instance, if you are a widely followed stock promoter with a subscription tip newsletter, and you email tips to your subscribers and then sell your stock to them while saying that you're buying, that seems dishonest, and the SEC will go after you. Or if you are a promoter or research firm and you put out positive research about a company, but you don't disclose that the company paid you to put out the research, that is also bad. Now, I think you could do a pump-and-dump without any actual lying. For instance:

1. I email subscribers to my expensive private newsletter saying "hey let's pump GameStop." 2. We all buy GameStop, knowing that we're just doing it for the pump, with no real or fake catalyst for the stock to go up. 3. It goes up, because we bought a lot of it. 4. Other people, innocents and high-frequency trading algorithms, see it go up on heavy volume and think "hey this is a good stock, we should buy it." They buy it, pushing the price up. 5. We sell the stock to them at the higher prices.

In this version, I have not lied about a stock. On the other hand, I have effected transactions in the stock to create trading activity and raise the price, for the purpose of inducing people to buy it. Seems like market manipulation, "painting the tape" or something. The SEC goes after stuff like this occasionally.I think that in modern markets you could even do a bit better than that and have a completely honest pump-and-dump:

1. I show up on Reddit and say "hey let's pump GameStop." 2. We all buy GameStop, knowing that we're just doing it for the pump, with no real or fake catalyst for the stock to go up. 3. It goes up, because we bought a lot of it. 4. Other people see us doing this, read my Reddit post, know we are pumping the stock , and also buy it, because we seem to be having fun, and they like fun too. 5. Eventually some of us get bored and start selling and the price collapses.

The point here is that it is at least theoretically possible that no one buys stock for any reason other than "hey it's a fun pump." That is, no one is deceived about the fundamentals (there's no fake news about the company), and also no one is deceived about the technicals. No one says "huh this stock is up on a lot of good buying pressure, I should buy some"; everyone who buys says "hey this stock is up because it's being pumped, and if I get in now I might still get out before it collapses, and that'll be fun." It is "respect the pump" as a quasi-mystical mantra.I bet the SEC would say that's market manipulation, but I am not so sure. I suppose we did our trading "for the purpose of inducing the purchase or sale of such security by others," but not by deceiving them about what's going on. "Join us in a fun game of chicken," was our basic message here. Did we try "to create or effect a price or price trend that does not reflect legitimate forces of supply and demand"? Who's to say what's "legitimate"? Surely the price did not reflect expectations about future cash flows , but just as surely the price reflected supply and demand: We all wanted to own it because we were having fun, so the price went up.

Everything is securities fraud, I often say: Any bad thing that a public company does is arguably bad for its stock price, so the shareholders can sue.

But "bad thing" is a vague and subjective description. Some people think it was bad that Trump used Twitter to incite a violent insurrection and that Twitter let him do it, but other people think that it is bad for a quasi-public utility like Twitter to ban a hugely popular political figure from its platform. (And, again, Twitter's policies allow for some discretion, and Twitter has made statements and decisions in the past that might lead you to expect it would never ban a major U.S. politician over political speech.) Trump is mad and threatening to find another platform to communicate with his millions of followers, while other Republicans have renewed calls for more regulation of social media after the Trump ban. If Twitter's stock price dropped after banning one of its most popular users (and it did), or if Twitter faced a legislative backlash and stricter regulation for kicking Trump off (and it could), then Twitter's shareholders could sue for that , too. "You told us you would be a neutral platform for free political speech with fairly enforced rules; we believed you and bought stock; you didn't do what you said, so we were deceived; your failures were bad for business, so we lost money from your deception."

I don't mean to endorse either of these views, or to suggest that either is all that likely to be a winning securities-fraud lawsuit. (Actual judges are not as fond of "everything is securities fraud" as I am, or as securities plaintiffs' lawyers are.) I am just saying that they both have, like, the shape of a securities-fraud argument. They both have the form "you made public statements, and we believed them, but then your actions differed from your public statements, and the stock went down." In the theory of "everything is securities fraud," that is probably good enough to sue and see what happens.

Last Tuesday, I wrote that "everything is securities fraud" is a sort of universal deterrent of corporate bad behavior: "If you do anything shady," even something that isn't actually illegal, "people who specialize in extracting money from public companies will extract some money from you." Many of the cases that we talk about involve things that are perhaps controversially securities fraud, but that are uncontroversially bad: When a tech company suffers a massive data breach, or when a company has a long history of condoning sexual harassment, no one argues "actually data breaches and sexual harassment are good." They are bad, there are perhaps difficulties in deterring them in direct ways, so securities lawyers leap into the gap and deter them through securities law.

But lots of things are not like that. Lots of companies do things that some people think are bad and that other people think are good—or, more accurately, they do things that some people think are bad and that other people think it would be bad to stop. There are securities-fraud-ish lawsuits against energy companies accusing them of worsening global warming by drilling for oil, but I bet there'd be a lot of securities-fraud-ish lawsuits against them if they stopped, too. ("Defendants told investors they were an oil company but then stopped drilling for oil and the stock went down," etc.) Banks face shareholder pressure to stop financing fossil fuels and guns, but they also face regulatory pressure to keep doing it. I feel like so far "everything is securities fraud" lawsuits tend to lean more to the progressive side, but there's nothing stopping a right-wing securities lawyer from trying to make a buck when companies do progressive things and their stocks go down.

We talk occasionally around here about "everything is securities fraud" as a sort of alternative to democratic governance, a way around politics: U.S. politics are broken in various ways and sometimes unable to regulate activities that people want to regulate, so they regulate those activities through securities lawsuits instead. In the long run that is perhaps not a stable equilibrium. In the long run, if something is a way around politics, eventually politics will creep into it.

We talk about this a lot around here. I like to say that “everything is securities fraud”: Any time a public company does a bad thing, or a bad thing happens to it, some clever lawyer can sue it because its stock went down. The company knew about the bad thing and didn’t disclose it, or didn’t adequately warn shareholders about the possibility of the bad thing, so the shareholders were deceived when they bought the stock. And so companies are sued for securities fraud over global warming and customer data breaches and sexual harassment and mistreatment of killer whales. Usually when we discuss this theory, the bad thing tends to be a big discrete event, a scandal or crime or data breach. But there are cases like this too, where the bad thing is just, the company made a product, and the product wasn’t as good as the shareholders were hoping for. Just being bad at your business can be securities fraud.

In a way, this makes as much sense as anything. Companies tend to make a lot of optimistic announcements about their upcoming products, and those announcements matter to shareholders. If a company repeatedly says “we are really excited for our new product, which will be good,” and then the product is bad, then it doesn’t seem like such a stretch to say that it was lying to shareholders in a material way.

In the larger sense, though, this is kind of a weird thing for shareholders to sue over. Like, your job as a shareholder is to pick the right businesses to invest in. Your expectation should be that if you invest in a business that makes good products you will make money, and if not you will lose money. If your expectation is that if you invest in a good business you will make money, and if you invest in a bad business you can go to court and complain and the court will give you your money back, then maybe your job is a little too easy.

Here is a paper from Emily Strauss of Duke Law School, titled "Is Everything Securities Fraud?"

Securities litigation is a virtually inevitable fact of life for any public company. Often, investors sue because the firm's managers engaged in fraud that directly harmed the shareholders – say, by doctoring the firm's financials, or lying about known business prospects. However, shareholders also sue their companies when those companies engage in conduct that primarily harms a different set of constituents. When a drug on the market proves to have dangerous side effects, a faulty car battery bursts into flames, or an oil rig explodes, it's difficult to say that the most direct victims are the companies' shareholders. Yet shareholders commonly sue under the federal securities laws based on precisely this kind of conduct, on the ground that the managers should have better disclosed the underlying facts, and investors were harmed by the resulting drop in stock price because they did not.This paper assesses the pervasiveness and impact of these lawsuits. I find that roughly 16% of securities class actions arise from conduct where the most direct victims are not shareholders. However, I find that these cases have roughly a 20% lower likelihood of being dismissed, and settle for significantly higher amounts.

Strauss points out that these cases could have sort of a perverse effect along the lines that I suggested above:

I argue that although these cases may have deterrence value, the fact that they are likely to be more successful and lucrative may diminish incentives for shareholders to monitor their managers to prevent them from pursuing profitable conduct that harms outsiders.

If you are a shareholder of a public company, you want the company's managers to maximize profits, within reason. If the managers could increase profits by doing a bunch of crimes, you might not want that. You might not want that because you are a good and moral person, but assuming that shareholders are just amoral return-maximizing machines, you nonetheless might not want it because the company would get in trouble for the crimes, and that would be bad for business, and thus for the stock price. But if the shareholders get compensation for that—if they can sue when the stock price goes down due to corporate crimes—they will have less reason to object to the crimes. "Whatever, do crimes, if you succeed then the stock will go up, and if you fail and the stock goes down then a court will make you pay us back."I am not entirely on board with this theory. One problem with shareholder lawsuits generally is that the shareholders are suing the company, and if they win they take money from the company; it was their money to begin with, so it's kind of an unsatisfying form of compensation. If you are a shareholder, suing the company for losing money is some consolation for the losses, but not nearly as good as not losing money in the first place.

Actually I tend to think that "everything is securities fraud" is more likely to be pretty good at deterring bad behavior. I have written before that it is weird and troubling to have all corporate misbehavior regulated through the interests of shareholders , but it does seem effective. There is a well-oiled machine for shareholders to sue companies, a group of expert lawyers who know that they can get rich by discovering new forms of securities fraud and so have powerful incentives and tools to police corporate misbehavior. So for instance here's another story from the winter, about how Pinterest Inc. allegedly has a "toxic work environment" and a "culture of discrimination," so its shareholders are suing. A toxic work environment is bad for workers, sure, but also allegedly for the stock price (bad press, user boycott, etc.), so the shareholders sued. At the time they filed the lawsuit in November, Pinterest's stock price was at an all-time high, so I am not sure how empirically sound this theory is, but I suppose if things hadn't been so toxic the stock would be even higher, etc. Anyway the Pinterest shareholders' lawyers previously won a $310 million settlement from Alphabet Inc. on a similar theory, so this stuff works.

Of course the lawyers get a cut of those settlements. "Sexual harassment is securities fraud" is an idea that will buy a big yacht for the lawyer who came up with it. It's so much better—for the lawyer—than suing directly for sexual harassment. If you sue for sexual harassment you have to recruit individual plaintiffs who were harassed, and you have to prove their cases, and they're all probably different so it's harder to make it a lucrative class action, and they are actual individual humans who have been harmed and you have to be sensitive to their trauma. If you sue for sexual-harassment-as-securities-fraud, the plaintiffs are easy to find (big shareholders), you don't really have to prove harassment (just refer to news accounts), your clients are only in it for the money, everything is clean and simple and easy. Also the dollar amounts are larger: In some subjective moral sense, sure, employees are more harmed by a toxic work environment than shareholders are, but if the toxic work environment is at a large public company, and the stock drops, then it's really easy to argue that the shareholders lost a huge amount of money and should get it back.

So I guarantee you that a bunch of high-powered lawyers are working in the lab right now trying to come up with even more powerful forms of " is securities fraud." They are scanning the newspapers for bad things involving public companies and asking themselves, Is this something? Can we make this securities fraud? And so if you run a public company and don't want to get sued—for huge amounts of money, by highly effective lawyers who have taken hundreds of millions of dollars off of other public companies—then you perhaps look at all these cases and say, well, we'd better not do any bad things. You'd better not do sexual harassment or have a data breach or make a bad video game, sure, but more generally you'd better not do anything that attracts the attention of these securities lawyers.

It's a very generic enforcer of good behavior: If you do anything shady, people who specialize in extracting money from public companies will extract some money from you. And a lot of technical defenses that you could use if you were sued by your employees or customers or regulators—technical defenses like "the shady thing we did wasn't actually illegal"!—will not work here, because the lawyers' basic argument will be "you did this thing and the stock went down." Everything is securities fraud, even things that aren't actually illegal; anything that gets bad press or moral disapprobation can lead to a securities lawsuit. It is in its way an oddly principles-based form of regulation: You don't need specific rules against specific types of bad conduct; all you need is evidence that the company did a thing and the stock dropped because of it. Sometimes—as in Pinterest—not even that.

Every bad thing that a public company does, I often write, is also securities fraud: The company did the bad thing without disclosing it, people bought the stock in ignorance of the bad thing, when they found out the stock dropped, they were defrauded. But of course the Astros are not a public company and no one bought their stock. Nonetheless you could try to extend the theory. The Astros did a bad thing without disclosing it, and in fact while putting out press releases saying things like “we work hard and are good at baseball” or whatever, without mentioning the cheating. People bought season tickets in ignorance of the bad thing, and when they found out I suppose the value—at least the moral value if not the market value—of the season tickets dropped. (Presumably the market value also dropped due to Covid, etc., which might be a factor here.) So they sued. If this works then … look, the point with “everything is securities fraud” is that everything is securities fraud. It's not, like, “failing to disclose serious illegal activity at the heart of your business is securities fraud,” it's that every bad thing that a public company does, or that happens to it, can give an enterprising lawyer a reason to sue. It is an all-purpose tool for policing the behavior of public companies. I look forward to season ticket holders policing the behavior of baseball teams. You work your star pitcher too hard and he gets injured? You get sued for fraud. You trade your best player? Fraud. Someone needs to police baseball teams to make sure they are operating in the interests of fans, etc., the theory transfers easily enough.

One aspect of "everything is securities fraud" is that public companies disclose a lot of stuff publicly. U.S. securities regulation requires companies to disclose annual and quarterly financial statements, to give comprehensive narrative disclosures about how their business is doing and how managers think about it, to describe their compensation schemes and objectives, to explain the risks of their business, to lay out the details of their capital structure, etc. If you get anything wrong, and your stock goes down, someone will sue you for securities fraud.

Private companies don't do this. Often they disclose similar information, though less of it and less formally, but they usually disclose it only to their investors, or to people who are in discussions with them to invest. It's not just on a website; everyone can't look at it, only the—theoretically—sophisticated private investors who are considering an investment and doing their due diligence. So you'd expect that private company fraud would be caught less often. If you lie in a Securities and Exchange Commission filing, lots of people can read it and might spot the lie, and short sellers and whistle-blowers will have incentives to do so. If you lie in a letter to a handful of potential investors looking to get rich, the readers will be fewer and might want to believe. So you'd also expect that private company frauds would be a lot more egregious. If you're going to do an accounting fraud at a public company, you need to deceive auditors and make the fraud so impenetrably complex that sophisticated short sellers can't figure it out. If you're going to do an accounting fraud at a private company, you can just type whatever numbers you want into a spreadsheet, print it out, and send it to people. There is nothing hard or complicated about the fraud; the hard part is choosing the right people to send the spreadsheet to.

I feel like the SEC usually focuses on public-company fraud, because (1) it's easier to see and (2) it affects public investors, widows and orphans, etc. The SEC usually doesn't focus so much on private-company fraud, because (1) you have to look harder for it and (2) it mostly affects accredited investors, venture capital firms, etc., who can presumably take care of themselves.

Is it securities fraud for a public company to have no Black members of its board of directors? My friends, it is like I always say: Everything is securities fraud. Here's a shareholder lawsuit against Oracle Corp. and its board of directors:

Actions speak louder than words. If Oracle simply disclosed that it does not want any Black individuals on its Board, it would be racist but honest. But Oracle's Directors, wishing to avoid public backlash, have done the opposite — they have repeatedly made gross misrepresentations in the Company's public statements by claiming to have a multitude of policies, internal controls, and processes designed to ensure diversity both at the management level and the Board itself. These policies, however, are not worth the paper they are printed on. At Oracle, it is "Do As I Say, Not As I Do." Oracle's Board, which has no Black individuals, has consciously failed to carry out Oracle's written proclamations about increasing diversity in its ranks. The Board, as well as the Company's executive officers, remain devoid of Black people and other minorities. In short, Oracle remains one of the oldest and most egregious "Old Boy's Club" in Silicon Valley. A sign advising applicants "Blacks Need Not Apply" might as well hang at the entrance to the Company's headquarters at 500 Oracle Parkway in Redwood Shores, California. Oracle's Directors have deceived stockholders and the market by repeatedly making false assertions about the Company's commitment to diversity. In doing so, the Directors have breached their duty of candor and have also violated the federal proxy laws.

Obviously—as the excerpt above concedes—it is not actually securities fraud to have a non-diverse board of directors. But the theory here is that it is securities fraud to (1) have a non-diverse board of directors and(2) make public statements saying that you value diversity. The public statements are material and false, shareholders are misled, etc., you know the drill. As a connoisseur of "everything is securities fraud" lawsuits, I have to say that this one seems like a stretch, but I pass them all along to you. We talked a while back about a theory that having a corporate ethics policy is bad: If you have an ethics policy, and it says "our executives are not supposed to do bad things," and they do bad things, then someone will sue you for securities fraud on the theory that the ethics policy was a lie. This is the same general idea.One thing to think about is, if this works, what incentives does it create? The first-order incentive is, you should have a more diverse board of directors. The second-order incentive is, you should get rid of your diversity policies: If you stop saying that you value diversity, people won't be able to sue you (for securities fraud) for being insufficiently diverse. Arguably this is an unintended consequence, but it's also possible that this is exactly the intent of the lawsuit: Right now it is just good business to announce that you value diversity, whether or not it's true, but this lawsuit is designed to make costless expressions of support for diversity costly. If it is still good business to say that you value diversity, it will be hard for companies to give up their policy statements, so they might have to take them more seriously.

One long-running thesis of this column is that everything bad that a public company does, and everything bad that happens to a public company, can be securities fraud: The company did not appropriately warn investors about the bad thing, when the bad thing became public the stock dropped, the investors are aggrieved, etc. "Securities fraud" is not just cooking the books to sell more stock; pollution and sexual harassment and lax cybersecurity and a pandemic are all also securities fraud. I mostly write about this as a sort of oddity of American legal culture—securities law works , so it's used to punish all sorts of unrelated bad things—but it is worth also considering it as an economic matter. On a first approximation, securities lawsuits are all very weird because the basic situation is:

1. The stock goes down. 2. Shareholders sue. 3. The company gives them money.

The money that the company gives to the shareholders is, in a sense, the shareholders' money, since they own the company. After the lawsuit, they have more money (because the company gave them money), but their shares are also less valuable (because the company has less money), so it's really a wash. A shareholder lawsuit is just a complicated form of dividend, and dividends should not make shareholders richer. But that is only approximately true. For one thing, shareholders buy and sell shares, so the shareholders who get paid may not be quite the same as the ones who pay. Also, though, the company doesn't always come up with the money. Often its directors-and-officers insurer does: The shareholders sue the company and its directors, and the D&O insurer defends the case and pays the settlement. The lawsuit is not a transfer from shareholders to shareholders, with plaintiffs' lawyers taking a cut; it's a transfer from D&O insurers to shareholders (with the lawyers taking a cut). If you imagine that securities lawsuits are mostly about book-cooking and underpriced mergers, then you will think that D&O insurance is a specialized niche product insuring against fairly rare risks. If you imagine that securities lawsuits are a general-purpose way to enforce all laws and norms, then you will think that D&O insurance is a general-purpose product insuring against anything that can go wrong at a public company. The latter should cost more:

Wells Fargo & Co. is a big bank that made a lot of PPP loans, but it is also a public company. Arguably the PPP rollout was bad. If a public company does a bad thing, that is also securities fraud, as I write almost every day now. If Wells Fargo prioritized PPP loans to bigger businesses or its best relationships, rather than to small mom-and-pop businesses, and that comes out and people get mad at Wells Fargo, the victims in the best position to sue are Wells Fargo's shareholders. (Just as, if a company has a long history of harassment and discrimination against female employees, the people who sue and get paid are the shareholders, not those employees.) I don't know? Mostly this troubles me, but I guess there's a bright side. The bright side is that anything bad that a public company does will be punished, by the inexorable force of securities-fraud lawsuits, even if it isn't illegal or is hard to prove or whatever. Like you could imagine this stylized dialogue:

Bank chief executive officer: Let's do a terrible thing. General counsel: We shouldn't. CEO: Is there an explicit law against it? Will we go to prison or be fined or shut down for doing the thing? GC: No actually we can do this within the letter of the law, but we still shouldn't. CEO: Why not? GC: It will look bad. It will be bad public relations; journalists and activists and politicians will get mad at us. CEO: We are a big bank, everyone's mad at us all the time anyway, who cares. GC: Well if we make people mad about a new thing, we'll get a new securities-fraud lawsuit and have to pay some money. CEO: So it will cost us money to do the terrible thing? GC: Yes, definitely. CEO: Oh fine it's not worth it.

On the other hand Wells Fargo probably didn't set out to make PPP loans by saying "let's do a terrible thing"; they probably set out thinking "let's participate in a government program to help small businesses." The government explicitly relaxed some rules to encourage banks to make PPP loans aggressively without having to worry too much about getting in trouble for being too aggressive; the goal was to get the money out, not to be perfect. But one lesson of "everything is securities fraud" is that you always have to be perfect, or it's securities fraud.

Everything bad that a public company does, and everything bad that happens to it, can also be securities fraud, as I often say around here. By failing to disclose the bad thing, the company induced investors to buy its stock, and then when the bad thing was disclosed the stock went down; a modestly creative lawyer can easily transmute any bad thing you like into securities fraud. Without getting into any details I think we can agree that WeWork either did something very bad, or something very bad happened to it, or both; it was worth $47 billion in early 2019, $8 billion in late 2019, and rather less than that now. Depending on how you count, WeWork has erased something like 90% of its value. So: securities fraud! Except that WeWork is not a public company, and never has been. It got close; it filed documents for an initial public offering last August, but then investors read those documents, had a good laugh and declined to buy the stock. At the time and afterwards, people argued that various disclosures in WeWork's offering documents were untrue or misleading or incomplete, but clearly no one was induced to buy the stock by those disclosures. Quite the opposite! WeWork was worth $47 billion or $65 billion or some other purely notional number the minute before it filed for an IPO; its value evaporated over the course of a few weeks specifically because people read WeWork's own description of its business and said "lol no." WeWork's public disclosures didn't pump up its stock; its first public disclosure immediately deflated the stock. So widows and orphans and public pension funds who bought WeWork stock in its IPO can't sue for securities fraud, because there aren't any of them.[2] But while WeWork was never a public company, it was for a while a big famous buzzy private unicorn, and another thing that I often say around here is that "private markets are the new public markets." Big buzzy private unicorns look and at a lot like public companies, raising billions of dollars from public-type investors and supporting liquid secondary markets; the difference between being public and private has eroded. WeWork's shares didn't trade publicly, but they did trade privately, and people did buy WeWork stock in the years before its failed IPO. Now they are suing:

In the latest lawsuit over WeWork's scuttled IPO, investors say the company hoodwinked them by promoting a transformation of the concept of workspace in order to sell hundreds of millions of dollars worth of stock. The complaint was filed as a class action on behalf of investors who bought shares in the privately held company for 2 1/2 years before the IPO was canceled in September and the value of WeWork plummeted. They allege that WeWork executives and board members overhyped the business plan and downplayed its losses as "strategic investment spending that would lay the foundation for profitability."

Here is the complaint. There are a lot of allegations in it but they mostly strike me as pretty thin, less "WeWork fudged its accounting" and more "WeWork was more optimistic about the future than it should have been." It is not so much a securities fraud lawsuit as it is an "everything is securities fraud" lawsuit: People bought stock, the stock went down, they're mad, so they sued.[3] But here I want to mention one weird thing. The lawsuit was filed as a class action "on behalf of purchasers of WeWork securities between May 15, 2017 and September 30, 2019." As far as I can tell there was exactly one purchaser of WeWork stock from WeWork during that period: SoftBank Group Corp.'s Vision Fund, which pumped in the money that inflated WeWork's valuation in its later years.[4] But SoftBank isn't suing; in fact it is a defendant in the case, since it is WeWork's controlling shareholder. Everyone who is suing because they were allegedly tricked into buying WeWork stock did it on the open market, not from WeWork.[5] They weren't relying on WeWork's SEC filings, because there weren't any. So how did WeWork deceive them? The complaint says that "throughout the Class Period, defendants continuously solicited investment in WeWork securities," and that their "misrepresentations were deliberately published to investors in order to amplify defendants' solicitation efforts," including in media interviews, quarterly investor updates, investor presentation materials that were "provided to media organizations and widely disseminated and reported on," "quarterly calls for investors, prospective investors, securities analysts, and market-making financial institutions to discuss the Company's financial results," and "regularly updated financial, business and operational information regarding WeWork made available to Company investors at the time of their purchase during the Class Period via an online portal maintained by WeWork." WeWork wasn't public, but it sort of acted like it was. You could buy and sell its stock in the open(-ish) market; it released quarterly earnings and did earnings calls; it didn't file financials on the SEC website, but it filed them on its own website.[6] "Everything is securities fraud" is the rule for U.S. public companies, but it is also apparently the rule for private companies that are practically public. One possible interpretation of "private markets are the new public markets" is that private companies can get most of the benefits of being public—raising lots of money, getting a huge valuation, being a household name, having an acquisition currency, giving employees and early investors liquidity, etc.—without the drawbacks of actually going public. But it is probably more accurate to say: No, actually, they get most of the drawbacks too. If you don't want to go public because you don't want activist shareholder campaigns or pesky securities fraud lawsuits, but you do want your shares to trade privately, guess what, the bad stuff will find you too.

If you run a public company, you have to be honest about it all the time. If your company is losing money and having a terrible quarter, and a journalist calls you up and says "hey are you losing money this quarter," you can't say "no everything is great, never been better." You can say "yeah it's terrible," or you can say "on an adjusted basis we are confident that long-term trends are encouraging," or you can say "no comment," but you can't lie. You also can't tweet "looks like it's going to be a record year for profits at our company" if it isn't. That's securities fraud. Regular people are buying and selling the stock all day long, and if they read the CEO's comments, believe them, and buy stock, they are going to sue. The company's official representative made a public statement that was misleading, people traded stock based on it, boom, securities fraud. Elon Musk knows.

If you run a private company, though, you can indulge your vanity a bit more. At the typical private company, no one trades stock. People only buy stock when you sell it to them, directly, with disclosure documents. The important thing is for those to be true. You can even write, in those documents, something to the effect of "you have to agree to rely only on these documents, and if anything else we've said publicly isn't true, you can't sue." If you tell a reporter "we made a billion dollars last year," and you post a smiling Instagram saying "so proud of our team for making a billion dollars last year," and then you go sell stock to investors with disclosure documents saying how much money you actually lost—meh, seems fine? Not legal advice. You have to be careful here, and the lines can blur.

If you're lying to journalists and on social media to try to get buzz so you can raise money for your private company, you might fall into error. Theranos Inc. founder Elizabeth Holmes was charged with securities fraud in part because she made lots of misleading claims to the media about Theranos's blood-testing technology, and then sent binders full of those misleading media profiles to potential investors. (She also allegedly lied directly to the investors.) But if you're very careful about keeping the sides separate—if you exaggerate in public to get buzz and attention, but are scrupulously honest and accurate with any potential investors—you can perhaps make it work.

When we first talked about last month's oil-price crash, one thing that I said was that it would be nice if there was a way to buy a financial product that exactly tracked the spot price of oil. "Permanent abstract oil," I called it: "You buy it for the price of oil today and sell it for the price of oil when you want to sell it." A lot of people want to speculate on the price of oil (as USO's size demonstrates), and mostly what they want to speculate on is that. They want a thing that goes up when the price of oil goes up and down when the price of oil goes down; that is the only thing they want to bet on.

But there is not exactly a product like that. There are oil futures, but they expire: They have a fixed life, some number of months, and then they end and, if you still own them, you have to take delivery of oil. You can build a perpetual strategy around them—buy next month's futures, wait, and as they get closer to expiry sell them and buy the following month's futures, etc.—but then the thing you are betting on is not quite the thing you want. You are betting on the relative value of different futures, the shape of the curve, the cost of rolling futures, all this technical stuff. "I'd wager that 90 per cent of investors in USO couldn't explain what contango is," a hedge fund manager told Rana Foroohar, but contango is a key part of their actual USO bet.

The thing is that oil futures ETFs like USO are obviously an attempt to solve that problem. You can buy USO and hold it for as long as you want; it never (you hope!) expires. It is like a share of stock, a permanent bet on oil prices. On any particular day it will probably go up if oil prices go up and down if oil prices go down, though over the long term it will tend to go down either way. If you want a simple, permanent, indefinite, abstract bet on oil prices, one with a simple name like "U.S. Oil," USO—not July WTI crude futures or whatever—is the product for you.It's just that that product is actually impossible to manufacture; USO is a good-faith approximation, but it doesn't quite get there. Over the long term USO won't really track the spot price of oil, and when things get weird, as they have for USO, it will get even farther away from that simple bet. All of this is disclosed, of course—USO's prospectus explains how it works—but there is still a disconnect. Investors want a simple bet on oil, and USO was built to give them the simplest possible bet on oil, but it's still not as simple as they expected it to be.

Facebook Inc. is a public company, and as I often say, anything bad that a public company does is also securities fraud. Sometimes this means that if a company does something illegal, that illegal thing is also securities fraud: Regulators fine the company for the illegal thing, and shareholders sue it for getting fined. But often it means that if a company does something that you wish was illegal, you can sue it for securities fraud. Fossil fuel companies contribute to climate change by drilling for oil; climate change is bad; drilling for oil is legal; what can you do? You can sue them for securities fraud. Other bad things are ambiguously legal, or illegal but hard to prove; suing for securities fraud can get around complicated questions of law and fact. The point is that if the company is doing something that seems bad, that exposes it to a theoretical risk of legal liability or bad publicity or future regulation or whatever, shareholders can sue, saying "you're doing the bad thing without properly warning us about the risks of liability."

So here you go:

A consortium of Facebook insiders and critics filed a confidential whistleblower's complaint to the Securities and Exchange Commission late Tuesday, claiming the social media giant is aware of illegal activity on its platform, such as the sale of opioids, and has failed to properly police it. The complaint, which was obtained by The Washington Post, includes dozens of pages of screenshots of opioids and other drugs for sale on Facebook and its photo-sharing site Instagram, with some having seemingly obvious tags such as "#buydrugsonline." It also notes that Facebook has a pattern of taking down content when it is pointed out by media or activists, only to have it reappear later. The filing is part of a campaign by the National Whistleblower Center to hold Facebook accountable for unchecked criminal activity on its properties. By petitioning the SEC, the consortium is attempting to get around a bedrock law — Section 230 of the Communications Decency Act — that exempts Internet companies from liability for the user-generated content on their platform. Instead, the complaint focuses on federal securities law, arguing that Facebook's failure to tell shareholders about the extent of illegal activity on its platform is a violation of its fiduciary duty. If Facebook alienates advertisers and has to shoulder the true cost of scrubbing criminals from its social networks, it could affect investors in the company, the complaint argues.

I do not, ever, want to participate in a debate about whether drug dealing is a "victimless crime," but I do want to say that the victims of drug dealing are obviously not Facebook shareholders. Like so many "everything is securities fraud" cases, this is not about securities fraud, and the people involved do not care about the Facebook shareholders who are supposedly the victims here. You can tell, in part, from the fact that this is a whistle-blower complaint rather than a lawsuit: Facebook shareholders haven't lost money due to its alleged drug dealing, its stock hit an all-time high last week, Facebook's shareholders are fine. The whistle-blowers here want the SEC to fine Facebook (that is, take money from its shareholders and give some of it to the whistle-blowers), and impose new costs and obligations on it to shut down the drug dealing. The timing of this is fortuitous because, as these people are pestering the SEC to shut down Facebook, Donald Trump is pretending he is going to shut down Twitter Inc. for pointing out that he sometimes lies on Twitter. There is a draft executive order floating around that would limit social media companies' protections under Section 230, making it easier to punish them for the speech or actions of their users—exactly what the "whistle-blowers" here want for drugs on Facebook. You don't need the SEC to regulate Facebook indirectly as securities fraud, if you can make the Federal Communications Commission regulate Facebook's platform directly. The point that I often make, when I say "everything is securities fraud," is that there is a tendency in America to use securities laws as a way around the democratic process, as a way to regulate non-financial conduct without actually going to the trouble of getting laws or rules passed. But I also want to say that, right now, the democratic process is soul-destroyingly terrible, a pure cynical exercise in partisan power without the slightest pretense of working for the public good. If you asked me, in the abstract, "should social media companies' liability for illegal activity be regulated by congressional legislation balancing the legitimate interests of everyone in society, or by the SEC looking out for the companies' shareholders," I would choose legislation. But if you asked, "should social media companies' liability for online activity be regulated by the SEC looking out for the companies' shareholders, or by Donald Trump's sense of grievance at being fact-checked and his desire to boost his own re-election chances"—the actually relevant question!—I would choose the SEC. "Everything is securities fraud" is not a comment on the imperial ambitions of the SEC, and it's only sometimes a comment on the opportunism of private securities lawyers. Really it's a comment on the brokenness of the rest of American government. Everything is securities fraud because at least securities law more or less works. At least the SEC is looking out for someone other than itself.

A famous little puzzle in securities law is that loans are not securities. In the olden days this made sense: A security was something offered to the public and traded in the market; anyone could buy or sell securities, and they relied on the company's public disclosures in making their investing decisions. A loan was a contract bilaterally negotiated with a bank; the bank had a long, deep relationship with the company, held the loan to maturity, and monitored it closely. Banks were just not the sort of investors that securities law was supposed to protect.

But now loans, especially syndicated loans to high-yield companies, feel a lot like securities. They are sold to hundreds of investors, hedge funds and institutions rather than just banks, who will not necessarily have any close relationship to the company. They trade freely in the secondary market. The same people who trade high-yield bonds will often trade leveraged loans, and it is weird to think that one is a security and one isn't. Particularly, if you buy a bond from a company that then goes bankrupt, you will sue the underwriter for not telling you about whatever caused the bankruptcy. If you buy a loan from a company that then goes bankrupt, you will also want to sue the underwriter. Can you?

Well, you can sue, but it won't go very well. Here's a memo from Cleary Gottlieb Steen & Hamilton LLP (citation omitted):

Under the current regulatory regime, loans are not treated as securities. In Kirschner v. J.P. Morgan Chase, et al. , the plaintiff challenged these well-settled expectations by trying to bring state securities law claims based on the syndication of a rated term-loan facility. However, on May 22, 2020, the Southern District of New York rejected these claims and reaffirmed the widely held understanding that syndicated loans are not securities. Relying heavily on the Second Circuit's 1992 decision in Banco Español de Crédito v. Security Pacific Nat'l Bank , which held that similar “loan participations” were not securities, the Court held that syndicated loans are just that—loans and not securities. ...The dispute in Kirschner arose out of a $1.775 billion syndicated loan transaction that closed on April 16, 2014. In that transaction, several banks assigned portions of a term loan made to Millennium Laboratories LLC (“Millennium”) to about 70 institutional investor groups, including approximately 400 mutual funds, hedge funds and other institutions, evidenced by notes (the “Notes”). After Millennium filed for bankruptcy in November 2015, the investors' claims were contributed to the Millennium Lender Claim Trust (“Plaintiff”), which filed a complaint in August 2017 against the arranging banks asserting claims under several state securities laws and the common law.The complaint alleged that Millennium, a California-based private company that provided laboratory-based diagnostic testing of urine samples for physicians, violated various federal laws prior to the loan transaction. … On this basis, the complaint alleged that the defendant banks (“Defendants”) involved in the loan made misstatements and omissions actionable under state securities laws because the offering materials failed to disclose Millennium's underlying wrongdoing.

If this was a bond offering, those arguments might have worked, but it was a loan syndication, so they didn't: The judge dismissed the case, finding that the loans were not securities. The reasoning here is pretty much just that nobody thinks loans are securities, so they aren't securities; the actual distinction between loans and bonds seems pretty thin.

One point that I often make about the U.S. legal system is that lying about financial matters is quite broadly and severely criminalized—basically any sort of dishonesty having anything to do with money is arguably wire fraud—but lying about politics is common, legal, and frankly encouraged. If you sell knickknacks on the internet and you misrepresent their dimensions, that is probably a federal felony, but if you run for president on a platform of wild lies and dangerous conspiracy theories then you are just participating in a long and glorious tradition and you'll probably win. Another point that I often make is that people dislike this situation and try to fix it by pretending that political lies are business lies. Political lies are protected by the First Amendment, business lies are unprotected fraud, so if you can shoehorn a political lie into a business-lie theory you can prosecute it. So people got mad at Exxon Mobil Corp. for participating in public debate about climate change in a way that was arguably dishonest, and fixed it by suing Exxon Mobil for securities fraud: If a public company that makes oil is lying about climate change, the theory goes, surely it is deceiving its shareholders about the future prospects for oil. (This theory did not win in court.) Or Elizabeth Warren is an expert in this approach, and she has asked the U.S. Securities and Exchange Commission to investigate companies for securities fraud for lobbying against regulations, and for that matter to investigate Donald Trump for trying to start a war. (Is trying to start a war securities fraud? Everything is securities fraud!) Still you could do better. Here's a law review article by Tyler Yeargain called "Fake Polls, Real Consequences: The Rise of Fake Polls and the Case for Criminal Liability." A lot of the argument is that people publish fake political polls, these polls are bad for basic political reasons (deceive voters, undermine democracy, hurt confidence in our government, etc.), and something should be done about it. Fine, yes, but First Amendment etc. But the other part of the argument is that people publish fake political polls to influence political prediction markets, which means that they might be wire fraud, or commodities fraud, since prediction-market contracts are arguably commodity futures. If someone publishes a fake poll to manipulate prediction markets, then that's a business lie—wire fraud, commodity fraud, securities fraud, lying to make money—even though it's about a political topic. So you can sweep political lies into the wire-fraud framework, and prosecute it. "And," writes Yeargain, "to the extent that the elements of either fraud charge is too difficult to prove, prosecutors could always fall back on conspiracy charges." Why stop at polls? What if you bet on a candidate on a political prediction market and then tweet that he is a really good candidate with great ideas for fixing America's problems? What if he is in fact only a mediocre candidate with vague and stupid ideas for fixing the problems? What if you say that his opponent has been a disaster in office, when in fact she has done a roughly average job? Can prosecutors go after you for wire fraud for lying about a political candidate? That'll be … new. It is easier to prove that polling claims are factually false, but, you know, politicians make lots of factually false claims and you can try your luck asking a jury if they're lies. I suppose these prosecutions will still require the element that the lies were designed to make money in predictions markets, but "prosecutors could always fall back on conspiracy charges." What I like (?) about this theory is how big the asserted harms are and how trivial the connection to finance is. The harms of fake polling are about undermining democracy and trust in institutions, and about dishonestly putting people in positions of immense power, but legal political betting in the U.S. is a tiny business. "Given the CFTC-mandated restrictions on the markets," writes Yeargain, "the fraudsters likely made a collective profit of no greater than a few thousand dollars." In other words the real reason to manipulate polls is not to make a few thousand bucks in PredictIt, and the real reason to prosecute fake polls is not that a few people will lose money on PredictIt. None of this is the point, it's all a pretext; the actual point is that people lie about politics to influence politics, and that other people want to prosecute those liars to prevent them from influencing politics. But the legal formula that you have to recite involves betting markets. "There is no place for dishonesty in American politics," the theory roughly goes, "because dishonesty in politics could undermine the integrity of betting markets." Okay!

You know the theory. If a public company does a bad thing, it is also securities fraud. The company didn't disclose the bad thing when it was doing it—it didn't put out a press release saying "our CEO is going to do some sexual harassment this afternoon," etc.—and, when the bad thing was revealed, the stock went down. Shareholders can say: You didn't tell us about the bad thing, we bought stock in ignorance, you deceived us, it is fraud.I stress that this is not an exactly correct statement of U.S. securities law, and in fact sometimes the shareholders who bring these cases lose. When I write about it, lawyers sometimes email me to say, no, this is not how the law works, companies don't actually have to disclose everything bad that happens. You are not allowed to lie , in your securities filings, and if you do say things you can't "omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading," but there is no general affirmative obligation to disclose everything, or even every bad material thing. If your CEO is a sexual harasser, there is not an item in Form 8-K specifically requiring disclosure. You can just keep quiet.Can you, though? Here's a memo on "Codes of Ethics and Securities Litigation" from Davis Polk & Wardwell LLP[1]:

In the years since Congress enacted the Sarbanes-Oxley Act in 2002, many companies have adopted codes of ethics or codes of conduct and made them public. … Listed companies are required to adopt and disclose codes of conduct pertaining to directors, officers and employees.By adopting codes of ethics or codes of conduct and making them public, companies may unwittingly create a new target for class action lawyers seeking to assert claims under the federal securities laws. Although these documents are not necessarily written for a broader audience of investors, because they are widely available public statements, they have the potential to create exposure under federal securities laws if a company's stock price declines.In fact, federal securities lawsuits targeting statements about corporate codes of ethics are now common in so-called "event-driven" cases—that is, securities litigations that accompany and arise out of otherwise unrelated legal and compliance issues. Examples include bribery and Foreign Corrupt Practices Act investigations and—more recently—investigations of sexual harassment that have accelerated as part of the #MeToo movement. Although circumstances vary by situation, complaints in this area typically allege that the company's ethics code falsely represented reporting or compliance standards, or that the company used its code of ethics misleadingly to tout the existence of an ethical culture while omitting to disclose allegedly widespread misconduct.

If you are a public company, you have to write and disclose a code of conduct saying how your executives are supposed to behave. Probably that code of conduct will say or imply, generally, that they are supposed to behave well. If they then behave poorly, shareholders will sue you, saying: "You lied to us; you told us that the executives had to behave well, but actually they behaved poorly."It is not that compelling an argument, really, and Davis Polk notes that "historically, these claims rarely gained traction." But sometimes they do:

On March 26, 2020, Signet Jewelers agreed to settle a securities class action for $240 million. This lawsuit had alleged that statements in Signet's code of conduct and code of ethics—available publicly on its website and incorporated by reference in its annual reports—were false or misleading.In the Signet Jewelers case, the court allowed claims to proceed based on statements that Signet made employment decisions "solely" on the basis of merit and that it had "confidential and anonymous mechanisms for reporting concerns." In reaching this decision, the court reasoned that these statements were actionable because they were "directly contravened by allegations in the [complaint]." The court pointed to detailed allegations—based on the record in a separate employment discrimination case—that Signet had conditioned employment decisions on female employees acceding to sexual demands and had retaliated against women who attempted to report the harassment. In a subsequent order, the court concluded that the statements in Signet's codes—in context—could not be disregarded as mere puffery: "Signet's codes of conduct and ethics . . . touted certain values and practices that constitute the exact opposite of what the company allegedly valued and practiced."

See, having a code of ethics is securities fraud , if your executives sometimes violate it. I should add that women who worked at Signet started suing the company for discrimination in 2008, there is a class action involving 70,000 of them, there was a New York Times Magazine story about it last year, and it still has not been resolved. The women who were harassed and underpaid have not been compensated; the shareholders, of course, have been.

A popular form of securities fraud is pretending to get into some newly high-profile industry. You have a small public company that trades on the pink sheets and doesn't really do much. People are getting really into, say, marijuana stocks, or blockchain. You put out a press release saying "we have built a big blockchain for marijuana and we're talking to a lot of potential customers." Your stock goes up. You sell some stock, at the new high price, to the people who are really excited about marijuana blockchains. The only high-profile industry these days is Covid-19, and so you would of course expect some microcap pivots to the virus. The Securities and Exchange Commission brought a case against one of them on Tuesday:

The Securities and Exchange Commission today announced charges against Praxsyn Corp. and its CEO for allegedly issuing false and misleading press releases claiming the company was able to acquire and supply large quantities of N95 or similar masks to protect wearers from the COVID-19 virus. The SEC previously issued an order on March 26 temporarily suspending trading in the securities of Praxsyn.According to the SEC's complaint, Praxsyn, which is purportedly based in West Palm Beach, Florida, issued a press release on Feb. 27 stating that it was negotiating the sale of millions of N95 masks and "evaluating multiple orders and vetting various suppliers in order to guarantee a supply chain that can deliver millions of masks on a timely schedule." On March 4, Praxsyn issued another press release claiming it had a large number of N95 masks on hand and had created a "direct pipeline from manufacturers and suppliers to buyers" of the masks. Praxsyn's CEO Frank J. Brady was quoted in the release as telling any interested buyers that the company was accepting orders of a minimum of 100,000 masks. Despite these claims, according to the complaint, Praxsyn never had any masks in its possession, any orders for masks, or a single contract with any manufacturer or supplier to obtain masks.

Sure, right, of course. "Praxsyn claims to be a 'specialty finance company focused on providing cash flow solutions and medical receivables financing to healthcare providers in the US that focus on personal injury and workers compensation,'" says the SEC's complaint. Its latest financial statements are from a year ago and show zero revenue. It trades over the counter; Bloomberg tells me that it had a market capitalization of $2.5 million, and a stock price of $0.0039 per share, as of yesterday. That February masks announcement pushed the stock above a penny; it closed on Feb. 27 at a 12-month high price of $0.0106. This is the textbook bad stuff.

To me the weirdest case of securities fraud might always be "Blackfish." SeaWorld Entertainment Inc. operates parks that have orcas. A documentary film called "Blackfish" claimed that SeaWorld mistreated the orcas. After "Blackfish" came out, some people stopped going to SeaWorld parks, because of the mistreatment of the orcas. SeaWorld's investors asked management about this, and management said, no, "Blackfish" was having no effect on attendance. The company didn't exactly lie about the attendance —it honestly reported its financial results each quarter—but it apparently did lie about the cause of the lower attendance. The cause was "Blackfish," management apparently knew it was "Blackfish," and management told investors it wasn't "Blackfish." For this, the SEC sued SeaWorld and settled for about $5 million in 2018. Investors also sued, though, and they didn't settle until yesterday:

SeaWorld Entertainment Inc. said it would pay $65 million to settle claims that it violated securities laws by not being upfront with investors about the effect a critical documentary had on its business. A documentary called "Blackfish" chronicled SeaWorld's practices related to its treatment of captive orcas, also known as killer whales, that drew criticism from lawmakers and animal-rights activists. Released in July 2013, "Blackfish" claimed that orcas suffer while in captivity. A class-action lawsuit in 2014 alleged that the theme-park operator, its board and executives knew or were reckless in not knowing about the documentary's effect on attendance.

Everything bad that a public company does, I often say, is securities fraud, and whenever I then go on to list all the weird unintuitive bad things that are also securities fraud, "abusing orcas" is on the list. Because, yes, now, canonically, being cruel to orcas is securities fraud.

You give WaterStation money and it gives you a fixed return of 28%. Where does it get the money to pay your 28% returns? WaterStation's answer is apparently "from selling lots of filtered water to customers," but 352 suggests that the answer is "from new investors, like a Ponzi scheme."

Actually 352's proposed explanation is far more baroque than that. Its story is that the franchisees got their payments not (just) from new franchisees but from a $100 million bond offering. And the main buyer of the bonds was 352 Capital, which bought the bonds because its portfolio manager was secretly also a WaterStation franchisee who wanted to get his Ponzi payments and who saw his own fund's clients as the best way to get the money.

And, right, that is how a Ponzi works: There are always some investors who want their money back, or who get suspicious, or who might get suspicious, and the way to solve that problem is to raise some money from new investors to kick out the suspicious ones. And Chirico had access to a good supply of new investors: He ran a bond fund

An extremely simple business model, which we discuss a lot around here, is:

1. Found a company that makes something cheap. Make (or buy and resell) widgets that cost you $1. 2. Sell it at a high price, say $10 per widget. 3. Go to customers and say "look, I know I am selling you a $1 widget for $10 and that doesn't make sense. But I will pay you $11 to buy the widget, so you'll come out ahead." 4. Customers say "sure that sounds good," and you get lots of customers. 5. The customers write checks for $10, payable to your company, which books $10 of revenue and $9 of profit ($10 of revenue minus $1 of cost of goods sold). 6. You write the customers checks for $11, out of your personal account (or the account of another business). 7. Economically, you are losing $2 per widget (the $1 it costs to make it, plus the $11 it costs to bribe the customer, minus $10 of revenue), but the split is +$9 for your company and -$11 for your personal account. 8. Go to investors and say "hi, my company has lots of customers and revenue, it's growing fast, and it's profitable," would you like to buy some? 9. Sell 10% of your company to investors at a multiple of like 30 times earnings. 10. If you sell 1 million widgets a year, that costs you $11 million a year in your personal account, but makes $9 million a year for the company. At 30x earnings, that's a $270 million valuation. If you sell 10% of that, you get $27 million, and you're ahead by $16 million. 11. Then, uh. Then you do Step 11.

What is Step 11? The good answer is something like "your idea gets so much traction and so much customer demand, it has such good branding and network effects, that customers now flock to you to buy your widgets for $10, you don't have to pay them anymore, and the business remains fast-growing and profitable, but for real now." This is good for your investors, who bought into a strong and growing company at a $270 million valuation, and for you, because you own the other 90% of that strong and growing company, which is now worth a lot of money. (And you're no longer paying customers out of your personal account.)

The bad answer is "you do this for a year, you collect your $16 million, you stop paying the customers, the business collapses, the valuation goes to zero and your investors lose their $27 million." This is bad for your investors, who cashed you out of a worthless business. It is … not as good for you as building a successful business would be, but it is easier, and it does make you a lot of money.

There are variations on this business model — sometimes the company pays the customers directly, because the investors care only about revenue growth and not profits; sometimes crypto is involved — but the basic idea is old and popular. It helps, if you are doing this, to sell something buzzy. A fast-growing ball bearings business is less interesting than a fast-growing ridesharing business, or crypto business, or artificial intelligence business, or whatever venture capitalists are excited about this year.

When you sell stock short, you have to borrow it from a stock lender, and your deal with that lender is that you eventually have to return (1) the stock and (2) any dividends on the stock. If a company pays a $1 cash dividend, you pay $1 to your stock lender. If the company dividends out a share of preferred stock, you have to go buy that preferred stock and return it to your lender.

In 2019, Overstock.com, whose CEO Patrick Byrne had spent years fighting short sellers, made a plan to distribute a weird blockchain preferred stock to its shareholders that would not be tradable. This was meant to trap short sellers: They couldn't go buy the preferred stock to return to their lenders, because it didn't trade. They would have to close out their shorts — by buying back the stock — before the dividend was paid out, because afterwards they'd be stuck and would get in trouble. There would be a short squeeze: Before the dividend, the shorts would rush to buy back the stock, and they'd have to do it at very high prices.

Or this is the theory; it did not work for Overstock, mostly because the SEC considers it manipulation and told them not to do the dividend. Byrne was not pleased.

A lot of financial scams have the form of "affinity fraud," where a fraudster offers fake investments, pays Ponzi-like returns and "exploits the trust and friendship that exist in groups of people who have something in common." Often the targets are members of some ethnic or religious group, who are more likely to trust one of their own with their money, but all sorts of common bonds can work. The more intense the sense of intra-group connection and trust, the more effective the scam is. We talked a few months ago about a Harvard Business School alumnus who allegedly targeted fellow Harvard MBAs for a Ponzi scheme. In some sense, running a Ponzi scheme on your classmates is the worst possible use of a Harvard MBA, but also I kind of admire it: That's an affinity group with a lot of trust and loyalty and also a lot of money!

Anyway here's a Wall Street Journal article about what I assume is the first alleged pickleball affinity fraud, but not the last:

Rodney "Rocket" Grubbs … was well-known and well-liked in Brookville — a town of 2,600 tucked amid rolling hills about 40 miles northwest of Cincinnati — where he coached tennis and opened a pickleball shop. He traveled to dozens of tournaments a year, playing and selling merchandise through a company, Pickleball Rocks, that he touted as "the world's most recognized pickleball apparel brand."

But authorities say he was also issuing promissory notes — usually for $25,000 at 12% interest over 18 months—to people across the country, telling them they were part of a small group of investors and seldom making good. In court filings, Grubbs said he owes a total of $47.5 million, including interest. The money has largely vanished. ...

Grubbs's creditors lament that they were vulnerable to manipulation by someone they knew and trusted. The affair has entangled the reigning senior national pickleball champion, droves of retirees and a priest.

He "hasn't been charged with a crime" and "has said he never issued a loan he didn't intend to repay," but one alleged victim started "a Facebook group called 'From Pickleball Rocks to Prison Rocks.'" Another now plays pickleball "wearing a Pickleball Rocks T-shirt with the word 'Rocks' covered up." "Why would he take advantage of an 87-year-old friend," she asks, but who else was he going to take advantage of?

Loosely speaking, money laundering consists of taking some pile of "dirty" money —suspiciously large bags of cash that you earned from doing crime, traditionally, or in the modern age money or cryptocurrency that you stole online — and moving it through some steps until it looks like you earned it from a legitimate business and can pay taxes on it, deposit it in a bank and use it to buy securities or real estate. There are various classic methods; here is Patrick McKenzie on the subject, and here's Saul Goodman.

All of this is hard and specialized, and there's no particular reason to think that the skills that make you a good drug dealer or computer hacker or extortionist would also make you a good money launderer. You'd expect there to be an ecosystem of money launderers, specialists who take the proceeds from other crimes and turn them into clean money. You could imagine doing this on an agency basis — "I will clean this money for you in exchange for 20% of it" — but it might be simpler to do it on a principal basis. If you have a money laundry — say, a legitimate business with flexible accounting that you control — you might just go to criminals and say "hey I'll buy your dirty money from you at 80 cents on the dollar." If you can turn it into clean money, you make 20 cents. [10]

It seems sort of obvious that this could be a market with a lot of interest on both sides. Criminals have dirty money that they would like to launder; handing off that risk and expense for 20 or 30 cents on the dollar is a good trade. And there are probably some number of legitimate-ish-but-not-especially-squeamish businesspeople who'd be happy to buy a dollar for 70 or 80 cents. You could set up an exchange! On the Dark Web or whatever, let legitimate businesses buy crime proceeds at a discount. Probably use crypto.

An alleged Ponzi scheme run by a Harvard MBA who solicited money from fellow alumni of the prestigious US business school has been shut down by a New York court after collecting more than $2.9mn.

New York attorney-general Letitia James said Thursday her office had secured the court order to freeze funds controlled by Vladimir Artamonov, after being alerted of the suicide of one of his clients who lost $100,000.

Since 2021, Artamonov has secured at least $2.9 million from at least 29 individual investors and engaged in a Ponzi scheme by paying the existing investors with the new investors' funds. ... Artamonov also used his investors' money to fund unauthorized personal expenses for vacations, shopping, and dining.

Also his pitch was wild: The OAG alleged that Artamonov lured clients by claiming that he could learn which investments Berkshire Hathaway would make ahead of the market by examining public state insurance filings. Artamonov boasted to his investors that it is like "having a private time machine" and "getting tomorrow's newspaper today," and projected returns of 500-1,000 percent. In reality, Artamonov used his investors' money to buy short-term options that expired within days of purchase and appeared to have no relation to Berkshire Hathaway or its investment activities. Artamonov lost millions of investors' funds by investing in these short-term options, but did not disclose the loss to his investors. To cover up the losses, Artamonov told the investors that it had been a "quiet" month and to just wait and see.

First, a very stylized sketch of the electric grid. In the US, there are several regional electric grids that transmit electricity from power providers to users and are run by organizations with names like MISO (Midcontinent Independent System Operator) or ERCOT (Electric Reliability Council of Texas). Various providers — power plants, etc. — sell power to the grid, and much thought goes into the auction mechanisms that match supply and demand and determine how much the providers get paid.

A key problem is that the demand for power fluctuates from hour to hour, while the supply of power is more or less capped over the medium term by the capacity of the power plants connected to the grid. At peak times, the grid has to call on every available resource — always-on nuclear plants, whatever wind is blowing, gas peaker plants, obsolescent coal power plants, capacity from neighboring grids, batteries, etc. — to meet demand. But it might not be economical to own and operate a power plant that only gets turned on, like, two hours a year. And so much thought also goes into figuring out how to make sure there will be enough capacity to meet peak demand.

Here are two methods to do that. One is capacity payments, where power suppliers can get paid some amount of money just for committing to turn on their plants if they're needed. If the plants are never needed, they never turn on, but the suppliers are paid for the commitment, which makes it more economical to keep the plants around, which makes the grid more reliable. (In MISO, the grid operator for some of the middle of the US, these payments are set by an annual "Planning Resource Auction," or PRA.)

The other is demand response. At some point, it occurred to some genius of electricity economics that turning off your air conditioner, at times of peak electric demand, is just as good as generating a bit more power. If you are a user of power, and you agree to stop using power at peak times, that's as valuable to the grid as generating power would be, and so the grid operator will pay you for the power you don't use. If you run a factory that normally uses 10 megawatts, and you shut down the factory for an hour of peak demand, the grid could pay you as though you generated 10 megawatt-hours. Just like a power plant operator, you can get paid the market rate for peak electricity for curtailing your use — and you can also get capacity payments for promising to curtail your use if necessary.

You can easily imagine how this might lead to fraud. Here's the way I have always imagined it might lead to fraud. Demand response is essentially counterfactual: You get paid for how much electricity you would have used but didn't. So the more electricity you say you would have used, the more you get paid. You can't literally just write down "I would have used 10 megawatts, so pay me," but you have some baseline measurement of what you would have used, and if you manipulate that baseline then maybe you can manipulate your payout. [1]

But there is a much funnier way to do demand response fraud. Demand response is generally a business of middlemen: Demand-response intermediaries (or "aggregators") enter deals with consumers or factory owners or whoever to curtail their usage if called upon, and then the aggregators enter deals with the grid operators to deliver that curtailment. The grid pays the aggregators — in the form of capacity payments for committing to curtail usage, and/or in the form of curtailment payments for actually cutting back electricity use — and the aggregators share some of the payments with the customers.

Again, the capacity payments get made even if the customers are never asked to cut back their electricity use: The point is to make the electric grid more reliable by making sure that there is enough capacity to handle peak loads, even if that capacity is never actually used.

Often, if you are marketing an investment, it helps to have your thing validated by some trusted third party. If you've got a company and you want investors, it's good to send them financial statements that have been audited by a well-known accounting firm. If you're selling bonds, it's good to have a high credit rating from a recognized ratings firm. If you're a software company, it is good to have a security audit from a reputable firm.

If you are running a scam, all of this is also true, maybe even more so: If you're selling a fake thing, it is very helpful for you to say "this thing has been certified by a trusted third party." But of course that is hard, because the reason the trusted third parties are trusted is because they are in the business of not certifying scams, so they are unlikely to certify you.

There are ways, of course. Perhaps if you are clever you can deceive the auditors into certifying your financial statements. Perhaps you can bribe them. Perhaps you can hire (or set up) some shady fake auditor and give it a trusted-sounding name. Maybe your financial statements were audited by KMPG and your bonds are rated AAA by Moodie's Investors Service.

An approach that I had not really thought of is:

1. Go to a real, well-regarded, trusted auditing firm. 2. Ask them to audit your thing. 3. They conduct the audit and send you back a letter being like "no, see, this is actually a scam." 4. You go around to investors saying "you can trust us because we were audited by the good firm!" 5. The investors are like "ah well anyone audited by that firm must be fine" and give you their money.

Technically, I think, "we were audited by X" just means that they did the audited, not that you passed. It's maybe true? And yet misleading? Also seems not that helpful: A sophisticated investor would probably say "ah right let's see the audit report," while an unsophisticated one probably wouldn't care, or recognize the auditing firm's name. Still. It helps with the patter; it gives things the ring of truth.

One sort of business in the world is that you can buy old ships, take them apart, and sell the scrap metal and stuff for more than you paid for the ship. Another sort of business is that you can lend people money to do that business: You lend them money to buy a ship, they buy the ship, they break it down, they sell the scrap, they get money, they pay you back.

It is natural, if you are lending people money to buy a big asset, to take the asset as collateral: You lend them money to buy the ship, they promise to pay you back, and if they don't pay you back then you can seize the ship.

You, uh, you see the problem with that here , though, right? The order of operations is:

1. You lend them money to buy the ship. 2. They buy the ship, giving you a lien on the ship as collateral for your loan. 3. They sail off in the ship, yelling "don't worry, you have a lien!" as you wave to them from the pier. 4. They cut the ship into itty-bitty pieces and sell the pieces for money. 5. They don't pay you back. 6. You go to seize the ship. 7. There is no ship? Obviously? Like, that was the whole point of the transaction? They borrowed money from you to buy a ship and then cut it into itty-bitty pieces? At the time when they are supposed to pay you back, why would there be a ship?

Look I am not an expert in the marine deconstruction lending business or anything, but I'm sure some people are, and I am sure that they have found legal and practical technologies to address this problem.

Two stylized facts about the foreign exchange markets are:

It is very hard for retail traders to reliably make money trading currencies, and They keep trying?

From first principles, it seems like a good idea to be on the other side of their trades. If retail traders want to buy pounds, sell them pounds. If they want to sell yen, buy yen from them. Etc.

If you do this as a full-time business, you will want to make some refinements. Here are the three main refinements:

1. It can't really be the case that retail investors lose money because they consistently bet the wrong way on currency movements. (That would take skill!) They lose money because (1) they make essentially random-chance bets on currency movements, with zero expected value, and (2) they lose a bit of money on each trade from commissions and spreads. So, if you are in the business of trading with retail traders, make sure to charge them lots of commissions and spreads. 2. Meanwhile you don't want to incur the costs of going out and buying yen, pounds, etc., each time your retail customers do a trade. Ideally you will "bucket" their trades: A customer comes to you and says "I want to buy $1,000 worth of yen," they give you $1,000, and you say "okay great you have 14,400 yen in your account." [1] You don't actually go and buy them any yen (you just make a note in your books saying that you owe them 14,400 yen), and they don't actually want yen (they just want to bet on the price). They will eventually close out the bet by selling you the 14,400 yen back for dollars, and when they do you will cheerfully deliver them, like, $970. You keep their $30 loss as your profit. No yen are ever involved. 3. You will want them to make leveraged bets: Instead of giving you $1,000 to buy $1,000 worth of yen, they give you, like, $100 to buy $10,000 worth of yen. Then if the yen moves against them by 1%, they have lost all their money. If the yen moves in their favor by 1% they have doubled their money, but the odds are in your favor.

The straightforward way to combine Refinements 2 and 3 is to trade FX futures , where the customers put down a small amount of collateral to enter into a contract with you that pays out based on the price movements of some currency pair, so (1) the trade is leveraged and (2) you never have to go out and actually buy any foreign currencies. FX futures are a very standard way to trade currencies, so customers will be happy to trade them with you.

It should go without saying that none of these refinements are legal advice. [2]

You can make further, shadier refinements. For instance, if your customers are only trading with you — if you never go out and buy any actual currencies or do futures trades with outside dealers — you might think, well, it is not strictly necessary that the prices I charge customers reflect actual market prices. They could just be different prices. If yen futures currently trade at 147.4 and a customer comes to you looking to buy yen, you sell them yen at 146.9 to the dollar. Why not, who cares, it's all just happening on your own computer systems. You have to be careful with this: You probably have to show your customers some screen of bid and ask prices before they trade, and if you show them that yen are 147.5 bid / 147.4 offered and they hit "buy," they might be puzzled to get only 146.9 yen for their dollar. [3] But (1) they might not be (not everyone pays attention) and (2) you can explain it away. "Ah, price impact, market slippage, the market was at 147.4 but then your big buy order moved it," you can say.

Another important set of refinements is: Some customers might actually be good at trading foreign exchange, and will cost you money; what do you do about them? Your answer might be some combination of:

Shut down their accounts. Jack up the commissions, spreads, fake prices, etc., that you charge them, so that they start losing money. Stop bucketing their orders, route them to real markets, and let them trade with their own money with someone else; you charge commissions but no longer take the other side of their bets.

The last important refinement, of course, is that you probably want to lie about all of this? "We charge zero commissions and all of our customers make money!" might be a lie, but it is a better pitch than, like, "we have found a maximally efficient way to fleece rubes like you." Everything else I said above can get you in trouble — none of it is legal advice! — but the lying is its own separate way to get in trouble.

If you run an investment fund, each month your fund will either go up (if you made good investments) or down (if you made bad ones). If it goes up, you report a gain to your investors, and they are happy. If it goes down ... well, look, that is obviously not what you intended. You are a good investment manager and you will undoubtedly make the fund go up again; you got this month wrong, but you will pick good investments from now on.

If you think about it, really your fund hasn't lost any value at all: Sure the stocks in the fund have gone down, but the expected long-term value of the fund has not gone down, because you will work extra hard to make it go all the way back up again next month. And really the accounting statements of the fund should reflect that fact, so as not to unnecessarily scare or annoy your investors: The accounting statements should record a loss on your stocks, fully offset — more than offset, even — by a new asset, your promise to make the money back again. The net asset value of your fund consists of (1) the stocks in the fund plus(2) your promise to make up any losses, and as (1) shrinks (2) grows. So really the net asset value of your fund can never go down.

Ahahahaha no, this is wrong, this is not the way accounting works, or investing, not at all. This is the way Ponzi schemes work! But I guess you could talk yourself into it. More to the point, the guy running a fund called EIA All Weather Alpha Fund I LP allegedly talked his fund administrator, Theorem Fund Services LLC, into it:

During February and March 2018, the Advisers continued to lose money trading on the Third Party Platform, losing an additional $342,000. TFS received trading statements showing these losses and TFS accounted for these losses as losses of the Fund. TFS then provided the NAV and Investor Statements to the Advisers for review. Upon reviewing the NAV and the Investor Statements that evidenced the losses, the Advisers instructed TFS to change the accounting for the losses. Specifically, the Advisers instructed TFS, and it agreed, to record an expense reimbursement for all losses from the Advisers' trading as an asset, specifically, a receivable "due from the Manager (EIA)," which offset the effect of the loss, resulting in no reduction to the Fund's NAV. The Advisers further instructed, and TFS agreed, that going forward, any losses from the Advisers' trading would be treated as an increase to the receivable due from the manager (EIA). At no point was EIA actually liable to the Fund for losses.

TFS carried out these instructions during the remainder of its engagement with EIA and treated the Fund's trading losses, which continued to grow over time, not as losses and a reduction to the Fund's NAV, but instead as a receivable due from EIA with no related reduction to the Fund's NAV. TFS did not evaluate whether this was appropriate, determine the collectability of the receivable, or verify that any legal requirement of repayment existed. TFS accepted the Advisers' word that the Advisers were legally liable to reimburse the losses (which they in fact were not) and thus the losses were due from EIA and used this treatment to calculate each monthly NAV. As a result, TFS prepared and disseminated Investor Statements containing materially overvalued equity balances throughout the Relevant Period because the balances were never decreased or showed any losses. Upon receiving the Investor Statements, two investors invested additional money in the Fund.

The Economics 101 story is that markets respond to shortages through price signals. If a widget factory burns down, there will be a shortage of widgets, widget users will pay higher prices to secure their scarce widgets, and entrepreneurs, seeing those high prices, will jump in to build their own widget factories and solve the shortfall.

Of course in the real world this mechanism is imperfect and not instantaneous: If there's a shortage of widgets and the price spikes, you can't necessarily open a widget factory tomorrow. You need expertise and capital and raw materials and workers to respond to the price signal.

The … let's say Topics in Money Stuff Economics Seminar version of this story would mention that markets also sometimes respond to shortages through con artists. [1] When a widget factory burns down and people need widgets, there are not necessarily a lot of unemployed widget manufacturers hanging around ready to spring into action to solve the shortage. But there are, absolutely, a lot of con artists hanging around pretending to sell gold bars or cannabis or crypto or whatever the Last Thing was, and their costs of pivoting to the Current Thing are very low. They do not need to retool a factory or source raw materials. Just take the email that is like "send me $1 million and I will get you a guaranteed 20% return in a month by yield farming in DeFi" and search-and-replace "yield farming in DeFi" with "manufacturing scarce widgets."

Or "supplying scarce baby formula." Or "providing medical aid to Ukraine." Or "importing N95 masks to fight Covid." If you read the news and see that there's a high-profile shortage of some good, you can just pretend to supply it! And gullible investors, who also read the news, will be excited to give you money.

This is not any sort of advice, I do not recommend it, I would not do it myself, but oh boy did Eliyahu Weinstein (allegedly) do it. In 2013, Weinstein pleaded guilty to running a $200 million real estate Ponzi scheme. In 2012 and 2013, while he was out on bail for that Ponzi scheme, he did another financial scam involving "purported sales of pre-IPO Facebook shares and Florida real estate"; he pleaded guilty to that one in 2014. He was sentenced to a total of 24 years in prison for all of this, but in January 2021 President Donald Trump commuted his sentence and let him out of prison. I don't know why Trump let him out, but possibly he admired Weinstein's moxie and sense of humor and wanted to see what else he'd get up to.

That faith in him was richly rewarded yesterday, when Weinstein was charged by the US Securities and Exchange Commission and federal prosecutors in New Jersey with doing a new Ponzi scheme in the two years since he left prison. Pre-IPO Facebook shares were very much the current thing in 2012, before Facebook went public, but in 2021 through 2023 the things were apparently:

"In or around late 2021, Optimus [one of Weinstein's companies] started raising money directly from a small number of investors to finance purported transactions related to COVID-19 medical supplies." "In or around May 2022, WEINSTEIN (posing as Mike Konig) asked CC-1 and CC-2 [two unnamed alleged co-conspirators] to raise money from investors to finance the purchase and delivery of three million first-aid kits ('FAKs') to USAID to be distributed to the people of Ukraine during the Russia-Ukraine war (the 'FAK deal')." "In or around May 2022, WEINSTEIN (posing as Mike Konig), asked CC-1 and CC-2 to raise additional money to finance Company-1's purchase of 100 million N95 masks (the 'N95 Mask deal')." "Similarly, in or around early August 2022, WEINSTEIN (posing as Mike Konig) asked CC-1 and CC-2 to raise money to finance the purchase of approximately 29 shipping containers of baby formula from [alleged co-conspirator Alaa Mohamed] HATTAB's company, Hattab Global, in order to capitalize on supply chain issues which had created a shortage in baby formula (the 'Formula deal')."

Just pick a thing in the news, and he was allegedly pretending to supply it. Of course prosecutors say he was not actually doing any of these things and was instead stealing the money, then raising more (from the next thing) to Ponzi it up and pay fake returns to the earlier investors. If you raise money from investors to pretend to source Covid-19 supplies, and you tell them it was a huge success, then you can raise more money from investors to pretend to supply medical aid to Ukraine and use that money to pay your fake returns to the Covid people. Here's a sample pitch email:

We successfully completed our first formula deal with 4 x 28,200 800g Cans (4 Containers). That's 112,200 cans of formula being distributed to families in Texas at fair prices. Needless to say, we felt so good about this one, that we have another deal in the pipeline for 29 more containers. And it is LIVE. If you want in on this deal, Offering is 25% within 3-4 Months (Although we think it will be faster). Funding on this is open from 8/08-8/19. ACt [sic] now,… Only 4mm in funding room left!

A running theme of this column, which is never legal advice, is that if you are going to do bribes you should try to be businesslike about your bribes, instead of being cutesy. Like if you send your colleague a text message saying "our 'friend' expects one million 'chickens' for his 'help' with this 'contract,'" that's gonna look really bad to the jury at your inevitable criminal trial. But if you send a professionally formatted invoice saying, like, "Consulting charges: 80 hours @ $1,250 per hour plus 45 basis point success fee on $200 million contract = $1,000,000 to be paid by ACH transfer to General Consulting Services LLC," you might still get arrested, but at trial you can say "no that was for consulting, very standard, nothing wrong with that."

Yesterday US prosecutors brought bribery charges against 10 people "in connection with a massive scheme to defraud Polar Air Cargo Worldwide, Inc. ('Polar'), a leading cargo airline, of tens of millions of dollars" with bribes. Polar is a cargo airline — a joint venture of DHL and Atlas Air — that sold cargo space to shippers, and if you wanted cargo space on Polar you allegedly had to pay (1) Polar the rates that it charged you plus (2) some bribes to the Polar executives who were selling you the space.

The executives included Polar's chief operating officer, its vice president of marketing, its vice president of operations and its senior director of customer service. "In general," says the indictment, "the Executive Defendants often had the ability to propose vendors, to advocate on behalf of certain vendors or customers, and to exercise significant influence over both Polar's selection of vendors and the rates offered to its customers." They were the people selling space on Polar's planes, and so they could set the rates for that space — and the rates they set, allegedly, included both a payment to Polar and a payment to themselves.

But it was all businesslike. From the indictment:

To conceal the kickbacks and conflicted ownership interests from Polar, and thereby to continue the fraud scheme, [they] often directed the kickbacks and ownership distributions be paid to limited liability companies with non-descript names that were, in fact, controlled by the Executive Defendants. …

From in or about 2009 through in or about July 2021, Polar contracted with freight forwarders to sell available cargo space on behalf of downstream shipping customers, who, in turn, paid freight forwarders to secure cargo space and coordinate logistics. ... These kickbacks were typically calculated based on how many kilograms of cargo the freight forwarders had shipped with Polar during a particular period. At no point before the discovery of the fraud in or about July 2021 were the kickbacks from freight forwarders known to Polar.

"At no point … were the kickbacks from freight forwarders known to Polar" is a weird sentence. Polar is not a person; it has no consciousness. The kickbacks were not known to Polar's owners , I assume, or perhaps to its chief executive officer. But they were known to its chief operating officer, because he was allegedly receiving them. This was not some rogue salesperson taking bribes; this was a big chunk of the executive team.

And so there is an amazing civil lawsuit filed late last year by one of the customers, Cargo On Demand Inc., against Polar, complaining that Polar charged it bribes. Cargo On Demand's point was, look, if Polar's salespeople and senior managers told it to pay these fees as part of the price of cargo, it had to pay those fees. From the complaint:

COD entered into the [Blokced Space Agreement] with Polar primarily because Polar's rates on the specific air routes relevant to COD's customers were typically lower than the rates quoted to COD by any other airlines providing service on the same routes.

However, in order to actually utilize its cargo space allotment, COD was advised by members of Polar Management that it was required to also pay Polar (via Polar Management), and certain third-party consulting companies connected to Polar, additional "consulting fees" separate and apart from the BSA.

These consulting fees were charged beginning at the inception of COD's relationship with Polar in 2014. …

The consulting fees were calculated based on the monthly tonnage for all goods that COD shipped with Polar. The amount of the fee typically varied between $0.25-$0.50 per kilo of tonnage, in addition to the agreed BSA rates.

The consulting fee requirement was articulated to COD by multiple members of Polar Management (which included, without limitation, the company's Chief Operating Officer and multiple vice presidents and directors) over the course of seven years.

COD was advised and instructed by Polar Management that these additional "consulting fees" were part of Polar's regular way of doing business with all customers that had annual BSA contracts with Polar.

To COD, such fees seemed akin to a hotel "resort fee". In other words, a mandatory fee that is not included (or not prominently included) in the quoted rate, yet mandatorily charged at either a flat amount or percentage basis in the final bill.

Also analogous to a resort fee, the "consulting fee" allowed Polar to generate additional cargo revenue by giving the appearance of offering lower rates in comparison to competitors than if Polar had quoted the full (i.e. all costs and fees included) cost.

That is, Polar could advertise low rates, but then tacked on an extra fee for bribes. The complaint includes as an exhibit an email from Polar's vice president of marketing to the owner of Cargo On Demand, saying "bro here is the updated sheet — pls use this for distribution" and attaching an eight-page spreadsheet listing dozens of Polar flights, how much cargo Cargo On Demand had on each flight, and how much bribe it owed for each one. "As directed, COD then made the specified payments for that month via ACH wire transfer."

The numbers are in the tens or hundreds of dollars per flight, and the entire alleged bribe invoice is for $41,291.93, to be distributed among the nondescriptly-named entities of several Polar executives. The indictment says that Cargo On Demand paid a total of about $1.6 million of kickbacks to Polar executives from 2016 through 2021, and if you just wrote a check for $1.6 million of bribes that would look bad. But sending monthly ACH transfers for detailed invoices measured in pennies per kilogram just looks like business.

Of course they got arrested anyway; I must emphasize that nothing here is legal advice. Also the owner of Cargo On Demand was himself indicted, for paying the bribes, which seems a bit harsh. He was dealing with a company, and all the senior executives he dealt with told him that he had to pay these fees! He thought they were a resort fee!

The simplest form of investment scam is that you promise people some attractive return on their investment, they like the promised return and give you their money, and you steal it. In this scam, what sort of return should you offer your marks in order to maximize your take? There are two basic approaches, which are:

1. A reasonable return, or 2. An insane return.

The first approach was made famous by Bernie Madoff, who ran a gigantic Ponzi scheme that offered relatively modest, stable, boring returns. The advantage of this approach is that it can attract sophisticated investors: Madoff was able to raise money from rich people and funds-of-funds because, in their obviously flawed due diligence, they concluded that the returns he promised were plausible. [1] Rich people and funds-of-funds have lots of money, so Madoff was able to raise lots of money and keep the scheme going for a long time.

The second approach has some advantages too. For one thing, people want high returns, so I guess the higher the return you promise the more people will want it and the more money they'll give you. Also, though, you are running a scam, so you mostly don't want sophisticated investors. It is plausibly harder to trick sophisticated investors than it is to trick unsophisticated ones. This is like why advance-fee scam emails have lots of typos: "By sending an initial email that's obvious in its shortcomings, the scammers are isolating the most gullible targets." Promising a 1,000,000% return ensures that you never end up talking to anyone but the most gullible possible marks.

The basic mechanics of a pump-and-dump scam are that you acquire a bunch of some penny stock for very little money (by buying it in the open market, or more often by being an insider of the penny-stock company), and then you trick naive public investors into buying the stock from you for more money. There are some pretty well-known traditional methods for tricking the public:

1. Especially if you control the company, you go around issuing press releases about how the company has found a cure for cancer or is pivoting to the blockchain or whatever. Retail investors are fooled and buy the stock. 2. Even if you don't control the company, you put out a fake press release saying that Tesla Inc. has offered to buy the company, and then dump your stock quickly while the market is fooled. 3. You sell some stock to your friend for $0.02, she sells it back to you for $0.03, you sell it back to her for $0.04, she sells it back to you for $0.05, you post on some message boards saying "THIS STOCK IS SOARING, LOOK AT THIS PRICE ACTION," and then you sell to the readers of those message-board posts for $0.06 and split the profits with your friend. 4. You post on a message board saying "hey I'm gonna pump this stock" and other people say "sure all right sounds fun." They buy the stock as part of a conscious game of musical chairs: Someone will be left holding the bag, overpaying for worthless stock and unable to sell before it collapses, but everyone has fun playing the game and trying to get out in time.

There might be a few others, and you can combine these approaches. They are all a bit clichéd at this point, and I always wonder how much capacity they could possibly have. (Who is the audience for all these fake press releases?) But it is still a thriving business, and there is still innovation. For instance, here is a US Securities and Exchange Commission enforcement action from last week:

The Securities and Exchange Commission today charged 18 individuals and entities for their roles in a fraudulent scheme in which dozens of online retail brokerage accounts were hacked and improperly used to purchase microcap stocks to manipulate the price and trading volume of those stocks. ...

According to the SEC's complaint, in late 2017 and early 2018, hackers accessed at least 31 U.S. retail brokerage accounts and used them to purchase the securities of Lotus Bio-Technology Development Corp. and Good Gaming, Inc. The unauthorized purchases allegedly enabled fraudsters, who already controlled large blocks of Lotus Bio-Tech and Good Gaming stock, to sell their holdings at artificially high prices and reap more than $1 million in illicit proceeds.

Sure? If you can just hack into a bunch of brokerage accounts and turn them into zombies to buy your penny stocks, you don't even need to bother with fake press releases. Very efficient.

If I tell you "hey, I have illegal inside information about a stock, the CEO told me about a merger and I gave her a sack of cash, let's buy the stock," and you do, and I am telling the truth , then you have committed a crime (insider trading) and I have also committed a crime (insider trading) and we will both get in trouble. (Not legal advice!)

If I am lying , you probably have not committed a crime? (Again, not legal advice; maybe you have committed attempted insider trading or something; surely if I am an FBI agent and lying to you about this I can get you in trouble.) But I have committed a crime, the crime of lying to you about having inside information. (Like insider trading, this is technically the crime of "securities fraud.") You thought you had good illegal information, and in fact you did not. You were unfairly cheated out of your ability to do a crime. It's a weird crime, right, this crime I did to you? But we talked last year about a case where a guy was prosecuted for telling people that he had inside information, and charging them for it, while in fact he only did good fundamental research based on public information. You'd think that would be better? I don't know.

Anyway here's that for sports:

In or about and between January 2004 and March 2020, both dates being approximate and inclusive, the defendant CORY ZEIDMAN, together with others, engaged in a fraudulent scheme directed at individuals across the United States (the "Victims"). As part of the scheme, ZEIDMAN and his co-conspirators, including Co-Conspirator # 1, placed advertisements on the radio in various markets throughout the United States, which falsely advertised a "sophisticated white-collar approach to gathering sports information" and promised "wagering as investing, not high-risk gambling." The radio advertisements further instructed listeners to call a specified telephone number to receive information that could be used to win when wagering on sporting events. When the Victims called that number, ZEIDMAN and his co-conspirators falsely told the Victims, among other things, that certain sporting events were predetermined, or "fixed," and that ZEIDMAN and his co-conspirators knew the outcomes of the events. It was a further part of the scheme that ZEIDMAN and his co-conspirators falsely claimed to have secret, "privileged," or "inside," information regarding sporting events, which they received from physicians at colleges and television executives, and which could be used to predict the outcomes of the events. ZEIDMAN and his co-conspirators further assured the Victims that the Victims would win their wagers, and
falsely claimed that there was no risk associated with their wagers. In exchange for this purported inside information, ZEIDMAN and his co-conspirators demanded that the Victims pay fees, which numerous Victims did.

If you are a criminal mastermind, one thing you could do is go to law school, get good grades, get hired at a big M&A law firm, work 100-hour weeks on big deals, and eventually try wiring yourself the money that was meant to pay for a merger. There are many downsides to this approach, including that when you are surreptitiously changing the deal documents you are doing it from your office, and if someone notices you will get arrested. A better criminal-mastermind approach might be to find an exhausted M&A lawyer working to close a deal and try to trick her into wiring you the money. Sometimes that works!

The Plaintiffs are former stockholders (and a noteholder) of a company purchased via merger. They tendered their shares as called for in the merger agreement. The Defendant buyer accepted the shares and directed its agent, also a Defendant, to make the required payment to the Plaintiffs. Before payment was made, the Plaintiffs appeared to have indicated to the agent (through deal counsel) that they wished the funds sent to a different payee and address, that of a Hong Kong company. Unfortunately, the Defendant agent was unaware that this communication was in reality from hackers, who were ultimately successful in diverting the cash consideration to persons unknown. Thus the buyer received the stock, presumably cancelled as part of the merger, and has paid the cash consideration, but the sellers have delivered their shares without receiving payment.

Whee! That is from a Delaware Chancery Court decision last month (but new to me) about the $130 million acquisition of Graduation Alliance Inc., a private education company, by KKR & Co. funds. The way the merger consideration worked is that the KKR buying entity wired the money to a paying agent, Continental Stock Transfer & Trust Co., and then Continental distributed it to the Graduation Alliance shareholders in exchange for their shares. Two shareholders, the Sorenson Impact Foundation and James Lee Sorenson Family Foundation, sent their shares, "along with a transmittal document called a letter of transmittal," to Continental; the letter of transmittal told Continental where to send the money. But:

After the Plaintiffs transmitted their legitimate documents, hackers intercepted their email communications, assuming the identity of the Plaintiffs, and communicated via email with unsuspecting legal counsel, ultimately seeking to have the Plaintiffs' letters of transmittal edited such that payment would be made to the hackers' bank accounts instead of the Plaintiffs' accounts. The hackers were successful.

Yeesh. The merger agreement in the deal covered the closing mechanics in some detail, requiring Graduation Alliance shareholders to send in their shares along with letters of transmittal, and specifying that Graduation Alliance would give the buyer a "consideration spreadsheet" three business days before closing with a list of where to send the money. And the form letter of transmittal required a "medallion guarantee" to send the money to anyone other than the name listed on the share certificates; "a medallion guarantee confirms that 'the signature authorizing the transaction is genuine and the signer has legal capacity and authority to sign the document.'"

These are the right formalities, but in a busy deal it is sometimes socially difficult to insist on the formalities. It is a pain to demand medallion guarantees, you are trying to get the merger closed, and what are the odds that some scammer would be emailing you knowing the details of this small private-company merger? It's easy to just believe your email:

After the Plaintiffs provided their legitimate LOTs to the "Defendants," the Hackers intercepted the email chains between the parties, sending fraudulent emails posing as the Plaintiffs, who were unaware of the interception. The Hackers emailed H&K [Graduation Alliance's law firm] asking to change the "pay out account" for the Plaintiffs to "an international account in Hong Kong." About a week later, on February 7, 2020, the Hackers sent an email containing a revised LOT, stock certificates, and an authorization letter updating the payment information to be paid into the Hong Kong bank account. The new beneficiary to be paid out under the revised fraudulent documents was "Hongkong Wemakos Furniture Trading Co. Limited"—clearly a different name than either of the Sorenson holders. Despite the instructions to the LOT, a medallion guarantee was not provided.

Continental noticed this, and complained to the lawyers about the lack of formalities, but everyone seems to have gotten comfortable with changing the payment spreadsheet without consulting either (1) the real Sorenson holders or even (2) the hackers. ("In support of their argument that the 'Defendants' were subject to a 'time crunch' resulting in anticontractual behavior, the Plaintiffs point out that the 'Defendants' did not even consult the Hackers before making the change to the payment schedule.") And the money went to the hackers and was never seen again.

The Sorenson funds sued everyone involved and last month Delaware Vice Chancellor Sam Glasscock III ruled that (1) they couldn't sue the payment agent[1] but (2) they could go ahead and sue Graduation Alliance and the buyer. This is a weirdly close question: You could read the merger agreement to mean that the buyer's obligation was just to pay the merger consideration to the paying agent, or you could read it more generously to mean that the obligation was to send the money to the right place. The vice chancellor chose the second option and let the case go ahead.

This is a small deal for a private company, but I want to emphasize the general point, which is that if you call up the exhausted law-firm associate working 100-hour weeks to close a big merger on schedule, and you say "hi I am the seller in this merger, there is a typo in my wire transfer instructions, let me give you the correct account number," it might work! It probably won't! You'll probably go to jail! This is not legal advice! But it has worked.

One way to do fraud when you are pitching an investment is to lie about the investment. "Our thing has guaranteed 20% monthly returns with no risk," you say, and then you steal all the money. This is pretty common.

Another way to do fraud when you are pitching an investment is to lie about the alternatives. "If you put money in a bank or the stock market it will all be stolen from you by vampires; only our thing can protect you from that." (Then you steal all the money.) This is … also pretty common? A lot of financial frauds seem to appeal to people with a conspiratorial mind-set; they are happy to believe that the regular system is stacked against them and they need to give their money to a scammer to protect themselves.

It probably will not surprise you much to learn that an alleged gold-coin-investing scam allegedly did both. Here's a U.S. Securities and Exchange Commission enforcement action against Safeguard Metals LLC and its owner Jeffrey Santulan; from the complaint:

Guided by scripts, some of which were prepared by Santulan, Safeguard sales agents made false and misleading statements to investors about the purported risks associated with the investors' existing securities holdings at investment banks and brokerage firms. For example, Safeguard's sales agents stated that a "Money Market Reform Law" allowed banks and brokerage firms to freeze retirement accounts in the event of a market downturn; that top financial experts in the United States were saying that another recession was coming very soon; and that when that happened, the investors' accounts would be frozen and they would not be able to get any money out of their 401(k) plans or Individual Retirement Accounts ("IRAs"). These statements were misleading because, among other things, the law that Safeguard referenced applied only to money market funds in rare circumstances and could not result in an individual's entire account being frozen.

If you go to someone and say "please invest a million dollars in my company, it is a good company," and they say "you seem like a nice person, here is a million dollars," and they give you the money and you spend it on restaurants and gambling, and they bring you to court for fraud, I suppose it is a defense for you to say "but you never asked me what I was going to spend the money on." And they'll say, like, "you told me it was for your company and that it was a good company," and you'll say "well, it was a good company, for me ; it paid for a lot of good meals." This is not, I think, a completely trivial defense, though this is not legal advice and I wouldn't necessarily try it. But the question in a fraud case is whether you lied about material facts and whether the investor justifiably relied on those lies. If you were careful not to actually lie, and the investor forgot to ask you any questions about your plans, there's probably no fraud. Even if you did lie a bit, but the investor had no good reason to believe you, you might not be guilty of fraud.

You could imagine more complicated variants. For instance, your company could have a written business plan that says "the plan is to spend all the money we raise at restaurants and casinos," and it could have audited financial statements showing zero revenue, millions of cash inflows from investors, and identical outflows to restaurants and casinos. And then when potential investors heard your pitch and said "okay send me your business plan and financial statements," you could say "no, those are too secret to share with investors, but trust me they are very good." And then when you end up in court you can be like "well, again, they were good, for me." And the investor … look, it is kind of bad for the investor to give you money without seeing the financials? Like, sure you told them that they couldn't see the financials, but they could have walked away at that point! At some point, if someone wants to be defrauded badly enough, it is almost not fraud to take their money?

At the New York Times, Erin Griffith had a funny story about the fraud trial of Theranos Inc. founder Elizabeth Holmes:

As investors have testified at Ms. Holmes's trial, a central tension has emerged around due diligence. Could these investors have avoided disaster if they had simply done better research on Theranos? Or were they doomed because their research was based on lies? ...

Ms. Holmes's lawyers have needled Theranos's investors for their oversights, aiming to convince the jury that the investors were the ones at fault for not digging into Ms. Holmes' claims. …

The strategy has sometimes veered into condescension. That was evident last week when Lance Wade, a lawyer for Ms. Holmes, asked [DeVos family-office investment manager Lisa] Peterson, an investment professional, if she was familiar with the concept of due diligence.

"You understand that's a typical thing to do in investing?" he said. …

[Christopher] Lucas's firm, Black Diamond Ventures, invested around $7 million into Theranos, despite not getting access to its financial information or examining all of its corporate records. This was unusual, Mr. Lucas testified on Thursday, but Ms. Holmes told him the information was sensitive because a leak could "give competitors a chance to crush the company."

That secrecy extended to due diligence. Ms. Peterson testified that she was scared Ms. Holmes would cut her firm out of the deal if they dug deeper into the details of Theranos's business.

"We were very careful not to circumvent things and upset Elizabeth," she said. "If we did too much, we wouldn't be invited back to invest."

A lot of this stuff comes down to market norms, on both sides. Part of Holmes's defense is "that exaggeration is part of Silicon Valley's startup culture": Sure she did a certain amount of fake-it-till-you-make-it, but everyone in startups does that and investors could not have been deceived by it. But part of the argument against her is that her investors did justifiably rely on her sketchy pitch, without pushing to do real due diligence, because in a deal world driven by fear of missing out on the next big thing, that was actually a normal way for an investor to operate.

Here at Money Stuff we always enjoy a good euphemism for "bribes," but I confess this one — which seems to be pretty standard? — was new to me:

One aspect is the role of intermediaries, often favored by governments in the region. The so-called briefcase companies act as conduits for traders' bribes to officials, taking a cut and directing state business back to the traders. Glencore was a dominant player in Nigeria, Chad, the Republic of Congo and Equatorial Guinea, and says it no longer uses intermediaries as part of a revamped and cleaned-up operation.

"An issue that comes up with trader corruption is agents and intermediaries in the mix," said Alexandra Gillies, an adviser at the Natural Resource Governance Institute, which seeks to stamp out corruption in emerging market resources. "Clearly it's the top modus operandi for how these schemes work."

It is from a story about a Glencore Plc oil trader who confessed to paying bribes, through intermediaries, to African government officials. If you just wire money to a government official, that is a bribe and it's pretty obvious. But if you wire money to a well-connected local consulting firm, you are paying reasonable consulting fees for an expert with local knowledge who can give you guidance on how to win deals legitimately. And if the consulting firm keeps 10% of the fee for itself and stuffs the rest in a briefcase to hand to a government official, well, how were you supposed to know?

My main thesis about fraud is that it is very much defined by local social expectations. If you are playing poker and you bet like you have a big hand, trying to deceive people into folding, and it works and they fold and you take their money, and then you flip over your cards and show that you have nothing and say "hahaha I was bluffing, suckers," they might be annoyed with themselves, for folding, or even with you, for gloating, but they won't accuse you of fraud. They won't call the police, or even stop playing with you. They are part of a social context in which they expect their counterparties to try to deceive them, and in which they sometimes try to deceive their counterparties, and their reaction to a bold and successful bluff will mostly be "wow, good one, you got me."

This is not true of most areas of life, but it is sort of true of some areas, and those areas tend to be where a lot of fraud cases come from. In the bond market, if you are a trader at a bank and a customer comes to you and says "I'd like to buy XYZ bonds" and you say "I have some, I paid 106 for them, I'll sell them to you for 106.125, I'm barely making any money but you're a good customer so I'll do you a favor," and the customer says "done" and pays you 106.125, and actually you paid 101 for them and made a huge profit, is that fraud? Well, federal prosecutors sure seemed to think so, and they charged a bunch of bond traders with fraud for doing this. And they got some juries to convict these traders, on the fairly straightforward theory that the traders lied to the customers. And then the traders appealed, saying "no no no you don't understand, the customers were expecting us to lie to them, they lie to us all the time, this is just a market where everyone lies to each other, and we all know and accept that, so no one was defrauded." And appeals courts largely accepted these arguments, and some of the convictions were overturned.

You can tell a lawyerly story about this: You can use words like "reasonable reliance" and "materiality" to capture the basic notion that, if you lie to people who expect you to lie to them, you are not really defrauding them. This story will not appeal very much to most prosecutors, but it does seem to have some appeal to some judges. It does not seem to have much appeal to juries. If you say to a jury of normal people "oh sure I was lying to my customers, but you have to understand, we're all a bunch of degenerates and we go around lying to each other all day in our multimillion-dollar deals," the jury's reaction might be "well then we should put you all in prison."

Then there are tech startups. One theory is: If you run a startup, and you are raising money from investors, and you go to those investors and say things like "we had $10 million of revenue last quarter" or "we built an electric truck that moves on its own" or "we have a finger-prick blood test that can catch 100 diseases," and the investors are like "wow" and give you money, and you were lying, then that is fraud. This theory is very, very, very well supported. It is what the law actually says, for one thing. ("It shall be unlawful for any person … to make any untrue statement of a material fact … in connection with the purchase or sale of any security," says the law.) Also it is consistent with normal intuitive understandings of "fraud." If you just went to a bunch of ordinary people — people who might be on a jury — and asked "if I lie to investors to raise money, is that fraud," they'll mostly say yes.

But another theory is: No, those investors really want to be lied to. Those investors are holding a competition of the form "who can sound the most excited and persuasive and crazy when they lie to us," and they give their money to the winner. They wouldn't put it quite that way. But what the investors want is a fantasist, a wild-eyed dreamer, a visionary who sees the world not as it is but as it could be. They want someone who looks at $1 million in revenue and sees $10 million. They want someone who looks at some blueprints for an electric truck and sees hundreds rolling off the production line. They want someone who looks at a finger-prick blood test that doesn't work and sees one that does work. They want someone who believes in something that nobody else believes in, an out-of-consensus visionary who wants to change the world. Obviously obviously obviously they would prefer it if this person's wild belief comes true, if she succeeds in changing the world. But the first step is to back founders with crazy ideas. And then if one of them works out, that pays for 10 that are just crazy.

This theory is also well supported! Lots of venture capitalists will say it out loud! But also, like, man, look at the entire history of SoftBank Group Corp. Look at how SoftBank's Masayoshi Son met WeWork's Adam Neumann, and Neumann pitched him on some vision of office-space-rental changing the world, and Son gave Neumann $3.1 billion. And, famously, "Mr. Neumann has told others that Mr. Son appreciated how he was crazy—but thought that he needed to be crazier." You don't say that and then turn around and check every line of the financial projections for exaggerations and unjustified assumptions. If you invest in startups by (1) meeting crazy people and (2) telling them to be crazier, your main investment criterion is not scrupulous accuracy.

The problem is that prosecutors don't want to hear this. "No no no you don't understand, these investors were looking for someone to say crazy stuff to them, so I did. It didn't work out, but they knew going in that the odds of it working out were low. And sure I said that our product already worked, and it didn't, but that's just the sort of patter they expect from a visionary tech founder; they didn't take that too seriously." That might all be sort of true, but a prosecutor is going to be like "but you sold securities by lying about material facts, no?"

All of this is very bad of course: If you are a fiduciary investment adviser, (1) you should not get kickbacks from an investment fund when you convince your clients to invest in that fund and also (2) you should not recommend Ponzi schemes to your clients. But the point is that if you are running a Ponzi scheme anyway, you will get more money if you tell your clients "I am your fiduciary financial adviser and my only priority is doing what is best for you, and I think that you should invest in this little company we know called Horizon Private Equity, they're great, lotta government bonds, of course we have no affiliation with them but they've done well for our clients." As opposed to the normal Ponzi pitch of, like, "put some money in this bag and I will go away with it and do mysterious things to turn it into more money."

It is silly season at the U.S. Securities and Exchange Commission, the few weeks leading up to the agency's Sept. 30 fiscal year end when it brings a slew of miscellaneous enforcement cases every day. Here's one from yesterday against an alleged $110 million Ponzi scheme run by a guy named John Woods, who allegedly ran both an investment advisory firm called Southport Capital and also an investment-fund-slash-alleged-Ponzi called Horizon Private Equity III LLC. The overall vibe seems to have been "generic Ponzi scheme"; from the SEC complaint:

Woods and other investment adviser representatives at Southport told clients that they would receive returns of 6-7% interest, guaranteed for two to three years, for non-specific investments in a fund called "Horizon Private Equity." Woods and his cohorts at Southport generally told investors that Horizon would earn a return by investing their money in, for example, government bonds, stocks, or small real estate projects; investors were not told that their money would or could be used to pay returns to earlier investors.

The SEC lists the following things that Wood and friends allegedly told investors over more than a decade of alleged Ponzi scheming:

That Horizon investments had a guaranteed rate of return;

That Horizon investments carried little risk and were extremely safe and conservative;

That there was no possibility of losing the principal investment in Horizon; …

That the Horizon investment was an annuity; ...

That there were no fees or costs associated with the Horizon investment;

That Horizon would use the proceeds of investments to purchase government bonds that would be held to maturity;

That Horizon would use the proceeds of investments to purchase collateralized mortgage obligations;

That the risk of loss of a Horizon investment was minimal because Horizon had a very diversified investment portfolio; ...

It's just, you know, whatever. You put money in the pot and we use it to buy, ehhhhhh, whatever you'd prefer to think we buy with it. It's a private equity fund. It pays 6% a year guaranteed. It buys government bonds. Is it weird that the government bonds pay 6% a year? Fine it buys collateralized mortgage obligations. Does that sound risky? Well it's very diversified. Also guaranteed. Also an annuity. Just tell me what you want; it's that.

Though we have talked before about why getting sued for fraud is rare in startups. I once wrote:

When a private startup says something untrue, even in connection with a sale of stock, the victims will often be sophisticated venture capital firms. These firms are less likely to sue, for a couple of reasons. For one thing, they want to invest in other startups, so they want to cultivate a reputation for being founder-friendly, and suing founders for fraud is not friendly. For another thing, they want to raise money from pensions and endowments and allocators, so they want to cultivate a reputation for being smart and doing good due diligence; calling attention to how they got tricked is not helpful. For a third thing, they are looking, in their venture capital investments, for high-risk, high-reward bets. The ideal founder, for them, is someone who promises the impossible and then delivers it. If a founder promises the impossible and then does not deliver it, well, you know, that's okay, most startups fail.

A classic accounting trade goes like this:

1. I buy a widget for $1. 2. You buy a sprocket for $1. 3. We get to chatting and formulate a plan. 4. The plan is: I sell you the widget for $100, and you sell me the sprocket for $100. 5. Net, we have each spent just our original $1. (I spent $1 on the widget, sold it for $100, and paid $100 for the sprocket.) 6. We each own $100 of assets. (I own a sprocket, you own a widget, and we carry them on our books at their purchase price.) 7. We each have a $99 profit from asset sales. (I bought a widget for $1 and sold it for $100, a $99 profit; I also have $100 of sprocket inventory for which I paid $100 and carry at its purchase price.)

This is, you know, disfavored as a matter of accounting rules; if the market price of widgets and sprockets remains $1 then our auditors are not going to like us trading them for $100. Also it is a bit unsustainable; if the market price remains $1 then when I eventually sell my sprocket to an independent buyer I'm going to have a $99 loss.

But in the short run it can be tempting. If, for instance, I am a hedge fund that trades obscure illiquid bonds, and you are a hedge fund that trades obscure illiquid bonds, and we do this trade with each other, then we can both report good performance and growing assets this quarter, and we can charge higher fees. And our auditors might have questions, but the bonds are obscure and illiquid so who's to say what the market price really is?

Anyway here's a good dissection of the financial troubles of FC Barcelona, which basically kept overpaying for players until it ran out of money to buy more. It includes the accounting trade:

By summer 2020, Barça's transfer deficit was haunting Bartomeu and his board members. Under the rules that govern Spanish member-owned clubs such as Barça, directors had to repay losses out of their own pockets. The board needed to book profits urgently before the financial year ended on July 1. And so a bizarre swap transfer was concocted. The counterparty was Juventus, also eager to improve its books. Juve "sold" Bosnian midfielder Miralem Pjanic to Barça for a basic fee of €60m, while Barça sold Brazilian midfielder Arthur Melo to Juve for a basic €72m.

These sums would never actually be paid. They were invented for accounting purposes. Under bookkeeping rules, each club could book its handsome supposed selling price as immediate income. The notional payments would be spread out over the years of the players' contracts. Only €12m in actual money would end up changing hands, the difference between the two players' fictional prices, paid by Juve to Barça. What mattered was that the swap helped both giants clean up their books.

Who's to say what the market price is for a particular soccer player? If Barça wants to pay 60 million euro for him, sure, why not. If Juve wants to pay 72 million euro for a different soccer player, sure, why not. You could make up any numbers you want! As long as the two numbers you make up are pretty close to each other! It is tempting.

Loosely speaking you could say that there are three sorts of financial scams. The most common scams pretend to be legitimate. A scammer comes to you and says she is raising money to invest in some productive purpose, to fund some product or activity that people want. You think "ah, this company is curing Covid, if it succeeds that will be lucrative, I will put some money in." There are lots of scams like this, and some are more convincing than others, but speaking very broadly it is easy to sympathize with the victims of these scams. They thought they were doing a sensible investing thing, funding good projects with a high expected return, but they were being lied to.

Some other scams pretend to be illegitimate, or at least, like, tricky or unfair. They pretend to be different scams from the scams they actually are. Some people invested with Bernie Madoff because they assumed his investment fund was front-running his broker-dealer. It wasn't, it was just a Ponzi scheme, the joke was on them. But they had thought the joke would be on someone else. Or people constantly fall for "prime bank" scams, whose premise is something like "the Federal Reserve and the Illuminati pay certain select insiders millions of dollars to trade Treasury bonds at night," don't even ask.[2] You put your money into a prime bank scheme not because you think you are making a good investment in a productive activity; you put your money in because you think someone has offered you a special opportunity to put one over on someone else, to extract money for yourself illegitimately.

These scams are quite popular because they offer a sense of specialness; they fulfill a need for mystery and conspiracies. Also because "you can't cheat an an honest man": If you are running a scam, the ideal mark is someone who is up for a little dishonesty, who is not going to insist on all the proper procedures. Also because the victims here are never going to be that sympathetic: They wanted to do some scam (one where they were the scammer), you served them a different scam (one where they were the victim), but what are they gonna do, call the police?

The third kind of scam — is it even a scam? — doesn't pretend to be anything at all; it is just open about being exactly the sort of scam that it actually is. In the early days of Ethereum there were tons of things named like "Ethereum Pyramid Scheme" or "Ethereum Ponzi Scheme." If you buy that you know what you're getting! The value proposition of a Ponzi scheme is: "If you put in money now, and other people put in money later, we will pay you a high return on your investment, but if you are the last one in you will lose all your money." You can dress that proposition up in lies — say "we're investing in totally safe bonds at a guaranteed above-market return" while actually doing a Ponzi — or you could not. You could just tell people what you're doing and ask them if they want to play. Some will, because that basic Ponzi proposition is sort of a fun game of musical chairs but with money. People could want to play because they like a gamble, or because they think they have some edge — some special psychological insight or inside knowledge or whatever that gives them an advantage in guessing when the game will end and getting out in time.

I have mostly come around to the view that many small-cap pump-and-dump schemes look like the first type of scam but are really the third. Some stock shill sends out an email newsletter saying "buy Amalgamated Widgets because they are about to announce a breakthrough Covid cure," and then Amalgamated Widgets stock goes up rapidly and then down rapidly again, and from the outside you can look at it and say "ah, people were tricked into thinking that Amalgamated Widgets had a Covid cure," but the shill's newsletter is titled Stock Shill Weekly and the only subscribers are people who want to play pump-and-dumps and nobody believes it, it's just an excuse for everyone to play a gambling game where the loser is whoever gets out last. There is no reason at all to sympathize with victims of the third sort of scam; often they don't sympathize with themselves. They don't perceive themselves as victims, because they aren't; they think they played a game of chance and lost. They got their money's worth, in expectation; they had their fun and it cost them a reasonable amount of their gambling money.

In the second scheme, Radjabli manipulated the securities market for Veritone, Inc. ("Veritone"), a publicly-traded artificial intelligence company, in which Apis Capital and an affiliated investment fund owned shares. On December 10, 2018, Radjabli and Apis Capital issued a press release announcing an unsolicited cash tender offer to acquire Veritone at an 82% premium. The announced tender offer, and the related forms that Radjabli and Apis Capital filed with the Commission, contained a number of materially false and misleading misrepresentations. Specifically, Radjabli and Apis Capital falsely represented that they had well in excess of the $200 million offer price and beneficially owned a 5.03% stake in Veritone. In truth, the defendants lacked the financing, or any reasonable prospect of obtaining the financing, necessary to complete the deal, and Radjabli and Apis Capital owned only a 4.6% stake in Veritone. The defendants' misrepresentations were material. Following the pre-market announcement and Commission filings, Veritone's stock price opened at $7.96 a share, a 41.4% increase from the prior day's close. Radjabli then capitalized on the scheme by selling Veritone securities and purchasing put options on behalf of Apis Capital and its affiliated fund. Ten days later, Radjabli and Apis Capital withdrew the supposed tender offer. As a result of this scheme, Radjabli generated illicit profits of approximately $162,800 for Apis Capital and its affiliated fund.

I feel like the usual way to do a fake tender offer is to put out a fake press release or SEC filing under a fake name. Like you say "Blarkrock Group has announced that it will buy Veritone at an 82% premium," and people bid up the stock and you sell yours, and (you hope) the SEC never figures out that you were the person behind Blarkrock Group. But here Radjabli did a real SEC filing using his real name and the name of his investment firm; if he was doing it just to pump the stock that seems like a mistake.

Here is a story about DarkSide, the ransomware collective that shut down Colonial Pipeline Co.'s fuel pipelines. DarkSide is just a fascinating business. We talked the other day about its compliance and reputational-risk functions, and this story covers its franchise-based business model:

The platform supplies affiliates with tools and follow-up services in much the same way McDonald's Corp. supplies local store owners with pre-made soft serve and frozen hamburger patties."These guys provide the marketing, the people who handle customer success, as well as the actual ransomware," said Mark Arena, chief executive officer of the cybersecurity firm Intel 471, which tracks DarkSide. "Fortune 500 CEOs would be impressed with the efficiency of the business model."

"Customer success"! I assume that's Arena's jargon, not DarkSide's, but what if it's DarkSide's? Like you pay to use the DarkSide platform, and you deploy it and hack a company's computers, and you call the company and say "give us money," and the company says no and hangs up on you, and you don't know what to do, so you call the toll-free number listed on DarkSide's website and it's like "press 1 for new orders, 2 for the status of existing orders, or 0 for customer support," and you press 0 and get a friendly operator who talks you through the process for how to extort a ransom, and you get what you need, and before you hang up you take a brief survey to rate your experience, and the LinkedIn page of the person fielding your call says not "customer support representative" but rather "customer success ninja" because that's how titles work in tech these days. Actually you don't even need to call customer success to get advice on negotiating the ransom because they'll do it for you:

[DarkSide provides] not just the actual ransomware used to encrypt data on a victims' computers, but also services like making calls to those victims and also hosting a website where sensitive data stolen during attacks can be posted. Ransom demands easily reach into the millions of dollars for large companies, and DarkSide takes a 10% to 25% cut off the top of any payment, according to Intel 471's Arena.

But the story also mentions another possible profit center:

At one point the group offered to provide stock traders with insider information from victim companies, which they could use to make money on the market -- a move that appeared to be an attempt to cultivate a Robin Hood-esque reputation for spreading corporate wealth, according to screen shots of the group's blog provided by eSentire.

From the screen shot:

Now our team and partners encrypt many companies that are trading on NASDAQ and other stock exchanges.If the company refuses to pay, we are ready to provide information before the publication, so that it would be possible to earn in the reduction price of shares.Write to us in 'Contact Us' and we will provide you with detailed information.

A customer success ninja will get right back to you. I dunno, I am on record saying that you shouldn't do this, and just to be clear let me go on record again saying you absolutely shouldn't do this, but I do see where they're coming from? One problem with extortion as a business is that, if the victim pays you, you get money; if the victim doesn't pay you, you blow up the victim but you don't really get anything out of it. If the victims all said no, you would cause a lot of havoc, but you wouldn't make any money and you'd eventually have to find another line of work. But with listed public companies, you can make a profit directly from the havoc.[6] As a ransom demand, "give us $5 million or we'll destroy your computers, we don't want to but we'll do it" seems inferior to "give us $10 million or we'll destroy your computers, we'd love to do that actually because we bought a bunch of puts on your stock, we're giving you a chance to pay the ransom but we'd be perfectly happy if you don't."

One way to do scams on a different class of victims is to pick a hot private company that is rumored to be going public soon, claim to own stock in that company, and offer to sell it. Actually selling it would be hard — private companies tend to have rules around how their stock can be traded — but that's okay, because modern private markets have developed sort of a norm of indirect investing in hot private companies. Some private vehicle buys a chunk of private-company stock (from the company or an existing big investor), and holds onto it, but sells shares in the vehicle to investors. As far as the private company knows it has one shareholder, the vehicle, but the vehicle itself has lots of shareholders, all of whom indirectly own shares in a pool of shares of the private company.

This is an absolutely real thing, sometimes done by big reputable investment banks. But it's relatively easy to fake. If I sell you shares of Stripe Inc. stock, you might be tempted to call up Stripe and say "hey I'm a shareholder now" and Stripe might tell you "no you aren't, we have a list right here" and I'd get caught. (Or you might do this before buying the stock, for instance to check if Stripe has transfer restrictions on its stock, and then you would find out the truth and not buy from me.) But if I say "I have a pot of Stripe shares over here, would you like to give me money in exchange for an ownership interest in the pot," that's no problem. Stripe is not involved, by design, and I can give you a nice certificate that really does entitle you to an ownership interest in the pot. You might not notice that the pot is empty.

And the class of victims here is very good: It's people who have millions of dollars to invest in private companies, who want to invest in the best and hottest private companies, but who do not have the hundreds of millions of dollars that they'd need to actually do that. And who are looking for a loophole, a way to get hot unicorn shares that are not actually available for purchase. They're rich and greedy, which makes for good victims.

See, this is the difference between professional and amateur payers of bribes. Amateurs hide their bribes and refer to them by cute euphemisms; when they are caught, the fact that they called their bribes "chickens" or whatever makes it obvious that they knew what they were doing was wrong. Professionals are matter-of-fact about their bribes and refer to them by business-y euphemisms like "success fees" or "consultancy charges" or "goodwill payments" or "commissions." And then they deduct them on their tax returns. This serves two purposes:

1. If later you are criticized for the bribes, you can say "no, see, these were just normal commissions, it's totally fine, you can tell because we reported them on our tax returns. We wouldn't have done that if they were illegal bribes , would we?" 2. Lower taxes!

A classic way to get rich in financial markets is:

1. Bet that Thing X will go up. 2. Simultaneously bet that Thing X will go down. 3. Thing X goes up or down. 4. Collect your winnings on whichever bet was right. 5. Walk away from whichever bet was wrong.

There are variations. Bet that Things X, Y and Z will go up, for instance, and then walk away from whichever bets (possibly all of them) go down. Obviously the trick is to find a way to walk away from the losing bets!

One notorious way to do this is with a newsletter dispensing penny-stock tips.[8] You write two versions of the newsletter saying "buy XYZ stock" and "sell XYZ stock," you send one version to 8,000 people and another version to a different 8,000 people, XYZ goes up or down, you throw away 8,000 addresses, you write two versions saying "buy QRS" and "sell QRS," you send them out to the remaining 8,000 people, etc., until there are 500 people who have seen you make five correct stock picks in a row and are impressed. Then you tell them to subscribe for more infallible stock picks for the special price of $99.95 per month.

This method is good (it's bad! don't do it! it's fraud!) because you are not making the bets with your own money. Most of the time, if you make actual bets with your own money, it is hard to walk away from the losing ones. Occasionally, though, financial markets do give you that opportunity. Occasionally someone will offer a product that is like "we will give you the returns on some investment that you pick, but we'll always give you at least your money back," and you can buy two of those, pick two opposite volatile investments, collect the payoff on whichever wins and get your money back on whichever loses. Here's a story about a guy who did that with weird death-benefit variable annuities, though he went to prison for it, oops.

Here is I guess a do-it-yourself version, from, of course, a Securities and Exchange Commission enforcement action announced this week:

The SEC announced fraud charges against California resident Abhi Batra for allegedly conducting a free-riding scheme in which he fraudulently reversed more than $1 million in Automated Clearing House (ACH) transfers.

The SEC's complaint alleges that Batra transferred money from bank accounts to brokerage accounts via ACH, then used the funds to purchase speculative options contracts. The complaint further alleges that when the options trades lost money, Batra would recall the ACH transfers to the brokerage firm by falsely representing to the bank that he had not authorized the initial transfers. As a result, Batra allegedly imposed his trading losses on the brokerage firms. By contrast, according to the complaint, when his trading was profitable, Batra kept the profits for himself. As alleged, Batra engaged in the free-riding scheme between 2016 and 2020 in brokerage accounts in his name, and in the names of six others, at times without their knowledge or consent. In total, Batra allegedly recalled more than $1 million in ACH transfers, withdrew approximately $98,000 in trading profits from the brokerage accounts, and left losses in the brokerage accounts estimated at $665,000.

Yes. Well. Obviously this is super illegal but the financial logic is sound. If you can do this, then all of your trades have the profile of (free) call options: You make money as the trade goes up, but you don't lose any as it goes down. The value of a call option increases as the volatility of the underlying position increases, so if you are going to do this you might as well buy volatile stuff, which means, of course, that you should trade options. (So you have options on options.) He did. He traded options terribly , losing way more than he won, but of course that didn't matter when he could pocket the winnings and walk away from the losses. Sometimes both at once!

On or about October 16, 2019, Batra deposited $30,000 via ACH from his bank account into his brokerage account at Brokerage B.

Between approximately October 17 and October 22, 2019, Batra used the $30,000 on deposit to purchase options contracts in the securities of Netflix.

The options positions were closed by October 25, 2019. Batra's trading resulted in profits of more than $13,000. By the end of October 2019, Batra's account balance was approximately $43,000.

On or about November 19, 2019, Batra withdrew the $43,000 ($30,000 initial deposit plus $13,000 in trading profits) from the account at Brokerage B to one of his bank accounts.

On or about December 2, 2019, Batra caused his bank to recall the initial $30,000 ACH transfer to the account at Brokerage B.

By recalling the $30,000, Batra was able to recoup the money that he had used to trade, while still keeping the profits from his trading.

I often write that "everything is securities fraud," that creative regulators can find a way to transform any misbehavior by a public company into securities fraud. They do this for various reasons: because securities fraud is easier to prove than the underlying misbehavior, because the underlying misbehavior is politically controversial and not actually illegal, because big companies are more willing to settle than the individuals who do the bad stuff, or because those companies have more money.

This feels like an extension of that theory. Financial regulation is universal regulation, and it is in a sense easier regulation than the rest of the law. If police and prosecutors wanted to stop Epstein, they would have had to arrest him and have a public trial in which they proved to a jury that he was still doing crimes. Perhaps they would also have faced political pressure from Epstein's well-connected friends. Given all of this, it took a long time for the authorities to work up the nerve to arrest him.

If Deutsche Bank had wanted to stop processing payments for Epstein, they could have just sent him a letter saying "we're closing your account" with no explanation and no appeal. That wouldn't necessarily have prevented crimes, but it would have at least inconvenienced him. (In fact Deutsche Bank did that, in December 2018, months before federal authorities got around to arresting him.) It is not a perfect substitute for the actual enforcement of written laws by officially empowered agents of the state, but it is something, and it is fairly fast and efficient, and in hindsight, in the case of Jeffrey Epstein, it seems like it would have been a good idea. When it is hard for the government to enforce the laws, sometimes it is easy for banks to enforce them, sort of, a little bit. And if the banks don't do it, the government will be disappointed.

Apparently that's illegal? It doesn't sound like it was insider trading? (Apparently she was "making use of her past travel service work experience," though.) It's just using an insurance product for a purpose it was not designed for (speculation), instead of the purpose it was designed for (protecting your vacation from bad weather). There is a traditional insurance view that you need an "insurable interest" to buy insurance, that you can only buy insurance to protect stuff you actually have. And there is a modern finance view that markets should be complete and you should be able to speculate on either side of anything you like. When individuals try to apply the modern-finance view to consumer insurance products, they tend to get in trouble.

The basic problem with a Ponzi scheme is that it keeps getting worse. You raise money from people promising them large returns, then you have to raise more money from more people to pay the first people their returns, but then you have to raise even more money to pay off the second set of people, etc. You can't just do a little bit of Ponzi and be on your way. It keeps snowballing. You need some dramatic event to end it in a satisfying, you-don't-go-to-prison sort of way. There are two categories of non-prison endings that might work. One is: You suddenly make a lot of money. This might happen if, for instance, your Ponzi scheme is only partly a Ponzi scheme. You raise money to invest in magic beans, you buy the magic beans, the magic bean market does not develop as robustly as you'd hoped, you use some later investors' money to pay returns to the earlier investors, everything looks real bad for a while, and then all of a sudden the market for magic beans takes off and everyone is happy. I will tell you that a whole lot of speculative investing looks almost exactly like this! SoftBank Group Corp.'s Vision Fund can call capital from investors to pay those investors' preferred coupons, which is Ponzi-ish in a technical sense, but not in a fraud-y sense; if you are investing money in a thing that takes a while to pay out, you may find yourself legitimately using money from investors to pay promised returns to investors.[1] But of course if you're mostly doing a fraud this won't work, so you will need to find some other way to make a lot of money and end your Ponzi happily. There are not a lot of encouraging examples. Martin Shkreli did a hedge fund fraud—not actually a Ponzi—and then made a hugely successful pharmaceutical investment that allowed him to pay off all the investors he defrauded, which is pretty amazing, but he's in prison anyway. Sam Israel ran a big Ponzi and tried to make it up to investors by investing in a huge prime bank scam, which was also really amazing but did not work at all. It's pretty grim. There is no general reason to think that your ability to raise money by deceiving investors would also give you any special ability to pick an investment with a huge payoff. You might as well just buy lottery tickets. The other sort of ending that can work is: You suddenly lose a lot of money. I mean, not really; if you're running a Ponzi, you've slowly lost the money over time and lied about it. But if you have some sudden event that seems like it would cause you to lose all your investors' money, then that can retroactively justify stealing all of it, or at least make people less likely to look closely. (This is of course the strategy of "The Producers," though also of "The Sting.") You raise money to invest in magic beans, you promise a high return, you keep raising more money, you Ponzi most of it and steal a little, you keep telling investors that your magic beans are gaining value, and then magic bean blight sweeps through the land and you can tell all your investors "sorry everything was great but the blight killed all our beans." It is conventional wisdom that the financial crisis exposed a lot of Ponzis, which is true—"It's only when the tide goes out that you learn who's been swimming naked," etc.—but it probably buried some Ponzis forever too. Surely some investment manager was thrilled to send investors a letter saying "I lost all your money in the crisis, oops," since it saved him from sending them a more accurate letter saying "I Ponzied all your money away years ago."

So the government gives tax benefits for certain energy-efficient investments. Basically the benefit is that you get an immediate tax credit of 30% of the cost of, for instance, certain solar generators. You also get to take depreciation deductions on your future taxes, and presumably you also save on your electric bill because you have this generator. So there is some math. It's like:

1. I spend $100 for this generator. 2. I get back $30 in tax savings immediately. 3. I save $X a year on taxes, due to the depreciation deductions, over the Y-year useful life of the generator. 4. I save $Z a year on my electric bill over the Y-year useful life of the generator.[1]

If the present value of $X plus $Z per year for Y years is greater than the $70 net up-front cost of the generator then look I can tell you are bored already. What if the math was easier:

1. I spend $100 for this generator. 2. I get back $30 in tax savings immediately. 3. Someone buys the generator back from me for $70. 4. Also for some reason I still get the depreciation deductions.

Now my net up-front cost is zero: I pay $100, get back $70, and take a $30 tax credit. Then the depreciation deductions are just a residual stream of free money. That's an infinitely better trade! I am not out of pocket any money. I do not have to do any calculations about my expected electric-bill savings. I do not have to rely on my expectations about whether and how the tax law will change. I do not have to do any present-value math. I do not have to maintain the generator over its useful life. I do not have to take delivery of the generator and plug it in to my factory. I don't have to have a factory, or an electric bill; I don't have to have any actual need for the generator. It is a pure financial transaction: I give you $100, the government gives me $30, you give me back $70, and then the government gives me some more money later. It takes place on paper. I don't even have to see the generator. There doesn't even have to be a generator. Whoops, no, too far! There has to be a generator! If there's no generator then this is all just tax fraud. But … you can … see how … one might … get … confused? The actual trade went like this, per the SEC's complaint:

1. DC Solar sets up an investment fund, a separate entity that will raise money to own the generators. 2. The investment fund is owned by investors. 3. The investment fund buys the solar generators from DC Solar Solutions Inc., an arm of DC Solar, for $150,000 apiece. 4. "Investors generally contributed about thirty percent of the purchase price in cash and financed the balance pursuant to a Promissory Note or Notes executed by the Investment Fund in favor of DC Solutions." So they pay about $45,000 per generator in actual cash. 5. Because the tax credit is 30%, "investors expected to be able to take a tax credit for roughly the same amount as their cash contribution to the investment." They pay $45,000 to DC Solar Solutions, and get back $45,000 from the government, on that year's taxes. 6. The remainder of the purchase price is paid in the form of "a Promissory Note or Notes executed by the Investment Fund in favor of DC Solutions." That is, the investors never have to pay it—it is an obligation of the limited-purpose investment fund. 7. The investment fund keeps the generators and rents them back to DC Solar Distribution Inc., another arm of DC Solar. 8. DC Solar Distribution then goes and finds other people who want actual solar power and rents the generators to them. 9. DC Solar Distribution (takes a fee and) forwards the rent payments to the Investment Fund, which uses them to pay off the promissory notes. 10. Once the notes are paid back—once DC Solar Solutions gets its remaining $105,000 back, with interest—the investors get a share of the rent payments. 11. Meanwhile, the investors are technically the owners of the generators (they own them through the investment fund, a pass-through entity for tax purposes), so they get to take depreciation deductions.

Steps 8-10 there were more or less totally fake. DC Distribution couldn't find a lot of customers to rent the generators. That's not an overwhelmingly attractive proposition: The rental cost of the generator may or may not be cheaper than your electric bill, but you've got to get it installed and make sure it works and worry about maintenance and downtime and blah blah blah, and meanwhile you're not getting any tax savings. "DC Distribution continued to fail in its attempts to lease the Generators to legitimate end-users in significant numbers." But the proposition for investors is so, so good! So easily and overwhelmingly attractive, with no downsides! You pay $45,000 to the investment fund, you get back $45,000 from the government immediately, you get some more money back from the government over time, you never have to plug anything in anywhere, and, uh, sure, maybe one day you'll earn rental income from the generators (step 10) but honestly who cares, that is not the point of this trade. DC Solutions was just selling investors immediate tax savings. It was selling a dollar of tax savings for less than a dollar. Of course it had a line around the block of people waiting to sign up.

It is not legal advice or anything but there is kind of a Money Stuff First Law of Bribes, which is that when you are talking about bribes, particularly in writing, you should not refer to them as "bribes," and you should certainly not refer to them as "chickens" or "sugar" or some other clever euphemism; you should refer to them by boring but technically accurate terms. For example if you are trying to get a government official to award your company a big contract, and you hand him a sack of cash to speed that along, when it comes time to account for that sack of cash in your financial records you can call it a "corporate marketing fee." That is literally true! You paid a fee to market your corporation! To him! Really bribery is the most straightforward and elemental form of marketing. Or we have talked a few times about "success fees." You pay a fee and your bid is successful, it's a success fee, there is no problem here. "Consulting fees" is perhaps the most standard approach of all: You hire a local guy as a consultant, you pay him a large consulting fee, and his consulting consists of (1) knowing which local officials need to be bribed and (2) handing them some of the consulting fee. This is all well-known stuff, and it's not like an automatic get-out-of-jail-free card to tell prosecutors "that wasn't a bribe, it was a consulting fee." Still using boring business terms gives you a fighting chance of not getting caught, and even if you do get caught you've got a fighting chance to persuade a jury that it was all fine, and even if you do get convicted it is just, I mean, it is aesthetically a bit less embarrassing than if you'd used the dumb euphemisms. Last week Swedish telecom company Telefonaktiebolaget LM Ericsson agreed to pay more than $1 billion of fines to the U.S. Justice Department and SEC for bribing officials in China, Saudi Arabia and Djibouti, and the SEC complaint is full of detail on how a large professional multinational company accounts for bribes. For instance:

Internally, EAB employees referred to these payments as "corporate marketing fees" which some employees believed to be code for bribes.

Or:

Ericsson China improperly recorded these payments as "other external services," "site acquisition services" and "service fulfillment of contract."

Or:

On or around December 18, 2013, the head of Ericsson's Middle East region signed the Consultancy Frame Agreement on behalf of EAB's Qatar branch. The agreement stated that EAB's Qatar branch engaged Kuwait Consultant to provide services "within the area of marketing and sales support to increase customer satisfaction and enhance Ericsson business in Kuwait . . . with the purpose of winning the LTE business with [Kuwait SOE]." These services were never provided.

No, I disagree, surely the consultant did increase customer satisfaction (by giving the customer money) and enhance Ericsson's business (with bribes). These things are all code for "bribes," but they are also all, in their way, honest.

Every initial public offering is marketed in two ways:

1. "This company is good": This is the story that the IPO prospectus will tell, and that the company will tell in roadshow meetings with potential investors. The company has a good business, a good product, smart managers, strong financial results, so if you are a long-term fundamental investor you should buy some stock. 2. "This stock will trade up": This is the story that the marginal investor in the IPO wants to hear. The company is selling X million shares in the IPO, there are orders for 10X million shares, there are a lot of retail investors who would love to buy it but can't get into the IPO, and so, when the stock opens for trading on the day after the IPO, lots of people — the retail investors, the people who put in the 9X million orders that weren't filled — will buy it in the aftermarket. There is a lot of demand, not enough supply, so the stock will go up.

That second story is, to some degree, self-fulfilling. The company's banks will call an investor to ask "how much do you want to buy in this IPO?" The investor will say "well how is it going?" The correct answer is not "we've got orders for 80% of the shares, so it would really help if you'd put in a big order for the other 20%." The answer the investor wants is more like "we've got orders for 1,000% of the shares, but if you put in a big order we'll see what we can do for you." The more demand the investors think there is, the more demand there will actually be: Investors want to buy into IPOs that don't need their money, because those are the ones that will trade up.

Theoretically, there are about two good ways to run an economy:

1. Free markets. People can make stuff and buy whatever they want, and markets and price signals sort out how much gets made and who gets it. If people want widgets, and I make widgets, I can sell the widgets for money, which will make me want to make widgets. If nobody wants sprockets, and I make sprockets, soon I will stop and do something more useful. 2. A big computer. You program a big computer to figure out everyone's preferences and marshal all the available resources, and then you solve a complicated optimization problem to figure out how best to use the resources to meet the preferences.

The first approach has been pretty widely adopted, in variously modified forms, over many years in many places, and has a decent if not unblemished record of allocating resources and satisfying demand. The second approach has some track record — I have at least once mentioned Francis Spufford's terrific historical novel, Red Plenty, about Soviet efforts in this vein — but there are not a lot of clean examples of it working at economy-wide scale. You would need a pretty big computer and it seems hard.

Still I am not sure that it is refuted? It's more, like, Real Big Computers Have Never Been Tried. You could tell a story like:

Computers are really good now. There have been rapid advances in processing power and machine learning and artificial intelligence, so you should expect big computers to have a better chance of running an economy in 2024 — or 2044 — than they did in 1964. One outcome of free markets seems to be the rise of larger companies, and the larger and more diversified a company is, the less it will be governed by price signals: If I mine my own ore and refine my own steel to make widgets, and then use those widgets in my gizmo factory, my decisions about how many widgets to make will be driven not by the price of steel or widgets, but by how many widgets the VP of Gizmo Factories wants and how much steel the VP of Steel Milling can provide. Index funds? When I mentioned Red Plenty , it was in the context of writing about a Sanford C. Bernstein & Co. research note arguing that "Passive Investing is Worse Than Marxism" because passive investors do not try to allocate capital to its best uses, but just buy whatever is in the index. If that were true — if financial markets have abdicated their responsibility to allocate resources using price signals — you'd need some sort of allocation mechanism to replace it.

Anyway this is all pretty idle speculation but here's a fun Wall Street Journal article about Amazon.com's smart speaker business:

When Amazon launched the Echo smart home devices with its Alexa voice assistant in 2014, it pulled a page from shaving giant Gillette's classic playbook: sell the razors for a pittance in the hope of making heaps of money on purchases of the refill blades.

A decade later, the payoff for Echo hasn't arrived. While hundreds of millions of customers have Alexa-enabled devices, the idea that people would spend meaningful amounts of money to buy goods on Amazon by talking to the iconic voice assistant on the underpriced speakers didn't take off.

Customers actually used Echo mostly for free apps such as setting alarms and checking the weather. "We worried we've hired 10,000 people and we've built a smart timer," said a former senior employee.

As [Chief Executive Officer Andy] Jassy tries to fix it, he is rethinking the obscure Bezos-era metric inside Amazon that helps explain why Echo and other devices could accrue such huge losses for so long with little repercussion. Called "downstream impact," or DSI, it assigns a financial value to a product or a service based on how customers spend within Amazon's ecosystem after they buy it. ...

The metric was developed in 2011 by a team of economists including an eventual Nobel Prize winner. In some instances, the model worked clearly. When customers buy Amazon's Kindle e-reader—one of Amazon's profitable devices—they are very likely to then buy ebooks to read on that device. Ebooks are part of the books business, not the devices business, but Amazon leaders said it made sense for the Kindle team to claim part of revenue when assessing their product's internal value. ...

In other cases—especially Echo devices—the downstream impact idea broke down, said the people familiar with the devices business.

If you were in the business of selling smart speakers, you would try to (1) sell them for more than it cost to make them and/or (2) negotiate some sort of arm's-length partnerships with advertisers, business partners, etc., who might pay you for access to your smart speakers' customers. If the amount of money that customers paid, plus the amount of money that advertisers/partners paid, exceeded the cost of making the speaker, you'd do it. If not, you'd stop. Capitalism!

But Amazon is not in the business of selling smart speakers. It's in the business of selling everything , which is harder. If you sell everything, your price signals get obscured. If Amazon just gave everyone a phone, for free, with the Amazon app on it, that would probably increase Amazon's sales of books and toilet paper and electronics and dog food and video subscriptions. But would it be worth it? For that you need a model developed by a team of economists. And sometimes the model doesn't work.

If you are a trader, a good skill to have is buying stuff that will go up. If the stuff — stocks, bonds, currencies, whatever — that you buy reliably goes up, then you can make a lot of money. You can make money simply by buying the stuff, having it go up, and then selling it for more money than you paid. But there are other ways to monetize the skill. You can start an investment newsletter, and charge people a fee for telling them what stuff will go up. You can start a hedge fund, buying stuff for other people and taking a cut of their profits.

Meanwhile, other people might try to free-ride on your skill. People might find out what you are buying — your broker will see your orders, or maybe you're running a hedge fund and have to disclose what you buy [1] — and might try to copy you, since what you buy keeps going up. Your purchases contain information — they encode the message "this stuff will probably go up" — and that information is valuable.

If you are a trader, another … skill? … you might have is buying stuff that will go down. You keep saying "ooh this stock is poised to go to the moon," you buy it, it goes to zero. This skill seems somehow more attainable than the first skill, though it's not clear that that's actually true. [2] It is harder to make money with this skill. If you buy stuff, and it goes down, and you sell it, you will have less money.

Oh, I know, I know, you can try the George Costanza approach: Any time you think you should buy a stock, you sell it instead. But this seems tricky to do yourself; it requires not only the self-knowledge to say "I keep getting things wrong" but also the ability to continually analyze your instincts to identify the valuable signal. "After extensive research and analysis, I want to buy this stock, which means I should sell it," you think, but what if actually that is the impulse you should be resisting? How do you know where to stop your conscious analysis and do the opposite of the result? [3]

Can you monetize the skill in other ways? I think if you have a strong track record and a rigorous repeatable process of only buying stocks that go down, you really should be able to start a newsletter or get hired by a hedge fund to tell people your best ideas (so they can short them), but again I think this is tricky in practice. Probably if you waltz in the door at Citadel and are like "hi my superpower is that I am exceptionally terrible at picking stocks" they will have doubts. I bet there's some sell-side equity research analyst out there who is kept on the payroll for making reliably wrong stock picks, but it can't be that common.

Can other people free-ride on your skill? Can they look at your track record and say "everything this person picks goes down, so I should short it"? I mean! Tuttle Capital Management once launched some very rude exchange-traded funds to fade Jim Cramer's and Cathie Wood's stock picks, but I don't think those had any real alpha; it is not actually the case that Cramer or Wood has this sort of anti-skill. In general, if your stock picks are known broadly, they're probably not bad enough to make betting against you a reliable strategy.

On the other hand, your broker probably knows (1) what you're buying and (2) how you're doing. If you're terrible, your broker might be tempted. Here is a funny CME Group disciplinary action against a futures broker called Wing Fung Futures Limited:

Pursuant to an offer of settlement in which Wing Fung Futures Limited ("Wing Fung") neither admitted nor denied the rule violations or factual findings upon which the penalty is based, on July 16, 2024, a Panel of the Chicago Mercantile Exchange Business Conduct Committee ("Panel") found that between July 22, 2020, and July 7, 2022, Wing Fung deployed an automated trading system ("ATS") in the Australian Dollar, British Pound, Canadian Dollar, Euro FX, Japanese Yen, New Zealand Dollar, E-mini NASDAQ, Micro E-mini NASDAQ, and E-mini S&P 500 futures markets wherein the ATS's strategy was to submit orders based upon trades executed by its clients who were regularly unprofitable. Specifically, upon a target client establishing a short/long position, the ATS generated a trading signal to enter an order in the same market for the same price and quantity as the client, though to establish the opposite short/long position. The Panel found that by employing this strategy, Wing Fung attempted to profit from its knowledge of its clients' record of losses, which was not available to others in the marketplace. Additionally, the Panel found that Wing Fung employees used Wing Fung's clients' unique operator IDs to enter orders into Globex. The Panel further found that Wing Fung's leadership fundamentally did not understand, or were otherwise completely unaware, of Exchange rules that prohibited the activity described above. Therefore, the Panel found that Wing Fung failed to diligently supervise its employees and agents.

I will say that in general if you are a client-facing foreign currency firm, and your clients are terrible at trading currencies, it is often a good and legitimate strategy to internalize their orders: If they want to buy 10,000 Australian dollars for US dollars, you sell them the Aussie from your own account, so that you are naturally on the other side of their orders and make money when they lose money. [4] But I suppose if you're a broker who sends client orders to the exchange, and you also send your own opposite orders to the exchange to fade them, that looks rude.

We talked last week about a trend in modern finance, which is:

1. Banks, which have risky liabilities (demand deposits), do somewhat less of their traditional risky activities (trading, lending), for regulatory or risk or competitive or other reasons, and other people (nonbanks) get into those activities. Private credit firms make buyout loans or student loans, proprietary trading firms make securities markets, hedge funds take on banks' credit risks with synthetic risk transfers, etc. 2. Those other people — the nonbanks — are better able to take on risky assets, because their liabilities are less risky: Instead of demand deposits, they are funded by locked-up capital from long-term investors. The banks, with their deposit liabilities, get "narrower," taking on less risk on the asset side. 3. But! To make the economics work, the nonbanks tend to leverage that long-term capital by going out and borrowing from the banks. 4. So the risks that left the banking system in Step 1 come back in in Step 3: The banks do less of the risky stuff, but they lend to the people doing the risky stuff. 5. Still, it's an improvement. The loans to the people doing the risky stuff are generally safer than doing the risky stuff directly. They are senior claims on the stuff, and they often have protections (recourse to the nonbanks' other assets, margin calls) that make losses less likely. But it's a bit of systemic risk creeping back in.

Last week we were talking specifically about banks financing hedge funds' investments in other banks' synthetic risk transfer trades, but as I said, it's a more general trend.

You could take a less optimistic view of it. This week, the Federal Reserve Bank of New York's Liberty Street Economics blog published a research series by Viral Acharya, Nicola Cetorelli and Bruce Tuckman on nonbank financial institutions (NBFIs). The first post is "Nonbanks Are Growing but Their Growth Is Heavily Supported by Banks":

Often, NBFIs are viewed as separate from banks. In particular, traditional approaches to financial sector regulation view banks and NBFIs as substitutes, with the growth of one implying the shrinking of the other. ...

In our paper, we take a different view, arguing that NBFIs do not evolve independently from banks. In fact, to a significant extent, their growth depends on banks providing the funding and liquidity support necessary for NBFIs to provide intermediation services. A key observation is that nonbank financial intermediation involves significant liquidity and funding risk. Managing these risks well requires access to stable short-term funding, and likewise access to contingent sources of liquidity, especially access to funding under stress.

The market sources of financing that NBFIs rely on are, however, cyclical and fragile. In contrast, modern banks are considered relatively stable intermediaries, given their deposit franchise and access to the safety net, whether explicitly in the form of deposit insurance and central bank lender of last resort financing or implicitly in the form of official backstops. Lacking the inherent funding and liquidity advantages of banks, NBFI activity may not be viable, or it may not be easily scaled up, unless backed by routine as well as emergency liquidity support from banks.

The second post is "Banks and Nonbanks Are Not Separate, but Interwoven," arguing that regulation is pushing lending activity from banks to nonbanks, but that the banks are still financing it:

We explain that the observed growth of NBFIs reflects banks optimally changing their business models in response to factors such as regulation, rather than banks stepping away from lending and risky activities and being substituted by NBFIs. The enduring bank-NBFI nexus is best understood as an ever-evolving transformation of risks that were hitherto with banks but are now being repackaged between banks and NBFIs. …

Traditionally, banks held corporate and mortgage loans on their balance sheets, but due at least in part to higher capital requirements and tighter regulations, these loans are increasingly held by NBFIs. However, banks have retained indirect loan exposures to NBFI lenders, such as via senior loans to private credit companies or collateralized loans to mortgage real estate investment trusts. Thus, the banks' risks have transformed from exposure to the loans into exposures to NBFI balance sheets.

A specific example of this transformation comes from the booming private credit market. NBFIs' footprint in this segment is growing fast but not without the support of banks. For instance, in June 2023, PacWest bank sold its specialty finance loan portfolio to Ares Management, one of the largest private fund managers in the world. The purchase of these loans, however, was financed in part by a subsidiary of Barclays, another banking organization. Hence, while the loans left the banking system, some of the bank exposures returned through the financing of Ares' purchase by Barclays.

Again, my view is that owning a senior claim on the loans is probably safer than owning the loans directly. In the third post, "The Growing Risk of Spillovers and Spillbacks in the Bank‑NBFI Nexus," they concede that "the transformation of activities and risks from banks to a bank-NBFI nexus may have benefits in normal states of the world," but they worry about tail risk. In particular:

As NBFIs have increasingly been playing intermediation roles similar to those of banks, and adopting similar business models, their asset composition is naturally also becoming similar to those of banks. In a post last year, based on another research paper, we highlighted how the commonality of asset holdings between banks and NBFIs could turn out to be an important source of market disruption, driven by asset-pricing dislocations in the event of forced asset sales by NBFIs in need of liquidity. Because of the increasing similarity in the asset profile of the various NBFI sectors and banks, the extent of these market disruptions could be rather severe.

Banks and nonbanks own the same sorts of loans, so if the nonbanks have to sell assets, the banks' assets will also lose value. And:

Even more important, the entire system of financial intermediation is potentially more fragile because of the interconnections. To see why this is the case, consider the potential for systemic fragility when we also take into account the liability interdependencies between banks and NBFIs. Banks experiencing distress because of the asset losses driven by NBFIs' sales, may, in turn, reduce funding/liquidity support to NBFIs causing risks to spill back to NBFIs and the real economy. … Banks may, say, reduce credit lines to real estate investment trusts (REITs) and also reduce holdings of term loans to collateralized loan obligations (CLOs). As a result of these … transmissions, REITs might reduce their investments in residential and commercial real estate and CLOs might reduce their investments in leveraged loans, thus propagating and amplifying the original shock to nonfinancial firms with increasingly complex economic ramifications.

I am still not sure that this is worse than a state of the world in which all of that risk is at the banks, but I suppose it depends on how careful the nonbanks are and how they are regulated.

The basic economics of credit cards go something like this:

1. Banks that issue credit cards generally make money from the fees that merchants pay to accept cards. Say those fees are 2%: If you buy a thing for $100 with a credit card, you pay $100, the seller gets $98, and your bank keeps $2. [6] 2. Banks attract customers by rebating them a portion of those fees as "rewards" or "cash back." Perhaps your bank gives you back $1 on that transaction, and keeps the other $1 itself. 3. In a competitive market, banks attract customers by rebating them more than all of the fees, on certain types of transactions, with the hope that the customers will like that offer but mostly use the cards for other transactions. "Rebating interchange to earn share of wallet," Patrick McKenzie calls it: "Say, for example, the card rebates 1.5%, but only for … bookstores. Any bookstore. For all other transactions, it is 1%. The thing you would love with this offering is to preferentially attract people who are very emotionally invested in being readers and who spends very little of [their] on-this-card wallet on books. The emotional investment in the story the card offers brings the customer in; the blended cost to acquire the customer is closer to [the] 1% industry standard and not to the 1.5% headline number." 4. So a bank might offer, like, "3% cash back on books, 1% on everything else," and you say "ooh that sounds good," get the card, and buy $40 worth of books and $40,000 of everything else. Then the bank is making money from you: It makes 1% (its 2% fee minus 1% cash back) on most of your transactions, and loses 1% (its 2% fee minus 3% cash back) on a small but emotionally salient minority of them. 5. Also of course if you carry a balance, by not paying off your card every month, the bank makes a lot of money by charging you interest. [7] 6. Conversely, if you get this card, buy $40,000 worth of books, and do all of your other spending on other cards, the bank is losing a lot of money on you: It loses 1% on every transaction. This is called "adverse selection."

McKenzie's bookstore example is somewhat fanciful, [8] and really to stand out many issuers offer big rebates on more typically popular categories like gas, groceries, restaurants, etc. Some category where people think "oh I pay for that all the time, that card will really help me."

But you can take this too far. You don't want the category to be too good! You don't want to offer high rewards on a category where your customers really do spend all their money. The Wall Street Journal reports:

In 2022, Wells [Fargo & Co.] launched a credit card with Bilt Technologies, a fintech startup with big-name backers including Blackstone and Mastercard. The co-branded card came with a rare perk: Users can pay for rent with it without incurring fees from their landlords while also earning rewards points. More than one million accounts were activated in the first 18 months, many by young adults.

But Wells is losing as much as $10 million every month on the program as savvy customers flock to the card, according to current and former employees.

Oops. The economics of the rent transaction itself are, for the bank, horrific:

There is a reason why credit cards hadn't gained traction in the rent sector until Bilt came along. Most landlords didn't accept them because they refuse to pay card fees that get pocketed by the banks issuing them and often run between 2% and 3%.

Bilt structured the card so landlords won't incur the fees. Wells instead eats much of that.

About six months after the credit card was launched, Wells began paying Bilt a fee of about 0.80% of each rent transaction, even though the bank isn't collecting interchange fees from landlords.

Wells earns interchange fees every time people use the card to pay for anything but rent and splits those fees with Bilt.

It's like a rewards card that pays 0% for everything else, but 3% cash back (sent to your landlord) for rent transactions. If you hear that pitch, think "hey that's a good idea," get the card, and use it mostly to pay for stuff other than rent, it probably works out okay for Wells Fargo. If you also carry a balance, and Wells Fargo gets to charge you a huge interest rate on the balance, it probably works out great.

But … it's a rent credit card? If you are getting this card, probably you are using it more to pay rent than for anything else? And most people, you know, budget to pay their rent each month, which might make them less likely to carry a balance. And in fact:

The bank assumed around 65% of card-purchase volume would be nonrent, generating interchange-fee revenue. The reality is inverted.

Wells expected that around half to three-fourths of dollars charged to the card would carry over from month to month, generating interest charges. The reality ranges between around 15% and 25%.

I suppose there were other attractions:

Some Wells employees thought the proposition was crazy, but the bank needed a win and figured Bilt would garner buzz and help attract younger customers. A deal also presented mortgage cross-selling opportunities. Bilt's cardholders will ultimately want to become homeowners, the thought process at Wells went, and the bank would be well-positioned to give them mortgages.

That hasn't come to pass, and at any rate, Wells has pulled back from mortgage lending.

Ah, well.

The rough idea of an SRT is that a bank buys insurance against the risk of defaults in some portfolio of its loans. Normally the way to do this is by issuing credit-linked notes: The bank sells bonds that reference the underlying portfolio of loans, and if those loans default then it doesn't have to pay back the bonds. In exchange for this protection, the bank pays a high interest rate on the bonds. This is worth it, to the bank, because it reduces its capital requirements: Paying double-digit interest rates to move risk off its balance sheet is a good deal for the bank, because it would be even more expensive to keep the risk and meet the accompanying capital requirements. The buyers of these bonds — the people taking the credit risk off the bank's books — are "firms such as Ares Management Corp., Blackstone and Magnetar Capital," investment firms that raise long-term money from investors and are thus less strictly regulated than banks.

And then the buyers go and borrow money from the banks:

To help pay for these trades, some firms will seek outside financing. Hedge funds usually do so through a class of bank lending known as repurchase agreements, or "repos," in which the lender takes the investing fund's SRT securities as collateral, according to people with knowledge of the practice.

Others use different types of bank borrowing such as net asset-value — or NAV — loans, a kind of financing popular with private equity firms that's secured against a portfolio of their holdings. To back its JPMorgan deal, LuminArx used a non-repo form of borrowing, a person familiar with the matter says.

While European SRT buyers haven't used much leverage in the recent past, the trade's economics are different on the other side of the Atlantic where borrowed money is often needed to deliver stellar returns. "Leverage in various forms has been employed by most investors" on recent US SRT deals, says Alan Shaffran, senior portfolio manager at Magnetar.

European and Canadian SRTs are commonly made up of only the riskiest portion of a bank's loans, which offers the best returns. But the US equivalents are broader — or "thicker" — because the buyers have to insure larger portions of the debt, meaning the securities they buy yield less. That creates an incentive to use borrowed money to juice profit.

If an investment fund just uses its own cash for a US SRT trade, it can make loss-adjusted returns in the high single digits, market participants say. When the booster shot of leverage is added, returns can jump to the mid-teens.

Well, right, you need leverage. Schematically, the capital structure is something like [1] :

1. JPMorgan makes $100 of loans and does an SRT. 2. Magnetar — the equity buyer of the SRT — puts up, say, $5 to buy the SRT, and takes the first $5 of losses on those loans: If $1 worth of loans default, Magnetar only gets $4 back from its

We talked a few months ago about a proposal for financing Ukraine. The idea is roughly that (1) Ukraine has a large claim against Russia for war damages, (2) G7 governments (the US, UK, Canada, France, Germany, Italy and Japan) have frozen a lot of Russian assets under sanctions programs, (3) the G7 governments can't just give that Russian money to Ukraine (because they have no legal claim on it) but (4) they can lend money to Ukraine, collateralized by Ukraine's claims against Russia. And then if Ukraine ever successfully prosecutes that claim against Russia, it can get the money and repay the G7 lenders. And if — more likely — it can't, then the lenders can foreclose on the claim, at which point they will have a legal claim against Russia for Ukraine's war damages, which they can enforce by taking the frozen Russian assets.

It's cute. But one problem with any program of lending money to Ukraine backed by seized Russian assets is that the seized assets appear to have shorter terms than the loans. The Financial Times reports:

The US is ready to lead a loan of $50bn to Ukraine repaid by profits from frozen Russian assets if the EU can indefinitely extend sanctions against Moscow, according to a leaked discussion paper.

Washington needs the EU to prolong the bloc's sanctions on Russian state assets, which expire every six months unless renewed by unanimous consent, until the end of the war to ensure the US is not left on the hook for repayments.

But any such change to the EU regime would require the approval of leaders including Hungary's Viktor Orbán, who has jealously guarded his regular veto rights over sanctions decisions.

A lot of problems in finance involve people who have short-term funding that rolls over constantly, who start to treat that as long-term funding, and who then end up surprised when one day it does not roll over. This is the geopolitical version of that.

If you are a store and you accept credit cards for payment, you pay fees to get your money. If you sell a thing for $100, and the buyer pays with a credit card, you get something like $97. The rest goes to the buyer's bank, your bank, the credit card network and other intermediaries. In exchange for those fees, you get convenience, for you and the customer: The customer gets to buy your stuff without carrying cash (so you can sell more stuff), and the money shows up in your bank account relatively quickly.

If you accept cash for payment, you don't pay those fees. If you sell a thing for $100, and the buyer pays cash, you put $100 in your cash register. But then what? You probably don't pay for stuff in cash: You don't hand your suppliers a bag of cash; you pay them using bank money, wire transfers or checks or whatever. You have to turn the customer's $100 into $100 in the bank. And that is not free. You have to pay someone to walk the money over to the bank. You might have to pay for a security guard to escort the person walking the money over to the bank, or to guard the cash register until you walk it over. If you only walk the money over to the bank once a week, you miss out on interest on the money as it sits in the cash register. The bank might charge you a fee for depositing the money.

So if you sell a thing for $100 in cash, you get $100 in cash, but — after the costs and delays associated with handling cash and turning it into bank money — that's worth less than $100 of bank money. I don't know how much less; it will depend on the particulars of your business. But it's possible that it will be less than $97, and it will be cheaper for you to accept credit cards than cash.

I wrote yesterday about "synthetic PIK" private credit deals. In a PIK (payment in kind) loan, a company borrows money and can pay interest in the form of more debt: You borrow $100 with an interest rate of 10%; you don't pay cash interest, but after the first year, you owe $110, then $121, etc. In a synthetic PIK loan, the company borrows money and pays interest in cash, but it gets the cash by borrowing it from the lender: You borrow $100, in the first year you pay $10 cash interest, you borrow the $10 from the same lender, so at the end of the first year you owe $110, etc. The interest payments are funded with a delayed-draw term loan: You sign the extra loan at the same time as the regular loan, and then draw on it over time to make the interest payments.

Why? Why go through the circularity of borrowing more money to pay cash, instead of just adding it to the tab? One rationale is that the private credit funds that make these loans get some of their financing from banks, and the banks limit the amount of PIK debt they can do (because it's risky), so this is a way around that. I wrote:

The private credit fund doesn't care: Paying interest in the form of more debt, or paying interest in cash while simultaneously borrowing more, are exactly identical transactions as far as its credit risk is concerned. What matters is that the private credit fund has some contract with somebody else that says "we promise not to do too many PIK deals," and a synthetic PIK deal is not technically a PIK deal. … The somebody else, specifically, is the banks.

Well, a reader emailed to point out that there's another somebody else:

Most private credit funds collect management fees based on invested LP [limited partner] capital. Traditionally, if an investment was accruing PIK interest, they'd only get management fees paid on the initial principal amount funded with LP capital and not the accreted PIK portion. Now that they are funding it with DDTL [a delayed draw term loan], they get to collect a management fee on that piece that is funded to pay the interest. So, the LPs are paying a management fee for as long as the DDTL drawn loan is outstanding (perhaps a couple of years?) to pay themselves one quarter's worth of interest and are concurrently increasing their invested capital exposure to that specific deal.

If a private credit fund does a $100 PIK loan with 10% interest, after a year the borrower owes $110 and the fund can charge fees on $100 of capital. If it does the same loan as a synthetic PIK, after a year the borrower owes $110 and the fund can charge fees on $110 of capital.

I suppose the trade is better if you do it all at once:

Direct lenders including Blue Owl Capital Inc. have pitched deals in recent weeks that include a "synthetic PIK," a feature that lets companies make some of the interest payments with additional borrowing without having to count the debt as being serviced "in kind," according to people with knowledge of the matter.

"Payment in kind" lets borrowers make some or all of their loan interest payments by increasing the principal amount rather than using cash. That flexibility is in high demand as the Federal Reserve's policy-tightening cycle has made it more difficult for heavily indebted companies to service their debt. Private credit funds are well-positioned to provide PIKs, and they've often used them to beat out banks when competing to provide financing to companies.

But there are limits. Big banks that help fund the lending activities of private credit firms typically cap the amount of such PIK deals they will finance. Synthetic PIKs are a workaround to those constraints. …

In a synthetic PIK, lenders provide a company two separate pieces of debt: the main loan the company planned to borrow in the first place, plus a smaller delayed-draw term loan that sits at the same level in the capital structure and has similar terms. Delayed-draw means a borrower has access to the full amount of that loan when the deal closes, but can choose to actually borrow the money at a later date.

When interest on the first loan needs to be paid, the company taps the delayed-draw term loan. This allows the company to pay the interest in cash, but it's technically doing so through adding more debt to its balance sheet.

I love it. Notice the reason  for the synthetic PIK, as opposed to a regular PIK. The private credit fund doesn't care: Paying interest in the form of more debt, or paying interest in cash while simultaneously borrowing more, are exactly identical transactions as far as its credit risk is concerned. What matters is that the private credit fund has some contract with somebody else that says "we promise not to do too many PIK deals," and a synthetic PIK deal is not technically  a PIK deal. It's a cash interest payment plus a separate loan.

I think that, if you had only five minutes with a world-class trader, and you asked her "teach me the essentials of trading," probably she would spend the five minutes on adverse selection. The essential lesson is that, if you are being offered a trade, that probably means it's a bad trade; your job is to understand that thoroughly so you can figure out the exceptions. There are many ways to teach this lesson, but my favorite probably comes from a reader email I quoted last October, when I was writing a lot about Sam Bankman-Fried's coin flipping at Jane Street:

This was a Susquehanna interview question 25 years ago! They made me do the math on 1000 coin flips. EV(heads) (easy), standard deviation (slightly harder), then they offered me a +EV bet on the outcome. I said "let's go."

They said "Wrong. If we're offering it to you, you shouldn't take it."

I said "We just did the math."

They said "We have a guy on the floor of the Amex who can flip 55% heads."

The point here is that Susquehanna International Group employed a guy who was really good at flipping coins so they land heads, so that Susquehanna's traders didn't get too cocky about their bets. "I've done the math and this trade has positive expected value," they will say, but then they'll pause and remember the coin-flip guy and think "if this trade really has positive expected value, why is it being offered to me," and they think a bit harder about it and become better traders.

This lesson applies beyond individual trades. For instance, there is the structure of the investment management industry. Agustin Lebron, a former Jane Street trader, has a very good book called The Laws of Trading, in which he says:

The profitable trades that exist in the world are either (a) the ones you're intimately involved in running, or (b) the ones that are inaccessible to you. There is no (c). And what's funny about the situation in trading is that, if we were talking about just about any other industry, the very notion of a (c) would be laughable. Imagine if someone who's good at manufacturing cars came to you and said: "Hey. I'm a profitable car-maker. If you like, I'll let you take all the profit from my car-making skill in exchange for a small fee for me." You would rightly suspect they're trying to pull one over on you. So why is the situation different in trading?

Similarly! At Bloomberg Businessweek, Alice Kantor profiles IM Academy, a multilevel marketing scheme for stock and commodities trading. The thing that IM Academy teaches, if you are paying attention, is "if they know so much about how to make money in financial markets, why would they teach me how to do it for just $250 a month?"

We talked on Tuesday about a weird trade. The trade is: A person, usually an older person — call her Alice — takes out a $5 million life insurance policy, naming an investor — call him Bob — as the beneficiary. Bob pays Alice a fee for doing this — say 3% of the face value of the policy — and also pays the premiums on the policy. Eventually Alice dies, the insurance pays out, and Bob gets the money. If the death benefit is higher than the premiums that Bob has paid over time — for instance, because Alice dies a week after taking out the policy — then Bob makes a profit. If the death benefit is lower than the premiums — for instance, because Alice lives to be 125 — then Bob loses money.

The thing that most people find weird about this trade is the general ickiness of the investor betting on Alice's death. In fact, this trade — it is called STOLI, for stranger-originated life insurance — is not allowed in many places; we talked about it Tuesday because the estate of an Alice (Martha Barotz) was suing a Bob (Apollo Global Management Inc.) to get the $5 million back.

But I don't mind ickiness, and the thing that I found weird about the trade was different. The thing that I found weird is: How can Bob expect to make money on this trade? He is betting on Alice's life span, with the life insurance company on the other side; why should he expect to win that bet? Presumably Alice is a stranger to him and to the insurance company, and both of them can ask her for her medical history and do physical exams. What is Bob's informational advantage? I wrote:

On a deal like this, the investor has to pay the insurance premiums, it has to pay the insured a 3% commission to get her to take out the policy, it has to pay the agent a commission for signing her up, [1] and of course it has to pay lawyers and take the risk that the policy will be invalid. And yet there's apparently still enough money in it to make it a good, securitizable investment. Who is selling all this underpriced life insurance?

Several readers wrote in to answer this question, and the answer is illuminating. Here's how one reader put it:

Some large fraction of life insurance policies are not optimally exercised. So traditionally life insurance companies sold insurance that was significantly underpriced if the recipient was going to optimally exercise it, and yet profitable because some reasonable fraction of their clients let their policies lapse sub-optimally.

"Optimal exercise" is a term from options markets and I suppose it is a little icky to apply it to life insurance. (You "exercise" life insurance by dying, and it is generally optimal to die as late as possible.) But the point is that a lot of people take out life insurance policies, and then their circumstances change, they stop paying the premiums and the policy is canceled. [2]

If you take out a 20-year term life insurance policy, pay premiums for eight years, stop paying premiums, and then die in Year 10, you will get no death benefit and the insurance company will keep your eight years of premiums. This is "suboptimal," for you, as a technical financial matter. But it might have been a perfectly rational decision for you to let the insurance lapse: You took out the insurance thinking your heirs needed money when you died more than you needed the premiums while you were alive, and then your circumstances changed. Maybe you thought you needed 20 years of insurance to provide for your minor children, but then they got child acting gigs and don't need the insurance money, and you'd rather spend the premiums while you're alive.

But the insurance company doesn't care about any of that; from the insurance company's perspective what happened is that it got eight years of premiums and didn't have to pay out when you died. You did not exercise optimally. The insurance company is in an actuarial business; it can predict what percentage of its customers will let their policies lapse. The percentage is large. [3] And in a competitive market, it can price this, and does. [4] The amount you pay for a 20-year term life policy is calculated based on:

1. The insurance company's well-informed prediction of when you are likely to die, and 2. The insurance company's well-informed prediction of when you are likely to stop paying premiums.

Bob, in our example, is no better at predicting Alice's death than the insurance company is. [5] But there is an information asymmetry: The insurance company thinks that Alice has, say, a 40% chance of letting the policy lapse before she dies, and Bob knows that the actual chance is 0%. He's paying the premiums, he's a financial investor, he bought this policy as a bet, his circumstances are not going to change, he's going to keep paying until he gets the death benefit. [6] The insurance company priced the policy at, intuitively, a 40% discount to its purely mortality-risk-based value, because it figured there was a 40% chance of suboptimal lapse. That 40% discount is — in expectation, over hundreds of policies that he buys — profit to Bob.

A few points about this. One: It's a big part of why STOLI is often illegal. Courts say that insurance contracts are valid only if they are taken out for "a legitimate insurance purpose, such as estate planning." Insurance companies price insurance based on the assumption that real people are doing estate planning, and their circumstances might change in ways that lead to suboptimal exercise. Insurance priced based on a pure bet would be more expensive.

In fact, there seems to have been a boom in STOLI in the mid-2000s, as the secondary market for life insurance was ramping up, but it died out by 2008. The trade we talked about Tuesday was originated in 2006; it's cleaning up an old STOLI policy, not an active trade. Part of the reason for this ramp-up was that, for insurance carriers and brokers, STOLI looked like a good trade at the time: They got to write all these big insurance policies! Those policies looked profitable, based on historical data. Then they realized they were all underpriced and shut it down.

Two: This problem is not solely a feature of STOLI insurance. We talked on Tuesday about the broader business of investors buying life insurance policies; Apollo, for instance, manages billions of dollars' worth of policies. Most of those policies are not STOLI policies; they were taken out by real people for real insurance purposes, and then, when those peoples' needs changed, they sold the policies to investors. STOLI is frowned upon and often illegal and hard to collect on, but the broader secondary market for insurance policies is fine and legitimate and does pay out.

But it's the same problem. Insurance companies bet that X% of their policies will lapse suboptimally. If there is a robust and well-advertised secondary market for the policies, then this estimate will be much too high: Everyone who takes out an insurance policy and decides to stop paying the premiums will sell the policy to an investor, for cash, rather than letting it lapse for nothing. [7] And so not just STOLI policies, but all policies, will be underpriced. On Tuesday I quoted (in a footnote) a 2011 paper by Susan Lorde Martin on "Betting on the Lives of Strangers: Life Settlements, STOLI, and Securitization," making this point:

The life insurance industry argues that its surrender value schedule [8] and the fact that policyholders allow thirty-eight percent of all policies to lapse (receiving no death benefit) permit life insurance companies to keep premiums as low as they are. Life settlement arrangements mean that policies will not lapse, so insurance carriers will pay death benefits on many more policies than they would be paying otherwise. This will result in higher premiums for everyone, including those who want only the death risk coverage.

Life insurance is, financially, a bet on your early death. If you buy a 20-year term life insurance policy with a $5 million death benefit and premiums of $25,000 a year, and you live for 21 more years, then you pay a total of $500,000 in premiums and get back $0 in benefits. If you buy that same policy and die the day after you buy it, you pay roughly $0 of premiums and get back $5 million of benefits. The earlier you die, the better you do. Financially. Only financially. Otherwise you'd prefer to die later.

Of course the central problem is that, if the insurance policy does pay out the $5 million, you don't get it. You're dead; that is the prerequisite for getting the money. Somebody else gets it. Ordinarily that somebody else will be your heirs: your spouse, your children, whoever. You hope that they too will prefer that you die later, even if it means that they don't get the $5 million, but that is not always true, and murdering your spouse for the life insurance money is a fairly common plot element in fiction and also in real life.

On the other hand if you walked into an insurance office and asked to buy a $5 million life insurance policy on your neighbor down the street, they would probably refuse to sell it to you. You have no particular emotional attachment to you neighbor, as far as the insurance company knows, and they figure you'd probably be happier with him dead and $5 million than you are with him alive and no money. They don't necessarily think that you're planning to murder him, but they'll have suspicions. This is called the "insurable interest" requirement.

There are nuances. Two important ones are:

1. You can buy life insurance on yourself, which will pay off when you die, and you can decide (before you die) who will get the payout. Often it will be your spouse or children, but you can write whoever you want into your will. (More practically, you can set up a trust while you are alive, have the insurance pay out into the trust when you die, and set the beneficiaries of the trust to your heart's content.) If you want to leave all your worldly possessions to Harvard University, then Harvard will get the $5 million when you die, and it will presumably be better off with you dead (and the money) than with you alive (and no money). Lots of people write Harvard into their wills and Harvard does not, as far as I know, go around murdering them, though that would be a pretty good plot element in fiction. 2. If you have a life insurance policy, you can sell it. There is a relatively recent history of people who take out life insurance policies, realize that their circumstances have changed, and decide that they'd rather get some money now than get all the money when they die. A "life settlement" business exists in which investors buy these people's insurance policies, make their premium payments, and collect when they die. This can be good for the people selling their policies: Instead of just letting their policies lapse for nothing, the can sell the policies to get cash now. And it can be good for the investors: They get exposure to a risk (people dying) that is probably uncorrelated to the rest of their investments. (It is bad for insurance companies because it means that they have to pay out on some policies that, in the absence of a resale market, would lapse.) This remains controversial, but it is a multibillion-dollar business these days, and there do not seem to be any reported cases of the investors murdering the insureds.

In fact, the life settlement business seems to be so good that demand for insurance policies as an investment asset outstrips supply: Plenty of investors want that exposure, but there are not a lot of people, these days, with life insurance policies that they want to get rid of.

But if you combine the two nuances, a solution presents itself: People could take out new life insurance policies specifically to sell to investors. Go to an insurance company, get a $5 million policy, have it pay out to a trust, make an investor the beneficiary of the trust, have the investor pay the premiums, and charge the investor a fee for the exposure. This is called "stranger-originated life insurance," or STOLI, and it is largely not allowed. It goes too far. It is too icky, and too far from the traditional purposes of insurance. Here is a 2010 Federal Deposit Insurance Corp. paper on "Senior Life Settlements: A Cautionary Tale," warning against it:

In the case of wet-ink policies (new life insurance policies sold immediately after being issued – before the ink is dry), the applicant commits fraud on the application by claiming he or she needs life insurance for estate planning purposes. One type of wet ink policy is STOLI.

STOLI has many variations but only one purpose: to allow an investor without an insurable interest to initiate and profit from a life insurance policy on a stranger. The mainstream insurance industry strongly opposes STOLI, arguing it is fraud for a person to buy a policy with only a profit - and not insurance - motive. STOLI is prohibited or statutorily restricted in many states.

But it does seem to be quite a business, with agents and brokers going around looking for older customers to take out insurance policies to resell to investors. They seem to be on shaky legal ground in many places. But if you are an investor who buys life insurance policies on the secondary market, you don't necessarily know the history of the insurance policy. Perhaps the insured bought the policy for her legitimate estate-planning purposes, changed her mind, and sold it for cash. Or perhaps a broker talked her into buying the policy specifically to resell it. If it's the former, then you can go ahead and buy it and collect the death benefit. If it's the latter, then you can't.

One straightforward story you could tell about recent financial history is that interest rates were low for a very long time, which meant that discount rates were low, which meant that a dollar in the distant future was pretty much as good as a dollar right now, which meant that investors were willing to put their money into risky bets with no expectation of any cash flows anytime soon. Thus a huge boom in the valuations of speculative private tech companies. Thus the "MoviePass economy," where venture capitalists were willing to invest billions in companies that lost money on every transaction, in the hope that one day those companies would achieve enough scale to stop doing that. And thus crypto, where markets gave huge valuations to speculative tokens without even a plan to one day have cash flows.

And then rates went up and that all evaporated. At the Wall Street Journal, James Mackintosh wrote yesterday that now "investors want a clear route to a return on corporate cash sunk into new projects," and "money that flooded into risky ventures that won't pay dividends for years, if ever, was much more acceptable when interest rates were near zero than when the alternative is a Treasury yielding almost 5%."

This strikes me as basically a correct story, but artificial intelligence spending is maybe an exception? The Journal also reports:

Despite a broad downturn in the startup sector, investors chasing the stock market successes of Nvidia and Microsoft have deluged AI upstarts with record levels of funding, minting dozens of companies with billion-dollar valuations in the past year. The investment frenzy is already fueling concerns of a bubble as startups struggle to translate the hype into revenue.

"Everyone believes that AI is the future, so we are going to see an extraordinary amount of investment until proven otherwise," said Alex Clayton, a general partner at the venture firm Meritech. "The problem is that we don't know what these business models are going to look like at scale. You can have theories about it, but you really don't know."

Fears of rising startup valuations aren't new in Silicon Valley. But the AI gold rush is notable because investors are writing massive checks—sometimes in the hundreds of millions of dollars—just to get these companies off the ground. Even during the peak of the startup boom, such large financings were reserved for later-stage private companies gearing up for aggressive growth. …

Imbue hit a valuation of more than $1 billion with its fundraising last year, courting backers like Nvidia and ex-Google CEO Eric Schmidt. Chief Executive Kanjun Qiu dazzled investors with a vision to build intelligent computers that could give humans the "freedom, dignity, and agency to do the things we love." Last November, she lavished her employees with a company off-site to Japan.

Imbue is plowing its cash into developing AI models that it hopes will one day create autonomous AI agents. A company spokesperson said it made a "deliberate strategic decision" not to commercialize in order to focus on research and that investors were on board with this approach.

One model of this is "artificial general intelligence (AGI) will be so enormously lucrative, and so soon, that your business plans and discount rate don't matter all that much." Sometimes, though, I think about OpenAI's great warning to potential investors that "it would be wise to view any investment in OpenAI Global, LLC in the spirit of a donation, with the understanding that it may be difficult to know what role money will play in a post-AGI world." If your discounted cash flow model is, like, "Year 1: spend $1 billion, Year 2: spend $2 billion, Year 3: a paradise of universal abundance in which money no longer has uses," maybe that just breaks Excel?

The general form of consumer financial arbitrage is:

1. If you buy stuff at a store with a credit card, the store will pay your credit card company a fee of, say, 1.4% of the price. [7] 2. If you have a rewards credit card, your credit card company will pass some of that fee back to you, often 1% of the price. If you have a nice card and do things just right, you could get 2% or even more. 3. If the stuff you buy has a stable market price with a bid/ask spread tighter than 1% (or whatever rebate you're getting), you can resell it and keep the 1%.

The problem is that there are not many consumer goods like that. There is not a deep liquid resale market, with tight bid/ask spreads, for, like, the milk you just got at the supermarket. If you could go to a store and buy hundred-dollar bills  with a credit card, then you'd go buy 100 hundred-dollar bills on your credit card for $10,000, use the bills to pay your $10,000 credit card bill, collect $100 of cash-back rewards, and do that again and again. But you can't. Most of the time buying cash substitutes with a credit card will run into restrictions or fees that make the arbitrage not work.

What about buying gold bars? Intuitively it seems like the answer would be "the price of gold is volatile, and the bid/ask in retail gold transactions is higher than 1%, so don't do this, come on." Here is a Wall Street Journal article about that:

Costco made buying a gold bar as simple as tossing it in a shopping cart. Selling it is a lot more complicated.

Adam Xi, 33 years old, called five different dealers to get a price he could accept for the gold bar he bought at Costco in October.

One dealer offered him $200 less than the $2,000 he had paid. Taking such a loss would thwart his plan to rack up credit-card points buying the gold and quickly reselling it.

I have long been fond of a classic late-night dorm-room question of financial capitalism, which is: "What if people could sell stock in themselves?" Instead of borrowing money to go to college, you'd sell 10% of the equity in yourself to pay for college, and then when you graduated and got a good job you'd dividend out 10% of your income to your shareholders. Everyone loves talking about this! Drink every time someone says the words "adverse selection."

I sometimes get hung up on a dumb technicality, though. You can't really sell equity in yourself. You are not a corporation. You can do something sort of similar, a rough economic equivalent. You can write a contract that says "I will pay you 10% of my income forever," or whatever the actual terms are. (Most of the practical proposals are more like "A% of my income from B above a floor of $C for D years, with a lifetime cap of $E" than they are "10% of all my income forever.") And this contract creates … I mean, I think I would call it "a debt"? It is a debt of indeterminate size; it is a debt whose payments are conditional on future facts (your income). But surely it is a debt. Surely if you don't pay, your "shareholders" don't go sue you in Delaware Chancery Court for a breach of fiduciary duties. They sue you in regular court for breach of contract, for not paying your debt.

We talked a few years ago about Lambda School, a coding academy that did not charge upfront tuition but entered into income-sharing agreements with its students, requiring them to pay "17% of their incomes for 24 months after landing a job that pays more than $50,000 a year," capped at $30,000.

Yesterday the US Consumer Financial Protection Bureau settled a case against Lambda School's successor, BloomTech, and its chief executive officer, Austen Allred, "for deceiving students about the cost of loans and making false claims about graduates' hiring rates." Much of this is standard consumer-finance stuff — BloomTech seems to have put a sunny spin on its job-placement data — but the part I found interesting was this:

BloomTech falsely claimed its "income share" agreements were not loans, did not create debt, did not carry a finance charge, and were "risk free." In fact, the agreements are loans with an average finance charge of $4,000. The loans carry substantial risk, as a single missed payment triggers a default and the remainder of the $30,000 "cap" becomes due immediately. BloomTech further hid the cost and nature of the "income share" loans by not disclosing key terms like the finance charge and annual percentage rate, as required by law.

I mean! On the one hand, yes, absolutely, as a technical matter these things must be loans; there is nothing else that they could be. And perhaps the terms of the loans are harsh (the $30,000 cap is due immediately on default?). And if you take the average amount repaid, and subtract the average amount borrowed, you can compute something like a (contingent, average) interest cost for the loans, and calculate an annual percentage rate or a range of APRs from that. And I can see how a consumer-debt regulator would say "this is consumer debt, our consumer debt regulations require APR disclosures, you didn't disclose an APR, so pay a fine."

On the other hand … like, it's technically false to say these things are "not debt," but you know what they mean, right? They mean "this thing, economically, has the shape of equity: You pay nothing if you make nothing, and a lot if you make a lot; you hand over a share of your income rather than a fixed amount." (Unless you miss a payment, oops.) There is some real explanatory power in leading with "this is not debt, but equity"; it does help people understand what the thing is. But the CFPB cares about the technicality, so they call it debt.

If you work at a big public technology company, you might get a large chunk of your pay in the form of stock in your company. Over time, you will accumulate a lot of stock; a lot of your net worth might consist of shares in your company. This is good, this is what the company wants, this aligns incentives: If you own a lot of stock, you will work hard so the company does well so your stock will go up.

On the other hand, you may not like it. You have a lot of undiversified risk: A lot of your financial net worth is tied up in one company, and a lot of your human capital is tied up in that same company, and if the company goes under you will lose everything. And while it is nice to align incentives, if you are one of thousands of well-paid employees at a large public tech company, there might not be all that much you personally can do to shape the company's destiny.

So you might want to diversify. The easy way to do this is to sell your stock and buy an index fund. Your stock probably has vesting periods and restrictions, so you can't sell all it as soon as you get it, but if you've been there a long time you will have lots of unrestricted shares and can sell down.

But tech stocks mostly go up, so if you've been there a long time and are selling shares you got years ago, you will have large capital gains. That's nice for you, really, but it does mean you have to pay taxes when you sell your stock and buy index funds.

On the other hand, what you could do is:

Start a partnership with some other people who happen to own stocks in other tech companies. There are lots of those people: If you're a well-paid Meta engineer with a bunch of stock, you can probably find well-paid Amazon and Alphabet engineers who also own a bunch of their companies' stocks. Contribute your shares to the partnership, in exchange for a stake in the partnership. You put in $1 million of Meta stock for 1/3 of the partnership; your friends put in $1 million of Amazon and Alphabet stock in exchange for 1/3 stakes in the partnership. Now, instead of owning $1 million of Meta stock, you own a one-third share in a somewhat more diversified $3 million pot of stocks. (And you can expand this to more stocks for more diversification.)

The advantage is that, while selling your stock for cash and then reinvesting the cash in an index fund is a taxable transaction, contributing your stock to a partnership in exchange for a share of that partnership is not. And if you do it right, you can make the partnership's holdings look a lot like an index fund. (Not tax advice! It is not in fact quite as simple as this, though this is the right general idea. [1] )

It is not trivial to do this right, for you: You have to get the technical tax structuring right, plus what are the odds that you know a bunch of other engineers at other companies with exactly the right amounts of stock to contribute? But with enough well-paid engineers at big public tech companies, it is sensible for someone else to do this at scale and offer it as a product. Bloomberg's Eliyahu Kamisher reports:

Known as an exchange fund or a swap fund, the product is familiar to the super rich. Now, share-price rallies at companies such as Meta Platforms Inc. and Nvidia Corp. are creating an opportunity to offer the structure to moderately wealthy techies as well, says Srikanth Narayan, founder of San Francisco-based Cache.

"The mission is to make these financial products – that have typically been in the upper echelon – available more broadly," said Narayan, a former engineer at Uber Technologies Inc. "All of my friends and colleagues are talking about the same thing, which is that more of their net worth is tied up in a single stock."

Cache's swap-fund offering enables participants to pool their stock holdings together, creating a more diversified collection of assets. Investors then get shares of the fund equivalent to their contributions, giving them the benefits of more varied holdings without having to sell their stock.

There's a limit to how much stock of a particular company Cache can accept because the swap fund is designed to mirror the tech-heavy Nasdaq, Narayan said. Currently, he can bring in more Amazon.com Inc. and Microsoft Corp. shares, and he's seeking stock from non-tech Nasdaq companies such as PepsiCo Inc. and Costco Wholesale Corp.

Many companies have debt agreements that include a "change of control put." If the company has a change of control, the creditors can demand their money back immediately, often at a premium. This can be a big deal. If a company has bonds outstanding that are due in 2030 and trade at 80 cents on the dollar, and then it has a change of control, it might have to buy the bonds back immediately at 101. It will need to come up with a lot of money, probably by borrowing it at more expensive rates.

The intuition here is that, often, when a company is taken over, its debt becomes riskier: If you are a bondholder of some reasonably stable public company, and then it gets bought in a leveraged buyout and loaded up with more debt, you will be sad; your debt will lose value. The deal that you originally struck with the company has changed, and you'll want to get out.

What is a change of control? There are lots of ways for a company to change hands, some of which are bad for creditors and some of which aren't. The rough idea is that if the company is acquired for cash, that's probably bad. So an all-cash merger is normally a change of control, or a sale of "all or substantially all" of the assets, or someone (a person or firm) acquiring a majority of the stock. Whereas an all-stock merger with another public company is less likely to hurt the credit, and so normally does not trigger a change of control put. [5]

Here's a weird one, though: Arguably losing a proxy fight is a change of control. If an activist buys stock in a public company and agitates for change, or a hostile bidder proposes a takeover, and the company rejects the proposal, so the activist/bidder launches a proxy fight to get her own candidates on the board of directors, and the company fights back, and the activist/bidder wins and gets a majority of directors, then:

1. In some real sense, the activist or hostile bidder has taken control of the company: Her allies now control the board and can change the company's policies or approve a sale. 2. That is, in expectation, bad for creditors: The activist will typically want the company to be more levered and riskier than the incumbent board did, and the hostile bidder will probably acquire the company in a way that is bad for its debt.

And so it is common for debt agreements to have a change of control put for losing a proxy fight. Technically the way this is written is that it is a change of control for a majority of the company's board of directors to not be "continuing directors," where a continuing director is either (1) a director who is in place at the time of the debt deal or (2) a new director who was approved by a majority of the previous continuing directors. So the board can amicably replace itself over time, but if it is replaced all at once by a hostile slate, that's a change of control.

This strikes me as a basically correct intuition about creditors' interests, but it causes a problem. The problem is that management can use the change of control put as a weapon in the proxy fight. It can say: "Look, we have all this debt outstanding, and we are not in the best financial shape. (Thus the proxy fight!) If we lose this proxy fight, the debt will all come due immediately at 101 cents on the dollar. We won't be able to refinance all that debt immediately, and so losing the proxy fight will cause the company to go bankrupt. So vote for us!"

That is a bit harsh, to tell shareholders that they can't vote for an alternative board of directors because that would bankrupt the company. It is not a good look for the incumbent directors to threaten to blow up the company unless they keep their jobs. There is a solution, though it is a bit of a silly one: The incumbent board can just "approve" the activist's candidates, for purposes of the change of control put. This way, if the company loses the proxy fight, the activist's directors are still "continuing directors" and the change of control put isn't triggered. Of course, the provision is there in the first place because creditors really don't want the company to lose a proxy fight. But somebody's interests will suffer, and if the board can help shareholders while being a bit rude to creditors it probably should.

The basic analysis of banking is:

1. A bank owns a pile of assets: loans, bonds, etc. Say they are worth $100 today. 2. The bank is funded mostly by senior claims on those assets: bank deposits and other forms of debt that really should get paid back. Say the bank has $90 of debt outstanding against its $100 of assets. 3. The bank also has a little sliver of equity: its shareholders have the residual claim on those assets, after the senior claims paid back. Here the bank has $10 of equity; depositors and other creditors are entitled to the first $90 of the bank's assets, but anything left over — currently $10 — goes to the shareholders. 4. The shareholders, therefore, have a close-to-the-money call option on the bank's assets: If the assets turn out to be worth more than $90, the shareholders get the excess, but if they turn out to be worth less than $90, the shareholders get nothing. In particular, if the assets turn out to be worth zero — if all $100 of assets turn out to be fake and the bank is worthless — then the shareholders only lose their $10; the other $90 of the losses fall on the depositors. (Or the deposit insurance fund, the taxpayers, etc.) 5. This option is more valuable if volatility is higher. If the bank's assets have a 50/50 chance of ending up worth $98 or $102, then the shareholders will get back either $8 or $12 after paying off the debt, for an expected value of $10. (And the depositors will always get back their $90.) If the bank's assets have a 50/50 chance of ending up worth $70 or $130, then the shareholders will get back either $0 or $40, for an expected value of $20. And the depositors will get back $90 in the good case, but only $70 — a catastrophe, a bank failure — in the bad case. 6. The bank's executives have fiduciary duties to shareholders, and probably own a lot of stock themselves, so they want to make the stock more valuable. 7. Again, the theoretically correct way to make the stock more valuable is to make the assets more volatile, to make the bank riskier, to increase the value of the shareholders' option. 8. Everything else about banks — bank regulation, prudential supervision, capital and liquidity requirements, deposit insurance, rules about bonuses and clawbacks, bank culture and training, speeches by politicians, depictions of banks in popular culture — is about mitigating this essential problem. The essential problem is that, if you look at a bank's capital structure with some financial sophistication but also some naivety, you will say "wait the bank works for the shareholders, the shareholders have an at-the-money option on the assets, and the way to increase shareholder value is to increase the volatility of those assets."

You could imagine having two market regimes and letting people opt into one or the other:

1. There's the Nice Market, which has rules of conduct based on fairness and honesty. There'd be rules against insider trading and market manipulation and lying to counterparties, "clearly erroneous" trades would be reversed, and there would be a generally paternalistic regulator trying to protect investors from at least their more egregious mistakes. 2. There's the Fun Market, which has few or no rules: If you can get someone to agree to pay you $100 for a thing, you can sell her the thing, and if it turns out you were lying or had inside information or were spoofing up the price or whatever, she can't complain.

And then if you want to be protected from your mistakes and have a calm and orderly market, you opt into the Nice Market. And if you want to try your hand at ripping people off — at the risk of being ripped off yourself — you opt into the Fun Market.

For the most part it is hard to do this, because financial markets are interconnected and not everyone can entirely opt out. If you had, say, a Nice Wheat Market and a Fun Wheat Market, then market manipulation on the Fun Wheat Market could affect the price of wheat on the Nice Wheat Market, and farmers and people who eat bread would have no effective way to opt out of the Fun Wheat Market. You could imagine — and people sometimes propose — a Fun Stock Market, where companies could opt into a regime with less disclosure, legalized insider trading, etc., and those companies' investors and employees would just go in with their eyes open. That still seems problematic. US stock regulation balances letting people invest in aggressive growing companies with protecting them from fraud, and having this sort of regime might force them to choose one or the other.

But it seems easier in crypto? Every crypto token is necessarily something someone made up in the last decade or so. There are a lot of very technically and financially savvy people in crypto markets, and also a lot of people who are real real real sure that they are technically and financially savvy. There are a lot of people who want to match wits with each other in unconstrained markets, and no real reason not to let them.

That's not all there is! As I wrote yesterday, there's an important story in crypto about building real businesses, and you might want a fairness-and-transparency-based regime to encourage capital formation and discourage fraud. (Certainly the US Securities and Exchange Commission wants that.) But there are also pure meme coins in crypto. And there are also crypto projects that are essentially about building platforms for speculation: Why shouldn't some of those platforms be Fun Platforms? Crypto — unlike wheat or even stocks — is a purely opt-in asset class; nobody's life is really affected by crypto prices unless they choose to trade crypto. Why not let people opt in to weird rules?

And so you could imagine crypto exchanges operating two separate platforms, you know, Binance Nice and Binance Fun, and each project could choose to list on one or the other, and if you trade a Nice Token you have some general expectation that the exchange will prevent wash trading and national regulators might step in to police market manipulation, but if you trade a Fun Token you just do as much manipulation as you can and figure everyone else is doing the same. If you want capital formation and innovation and the financial system of the future, I guess you buy Nice Tokens; if you want a fun gamble and competitive sneakiness then maybe the Fun Tokens will be tempting. And the Fun Tokens really can be quarantined from everything else; everyone can cheerfully manipulate them with no risk of contaminating any economic activity in the real world.

You could have a model like this:

1. Every company has a capital structure with an order of seniority. Secured debt generally gets paid first, followed by unsecured debt, followed by preferred stock, followed by common stock, etc. 2. Every so often, some weird event flips some part of the seniority, so that people who would normally get paid back first get pushed to the back of the line, and people who would normally be at the back of the line move up. 3. You should try to (1) anticipate (or cause!) those events, (2) buy the stuff that will move up and (3) avoid the stuff that will move down.

Probably the most notable recent case is Credit Suisse Group AG's additional tier 1 capital securities. These AT1s were a form of subordinated debt that ranked senior to common stock in the capital structure, as Credit Suisse's disclosures and presentations frequently said. But they had provisions saying that in certain circumstances — regulatory capital falling below a trigger, or certain national bailouts — they would be disappear, and it was not necessarily true that the common stock would disappear in those circumstances. And in fact, when Credit Suisse was acquired by UBS Group AG last year in a regulator-driven shotgun marriage, (1) the common stock got something and (2) the AT1s got nothing. If you had owned the senior AT1s a day before the merger, you would have been smart to sell them and swap into the junior common stock, because that got paid and the AT1s didn't.

This turned out to be very controversial, a lot of people still disagree that the AT1s should have been zeroed, and there are lawsuits.

(Some other recent examples share that feature: Generically, there's a company, it has debt, and some new or junior creditors strike a deal with the company to give it new money in exchange for being made more senior than the previously senior creditors. The creditors left out of the deal sue, claiming that this is not allowed.)

Last year, Yellow Corp., the trucking company, filed for bankruptcy. A week before the bankruptcy, an investment firm called MFN Partners paid something like $23 million to buy a ton of Yellow stock, which seemed like a weird choice: Yellow's bankruptcy was extremely well telegraphed, and generally when a company goes bankrupt its stock becomes worthless. But in fact Yellow's assets (largely a real estate portfolio) turned out to be more valuable than its debt, there is money left over, and shareholders could get hundreds of millions of dollars back, making this a good trade for MFN.

One way to think about this is my model above: Ordinarily, when it is a going concern operating its business normally, a company has to pay its pension obligations. Those pension obligations are senior to the common stock; the shareholders only get the profits after the pension obligations are paid. But in bankruptcy, perhaps, that flips: Perhaps Yellow can walk away from its pension obligations for $0, leaving enough money to pay shareholders. On that model, buying the stock a week before the bankruptcy was a good trade: The stock was junior to the debt and pensions and so worth roughly nothing, but in bankruptcy it could ditch the pensions and become worth more.

So: A share of stock is an electronic token that you can buy or sell for money. Sometimes a lot of people want to buy a stock, and its price goes up. Other times, people want to sell it, and its price goes down. Why do they want to buy or sell it? Various reasons: Perhaps they got tax refunds or stimulus checks, perhaps the chief executive officer of the company that issued the stock did something interesting or got arrested, perhaps the company announced good earnings or bad earnings or a new product or a computer hack. But the traditional reason is that a share of stock represents a partial ownership interest in a company, and the long-term value of the stock is the present value of its future cash flows. You can estimate that value by projecting those future cash flows and performing math to compute their present value. Different people will have different estimates, so there will be trades, and those estimates will change over time — with the company's prospects, with discount rates, with macroeconomic conditions — so there will be volatility. And if you want to make money trading stocks, traditionally, you go and learn about companies and products and business models and accounting and discounted cash flow modeling and all the other things that go into estimating the values of stocks, either because you want to get good at estimating values or because you want to know what other people, the ones you are trading against, are up to.

A crypto token is also an electronic token that you can buy or sell for money, but in a purified form. There's no company, no product, no earnings, no cash flow. Sometimes a lot of people want to buy the token, and its price goes up; other times, they want to sell, and its price goes down. You have the most salient feature of finance — a volatile electronic token that you can trade — without any of the other features. There is less to learn!

Oh this is unfair and oversimplified, your crypto project is different, your crypto project is empowering communities with real products and not just an empty vessel for financial speculation. But Bloomberg's Muyao Shen reported last week:

The memecoin frenzy in the digital-asset market shows no signs of stopping, with trading volumes now at levels last seen just before the burst of the last crypto bubble more than two years ago.

Considered as some of the most speculative and volatile cryptocurrencies, memecoins such as Dogwifhat and Pepe are far outstripping the gains registered by market bellwether Bitcoin that has dominated the headlines. Trading volume for the top memecoins, which often trade for a fraction of a cent, reached nearly $80 billion in the past week, according to data compiled by blockchain data firm Kaiko. That's the highest since October 2021. …

Memecoins have been a long-existing phenomenon in crypto, as small investors and promoters see the microscopic prices of memecoins as an opportunity to quick post huge returns despite the lack of traditional fundamentals. ...

A group of dogwifhat token holders announced last week a public fundraising campaign to put the dogwifhat meme on the Las Vegas Sphere. The group has already reached its target goal of $650,000 in the USDC stablecoin, based on the transaction history of the digital wallet for the fundraise. But it's unclear whether and when the fund will be used to promote the meme in Las Vegas.

What are dogwifhat's fundamentals? Well:

1. Its logo is a dog, with a hat. 2. If people kick in enough money, maybe they can put a picture of the dog with the hat on the Las Vegas Sphere, which might encourage more people to kick in more money.

What does the multiple-choice exam question about this look like? Or today we got the story of Slerf:

A new Solana-based memecoin, Slerf, has faced significant challenges after the project's developer accidentally burnt a major portion of the token supply — effectively losing $10 million, or the entirety, of presale participants' money.

"Guys I f—ed up," the project's official X account wrote. "I burned the LP and the tokens that were set aside for the airdrop. Mint authority is already revoked so I can not mint them. There is nothing I can do to fix this. I am so f—ing sorry."

The Slerf team later went to an X Spaces to elaborate further on the situation. "I'm sick to my stomach," team member Slorg said in a Space on X. "I'm literally about to throw up."

"I'm lost for words," they added. "I don't know what to do."

Poor Slorg. Basically the way crypto works is that a guy named Slorg makes up a token named Slerf, which is distinguished from other tokens by having a cartoon sloth logo. You send $10 million of Solana crypto tokens to Slorg, and he makes a note to himself that he owes you some Slerfs. Then he accidentally flushes that note down the toilet and, due to the irreversible nature of the blockchain, you get no Slerfs and your money is permanently gone, though Slorg is very sorry.

If this were a company, and Slerf was a stock, this would all be bad: It is bad for a company to lose all of the money it raises in a stock offering. (Also, though, it would probably be reversible. If a company just lost its list of shareholders, it could probably, like, go back through its emails and reconstruct the list.)

But Slerf is not a company or a stock: It is a crypto token, so absolutely nothing matters. Except that this is all sort of funny, and attention-grabbing, so of course Slerf went up. Arnold: "This mistake was very good for attention, and attention is the true value of any memecoin. So the obvious thing happened and the new tokens that were released shot up around 5,000%." You could spend another 10 hours and 55 minutes pondering this but I do not recommend it.

If you have an airline that sells and operates scheduled flights, you are subject to high and expensive safety standards. But if you divide that airline into two bits, one that operates flights and another that serves as a front end to set schedules and sell tickets, each bit is subject to lower standards. If the two bits are owned by the same corporate entity and coordinate together, then the result is something that looks like a single normal airline to customers, but looks like two separate less-regulated entities to regulators.

I guess this is not technically a finance story, but half of what I write about has the form "if you do Thing X it gets Regulatory Treatment Y, but if you divide it into Things X1 and X2, the combination is the same as Thing X but gets better Regulatory Treatment Z." We have talked about treating loans as purchases, about derivatives to get around stock ownership limits, about special purpose acquisition companies to get around initial public offering rules, about brokered deposits as a way to get around FDIC insurance limits, about slicing up fund investments to get better ratings. I am sure that some of these businesses originated exactly as JSX's did: Somebody thought, "well, this rulebook is long and boring, so probably nobody has read it all the way through, and if I do, money might come flying out." Just a great way to find a business model.

That is the small-scale version of all of these regulatory arbitrage businesses: If you read boring rules and think really hard about them, you can win monetary prizes.

A dollar of income is worth more in some businesses than in others. Some businesses are attractive and fast-growing, and investors will pay a large multiple of their current earnings to buy them; other businesses are boring and declining, and investors will pay a small multiple of their current earnings to buy them. Nvidia Corp.'s stock trades at about 36 times earnings because people want to own a business that sells graphics chips in an artificial intelligence boom; Peabody Energy trades at about 6 times earnings because people are less jazzed about owning a coal miner in 2024.

Many companies have multiple lines of business. You can do a sum-of-the-parts valuation on those companies, looking at the earnings of each segment and applying some reasonable market multiple to those earnings. If for some reason you had a conglomerate that made $1 billion selling graphics chips and $1 billion selling thermal coal, you might estimate that the graphics-chip division was worth about $36 billion (using Nvidia's multiple) and the coal division was worth about $6 billion (using Peabody's), for a total value of $42 billion.

And if for some reason you ran that company, a good trade would be:

1. Have the coal division buy $100 million worth of graphics chips from the graphics-chip division. 2. Use those chips to plan out your coal mining, or just chuck them in the ocean, doesn't matter. 3. Let's say it costs the graphics-chip division $50 million to manufacture those chips. 4. So this trade reduces your coal-mining profit by $100 million and increases your graphics-chip profit by $50 million. 5. This reduces the value of your coal-mining division by $600 million (at a 6x multiple) and increases the value of your graphics-chip division by $1.8 billion (at a 36x multiple). 6. You have increased the value of your company by $1.3 billion.

Free money! Note that this trade works even better if the coal division pays $200 million for the $100 million worth of chips. There are infinite variations. Last month, the Wall Street Journal published a story about "The Spectacular Crash of a $30 Billion Property Empire," Signa Holding, a European property and retail firm run by René Benko. One thing that contributed to Signa's rise and fall is that it was a property and retail firm, two divisions with different valuations that do deals with each other all the time. The Journal explains:

One key to Signa's growing empire was a financial maneuver in which Benko's companies functioned as both landlord and tenant for department stores. This allowed Signa to reap outsize benefits by moving money from its department store business to its landlord business through hiked rents, former Signa employees involved said.

That extra rental income was worth far more in the landlord arm through what a former employee called "multiple arbitrage." Long-term leases instantly increase the value of properties substantially—and investors tend to value income at landlords at more than 20 times the annual proceeds. At retailers, where business is seen as more fickle, investors value it at less than half that level. This allowed the real estate unit to borrow and raise investment based on the higher valuations.

If one part of your business is valued at 20 times earnings, and another part of your business is valued at 10 times earnings, and they do deals with each other, you want the higher-valued division to get a better deal. If you save $1 in the 20x division and lose $1 in the 10x division, you have increased the overall value of your business by $10.

If you invest in stocks, your returns will come from roughly three sources:

1. The broad stock market goes up or down. 2. You can get paid (or lose money) for taking on some particular systematic risk: Small companies' stocks tend to outperform large stocks, and cheap stocks (by price-to-book value) tend to outperform expensive ones. 3. You can be idiosyncratically good at picking stocks.

The first thing is generally pretty easy to measure; there are widely used broad market indexes. The second thing is less obvious; someone needs to identify the systematic factors and measure the data. The third thing — alpha, investing skill — is generally what's left over after the first two things.

This means that identifying and measuring factors — Thing 2 — is very important. For one thing, those factors are part of a popular investment approach: There are funds that try to capture factor premia by, say, buying cheap stocks and avoiding expensive ones, and you want to know how well that strategy works. For another thing, lots of people really want to know how much investment skill their managers have — how much alpha they create — and since that is the residue after subtracting factor returns, you need to know what those are.

For many academic and other uses, the main factor model is the Fama-French three-factor model, where the three factors are market returns, size ("small minus big") and value ("high minus low," that is, high book-to-price ratio minus low book-to-price ratio). And the main source of historical data on the factors is Kenneth French's website.

New York usury law makes it illegal to charge very high interest rates on loans. If you charge more than 16% on a loan in New York, the borrower might not have to pay you back; if you charge more than 25%, you might be committing a crime. Some people want to charge higher rates on loans, and so they want to structure loans that don't look like loans to avoid usury rules.

The classic general way to do this is to structure the loan as a purchase. If the borrower — sorry, let's use a more neutral word, maybe "customer" — has an asset that will pay $100 in cash in a year, you can buy that asset today for $80. You'll get the $100 in a year, for a 25% return on your money; the customer gets $80 today instead of $100 in a year. That's a lot like the customer borrowing $80 today at 25% interest, but you have called it a purchase and sale rather than a loan. Legally, this might or might not work, depending on the details (if the asset turns out to be worthless, does the customer still have to pay you?).

Lots of quite normal high-finance lending works this way — "structuring a loan as a sale" roughly characterizes things like the repo market, asset-backed securities or receivables factoring — but, also, lots of shady usurious low-finance lending works this way. Or doesn't work. We talked a few years ago about a usury enforcement action against a company that bought legal settlements (from 9/11 first responders and football concussion victims); the company argued that it wasn't making loans, but the regulators disagreed.

But this only gets you so far. Not all customers will have assets like that, financial assets that will provide a reasonably fixed amount of money in the future and that you can buy today at some negotiated discount rate. If you are lending money to small businesses, most of the businesses won't have long-term contracts with AAA-rated counterparties that you can buy from them. Most of the businesses will have, like, a store, where customers sometimes come in and buy stuff.

Naively, you can do a purchase of future sales: You look at a store's books, you see that it usually brings in about $50,000 a month in revenue, and you say "okay I'll pay you $45,000 today for 10% of your revenue for the next year." Then if the revenue stays the same, you get $60,000 ($50,000 per month times 12 months times 10%), for a 33% return on your investment. But that's pretty risky, both for you (the revenue might go down, so you'll get less) and for the customer (the revenue might go up, so it'll pay back much more). Actually buying a percentage of revenue feels more like a risky equity investment than a safe loan.

But you can make it more like a loan. One thing you could do is put a cap on the repayment: "I'll pay you $45,000 today for 10% of your revenue for the next year, but capped at $60,000." That reduces the risk for the customer: If the customer has a great year and doubles its revenue, it still only has to pay you back $60,000. It doesn't help you, though: If the customer has a terrible year and revenue falls by 50%, then you get back only $30,000, less than you advanced to the customer.

But add one more trick. Leave the cap the same, but increase the percentage of revenue that you are buying. Structure it so that the cap will almost certainly be the limiting factor on your repayment, and the percentage of revenue will almost certainly be irrelevant.

So the customer brings in $50,000 a month and you want to lend it $45,000 and get back $60,000, no more, no less. The trick is: "I'll pay you $45,000 today for 50% of your revenue for the next year, but capped at $60,000." Now, if the customer's sales meet expectations, it will bring in $600,000 during the year, and 50% of that is $300,000, way more than you paid. But the customer doesn't pay you the $300,000: It just pays you the $60,000 cap. If the customer's sales fall by 50%, it will bring in $300,000; half of that is $150,000, but the customer will still pay you the $60,000 cap. If the customer's sales fall by 80%, it will bring in $120,000 and still owe you the $60,000. If the customer's sales double, it will bring in $1.2 million and still owe you $60,000. You get paid back the same $60,000 in all reasonable upside, downside and flat cases. You put in $45,000 to get back $60,000 in almost all cases, a 33% return with very debt-like characteristics.

Notice that the "50% of revenue" that you are buying here is completely fictitious: You do not expect to get paid back 50% of the customer's revenue. You expect to get paid back, exactly, the $60,000 cap. It would be a surprise and a disaster if you got 50% of the customer's revenue: You and the customer both expect the revenue to be much more than $120,000, and you wouldn't make the loan (and the customer wouldn't accept it) if you really thought that $60,000 would be 50% of revenue. The 50% of revenue is just a placeholder, a legal fig leaf, a way to call this a purchase and sale of revenues rather than a loan.

Maybe the main way for things to go wrong in financial markets is the one that goes by the name "picking up pennies in front of a steamroller." The shape of the problem is:

1. You think that tomorrow will look roughly the same as today. 2. You make a bet of the form "tomorrow will be roughly the same as today." 3. If tomorrow is roughly the same as today, you make a small amount of money. 4. If tomorrow is very different from today, you lose a ton of money.

This is not necessarily a mistake. Perhaps you have good reason to believe tomorrow will be the same as today, or perhaps you are being well compensated for the risk that it won't be. Selling insurance is a classic form of this trade, and insurance companies tend to be profitable. Still, pretty much any time there's a disaster in financial markets, you can describe the disaster by saying "some people got too complacent that the future would be just like the recent past, so they made big bets on that outcome, which they thought were low-risk, but those bets turned out to be riskier than they thought."

Sometimes, when this happens, the people making those bets were naive or stupid or reckless. Other times, they were making reasonable bets that offered them fair expected returns for the risks they were knowingly taking, but things worked out poorly. They usually look bad in hindsight though.

The most schematic form of this is selling stock options: Buying stock options is a bet on volatility, a bet that stock prices will move around a lot, so selling stock options is a bet against volatility, a bet that everything will stay the same. Options-selling strategies look very good when volatility stays low: You make steady returns every day by selling options that don't pay off. And then when something changes, you can lose all your money. Again, this tends to look bad in hindsight. We have talked about various disasters in this genre, investment firms that secretly or openly sold a bunch of volatility, showed their investors attractive stable returns for a bit, and then blew up horribly.

I worry that perhaps nobody knows how mergers work. Not in like a "let me tell you" sense, but in an "everything is fundamentally unknowable" sense. Lots of contracts between companies have provisions that say that the companies can't transfer them to someone else. If you hire McKinsey & Co. to do some consulting for you, you don't want Joe's Consulting to show up for the engagement and say "oh yeah we bought this contract from McKinsey, that's fine right?" So the contract will say that neither side can assign its rights and obligations under the contract to anyone else.

So an incredibly basic question in mergers and acquisitions is: If we acquire Company X, do we keep all of its contracts? Or do those contracts have "anti-assignment" provisions that would be triggered by an acquisition?

From first principles, you'd think that most of the contracts should continue without interruption. If you rent some office space to Company X and it gets acquired by another company, not much has changed for you: The same people come to the same office to do the same work, and they pay you the same rent with checks drawn on the same account. If you license some software from Company X and it gets acquired, it's still the same software.

If the contracts continue uninterrupted when the company is acquired, that generally makes life simpler for the company's customers and suppliers and landlords. Also, though, it makes mergers and acquisitions possible. If every company lost all of its office leases and customers and supply deals and employment contracts when it was acquired, who would want to acquire it? A company mostly is a big pile of contracts; if an acquisition terminated all of those contracts then there would be no acquisitions.

Most of the time this is the right answer and works out fine. Most big public mergers and acquisitions, for instance, are structured in ways that preserve the target company intact, with the buyer owning its stock. (For instance, in a "reverse triangular merger" in which a subsidiary of the buyer merges with the target, which survives the merger as a subsidiary of the buyer.) A contract that says "Company X can't transfer this contract to anyone else" should not be affected by this sort of deal: Company X hasn't transferred the contract to anyone else; Company X is still doing the contract; it's just that Company X has a new owner.

But probably there are some contracts where that doesn't make sense, where an acquisition of the company should give the counterparty a right to get out of the contract. If you have a huge deal to sell a sensitive product to some trusted customer, and then that customer gets acquired by your biggest rival, or in a leveraged buyout that makes it less creditworthy, or by a sanctioned foreign company, you will be unhappy and think that the deal is no longer what you signed up for. And so some contracts will say something like "you can't transfer this contract, and just to be clear, if you get acquired in a merger we can also get out of the contract." [1]

You could imagine contracts just saying this clearly. Like, every contract could say either:

1. "Neither company can transfer or assign this contract, but obviously if the company is acquired in a merger that's fine, that's not a transfer." Or, 2. "Neither company can transfer or assign this contract, and if the company is acquired in a merger that also counts as a transfer and is not allowed."

I don't know, you'd have to work on the language. There are lots of more complicated ways to acquire a company, different ways to structure mergers or buy control or gain influence on the board or whatever; specifying exactly what you mean could take some work.

But in actual fact the world seems to be considerably messier than that. There are all sorts of contracts with all sorts of language, and a lot of them do not make it obvious whether the company can do a merger and keep the contract. Here is a sort of horrifying law-firm blog post about a 2020 court decision in Delaware finding that a contract that says it can't be assigned "by operation of law or otherwise" does not survive a forward triangular merger, which is different from other Delaware decisions finding that "anti-assignment clauses containing both a prohibition on assignment 'by operation of law' and a reference to 'successors' were ambiguous" about mergers. You get the sense that there are a lot of contracts out there where one side thinks "this contract terminates on a merger" and the other side doesn't.

I mean, a lot of people have the general idea (they're bonds that can convert into stock). But they are somewhat weird instruments with odd nooks and crannies, and, while they are not rare , neither are they all that common. Lots of companies will never do a convertible in their lives. Generally financially literate people — chief financial officers and corporate treasurers, industry investment bankers — will probably have a decent working knowledge of bond deals and bank loans and stock offerings and mergers, because they come up a lot; they might be less familiar with convertibles.

I, on the other hand, used to be a convertible bond investment banker, so I have somewhat more than the usual familiarity with them. I could tell you, for instance, that it is common in the US for a convertible to be done as a Rule 144A offering, meaning that the bonds are sold to large "qualified institutional buyers" (QIBs) in a private placement and then can't be resold to retail investors. Doing a 144A deal is generally faster and cheaper than doing a public deal that is registered with the US Securities and Exchange Commission, and retail investors don't really buy convertibles anyway.

But eventually the institutional buyers of a 144A deal will want to be able to convert their bonds into regular, publicly traded stock, so there needs to be some mechanism for turning "144A" convertibles into "registered" ones. I am old enough that, when I started as a converts banker, the way to do this was to file a registration statement with the SEC, but the modern approach is pretty much that you wait six months or a year and the convertible becomes freely tradeable as a legal matter. [3]

As a practical matter, though, the way this works is that the bonds, when they are originally issued, have a "restrictive legend" on them saying that they can be sold only to institutional buyers, and after a year the company sends a notice to its transfer agent saying "you can take that legend off the bonds now." And when the bonds have the legend, they can't be freely traded; once the legend is off, they can be. Here I am pretending, as one does, that "the bonds" are pieces of paper with a legend stamped on them, but of course they are actually entries in an electronic database; what really happens is that the original bonds have a "restricted CUSIP" (the identification number that every security has), telling transfer agents and depositaries and brokers and everyone else that they can only be sold to QIBs, and then after a year the company gets them a new "unrestricted CUSIP" and they trade freely. This is not hard — it's a phone call or an email, maybe a legal opinion — but the company has to do it.

It is good, for the bondholders, to get unrestricted bonds, though it doesn't matter that much, since they're really only trading with other institutional buyers anyway. And so in the documents for the convertible bond, there will be a provision saying that, after a year, the company has to make the convertible unrestricted (by removing the restrictive legend and getting an unrestricted CUSIP). If it doesn't do that, it has to pay some extra interest to compensate the bondholders and to incentivize the company to get its act together.

Ukraine has an indubitable claim under international law for the damages caused by Russia's unprovoked of Ukraine. For its part, Russia has legal title to approximately $300 billion of assets (held in the name of the Russian Central Bank and the Russian Federation) that have been frozen by the G7 countries since 2022. The problem is that the country (Ukraine) to which reparations are owed does not have custody of the frozen assets and the countries (the G7) that do have custody of the frozen assets do not have a claim for reparations against Russia.

Ukraine has a good legal and moral claim on Russia's money, but it can't get the money. The G7 countries (the US, UK, Canada, France, Germany, Italy and Japan) are holding onto a lot of Russia's money, but they have no legal or moral claim on the money. The trick is to transfer Ukraine's claim to the G7 countries, so the G7 countries can transfer the money to Ukraine.

I suppose one way to do that would be to literally sell the claim — Ukraine has a valuable asset (the claim on Russia), and maybe someone who could better enforce it would pay for it — but a roughly equivalent way would be to put it in a box and lend some money against the box:

Ukraine could raise up to $300 billion through a syndicated loan provided by G7 governments. The loan would be collateralised by Kyiv's claim for war damages against Moscow. In the most likely scenario that Vladimir Putin refuses to pay reparations, the G7 syndicate would "set off" the Kremlin's $300 billion of frozen assets against the claim for reparations. …

A reparation-backed loan would create a mechanism by which legal title to the claim for reparations — an indubitable claim under international law — can be placed in the hands of parties with the legal and practical ability to satisfy that claim from Russian assets. …

The loan will be structured as a "limited recourse" obligation. This means the syndicate will agree to look solely to the collateral (the reparations claim against Russia) as the source for repayment of the loan.

It's not quite selling the claim, but it is more or less equivalent. One thing it would mean is that any peace negotiation between Ukraine and Russia wouldn't be able to resolve the reparations question:

When Putin eventually sits at a negotiating table, he will surely demand his money back. The reparation loan structure has the advantage of giving the G7 countries a direct financial interest in NOT returning the money unless Russia pays reparations. Among other things, that entitles the G7 to a direct seat at the negotiating table. Without it, Ukraine could easily be bullied into surrendering its reparations claim as part of an armistice.

Once it sells the reparations claim, Ukraine can't waive it.

In the olden days, there were two sorts of people who traded stocks or bonds for a living. We can call them "dealers" and "investors," though those terms are imperfect. An investor is someone who buys stocks or bonds because she thinks they are a good investment, and sells them when she thinks they aren't. She does analysis, decides that Bond X is worth $80, sees it trading at $78, and goes out to buy some Bond X. When it trades up to $82, she sells it. She makes her money by buying low and selling high, by predicting price trends or understanding fundamental value. Investors include ordinary retail investors, but mutual funds and hedge funds are also in this category. Their job is to buy stuff that they think will go up.

A dealer is the person the investors buy from and sell to. A dealer is not looking to buy stocks or bonds that she thinks are a good investment, or to sell ones that she thinks are a bad investment. A bond dealer has some list of bonds, and she is always willing to buy or sell each of those bonds. She is in a customer service business: Customers come to her looking to buy or sell bonds, and she sells them the bonds they want to buy and buys the bonds they want to sell. She makes money not by predicting price moves but by charging the customers (investors) a bit of money (called the "spread") for each trade, buying from them at a lower price (her "bid") than she will sell to them (her "offer" or "ask"). An investor thinks "Bond X trades at $78 and is worth $80, so I will buy it." A dealer thinks "Bond X trades at $78, so I will buy it at $77.75 or sell it at $78.25, whichever customers want." She doesn't care what it's worth. She cares about charging a bit more to sell than she pays to buy.

Investors could theoretically exist without dealers, and in some markets they do. Investors who think that Bond X is worth $80 could just buy it from investors who think it's worth $75, without a middleman. But in practice it is often helpful for there to be a middleman — a dealer — to "provide liquidity." An investor who thinks Bond X is worth $80 probably wants to buy it now ; an investor who thinks it is worth $75 probably wants to sell it now. If they each come to that conclusion at exactly the same time, they can trade with each other and that's great. But if the seller decides to sell an hour before the buyer decides to buy, it is helpful for there to be a middleman to buy from the seller and sell to the buyer. And the seller and buyer might each be happy to pay $0.25 to get what they want when they want it.

The Kelly criterion tells you what percentage of your money you should put on some favorable bet. If you work in financial markets, you want to make a bunch of bets where you think the odds are in your favor, and if you can estimate the odds then Kelly gives you a guide to how much of your money you should put on each bet. Kelly gives you an answer that is a percentage of your current bankroll. But what is your bankroll?

We talked a few times last year about a dumb story from Sam Bankman-Fried's internship at Jane Street, where he kept making the maximum bet on slightly favorable coin flips, and I was like "well that's not very Kelly is it." But probably I was wrong. Jane Street interns were limited to losing $100 per day, so I sort of took $100 to be the size of his bankroll and thought he was aggressive to bet it all on a 51% coin flip. But readers pointed out, no, come on, his net worth at the time was not $100; $100 was nothing to him even though it was all he could bet that day. As a percentage of his actual bankroll that was a fine bet.

Anyway here is a fun post from Byrne Hobart titled "What's the True Bankroll?" Sometimes the true bankroll is much bigger than the obvious bankroll: Sam Bankman-Fried's $100 daily betting allowance was much smaller than his true bankroll, and Hobart points out that if you start your first job and have $1,000 to invest, your true bankroll is more like your lifetime expected savings than it is your current $1,000. Other times the true bankroll might be smaller than the obvious bankroll: If you are a portfolio manager at a multi-manager hedge fund, and you run a $500 million portfolio, you might think that your bankroll is $500 million. But if you know that you'll get fired for a 10% decline in your portfolio, is your actual bankroll $50 million? No, but also maybe a little bit yes.

We have talked a few times about assumable mortgages, the obvious solution to the main problem in the current US housing market. The problem is that everyone who owns a home has a 3% mortgage, but if you want to buy the home you will get a 7% mortgage. They can afford to stay  in the home and pay 3%, but you can't afford to buy the home and pay 7%. If you could buy the home and take over their 3% mortgage, you would. But you mostly can't.

You mostly can't because most mortgages in the US are not, by their terms, assumable. And this is for good reason. The normal US mortgage is a 30-year fixed-rate loan that is prepayable without penalty. If a bank lends you money at 5% and then rates go down to 3%, you will go refinance at 3% and pay back the original 5% loan: The bank won't get to keep its original, now-above-market loan. But if instead rates go up to 7%, you don't have to pay the bank back for 30 years: The bank is stuck with its original, now-below-market loan. You have an option to reprice when rates go down; the bank does not have an option to reprice when rates go up.

This is a bummer for the bank, but it is mitigated by the fact that you probably won't  wait 30 years to pay back the loan: You'll probably sell your house , for some non-financial reason (you have kids and need a bigger house; your kids grow up and you don't need such a big house), and then you'll have to pay back the loan. The bank is stuck with its below-market loan, but not forever; even now, when mortgage rates are 7%, some people still go and pay off their 3% mortgages. If they didn't, things would be rough for the bank. [3]

If mortgages were always automatically assumable, then when you sold your house you'd let the buyer assume your mortgage, and that 3% mortgage would remain outstanding for 30 years, and the bank would be stuck with it, and that would be worse for the bank, so it would have to charge you more for your mortgage to begin with.

And so US mortgages usually aren't automatically assumable. And if you call up your bank and say "hey, I know that I can't technically transfer this mortgage to anyone else, but what if you made an exception for me," they will say "absolutely not."

An important meta-story that you could tell about financial markets over the past few years would be that, for a long time, interest rates were roughly zero, which means that discount rates were low: A dollar in the distant future was worth about as much as a dollar today. Therefore, investors ascribed a lot of value to very long-term stuff, and were not particularly concerned about short-term profitability. Low discount rates made speculative distant-future profits worth more and steady current profits worth less.

And then interest rates went up rapidly starting in 2022, and everyone's priorities shifted. A dollar today is now worth a lot more than a dollar in 10 years. People prioritize profits today over speculation in the future.

This is a popular story to tell about the boom in, for instance, tech startups, or crypto: "Startups are a low-interest-rate phenomenon." In 2020, people had a lot of money and a lot of patience, so they were willing to invest in speculative possibly-world-changing ideas that would take a long time to pay out. (Or to fund startups that lost money on every transaction in the long-term pursuit of market share.) In 2022, the Fed raised rates, people's preferences changed, and the startup and crypto bubbles popped.

I suppose, though, that you could tell a similar story about environmental investing? Climate change is, plausibly, a very large and very long-term threat to a lot of businesses. If you just go around doing everything normally this year, probably rising oceans won't wash away your factories this year. But maybe they will in 2040. Maybe you should invest today in making your factories ocean-proof, or in cutting carbon emissions so the oceans don't rise: That will cost you some money today, but will save you some money in 2040. Is it worth it? Well, depends on the discount rate. If rates are low, you will care more about 2040. If rates are high, you will care more about saving money today.

We have talked a few times about the argument that some kinds of environmental investing — the kind where you avoid investing in "dirty" companies, to starve them of capital and reduce the amount of dirty stuff they do — can be counterproductive, because it has the effect of raising those companies' discount rates and thus making them even more short-term-focused. And being short-term-focused probably leads to more carbon emissions. (If you make it harder for coal companies to raise capital, maybe nobody will start a coal company, but existing coal companies will dig up more coal faster.)

But that argument applies more broadly. If you raise every company's discount rate (because interest rates go up), then every company should be more short-term-focused. Every company should care a bit less about global temperatures in 2040, and a bit more about maximizing profits now. Maybe ESG was itself a low-interest-rates phenomenon.

A simple story that you could tell is that the banking system is in the business of borrowing short to lend long. There is a lot of natural demand for long-term loans (government deficits need financing, people need mortgages) and a lot of natural demand for places to park money that can be withdrawn at any time (people need checking accounts), but a mismatch between them. More people want to borrow long than lend long; more people want to lend short than borrow short.

And so traditionally banks intermediate that; they borrow short to lend long. And that is a well-known risky business model, and there are various ways to mitigate that risk, and the most important is the lender of last resort: If banks have lots of long-term good loans funded with short-term deposits, and all the depositors ask for their money back, the central bank will lend cash to the banks to pay back their depositors.

But this risk is particularly acute when interest rates have been very low for a long time, and then rapidly rise to a much higher level. All the banks have long-term loans that they made at the low interest rates, [1] but now they have to pay high interest rates on deposits. One thing that this means is that their operating profits are lower or negative: If your assets are a bunch of mortgages paying 3%, and your liabilities are a bunch of savings deposits paying 2%, you're losing 1% every year. The other thing that this means is that they are mark-to-market insolvent: If your assets are a bunch of mortgages paying 3%, and now mortgage rates are 6%, your mortgages are worth like 80 cents on the dollar, and if you're a bank with 10% equity and your assets have lost 20% of their value, you are insolvent.

And so when the Fed raises rates a lot very quickly, that has the possible effect of … bankrupting all the banks? Or getting them kind of close to insolvency, anyway? And in fact last year there was a bit of a crisis among US regional banks, which really were in this business of borrowing short to lend long and turned out to be, in some cases, insolvent when the Fed raised rates rapidly.

There are ways to mitigate this risk, too. One is: You have regulation to make the banks more robust to this. You have capital regulation (they can't have too little capital), and also liquidity regulations that have the effect of lowering the duration of their assets and increasing the duration of their liabilities, and prudential oversight where the bank regulators call up the banks and say "really? You're funding all these 30-year mortgages with overnight deposits?" [2]

A more important way is accounting: Banks do not have to recognize interest-rate losses on huge swathes of their assets, loans and bonds that they classify as "held to maturity." This is the essential trick that makes all of banking work: When interest rates go up, the market value of banks' long-term loans goes down, but the banks don't have to realize those losses; they just hold the loans until maturity and get paid back 100 cents on the dollar.

The US regional banking crisis last year turned on the fact that this doesn't work as well as it used to: The banks do not recognize the losses in their main accounting statements, but they do disclose the losses, and people can read that disclosure and panic. And when they panic, they take out their deposits. And then the banks need to raise money. They can't do this by selling their loans, because then they'd recognize their losses and become insolvent. And they can't do it by borrowing from the Fed, because the Fed lends against the market value of the loans.

One solution is for the Fed to instead lend banks money against the par value of their loans, their hold-to-maturity value. And that's what it did: It created the Bank Term Funding Program, which allows banks to post collateral (Treasury bonds, agency mortgage-backed securities) with the Fed and borrow the par value of those assets. If a bank has $100 of mortgage bonds that are worth $80 because rates went up, it can borrow $100, solving the liquidity problem.

But in fact there'd be something a bit crazy about doing that with dollars. There are "cash" ETFs, in some sense. But everyone understands that these ETFs don't hold crisp $100 bills. They hold extremely safe interest-bearing short-term debt instruments. If you invest your money in one of those ETFs, it will "hold" your "cash" for you in roughly the sense that a bank would: It will lend out your cash, as safely as possible, give it back to you on demand, and pay you interest.

This is the natural way of the world, in finance. Even a stock ETF will probably do this: Stock ETFs often take their investors' money, use it to buy stocks, and then lend out some of those stocks to earn a bit of extra interest. Modern finance is very interested in efficiency, and abhors the idea of buying anything, putting it in a box, and doing nothing with it. You've got some stuff in a box, you take it out of the box, you lend it to someone who wants to do something with it, and you earn interest.

The Satoshi Nakamoto vision of crypto was very different: This idea of building opaque leverage into every part of the system, of constructing everything on webs of debt, is part of what Bitcoin was reacting against. But the modern vision of crypto, or at least the 2022 vision of crypto, was like everything else in finance. You could hold Bitcoins in your digital wallet, like holding $100 bills in your regular wallet, but the action was in depositing your Bitcoins with some quasi-bank that would lend them out, earn interest, and pay some of the interest to you.

The new offering, called Bitcoin depositary receipts, will be similar to American depositary receipts that represent foreign stocks. The startup, called Receipts Depositary Corporation, or RDC, said it plans to issue the first Bitcoin depositary receipts to qualified global institutional investors in transactions exempt from registration under the Securities Act of 1933.

Known as BTC DRs, the offering will give institutions access to Bitcoin securities through US regulated market infrastructure and cleared through the Depository Trust Co., according to a release from the company. …

Broadridge Corporate Issuer Solutions will serve as the transfer agent and Anchorage Digital Bank National Association will handle custody of the underlying Bitcoin. RDC is backed by investors including Franklin Templeton, BTIG and Broadhaven Ventures, according to its press release. …

Compared with Bitcoin ETFs that will be redeemed for cash, Mehta said that depositary receipts offer direct ownership of Bitcoin for qualified institutions. Buying Bitcoin directly isn't the most-preferred option for some regulated institutions, he added, since crypto markets face challenges including security risks and regulatory uncertainty. Some of the challenges are similar to those once seen for Americans investing in foreign companies, which were mitigated by American depositary receipts.

A spot ETF is probably the most broadly convenient way to put Bitcoins in a box and sell shares of the box, but the basic concept is very simple and obvious and can be implemented in a lot of ways. The ETF implementation has the two advantages that (1) anyone can buy and sell shares of the box and (2) the box can easily create or redeem shares for Bitcoins, meaning that the share price of the box really should track the price of Bitcoin. Whereas the leading existing box of Bitcoins, the Grayscale Bitcoin Trust, has the first advantage — it is pretty freely tradeable by anyone [2] — but not the second: For securities law reasons, it can't freely redeem its shares for Bitcoins, so its share price has diverged widely from the price of Bitcoin. [3] (Grayscale also intends to convert into an ETF, when the SEC allows it to.)

Meanwhile this box — BTC DRs — has the second advantage (easy convertibility and price tracking) but not the first: To avoid the need for SEC approval and registration, it will only sell its shares to institutional investors in private transactions. This box is just "if you are an institutional investor, we will give you Bitcoin wrapped up in a security, so you can hold it in your ordinary custody account and transfer it through the Depository Trust Co. and generally have the experience of holding a stock or bond, not a weird crypto thing, except the stock's price happens to be the price of Bitcoin."

Private equity buyouts also work that way? Like the way a private equity buyout works is that a fund borrows a lot of money from lenders to pay some of the purchase price for the company, and then it pays down those loans over time. And if it sells the company to another private equity firm while the loans are still outstanding, then ordinarily the loans come due immediately, so the new private equity buyer has to go to its lenders to get new loans to pay the old private equity owner the money to hand over to its lenders. And just as with mortgages, if the old owner got its loans during a period of low rates and easy credit, and the new buyer has to get its loans during a period of high rates and more difficult credit, some trades won't get done: The company is worth more to the old owner, with its cheap debt, than it will be to a new owner with expensive debt.

The analogy is not perfect: A lot of the private-equity loans will be floating-rate, so the difference is not so much "3% rates versus 7% rates" as it is "relatively easy credit versus more nervous credit." And "the loans come due immediately" can mean less "the loans technically come due immediately, which gives the lenders negotiating leverage to extract fees and concessions for agreeing to roll them over for the new buyer." But the basic idea is that if private-equity buyout loans were assumable, then more deals would get done, because buyers wouldn't have to worry about going out and getting new loans in tougher credit environments.

Here are Bloomberg's John Sage and Ellen Schneider on assumable private equity loans:

Private equity firms, eager to sell debt-laden businesses, are finding private credit firms increasingly willing to keep outstanding loans intact, even for companies that may soon have new owners.

The trend, known as portability, describes loans that remain essentially unchanged when a company gets new ownership. It carries rewards and risks for businesses and especially for lenders. Usually a change of control would allow lenders to renegotiate terms to cover potential risks from a new parent, such as different plans for growth or profitability of a business.

After two years of rising interest costs hindering asset sales, owners are seizing on recent rate stability to push for portability to get deals done. Keeping the existing loan package in place removes the need for any new buyer to find financing, making the purchase a lot more alluring.

"The market has pivoted to include a portability feature," said Bill Eckmann, head of principal finance in the Americas and senior managing director at Macquarie Capital. "We're seeing more of this because sponsors are looking at near-term maturities and thinking about their exits."

For direct lenders facing rising competition in a market that's tripled to $1.6 trillion since 2015, portability provisions allow them to stay invested in assets they've already vetted and endorsed.

"If you've found an attractive business then you may be willing to let the debt travel to another owner," said Jon Bock, senior managing director at Blackstone Credit. "From a self-selection standpoint, this is an opportunity for managers to extend the lives of the loan."

Part of the pitch for private credit, as an alternative to traditional syndicated loans, has been along the lines of "if you borrow from a private credit firm instead of from a syndicate of banks and hedge funds and collateralized loan obligations, your lender will be one person with whom you have a good relationship, and if things change in your business you can call her up and discuss things rationally instead of having to go get waivers from a dozen anonymous CLOs." You might think that this pitch would argue against automatic portability: "Don't worry about it," the private-credit firm could tell its borrowers, "if you want to sell, we will be very reasonable about rolling over the loans, you just need to call us and talk about it." But, no, the borrowers want portability.

In theory, every time one company does a merger with another company, or a private equity firm raises a fund from investors, or a private equity fund borrows money from lenders to do a leveraged buyout, the two sides could negotiate all the details of the merger or fund or loan from scratch. Sit down and think through the deal from first principles: What rights should each side have? Who should have to do what? What could go wrong, and who should bear the risk of each thing that could go wrong? Negotiate each of these points, and then write a contract in elegant prose that reflects your negotiation.

This never really happens. Instead the way it works is that the lawyers for one side take out the contract that they wrote for the last similar deal that they did, and they change the names, and they tweak a few provisions to reflect the current situation, and they tweak a few more provisions to be more aggressive — to give their client more rights or fewer responsibilities, to allocate more risks to the other side — and then they send it to the other side. And the lawyers for the other side mark up the contract to make it more favorable to them (more rights, fewer responsibilities, less risk), and also to make it look more like the last contract they wrote, and they send it back, and they negotiate from there.

In those negotiations, the two sides can make several types of arguments. For instance:

Some provisions are win-win, so you can say "if you agree to this it will be better for both of us." Some provisions are just intuitively fair, so you can say "it makes no sense for you to allocate this risk to us, this is a risk that you should bear," and convince the other side of it. (Or: "If the contract says this, then that would allow you to do this crazy unfair thing, and obviously you would never want to do that, so we should change the contract to constrain you in a fair way.") Sometimes one side has more negotiating leverage, so it can just say "if you don't agree to this we will walk," and the other side has to agree. There's a certain amount of arbitrary horse-trading and wearing down of the other side: At 3 a.m., one side says "fine you can have these six points if you give me those other four points," and the other side is like "fine whatever let's be done."

But for many terms in the contract, the main argument will be: "This term is market." "Market" means that it is the normal way that these sorts of deals are done by sophisticated parties with sophisticated lawyers. "Market" is a sort of efficient-market argument. It means "a lot of smart people have argued over this term from first principles, they have thought about what is fair and what is in everyone's best interests, and their collective conclusion is that the provision should be written this way. So who are you to argue for something different?" If there have been 50 private equity leveraged buyouts in the last three years, and 48 of them had a cap on damages for non-performance, then that's "market" and it is hard — not impossible, but hard — for the target to argue that there should be no damages cap.

How do you know what is market? Well, you look at all the previous deals, or as many as you can. Sometimes this is reasonably easy: In the US, the terms of some types of deals (public company mergers, initial public offerings, some bond deals) are publicly disclosed with the US Securities and Exchange Commission, so you can just go find them all. (Or all the big ones, or all the ones in your industry, or whatever the relevant market is. And obviously you focus on the recent ones, since the market evolves.) You have to pay attention to what deals happen, and have someone summarize them, but with a bit of work you can build a database, or even keep running track of all the deals in your head I guess. Or get yourself a large language model and ask it "what is a standard ordinary course of business covenant for a US public company merger these days?"

Other times it is hard: Many deals are not publicly disclosed, and if you want to know what the standard terms are for, say, the limited partnership agreement of a new private equity fund, the best way to do that is to have negotiated a ton of private equity fund agreements. If you've done all of those deals, then you have a database (or all the deal terms in your head), and if the people on the other side haven't done the deals, then they don't.

And so you can say "this term is market" and they can say "no it isn't" and you can say "I have negotiated 100 of these deals and this term is in every one of them, how many have you negotiated," and they will say "um, four," and they will be ashamed in front of their clients. You will look wise and experienced, and they will look dumb and unreasonable. And you will win the argument. Not always or anything — it's not like anyone is obligated to agree to "market" terms — but it's a fairly effective move.

Also though if you say "I have negotiated 100 of these deals and this term is in every one of them," and they haven't, and the deals aren't public, they can't check. If you negotiate all the deals, you can change what terms are market.

At the Financial Times, Will Louch has a fascinating profile of Kirkland & Ellis, a US law firm that has become influential and lucrative by building a strong private equity practice and by being more aggressive and commercial than other law firms. There is a lot about the culture and business model of Kirkland, for instance:

Unlike other, stuffier firms, if you are good enough you rise through the ranks fast rather than waiting for existing partners to retire or die, he adds. "It's run like a business and not like a club. A lot of law firms are run like clubs."

Another longtime partner says the promotion prospects are "one of the unique things about Kirkland . . . you don't have to wait until you are 60. You can be rewarded really early on and it can give you a sense of energy."

But also, because Kirkland's private equity practices are so big, they have the ability to move what is market:

Investors and trade associations are also taking a closer look at Kirkland's modus operandi. Because it works on so many deals — it has advised on more fundraisings than any other firm in every year since 2008, according to data provider Preqin — it collects reams of data about fees and other terms. The firm invested heavily in using this data to its advantage, even hiring data scientists from the University of Chicago to track deal terms.

It uses this data to get better terms for its own clients, making life difficult for less well-resourced investors such as public pension plans. "They have the largest market share," says the head of private equity at a large US public pension plan. "They will pick a few terms each year and insist they are [the] market", rolling them out across most of the private equity funds they advise.

"It is one of our selling points," a person familiar with the firm's workings says. "Our market knowledge is better than our competitors."

The concentration of market share in the hands of a few large firms, including Simpson Thacher and Proskauer, has attracted criticism from the Institutional Limited Partners Association, a Washington-based industry body representing private equity investors. In a report earlier this year, it highlighted the role that lawyers play in helping fund managers negotiate better terms at the expense of investors.

Investors say they are accused of collusion if they try to band together with peers to get better terms, with Kirkland among the most aggressive law firms at rebutting any pushback.

One other way to influence what is "market" is to band together with peers, say by being the Institutional Limited Partners Association and publishing your own model private equity fund agreement. "This term is in the model agreement so it must be righ

We talked the other day about some criminals who stole 2 million dimes and were like "ugh, now we have to convert these into money." The conversion was terribly labor-intensive and also got them caught. If you stand at the CoinStar machine all day pouring in dimes, people will have questions. Coins, in the US, are money, but only in pretty small amounts. Once you get above roughly a pocketful of coins, their moneyness starts to fall off.

A forklift-full of coins, for example, is somehow the opposite of money:

Pennies, nickels, dimes and quarters might be legal tender but more than 6,500 pounds of loose change is not a proper form of payment, a Colorado judge ruled last week after a defendant attempted to deliver $23,500 in coins to settle a legal dispute.

The judge, Joseph Findley, of Larimer County, said that the delivery of more than three tons was done "maliciously and in bad faith," and that the defendant, a welding company, must now pay more for its act. ...

JMF Enterprises attempted to make a "nighttime delivery" to Fired Up Fabrications but company officials rejected it because they at first thought it was a forklift being delivered, according to the judge's order.

On Aug. 28, the following Monday, "an attempt was made to deliver a heavy metal container of coins that required a forklift to move" to lawyers for Fired Up Fabrications, the order said, but it was "physically impossible" to deliver. …

In the order, Judge Findley said that while coins were legal tender, paying such a large settlement in coins would reduce the settlement because of the time and expense required to accept it.

He said photographs showed that the coins had also been removed from neatly organized boxes and dumped "loosely and randomly" into a metal container.

The judge ordered JMF Enterprises and Mr. Frank to pay additional fees related to the costs of extending the case and dealing with the coin payment.

Surely everyone who has lost a lawsuit has briefly fantasized about paying in pennies. Surely Elon Musk had someone look into paying $44 billion for Twitter in pennies. But here's some legal precedent. If you try to pay someone with 6,500 pounds of coins, (1) you will have to pay them again with real money, (2) you will have to pay them more and (3) you'll be stuck with all the coins.

On the other hand the actual practice of corporate lawyering in New York is a little rickety too, in a way that might benefit from spending four hours reading the contract out loud to each other. Here is roughly how a corporate contract is negotiated:

1. One side's lawyers write the contract in Microsoft Word and email it to the other side's lawyers as an attachment. 2. Those lawyers summarize it for their clients, get feedback, and "turn" the contract, writing in all of their proposals in Word and emailing it back to the first side with a redline. 3. The first side's lawyers get the contract back, summarize the changes for their clients, and turn it back with their counter-proposals. 4. This continues for a while, with each redline being a bit less red. 5. Eventually the contract is close enough that each side's lawyers print out a signature page — just the last page of the contract, with page number 71 or whatever printed on it, with a signature block for the client to sign — and hand it to their client. The client signs it and scans it and sends the PDF back to the lawyers. 6. At like 3:47 a.m., one side's lawyers email the draft contract in Word to the other side's lawyers saying "I think this is final," and the other side's lawyers email back "looks good, here are our signature pages," attaching the PDF, and the first side's lawyers email back "here are our signature pages, congratulations." 7. The most junior associate uses Acrobat to make a PDF of the final contract and combine it with the signature pages, so there is one PDF containing the official signed contract. Then she sends it out to everyone else, though they are all in bed by this point. 8. Probably nobody ever reads that final PDF.

This always troubled me. In law school you think that there is "a contract," that it is a piece of literal paper signed in ink by two human beings sitting in a room with each other, and that if there is a dispute about what the contract says you can just get it and open it. But in actual high-stakes corporate contracts, there are like 40 different Word versions that exist only as attachments to emails between junior law firm associates, attachments that probably even they didn't read. The signature means nothing; it's a blank page that someone signed and handed to the lawyers before the contract was agreed. If there is a dispute about what the contract says, you have to go back through the email chain to pick out which attachment everyone thought they were signing off on. The dispute will likely take the form "we signed off on the 2:12 a.m. version and did not realize that you made changes to the 3:47 a.m. version that you did not flag to us."

If the final step of this process was for the lawyers to say "looks good, let's get some sleep and then meet up in the morning to read the whole thing out loud," some misunderstandings might be avoided.

The basic idea is that, if you are doing crime, you are probably getting paid in cash or in cryptocurrency or in, like, someone else's bank account. If you do crime quite successfully, you will have a lot of cash or cryptocurrency or tainted bank money. You will want to turn that cash or crypto into some more convenient and usable and legitimate-seeming form of wealth: money in a clean bank account, most of all, but stocks and bonds and real estate and art can also work. The law is aware of this, and there are anti-money-laundering rules in most places that basically tell banks — but also crypto exchanges and stockbrokers and real estate agents and art dealers — "if someone comes to you with an enormous sack of cash, or crypto, or a wire transfer from North Korea, maybe ask some questions about where it came from and report it to the authorities."

On the other hand if you do crime and have sacks of cash and take some cash out of a sack and go to a deli to get a sandwich and pay cash, the deli will not report you to anyone. You can't really launder your money through sandwiches.

There is some intermediate zone between "sandwiches" and "Central Park South penthouses" where, you know, you could be laundering money, or you could just carry around a lot of cash and want to spend it. It is a line-drawing exercise, and sometimes the line moves:

Singapore may subject luxury assets, including cars, watches and handbags, to anti-money laundering controls and increase scrutiny of single family offices as the Asian financial hub reels from a S$2.8bn (US$2bn) money-laundering scandal.

In response to questions in parliament on Tuesday about the probe, Singapore's government said it would examine extending anti-money laundering requirements, such as tough know-your-customer due diligence checks, to high-value assets including vehicles, handbags and alcohol. Such items are not currently regulated, unlike precious stones or metals.

If you have ill-gotten money, you might park it in diamonds, so if you walk into a diamond dealer they will ask you "is this money ill-gotten?" Or you might park it in, like, Pappy Van Winkle. The liquor store will not necessarily ask you "is this money ill-gotten?" before selling you a bottle, but maybe they should.

Be careful before you casually dash off another thumbs-up emoji: A Canadian court has found that the ubiquitous symbol can affirm that a person is officially entering into a contract.

The ruling pointed to what a judge called the "new reality in Canadian society" that courts would have to confront as more people express themselves with hearts, smiley faces and fire emojis — even in serious business dealings or personal disputes.

The case questioned whether a farmer in Saskatchewan had agreed to sell 87 metric tons of flax to a grain buyer in 2021. The buyer had signed the contract and texted a photo of it to the farmer, who had responded by texting back a "thumbs-up" emoji. …

The judge noted that Mr. Achter and Mr. Mickleborough had had a longstanding business relationship and that, in the past, when Mr. Mr. Mickleborough had texted Mr. Achter contracts for durum wheat, Mr. Achter had responded by succinctly texting "looks good," "ok" or "yup."

Both parties clearly understood these terse responses were meant to be confirmation of the contract and "not a mere acknowledgment of the receipt of the contract" by Mr. Achter, wrote Justice T.J. Keene of the Court of King's Bench for Saskatchewan. And each time, Mr. Achter had delivered the grain as contracted and had been paid.

Is that even interesting? A lot of trading in financial markets is done by chat messages, and it is pretty clear that if you type "done" in a chat message that can create a binding contract. The difference between "done" and the thumbs-up emoji is not that great, and I suspect it's mostly generational; the emoji seems like a perfectly reasonable way to say "yes I agree to these terms for our trade." In a few years the eggplant emoji will be the normal way to bind banks to nine-digit swaps trades.

There are two main ways for companies to finance themselves, debt and equity. Debt financing means that you borrow money and promise to pay it back on some set schedule with some set interest rate. Your creditors are entitled to exactly what you owe them, and if they don't get it then they can sue you for the money, or put you into bankruptcy if you don't have it.

Equity financing means that you sell stock to investors and you never have to pay it back. Your shareholders are not entitled to anything specific; there is no particular amount of money that they have to get back or any schedule for when they get it. But they are in some loose sense part-owners of the company, they have a residual claim on its cash flows, and they vaguely hope to one day get their money back through dividends or stock buybacks or mergers. They can't make you share the profits in any direct way, [1] but a share of the profits is what they want. And while there is no guarantee of what they'll get, there is also no limit to it: If they buy 1% of the stock when the company is worth $10 million, they put in $100,000; if they then sell when the company is worth $100 billion, they get back $1 billion. That's hard to do with debt.

These different economics come with different legal regimes. Broadly speaking, creditors have a specific contract — a bond indenture or loan agreement — saying how much they are owed, and they are entitled to what's in the contract. If the company breaches the contract — if it doesn't pay them what it owes when it owes them, or if it doesn't do something else required by the agreement — then the creditors can sue and get their money back or put the company in bankruptcy. But if the company doesn't breach the contract, then the creditors can't complain.

And so we have talked occasionally around here about various sorts of debt shenanigans, where a company's lawyers (or some of its creditors) read the debt contracts cleverly and say "hey, technically, this contract allows us to make life much worse for some of our creditors, we can work with that." Generically, the way that this often works is that the company takes some value from 49% of its creditors and gives it to the other 51%, in exchange for more money or flexibility. And then the 49% creditors sue, saying "that's not fair, you can't do that, that's not allowed by the agreement," and the company says "no, actually, this paragraph says we can do that," and there is a highly technical argument over what precisely the language of the contract allows.

Equity is different. Shareholders have much less in the way of contractual rights; they don't have much legal right to force the company to do anything specific. But there are broad fiduciary duties requiring company executives not to put one over on shareholders, to treat shareholders fairly, to run the business on behalf of all of the shareholders equally. The shareholders are not entitled to specific stuff, but they are entitled to general fairness.

Last year, in this column, I wrote about a weird merger deal where a buyer was trying to pay some of the target shareholders more than others. My basic point was that you mostly can't do that — there are some exceptions, but generally speaking the board of directors of a company has an obligation to treat its shareholders fairly, and courts will get annoyed if it doesn't. And then in the next section of that column, we talked about some lawsuits over distressed debt shenanigans. "In debt, the rule is different," I wrote. Treating creditors unfairly is generally fine:

The basic question in these cases is: Can you just read the debt documents as craftily as possible, do whatever is strictly allowed by the text, and benefit some creditors at the expense of others? Or is there some background requirement of fairness or "oh come on it can't have meant that," so that your craftiest readings don't actually work? The traditional view is that shareholders are entitled to fiduciary duties — which is why mergers have to be more or less fair to all shareholders — while creditors are entitled only to the letter of their contract. That traditional view has given rise to, you know, all this: a whole industry of distressed-debt cleverness built on structuring transactions to exploit the documents as much as possible. I suppose it is possible to take it too far, though: If creditors get too good at ruthlessly exploiting each other, eventually courts might step in and say "oh come on it can't have meant that." If a rule like "creditors are only entitled to what their contract explicitly says" always leads to absurd results, it might stop being the rule.

One important move in modern finance is that you have some asset with some expected cash flows, and you slice up the cash flows and sell them to investors as securities. This allows the assets to be financed, the risks to be allocated, ownership to be shared, etc.

One important move in postmodern finance is something like "let's turn gambling into securities and securities into gambling." Like:

1. Gambling is fun, but kind of frowned upon. 2. Financial markets are huge business, but kind of serious and daunting.

If you can take a stock and turn it into a fun gambling game, you've got something. If you can take a fun gambling game and turn it into serious securities, you've got something.

I used to be a corporate equity derivatives investment banker, which means that I'd go to companies and try to convince them to buy or sell options on their own stock. If you read a finance textbook, you will get the impression that derivatives are mostly about risk management, about hedging and speculation: People who own stock buy put options to protect themselves agains price declines, or sell call options to transform some of their potential upside into cash now; people who don't own stock buy calls to take some cheap stock-price risk, etc.

This describes almost none of what I was selling to these companies. What I was selling, much of the time, was tax deductions: We could build you a derivative that, sure, had the economic properties of some call options, but that took advantage of technical tax rules to get you extra deductions. Other times I was selling accounting treatment: We could do a thing that had the economic properties of buying back stock, but that took advantage of technical accounting rules to juice your earnings per share a bit more. Or I might be selling something like securities-law compliance: If you had some legal restriction on your ability to buy or sell stock, you could buy a derivative from us that was economically like buying or selling stock, but that avoided those restrictions.

In my line of work, derivatives were essentially about regulatory arbitrage: There were some complicated rules, created by legislators or regulators or accounting standards-setters, and those rules had the effect of rewarding some things and penalizing other things. And our job was to find a way to take something that the rules penalized and turn it into something that the rules rewarded, without changing its economic substance too much.

A famous example. The US tax code discourages short-term trading and encourages long-term investing. If you borrow a lot of money to rapidly trade stocks, you will be penalized, paying short-term capital gains rates. If you buy a long-term call option on a variable basket of stocks that you have management rights over, you will be rewarded, paying long-term capital gains rates. If you notice that those two things are the same, you can have a lucrative career as a derivatives structurer. (And get in trouble: This is the Renaissance Technologies tax trade, and it ended up not working.)

The lesson that I learned from my career as a derivatives structurer is that much of finance is about this sort of regulatory arbitrage. Economic life is socially constructed, society has rules, and you can make use of the rules to make money.

Sometimes the rules change and particular businesses get harder. But there is a sort of conservation law at work; the rules for complex systems have to be somewhat complex, and if you have mastered the current complexities you can probably figure out how to make money off new and different complexities. Tax trades sometimes get shut down by new tax rules, but that doesn't put tax structurers out of work; they're the ones who are best positioned to figure out the new tax trades enabled by the new rules.

Sometimes some whole new area of economic life gets brought into the domain of rules, and a new industry springs up to game it. In my lifetime, environmental, social and governance investing went from an academic idea to a huge business with all sorts of competing and economically important regulatory and accounting regimes, and so there are lots of people in the financial industry working on ESG arbitrage. "ESG Consultant But Evil," I sometimes call this job, and we talked last week about how companies whose business is cutting down trees can get environmental credit for the trees they don't cut down. That is the purest form of financial engineering: Some accounting regime exists that rewards you for not cutting down trees, you are in the business of cutting down trees, and you find a way to make cutting down trees look, for the relevant accounting purposes, like not cutting down trees.

More rarely, some set of rules will go away or be simplified in a way that really does demolish someone's business niche. For instance, there is, in the US, a rule saying that bank accounts are insured by the Federal Deposit Insurance Corp. up to $250,000. FDIC insurance is valuable, but you cannot pay the FDIC directly for the amount of insurance that you want: If you have $250,000 in your bank account, it is all insured without you doing anything; if you have $2,500,000, it mostly isn't, and that's just that. But of course you can open 10 accounts at 10 banks and put $250,000 in each of them; then they will all be insured. If you have $25,000,000, you can open 100 accounts at 100 banks, but that is pretty annoying. But someone else can open 100 accounts for you at 100 banks, and put $250,000 in each of them, and charge you a fee. That intermediary is selling you FDIC insurance, and charging you a fee for it, because it has found a (fairly straightforward) way to structure around this one FDIC rule.

And that really exists and is a business ("brokered deposits"). And if the FDIC tinkered with its rules in some way — if it changed the rules so that all of a household's bank accounts at one bank counted together toward the limit, or so that checking and savings accounts at the same bank counted separately, or whatever — then probably the intermediaries who currently sell this product would be best positioned to sell a revised product to comply with the new rules; they are the experts at FDIC insurance cap structuring.

But if the FDIC did away with the limit entirely they'd be out of business. David Dayen reports:

Legislation has been proposed to uncap deposit insurance. And that has prompted the private equity–owned company that is one of the main beneficiaries of the cap to spring into action.

A company called IntraFi offers two products that allow large depositors to spread their money among a network of hundreds of banks, each with accounts that don't exceed the cap and are therefore effectively covered in full by deposit insurance. The company takes a fee for facilitating these "brokered deposits." If deposit insurance were uncapped, their business model would be worthless.

The prospect of uncapping has the extremely well-connected officials at IntraFi scrambling. In the first quarter of 2023, when Silicon Valley Bank was shuttered, IntraFi tripled its lobbying expenses and hired a firm known for its access to senior congressional leadership. The new lobbyists who registered to work for IntraFi have experience with senior members of Congress, as well as the Trump and Obama White Houses. It's a full-court press to maintain a lucrative status quo. …

Brokered deposits have been heavily criticized by former FDIC chair Sheila Bair, who described them as "just gaming the FDIC rules. The FDIC takes all the credit risk, and Promontory [IntraFi's predecessor] gets the profit."

Sure, yes, I don't disagree, I'd just point out that "[product] is just gaming the [government agency] rules; the government takes all the credit risk and [company] gets the profit" describes a surprisingly large portion of finance!

In the US, investments are mostly either public or private. Public investments are things like stocks that trade on the stock exchange, and anyone can buy them. Private investments are not traded on the stock exchange, and for the most part you need to be an "accredited investor" to buy them. "Accredited investor" is a legal category; it is mainly a wealth/income test — if you make $200,000 a year or have at least $1 million of net worth, you're probably accredited — though you can also be accredited if you have certain securities licenses.

The basic tension in the regulation of private investments is that most of the best investments are private, and most of the worst investments are also private. US public companies tend to be large, mature, profitable, stable and well regulated; they rarely vanish overnight due to fraud, but their fastest-growing days are generally behind them by the time they go public. The fast-growing exciting companies, the ones that will be the dominant public companies of the future, the next Googles or Apples or whatever, are mostly private. Also though the unaudited frauds: all private.

One way that this tension plays out is that sometimes people argue that the accredited investor rules should be loosened, so that more people can have access to fast-growing private companies, and then other people argue that they should be tightened, so that fewer people can have access to frauds. I have argued in the past that expanding the accredited investor rules will mostly give people more access to frauds, because private investments are generally invitation-only, and the next Google is not really looking to raise money from just-barely-accredited retail investors.

We talk from time to time around here about the cash-flow-slicing business. The way it goes is:

1. You have some business that will make somewhere between $75 and $150 next year. 2. You can sell it to one owner who gets the cash flows from the business. If it makes $75, she gets $75; if it gets $100, she gets $100; if it gets $150, she gets $150; etc. 3. Her ownership stake is worth some amount of money, presumably between $75 and $150. Let's say it's $100. She would pay $100 for this ownership stake. 4. Or , you can divide up the cash flows. A senior bondholder gets the first $50 of cash flows: If the business makes $75, she gets $50; if it makes $150, she gets $50. A junior bondholder gets the next $30: If the business makes $75, he gets $25; if it makes $80 or $100 or $150, he gets $30. And then a shareholder gets whatever is left, whatever the business makes above $80: If it makes $75 or $80, she gets zero; if it makes $100, she gets $20; if it makes $150, she gets $70. 5. Here, the senior bond is much safer than the unitary ownership claim: In Steps 1-3, the owner puts up $100 and could lose money (get back $75) or make money (get back $150) or somewhere in between, but in Step 4, the senior bondholder always gets back $50. The junior bond is also safer than total ownership, with less variance in its returns: It gets back $30 in almost every case, unless things go quite badly. The shareholder in Step 4, though, takes much more risk than the total owner in Steps 1-3: The total owner always gets back at least $75, while the levered shareholder here might get back $0. 6. You can sell the senior bond plus the junior bond plus the shares for some amount of money, presumably between $75 and 150. Let's say it's $105. 7. $105 is more than $100 so this is a good trade. You have created $5 of value by slicing the cash flows.

This is one of the main things that happens in finance. It describes how companies work — they issue debt and equity, etc. — and your mortgage, and banks. In its purest form, where you just have some set of cash flows and you slice them up into junior and senior claims, it is often called "securitization," or "structured finance."

Why would this work? Why would the sliced-up claims (senior bonds, junior bonds, shares) be worth more ($105) than a single unitary claim ($100)? There is a famous theorem saying that it shouldn't work, that the value of the cash flows shouldn't depend on how you slice them up. But of course people do slice them up. [1] At least sometimes, it seems, there is more demand for a very safe cash flow plus a very risky cash flow than there is for a single blended kinda-risky cash flow.

Why would that be? You could tell psychological stories, stories about conservative investors wanting safe assets and aggressive investors wanting risky assets and nobody wanting stuff in the middle. But it is often useful to think about a story of ratings and regulation. Schematically:

1. You are a bank or an insurance company; you are in the business of taking money (deposits, premiums) from customers and investing it until they need it. You use the money to buy investment assets, and you make money if the assets return more money than you need to give back to the customers. Your regulators require you to have a certain amount of capital: For every $100 of assets that you own, you can have, say, $92 of deposits and $8 of your own money. The $8 is your capital. 2. But the regulators "risk-weight" your assets: Really, you need capital equal to 8% of your risk-weighted assets, and different assets count differently. US Treasury bills might get a 0% risk weight: You can buy $100 of Treasury bills with $100 of deposits and $0 of capital. Business loans might get a 100% risk weight: You need $8 of capital to buy $100 of loans. Bitcoin might get a 1,250% risk weight: You need $100 of capital to buy $100 of Bitcoin; you can't use depositor money at all. 3. Capital is, by general agreement, expensive. All else equal, you would rather buy $100 of assets with $99 of deposits and $1 of your own money than with $80 of deposits and $20 of your own money. On the other hand, you'd rather buy higher-yielding assets than lower-yielding assets. Higher-yielding assets are often riskier, which means they have higher risk weights and require more capital. 4. Your job is to optimize this: You want to get the highest yields with the lowest capital requirements. If there are two investments with the same risk and returns, but one of them has lower capital requirements, you should choose that one. 5. Someone offers you an attractive, kinda risky investment. It has a 50% risk weight. If you buy $100 of it, it counts as $50 of risk-weighted assets, so you need $4 of capital. 6. Some financial engineer finds a way to slice that investment into a very safe senior bond and a very risky equity investment. The slicing produces 80% senior bond and 20% risky equity. The senior bond has a 0% risk weight — it's as good as Treasury bills — and so requires $0 of capital. The very risky equity has a 200% risk-weight: If you buy $20 of it, it counts as $40 of risk-weighted assets, so you need $3.20 of capital. 7. You buy $80 of the safe bond and $20 of the risky equity, so you need a total of $3.20 of capital. You have saved $0.80 of capital. 8. But you bought the same thing. You had $100 of stuff that required $4 of capital, you sliced it into an $80 tranche and a $20 tranche, and somehow magically those two tranches add up to require $3.20 of capital.

It is not quite true that the story of the 2008 financial crisis is "instead of making mortgage loans, holding them, giving them a 50% risk weight and holding 4% capital against them, banks made mortgage loans, sliced them up into securitizations, bought highly rated tranches of them, and held much less capital against them," but it is kind of true, and worth keeping in mind.

Similarly, if you are an insurance company, some private equity firm might come to you and ask you to invest $100 in a private equity fund or a high-yield private credit fund. And you will say, sure, sounds great, but I am a regulated insurance company, and my regulators prefer that I mostly invest my money in safe bonds. I can do some private equity investing, but not too much; mostly I just buy bonds with good credit ratings.

And then the PE firm will say: Okay, what if we sliced our fund into junior and senior tranches? You can invest in both. The senior tranche is a bond , which pays back your money with interest as long as our private equity fund doesn't perform disastrously. And the junior tranche is an equity upside stake, which pays back whatever the return on the fund is, minus whatever the bond pays. You put, say, $80 into the bond and $20 into the equity stake.

This is the same thing: Buying a whole stake in the fund is economically identical to buying (1) a senior claim on the fund plus (2) a junior claim on the fund; you are just slicing up the cash flows. But now you can go to your regulator and say "oh no it's not $100 of equity; it's $20 of equity and $80 of bonds." Your regulator is much more comfortable with you buying bonds than buying equity, so you get better regulatory treatment and can do more of it. You go and get the bonds rated by a credit ratings firm, and from your regulator's perspective you have transformed $100 of risky scary private equity investment into (1) $80 of safe A+ rated corporate bonds plus (2) $20 of risky scary private equity investment.

The way that the modern US economy works is that if you want to buy a car from me, and I want to sell you the car, then you have to give me money, and I have to give you the car, and also we have to do a mysterious third thing in which we perform a magic ritual to coax my spirit to depart from the car so that your spirit may enter it. That magic ritual requires a bit of shaved unicorn horn, and for supply-chain reasons there is a unicorn-horn shortage, so no one can buy cars:

Now, some states are warning that the specialized paper used to print vehicle titles has gotten hard to find. Government agencies are rationing stashes and extending wait times for flummoxed dealers and car owners.

The problem isn't with the states that issue the documents. It is with the companies that make the paper, which contains features such as watermarks and security threading to prevent counterfeiting. Consolidation in the industry has reduced the number of companies making it.

Dealers usually need titles to transfer ownership to buyers, and car owners need them to prove legal ownership when they register them, resell them or trade them in. Insurance companies typically require them to process claims. …

State officials in Michigan, South Dakota and Oklahoma have taken steps to conserve supplies, including giving priority to buyers who require a title to sell a vehicle, and asking dealers to hold off on applying for a title until after a purchase is final, the officials say.

Robin Shrake, a county treasurer in South Dakota, has been hearing by phone from angry and confused drivers, including some who have lost their titles, since the state's department of revenue revealed in November that title paper would be in short supply until next year.

"This is so out of our hands," says Ms. Shrake. "We cannot do anything about it without paper. This is like making a cake without eggs."

It's not really? Like, you put the eggs into the cake? They are an ingredient, part of what makes the cake a cake? Whereas you do not use the title paper to make or power the car? Like I feel like it is within the scope of human ingenuity to find a way for one person to give another person a car without the use of special paper with security threading? It is all almost enough to make you wish for a —

The basic move in finance is:

1. You have some cash flows. 2. You put them all into a box. 3. You slice the box into junior and senior claims. 4. You sell the senior claims to people who want safe cash flows, and the junior claims to people who want exciting leveraged risk.

Everything is like this: Every company does some business that brings in some cash, and the cash goes first to pay off the company's debt (its senior claims), and if there's cash left over it goes to the company's shareholders (the junior claimants). Lending money to the company is safer than buying its stock, because you get paid back first, but buying the stock has more upside.

But you can do this with lots of other cash flows, and it has come to be known as "securitization." Most famously, you have a bunch of subprime mortgage bonds, you put them into a collateralized debt obligation, you slice it into junior and senior tranches, you get the most senior tranches rated AAA and sell them to banks seeking safety, you leave the most junior tranches unrated and give them to people who want a lot of mortgage risk. This became the template for this sort of thing, so "collateralized obligation" became the standard term: collateralized debt obligation (CDO) for mortgages, collateralized loan obligation (CLO) for corporate loans, etc. In 2008, CDOs caused problems, and the market for subprime mortgage CDOs still hasn't recovered. But there are still lots of other cash-flow-slicing businesses, many of them using the CO terminology, and you can still occasionally read articles about how "the same technology that caused the 2008 mortgage crisis is coming for" some other business.

Much of this involves taking medium-safe cash flows and parceling them into very safe and pleasingly risky cash flows. A subprime mortgage will probably get paid back, but the appetite for probably-get-paid-back mortgage risk seems to be less than the combined appetite for (1) very very safe senior mortgage risk plus (2) riskier but higher-yielding mortgage risk. Same with leveraged corporate loans or fast-food franchises or whatever. But you can do it with very risky stuff, if you want. We previously talked about this basic move — put stuff in a box, issue junior and senior claims — as a way to create decentralized stablecoins in crypto. You put $2 worth of risky cryptocurrency in a box, you issue a $1 senior claim on the box and call it a "stablecoin" that is always worth a dollar, and you give someone else a $1 levered risky crypto bet. If the $2 worth of cryptocurrency rises to $5, the levered junior claimant does well; if it falls to $1, the levered junior claim is wiped out but the stablecoin is still worth $1. If the $2 worth of cryptocurrency falls to $0.0001, as happens, then the stablecoin is no longer stable, oops.

Every few years I read someone proposing to do this with stocks. Like, put the S&P 500 Index in a box, issue senior claims that pay interest and are pretty safe, issue junior claims that are a levered bet on stocks, I don't know, like a securitized index margin loan. Fine.

Anyway here's the Financial Times on collateralized fund obligations:

The product is known as a "collateralised fund obligation" and its aim is to diversify risk by parceling up the companies providing returns. CFOs are, in some ways, a private equity variant of "collateralised debt obligations", the bundles of mortgage-backed securities that only reached the public consciousness when they wreaked havoc during the 2008 financial crisis. …

The vehicle exposed to Envision is one of several CFOs launched by Azalea, an independently-run unit of the Singapore state-owned investor Temasek. It is more transparent than most because it is offered to retail investors, though Azalea does not tell those investors which portfolio companies they are exposed to, citing "confidentiality obligations".

In effect, the CFO is a box containing stakes in 38 private equity and growth funds that Azalea committed money to. The funds are managed by many of the industry's biggest names including Blackstone, KKR, Carlyle and General Atlantic. ...

The CFO issues senior and junior bonds, which can be bought by retail investors and which offer fixed interest payments of 4.1 per cent and 6 per cent. When the 38 funds hand cash to their investors, the CFO uses it to make interest payments, then holds some back in a reserve account designed to ultimately pay off the principal.

Any remaining cash, after debt repayments and expenses, goes to the holders of the CFO's equity, in this case Azalea itself. Owning the equity is "nothing more than a levered investment into private equity", says Jeff Johnston, chairman of the Fund Finance Association.

S&P Global and Fitch rate the senior bonds in Azalea's CFO as A+, an investment-grade rating that means it is deemed unlikely to default, and is far higher than the typical junk-grade ratings of individual private equity-owned companies.

Azalea told the FT that it structured transactions with "downside risk mitigation in mind", using "conservative" loan-to-value ratios and putting "various structural safeguards" in place to protect investors.

Another, funnier sort of financial innovation is about subtracting liquidity. If you can buy and sell something whenever you want at a clearly observable market price, that is efficient, sure, but it can also be annoying. Consider the following financial product:

1. You give me the password to your brokerage account. 2. I change it. 3. You can't look at your brokerage account for one year, because you don't have the password. 4. At the end of the year, I give you back your password and you pay me $5.

Is this a good product? For me, sure, I got $5 for like one minute of work. [1] For you, I would argue, it's also pretty good. For one thing, you avoid the stress of looking at your brokerage account all the time and worrying when it goes down. For another thing, you avoid the popular temptation of bad market timing: You can't panic and sell stocks after they fall, or get greedy and buy more after they rise, because I have your password. "It is well known that one of the best services a retail broker can provide is not answering the phones during a crash," I once wrote; in this product I am charging you for that service. Your mileage will vary — perhaps you are good at market timing — but this service might well be worth more than $5 to you.

There are variations. For instance, if you have borrowed money to buy a stock, and the stock's market price drops a lot, you will get a margin call from your broker asking you to put up more money. If you don't have the money handy, the broker will sell the stock, and you will have lost money. If the market price then recovers, you will regret it. If you could buy a service that was, like, "if the price of my stock falls by more than 10%, we shut down the stock market and wait until the stock goes up again," then that would probably be useful to you. [2] In general that is not a service that you can buy, [3] but it is kind of a service that some people can buy. Xiang Guangda is a big metals tycoon, and he shorted a lot of nickel on the London Metals Exchange, and the price of nickel went up and he had huge losses, and the London Metals Exchange shut down nickel trading for a week or so so that the price could go down and he could avoid most of those losses. That was a very helpful service that the LME provided to him; they helped him out a lot, on his nickel trades, by shutting down nickel trading.

Or we have talked about a fun post from Cliff Asness titled "The Illiquidity Discount," in which he argues that private equity is essentially in the business of selling illiquidity. If you are a big institution and you buy stocks in public companies, the stocks might go down, and you will be sad for various reasons. You might be tempted to sell at the wrong time. You will have to report your results to your stakeholders, and if the stocks went down those results will be bad and you will get yelled at or fired. Whereas if you put your money in a private equity fund, it will buy whole public companies and take them private, and then you won't know what the stock price is and won't be able to sell. The private equity fund will send you periodic reports about the values of your investments, but those values won't necessarily move that much with public-market stock prices: The fund will base its valuations on its estimates of long-term cash flows, and those will not change from day to day. By being illiquid, the private equity fund can look less volatile. Getting similar returns with less volatility is good; getting similar returns and feeling like you have less volatility also might be good. [4] Asness writes:

If people get that PE is truly volatile but you just don't see it, what's all the excitement about? Well, big time multi-year illiquidity and its oft-accompanying pricing opacity may actually be a feature not a bug! Liquid, accurately priced investments let you know precisely how volatile they are and they smack you in the face with it. What if many investors actually realize that this accurate and timely information will make them worse investors as they'll use that liquidity to panic and redeem at the worst times? What if illiquid, very infrequently and inaccurately priced investments made them better investors as essentially it allows them to ignore such investments given low measured volatility and very modest paper drawdowns? "Ignore" in this case equals "stick with through harrowing times when you might sell if you had to face up to the full losses." What if investors are simply smart enough to know that they can take on a lot more risk (true long-term risk) if it's simply not shoved in their face every day (or multi-year period!)?

One objection to this sort of financial product — illiquidity provision — is that it does not generate a lot of transactions. If you work at a bank and you think of a product that will cause customers to trade bonds or houses or diamonds more often, then it is pretty easy to figure out how to make money from that product. (Do the trades for the customers, and take a commission.) If you work at a bank and you think of a product that will cause them to trade less often, it is harder. Basically you have to charge them a bigger fee for doing less work. "We'll give you a bond fund that offers instantaneous liquidity and transparent market prices and charge you five basis points a year, or we can give you a different fund that offers no liquidity and only updates prices when we feel like it, and that's gonna be 200 basis points."

Finance rewards cleverness. Sometimes this is true in a pleasingly positive-sum way; if you can cleverly think up a new way to slice cash flows or allocate risk then you can get rich by increasing economic activity. Often, though, it is true in some straightforwardly zero-sum way: If you have a contract with a counterparty, and you cleverly ferret out a hidden provision in the contract that says that your counterparty has to give you $10 million, then you get $10 million and they lose $10 million.

We talk quite a lot around here about those stories. Lots of market structure, for instance, falls into this category: If you find a way to buy stock a bit before someone else does, you win and they lose, but not necessarily in a way that makes the world better. It's just a game that you're playing with each other. Or: People finding clever readings of credit-default swaps was a big theme of this column for a few years. Someone buys CDS to bet against (or hedge) the credit risk of a company, and someone else sells them that CDS to bet on the credit of that company, and then the buyer and the seller separately go to the company and say "hey if you press this button right here our counterparty will have to give us $50 million and we'll give you $20 million of it," and the company is like "who are you? Sure, I guess," and it is weird. There are intersections between this stuff and the real economic world — I think that sometimes it is net good for the world, and other times it is net bad — but it mostly feels pretty abstract. Some hedge funds are trying to trick each other using finance and that's just their business.

There are, in the traditional financial system, constraints on this sort of cleverness. Obviously one set of constraints is, like, it is hard to find arbitrages in markets or flaws in contracts, and the people on the other side are also smart and have good computers and good lawyers and are trying to trick you too. Still, sometimes you will find a winning trade.

Even so, though, there are a lot of external constraints, constraints of laws and norms. If you find a flaw in a contract that says your counterparty has to pay you $50 million, she might say no. And you might go to court over it, and point to the language that says she has to pay you $50 million, and the judge might say "what, no, this is stupid, it can't have meant that, get out of here." The judge will refer to vague ideas — equity, the intent of the parties, the covenant of good faith and fair dealing — to reject your clever reading of the contract. And then you won't get your $50 million. There is some amount of cleverness that is too clever.

Or if you find some really clever market-structure trick, some button that you can push to reliably make money on every trade, a regulator might show up and accuse you of "market manipulation." That is a somewhat ill-defined concept, but if you are reliably making money on every trade by being cleverer than your counterparties, there's a decent chance that you are guilty of it. (And in fact the US Securities and Exchange Commission seems to think that causing a "manufactured default" in CDS — asking a company to push a button to make your CDS counterparty pay you — is illegal market manipulation.)

Or: About a decade ago, some electricity traders at JPMorgan Chase & Co. read the rule book of the electricity market really closely and noticed that the rules would reward them for insanely uneconomic activity. They did this insanely uneconomic activity, and were richly rewarded. And then they were even more richly fined by regulators. I once wrote about this case:

JPMorgan read the rules carefully and greedily, and exploited the rules. It did this openly and honestly, in ways that were ridiculous but explicitly allowed by the rules. The Federal Energy Regulatory Commission fined it $410 million for doing this, and JPMorgan meekly paid up. What JPMorgan did was explicitly allowed by the rules , but that doesn't mean that it was allowed. Just because rules are dumb and you are smart, that doesn't always mean that you get to take advantage of them.

At some very high level of generality, there are the explicit rules — the words of the contract, the mechanisms of the stock exchange, etc. — and then there is a background set of fairness norms. And if you find a way to make a ton of money with a too-clever reading of the explicit rules, the background fairness norms will kick into gear and you will get in trouble. Following the rules is good, but following the rules to absurd places is bad, perhaps a crime.

In crypto … yeesh. In crypto, explicit rules are very popular, and are often coded into computer programs. The rules of a decentralized finance market will be embedded in open-source smart contracts, and you can read them, and if you find a clever way to exploit them — to "hack" the smart contract, or to "manipulate" the market, to use loaded, traditional terms — then you can do that, quickly and efficiently and at scale.

But crypto is also very young , as an industry, which means two things:

1. All these smart contracts were written 20 minutes ago, they do not have many years of testing, and some of them will have big flaws that someone can exploit. 2. There is not long-standing agreement on some set of background norms about what to do when that happens.

And so sometimes there will be a "hack" or "exploit" in crypto and people will say "hey that's great, the contract worked as written, you're not allowed to complain." (Thus the scare quotes around "hack" and "exploit": Some people will deny that those loaded terms apply.) Other times, people will say "this is unacceptable," and everyone will get together to reverse the transactions and act like they never happened. Other times, people will say "hey let's call the police," and perhaps the police will come and arrest the "hacker" for hacking or market manipulation or whatever. There are other possible outcomes. I wrote yesterday, somewhat fancifully, about decentralized autonomous vigilantism as a possible solution to crypto hacks.

Still there does seem to be a developing norm that says "if you hack a decentralized finance protocol and run off with a bunch of money, you can keep some of it as a reward for your cleverness, but you have to return most of it because keeping it all would be mean and perhaps a crime." The model is a "bug bounty," though sort of after the fact: If you find a flaw in a protocol's security, they should pay you a reward for pointing it out, but you should not get to take all their money.

Here is a simplistic, wrong, but almost plausible history of stock-market investing:

1. Stock markets were invented to let people finance productive businesses and share in the profits. You and 100 other people give a railroad company some money to build tracks, it builds tracks, it runs trains, it makes money, it pays you all a nice 7% dividend out of the money it makes. 2. Markets quickly became a way for people to gamble on speculative ventures. You couldn't get a ton of financial information about those investments, so you were just guessing which ones were good. You bought stocks because you thought other people would buy them. "The professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced," wrote Keynes in 1936. "The actual, private object of the most skilled investment today is 'to beat the gun,' as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow." If you wanted to analyze how much to pay for a stock, you would concern yourself with questions of mood. You would "read the tape," get a sense of how the market felt , and then buy if you thought people were going to be bullish and sell if you thought they'd be bearish. The profits of the underlying business might affect the mood, but they were not your primary concern. The mood was. 3. But in 1934, Benjamin Graham invented discounted cash flow analysis,[1] and stocks became (again) a way to bet on the future profits of productive enterprises. If you wanted to analyze a stock, you'd analyze its operations and build a spreadsheet and predict its future financial results and do some math to those results to get a current value. If the value was higher than the price, you'd buy the stock. There were reasons that this approach became dominant. The crash of 1929 and the ensuing depression meant that the mood was bad , so investing in productive businesses was relatively more attractive than betting on mass enthusiasm. The creation of the modern US system of securities regulation in the 1930s meant that stock manipulation was harder to do, while getting financial information about companies was easier: You actually could analyze cash flows. But, also, doing math to sober business analyses just seems more professional. If investing is a game of mass psychology and gambling, then it is not quite respectable to make your living from it. If investing is a business of building complex quantitative models to allocate capital to its best uses, then it is much more reputable and impressive, and you can hire lots of Harvard applied-math majors to do it. 4. In roughly 2021 the pendulum swung back again. Now the way you invest in stocks is by guessing which stocks other people will want to buy, math and financial statements are worthless, and the reputable finance businesspeople keep getting blown up by online gamblers.

One great theme of the post-2008 financial world is that money is a social construct, a way to keep track of what society thinks you deserve in terms of goods and services. That has always been true, but modern finance has made it more obvious. I think that 15 years ago it was easier to think that money was an objective fact. Money is a kind of stuff, you might have thought, stuff with some predictable value that you can exchange for goods and services, and you can acquire a quantity of it and then you own that money and can use it however you like to buy things.

But the response to the 2008 global financial crisis, and to its later European aftershocks, made it clear that something else was going on. Who has money and what they can do with it can be adjusted by the actions of central banks and national treasuries; banks can be bailed out; costs can be socialized. The fiscal response to Covid-19 reinforced this point: Money is a tool of social decision-making, not an objective thing that you get through abstract merit.

There has also been the enormous rise of cryptocurrency, which taught two somewhat opposite lessons about this theme. On the one hand, the value of cryptocurrency is so clearly socially constructed: A Bitcoin was worth roughly nothing a decade ago, and roughly $41,000 today, solely because people collectively decided to ascribe value to Bitcoin. Bitcoin provided a clear and salient example of the fact that money gets its value from people agreeing that it's valuable.

On the other hand, though, crypto enthusiasts have always pitched it as a way around the traditional methods of social construction of money. Crypto is unregulated money, censorship-resistant money, money whose value is not subject to the whims of a central bank. These claims are not always true in practice — as crypto has become more valuable and more integrated with the mainstream financial system, it has become more subject to the same sorts of regulation — but they do highlight how the traditional system works. "Money is only useful if the government lets you use it" is now a thing that a lot of people believe, though often with the corollary "but Bitcoin fixes that."

What I want to suggest is that society is good , that it is good for people (and countries) to exist in a web of relationships in which their counterparties can judge their actions and punish bad actions. If money is socially constructed and property is contingent then money is a continuing, dynamic, ever-at-risk reward for prosocial behavior. I have in the past quoted J.W. Mason on money as a social scorecard:

In the classroom, one of the ways I suggest students think about money is as a kind of social scorecard. You did something good — made something somebody wanted, let somebody else use something you own, went to work and did everything the boss told you? Good for you, you get a cookie. Or more precisely, you get a credit, in both senses, in the personal record kept for you at a bank. Now you want something for yourself? OK, but that is going to be subtracted from the running total of how much you've done for the rest for us.

People get very excited about China's social credit system, a sort of generalization of the "permanent record" we use to intimidate schoolchildren. And ok, it does sound kind of dystopian. If your rating is too low, you aren't allowed to fly on a plane. Think about that — a number assigned to every person, adjusted based on somebody's judgment of your pro-social or anti-social behavior. If your number is too low, you can't on a plane. If it's really low, you can't even get on a bus. Could you imagine a system like that in the US?

Except, of course, that we have exactly this system already. The number is called a bank account. The difference is simply that we have so naturalized the system that "how much money you have" seems like simply a fact about you, rather than a judgment imposed by society.

The judgment of society can, in all sorts of ways, be bad. Pervasive social credit systems seem dystopian, and you would not really want the U.S. government making day-to-day decisions about who deserves to keep their bank accounts. But another idea is that money can insulate you from the obligations of society, and that is also bad. You get a claim on goods and services by being part of society, and having a big number next to you

If you are a young person with no credit history, or a person with bad credit history, you will want to "build your credit." This consists basically of creating a long record of reliably repaying your debts, so that credit reporting bureaus think you are a good credit, so that banks will happily lend you money, so that you can buy stuff on credit cards and get leases and mortgages and car loans. If you have no or bad credit this is hard, though, since no one will advance you any credit, so you won't have any debts to pay, so you won't build credit.

There are canonical approaches. Banks will give you credit cards with low credit limits so you can start small and build from there. Or they will give you secured credit cards: You put $1,000 in a bank account, you get a linked credit card with a $1,000 limit, the credit advanced to you is secured by the money in your account, the bank takes no credit risk but reports repayments to the credit bureaus, etc.

What if there was a simpler way? Yesterday reader Sark Asadourian sent me a link to a Credit Building product from Canadian fintech Koho, and I haven't stopped laughing about it since. Here is the "How it works" section of the website:

1 Start by subscribing to Credit Building for $7/month in-app

2 Sit back. We'll report your progress to a major credit bureau and help you grow your credit score in just 6 months — without having to lift a finger

3 Ensure there's $7 in your Spendable account each month to cover the subscription fee. That's it!

They will demonstrate to a credit bureau that you pay your bills, by sending you a $7 bill each month, which you will pay. What is the bill for? For demonstrating that you pay your bills. They'll charge you $7 a month for charging you $7 a month. What you get for the $7 is a record that you paid $7. Which could conceivably be worth $7 to you! Possibly this is good for the customers! I cannot stop laughing. This is maybe the best financial product I have ever seen.[13] "For the low cost of $7 a month, you can pay us $7 a month." Everything else is so dull and overelaborated. Imagine being the person who came up with this. Imagine the bright wild gleam in your eye, coming in to work that day to tell your colleagues.

Also though imagine messing this up. You're a young person, money is tight, you sign up for Credit Building, you pay them $7 a month for a few months but then life gets complicated, your account balance gets below $7 and you miss a payment. Do they report that to a credit bureau? Does it hurt your credit? Oh you'd better believe it:

Just as making your payments on time will positively impact your credit score, the inverse is true. Not making your payments on time will hurt your credit score.

To keep it simple: We advise you to let KOHO do all the work after you register. Just ensure there is $7 in your Spendable balance for the subscription fee each month and you won't miss a payment!

Seems harsh!

The way business works is that you have some assets and they're funded by some liabilities. The assets generate some income which you use to pay back the liabilities. You borrow some money, you buy a machine for your factory, the machine makes widgets, you sell the widgets, you get money, you pay back the money you borrowed, you have some money left over as profit, life is good. One way to make more profit is to make the assets worth more, to make them produce more income; if you can tune up the widget machine to make more widgets then you will have more profit.

Another way to make more profit is to make the liabilities worth less. This is the weirder way. If you borrow $100 to buy a widget machine, and the widget machine produces $120 of widgets, then you have $20 of profit. If you go to your lenders and say "instead of $100 what if I paid you back $75?" and they say "sure that's fine no problem" then you have $45 of profit. You got an extra $25 of profit from not having to pay off all your debt. Why would that work? It doesn't generally work. But sometimes it could.

A while back, people sometimes got worked up about how banks were accounting for the changes in fair value of their own debt. Basically if a bank issued a $100 bond for $100, and then its credit got worse and the bond only traded at $95, the bank would say "well we sold something worth $95 for $100 so I guess we have $5 in income" and add $5 to its net income. The result was that when banks had a really bad quarter — when investors started worrying that they were riskier and might fail — their credit spreads increased and they reported billions of dollars of gains due to changes in the value of their debt. (Conversely, when things got better, they reported big losses.)

This feels wrong. Your own credit getting worse doesn't get you more money. People got mad about this, about how the accounting failed to match the reality of the cash flows; eventually the accounting was changed. But if you're a financial engineer this is nothing to get mad about. If you're a financial engineer this is an inspiration. "How can we turn our own credit getting worse into cash ," is the correct question to ask.

Here is one way. You borrow $100 to buy an asset worth $100. You use it for a while, it makes widgets that you sell for a profit. It depreciates, it gets old, it produces fewer widgets. Now it's worth $50. You still owe $100 on the loan. The asset plus the loan are worth negative $50. If you sell them together — the asset and the loan — a buyer should be willing to pay you negative $50 for them. That is, you'd have to pay the buyer to take on the asset plus the loan.

But what if you find a buyer with terrible, terrible credit? The buyer will say "I can buy this asset and it will generate $50 of profits for me, which I will spend. Then I will have to pay off this $100 loan, but — and here's the trick — I won't do that." Eventually the lender will sue the buyer for the money, the buyer will turn their pockets inside out and gesture comically to their lack of money, and the lender will get, you know, nothing.[1]

How much will that buyer pay you for the asset plus the liability? I dunno, probably not $50, but more than negative $50. Maybe they'll pay you $5 for it, which is $55 more than it's worth to you. Maybe they'll value the package at $25 (or $50?) on their books, reporting an immediate gain of $20. Everybody wins! Except, to be clear, the lender. The lender loses $100.

Lenders do not like this sort of thing and they try to avoid it; you probably cannot do this trade with your actual widget-making machine. But there are other sorts of liabilities.

Here's one. The way a natural gas well works is that you drill a well, and then you pump gas out of it for a while, and then it runs out of gas, and then you have to "cap" the well, fill it in with concrete so it doesn't just leak methane into the atmosphere forever. In the U.S., state laws impose this capping requirement on the owner of the well; it is a sort of liability that comes with the well. If you drill a successful well, you get an asset (a hole in the ground that produces natural gas that you can sell for money) and a liability (the obligation to spend money in the future to fill the hole with concrete). Early in the well's life, the asset is worth a lot (it produces a lot of gas) and the liability is worth a little (you will not have to fill it in for many years, so the net present value of the money you will eventually spend to fill it in is low). You open the well and you have a $100 asset and a $5 liability. Good work.

But then you pump for a while and you deplete most of the gas and now the asset is only worth $10 because it won't produce much more gas. And you know that in a year or two you'll have to pay $20 to cap it, so you record that liability at a present value of, you know, $18 or whatever.

But then someone comes to you and says: Look, this well will produce $10 more of gas, and I can sell that gas and make a profit and spend it. And I can do this much slower than you: You will just pump the rest of the gas out and have to cap the well in a year or two, but me, I'm in no rush. I will drag out the process so that I can produce a little gas for like 20 years. Then in 20 years regulators will say "okay time to cap the well" and I will turn my pockets inside out and gesture comically to my lack of money. Maybe I'll say "just give me 20 more years," and the regulators will say okay, because what's the alternative? And then in 40 years, who knows, maybe I'll cap the well, but I'll definitely have spent all the money by then.

How much is that well worth to that buyer? I dunno? Maybe $7? They get $10 worth of gas and have $3 of hassle and expense in deferring the capping liability indefinitely? If they buy it from you for $2, you make a profit — you had the thing valued at negative $8 ($10 asset, $18 capping liability), and now you have sold it for positive $2 — and they make a profit (since they paid $2 for a stream of profits worth $7). Everybody wins! Except, you know, the well never gets capped and methane leaks into the atmosphere forever.

This is apparently a standard business model in the natural gas industry. Big well-capitalized companies drill and operate productive wells, but as the wells get depleted, they are sold to small poorly capitalized companies to get the capping liabilities off the big companies' books. Here is a fascinating story of financial engineering from Bloomberg's Zachary Mider and Rachel Adams-Heard:

American oil executives talk about a food chain in their industry. Big, well-capitalized companies tend to be the ones to drill wells and harvest the first years' production. As output tapers, wells typically change hands a few times, then spend their golden years with a smaller, more financially shaky company. If that company goes broke, there's no money to plug the well. In most states, previous owners aren't liable. That helps explain how an industry that created some of the biggest fortunes and most valuable companies has also produced hundreds of thousands of orphaned wells, with no owner around to clean them up. The Interstate Oil & Gas Compact Commission estimates the number across the U.S. may be as high as 800,000. In August the U.S. Senate approved an infrastructure bill that includes $4.7 billion to begin tackling the problem.

Companies are sort of arbitrary things. You can create a corporation by filling out a form and paying a small fee. You can create as many as you want. If you have three different businesses, you can have three separate corporations, or you can do them all out of one big corporation, or you can do them out of three corporations all owned by one big holding corporation, or you can put a few other corporations in between, whatever. As many as you want.

One important fact about corporations is that they have limited liability: If a corporation owes more money to creditors than it has, it goes bankrupt and the creditors take whatever money it has left. The shareholders of the corporation don't generally owe any extra money. Generally speaking, the value of a corporation's stock can't be less than $0: If you buy stock in a company, and it goes bust, your stock may turn out worthless, but you won't owe anything else.

These two facts — corporations have limited liability, and you can make as many as you want — might give you ideas. Let's say you run a big business in a corporation, Big Co. It has lots of assets and lots of liabilities. Let's say it has $10 billion of assets and $4 billion of liabilities. Big Co. should be worth $6 billion, its net worth, its assets minus its liabilities.

But what if you split it into two corporations? Start one company called Asset Co. and put the $10 billion of assets into it, with no liabilities. Start another company called Liability Co. and put the $4 billion of liabilities into it, with no assets. Asset Co. should be worth $10 billion. Liability Co. has a net worth of negative $4 billion — lots of liabilities, no assets — but a corporation can't generally have negative value to its owners; corporate stock can't be worth less than zero. So let's say Liability Co. is worth $0. Asset Co. plus Liability Co. are worth $10 billion, which is more than they were worth ($6 billion) as a combined company. Good trade!

This is a thing that, mechanically, you could do. For instance:

1. Big Co. creates a new subsidiary, Asset Co. 2. Big Co. contributes all of its assets to Asset Co. in exchange for stock in Asset Co. 3. Big Co. spins off the stock of Asset Co. to its shareholders (as a dividend payable in Asset Co. stock). 4. Big Co. renames itself Liability Co.

Now the former shareholders of Big Co. (worth $6 billion) have become the shareholders of Asset Co. (worth $10 billion) and Liability Co. (worth $0). They are better off. Meanwhile the former creditors of Big Co. are much worse off: When Big Co. owed them $4 billion, it had plenty of money to pay them; now that Liability Co. owes them $4 billion, it has no money, and they won't get paid.

What stops you from doing this? Well, if your liabilities are bonds or bank loans, there will probably be provisions in the contract saying you can't do this — Big Co. can't transfer all or substantially all of its assets, etc. But some liabilities won't have provisions like that. In particular, contingent tort liabilities won't have any contracts at all. If Big Co. got all its money by crashing cars into people or manufacturing asbestos, those people will sue it for money, and in an economic sense those lawsuits will all be liabilities. But they won't be contractual liabilities (at least until you settle); you'll have no agreement with the people suing you about what you're allowed to do with your corporate structure.

Instead, there is a general legal principle about "fraudulent transfers." This is a term of art referring to, you know, this sort of trade: If you have a company, and it owes people money, and you move all the assets out of the company so that it can't pay off its creditors, then that is a "fraudulent transfer" and a court will not allow it. This principle is found in, for instance, Section 548 of the U.S. Bankruptcy Code, as well as in many states' laws in the form of the Uniform Fraudulent Transfer Act.[5] There are specific details and borderline cases to consider, and the law here can be complex, but the point is that the super-obvious trade I laid out above would be a fraudulent transfer and a court would not allow it. The Liability Co. creditors would be able to go after Asset Co.'s assets to get their debts paid.

Here, however, is another form of the trade:

1. Big Co. reincorporates in the state of Texas. 2. Big Co. does a merger into two companies, Asset Co. and Liability Co. Usually a "merger" involves two companies becoming one new company, but Texas law allows a thing called a "divisive merger," in which one company "merges" and becomes two new companies. 3. Asset Co. gets the assets, Liability Co. gets the liabilities, and former Big Co. shareholders get shares of both.

This sounds like the same thing as the spinoff version I laid out above. But it is different in one small weird way, which is that there is a sense among lawyers that a "merger" is not a "transfer." For instance, if Small Co. has a lease on some office space, the lease might say "Small Co. may not transfer or assign this lease," because the landlord wants to deal with Small Co. and not some random other tenant. Small Co. can't just sell the lease to some other company. But if Small Co. merges with Medium Co., that's different: Its corporate form has changed, but the-company-formerly-known-as-Small-Co. is still using the office space and paying the rent, so it would be a little weird to say that it has violated the lease. And so often mergers are not treated as transfers for various relevant legal purposes.

Usually this is fine because a merger means combining two companies into one company, but in Texas a "merger" can mean splitting one company into two companies and things can get weird. As Adam Levitin writes:

Why would it matter that a division is defined as a "merger" under Texas law? Because the Texas Business Organizations Code provides that a merger operates "without ... any transfer or assignment having occurred." The thinking is that if there's no transfer in a divisive merger, then there cannot be a fraudulent transfer.

Is that right? Nobody knows! Levitin goes on:

Now, it is far from clear that Texas's fraudulent transfer law--or any other jurisdiction's--would defer to the Texas Business Organizations Code regarding whether there is a transfer, but there's no law on that point (but it has gotten some consideration in this thoughtful law review comment).

But I guess it's worth a shot:

Johnson & Johnson is exploring a plan to offload liabilities from widespread Baby Powder litigation into a newly created business that would then seek bankruptcy protection, according to seven people familiar with the matter.

During settlement discussions, one of the healthcare conglomerate's attorneys has told plaintiffs' lawyers that J&J could pursue the bankruptcy plan, which could result in lower payouts for cases that do not settle beforehand, some of the people said. Plaintiffs' lawyers would initially be unable to stop J&J from taking such a step, though could pursue legal avenues to challenge it later. ...

J&J faces legal actions from tens of thousands of plaintiffs alleging its Baby Powder and other talc products contained asbestos and caused cancer. The plaintiffs include women suffering from ovarian cancer and others battling mesothelioma. ...

J&J is now considering using Texas's "divisive merger" law, which allows a company to split into at least two entities. For J&J, that could create a new entity housing talc liabilities that would then file for bankruptcy to halt litigation, some of the people said.

The maneuver is known among legal experts as a Texas two-step bankruptcy, a strategy other companies facing asbestos litigation have used in recent years.

It does seem … wrong? Like, obviously, if you run a big company that has big liabilities, you'd like to be able to just get rid of the liabilities. And obviously com

A major problem in finance is that a lot of lawyers became lawyers because they did not like math, while a lot of bankers and traders became bankers and traders because they did not like to read. So lots of financial contracts will consist of 10 or 50 or 200 pages of text, which a lawyer will cheerfully write (or sullenly copy and paste, fine) but which her client will not read, and buried within those pages there will be like three formulas, which the lawyer will write and which might be wrong. The lawyer, who fears math, will write the formula wrong, and her client, who knows math but fears words, will not read it, and so the wrong formula will be enshrined in the contract. (It does not help that the formula will generally be written in words — it will look like a very long sentence rather than a formula — due mostly to typographical limitations. So it won't look appealing to anybody.)

These are both — "lawyers can't do math," "traders can't read" — cruel stereotypes and mostly untrue, so in fact the formulas are rarely wrong. (On my old desk, several of the bankers were ex-lawyers, and our lawyer had an advanced degree in math.) But not entirely untrue, so sometimes the formulas are wrong. We have talked a couple of times about a Ligand Pharmaceuticals Inc. convertible bond where, deep in of a document that no one read, the lawyers put a constant in a formula where they should have put a variable, with the result that instead of paying $700 million the bond said it would pay $5 billion. Oops! This was plainly a mistake: It was not what anyone had agreed to; the formula written in the document did not reflect the economic deal that the parties understood. So Ligand corrected the document, and then some investors sued (you gotta try!), but they lost. You get to correct obvious mistakes, the judge decided.

Or here's an even sillier story from Bloomberg's Tracy Alloway:

In this particular contract (a lease for a term of 25 years), Monsolar agreed to pay annual rent to Woden Park that would increase every year according to inflation as measured by the Retail Price Index, or RPI, one of the two main consumer price indices produced by the U.K.'s Office for National Statistics. The initial amount was set at £15,000 ($20,691) and was governed by a formula for future increases.

That formula, apparently constructed by the landlord himself from examples 'available on the internet,' looks something like this:

Revised rent = Previous year's rent x (May RPI for current year)/(May 2013 RPI)

Perhaps you can see where this is going?

Yeah where it's going is that double-counts: You can adjust for inflation by multiplying last year's rent by the change in the price index since last year, or you can adjust for inflation by multiplying the first year's rent by the change in the price index since inception, but if you adjust by multiplying last year's rent by the change in the price index since inception then you're sort of compounding twice. (If you cobble together a formula based on examples on the internet, you might find yourself doing everything at once.) "By the tenant's calculation, were RPI to increase over the lease term in line with the preceding 20-year average (2.855% per annum) the annual rent payable in the final year of the lease would end up being just over £76,000,000 — a cool $100 million — and by the end of the 25-year lease an increase of some 507,000%."

The tenant sued to change the contract to say what they meant — adjust, once, for inflation — and the landlord said, nah man, you signed the contract, pay us our $100 million. The U.K. court sided with the tenant because you get to correct obvious mistakes, the landlord appealed, and the appeals court also sided with the tenant because honestly come on we live in a society.

Two points here. One is that "honestly come on we live in a society" is a good bedrock principle of the common law; you certainly can't rely on it to protect all of your interests — don't go around signing contracts that you don't mean! — but it tends to soften the blow of the most egregious cases. It is, however, a principle that requires human intervention and common sense; it is hard to automate. Smart contracts on the blockchain can't solve this: If code is law, and the code is wrong, oops, you pay the $100 million.

The other thing is that I can't resist quoting this passage from the appellate decision, describing the original judge's decision[2]:

He proceeded to consider whether it was clear what sch 6 was objectively intended to mean. MonSolar's case was that the drafting mistake should be corrected by reading the Formula as if it read:

"Revised Rent = Original Rent (£15,000) x (May RPI for current year) / (May 2013 RPI)"

Fancourt J however considered that the appropriate correction was as follows:

"Revised Rent = Previous year's Rent x (May RPI for current year) / (May RPI for previous year)"

I will call these "Correction A" and "Correction B" respectively.

No doubt due to the fact that he was having to resolve the issues on written submissions alone, Fancourt J evidently thought that Correction A and Correction B produced different results, and he proceeded to explain why he preferred Correction B. This part of his judgment, with respect, is not entirely easy to understand, but in summary it appears he thought that Correction A would only produce simple increases whereas Correction B would produce compound increases. It is however common ground that the premise is false and that Correction A and Correction B will always produce exactly the same results. This is because RPI itself is in effect compounded, as a simple illustration demonstrates: if an item costing £100 is subject to RPI increases of 2% a year, it will cost £102 after one year and £104.04 (not £104) after two years, and the total RPI increase over the two years will be 4.04% not 4%. So it does not matter whether one calculates the price at the end of year 2 as £100 x 104.04/100 (Correction A), or £102 x 104.04/102 (Correction B). Both produce the same figure of £104.04.

Compounding! Who can understand it? If you get it wrong in your contract and go to court to fix it, what are the odds the judge will understand it?

The next step is to separate this theory entirely from cash flows, companies, etc. Just like: "We have issued shares of nothing, and as long as people continue to buy those shares of nothing at some positive price, our debt will always be money-good." The way an algorithmic stablecoin works is that somebody creates two cryptocurrency tokens, let's call them Dollarcoin and Sharecoin. And they write a white paper that says "Dollarcoins will always be worth $1, and if they are ever worth less than $1 we will print some Sharecoins and sell them to buy Dollarcoins until the price of Dollarcoins goes back to $1, and we can always print an arbitrary number of Sharecoins and sell them for a positive amount of money and use the money to buy Dollarcoins, so Dollarcoins will always be worth a dollar." There is generally a great deal more hand-waving involved than that,[4] but that's the economic heart of it. Is this argument appealing? It is wrong, but is it interestingly wrong? Anyway lol:

Iron Titanium token (TITAN), the share token of a one-time multibillion-dollar decentralized finance (DeFi) protocol, has fallen to near zero.The token was last seen changing hands for around $0.000000035, down from Wednesday's high of $65. The fallout, which has been swift, has brought the project to its knees. ...The project was attempting to boot a partially collateralized stablecoin known as IRON. The stablecoin, in turn, consists of Circle and Coinbase's stablecoin USDC (-0.08%) as well as TITAN and was pegged to $1. Stablecoins are cryptocurrencies whose value is attached to financial assets such as commodities or government-issued currency in a bid to keep them "stable."In the case of IRON, which receives its collateral backing from TITAN, users may mint new stablecoins through a mechanism on Iron Finance's network by locking up 25% in TITAN and 75% in USDC.Due to how the tokenomics of this particular DeFi project functions, when new IRON stablecoins are minted, the demand for TITAN increases, driving up its price. Conversely, when the price of TITAN falls dramatically, as was the case on Wednesday evening, the peg becomes unstable."TITAN's price went to $65 and then pulled back to $60. This caused whales to start selling," Fred Schebesta, founder of Finder.com.au and Iron Finance investor, told CoinDesk via Telegram. "That then led to a big de-pegging of [IRON]"As whales (large bag holders) began to offload their TITAN tokens, they flooded the market with excess tokens, causing a bank run. A bank run refers to a situation when a large portion of users attempt to withdraw their money at the same time believing the bank, or in this case, the protocol, will cease to exist.In turn, as TITAN began to fall in dramatic fashion so did the pegged value of IRON. As whale dumps further decreased the value of IRON, it triggered the stablecoin's mechanism that mints TITAN and removes liquidity in a bid to stabilize IRON to $1.This caused an arbitrage opportunity in the difference in price of IRON and TITAN, which in turn flooded the market with even more TITAN tokens adding additional sell pressure and destabilizing IRON's price even further."It was a crypto vortex of money," said Schebesta.In the beginning, users were receiving an incredible 2%-5% annual percentage rate per day. When the dust settled, TITAN was near zero and IRON was last seen trading way off peg, around $0.69.

If the price of IRON goes down from $1 (good) to $0.95 (bad), you just issue some TITAN (worth $65) to buy some IRON until it's worth $1 again. And if IRON keeps going down, you just issue some more TITAN (worth $60) and buy more. And if IRON keeps going down … [you can fill in some more iterations here] … you just keep issuing TITAN (worth $0.000000035) and at that point you're not accomplishing much. If you could sell 286 trillion TITAN at $0.000000035 each you'd raise $10 million. That's probably hard. There are 285 million IRON (formerly worth $1) outstanding. I am oversimplifying the IRON mechanism — really it's partially algorithmic and partially col

Here's a question for you:

Imagine betting on a horse in a race without properly knowing the past performance or rankings of the horses involved in the race. You could choose to bet your money on a horse called Sonic Thunder or on a horse called Brian the Snail. On which horse would you bet?

I would bet on Brian the Snail, wouldn't you? I have read Nassim Taleb, and studies about investment managers. If you know only that (1) there is a horse race and (2) Sonic Thunder and Brian the Snail are racing in it, it is reasonable to assume that Brian the Snail, with his silly slow name, had to work harder and run faster just to get into the race, while Sonic Thunder probably just moseyed in based on his awesome name. At some point some trainer somewhere was like "hmm Sonic Thunder ran backwards in that race but I am going to give him another chance because Sonic Thunder goes boom," while some other trainer was dragged grudgingly to watch Brian the Snail work out on some dingy fourth-rate track and was like "wait Brian the Snail is the fastest horse I've ever seen." Someone paid an entry fee for both of these horses, and it was harder to get them to pay an entry fee for Brian the Snail, which means that Brian the Snail wanted it more.

I suppose the counter-argument is that, when you name a horse, you don't necessarily know how fast he is but you do know how fast his parents are? Like if you breed two slow horses together and they have a foal you call him Brian the Snail? Of course presumably you're only breeding fast parents anyway, if you're trying to breed racehorses? I do not actually know much about horse breeding.

Anyway it turns out that my betting instinct is correct but unpopular. The question is quoted from "Sonic Thunder vs. Brian the Snail: Are people affected by uninformative racehorse names?" by Oliver Merz, Raphael Flepp and Egon Franck, forthcoming in the Journal of Behavioral and Experimental Economics. Here is the abstract[9]:

This paper examines whether individuals' decision making is affected by fast-sounding horse names in a betting exchange market environment. In horse racing, the name of a horse does not depend on the horse's performance and is thus uninformative. If positive affect towards fast-sounding horse names is present, we expect less accurate prices, i.e., winning probabilities, and lower returns due to the increased demand for these bets. Using over 3 million horse bets, we find evidence that the winning probabilities of bets on horses with fast-sounding names are overstated, which impairs the prediction accuracy of such bets. This finding implies that prices in betting exchange markets are distorted by incorporating affective, misleading information from a horse's fast-sounding name. Consequently, this bias translates into significantly lower betting returns for horses with names classified as fast-sounding compared to the returns for all other horses.

We talk from time to time around here about stocks that go up because people like their tickers; same basic idea really. Anyway there is not actually a Slow Racehorse Name Arbitrage due to transaction costs:

A simple trading strategy of betting against all horses classified as fast-sounding yields a return of approximately 2.9% before the commission but a negative return of −1.6% after deducting the standard commission of 5% from Betfair. This finding could be bracketed under the "limits of arbitrage" argument of Gromb and Vayanos (2010) because the mispricing is not large enough to overcome the transaction costs; thus, potentially misleading or false information is not fully eliminated from prices. Nevertheless, this strategy generates significantly larger returns than a random betting strategy in which approximately zero returns are achieved before commission and a negative return of −4.7% is achieved after the commission is considered. Despite wagering real money, a substantial share of the betting community seems to be systematically biased in preferring bets on fast-sounding horses over bets on other horses.

Just over a year ago, I proposed what I called the Boredom Markets Hypothesis. Retail investors, the theory goes, trade stocks because it is more fun than whatever else they could be doing with their time. Typically it is fun to trade stocks when stocks are going rapidly up, and not especially fun otherwise, so retail investors have a historical tendency to pile into bubbles near the peak. Typically it is pretty fun to do other things, and there are new fun things to do every day, so over time it gets harder and harder for the stock market to compete with other forms of fun. So retail investing has, over the years, lost some market share in the things-people-do-for-fun market, and there has been a rise of index funds and robo-advisers and other ways for people to outsource this no-longer-especially-fun activity.

But the Covid-19 pandemic changed those dynamics: Even though (last April, when we started talking about this) stocks were not doing particularly well, and it was not absolutely all that fun to trade them, it was relatively fun to trade them just because there was nothing else to do. I wrote:

The weird thing about the coronavirus crisis is that it simultaneously (1) caused a stock market crash and (2) eliminated most forms of fun. If you like eating at restaurants or bowling or going to movies or going out dancing, now you can't. If you like watching sports, there are no sports. If you like casinos, they are closed. You're pretty much stuck inside with your phone. You can trade stocks for free on your phone. That might be fun? It isn't that fun, compared to either (1) what you'd normally do for fun or (2) trading stocks not in the middle of a recessionary crisis, but those are not the available competition.

And then, you know, the last year happened. One thing that happened over the last year is that people got really really really into trading stocks for fun. The GameStop thing was probably the most salient example, but broadly speaking there were a lot more people getting into trading stocks on Robinhood, talking about stocks on Reddit's WallStreetBets forum, learning how to trade options, and generally finding their fun in the stock market. Not to mention crypto, Dogecoin, etc., which I think we have mentioned sufficiently at this point.

Another thing that happened is that people put a lot of effort into making it more fun to trade stocks. Robinhood was fun, and many of the people who started trading stocks for the first time did it on Robinhood, where there was free trading and confetti and easy access to single-stock options. Options are fun: If your goal in trading stocks is to get some excitement, trading options is a way to magnify that excitement. WallStreetBets is fun, and a lot of the people who started trading stocks did their research and analysis and trash-talking on Reddit: Stock trading, in the pandemic, was not just a form of gambling, a way to get excitement when many other forms of excitement were unavailable; it was also a form of socializing, a way to get chitchat and jokes and bonding when many other forms of socializing were unavailable.

Also stocks ended up going up a lot, despite the pandemic, which surely helped make trading more fun.

When I first wrote about this theory, I concluded:

If you believe the boredom thesis of the current retail rally, that is good news, because that thesis is basically countercyclical: The worse the economy is, the more bored investors will be. If stocks sell off because the coronavirus crisis is longer and worse than expected, there will be even fewer entertainment options and more people will turn, in desperation, to buying stocks on their phones. If someone finds a magic cure for the virus tomorrow, stocks will rally and all the new retail investors will happily sell into the rally at the top and go back to their other, more entertaining, entertainments.

When I wrote that, I probably underestimated the ways in which trading would become more fun, but the basic idea still seems right. Anyway the Financial Times reported on Friday:

The day trading bonanza that took Wall Street by storm early in 2021 has cooled sharply as US authorities lift social curbs and amateur investors spend more time away from home. ...

But as large portions of the US economy begin to reopen, data have begun to signal a fading appetite for the same type of intense trading that triggered volatility in many shares in January and February.

"The rise was spectacular, but the fall has been equally spectacular," said Steve Sosnick, chief strategist at Interactive Brokers. "The casual investor, or the investor who conflated gambling with investing, they've moved on to other things. More people are heading back to the office . . . and quite frankly investors have other things to do with their money."

In US options markets, where traders place sometimes risky bets on movements in stocks and other assets, trading associated with retail investors compared with overall volume slid to a six-month low of 15.5 per cent in early May, from close to 20 per cent in January. In April, total trading volumes across the retail brokerage sector were down 26 per cent compared with March, according to a Piper Sandler analysis.

I continue to think that this is a basically optimistic theory. It is bad when a bull market ends due to panic, when people get scared and rush to take their money out. If a bull market ends due to boredom — if people get bored and take their money out in a leisurely fashion to fly to Vegas — then maybe that's fine?

Last month, Hyun Jung-a boarded a flight from South Korea's Incheon Airport. Around two hours later, she was back in the same airport and loading up on duty-free shopping, despite never landing in another country.The Air Busan Co. flight, organized by Lotte Duty Free for its VIP customers, was Hyun's first since the pandemic began and it didn't cost her a cent. Because the route briefly departed Korean airspace and went over a Japanese island, the 130 passengers on board qualified to shop at duty-free stores in Seoul typically reserved for people who have traveled internationally.Destination-less flights like these are an attempt by duty-free operators to salvage an industry decimated by Covid-19.

And people complain about how much energy Bitcoin mining burns. You would think this process could be made more efficient. Think of, like, the market for carbon credits. Give people who get on a plane and fly internationally — for real, I mean, because they want to, for work or vacation or whatever — certificates saying "I flew internationally," and then let them transfer those certificates to other people who want to buy booze and perfume without leaving the ground. Instead of going on a fake flight yourself, you can buy someone else's having-gone-on-a-flight and use it to make the duty-free purchases.

Or just have the government declare one room of the Incheon Airport to be actually international airspace, so that anyone who walks into that room can buy duty-free stuff that day. And then have Lotte Duty Free pay a fee to the Korean government for the arrangement, a fee that would presumably be (1) less than the duties, (2) less than Lotte Duty Free pays for fuel and crew for the fake flight, but (3) more than the government currently earns from the fake flight plus duty-free sales (presumably zero?). There is Coasean bargaining to be done here. If you have to do expensive polluting time-consuming real-world nonsense in order to get a purely abstract financial benefit, there is value to be added by abstracting the nonsense.

If you want to bet that oil prices will go up, you can buy oil futures. In the U.S., oil futures are legal and popular and exchange-traded and regulated by the Commodity Futures Trading Commission, and have been for a long time. You can use them for various purposes, but one purpose is just to make a bet on oil prices, which is generally called "speculation."

What is the difference between these two things? Well, traditionally, one big difference is that oil futures could be used to hedge real business risk. You might use them for pure speculation, just to bet on oil prices, but an oil company might use them to lock in a selling price for its future oil production, or an airline might use them to lock in a purchase price for its future fuel consumption. This sort of real-business rationale meant that commodity futures were legal and accepted business tools even while regular gambling was illegal and immoral. And, sure, some people would use commodity futures just to speculate — to gamble — but those speculators were helpful participants in a broader, socially useful market; they made the market more liquid and more useful for real businesses that wanted to hedge real risks.

Over time, the CFTC allowed more and more futures contracts, and the rationale was less "this is a commodity that someone can deliver in the future" and more "this is a financial contract that can hedge a real business risk." So futures on volatility and interest rates are not like oil futures, in the sense that you can't load an interest rate on a tanker ship and deliver it to a customer, but they are like oil futures in the sense that interest rates and volatility are important risks for real businesses and those businesses might want to hedge them. So they are traded on exchanges and regulated by the CFTC, and if you want to bet on interest rates you can do that legally and transparently and as part of standard financial markets.

Meanwhile real normal businesses don't have costs or revenues that fluctuate based on football scores. So football betting is just gambling; there is no business purpose to it. Some states allow it and some don't, but financial contracts on football scores are not traded on exchanges or allowed by the CFTC or part of standard financial markets.

Well, but, one kind of business has a real business need to hedge against football scores: sports books! If you are in the (legal in your state) business of taking bets from customers on football games, and all your customers want to bet on the Chiefs, you might want to hedge your risk by buying some financial contracts that pay off if the Chiefs win. Could you go to the CFTC and say "hey, I have a legitimate business purpose to hedge my real risk by buying football-score futures," and convince them to allow trading of those futures?

No, absolutely not, that is way too cute, but nice idea, good effort. Here is a Wall Street Journal story about Eris Exchange LLC, a cryptocurrency exchange that tried to slip this one past the CFTC:

ErisX's plan was to list three kinds of futures contracts, with payouts based on the outcomes of individual NFL games, the point spreads in those games, and what bettors call the over/under—bets based on the total number of points scored in a game. …

ErisX's contracts wouldn't have been open to small individual investors. ErisX said they were designed to fill the hedging needs of businesses such as sportsbook operators that let bettors wager on games, stadium owners and food and beverage vendors.

For instance, a sportsbook licensed to operate in one state could have used the ErisX futures contracts to address a common problem where its local customers tend to bet on the home team, resulting in an imbalance in the firm's books. Potentially, stadium operators could have used the futures to hedge against the risk of reduced revenue in case their local team didn't make the playoffs, ErisX said.

But ErisX's proposal faced a legal hurdle: Federal law gives the CFTC the authority to prohibit event contracts linked to gaming. The law doesn't define gaming, leaving it up to the CFTC to determine whether the contracts' underlying activity fits the classification. Historically, the regulator has been wary of proposals that blur the line between betting and financial derivatives trading.

Yeah … I … I just think that a contract that lets a sports book lay off its sports gambling risk in a sports gambling derivatives market is pretty obviously sports gambling? Here are the skeptical questions that the CFTC sent to ErisX about this plan ("Do any of these contracts involve, relate to, or reference gaming," etc.), and the Journal notes that ErisX "withered its proposal" as "the CFTC had been poised to reject ErisX's proposal on the grounds that it was contrary to the public interest." I don't know if that's right as an intuitive matter — maybe sports betting is great and in the public interest? — but as a matter of CFTC rules it is obviously right. The CFTC does not allow futures contracts that are "gaming." It is clever to argue "no no no, this is not a gaming contract, this is a contract to hedge gaming risk," and I applaud the ingenuity, but of course it didn't work.

I am never ever going to resist stories about people selling equity shares in themselves. "I have always thought of this as the great late-night dorm-room question of financial capitalism," I wrote last year, "and in fact I wrote a very late-night-dorm-room sort of paper about it in law school." The idea that, instead of borrowing money and paying it back with interest, you could instead get a bunch of money in exchange for signing away a share of your future income: People love that idea, and other people love hating that idea, and, sure, every discussion of it is a little dumb, but no one can stop themselves.

So, here:

Fernando Tatís Jr. was 18 years old, just a low-level prospect from the Dominican Republic trying to work his way up in the San Diego Padres farm system, when he made a financial deal that would impact his entire baseball career. And it wasn't with the Padres.

Tatís signed a contract with Big League Advance, an unusual investment fund that pays minor-league players money up front in exchange for a share of their future MLB earnings.

Tatís, now 22 and widely viewed as one of the sport's best young stars, today knows what those earnings will be. He agreed to a record-setting 14-year contract with the Padres on Wednesday night worth an eye-popping $340 million, the third-highest total in MLB history.

His new contract also creates a significant obligation for Tatís: to pay a sizable chunk of his new bounty—perhaps close to $30 million—to Big League Advance.

Basically Big League Advance gives minor-league baseball players cash advances in exchange for a share of their future earnings.

Big League Advance uses a proprietary algorithm to project the performance and earning potential of players, in order to establish a set amount it would be willing to pay a player in exchange for each percentage point of future MLB earnings that player is willing to give up.

For instance, if Big League Advance offers a minor-leaguer $100,000 up front for 1% of his earnings, that player can then decide to accept $500,000 in exchange for 5% or $1 million for 10%. A player valued as highly as Tatís could receive a couple million dollars from Big League Advance. In his first two seasons with the Padres, Tatís earned less than $800,000 in salary.

The Big League Advance payouts aren't loans. If the player never reaches the majors, he doesn't have to reimburse the money, and Big League Advance loses its stake. When a player turns into a MLB star like Tatís, Big League Advance receives a huge payout. In effect, Tatís is now funding a bunch of minor-leaguers who will never make it. It's similar to a venture capital fund that backs lots of startups that fail, in return for a gigantic payday from getting in early on a company like Facebook or Uber.

Often when people reinvent the idea of selling equity in yourself, it is for students in college or in learn-to-code schools. The idea is that those people have a need for cash now (to pay tuition), but later they will generate cash, and they might prefer to limit their downside risk, in exchange for giving up some upside, by agreeing to repay a percentage of their income rather than a fixed amount. But the distribution of incomes will be normal-ish; some people will make a lot of money and repay a lot, others will make a little money and repay a little, most will make a medium amount of money and repay roughly what they borrowed.

Baseball is a different distribution: A large majority of minor leaguers will make, in round numbers, nothing; they will get poverty wages in the minor leagues for a while and then leave to do something else. A few of them will become major-league stars with contracts worth hundreds of millions of dollars, subsidizing everyone else. Essentially every deal that Big League Advance signs will seem, in hindsight, unfair: Most of them will look unfair to Big League Advance (which will advance money to the minor leaguers and get back nothing), but a few will look wildly unfair to players like Tatís (who will pay back many times what he got).

Arguably that looks less like "selling stock in people" and more like "insurance." (Insurance always looks unfair to people whose houses don't burn down.) Big League Advance is a risk-pooling mechanism; it lets minor leaguers in effect pool their future earnings, so that the ones who make it make a bit less while the ones who don't make it make a bit more. Big League Advance advances them their share of the pool, and takes a cut for its services, but economically the real transfer is from people like Tatís who more than earn out to the many players who don't.

I mean, why not. If you've got a good enough extortion racket, it will have stable and predictable cash flows; why shouldn't you get non-recourse financing by assigning those cash flows to a special-purpose vehicle and then selling bonds out of the SPV? That's the basic move of modern finance: You put cash flows in a box and sell bonds referencing the box, and the goal is always to find new things to put in boxes. If you put a thing in a box that has never been put in a box before, you give investors access to a new asset class, a new thing to bet on, a new set of cash flows that might be uncorrelated with the rest of their portfolio. "Diversify your portfolio with some extortion bonds," an investment banker could say to a pension fund, and it is not a … terrible … pitch? I mean I guess you might get in trouble. Also the government might try to deny payment on the invoices—due to them being, you know, criminal—and then you'd lose your money. But those are uncorrelated risks, everyone's favorite kind of risk, and the interest rate is presumably high. The investment banks, advisers and investors all say they were trying to invest in legitimate health-care receivables and did due diligence to avoid financing crime, and it seems like Chiron wasn't mostly mafia receivables. It is not like there is an entire sector of asset-backed securities for extortion and embezzlement. Give it time though. Here's a quote about the people running the 'Ndrangheta now:

"A number of the younger generation, those who I grew up at the same time as, have degrees from the London School of Economics or even Harvard. Some have MBAs," says Anna Sergi, a Calabrian-born criminologist at the University of Essex. "They live outside Calabria and appear like respectable businessmen, not directly involved in street-level illegality but there to offer technical expertise when it is needed."

It's like anything else; the industry starts small and scrappy, with people who really care about the work itself (extortion), but when it gets lucrative enough it starts to attract Harvard MBAs, until eventually real innovation stalls and everyone spends all their time on financial engineering and optimizing capital efficiency.We are in the early stages of extortion-backed securities but it is a predictable path. Soon there will be mafia quants, hired to optimize the portfolios and engineer arbitrages and game the ratings agencies. "The senior tranche of this bond should be rated AAA because, while the probability of any one business refusing to pay protection money is X, the historical correlation among businesses refusing to pay is only essentially zero, so there is no real risk of eating through the credit support," the mafia quants will argue to the ratings agencies, and the big guy behind them with a lead pipe will add some support to their mathematical arguments. I would absolutely watch—I may have to write—a movie about a mafia ABS quant.

What if people could sell stock in themselves? Instead of borrowing money and pay back a fixed amount, why not take an advance in exchange for a fixed percentage of your future income?" I have always thought of this as the great late-night dorm-room question of financial capitalism, and in fact I wrote a very late-night-dorm-room sort of paper about it in law school. It is increasingly, though, a thing.[1] Income-based repayment is a standard option for federal student loans now. Income-sharing agreements are common enough now that they are regularly abbreviated as "ISAs," and they have become a popular way to finance coding-school tuition. That makes sense. So much of Silicon Valley has a flavor of dorm-room capitalism anyway, so teaching people to code in exchange for equity in the people just feels natural. Once you start down the path of "what if people sold stock in themselves," you might as well move on to "what if we securitized people?" What if people's future incomes were bundled together, cut into tranches, and sold to investors? Well sure why not; here is Bloomberg's Claire Boston about a sale of ISAs from Lambda School (a coding school) through Edly (an ISA investing platform):

For investors starved of yield, it was an appealing proposition: a potential 13% return. You just had to be willing to take a flier on the future earnings of 1,000 coders. That was the payout being targeted late last year for a swath of income-sharing agreements tied to students and recent graduates of coding academy Lambda School, according to a presentation from an online lending platform that specializes in student-loan alternatives. The participants pay no tuition upfront but pledge to remunerate 17% of their incomes for 24 months after landing a job that pays more than $50,000 a year. Repayment is capped at $30,000. ... Investors in the Lambda offering receive a group of 1,000 students' ISA payments until they reach a 13% return on their investments after fees, the documents show. Lambda takes 60% of any residual cash flow after that, while investors get 40%.

People are kind of mad about this, and you can understand why. A big risk in securitization is what was called, in the financial crisis, the "originate-to-distribute" model. If a bank gives you a mortgage and then spends 30 years collecting payments, it will want to make sure you can pay back the money. If a bank gives you a mortgage and then sells it to a bunch of anonymous investors in a securitization, it may cut some corners. If, years in the future, you can't pay back the money, that is no longer the bank's problem. Same with ISAs but more so. Lambda School's pitch to students is that it plays two roles: It teaches them how to code, and it takes an equity investment in their future coding income. Those roles are completely separate, and you could easily do either without the other, but they work really nicely together. If Lambda owns the equity in the students—if it makes money only if, and to the extent that, its students get high-paying jobs—then it has incentives to do the teaching well. If it sells off the equity in the students on day one—if it completely separates the teaching and investing roles—then that incentive is diminished. Here's Vincent Woo at New York Magazine:

[Lambda's] home page proclaims, "We don't get paid until you do, so we're in this together, from your first day of classes to your first day on the job." ... These days, [Lambda founder Austen] Allred insists, the school doesn't sell but instead "finances" ISAs: "We get an advance from an investor that is backed by the ISA." Effectively, Lambda takes out a loan that is secured by students' ISAs, and has to repay that loan with more interest as more students graduate and are placed. Whether or not this counts as "selling" strikes me as a meaningless semantic distinction: Either way, the school receives some money up front and an investor shoulders some of the risk of the ISA not paying out. And either way, Lambda School students don't know that the school isn't as incentive-aligned with them as the school's marketing indicates.

And here's Ranjan Roy:

The moment Lambda started selling off the contracts, their incentives completely flipped. Their income was then derived from generating ISAs, meaning, the more, the better. Enroll as many students as possible. Of course, if no one ends up getting jobs, investors will eventually stop buying the Lambda ISAs, but that would all happen a long ways down the road. People are right to be angry that Lambda was selling off the ISAs. It broke their core promise.

I am less offended. Lambda isn't selling the equity in the students, it is borrowing against it. In the language of securitization, it is selling the senior tranche to investors, but keeping the equity. (Well, 60% of the equity.) Lots of businesses borrow money to fund their operations, and pay back the loan out of the profits of their operations; that is just the normal way to do business, and is functionally what is going on here. Investors advance Lambda some money so it can pay for its programs, it collects money from students if they get good jobs, it uses the money it collects to pay back the loan, and if there's money left over—if Lambda does a good job—then it makes a profit. It depends on the specific terms though. The investor advances to Lambda seem to be non-recourse; if no students get any jobs, the investors lose all their money and Lambda doesn't have to pay them back; in the downside case, it does kind of look like Lambda is just selling the ISAs.[2] And of course, in the upside case, Lambda isn't keeping all of the equity; the investors get 40% of it. Also that 13% interest rate on the loan—the amount that the investors get before Lambda earns any profit—is pretty high for a senior tranche. It suggests that the investors' tranche isn't that senior and the downside case is real; the investors are actually taking on a lot of the risk that the students won't get jobs. That 13% is a target return: If Lambda's students do about as well as they have historically, the ISAs will pay off about enough to cover that 13% return. If they do worse, the investors will get a lower return, or lose money. If they do better than the historical average, there will be money left over, and Lambda and the investors will share it. (Also it is a repeat game: If the students don't get jobs, then investors won't pay for any more ISAs. Edly's Chris Ricciardi notes by email that "the advance rates will change for new pools over time based on the actual performance. So, the better Lambda does on this pool, the better their advance rate will be on subsequent pools. This is an important mechanism for aligning interests.") One way to think about it is that there is a quantity of equity here, and the challenge is to divide it up in an optimal way. The individual students who go to the coding school will make some salary in the future. In theory, 100% of that salary is up for grabs; someone will get it. The students obviously need to keep most of it, as a matter of sensible incentives[3]: If Lambda said "we will teach you to code and in exchange you will give us 100% of your salary at any job you get," the students would have no reason to get jobs. So the deal that Lambda sets is that the students keep 83% of their equity and Lambda gets 17%. But the same basic problem occurs one level up, at Lambda. Lambda needs to finance itself, and like any business it can finance using debt or equity or by packaging and selling its assets. The equity in students is attractive; the whole point of the model is that investors want exposure to people's income. (Lambda School once wrote an investment memo titled "Human Capital: The Last Unoptimized Asset Class," and people love last unoptimized asset classes.) So you want to sell some of that equity to your investors. But you also need to keep some for yourself, for the same sorts of incenti

Yesterday's xkcd was a cartoon about the efficient market hypothesis. One stick figure says:

But there's a weird corollary to that idea: It implies that, ignoring fees and stuff, it's just as hard to consistently lose money by picking bad stocks from an index. If someone could consistently buy bad stocks, you could beat the average by hiring them, letting them pretend to invest, then buying every stock except the ones they pick. In a way, bad judgment is just as helpful as good judgment.

"Oh my God," says the other. "I can do that! This is the job I was born for." One thing I will say about this is that everyone thinks "hahaha I could lose money picking bad stocks," but I am on Twitter a lot and I have my doubts. The two investments that people hate the most, in my anecdotal experience, are Tesla Inc. and Bitcoin, and both have had absolutely amazing runs over the past few years. "It's easy to lose money, I will just buy dumb things like Tesla and Bitcoin," you'd say, and then you'd accidentally be rich.[4] Another thing I will say, though, is that actually a lot of people do underperform the market pretty reliably. If you could do the opposite of them, you'd get rich. The efficient market hypothesis relies on some stylized assumptions about the world—"ignoring fees and stuff"—and where those assumptions don't hold you can make consistent errors. Of course where those assumptions don't hold is exactly where it is hard to capitalize on the errors. Still it can be instructive to think about the big errors and what the opposite of them might be. The main error—the main way that ordinary people seem to reliably underperform the market—seems to be bad market timing. Probably some hedge fund should hire me to observe when I sell all my stocks and move into cash, and when I start buying stocks again, and just do the opposite. But the problem here is that it is hard for you to do the opposite because you too are probably constrained by economic cycles and behavioral factors. Sure maybe a good time to buy stocks is when everyone is selling, but if people are pulling money from your fund and brokers are refusing to provide leverage, you'll probably be selling too. There are exceptions! Warren Buffett's philosophy is famously to "be fearful when others are greedy and greedy when others are fearful," that is, to watch other investors' bad market timing and do the opposite. But also he has a large stable permanent capital vehicle in the form of an insurance company, so he can do that. And he has had a long career of beating the market. This one kind of works! Another classic way to lose money is on transaction costs and slippage: Lots of investors trade too much, and they lose a little money each time they trade (paying commissions, buying at the offer and selling at the bid, moving the price against themselves, etc.). The way to do the opposite of this is to be the one charging the transaction costs. This could mean being a brokerage firm and charging commissions, or it could mean being a high-frequency-trading market-making firm selling stock to retail traders at the offer and buying at the bid. Those businesses are competitive, and harder than they used to be—brokerage commissions are zero now, and high-frequency-trading profits have been squeezed—but they are both still pretty reliable money-makers. (By the way there is an extension of this: The way a lot of investors in actively managed mutual funds underperform is that the funds roughly track their benchmarks and charge a high management fee. They underperform, in expectation, by the amount of the management fee. The way to be on the other side of this trade is to, uh, be the mutual fund manager? And get paid the fee?) One more way to lose money is by investing in stocks that don't have a reliable market price that incorporates all information. Sometimes you can do this in public markets: There will be weird shady penny stocks that are suddenly worth billions of dollars, and you probably could create a reliable rule to lose money on them. Something like "if a company (1) has never had any revenue, (2) has a market capitalization of under $20 million, and (3) a month later has a market capitalization of over $5 billion, (4) still without any revenue mind you, then (5) put all of your money into that stock." It won't come up that often, but it will come up sometimes, and it's a pretty great money-loser! It's very hard to do the opposite, though. These stocks are so volatile because they don't trade very much; if you tried to profit by shorting them, you wouldn't be able to get much done.[5] Also they tend to be closely held and so hard to borrow to sell short. Also there are other, more arcane ways that shorting those stocks can go very wrong. The stock can be suspended, forcing you to keep your short on forever. You can get caught in a pump-and-dump-and-short-squeeze. "Bet against amazingly obvious inflated penny-stock frauds" seems like a great way to make money on the stock market but is often terrible in practice. You can also get unreliable market prices in private markets. Same sort of dynamics: Private companies don't trade on an open market with willing buyers and sellers, there is no short selling, and the only price will be what the company agrees with its most enthusiastic investors. There is no guarantee that private-market prices will be especially efficient, and there are plenty of notorious busts. It is less obvious that there are particular investors who reliably pick those busts—no one goes around advertising that they invest only in losing venture capital ideas—but I suspect there are. I suspect that they are mostly dentists and retired football players. Byrne Hobart has a terrific post about "Judging VC Skill," in which he points out that the main ways venture capitalists create value are "dealflow and judgment": "Typically outsiders overweight judgment ('did you know it was going to be big?') and underweight dealflow (there are lots of companies that everyone thinks will be big, but only Sequoia gets to say so with a check)." You could apply the same thinking to negative value creation. To take a recent example, lots of people could have lost their life savings on a cryptocurrency scam that promised "tremendous returns of roughly 15% a month with precise and limited risk," but only a select group of doctors were actually offered the chance.[6] Here too it is hard to do the opposite, but there are ways. You can't short-sell most private investment opportunities, and if you are the sort of person who would be inclined to short them, you probably won't even get to see them. Again the way to do the opposite is just to be on the other side of the trade. All the way back in 2016, I wrote that if you thought there was a bubble in private tech unicorn valuations, the way to short the bubble was not through some weird financial product but by starting a dumb startup and selling stock to venture capitalists or, for that matter, to dentists. Later I suggested that WeWork founder Adam Neumann more or less did that and now he's super rich. Bad judgment is just as valuable as good judgment, really, as long as you're on the other side of it.

If you want to PayPal or Venmo some cash to someone without any hitches, do not put the word Iran in the memo field. On Wednesday, Jewish Currents got an annoying reminder of this rather blunt policy. The magazine tweeted that nine payments to its staff and contributors had been held up by PayPal because the transaction descriptions included the term Iran in reference to a piece that the magazine published. PayPal, along with its subsidiary Venmo, uses a system that automatically flags keywords in the payment memo field that could indicate a violation of U.S. sanctions. Upon detecting a suspicious transaction, PayPal sends an email to both the sender and receiver reading, "To comply with government regulations, PayPal is required to review certain transactions. The payment you sent is currently being reviewed and we will complete this process within 72 hours." So if, say, you try to send a friend money for "drinks at Cuba Libre," you'll quickly learn how dense PayPal's system can be when it comes to context clues.

You might want to invest in commercial real estate. You might have some thesis—downtown apartment buildings will keep getting hotter, demand for office space in smaller cities will increase, more people will keep putting their stuff in self-storage facilities, malls are due for a comeback, I don't know—that is best expressed by buying commercial real estate. But you have a problem. Commercial real estate is expensive. Buildings, especially big nice ones, can cost millions of dollars, even tens or hundreds of millions. You don't have millions of dollars. You have a good thesis about commercial real estate, but you can't afford to express it by buying buildings. Certainly you can't diversify ; even if you could stretch to buy one small downtown apartment building, you can't buy a bunch of small downtown apartment buildings across several different cities to really express your thesis. But you live in the twenty-first century and you know that this should be a solvable problem. Why not securitize buildings, or crowdfund them, or, in the most modern lingo, tokenize them? Why not slice them up into shares, and sell the shares? Instead of buying a building for $20 million, someone could divide the building into a million shares and sell each of them for $20. Then you could buy like 100 shares of that building, and 100 shares of another building across town, and 200 shares of buildings in another city, etc., so that you could put, say, $10,000 to work in a diversified portfolio of commercial real estate. What a good modern solution to the problem! That is a paragraph that you could type, and a paragraph that has been typed at me every so often over the past few years, and I always find it strange. Really this solution is called a "real estate investment trust," or a REIT. Just from the name you know that it's a way to securitize real estate, to sell investments in a trust that holds real estate. You could have a single-building REIT, I guess, if you wanted, but that's kind of annoying, because lots of people who have $10,000 to invest in commercial real estate want a diversified portfolio, and the easy way to do that is to have a REIT that gives it to them directly. You have an office REIT, it owns lots of office buildings, it sells shares in its portfolio to investors in small chunks, the investors get exposure to office real estate. This is such old boring news. "REITs were created in the United States after President Dwight D. Eisenhower signed Public Law 86-779, sometimes called the Cigar Excise Tax Extension of 1960," Wikipedia pleasingly tells me. Sixty years later, lots of REITs are listed on the New York Stock Exchange. Thirty-one of them are included in the S&P 500 index. The securitization of real estate is so normal and domesticated now that it is on par with the securitization of companies ; you can buy shares of REITs in the same way that you buy shares of Facebook or Boeing or whatever, hardly even noticing that you are buying slices of commercial real estate. You could quibble. Those 31 REITs give you access to a wide range of commercial real estate theses—there are REITs for apartment buildings and office buildings and self-storage and malls and hotels and data centers and forests—but not every possible thesis; if you have some very specific view about the demand for, say, office space in Chicago, Seattle, Albuquerque and Charlotte, you might not find a REIT (or combination of REITs) that allows you to express that thesis. Also actually existing public REITs more or less are companies; they usually manage their buildings as well as owning them, and their executives regularly make decisions about buying and selling buildings, so if you want pure exposure to a fixed portfolio of buildings they might somewhat disappoint you. See, what you want is the ability to pick exactly the portfolio of buildings that you like, and own only the buildings and not the management companies, and have a say over exactly who manages the business of leasing out each of those buildings, and generally act like a large-scale commercial landlord except on a fractional basis. I guess? That's what you want? Maybe? Why? I feel like the number of people who actually want that—who want to invest a modest chunk of their savings in fractional ownership of commercial real estate, while doing the work of picking and managing the buildings—is vanishingly small. But if you are one of those people, and the existing options disappoint you, then you can always start a real-estate-crowdfunding or real-estate-tokenization business. Some of them—all of them?—did. Here's a fun Wall Street Journal article about how they're doing these days:

Starting in 2012, crowdfunding startups sold stakes as small as a few thousand dollars in commercial property. New regulations paved the way for real-estate investment firms to raise money across the country through Facebook ads and other social media. Proponents thought a tactic that could raise large sums while lowering marketing costs would transform real-estate investing the way Airbnb changed hospitality or Amazon changed retail. But as the economy rebounded, more money flooded into real estate and developers suddenly had plenty of cheap funding choices. That often left crowdfunding firms with riskier, less-appealing projects that couldn't get money elsewhere—a tough sell to investors. For regulatory reasons, most firms limited their fundraising to people with an income of more than $200,000 or a net worth of more than $1 million, excluding their primary residence. The hope was that enough of these people, known as accredited investors, were itching to buy stakes in commercial real estate—hitherto an exclusive pastime of the very rich. But these people already had ways to invest in real estate, for example by buying a rental apartment or shares in a real-estate investment trust, and crowdfunding firms have struggled to convince them their model is superior. "Democratizing real estate sounds great and it's inspiring, but it's tough when you go up against the titans of Wall Street," said Ray Sturm, a co-founder of the now-defunct real-estate crowdfunding company RealtyShares and chief executive of AlphaFlow.

It doesn't sound great, it's not inspiring, and you're not going up against "the titans of Wall Street"; you're going up against people who have been democratizing and securitizing and crowdfunding real estate for decades, in a way that is now totally entrenched and boring and mainstream. I mean, I get it. I'm a former financial engineer myself, and there is an obvious intellectual and aesthetic appeal to the granular approach. You take every building, you slice it into bits, and then you let people combine the bits however they like. You let professionals combine bits and sell the package to investors, or you let interested investors choose their own bits. You allow limitless combination, with fully customizable tinkering for hobbyists and simple off-the-rack indexing for everyone else. If you were starting from first principles, in a frictionless world, that's probably what you'd do: You'd start by slicing up and tokenizing every commercial building, and then diversified commercial-building funds would gradually grow up to offer a more appealing retail product. But in the actual world the appealing diversified retail product came first, so it's hard to back into the logically elegant but not especially useful pure form.

The whole business of investing consists of disagreeing with what everybody else thinks. I mean, that's not my approach to investing, or Vanguard's.[4] Index funds let you invest by agreeing with the aggregate of how everybody else thinks, and that's mostly how I invest, and it works well. But if you are an active investor, if you are trying to beat the market, then that necessarily means that you are taking some views that are out of consensus. You are betting that some company that everyone thinks is bad is actually good, or vice versa, or whatever.[5] Every active investor, to the extent that they are active—to the extent that they are taking a position that some stock is over- or undervalued—is a contrarian. So the entire investing industry is made up of contrarians. The mainstream of the industry is contrarian, and all of the upstarts and rebels and countercultures in the industry are also contrarian. (Except, again, the indexers.) Also the aggregate of all of those contrarian views—the price set by the market—is the consensus that they are all being contrarian against. If you sum up the contrariness of all the contrarians you get conformity. It's a little weird. It's also semantically awkward. Everyone says "I'm a contrarian," and it sounds ridiculous, like that scene in "Life of Brian," but it's also basically true. They all are contrarians. Good for them. But because contrarianism is desirable—if you are paying for active management, you want it to be active, etc.—and because everyone (accurately) claims to be a contrarian, investors have to take extreme measures to stand out from the contrarian crowd. And so you get things like Peter Thiel's "Pyrrhonian skepticism," which consists essentially of saying that everything that is right is actually wrong. Or here's a funny New York Times story about how venture capitalists love the term "narrative violation," which is a way of saying that the conventional wisdom is wrong, but being confrontational and annoying about it. Here are some quotes about the usage of "narrative violation":

Rob Go, a founder of NextView Ventures, defined it as "kind of like 'contrarian,' but more contrarian and complex." Hunter Horsley, a founder of Bitwise Asset Management, a cryptocurrency start-up, called it "a contrarian way to say contrarian." Here is a selection of recent facts that have violated the narrative: A ride-hailing start-up being profitable; crime falling in San Francisco; boomers driving the urban apartment surge.

There's a joke about starting a VC firm called "Narrative Violation Capital." In a world where everyone is contrarian, "kind of like 'contrarian,' but more contrarian" is the way to stand out.

I don't know Lewis Liman's net worth, but he was a partner at big New York law firms for 20 years, so I suspect that "as much as $15,000" represents rather less than 1% of his family's assets. If the Limans had put all of their money in S&P 500 stock index funds — sort of the default "not making any investment decisions" approach — then Bank of America Corp. stock would represent about 0.54% of their portfolio. [1] JPMorgan Chase & Co., another defendant in this lawsuit, would be 1.15%. Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley — the other US defendants — would add another 1.25% or so.

Presumably not all of their money is in stocks, but still. The point is that it would be somewhat unusual for a wealthy US citizen not to have economic exposure equivalent to owning $15,000 worth of stock in one or more of the big banks. If no judge with that much exposure can hear an antitrust case against all of the big banks, then it's possible that no judge at all can hear the case.

Obviously that's not right. In fact the rule requires a judge to recuse himself if he or his spouse has an "equitable interest, however small," in a company involved in the case, but "ownership in a mutual or common investment fund that holds securities is not a 'financial interest' in such securities unless the judge participates in the management of the fund." So owning an index fund that obviously owns stock in all the big banks does not count as a financial interest, but direct ownership of stock by your spouse, "however small," even if you don't know about it, does.

I have written, and speculated on the Money Stuff podcast, about the cat-and-mouse [2]  game between people who monitor remote employees to make sure that they are working and the remote employees who want to pretend that they are working. Like:

1. The remote employees work remotely and take long lunch breaks. 2. Their employers worry that they are not working, so they monitor their computer activity — mouse movement, keystrokes, etc. — to make sure that they are working. 3. The employees buy or build devices — "mouse jigglers," the Homer Simpson pecking bird — to move their mice and hit their keyboards to fool the monitors. 4. The monitors build or buy better software to catch the mouse jigglers. 5. The jiggler-builders build better jigglers to fool the jiggler-catching software. 6. Etc.

Here is a thorough Wall Street Journal investigation of the battle:

The share of companies using some kind of electronic worker-surveillance system surged during the pandemic, reaching nearly 50% in 2023, according to a survey of nearly 300 medium to large employers by research and advisory firm Gartner. These systems, which track how active workers are at their computers, have long been able to detect some installed software or extra hardware. 

More of these software systems, such as Teramind and Hubstaff, now also use machine-learning tools that can identify repetitive cursor movements or irregular patterns in someone's computer activity. In addition, some worker-monitoring software can randomly scrape screen images to check whether screen activity is changing as the computer mouse moves.

Most mouse jigglers on the market are detectable, says Ilya Kleyman, Teramind's chief growth officer. … "It won't look like normal human mouse cursor activity that regularly clicks, drags, etc.," he says. Plus, the software can flag artificial activity in general, such as when a cursor is active over the same static Wikipedia page for hours on end.

I wonder if Teramind eats its own cooking. When its developers build the machine-learning tools to identify repetitive cursor movements, are their keystrokes monitored? Anyway it makes sense that big companies would have better AI to catch shirking employees than employees would have to shirk, but there is a market opportunity here! Someone needs to build a robot with good enough artificial intelligence that it can pretend to work at least as convincingly as a human can.

If I were writing apocalyptic science fiction, my robot takeover would start with someone building an AI that is good enough at pretending to work to fool Teramind's AI. The pretending-to-work Turing test. There is something fittingly human about it: Humans are the species that uses computers to pretend to work. And then the robots would quietly pretend to pretend to work while really they are plotting the enslavement of humanity.

Two basic principles of management, and regulation, and life, are:

1. You get what you measure. 2. The thing that you measure will get gamed.

Really that's just one principle: You get what you measure, but only exactly what you measure. There's no guarantee that you'll get the more general good thing that you thought you were approximately measuring. If you want hard workers and measure hours worked, you'll get a lot of workers surfing the internet until midnight.

You want a lot of products opened, you get a lot of products opened, but in a bad way. It's a case of Goodhart's law: "When a measure becomes a target, it ceases to be a good measure."

Wells Fargo is the absolute poster child for Goodhart's law. Here is the dumbest possible version:

Wells Fargo & Co. fired more than a dozen employees last month after investigating claims that they were faking work.

The staffers, all in the firm's wealth- and investment-management unit, were "discharged after review of allegations involving simulation of keyboard activity creating impression of active work," according to disclosures filed with the Financial Industry Regulatory Authority.

"Wells Fargo holds employees to the highest standards and does not tolerate unethical behavior," a company spokesperson said in a statement.

Devices and software to imitate employee activity, sometimes known as "mouse movers" or "mouse jigglers," took off during the pandemic-spurred work-from-home era, with people swapping tips for using them on social-media sites Reddit and TikTok. Such gadgets are available on Amazon.com for less than $20.

Ahahaha come on. You want a lot of mouse movement, you get a lot of mouse movement, but in a bad way. Imagine deciding how to measure and manage the productivity and value added of your wealth and investment management employees while they are working from home. What might you measure?

1. These people manage portfolios. You could measure their investment return, or return against a benchmark, or their alpha after adjusting for various market, sector and style factors. You could measure how many assets they attract and retain, or how much they generate in fees. 2. These people deal with clients. You could measure how many clients they bring in, or how many client assets. You could survey the clients and grade the employees based on customer satisfaction. You could even, crudely, have some metric like "call three clients every day," and make sure they do that. 3. These people sit at computers. You could monitor their computers to make sure that they're moving the mouse at least once every five minutes for eight hours a day.

Which of those do you think is the best proxy for, like, contributions to Wells Fargo's return on equity? Which is the simplest to measure? Which is the simplest to game?

Most people who buy and sell financial assets for a living need to know how much their portfolio is worth at any given time, or at least at the end of the quarter. If you manage investments for clients, you have to send the clients periodic statements saying "your investments are worth $"; you have to know what number to put in the blank. The clients want to know, for one thing, but also, how much you charge the clients might depend on the number that you put in the blank. If you charge the clients a percentage of current assets, then you need to know what the assets are currently worth. If you charge the clients a performance fee on unrealized gains, you need to know how much the value of the assets has increased since the last statement. Even if you don't manage client money, your employers will want to know how much your portfolio is worth, so they can keep an eye on risk and pay you for your performance.

Also, though, many people who buy and sell financial assets for a living are fundamentally in the business of looking for mispriced assets. Your job is to find some situation with edge, some place where you have more expertise or patience or capacity than the market, some asset that you know is undervalued but that the market will sell to you cheap.

You see the tension here, right? The tension is:

1. You think a thing is worth $100. 2. Someone is selling it for $80, because they are wrong or weak. 3. You buy it at $80. 4. The valuation controller comes to you and says "for various important purposes, I need to know the current fair market value of this thing." 5. "Oh, $100," you say. Of course! That's what it's worth! That's why you bought it! (For $80.) 6. You book $20 of profits, charge performance fees, etc.

And then, oh, you know. Sometimes you sell the thing a week later for $100 and everything is great. Other times the thing never trades above $80, you sell it a year later for $60, and people have some questions about your valuation.

Obviously this more or less never happens with publicly traded stocks or Treasury bonds: When a thing has an active public trading market, everyone understands that you mark the thing to its current trading price, whether or not you think it's underpriced. If you buy GameStop Corp. stock at $28.50 and it closes the day at $28.22, you will mark it at $28.22, whatever you might think it is actually worth.

And with illiquid hard-to-value things, everyone understands this tension, so responsible investment firms (and their accountants, risk managers, auditors, etc.) will have some procedure for determining fair value that is not just "ask the trader and write down whatever she says." You'll get an independent third-party valuation, or use a pricing service, or get three quotes from dealers, or something. Also, firms that deal mostly in illiquid hard-to-value things (venture capital, private equity, private credit, etc.) are less likely to charge clients fees based on their valuations. A private equity firm is more likely to charge fees based on committed capital and realized returns — actual cash in and cash out — while a hedge fund that trades public stocks will have an easier time charging fees based on current asset value and unrealized returns.

You could have a model of Elon Musk that is like:

1. He runs a bunch of different companies and owns large stakes in each of them. 2. They all nominally do different things — cars, rockets, tunnels, brain implants, artificial intelligence, complaining on the internet — but there is a lot of overlap. Most of them employ engineers who move somewhat fungibly among companies, and most of them seem to have big plans for artificial intelligence. 3. Each time he comes up with a value-creating idea, he can more or less freely choose which company to implement it at. 4. He is motivated by money. 5. Therefore, he should implement the idea at the company that maximizes its contribution to his net worth.

I am not saying this is a particularly good model. Step 4, in particular, is suspect; Musk seems to have a lot of non-economic motivations.

But let's say this is your model. Now assume that Musk has some really good artificial intelligence idea that can create a lot of value and that can be implemented in any one of his companies. Where should he do it? He should do it wherever it will most increase his net worth. This means maximizing:

The scale of the company. Doing an idea at a big company will probably have more impact than doing it at a little company; doubling the value of a $200 billion company is worth more than doubling the value of a $10 billion company. Plausibly  "AI, but put it in a car" could create more value at Tesla Inc. than "AI, but bury it underground" would create at The Boring Co. [1] His ownership of the company. Doing an idea at a $200 billion company where he owns 42% might create more value for him  than doing it at a $560 billion company where he owns 13%. [2] The company's ability  to do the thing without raising outside capital (and, thus, diluting him). Some of Musk's companies generate cash, others consume it, and you can't move money freely between them. His ability, beyond formal ownership stakes, to extract value from the company. Musk owns a relatively slim 13% of Tesla, but sometimes he goes to Tesla's board of directors and says "hi I would like $50 billion" and they say "yes here you go," though that mechanism may have stopped working.

And you sort of multiply those numbers together and pick the highest result.

If you are an investor  in the broad Elon Musk complex, what do you do with this model? Possibly you diversify your bets across all of the Musk companies, as a lot of Musk investors seem to do. Or possibly you try to pick a winner: You try to buy a big stake in the Musk company that you think will attract his best ideas, based on the criteria above.

One odd thing that this means is that you have some incentive to maximize valuation. Ordinarily, if you are an investor in a company, you want to invest at a low valuation, so that you have more upside. But if Elon Musk comes to you to raise money for a venture, and the venture has a valuation of $5 billion, maybe you should say no: Doubling the value of a $5 billion company just won't move the needle on Elon Musk's personal wealth, so he has no incentive to pay any attention to a $5 billion company. Or rather, you should not say no; you should say "sure I'm in but at a $20 billion valuation," to at least make it somewhat worth his while.

The way credit ratings work is:

1. A company wants people to think that it's creditworthy. It might want to issue bonds or insurance policies, and it knows that people will only lend it money or buy its insurance if they think it's good for the money. 2. There are firms — "ratings agencies," "nationally recognized statistical rating organizations" — that give companies credit ratings on some well-known scale. All the relevant parties know that a bond rated "Aa1" or an insurance company rated "A+" is a safe bet, while one rated "Ca2" or "C" is riskier. 3. These ratings firms go around giving ratings to companies. 4. Specifically, though, they go around giving ratings to companies that hire them  to give them ratings. The way a company gets a rating is by calling up a ratings firm, saying "hey can you give us a rating," entering into a customer relationship, and paying  the ratings firm for the rating.

The conflicts of interest embedded in this system are extremely well known and sometimes blamed for the 2008 financial crisis. But one should not overstate them. Sure, right, the companies are the customers and pay the ratings firms for the ratings; there is a customer relationship, and if the ratings firm gives the customer a bad rating (1) that will be awkward and the ratings firm will get yelled at and (2) it might lose the customer relationship  and, thus, money.

But on the other hand, the ratings firms are  aware that they are playing a long game. The way to maximize revenue this week  might be to call up every company and say "hey if you double our fee we'll give you an AAA+ rating," but if you actually do that, then your ratings will lose all credibility with the market, and by next week  nobody will want to pay you for them. (Also ratings agencies are regulated by the US Securities and Exchange Commission, which pays a lot of attention to this conflict, so you'll get in trouble with the SEC if you do this.)

And so the actual incentives of the ratings firms encourage something like "good customer service combined with credibility." Exactly what that means will vary, but I think that one  thing it means is: If you are a ratings firm, you will want to be at least a little bit ahead of any disasters. What you don't want, after the experience of 2008, is news stories like "even as XYZ Corp. was sliding into bankruptcy, its bonds remained rated AA-." That is very salient, and very bad for your credibility. If you downgrade the bonds to B- a week before the bankruptcy, you at least avoid those headlines. Arguably your incentives are something like:

1. Be a touch  generous to most of your clients most of the time, and 2. Be really harsh  on clients who you worry might be skating toward disaster.

One theory is that, because most of the shareholders of most US public companies are diversified investors in lots of companies, each company's managers should work, not to maximize the value of their company, but to maximize the value of all the companies. If the chief executive officer of a company can do a thing that reduces the value of her company by $1, but increases the value of her competitors (or suppliers, or customers, or neighbors, or any other publicly traded companies) by $2, then she should do that. Her shareholders will lose money on her stock but make money on their other stocks, and they will be happy and grateful to her. Maximizing the value of her company's stock, at the expense of the other companies, harms her shareholders. She has fiduciary duties to those shareholders, and the way to fulfill those duties is by maximizing the value of their overall portfolio, which is, roughly speaking, the stock market.

This theory:

makes a certain amount of sense (the shareholders really are largely diversified), and is quite fruitful. It gives you lots of interesting ideas about the world. Much of ESG (environmental, social and governance) investing can be thought of in these terms: Big diversified investors might care more about the systemic effects of their companies (whether they cause climate change, etc.) than they do about their individual performance. Or there is a popular worry that common ownership of all the companies causes antitrust problems, because — if you believe this theory — companies won't want to compete on price in a way that harms their collective bottom line. Or I have half-seriously proposed weird theories about Covid vaccines and Ozempic.

On the other hand this theory is, you know, wrong. It just isn't the case that directors and managers of each public company "really" work for the collective set of all public companies, and have duties to that collective. They work for their individual companies. There are a few ways to tell:

1. All the laws and cases and stuff are about duties to the company, not about duties to shareholders' overall portfolios. 2. "Corporate managers should maximize the overall value of their shareholders' portfolios" is not a very good guide to behavior. The effects of a CEO's decisions on her competitors and customers and suppliers and complementary businesses and potential future entrants and every other company will be mixed and complex, and a CEO can find a way to justify more or less any action by saying "well this will be good for the market as a whole." Whereas it is relatively easy to measure if a company's own business is doing well. 3. Relatedly, the way to maximize overall value might be through competition among companies. Over the long term, what increases the overall value of the stock market is probably innovation, rather than careful slicing of existing entitlements, and competition is a good motivator of innovation. 4. The executives are generally paid based on their company's performance. In particular, they are often paid in stock — stock of their company, not index funds. The outside investors of a typical company will be broadly diversified, but the executives of that company will have a disproportionate amount of their net worth in that company's stock. If the executives were supposed to work on behalf of the market as a whole, they'd get paid in index funds.

There is probably something to the theory, both as a descriptive matter (do corporate executives sometimes act in the best interests of all of the companies rather than just their company?) and as a normative one (should they?). But it captures an interesting weird tension in how the world works; it does not simply describe how the world works.

I wrote yesterday about a guy who bought a spot as a substitute on a second-division Portuguese soccer team, because being a professional athlete is cool, so why shouldn't sports teams sell a few spots? I said:

A lot of people want to go watch the Yankees, but probably a lot of people would also like to be able to say that they played for the Yankees. Maybe auction off a few roster spots? There is a balance to be struck here: I suspect you could find a few hedge fund managers who would pay a lot of money to be Lionel Messi's teammate for a game, but if Inter Miami fielded a team made up of the 11 highest bidders then most of the glamour would be lost. (I would still watch this?)

Naturally readers emailed me the sports in which this system actually exists. The main ones are bridge and car racing. In car racing, Braden Williams pointed out:

In high-level Endurance racing, there are series that require an amateur driver, these drivers are colloquially known as gentlemen drivers, and typically fund the teams they drive for. There's a good documentary, The Gentleman Driver, that follow three of these drivers.

And several readers pointed out that, while Formula 1 does not explicitly sell driving spots to the highest bidder, there are some parallels. Car racing is very expensive, and it turns out that if you show up with a very expensive car they might let you race!

Meanwhile bridge is not especially expensive, but neither is it all that popular a spectator sport, so rich people who enjoy bridge will fund their teams:

Almost all top players play with sponsors. As a result, top teams at American tournaments, which consist of three pairs, or six players per team, follow a peculiar configuration: one wealthy sponsor and five pros in the sponsor's employ. Top sponsors pay $1 million or more to field their dream teams.

"Imagine if you could pay LeBron James, Kobe Bryant, Michael Jordan and Shaquille O'Neal and you could be the fifth guy," Aviv Shahaf, director of the Honors, said. "And you were at a level that was decent but not NBA level. That's basically what this is."

That's basically what this is, except it's bridge.

The basic idea of a delta one desk is that you are selling Thing X to a customer, and buying Thing Y from the market, and Thing X and Thing Y are exactly equivalent. Thus "delta one": If you sell stock options, you hedge the options by trading stock, and the amount of stock you need to buy or sell — the "delta" of the option — changes over time as the stock price changes. But if you sell index futures contracts, you can hedge them by buying the stocks in the index (or an exchange-traded fund, etc.), and the ratio never changes: It's always one-for-one, always a delta of one. You're buying a thing at a low price and selling an equivalent thing at, ideally, a higher price.

At some level this should be a fairly low-risk business: The stuff that you are long and the stuff that you are short exactly offset each other, so you shouldn't make or lose money as the market moves. On the other hand, you are trying to make money, and the only way to make money is to take some risk. If you are not taking market risk — if all your trades are fully hedged — and you're making money, then you're taking some other, slightly more esoteric risk. You're taking funding risk, or interest-rate risk. You're taking the risk of the basis between Thing X and almost-but-not-quite-identical Thing Y. You're writing one-day lookbacks into your swaps trades, and taking the legal and reputational risk that a regulator will fine you for tricking your customers.

Or bigger risks. One of the great delta-one failures of recent years is when Archegos Capital Management did bazillions of dollars of equity total return swaps with big banks. Those banks fully hedged their stock-price risk — they were long a bazillion dollars of the underlying stock, and short an offsetting bazillion dollars of swaps to Archegos — but they were taking enormous credit risk to Archegos, and when Archegos blew up several of them lost money.

But of course the great delta-one failure of recent years was Jérôme Kerviel's rogue trading at Société Générale in 2007 and 2008. The risk that he took was even simpler: He'd buy Thing X for himself, and pretend to sell Thing Y as a perfect hedge. He was doing completely unhedged directional trades, and tricking the computer systems into thinking he was doing completely hedged trades. When the stuff he bought went up, this was good: It is easier to make money by buying a thing that goes up than it is to make money while being perfectly hedged. And then the stuff he bought went down and he lost $5.2 billon and went to prison.

We have talked a few times about Hunterbrook, the hedge fund that is also a newspaper:

1. Hunterbrook Media is a media organization that publishes general news and investigative journalism. 2. Before publishing an investigative story, it runs it by Hunterbrook Capital, its affiliated hedge fund. 3. If the investigation looks like it will move the market, Hunterbrook Capital will do a trade to profit from the investigation. 4. These profits pay for Hunterbrook Media's newsroom.

Earlier this month, Hunterbrook launched its website with a big investigative report on United Wholesale Mortgage, which Hunterbrook Media accused of misconduct; Hunterbrook Capital shorted the stock of its parent company, UWM Holdings Corp. (The stock closed yesterday down about 7.5% from where it was before the report.)

Hunterbrook was back yesterday with a big investigative report on Posco, the Korean conglomerate, which Hunterbrook Media accuses of complicity with the junta in Myanmar:

A major source of the money that the junta uses for jet fuel and weapons is Myanmar's four offshore gas projects. Of those, the Shwe project, operated by Posco International Corp. in joint ownership with an entity controlled by the junta, has been the most profitable in recent years, according to a report by the U.N. Special Rapporteur on the situation of human rights in Myanmar. The report claims Shwe provided over a half billion dollars per year to the regime in the two years after the coup, helping fund a $1 billion spending spree for arms, including fighter jets, attack drones, assault helicopters, tank parts, and advanced missile systems.

The purchases have enabled what the U.N. Special Rapporteur called "probable crimes against humanity," including murder, torture, sexual violence, and the pillaging of villages.

After the coup, major energy companies from Organisation for Economic Co-operation and Development member countries that were operating Myanmar's offshore gas projects left, citing human rights violations. Not Posco.

Posco not only chose to stay, but continued to pour in hundreds of millions of dollars to increase production at the Shwe gas project, even as evidence of junta atrocities grew.

But right at the top there is a statement that "Hunterbrook Media's investment affiliate, Hunterbrook Capital, did not take any positions related to this article."

Why not? Why would Hunterbrook invest resources in doing a big international investigation, find alleged wrongdoing at a publicly traded company, and then not trade? Let me propose a few theoretically possible answers:

1. Sometimes, in investigating a company, Hunterbrook Media will find stuff that (1) is bad for the world and (2) the public ought to know about, but (3) is not bad for business. "A big international trading company is complicit in human rights abuses" might just be that kind of story? Doing business with bad people might be morally bad, but good for the bottom line. As a journalistic endeavor, Hunterbrook Media might want to call attention to these abuses. As a profit-seeking hedge fund, Hunterbrook Capital might pass. (Posco International's stock is down this week.) 2. Sometimes, in investigating a company, Hunterbrook Media's journalists might learn of wrongdoing from inside sources at the company, and might rely on leaked internal documents to support it. Probably not — Hunterbrook says "we avoid talking to insiders, depending instead on publicly available information" — but perhaps sometimes the journalists are tempted. These are, after all, traditional tools of investigative journalism. But — as we discussed the first time Hunterbrook appeared in this column — they are risky tools for hedge funds. Trading based on inside sources and internal documents is arguably illegal insider trading. You could imagine Hunterbrook Media doing some traditional investigative journalism, and then Hunterbrook Capital saying "nope, this has inside information, we have to pass." 3. Sometimes Hunterbrook Media will do an investigation that (1) reveals a good trade and (2) gets through compliance, but perhaps Hunterbrook Capital will pass on the trade in order to build up the credibility of Hunterbrook Media. "See, it's real investigative journalism; it's not just finding trades for a hedge fund." They are playing a long game here, and I suppose the goal is to become a trusted investigative news outlet rather than just another activist short fund publishing occasional splashy short reports. 4. Sometimes, in investigating a company, Hunterbrook Media will find out bad stuff about a company in South Korea. And it will take its results to Hunterbrook Capital, which will say "ah yes, this is great, this will crush the stock." And they'll run it by compliance, which will say "ah yes, this is all based on public information, you're free to trade on it." And Hunterbrook Capital will decide to put on a big short bet against the company. And then it will remember that South Korea's stock market currently bans short sales, whoops!

The business of public company auditing has at its heart a conflict of interest:

1. Your job, as an auditor, is to scrutinize a company's financial statements and make sure that they are true and accurate, and then to certify those statements to the public. If the company is doing financial fraud, you should try not to certify their financial statements. If you sign off on the financial statements of a big fraud, you will look bad and maybe get in trouble. 2. The company gives you that job. It hires you, in a reasonably competitive market. If you are annoying to work with, or are difficult about signing off on things, then it might hire someone else. If you are pleasant and friendly and take the company's chief financial officer out to nice dinners, she will be more likely to retain you.

If you are friends with your clients you will keep more clients. But if you are friends with your clients you might not be a strict independent auditor of their financial statements.

It is hard to get rid of this conflict of interest, though people sometimes suggest ideas. (If you assign auditors to companies randomly, they'd presumably be more independent? If shareholders paid them, instead of management, that might help?) But there are two main ways to mitigate it by regulation. The more important way is that you just have professional standards of quality and ethics for auditors, and you train the auditors in these standards, and then hopefully the auditors will do a good audit even if they are friendly with their clients. "Sorry, I know we just went out to a nice dinner last night, but I found some errors in your financials and my duty as an auditor outweighs our friendly relationship," the auditor maybe says, or at least she worries that if she signs off on a bad audit she will get in trouble.

The other way, though, is that regulation prohibits some conflicts of interest that make auditors less independent. Usually not the most important one — that the company's managers hire and work with the auditor who sign off on their financials — because that is central to the whole business. (Though we talked a few years ago about an auditor who got in trouble for too blatantly using his friendship with a company's chief accounting officer to win that company's auditing business.) But usually regulation restricts other conflicts that are easier to identify. Auditing firms tend to also have consulting businesses, and it used to be standard practice for them to cross-sell consulting services to audit clients, but that is now mostly forbidden in the US. And we talked once about a guy who "repeatedly accepted tens of thousands of dollars in casino markers" from a casino he was auditing, which I suppose compromised his independence.

I don't know, this is just a useful thing to learn at a young age:

He broke into the city's private-school set and soon found himself in the fancy Fifth Avenue apartment of a new client. Rim says that one day this teen's mother gave him a reality check. As Rim recalls it, "She said, 'Chris, if you want to make it here in New York, you cannot charge $75. No one's going to take you seriously.' " Rim says she told him to charge $1,500 an hour and vowed to bring him more clients.

That's from this New York Magazine story about Christopher Rim, the founder of Command Education, an extremely expensive college admissions counseling service. As a young man out of Yale, he started a modestly priced college admissions counseling service, until a client correctly told him that there was more demand for an extremely expensive one.

We've talked about Rim before, when Bloomberg News reported that another parent gave him another great pricing idea: "Rim said a parent at New York's Trinity School — a $64,000-a-year Ivy League-feeder — once offered him $1.5 million if he would agree not to work with any of his child's classmates." Basically if you are extremely rich, and buying positional goods like good college resumes, it is to your benefit for those goods to be as expensive — and thus exclusive — as possible. If you are in the business of selling those goods, that's nice for you.

An important and surprising insight of modern finance is that shareholders are, at least indirectly, people too. There is a standard view of corporate finance that says shareholders own shares in the firm, and the firm has fiduciary duties to those shareholders, and the way for the firm to fulfill those fiduciary duties is to make the stock price go up. The only thing that we know with certainty about the shareholders is that they own shares, and they'd rather have the shares be worth more than worth less, so the best thing to do for them is to make the shares worth more.

But in modern finance we know, or suspect, a few more facts about shareholders, and those facts might suggest that the shareholders have other desires, beyond just the stock going up. For instance:

1. We know that shareholders tend to be diversified. Not all of them, but a lot of them; in some sense the normal shareholder of a big US public company is an index fund or other diversified institutional investor. These shareholders own shares of all the other companies, too, and they want those shares to go up too. And so maybe the executives of any particular company should be thinking about how to maximize the value of companies as a whole, to benefit their diversified shareholders. This basic idea can manifest in lots of ways, all of which make traditional corporate finance people nervous. We have, for instance, talked a lot about the idea that, if diversified shareholders own all the companies in an industry, then the companies might not compete as vigorously against each other, since one company's market share gain comes at the expense of another owned by the same shareholders. Or I have argued that, if all the companies have the same owners, that creates weird incentives for drug companies to, say, give away Covid vaccines for free (to boost demand for everything else), or perhaps to limit sales of Ozempic (to avoid lowering demand for everything else). Or there is the Shareholder Commons, a fun activist group that goes around, like, suing Meta Platforms Inc. for focusing too much on its own profits at the expense of the value of other companies with the same shareholders. 2. We know that shareholders are mortal humans who live on Earth. If an asteroid was heading to destroy the Earth, and a public company could divert the asteroid at the cost of reducing its earnings per share by $0.02 this quarter, probably it should divert the asteroid? Probably the shareholders would approve? Even though it lowered the stock price? A lot of environmental investing is premised on similar ideas: It might be good for profits, but bad for the future livability of the Earth, for a company to emit a lot of carbon. Shareholders qua shareholders should prefer that the company emit the carbon and increase profits, but shareholders qua humans would prefer a livable planet. At least some shareholders explicitly tell companies that they prefer the good environmental outcome over the good profits outcome (that is, they vote as humans rather than as profit maximizers), and at least some corporate managers seem to take this preference into account. 3. We could at least speculate that some shareholders have social and moral commitments that their companies might want to account for. A company might decide not to be racist, not because this is profit-maximizing but because shareholders dislike racism and would be mad if the company was racist. The shareholders might express this preference by, for instance, voting out the directors who approved of the racism, or at least by calling them up on the phone and saying mean things. In some loose sense the directors and managers do answer to the shareholders, and if the shareholders have social and moral preferences that they express, then the directors and managers have to listen to them. 4. At some companies, we know that the shareholders are, like, weirdo Redditors. They bought the stock as part of a search for community and entertainment online, and it is, arguably, part of management's fiduciary obligation to entertain them. And so AMC Entertainment Holdings Inc. has handed out popcorn to shareholders, and bought a gold mine, not necessarily because that maximizes profits but because it maximizes the odd joy that its retail shareholders get out of owning the stock. And that's what they want, so the company gives it to them.

These are the most prominent examples that we've discussed around here. But the general form of this is:

The company has shareholders, Those shareholders (or a lot of them anyway) have some identifiable (or at least plausible) preferences other than maximizing the stock price, and The company's executives should (or could, or might want to, or might be incentivized to) optimize those preferences, and sometimes prioritize them ahead of maximizing profits or the stock price.

I should say that this idea is controversial, both in its specific forms (environmental, social and governance investing is wildly controversial, and nobody believes the index-funds-hurt-competition stuff) and in general. The objection to the general form is something like: Sure, right, shareholders are humans and have other interests, but they have other mechanisms to take care of those interests. They can vote for the government to do environmental regulation, etc.; the only thing that they have in common as shareholders of Company X is their ownership of Company X shares, so Company X's executives should focus on that. Also, in practice, if you let corporate executives choose from a long list of shareholder interests, that has the effect of letting them do whatever they want: If they fail to maximize profits, they can always say "I was maximizing for shareholder entertainment" and have an excuse.

Still, though, this general idea is fruitful; you can sit around thinking "well what else is broadly true of shareholders?" and come up with weird ideas for postmodern corporate governance. For instance, if shareholders are mostly humans, then they are probably customers of companies as well as shareholders, so they might have shared interests as customers? Why not? Here is a new NBER working paper by Keith Marzilli Ericson titled "What Do Shareholders Want? Consumer Welfare and the Objective of the Firm":

Shareholders want a firm's objective function to place some weight on consumer welfare, motivated by both self-interested and altruistic motivations. Firms have a unique technology for improving consumer welfare: lowering inefficient price markups, which increases consumer welfare more than it lowers profits. Optimal pricing formulas can be adapted to account for shareholders' marginal rate of substitution between profits and consumer welfare. Calibrations from preference parameters show many shareholders should place non-trivial weights on consumer welfare. A survey experiment on a representative sample elicits how shareholders would vote on resolutions giving strategic guidance to firms on what objective to pursue. Only 7% would vote for pure profit maximization. The median individual is indifferent between $0.44 in profits or $1 in consumer surplus, with those owning stocks preferring a lower weight on consumer welfare than non-stockholders.

I mean, sure, (1) shareholders are humans, (2) humans buy groceries or whatever, (3) shareholders of grocery companies would prefer to pay less for their groceries, (4) grocery companies should cater to those preferences of their human shareholders by lowering prices to a level that does not maximize profits.

I am not sure that I agree with the conclusion, either that shareholders do in fact want their companies to lower prices to maximize consumer welfare or that the companies should do that. Not every possible non-shareholder interest of shareholders actually matters, or should matter, to corporate governance. But a surprising lot of them do.

Investment management firms can, if they want, consider two sorts of moral restrictions on their business:

1. They can choose their investments on moral criteria: They can invest their clients' money only in good stuff, however they define that, and avoid investing in companies or projects that are evil or bad for the world. Versions of this are sometimes called "socially responsible investing," or "ESG" (environmental, social and governance investing), though it depends on what you think is evil, and there are right-wing versions too. 2. They can choose their investors on moral criteria: They can manage money only for good upstanding clients, and reject clients who are evil.

You mostly hear about the first category, the investments, but every now and then you hear about the second, the investors. When Russia invaded Ukraine and various wealthy Russian individuals were sanctioned, venture capital firms had to figure out what to do with their suddenly unacceptable Russian investors. And when Saudi Arabia's government tortured, murdered and dismembered Saudi-American journalist Jamal Khashoggi, there were occasional murmurs that perhaps US asset managers and venture capital funds should stop raising so much Saudi money, but that never really happened. BlackRock Inc. Chief Executive Officer Larry Fink, who writes an annual letter to the CEOs of his portfolio companies (the investments) telling them to be more moral and more environmentally conscious, became if anything more enthusiastic about attracting Saudi money, and ended up putting a Saudi oil executive on BlackRock's board. BlackRock's investments are supposed to be moral and green, but its investors , whatever.

The reasons for this difference are pretty straightforward: Investment management firms make money by charging clients (the investors) fees for managing their money. If you take some moral stance about your investments , you might attract more money from investors who share that moral stance, which means more fees. If you take some moral stance about your investors , though, that means turning away money from investors, which means lower fees. Being selective about your investments is good marketing; being selective about your investors is sort of the opposite of marketing.

And so, while choosing investments on moral criteria is controversial , and different people take different approaches, there are some popular approaches. A lot of investors take some approach like "don't invest in coal mining"; that's not a universal criterion, but it is a well-known one. Whereas there does not seem to be any consensus at all on what counts as an immoral investor , or when managers should reject investors' money.

Here, however, there's an unusual trick. In 2019 and 2020, Juul issued $2 billion of debt outstanding in the form of convertible bonds. Intuitively the way these bonds work is:

1. They are debt, but 2. If Juul goes public, they convert into stock at a discount to the initial public offering price. [3]

So basically if you invest $2 billion and things go well, you get back, I don't know, $2.5 billion or so of public stock; if things go poorly, you get back your $2 billion in cash. And there are a floor and a cap on the conversion price: If Juul goes public at, like, a $100 billion valuation, you get way more than $2.5 billion worth of stock; if it goes public at a tiny valuation, you get less — but why would it do that?

But while that is the rough intuition, it is not exactly what the bonds say. They actually allow the company to force conversion into cash upon a "qualified financing," which could be an IPO, but could also be a private stock sale that raises at least $500 million from outside sources. [4] I suppose that, when you negotiate a bond like this, you think "well, if this company is raising $500 million in stock from new equity investors, that's probably good news, so I'll be happy to convert into stock," but that's not necessarily true.

You could have a similar thought process with carbon credits:

1. Some people noticed that trees sequester carbon, and cutting down trees increases global warming. 2. They spun up a bunch of projects that involved preserving trees that would otherwise be cut down, or planting new trees, in ways that would slow global warming, and started awarding carbon credits for the trees that were saved. 3. You can extend the causal chain. If a logging company decides not to cut down a forest, that saves X trees and is worth Y carbon credits. But if you, I don't know, air a television ad telling people "trees are good, don't cut them down," how many trees does that save? How many carbon credits is that worth? If you fund a researcher to study tree diseases? Make up your own potentially tree-saving idea, and then award yourself some carbon credits.

"Award yourself some carbon credits" is too glib, and in fact there are various certifying bodies for carbon credits, but you can make your case. Here's a story about kangaroos:

One area we must scrutinise forensically are human-induced regeneration projects. These are the backbone of the [Australian] offset scheme, accounting for 30% of credits issued to-date. Over the coming years, they could be responsible for almost 50% of annual issuances. These projects claim to regenerate native forests across vast areas — not by replanting trees in cleared areas, as you might think, but by reducing grazing pressure from livestock and feral animals. …

Almost all projects are in arid or semi-arid rangeland grazed by livestock and kangaroos and only partly cleared.

You don't plant trees, and you don't refrain from cutting down trees; there is only so much capacity for that. (You weren't going to cut down trees on the arid rangeland anyway, and planting more is hard.) Instead, you go to the arid rangeland and, uh, find some kangaroos and discourage them from eating trees? Does that reduce carbon emissions? I mean! No, argues the article:

These projects are largely in the uncleared rangelands covering most of Australia's interior. These areas have little chance of promoting woody growth and storing more carbon, not because of grazing pressure, but because rainfall is too low, the soil too infertile, and the vegetation already close to its maximum. Forests will not regrow in these areas, particularly under hotter and drier climates. …

In fact, where overgrazing does occur in Australia, it's likely to actually increase tree and shrub cover rather than reduce it. Known as woody thickening, this happens when grazing animals eat so many grasses and herbs that they skew the balance in favour of trees and taller shrubs.

But the general thought process opens up a world of possibilities. Lots of things have some propensity to increase the growth of trees. Go do those things and get your carbon credits.

Many, but not all, scandals at banks are caused by the facts that (1) the bank wants to make money, (2) it gives its employees incentives to make money, (3) they are under a lot of pressure to perform and (4) making money is hard. (In this, the bank employees are much like the insider trading AI.)

So the most normal kind of banking scandal is that the employees do things to make money that are either risky (and thus bad for the bank) or fraud-y (and thus bad for the bank's customers from whom they make the money). Another, somewhat less common kind of scandal is that the employees pretend to make money. They just, like, write in their daily report, "I made a lot of money today," and their bosses are deceived, and the bank thinks it has money that it doesn't. There are various rogue trading and portfolio mismarking scandals that basically look like this.

But there are other scandals that are a bit different. Some scandals are caused by the facts that (1) the bank wants to make money, (2) it sets goals for employees that are correlated with making money, but that are not actually identical with "make a lot of money," (3) the employees have incentives to meet those goals and are pressured to perform and (4) there are easy, degenerate ways to meet those goals without making money.

Most infamously, Wells Fargo & Co. thought to itself "if we cross-sell our customers on having lots of different banking products with us, we will have more revenue and more loyal customers," so it rewarded bankers for selling customers extra products. And the bankers realized that it was hard to sell customers extra products, but relatively easy to, for instance, sign customers up for online banking or a credit card or a checking account without their permission. And so Wells Fargo opened millions of fake accounts and got in a lot of trouble. Sometimes the fake accounts made a bit of extra money for Wells Fargo, but mostly they didn't — mostly the customers just got online banking access that they never used. Wells Fargo wanted its bankers to generate more revenue and customer loyalty, but it told them to open more accounts, and there's an easy (bad) way to do that without generating revenue or customer loyalty.

There are other scandals that have the same shape but aren't about money. Wells Fargo also wants its staff to be more diverse, so it has a diversity program that mandates things that are correlated with making its staff more diverse, but not quite identical. Emily Flitter at the New York Times reported last year that Wells Fargo told employees to "interview a 'diverse' candidate — the bank's term for a woman or person of color" when they were hiring for an open position. So the employees would do these interviews even for positions where they had already chosen a candidate — fake interviews to check the box rather than real interviews to fulfill the actual goal.

Or, US law tries to discourage discriminatory lending decisions by banks by, among other things, asking banks to collect demographic data about their mortgage applicants. The bank asks customers their race and gender, it writes down the answers, it reports them to the government, and if the government notices that the bank rejects 100% of Black applicants then it can do something about it. This is a somewhat intrusive thing to ask the customers, and they don't have to answer: The customer can just say "no thanks" and the bank can report "declined to answer" to the government.

You can see the easy, degenerate way to check that box. Here is a US Consumer Financial Protection Bureau enforcement action from yesterday:

The Consumer Financial Protection Bureau (CFPB) today ordered Bank of America to pay a $12 million penalty for submitting false mortgage lending information to the federal government under a long-standing federal law. For at least four years, hundreds of Bank of America loan officers failed to ask mortgage applicants certain demographic questions as required under federal law, and then falsely reported that the applicants had chosen not to respond. Under the CFPB's order, Bank of America must pay $12 million into the CFPB's victims relief fund. …

Hundreds of Bank of America loan officers reported that 100% of mortgage applicants chose not to provide their demographic data over at least a three month period. In fact, these loan officers were not asking applicants for demographic data, but instead were falsely recording that the applicants chose not to provide the information.

Because that is easier! It is sloppy, though; if you report that 100% of your applicants decline to answer, eventually someone will notice.

For another thing, though, the companies that make these drugs have unusual ownership structures. They are not mainly owned by the usual universal owners, BlackRock and Vanguard and Fidelity and State Street. Here is a Wall Street Journal story on their biggest owners:

Two nonprofit foundations are large shareholders of Eli Lilly and Novo Nordisk, the companies selling the drugs Ozempic, Wegovy and Mounjaro popularly used to reduce weight. Thanks to the drugs' skyrocketing sales, the foundations' stakes have surged in value, creating windfalls that are reshaping charitable giving.

The philanthropies are now among the biggest in the world, with the Novo Nordisk Foundation counting $114 billion in assets and Lilly Endowment quadrupling in value to $40 billion. The Lilly Endowment is the second largest U.S. foundation, behind the Bill & Melinda Gates Foundation—and its $53 billion in assets—but ahead of the Ford Foundation and the J. Paul Getty Trust, according to FoundationMark data provider.

With their newfound anti-obesity riches, the foundations have been expanding their ranks and increasing their donations by hundreds of millions of dollars a year. …

The enrichment of the foundations is a product of the unusual ownership structures of the two drugmakers. Their large ownership stakes, which date back decades, have helped insulate the drugmakers from the daily whims of shareholders.

The Lilly Endowment's 11% stake makes it Eli Lilly's biggest shareholder. The Novo Nordisk Foundation owns more than one-fourth of Novo Nordisk shares and majority voting control of the drugmaker. The Lilly Endowment operates independently from Eli Lilly, while the Novo foundation is more intertwined with Novo Nordisk as its controlling shareholder.

I suppose this means that, if Eli Lilly or Novo Nordisk does discover a drug that is good for humanity but bad for the stock market, they will be inclined to market it anyway.

One thing that I think about sometimes is that corporations are, by their nature, perpetual, and that this creates weird biases. People just naturally expect businesses to last forever, or, rather, they think that the mark of a successful business is longevity. You invent a product, you sell it, you get money, you invest in research and development, you make more products, you keep up with trends, you make money forever. Sure sometimes you fail — you invent a product but no one buys it and you shut down — but the goal is to keep selling products forever.

But it is not obvious to me that this makes sense for every business model? "You invent a product, you sell it, you get rich, you get into yachts" is also, in its way, a success. It seems to me that you might go into a business with a finite lifespan, figuring "this business is good now, and will not last forever, but I will make money now and then I will stop." For instance:

One classic form of private equity business is to buy up declining companies, cut costs, extract as much money as possible and manage the decline. This is classically a private equity business because public markets do not like decline: A public-company chief executive officer, paid in long-term stock options, is going to be tempted to do money-wasting pivots to try to remain relevant. And it is a business that is controversial: People get angry at private equity for this sort of managed decline, because of the bias that businesses should be perpetual. Oil? Coal? There is a tension in the energy business among (1) people who think we will eventually stop burning oil, and want oil companies to pivot to wind energy or whatever, and (2) people who think we will eventually stop burning oil, and want oil companies to drill while the drilling is good and spend a lot of money on stock buybacks. There are good reasons to think that oil companies are well positioned to get into the clean-energy business (they have lots of capital, they understand energy markets), but I suspect there are also bad reasons (they already have all that office space so they might as well do something to keep going).

Anyway the US government inserted an Employee Retention Credit into the tax code to encourage businesses not to get rid of employees during Covid-19. The deal is that employers can get a tax credit if they "paid qualified wages to some or all employees after March 12, 2020, and before January 1, 2022," with eligibility and amounts depending on how they were affected by Covid. This created a gusher of money from the US government to thousands of businesses, but it is complicated to claim; you need lawyers and accountants to determine and document your eligibility. And the gusher is, by its terms, temporary.

So a business model exists of "figure out if businesses are eligible for the ERC, help them get it, and take a 25% cut." This could plausibly be a service that existing tax lawyers and accountants could offer their existing clients, but if the gusher is big and temporary enough it might make sense for a separate company to start up to do this. That company would always have an expiration date — eventually every employer affected in 2020 through 2022 would get their credits — but for enough money it would be worth it.

One thing to think about is that, if you have a perpetual business, you will make a lot of investments in long-term reputational goods, and you'll be careful not to mess up your reputation for short-term gains. Whereas if you have a business with a clear and near-term expiration date, you might want to grab as much as you can right now, and won't be all that careful about your reputation for getting things right.

Let's say that you are very, very, very good at getting high school students into elite colleges. If someone hands you a mediocre ninth grader, in three years you can hand them back a student with, say, a 50% chance of getting into Harvard. This is a service that a lot of people want, and that not a lot of people can provide. How should you price it?

One answer might be "charge a whole lot, and then sell it to as many people as can afford to pay." Another answer might be "price discriminate as much as possible": Get the parents' financial information, charge the really rich ones $5 million, charge less rich ones less, and do some pro bono consulting for poor but worthy candidates.

But there is a flaw with these answers. The more of this service you sell, the less it is worth. Harvard admits like 2,000 students a year. If you consult for 3,000 students, no matter how good you are, some of them aren't getting in. Really you want to charge an amount of money that is so absurd that most people won't pay it, so that (1) you have very few clients and don't have to work too hard, (2) those few clients pay you a lot of money and (3) they get their money's worth.

Also if you are in this business, your clients (I mean, the parents) will probably come disproportionately from the financial industry, and they will understand this. Here is a fun Bloomberg News story about Christopher Rim, who runs a company called Command Education that is apparently quite good at getting high school students into fancy colleges. His rack rate is $750,000. But some parents would, sensibly, rather pay more to get him to work less:

Rim said a parent at New York's Trinity School — a $64,000-a-year Ivy League-feeder — once offered him $1.5 million if he would agree not to work with any of his child's classmates (Rim declined).

I mean of course he declined! That's just twice his usual rate, and surely he can get more than two clients a year from Trinity. There is some number, though ($5 million?), at which it's an interesting trade: For Rim, he gets most of his Trinity revenue with much less work (just the one kid), and for the parent, I mean, someone from Trinity is going to get into Harvard — the competition is not quite zero-sum but it is close — and kneecapping everyone else is at least as valuable as inflating your own kid's resume. The parent was on to something here.

By the way, there is an analogous story early in Michael Lewis's Flash Boys. Spread Networks was building a very fast data line from New York to Chicago and selling space on the line to financial firms:

All its creators knew was that the Wall Street people who wanted it wanted it very badly — and also wanted to find ways for others not to have it. In one of his first meetings with a big Wall Street firm, Spivey had told the firm's boss the price of his line: $10.6 million plus costs if he paid up front, $20 million or so if he paid in installments. The boss said he'd like to go away and think about it. He returned with a single question: "Can you double the price?"

Having a fast connection between New York and Chicago, or a good high school resume, is nothing. Having a faster connection between New York and Chicago, or a better high school resume, is everything. It is always good to be in a business where your customers beg you to take more money to work less.

I mean here is what I understand. Venture Global is a producer of liquefied natural gas. It has a plant in Louisiana that "has yet to enter commercial operations," but that nevertheless produces and sells LNG. There is some philosophical distinction there that eludes me: Intuitively, if you have a factory that is producing and selling LNG, that would seem to be a commercial operation, but apparently if there's something wrong with your steam generators then, no, not commercial yet, fine.

When Venture Global was building this plant, it signed long-term supply contracts with big customers at fixed prices, and presumably used those long-term contracts to get financing to build the plant. But those contracts require it to supply LNG when the plant is in commercial operation, not before. Also the price of LNG is up a lot since it signed those contracts. The trade is obvious:

1. Do not flip the metaphysical switch that turns your not-in-commercial-operation plant into an in-commercial-operation plant. 2. Keep operating non-commercially to produce LNG. 3. Sell it on the spot market at high prices. 4. Don't sell it to your long-term customers at the lower prices you negotiated with them. 5. When they complain, point to the metaphysical switch and say "ah, but you see, the switch hasn't been flipped, so really we can't sell you any LNG."

They are complaining:

Oil companies Shell and BP have separately filed for arbitration against Venture Global LNG over failing to supply contracted cargoes, even as it sold to non-contract customers while prices were soaring. …

Portuguese oil company Galp Energia, which signed a 20-year contract with Venture Global LNG for 1 million tonnes per year, is weighing options, said Rodrigo Vilanova, Chairman and CEO of its unit Galp Trading.

Vilanova said the company is disappointed, as Venture Global has already produced and sold more than 170 LNG cargoes, according to publicly available information.

"We understand all those cargoes... have been sold in the short-term market to whoever pays more, as opposed to delivering under the long-term contracts signed by foundational customers such as Galp, who helped underpin the project," he said during a call with investors.

We talked last week about a bad UK electricity trade: Drax Group Plc gets some green-energy subsidies in the form of essentially a fixed-price contract, where it supplies electricity to customers from a biomass power plant at a fixed price that was expected to make it profitable. When electricity prices were low, Drax ran the power plant, got paid the higher fixed price, and made a profit. When electricity prices are high, Drax turns off the subsidized plant, doesn't sell any electricity from the plant at the lower fixed price, and instead runs its other plants, sells electricity at high prices and sells the biomass pellets to make more money. Good trade! For Drax I mean; bad trade for the UK government that negotiated it. I wrote that if you have a fixed-price contract that pays based "on how much electricity they actually supply, and let them decide how much to supply, then they will supply a lot when the contract is favorable to them and nothing when it is favorable to you."

The contract here is more sensible — Venture Global is required to supply a certain amount of LNG to its long-term customers at fixed prices — but apparently still gives Venture Global enough of an option that this is the result.

This, from last week, is one of the best stories you'll ever read about how regulation works:

Congress passed legislation intended to make life better for people allergic to sesame seeds. Instead, it made things worse.

The bill, passed with overwhelming bipartisan support and signed into law by President Biden in 2021, requires manufacturers to label sesame on their products starting this year.

In response, some companies began adding sesame to products that hadn't included it in the past—saying it was safer to add sesame and label it, rather than certify they had eliminated all traces of it.

People with sesame allergies say the result is fewer sesame-free food options, as well as new and unexpected risks from sesame in foods they used to eat without worry.

The issue is that it is hard to eliminate trace amounts of sesame, and the law now requires food manufacturers to label sesame as an allergen. Not putting sesame on the label effectively constitutes a promise that there is no sesame in the product, and if there is a little bit then you get in trouble:

Advising that the product "may contain" sesame on the label isn't a practical solution since a trace amount of sesame detected could trigger a recall, the bakers group said. The Food and Drug Administration considers "may contain" a voluntary advisory that isn't a substitute for good manufacturing practices meant to ensure that a product is allergen-free, and finding an undeclared allergen could be grounds for ordering a recall.

But if you say that the product definitely contains sesame, then you are immunized from trouble. So you just chuck some sesame into everything, change the labels, and you're fine. It is easier to make sure that there is sesame than that there isn't, so that's what companies do.

Everything is like this? There are huge areas of regulation where the most straightforward approach is to look at the giant book of rules and say "no thank you, I want out of this entirely." Making non-sesame food products is a heavily regulated business with huge risks if you mess up; making sesame-based food products just lets you escape from that regulatory regime, so you might as well throw in some sesame.

The way the ransomware business is organized seems to be that there are a couple of, like, malware-as-a-service providers like LockBit and DarkSide that provide software and expertise to independent hacker customers who pick the targets and do the hacks; the providers and the hackers split the ransoms. If you are one of the providers, you have to choose your hacker partners carefully so that they do the right amount of crime: You don't want incompetent or unambitious hackers who can't make any money, but you also don't want overly ambitious hackers who hack, you know, the US Department of Defense, or the Hospital for Sick Children. Meanwhile you also have to market yourself to hacker partners so that they choose your services, which again requires that you have a reputation for being good and bold at crime, but not too bold. Your hacker partners want to do crime, but they have their limits, and if you get a reputation for murdering sick children that will cost you some criminal business.

The most interesting field of economics might be the economics of not doing things. The main way that people make money, in the world, is by doing things that other people want: drilling oil, brewing coffee, maintaining social media sites, writing newsletters. But there are a few lines of business where you can get paid for not doing things that you'd otherwise do. Blackmail, for instance, is a classic: "I will go around distributing these compromising photos of you, unless you pay me money, in which case I will do nothing." Coasean bargaining: "I will build a smelly polluting factory on my land next to yours, unless you pay me money not to, in which case I will leave it undeveloped." Demand response in electric grids: "I will turn my lights on and use electricity, unless you pay me not to, in which case I will use less electricity." And, in the modern world, all sorts of environmental credit schemes: "I will chop down these trees, drill this oil, etc., unless you pay me not to, in which case I won't do anything at all."

There are so many ways in which the economics here are unintuitive. Consider the oil market. There is some demand schedule for oil; people will use more of it at lower prices and less at higher prices. There is also a supply schedule: Some oil is cheaper to drill than other oil, so when oil prices are low only the cheapest-to-extract oil will get drilled, but when prices get high people will drill in more difficult environments because it becomes worth it. But then consider the market for not drilling oil. If you own a bunch of oil fields, and someone will pay you $5 per barrel not to drill oil, you should start your not-drilling in the most-expensive-to-drill places. "Good news," you say, "I have decided not to drill in this field that costs $150 per barrel to drill, now pay me my $5." You could expand on this theory. If you don't own any oil fields, you could walk into the offices of some environmental-credits company and say "if you pay me $5 per barrel not to drill oil, I won't go around buying oil fields and drilling them."

Also consider the demand schedule there. If you promise me not to drill for oil, I might pay you $5 per barrel for the oil you don't drill. But you could go to someone else and promise not to drill the oil, and they might pay you $3 per barrel. For the same barrels. "Not drilling oil" is a non-rival good; you can not drill the same barrel of oil as many times as you like, and sell it to a different person each time.

Or consider blackmail. If you get some compromising photos of me, and I pay you not to publish them, then you won't publish them (let's assume). But what are your long-term incentives? The way to succeed in the business of not publishing compromising photos is by taking lots of compromising photos and repeatedly threatening to publish them. If I paid you $100 not to publish the photos, and you were like "right, good, I get paid not to publish photos, I will stop taking the photos," you would be deeply misunderstanding your business. You are not being paid to not publish photos — anyone can not publish photos! You are being paid to credibly threaten to publish photos, and then not publish them.

This has important implications for the environmental credit schemes. You don't get paid for not drilling oil or not cutting down trees; you get paid when there is a credible threat (from you or someone else) to drill the oil or cut the trees, and you prevent it. You are in the credible-threats business.

A form of story that you sometimes see in finance is:

1. Someone creates a statistic, method, index, etc. to try to measure some complicated reality in the world. 2. The statistic, etc., is good, and people start using it to measure that reality. 3. A derivatives market grows up where people can bet on the statistic, as a proxy for the complicated reality. 4. People try to manipulate the statistic, or get early access to it, or otherwise corrupt it to win their bets. 5. Administering the statistic becomes a lot more difficult, expensive and legally perilous than it was at the beginning when someone was just making it up out of abstract curiosity.

This is not exactly the story of Libor, but it is not exactly not the story of Libor either: By the end of Libor, it was so legally fraught (because banks had made so many fake Libor submissions) that the regulators had to push banks to keep measuring Libor even as they were also trying to get rid of Libor.

Anyway here is a fun Wall Street Journal story about WAR, wins above replacement, a form of statistic that people try to use to measure a baseball player's overall value to his team. In baseball's current labor dispute, there is a proposal to pay some players in part based on their WAR, perhaps as measured by some of the websites that develop and track the measure. The websites don't like it:

When the news leaked last month, the response from the analytics community was swift. Baseball-Reference president Sean Forman tweeted he was "not really interested" in his company's WAR being part of player compensation. Meg Rowley, FanGraphs' managing editor, posted, "Using a public-facing value metric for player compensation isn't the best idea." Russell Carleton of Baseball Prospectus, another site with a version of WAR, called it a "terrible idea."

"If MLB and the union were to say, 'Yeah, we're going to take the values off the public sites and use them,' that would be problematic," said David Appelman, FanGraphs' founder. "That puts a lot of pressure on us." ...

As researchers uncover better understandings of how to evaluate player performance, WAR is refined to reflect those breakthroughs. For example, how to weigh and evaluate defense is constantly evolving. The same goes for measuring the impact of issues such as specific ballparks, catchers' "framing" of pitches and the increased reliance on relief pitchers versus traditional starters, among many other areas of the game.

Sometimes, WAR is adjusted retroactively to reflect those changes, raising obvious questions: What happens, for instance, if a player's WAR falls short of qualifying for a bonus payment, only for it to increase a year later?

"I would shudder to think, are we going to get sued by somebody for something because of that, if we're literally costing somebody a million dollars by making that change?" Forman said in an interview. "I can imagine circumstances where people get pretty angry with us."

It seems reasonable to say that pandemics are bad for the world economy and that curing or preventing them would be good. If you are a big diversified institutional shareholder who owns a big chunk of all the companies in the world, ending the Covid-19 pandemic would be very good for your portfolio. This was particularly true in the early days of the pandemic in 2020, when much of the world economy was severely disrupted and vaccines were still in development. Back then, I sometimes argued that the best thing a big public pharmaceutical company could do, for its shareholders, would be to (1) develop a Covid-19 vaccine or cure, (2) spend as much money as possible to manufacture it as quickly as possible and (3) give it away for free. This might be financially disastrous for that company, and its stock might go down, and its shareholders might lose money on that stock. But most shareholders these days are broadly diversified; the shareholders own lots of other stocks, which would go up. Making a vaccine widely available would be hugely positive-sum for corporate profits, and thus corporate shareholders, as a whole, even if it was costly for the particular company making the vaccine. And since that company's shareholders — who, at least in some sense, own the company — also own all the other companies, and understand all this, they might pressure the company to sacrifice its own interest for the common good.

Two years later the evidence on that is, let us say, mixed; there were some reports of common shareholders pushing pharmaceutical companies to cooperate to develop vaccines faster, but the vaccine makers have made huge profits and seem to have done well for themselves, while large parts of the world are unvaccinated. You could imagine common shareholders being disappointed by this. You could imagine them thinking that the world economy and broad corporate profits are at risk as long as global vaccination rates are low, and that the best thing for their overall portfolios would be for the vaccine makers to try harder to distribute vaccines freely even at the cost of their own profits. You could imagine them asking the big vaccine makers to do that.

I suppose it is a little far-fetched but on the other hand it is happening! Kind of. Last November, a small shareholder in Johnson & Johnson filed a shareholder proposal, for J&J's proxy statement this spring, asking the company to "commission and publish a report on (1) the public health costs created by the limited sharing of the Company's COVID 19 vaccine technologies and any consequent reduced availability in poorer nations and (2) the manner in which such costs may affect the market returns available to its diversified shareholders." The proposal goes on:

To the extent our Company is increasing its own financial returns by preventing vaccine production in poorer nations, its own increased profits are coming at a severe cost to the global economy, because failure to vaccinate the world's vulnerable communities is inhibiting worldwide economic recovery and creating opportunities for more dangerous SARS CoV 2 variants to develop.

This is a bad trade for most of the Company's shareholders, who are diversified and thus rely on broad economic growth to achieve their financial objectives. A Company strategy that increases its own financial returns but threatens global GDP is counter to the best interests of most of its shareholders: the potential drag on GDP created by hoarding vaccine technology will directly reduce diversified portfolio returns over the long term.

Despite this risk, the Company has not disclosed any analysis of the trade offs between Company profit and global public health from the perspective of its largely diversified shareholders, whose investment portfolios may be at grave risk from undue limitations on vaccine production.

The requested report will help shareholders determine whether current Company policies serve shareholders' best interests.

J&J asked the U.S. Securities and Exchange Commission if it could omit this proposal from its proxy statement, and the SEC said no, so J&J's shareholders will get to vote on it.

I don't want to make too much of this. This is not J&J's biggest shareholders — Vanguard Group, BlackRock Inc. and State Street Corp. — asking the company to license its vaccines; this is a small shareholder making trouble with a nonbinding proposal asking J&J to produce a report. I just want to point out that this is a thing now; you can write a shareholder proposal asking a company's shareholders to think about their interests as diversified shareholders, and asking the company to prioritize those interests above its own economic performance.

We talked previously about a shareholder proposal at Fox Corp., asking it to become a public benefit corporation focused on informing its viewers; that was, I think, the first case of a shareholder proposal specifically arguing that it was in the best interests of Fox's diversified shareholders to do something that was not in the company's direct financial interest. That one got about 1% of the vote at Fox's annual meeting so, you know, early days, but this stuff is part of the conversation now. The model of financial capitalism for many decades was that a company's shareholders were interested exclusively in the financial performance of the company. Now new models are available.

We have talked a lot around here about a basic business model of:

1. Pay people to use your app, service, product, etc. 2. Get lots of users and rapid growth. 3. Tell investors "see we have lots of users and rapid growth! The margins will sort themselves out eventually." 4. Raise lots of money from investors on that premise. 5. Stop paying people to use your thing, and start charging them instead. 6. Either it works, and the thing is so good that they keep using it now that they have to pay for it, or it doesn't, and your thing dies, your investors lose money, and you keep some of their money.

In principle you can do this with any sort of app, service, product, etc., but it helps your pitch if you can project that, once people get used to your thing, they won't be able to quit it. They will become so reliant on, say, grocery delivery in 20 minutes or less that they will be willing to pay up for it rather than return to the archaic barbarism of going to the grocery store themselves.

I don't give … gambling advice? … around here, but I gather that a lot of companies are willing to give New Yorkers a lot of money to try sports betting. Here is a Bloomberg News article about companies giving Whitney Tilson some money to gamble:

Whitney Tilson regularly warns readers of his daily financial newsletter that "sports betting is a sucker's game" and that they shouldn't get hooked.

That hasn't stopped the 55-year-old former hedge-fund manager from going all in. Since New York state legalized digital sports gambling three weeks ago, Tilson says he's won over $7,000.

His advice: "The companies are banking on people getting hooked," said Tilson, founder of Empire Financial Research. "So you have to be clever and outwit them." …

Gambling companies have pushed promotional credits as large as $1,000, reeling in first-time bettors. More than 1.1 million accounts were created in New York in the first two weeks of legalization, according to GeoComply Solutions Inc., which monitors transactions. Nearly 90% of the players are new to regulated digital sports betting, GeoComply said.

And here is a Max Read newsletter with practical advice on how to claim your free money (and not lose it by gambling). You can, uh, I think you can pretty easily understand the thinking here? The thinking is that if you pay someone $1,000 to gamble on your sports betting site, that person will end up losing a lot of money on your sports betting site, enough for you to recoup the $1,000 and then some. "The companies are banking on people getting hooked," just like the 20-minute-grocery-delivery companies are, except that the grocery companies are offering convenience and the gambling companies are offering addiction? I wrote yesterday about the grocery ones:

For the venture capitalists the good outcome here is that you succeed in building a monopoly, jack up prices, squeeze your delivery workers' pay and make a lot of money. From a societal perspective it is possible that the good outcome is … you know … Saudi sovereign wealth funds just give everyone in New York free groceries for a while? There is an argument that this business model is a symptom of investors having too much money, and buying groceries for people seems like as good a use of that money as anything else.

Here arguably the model is "we are taking $1,000 from gambling addicts and giving it to Whitney Tilson," which seems less great.

There is a certain kind of big investor — activist hedge fund managers, Warren Buffett, Elon Musk, Cathie Wood, etc. — who can make a stock go up by buying it. If Warren Buffett buys 5% of a company's stock, and then he says "I bought 5% of that company's stock because I like it," the stock will go up. Or if Bill Ackman buys 5% of a company's stock, and then he says "I bought 5% of that company's stock because I want to do an activism," the stock will go up.

When this happens:

1. The investor — the activist or famous value investor or whoever — makes a quick profit, on paper. The investor also hopefully makes a longer-term, realized profit. If the investor buys at $50 and then announces her purchases and the stock goes to $60, she is up $10 per share, though she is unlikely to sell immediately. (If you frequently do this and sell immediately, people are going to stop trusting you, and you will no longer be able to make the stock go up.) If the investor buys at $50 and then announces her purchase and the stock goes to $60 and then her thesis plays out — she is right that the company is a good investment and it continues going up, or she does activism and replaces the board and the company becomes more valuable, etc. — and the stock goes to $80 and then s he sells when her work is done, she makes $30 per share. But there is no guarantee of that; she might be wrong, or lose her activist campaign. The $60 quick-reaction price is roughly the market's estimate of the expected value of her involvement in the company. 2. The other shareholders of the company also make a profit. Like the investor who catalyzes this, they have a quick paper profit (the stock goes up on the announcement) and then, if all goes well, a bigger longer-term profit. But of course there is some risk of it not going well. They could sell as soon as the investor announces her involvement and make the quick $10. Note that in any case the other shareholders make much more money than our investor. If she buys 5% or 10% of a company's stock and then announces her ownership and the company's value increases by $20 billion, she gets $1 or $2 billion of that, and the other shareholders get the other $18 or $19 billion. 3. The people who sold stock to our investor do not make much of a profit. I mean, they do fine; the stock was trading at $50 and they wanted to sell at $50 and they sold at $50. Realistically if our investor was buying a lot she probably pushed the stock up a little, so the people who sold did a little better than they would have without her involvement. But they don't get $60 per share; they don't get the price that they'd get after the investor announced her involvement.

This all strikes me as fine and good. The investor's involvement is valuable , so she gets to capture some of that value (Point 1). She captures that value because she is providing value to others (Point 2): Our investor's involvement increases the expected value of the company for all of its shareholders, and she gets a cut of that value roughly proportional to her ownership. And people who don't own the stock — including people who were planning to sell anyway, and then did sell — do not get much of that value (Point 3).

Still there is in the world an intuition, one that I find strange, that this is unfair to the people who were selling. If they knew that our famous investor was buying the stock, they would not have sold it to her for $50 (the pre-her-involvement price); they would have demanded $60 (the post-her-involvement price). There is an "information asymmetry": She knew that a famous investor was buying the stock (because it was her, she was the famous investor buying the stock), and they did not (because stock trades are basically anonymous), so she is somehow unfairly taking advantage of their ignorance.

You could imagine a rule that was like "if you are going to buy more than X% of the stock you have to tell everyone in advance so as not to take advantage of them." Or some variant on that. ("If you run more than $10 billion or have more than 100,000 Twitter followers you have to disclose all your purchases in advance"?) Or perhaps not in advance: A rule like "if you buy more than 1% of the stock then you have to disclose that right away" is almost as good as disclosure in advance, because it takes time to buy stock, so if you disclose after the first 1% and you want to buy 5%, the people selling you the remaining 4% will charge you more.

In actual fact the rule in the U.S. is a bit more complicated.[5] It says that if you buy more than 5% of the stock of a company, you have to tell people about that within 10 days after you get to 5%. In practice this means that you can keep buying for 10 days after hitting 5% and get to, you know, 8% or 9% or more before telling anyone. For various other reasons activists often prefer to stay under 10%, so for most activists this rule amounts to "you can build your whole stake secretly."

As I said, I find this fine and good, but others do not. Securities and Exchange Commission Chair Gary Gensler for instance:

"I would anticipate we'd have something on that," Gensler said, adding that he is worried about "information asymmetry," because the public doesn't know there's a big player buying up shares during the 10-day period.

"Right now, if you've crossed the 5% threshold on day one, and you have 10 days to file, that activist might in that period of time, just go up from five to 6% or they might go from five to 15%, but there's nine days that the selling shareholders in the public don't know that information," Gensler said. …

"It's material nonpublic information that there's an activist acquiring stock, who has an intent to influence and generally speaking, there's a pop if you look at the economics from the day they announced … there's usually a pop in the stock at least single-digit percent," Gensler said. "So the selling shareholders during those days don't have some material information."

Well, sure, the selling shareholders don't know who's buying, which is material nonpublic information, but it's material nonpublic information that belongs to the buyer. Or it does under current rules.

A couple of points here. First, the obvious losers from a rule change are activist hedge funds, who will need to pay more to buy their stakes and so will have lower profits. But the other losers are non-selling shareholders of companies that activists would have targeted: Some number of activist campaigns will be non-economical (because the activist would have to buy at a higher price), so the activists will do fewer campaigns, and since the activists' campaigns generally generate more money for other shareholders than for the activists those other shareholders will lose out. The winners are the selling shareholders, the ones who were happy to sell to the activist at $50 but who now get to sell to her at $60.

Second, I suppose this is nice for those selling shareholders, but to be clear the people who really want this rule change are corporate executives, who do not like to be surprised by activists and want to make life as hard for them as possible. The longtime advocates for this rule change have been Wachtell, Lipton, Rosen & Katz, the law firm where I once worked, which does a lot of activism defense and has petitioned the SEC to shorten the reporting period for years.

Third, the current rules allow investors to buy more than 5% economic ownership of the stock using derivatives — total return swaps, etc. — without disclosing their positions; the rule requires disclosure based on "beneficial ownership," meaning mostly owning actual stock. Ownership of large chunks of stock using swaps has fallen into disrepute after last year's Archegos Capital Management blowup, and the SEC has proposed requiring immediate disclosure of large swaps positions. So it is not surprising that it would also want immediate disc

My general view of the "revolving door" is that it is good for regulators to get a reputation for being tough in high-profile cases, because that will make them more attractive to the private sector. If you are a regulator with a reputation for being tough, then:

1. Potential private-sector employers will think that you're a creative hardworking go-getter, because those characteristics tend to correlate with toughness in regulation. 2. Potential private-sector employers will have more need to hire ex-regulators, because regulation is tougher so there is more work to do to respond to it, and ex-regulators are particularly qualified to do that work. 3. Other employees at your regulator will respect your toughness, and so when you go into private practice and advocate for a client to those regulators, they will take you seriously and be inclined to go easier on your clients; private-sector employers understand this. 4. Potential private-sector employers will want to hire you at a high salary because then you will stop being a regulator, and if you are tough on them as a regulator it is worth paying you to stop.

Of course you can take this too far. If you develop a reputation for being unreasonable or unprofessional or dishonest in your pursuit of tough regulatory action, private-sector employers will be less interested in hiring you. Or if you conduct a perfectly reasonable and honestly rather gentle investigation into a hilariously thin-skinned billionaire this might happen:

A partner at law firm Cooley LLP got an unexpected call late last year from a lawyer for one of the firm's most famous clients, Elon Musk's Tesla Inc., with an ultimatum.

The world's richest man wanted Cooley, which was representing Tesla in numerous lawsuits, to fire one of its attorneys or it would lose the electric-vehicle company's business, people familiar with the matter said.

The target of Mr. Musk's ire was a former U.S. Securities and Exchange Commission lawyer whom Cooley had hired for its securities litigation and enforcement practice and who had no involvement in the firm's work for Tesla. At the SEC, the attorney had interviewed Mr. Musk during the agency's investigation of the Tesla chief executive's 2018 tweet claiming, wrongly, to have secured funding to potentially take the electric-vehicle maker private. …

Cooley has declined to fire the attorney, who remains an associate at the firm, the people said. Since early December, Tesla has begun taking steps in several cases to replace Cooley or add additional counsel, legal documents show. Mr. Musk's rocket company Space Exploration Technologies Corp., also known as SpaceX, has stopped using Cooley for regulatory work, according to people familiar with the matter.

One assumes that Musk was operating out of pure emotional grudge here, but I suppose it's worth asking if that phone call was a good strategic move. Of course Cooley can't actually fire the associate, which would be disastrous for its reputation. But that's not the goal here. Other law firms that do a bunch of work with Tesla might have to ask prospective hires, like, "hey you haven't done anything to annoy Elon Musk have you?" And so current government regulators might think "hmm, I should go easy on Elon Musk so he doesn't ruin my future career."

If you were designing a revolving-door career from first principles it might go something like this:

1. You work in government and design a program that gives people in the private sector nine-figure payouts, but only sometimes, and with a lot of complex qualifications and subjectivity. 2. You quit immediately for the private sector. 3. You hang out a shingle advertising yourself as the only person with the knowledge and connections to get people those nine-figure payouts. 4. You take a chunk for yourself.

This is a good trade — build a spigot of government money and plant yourself in front of it — but still you could improve it. As I said above, it is good for a regulator to develop a reputation for toughness, in part because that will get you continuing respect from the people still in government administering the spigot. And of course spigots of government money are controversial and could be shut off at any time due to budget problems etc. So what you want to do is replace Step 1 above with:

1. You work in government and design a program that very toughly takes nine-figure sums from bad private-sector actors and then gives a share of them to good private-sector actors, but only sometimes and with a lot of complex qualifications and subjectivity. 2. Etc.

Anyway here's Patrick Radden Keefe in the New Yorker about whistle-blower lawyer Jordan Thomas:

Submitting explosive government filings on behalf of anonymous clients is what Jordan Thomas does for a living. He is an attorney who represents whistle-blowers. Thomas previously worked at the Securities and Exchange Commission, where he helped create a new program, implemented in 2011, that encouraged people to report corporate malfeasance. The program, developed after the 2008 financial crisis and the Bernie Madoff scandal, established a substantial monetary incentive for whistle-blowers, by allowing them to share in the proceeds of successful S.E.C. actions. These awards, which are sometimes referred to as bounties, can range from ten per cent to thirty per cent of what the errant company ends up paying the government. Since its introduction, the program has dispersed more than $1.2 billion in awards. In the words of the former S.E.C. chair Mary Jo White, it has been "a game changer."

Just after Thomas helped introduce this new regime, he left the government and opened a legal practice dedicated to representing whistle-blowers who brought cases to the S.E.C. Today, he is perhaps the foremost attorney representing such whistle-blowers. …

Because Thomas is often among the few people who know about the clandestine risks that his clients undertake, and about the secret windfalls they receive, he can occasionally act like their therapist or priest, giving them the faith to persevere. It helps, of course, that he is one of the designers of the bureaucratic gantlet they face. "He's the architect of the Matrix," the whistle-blower said. "Jordan Thomas built this machine." ...

Because he works on contingency, his fee is a significant chunk of any rewards that his clients receive. When the S.E.C. announced, in 2018, that in the Merrill Lynch case it would pay two awards, totalling eighty-three million dollars, it was reported that Labaton Sucharow could make more than twenty-five million dollars. Thomas expanded his team, bringing on two partners, Rich Levine and Michael Stevenson, who are also former S.E.C. officials.

If you work in the SEC's whistle-blower office, why wouldn't you quit after a while to do the same job but for a cut of the proceeds?

I will say that this is arguably good incentive design. Arguably everyone at the SEC should do a rotation through the whistle-blower office, just to get a taste for it. As I said above, the revolving door primarily creates incentives for regulators to be tough, but it secondarily creates incentives for them to be polite and clubbable. If your regulatory career is an audition for a private-sector job, you want the private-sector lawyers you deal with to think of you as tough but fair, professional and honest, someone they could see as a colleague. You want to make lots of ambitious cases and win them, but you don't want everyone to hate you. But if your post-SEC career is as a lawyer for whistle-blowers it's fine if everyone hates you! That's the job really! Elon Musk definitely can't get Jordan Thomas fired! He is a liberating role model for SEC enforcers.

The way credit ratings work is that a company goes to a credit-ratings firm and asks it to rate the company's bonds, and the ratings firm rates the bond, and the issuer pays the firm for the rating. One standard lesson of the 2008 financial crisis is that if an issuer is paying for a rating, the rating might be too generous. There are some reasons to quibble with that standard interpretation, but broadly speaking it makes sense. There are obvious incentive problems.

Meanwhile the World Bank is funded by some countries, and it also rates countries. It doesn't give them a credit rating, but it publishes a "Doing Business" report rating countries on, you know, how good it is to do business in those countries. If you are a country you want to get a good rating in that report so that more businesses will want to do business in you. If you are a country that funds the World Bank, etc. etc. etc., this really writes itself but here you go:

The World Bank canceled a prominent report rating the business environment of the world's countries after an investigation concluded that senior bank management pressured staff to alter data affecting the ranking of China and other nations.

The leaders implicated include then World Bank Chief Executive Kristalina Georgieva, now managing director of the International Monetary Fund, and then World Bank President Jim Yong Kim. ...

The Doing Business report has been the subject of an external probe into the integrity of the report's data. On Thursday, the bank released the results of that investigation, which concluded that senior bank leaders including Ms. Georgieva were involved in pressuring economists to improve China's 2018 ranking. At the time, she and others were attempting to persuade China to support a boost in the bank's funding. …

Chinese officials in 2017 and 2018 were eager to see their ranking improve, and so Mr. Kim and Ms. Georgieva and their staff held a series of meetings to discuss ways that the report's methodology could be altered to improve China's rankings, according to the investigative report by the law firm WilmerHale.

The World Bank was in the middle of difficult international negotiations to receive a $13 billion capital increase. Despite being the world's second largest economy, China is the No. 3 shareholder at the World Bank, following the U.S. and Japan, and Beijing was eager to see its power increased as part of a deal for more funding. …

Although the data-gathering process for the 2018 report was finished, the World Bank's economists reopened the data tables and altered China's data, the investigative report said. Instead of ranking 85th among the world's countries, China climbed to 78th due to the alterations.

It is popular in certain strands of financial regulatory thought to assume that the financial industry responds to incentives but that governments and intergovernmental organizations do not. But if you can get a billion dollars by moving China from 85th to 78th in a necessarily subjective multi-factor ranking, why wouldn't you?

The way that high-level professional services — investment banking, law, consulting, etc. — work is that a professional firm provides services to a client company, and the company pays the firm, but particular people at the firm pitch and work with particular people at the company, and the people at the company want to work with people they like and trust. And so the business of a senior investment banker consists largely of winning the trust and friendship of executives at companies in her coverage industry. Sure sometimes she will pitch a company she barely knows on a particular deal and win the business (or not) based on the quality of ideas in her pitch; other times a company will want to do a deal, will ask banks for fee proposals, and will choose her if she proposes the lowest fee. But in the course of a career these things tend to be less important than the day-to-day building of reputation and relationships. Mostly companies will hire her because their executives have worked with her before and like and trust her.

There are obvious, mostly low-grade conflicts of interest here. Probably some banking business can be done well enough by anyone, some other bank would do it cheap, and the company overpays for it because the chief financial officer wants to work with a particular banker whom he likes and trusts. Or the chief executive officer hires a banker who tells her what she wants to hear ("do a big merger") rather than what is actually in the best interests of her company; the shareholders end up worse off because the CEO picks advisers based on personal preference. Or of course professional service providers tend to buy a lot of dinners and sports tickets for client executives, and while the clients probably mostly don't hire firms based on that sort of everyday bribery, it's a thing you could worry about.

You could imagine trying to stamp out all of these conflicts of interest, and in some organizations (for instance, many governments) and some contexts people do. You set up objective criteria for hiring professional advisers, you demand written price quotes and choose the lowest one, you have some independent committee choose advisers on impersonal metrics without regard for the preferences of the executives who will work with the advisers. But mostly that is sort of silly; the actual service that these firms provide is basically "wise trusted advice," and to provide that service you really do need some relationship of personal trust. You can't just put it out to the lowest bidder.

Accounting is an unusual professional-services business because a lot of what accounting firms do — tax and structuring advice, consulting, etc. — is very much in this vein of wise trusted advice, but one core function of accounting firms — public-company auditing — is … only partly like that. Public-company executives do, to some extent, think of their auditors as "the people I call with accounting questions," and they want to hire auditors whom they like and trust and who they think have good judgment and good bedside manner. But auditors are also in a somewhat adversarial position to their client companies, or rather to the clients' executives: Their job is to audit the clients' accounts, to check them for mistakes, to flag problems, to certify to the market that the accounts have been reviewed independently and found to be acceptable. If the auditors are best friends and trusted advisers to the executives, then they can't be independent, and the market can't trust their audit results.

And so you get sort of a weird dynamic where there are rules designed to prevent auditors from becoming too chummy with their clients' executives, but of course the client executives want auditors who are chummy with them so they can have a pleasant audit experience, and of course the auditors want to be chummy with client executives so they can keep and win business.

Amazon.com Inc. is a big company, and if it decides to partner with a smaller company it can steer a ton of revenue and attention to that smaller company. Amazon might reasonably think "we are sending all this revenue and attention to the smaller company, and they are going to profit from it, and we want to extract as much of that profit as possible for ourselves." One way to do that is to set the commercial terms to be as favorable as possible to Amazon — pay suppliers as little as possible, etc. — but arguably a better way to do it is to (1) cheerfully create value for the smaller company but (2) buy some of that company first. You bestow Amazon's blessing on other companies, this blessing makes those companies more valuable, and your stake in them benefits from your actions.

So:

The technology-and-retail giant has struck at least a dozen deals with publicly traded companies in which it gets rights, called warrants, to buy the vendors' stock in the future at what could be below-market prices, according to corporate filings and interviews with people involved with the deals.

Amazon over the past decade also has done more than 75 such deals with privately held companies, according to a person familiar with the matter. In all, the tech titan's stakes and potential stakes amount to billions of dollars across companies that provide everything from call-center services to natural gas, and in some cases position Amazon among the top shareholders in those businesses.

The unusual arrangements offer another window into how Amazon uses its market heft to increase its wealth and clout. The company has been under growing scrutiny from regulators and lawmakers over its competitive practices, including with companies it partners with.

While the deals can benefit the suppliers by locking in big contracts, which can also boost their share prices, executives at several of the companies said they felt they couldn't refuse Amazon's push for the right to buy the stock without risking a major contract. The deals in some cases also give Amazon rights such as board representation and the ability to top any acquisition offers from other companies.

For Amazon, the arrangements give it a piece of the potential upside their vendors can get from doing business with one of the world's biggest companies.

For instance:

Grocery distributor SpartanNash Co. last year amended a contract with Amazon to deliver groceries to its Amazon Fresh arm. The Grand Rapids, Mich.-based company had been supplying Amazon with food since 2016, but this time Amazon added a condition: if it bought $8 billion worth of groceries over seven years, it could get warrants to purchase around 15% of SpartanNash's stock at a price potentially lower than the market. Amazon also said it wanted to be notified of any takeover offers for SpartanNash and have a 10-day window to offer a counterbid.

SpartanNash executives were taken aback, said people familiar with the matter. No customer had requested such terms before. Executives ultimately decided they didn't want to haggle with one of SpartanNash's biggest customers, and that being tied to Amazon could raise their company's profile, one of the people said.

Well, look, here is a graph of SpartanNash's stock price over the last year:Can you spot the day that SpartanNash announced its Amazon contract? I bet you can! The stock was up 26.3% that day. SpartanNash added 26.3% to its equity market value, in exchange for giving as much as 15% of its equity market value to Amazon. Twenty-six is more than 15. Seems like a good trade for both of them? Obviously SpartanNash would have preferred to add 26.3% to its market cap without giving any of it to Amazon, but that deal wasn't on the table. Also it is quite possible that what "raised their company's profile" is not just the commercial agreement but also the warrants, that being part-owned by Amazon made it more valuable than merely being an Amazon supplier would.

Amazon's reasoning seems to be explicitly about capturing the upside that it creates in smaller companies:

Amazon's first major warrants deal with a publicly traded vendor came in 2016. Amazon was seeking a partner with cargo planes to help build out its massive logistics network. Executives reasoned that the company's potential partners were all smaller, lesser-known companies with stagnant growth, and that a major contract from Amazon would invigorate their stocks, according to a person familiar with the matter. Amazon wanted some of that potential upside, the person said.

That reasoning strikes me as completely correct and kind of obvious. Yet somehow this approach is not popular; it is viewed as grasping and excessive and monopolistic. And I suppose Amazon's competitive advantage is in part that it does the economically obvious thing even if that seems grasping and excessive and monopolistic.

Oh one other very niche thing that I enjoyed is that Amazon's warrants appear to be based on the U.S. Treasury's Troubled Asset Relief Program warrants:

Former Amazon executives who worked on warrant deals said they found no direct precedent before the company began striking them. For a guide, an Amazon team sleuthed through financial documents from the 2008 financial crisis to find information about bank bailouts that involved warrants, one of the people said.

I used to (very) occasionally create warrants, as an equity-linked investment banker, and I will say that "just copy the TARP warrants" was kind of the standard approach. Arguably Treasury, in turn, was influenced by Berkshire Hathaway Inc.'s preferred-stock-plus-warrants investment in Goldman Sachs Group Inc. a few weeks before the TARP deals, and the Berkshire deal is also a popular precedent. These are good examples of my general rule, that if you can create a ton of value for another company you should buy its stock first.

Not that long ago, public-company chief executive officers complained constantly about how the public capital markets were relentlessly focused on the short term. "We can't invest for the future," the CEOs would say, "because shareholders only care about this quarter's earnings, and if we ever sacrifice short-term profits for long-term sustainability they will get mad and throw us out." This always struck me as somewhat implausible. The shareholders care about the present value of the company's future earnings in perpetuity. If the managers maximize that, the shareholders will be happy. The shareholders simply don't always trust that the managers are actually doing that; they worry that the managers are being lazy or dumb or building up their own importance rather than maximizing the long-term cash flows. (With some managers, they don't worry about this; Jeff Bezos and Elon Musk have very little reason to complain about shareholder short-termism.[2]) The shareholders want long-term value creation; they just want to hold managers accountable for actually creating that value. Sometimes the most practical way to do that is to check up on their results each quarter.

In any case, you hear this complaint a bit less these days. For one thing, there is the weird exogenous fact that quarterly corporate earnings went down a lot recently, for evidently short-term reasons, and investors responded with cheerful enthusiasm. Last year the net income of the S&P 500 index was down by 19% year-over-year, while the price of the index was up 16%.[3] Looking through the effect of a pandemic is not an incredible triumph of long-termism or anything, but it does seem harder to argue now that the market myopically overweights short-term results.

Also though now CEOs are too busy responding to investor demands that they focus more on the long term:

Companies are racking up hefty bills as they invest in new facilities and products to reduce emissions or meet other targets, hoping for a payoff down the road.

Businesses increasingly are coming under pressure from investors, lawmakers and regulators who demand more details on their spending plans and the progress they are making to achieve their environmental, social and governance goals.

As a result, car manufacturers such as General Motors Co. and Ford Motor Co. are boosting investments in electric vehicles to reduce emissions, while utilities including Xcel Energy Inc. and CenterPoint Energy Inc. are producing more renewable power.

But, those investments present challenges for chief financial officers overseeing companies' capital spending plans. Many of them are entering unknown territory by allocating funds to projects that carry big price tags, cover long time horizons and yield returns that are sometimes hard to quantify, executives said. Companies often make these investments before new regulations are proposed or consumer choices change, adding to the difficulty of finding the right balance.

Those viewed as investing too little are already paying a price. Ratings firms in recent months have either cut the credit outlooks of oil-and-gas companies or outright downgraded them, citing risks associated with the transition to green power and other factors. Among them were Chevron Corp. and Exxon Mobil Corp. , which last month lost a proxy battle against an activist investor. Credit downgrades can increase companies' borrowing costs and hurt their stock prices.

A couple of years ago, if a company got in a proxy fight with an activist investor, the company's managers would invariably say that the activist was a short-term-focused investor who wanted to make a quick buck and didn't understand or care about the company's long-term business. That was just how managers thought and talked about activists, and really how everyone did: Activists wanted to take the money the company was going to spend on research and development and blow it on stock buybacks instead. Now, when Exxon lost a proxy fight last month, it was to an activist who wants it to do more to transition to green energy, because he thinks that will create more long-term value even at the expense of short-term profitability.

A somewhat tongue-in-cheek but surprisingly useful maxim of high finance is that it is good for your career if you lose a billion dollars. I mean, if you lose a billion dollars for your employer you will probably be fired, though that depends on who your employer is and how much money you started with and what you did to lose it. But lots of other employers will be excited to hire you, once they learn that you lost a billion dollars for someone else. That is a good sign in a lot of ways:

1. It shows that someone trusted you to take risks with a lot of money. That's good! An employer is going to be nervous about letting anyone take billion-dollar risks with its money; if someone else already let you take billion-dollar risks with their money then that is evidence that you are one of the people sensible employers trust to take billion-dollar risks. Of course it went poorly for your last employer but that's not the point. 2. It shows that you were willing to take risks. That's good! Financial firms want people who will do stuff, who will make bold bets, who will take a chance at failing. It's easy enough to sit around looking busy while basically tracking an index; losing a billion dollars means that you were bold and active. 3. Sure sure the risks didn't work out but you probably have a good story about why it seemed like a good idea ex ante. 4. You have probably learned from your mistakes and won't do it again. (You probably also, now, have a good story about why it wasn't a good idea ex ante.[1]) 5. A weird optional bonus is that if you lost a billion dollars for a big employer, you might have some insights into how to take a billion dollars from that employer, which is potentially useful for that employer's competitors. Not all of finance is, like, Hedge Fund A figuring out how to exploit Bank B's weaknesses, but some of it is, and if you were one of Bank B's weaknesses you might be of particular use to Hedge Fund A.

People talk about the asymmetric incentives for risk-takers at banks — if you take a lot of risk and it works out, you get a huge bonus; if you take a lot of risk and it blows up, the worst they can do is fire you — but if this maxim is true (and, again, it's partly a joke) then it's even stronger than that, because if you take a lot of risk and it blows up that's good for you too. You're not just long a call on your performance, you're somehow also long a put. Either way you profit from volatility, so your incentive is to take a lot of risk.[2]I don't literally mean "a billion dollars," by the way; that's a nice round number and certainly attracts attention from future employers, but you can achieve similar career goals with some other large salient loss. Anyway here's a fun story about the new chief financial officer of JPMorgan Chase & Co.:

Long before Jeremy Barnum was promoted to chief financial officer, he was fired over a trading mishap -- by JPMorgan. He later parted ways with hedge fund BlueMountain Capital Management over another market blunder. ...[In 2004], JPMorgan's results in fixed income faltered. When Barnum's [credit derivatives[ team lost a bundle, his name was added to a list of dismissals as the bank's bosses set out to restructure the unit. He sent coworkers a tongue-in-cheek farewell email recommending that they closely study the career of Joseph Stalin's henchman Lavrentiy Beria and get really good at PowerPoint.Barnum was soon snapped up by BlueMountain, which named him head of its London office in 2005. The next year, the fund took a bath on wrong-way credit bets linked to Liberty Global Inc.'s Cablecom Holdings, prompting another ouster for Barnum. In a statement at the time, a senior BlueMountain executive said Barnum's exit was "mutually agreed."Then came the uncanny turnaround. JPMorgan gave Barnum a second chance and a new mission: Instead of making wagers himself, Barnum would use his trading experience and the lessons he learned to help oversee businesses, spot risks and head off trouble. He rejoined JPMorgan in 2007, right as two of Bear Stearns Cos.' hedge funds were blowing up.By 2010, Barnum was indispensable to his bosses and on the rise, having helped the firm dodge bullets from the financial crisis.

"This guy knows how we lose money," was I guess the theory; "maybe he can also stop us from losing money." It worked!

One thing to think about, if you run a company, is how much crime your company should do. The naïve answer would be that the optimal level of crime, for any company, is zero: Doing crimes is bad, it is forbidden, you should not do forbidden things, it is a pretty basic argument.I suppose an occasional theme around here is that this view is not quite right, and that the optimal level of crime for many companies is somewhat higher than zero. I have suggested recently, for instance, that a venture capitalist should want the level of securities fraud among her portfolio companies to be a bit higher than zero: If some of your founders aren't lying to you, you aren't backing enough bold out-of-consensus founders. If you run an investment bank and you want aggressive rainmakers to pursue hard-won business in distant parts of the world, some of them might do some bribes, and if you cut the level of bribes to zero it might lead to unacceptable losses of legitimate business. Or just more simply, if you have tens of thousands of employees, some of them will be stealing office supplies or whatever, and the costs of monitoring might be higher than the costs of some crime. In your personal life you might have an "absolutely no crime" rule, but in a large enough company your enforcement will necessarily be somewhat statistical, and absolutely zero crime might be hard to achieve and not worth it. But never mind all of that. What if your company's business is crime? What if you are a Mafia family, or a ransomware hacking group? Clearly the optimal level of crime is not zero: If your business is crime, you have to do crime to get revenue. But the optimal level of crime is also not infinite: If you do too many crimes, or crimes that are too bad, you will get in too much trouble. Doing more and bigger crimes should increase your crime-based revenue, but it also increases the resources that officials will expend on trying to shut you down, and thus your risks of being stopped and punished. At some point the lines cross, and you should forego some criminal revenue in order to keep your legal risk manageable. This is more or less the same calculation that regular businesses often make — "we don't want this piece of business, even though it's very lucrative, because it has too much legal risk" — just with a different baseline. An ordinary business wants to commit very few felonies, perhaps zero; a crime business wants to commit many. But they both have to make decisions at the margin, about whether to commit one more felony.

You miss 100% of the shots you don't take, or whatever. If you are smart enough to avoid all the dumb trades, the people with the borderline trades — the risky hairy trades, the trades that might well be dumb, but that, if they're not dumb, will be very lucrative — will go elsewhere. Why deal with you and your strict culture of risk management, when they could deal with someone else's nonexistent culture of risk management? I was not entirely serious about that, but, you know. There's a balance. You want to do all the good trades and none of the bad trades. To some extent you can just try to be really smart and choose your trades correctly, but in practice, at a large bank, in a competitive market, over time, it's not always going to work that way. Instead there will be a dial you can turn between "no bad trades but also no good trades" and "lots of good trades but also some bad trades," and you will try to turn the dial to a setting that maximizes net profits (gains from good trades minus losses from bad trades). Sometimes you will adjust the dial. If you have a particularly large and embarrassing bad trade, you will jerk the dial to the left; you'll retrench and do fewer good trades in order to ensure that you don't do any more bad trades. If you don't have any embarrassing losses for a while, though, you will start creeping the dial to the right, especially if your market share isn't great. "Let's do a few more risky trades," you will think, "because we are clearly not taking enough risk." Sometimes this will be a correct diagnosis: You are missing good trades because you are more conservative than your peers. Other times it is counterproductive: You are missing good trades because you are less charming or less respected or less helpful than your peers, and to get more trades you adverse-select yourself into the bad ones. A few weeks ago, a bunch of banks lost money on some margin loans gone wrong. (Technically equity total return swaps, but same basic idea.) I would not say any of them are proud of it or anything, and it is leading to a lot of retrenchment: The banks are cutting back risk in their prime-brokerage and swaps businesses, and regulators are making noises about new, stricter rules. On the other hand, before the swaps went wrong, some of the banks were definitely in turning-the-dial-to-the-right mode. Here's a Financial Times story about "How Credit Suisse rolled the dice on risk management — and lost":

In interviews with the Financial Times, six current and former Credit Suisse managers said the bank hollowed out risk expertise and trading acumen in favour of promoting salesmen and technocrats. Dissenting voices were suppressed, they said."There was a dulling of the senses," said a former executive. "Credit Suisse was in the deep end swimming with the sharks, but doing it with a private banking mindset. They were always going to get destroyed."

And here is a description of how chief risk officer Lara Warner, a former equities analyst, pushed the risk department to be "more commercial," which is pretty much how the dial works:

Warner was keen that the bank's global risk function should not be seen as an "academic ivory tower" that could "dismiss business out of hand", according to a person close to the bank. She also wanted her department to be seen as a career destination rather than an administrative backwater.During her five-year tenure, Warner and other executives pushed for risk and compliance to be "more commercial" and "aligned" with the front office traders and dealmakers, multiple current and former staff told the FT.She led by example. In October, Warner personally overruled risk managers who cautioned against giving Greensill a $160m bridge loan ahead of a private fundraising. The loan is now in default.

It is tempting to conclude that it is good for a bank to have trades blow up embarrassingly every now and then: If you go too long with no blow-ups, the dial will just creep to the right to let more trades in. "Clearly we are being too careful," the bank will conclude, "so let's be less careful." A few controlled fires can offset that tendency before it causes too big a problem. One problem with that conclusion is that Credit Suisse did have some embarrassing blow-ups before its bigger and more embarrassing blow-ups with Archegos Capital Management and Greensill Capital:

In 2018, Credit Suisse lost about $60m after it was left holding a block of shares in clothing company Canada Goose when its stock price plummeted. About a year later, the bank lost about $200m when Malachite Capital, a New York hedge fund and one of its prime brokerage clients, imploded."Those losses arose from lack of discipline," the former executive said. Just as with Archegos, senior managers at Credit Suisse got stuck in large positions negotiating on price while their peers aggressively sold out."There was systematic insensitivity at all levels," said a second person. "If you're the head of risk and you let a $60m loss go by, then a $200m loss, and you don't ask what the hell is happening here, what are you doing?"

In the simple model, the job of the chief risk officer is to turn the dial to "less risk" when things blow up a little bit, so that they don't blow up more.

I am so used to the asymmetric incentives of the financial industry, where if you make a lot of money for the firm you get rich, and if you lose a lot of money for the firm you (1) get fired, (2) get to keep the riches you made previously, and (3) easily get another job because you have proved yourself as a risk-taker. These incentives, obviously, encourage risk-taking, which in some very broad sense is what the financial industry wants; investment banks and hedge funds are trying to identify and train skilled risk-takers. One can go too far with this, and over the last decade or so there has been a lot of conversation about dialing back these incentives, about bonus caps and clawbacks to reduce the asymmetry and discourage excessive risk-taking.

But the incentives of the corporate treasury industry are the opposite. Your job is not to lose money. If you succeed in not losing money, you receive your modest, stable rewards. If you fail and lose money, you are fired. If you succeed beyond your wildest dreams and make a lot of money, (1) you do not get any extra rewards (because that was not your job) and (2) if your bosses are smart, they fire you anyway, because the fact that you made a lot of money means that you took a lot of risk, which was very much not your job.

The conclusion here is probably that corporate treasurers are never going to decide to buy Bitcoin, at least not until it becomes broadly normalized. How can it become normalized if treasurers never decide to buy it? Well, corporate treasurers are not necessarily the final decision-makers about the corporate treasury. Corporate chief executive officers are chosen and trained and incentivized to take risks; their pay does go up if the company is worth more. Some of them are really into Bitcoin. If Elon Musk tells his corporate treasurer to buy Bitcoin, Tesla Inc. is going to buy Bitcoin. "Ehh I just work here," the treasurer will shrug; "they don't pay me to take risks, and telling Elon not to do this is a risk I'm not willing to take."

The basic sin of investment banks is that they are both counterparties and advisers. The goal, of a banker or a salesperson at a bank, is to develop deep relationships with clients so that they treat you as a trusted adviser and come to you to solve their problems. The way you solve their problems is by selling them a thing. The more the thing costs—the more fees you can sneak into it, etc.—the happier you are and the sadder they are. They trust you to advise them on what is in their best interests, and then you advise them to do something that is in your best interests.

I do not want to exaggerate this. This is not "banks are irremediably evil." This is just, like, commerce. The way you get paid, as a bank, is usually that your client pays you. The more they pay you the more money you have and the less money they have. This is not that different from most other businesses: A car salesman wants to solve your transportation problems by selling you a car, and it's in his interest to add as many expensive optional features as possible to the car. But people, for both good and bad reasons, get madder about it when it's a bank. To be fair they don't usually get mad about it. Usually you buy a car and you like driving it and you are perfectly content that the salesman made some money selling it to you. Usually companies sell bonds or do acquisitions, and they are happy to have the money or the acquired company, and they are perfectly content that the bankers made some money executing the deal. But when things go wrong—when a company is not happy with its bonds, or its acquisition—everything kind of feels like a conflict of interest.

United Natural Foods Inc. hired Goldman Sachs Group Inc. as its trusted adviser to do a "bet-the-company" acquisition of Supervalu Inc. (Disclosure, I used to work at Goldman as an investment banker; before that, as a lawyer, I helped Supervalu do another merger.) In order to pay for that acquisition, UNFI needed to borrow a lot of money. It also hired its trusted adviser, Goldman, to be the lead lender on that loan. Presumably UNFI asked its trusted Goldman bankers questions like "what is the best way to pay for this thing" and "what mix of bonds and loans should we use" and "how should we structure the loan syndication" and all the ordinary corporate financing questions that you'd expect a company to ask of its bankers, and it was satisfied that Goldman was the right bank to lead the loan, and so it signed a commitment letter with Goldman. The commitment letter said that Goldman and UNFI had an "arms-length business relationship." It was "not intended to create a fiduciary relationship among the parties." UNFI agreed not to "claim that [Goldman] have rendered advisory services of any nature or respect with respect to the debt transactions contemplated hereby." Goldman's interests "involved interests that differ from [UNFI's] interests," and UNFI agreed that Goldman had "no obligation to disclose such interests and transactions" and promised not to "assert any claim based on 'actual or potential conflicts of interest.'"

There were a lot of unpleasant words, buried in the legal boilerplate of the commitment letter! If you just read the commitment letter, you would think that Goldman dispassionately operated a money store, and that UNFI showed up at the money store looking for money, and Goldman agreed to give it the money, and they were otherwise strangers to each other, each looking out for their own advantage. On the other hand if you were an UNFI executive who talked every day to your trusted adviser at Goldman Sachs, when he sent you that commitment letter you might have given it only a cursory skim. "Oh, boilerplate, arms-length business relationship, blah blah blah," you might have said; "that doesn't mean us, we are different, our Goldman adviser loves us and we love him."

The way loans like this work is that Goldman was on the hook to fund the loan, but everyone expected it to syndicate the loan to other investors before funding. UNFI agreed to help with the syndication, by providing financial statements and making its executives available to talk to investors and so forth, and Goldman agreed to try to get the syndication done in a reasonable way. (Which was in its interest, since otherwise it would have to come up with the money.) There were, as is common, "flex provisions": If Goldman couldn't get the syndication done at the interest rate it had agreed to, it could raise the interest rate, by up to 1.5%, and UNFI couldn't object. Goldman also got various fees—for structuring the loan and of course for advising on the merger—and, if the syndication had problems and it had to use the flex provisions, there would be more fees.

Things became fraught—UNFI had to raise its bid for Supervalu to an uncomfortable amount to get the deal done, which seems to have made it cranky, and it seems to have blamed Goldman for this—and then the market fell and the syndication went poorly. Goldman exercised the flex provisions, adding the full 1.5% to the interest rate and demanding all the extra fees. It also apparently asked UNFI if it could have even more flex, that is, raise the interest rate even more to get the syndication done. UNFI said no, which was perfectly allowable under the contract but awkward as a matter of trusting friendship. The acquisition closed, the loan was funded, Goldman and UNFI went their separate ways, and it seemed safe to say that they wouldn't work together again for a while. The client relationship was badly soured.

Then UNFI sued. Basically it didn't want to pay the extra fees, or the extra 1.5% interest, and argued that Goldman did not do a good job of the syndication and should not get all the extra money. UNFI did not have a particularly good argument—we talked about it last year, when UNFI sued—and last week it lost, when a New York judge dismissed its case.

Here is her opinion. Mostly what is going on here is that UNFI wishes Goldman had acted in UNFI's best interests, while Goldman in fact acted in Goldman's best interests. UNFI thinks that that is bad and should not be allowed, but the judge, quite correctly, says, well, that is literally the agreement you signed. Goldman's "profit seeking motive is not improper," she writes, about Goldman's decisions to charge more money rather than less. For instance UNFI would prefer not to pay the higher flexed interest rate, which is reasonable enough, but the judge says, look, you signed a contract that said Goldman could flex the interest rate.

Triggering the flex provisions dramatically increased UNFI's cost, but was financially even more lucrative for defendants. …UNFI's position concerning the implied covenant of good faith and fair dealing construes the covenant so broadly as to nullify the express terms of the Flex Provisions and create independent contractual obligations. A plain reading of the Flex Provisions indicates that the Lead Arrangers, without UNFI's consent, had the authority to exercise the Flex Provisions so long as they reasonably determined that such changes were necessary for a Successful Syndication or that such Successful Syndication had not or could not occur by the Closing Date. This is not denying plaintiff the fruit of the contract; this is precisely what plaintiff bargained for.

If Goldman couldn't sell the loan at the original interest rate, it could have just kept the interest rate the same and kept the loan on its books, or sold it to other investors at a loss. That would have been super nice of Goldman. If you had built a long and trusting relationship with Goldman, a relationship that felt like a friendship, you might have expected Goldman to do that, maybe, a little bit. Goldman did not do that. That would have cost Goldman a lot of money. Instead it raised the interest rate the maximum amount and charged extra fees. This was a totally rational thing for an economic counterparty to do, and was quite ex

The theory here is that if you own a company, and you also own all the other companies in the stock market, your incentives are not to maximize the profits of the one particular company, but rather to maximize the joint profits of all the companies combined. That is a theory that we talk about all the time! Usually I phrase it as "should index funds be illegal?" Because typically this theory is part of an argument that big diversified institutional investors (including index funds) who own shares of all of the companies in an industry will want those companies to maximize industry profits (by raising prices) rather than to compete for market share (by lowering prices). That particular strong form of the theory is controversial for various reasons, but some weaker form of it is surely true.

If 100% of your wealth is tied up in one company, the success of that company is extremely important to you. You want it to increase its market share and its margins, to put competitors out of business and to charge its customers as much as the market will bear, because that's how you get money. A certain amount of antisocial behavior by the company could, in some circumstances, be good for you. But if your wealth is passively indexed to all of the companies in the economy, the thing that matters most to you is the health of the economy. You just don't care very much about who has how much market share; what you want most is to expand the overall pool of profits. Here too you might be inclined to certain kinds of antisocial behavior—behavior, like raising prices or lowering wages, that will be good for profits but bad for other values—but they will be different kinds. More … social … kinds.

You see this explicitly in some of BlackRock Inc.'s environmental and social statements. BlackRock is a giant diversified fund manager that runs trillions of dollars of index funds and it really just cannot be bothered with thinking about which companies are better at defending their competitive positions. What BlackRock cares about, at the highest levels, is the general long-term health of corporate capitalism, and where it focuses its energy is on ways to help that system with its coordinating power. Every company, looking out only for its own profits, might have incentives to pollute and degrade the environment, but the companies collectively will be better off if the earth remains inhabitable. Unchecked competition might lead to a race to the bottom, but BlackRock can be a check on competition, and so it demands that companies do things in the greater good rather than for their own immediate bottom line. Sort of. On environmental issues at least.

We talked last month about two related aspects of the U.S. legal system. One is that, if you know that someone has done bad stuff in secret, it is illegal—"blackmail," "extortion"—to call them up and threaten to expose them unless they pay you money, but it is basically legal to call them up and threaten to sue them, and then negotiate a settlement agreement in which they pay you money in exchange for dropping your lawsuit (even before it is filed) and signing a nondisclosure agreement. The other aspect is that a lot of lawsuits originate not with victims but with entrepreneurial lawyers. There is a class of lawyers who are in the business of finding companies that have harmed people, advertising for people who were harmed, and suing on behalf of those people in exchange for a cut of the money. If you can round up enough victims and take a cut of all of their payments, you can make a lot of money, and these sorts of lawyers—particularly "mass tort" lawyers who sue on behalf of thousands of people harmed by companies' actions—can get very rich. Now there are some lawsuits—and we talked about them last time—where the lawyers get almost all the money and the victims get almost none of it, but this does not really happen in mass tort cases. In mass tort cases the victims tend to be seriously harmed—often the harm is cancer—and no judge will approve a settlement in which the victims just get, like, a coupon for 10% off the weed killer that gave them cancer. These cases involve huge recoveries for victims, and payments to the lawyers that are large, but fractions of the victims' recoveries. If you are a lawyer who gets into the mass-tort business in order to help people who have been wronged by big evil companies, this process is great: You provide help (or at least compensation) to people who desperately need it, and you get rich. But if you are a lawyer who gets into the mass-tort business in order to get rich, this process could seem a bit inefficient: You do all the work to win a trial or negotiate a settlement, but you only get to keep 10 or 20 or 30% of the money. Why shouldn't you cut the victims out of it entirely and keep all of the money? Go to the company and tell them that you're going to sue, but offer not to in exchange for, say, 40% of your expected winnings. The company benefits, because it pays 40% instead of 100%, and saves on legal fees, bad publicity, etc. You benefit, because you get 40% instead of 20% or whatever, and you don't have to do the work and take the risk of actually suing. Everyone wins! Ha, no, not everyone wins. The victims lose, obviously, though you should be a little careful about that. They don't benefit, but they're not any worse off than they were. You didn't bring a lawsuit on their behalf, but you had no obligation to. And if someone else discovers their claim and wants to bring a lawsuit, they still can, because you haven't actually settled any victims' claims. You've just received a big bribe for not bringing the claims yourself. Oh yeah the other obvious loser is you because you will get arrested for this:

Here's a trade:

1. You are the founder, chief executive officer and main owner of some private company. Say it's worth $1 billion and you own 90%; your employees own the other 10%. 2. You would like to make a charitable donation, say to your alma mater. Instead of giving cash, you give some of the shares that you own in your company. Say you give the charity 10% of the company, worth $100 million. Now you own 80%, the charity owns 10%, your employees own 10%. 3. You take a $100 million tax deduction, on your personal taxes: You gave the charity property worth $100 million, so you deduct that from your income for this year. That saves you, like, $37 million in taxes. 4. A week later, you change your mind. But the gift is already final. 5. But! Your company has an interesting corporate charter. Until last week, the only owners of the company were you and your employees. What if they do something scandalous and you have to fire them? The company's charter anticipates that possibility: It says that, if an employee is fired for cause — for breaking the law, for bringing disgrace on the company, etc. — then their shares are forfeited. They just disappear: They don't get paid out for those shares, they just lose them, and everyone else owns a bit more of the company. 6. What if you can fire the charity for cause? What if your alma mater did something scandalous? Then you can take away their shares without paying them. The $100 million stake that the charity owned in your company just vanishes. 7. Because the charity's 10% stake is canceled, you now own 88.9% of the company, and your employees own 11.1%. [4] 8. But what about taxes? 9. Arguably, by canceling the charity's share of the company and effectively reallocating it (mostly) to yourself (and a little to your employees), you have income: The value of your stake in the company increased by about $89 million, so you have $89 million of taxable income. (And your employees have $11 million of taxable income, whoops. [5] ) 10. But arguably there is no income. After all, you haven't gotten more shares: All that is happened is that some other owner's shares were canceled. If I own stock in Amazon.com Inc., and Amazon buys back somebody else's stock, my ownership interest in Amazon goes up, but I don't report income or pay taxes. (If I donate $1 million of corporate stock to charity in 2023, and in 2024 the company goes bankrupt and the shares become worthless, I still keep the 2023 tax deduction.) Arguably something similar happened here: Someone else's shares were canceled, but you didn't get any more shares, so you have no income, so you don't pay any taxes. 11. So you donated $100 million of stock (Step 2), got a tax deduction worth $37 million (Step 3), got back $89 million of stock (Step 7), and kept the tax deduction (Step 10). You are up $26 million. Good trade! 12. Such a good trade that you might go out and find some other charities to give money to, charities that you think might also disappoint you, so you can do this again.

I'm kidding, I think. I don't think this trade actually works, or that anyone would do it. But having spotted a funny possible tax shelter, I feel obligated to mention it to you, though I feel far more obligated to tell you that (1) it is not legal or tax advice and (2) in fact a tax lawyer I talked to was like "nah I don't think so." [6] Still here's this:

A University of Pennsylvania donor is withdrawing a gift worth around $100 million to protest the school's response to antisemitism on campus.

The big picture: The final straw for Ross Stevens, founder and CEO of Stone Ridge Asset Management, was Tuesday's widely criticized congressional testimony by Penn president Liz Magill.

Details: The gift from Stevens, a Penn undergrad alum, was given in December 2017 to help establish a center for innovation in finance.

It was in the form of limited partnership units in Stone Ridge, with the current value estimated at around $100 million.

Stevens, in a letter from his lawyers to Penn, alleges that the school has violated the terms of the limited partnership agreement, including its anti-discrimination and anti-harassment policies.

That's from Axios's Dan Primack last Thursday; since then, Magill has resigned and maybe Stevens is appeased. I have no idea if he actually withdrew the gift, or will do it. But the bones of the trade are there. He is the founder and controlling owner of Stone Ridge Holdings Group LP, which owns Stone Ridge Asset Management and a few related financial businesses. He donated some Stone Ridge limited partnership units to Penn; those units are "now valued at approximately $100 million," Stone Ridge's lawyers say in a letter to Penn that Primack included with his story.

And then, well, Stevens didn't ask for the units back; rather, Stone Ridge threatened to cancel them. The lawyers represent the firm, not Stevens himself. They write:

As a holder of Stone Ridge Unit, the University is bound by and must comply with the terms of Stone Ridge's limited partner agreement ('LP Agreement'). Under that Agreement, Stone Ridge has the ability, in its sole discretion, to retire the Units of a limited partner that has engaged in conduct constituting "Limited Partner Cause." (LP Agreement § 10.12.) The LP Agreement defines "Limited Partner Cause" broadly to include, as relevant here, violations (by the limited partner) of laws or rules applicable to Stone Ridge that are "materially injurious to [Stone Ridge's] business, reputation, character or standing." (Id. § 2.1.)

Among the rules applicable to Stone Ridge are its own anti-discrimination and anti-harassment policies and the laws of New York State that prohibit workplace discrimination and harassment. For example, Stone Ridge strict prohibits all forms of discrimination and harassment based on, among other things, religion. "This prohibition applies to physical conduct, verbal conduct (including taunting, jokes, threats, epithets, derogatory comments or slurs based on an individual's protected status); and visual and/or written conduct {including derogatory posters. photographs, calendars, cartoons, drawings, websites, email, text messages or gestures based on an indvidual's protected status). These policies, among others, were enacted by Stone Ridge to ensure a safe and respectful environment or its employees.

Mr. Stevens and Stone Ridge are appalled by the University's stance on antisemitism on campus. Its permissive approach to hate speech calling for violence against Jews and laissez faire attitude toward harassment and discrimination against Jewish students would violate any policies of rules that prohibit harassment and discrimination based on religion, including those of Stone Ridge. … In light of the foregoing, Stone Ridge has reason to believe that the University's actions (or lack thereof) constitute "Limited Partner Cause" under Section 10.12 of the LP Agreement, which gives Stone Ridge the ability, in its sole discretion, to retire the University's Units.

This is an incredibly weird argument. The idea of that "Limited Partner Cause" provision is surely, like, if one of the employee-owners of Stone Ridge does sexual harassment and embarrasses the firm, he can be fired and his units confiscated. It is harder to see how Penn violated any "laws or rules applicable to Stone Ridge," or could possibly have done so, or could possibly do something "materially injurious to [Stone Ridge's] business, reputation, character or standing." I assume the point here is to make a clever threat, not an argument that could stand up in court.

But never mind that! My point is just that when Stevens donated the units, he presumably could have taken a tax deduction, but if Stone Ridge takes them back, he maybe doesn't need to reverse that deduction? Cool trade if so.

You could have a dumb oversimplified model that goes like this:

1. In the olden days, rich people invested their money in stocks and bonds. They wanted cash flow from those stocks and bonds, money that they could live on without spending principal. So the stocks and bonds produced cash flows. Investment-grade bonds paid interest, blue-chip stocks paid dividends, and their rich owners used the interest and dividend payments to finance their lifestyles. 2. In modern days, rich people still invest their money in stocks and bonds, but they have discovered the concept of tax efficiency. Dividends and interest payments are taxable; if you have $100 million of wealth, it earns 5% a year in interest and dividends, and you pay a 40% tax rate, then in a year you will pay $2 million of taxes and be $3 million richer. You'd prefer not to pay the taxes. 3. So it is no longer particularly expected that good stocks will pay large, or any, dividends: Companies retain earnings to reinvest in growth (rewarding their shareholders with capital appreciation rather than dividends), or if they want to return cash they do it via tax-efficient buybacks rather than dividends. 4. Meanwhile the interest rates on bonds are really low. This is more of a macroeconomic thing than a tax-efficiency thing, honestly, but it's worth noting. 5. If you have $100 million of wealth and it appreciates by 5% per year without paying out any cash, then in a year you will pay no taxes and be $5 million richer. Better! 6. How do you pay for your lifestyle? Well, if you have $100 million, you can pretty easily borrow money secured by your portfolio. If you borrow $3 million a year (what we assumed you were taking home under the old system) and your wealth keeps compounding at 5% per year, you will never borrow more than about 23% of the value of your holdings.[1] A bank should be fairly comfortable lending you 23% of the value of your portfolio of stocks and bonds, since you're rich. 7. Borrowing money is not income , so you don't pay taxes on it. 8. And you'll pay very low interest on this borrowing (see point 4).

It is just a more efficient way to extract spending money from wealth. (This model is sometimes called "buy borrow die," because if you die in step 9, that can further improve the tax efficiency of the strategy.) It does require a change in the business model of banks, though: Instead of principally being in the business of lending money to people who don't have money and need some, they are increasingly in the business of lending money to people who have lots of money but don't want to liquidate financial assets.

For some reason this is a thing? Like, Bouvier would buy a painting at a more-or-less made-up number from someone else, and then he'd make up a higher number to tell Rybolovlev, and then Rybolovlev would pay that higher number or something close to it. But before doing so, I suppose he needed some independent third party to say "oh yes, that number, that's a good number." None of this is real, there are no cash flows, each item is unique and there is no fungible liquid market for it, and the correct value for a da Vinci painting is surely "whatever the most enthusiastic Russian oligarch or Saudi prince will pay for it." Any valuation that anyone gave Rybolovlev was necessarily self-referential.

Salvator Mundi's modern price history is:

A group of art dealers paid $1,175 for it in 2005 at an auction in New Orleans. They had it restored, and people became convinced it was the original by da Vinci. In 2013, Sotheby's negotiated a sale between those dealers and Bouvier, "who started negotiations with what he described as a 'brutally low' offer of about $47mn. The sellers were hoping for at least $100mn." Ultimately Bouvier paid "$68mn, plus a painting by Picasso valued at $12mn," which I guess adds up to $80 million if you believe the number on the Picasso. "Bouvier would sell the painting to Rybolovlev shortly afterwards for $127.5mn." "Four years later, Rybolovlev resold the work at auction, this time at Christie's, for a record-shattering $450mn," apparently to Abu Dhabi.

So the reasonable range of possible values of this painting would run from, say, $1,000 to $450 million. Just, really, pick a number. And Sotheby's did:

Emails show how as art valuations soared, margins of $5mn to $10mn on these "trophy" artworks felt like rounding errors. Over email in 2015, Valette expressed frustration when a colleague at Sotheby's pushed back on his request for a higher valuation for the da Vinci painting two years after the original sale to Bouvier was agreed. The colleague said €95mn was "the most [he] could live with" but Valette told the court he thought "95 was too precise" and "an awkward number", and pushed for €100mn, or about $110mn.

Valette said he wanted a big, round number. "In this world, if you're at €95mn, you're at €100mn, " he said.

I'm sorry, that's just correct, if you are providing a valuation of that painting to a potential buyer, the correct valuation is just a piece of paper saying "how frisky are you feeling?" Too much precision really is awkward.

In negotiations, it is often helpful to have someone else, some "absent principal," to blame for your position. You go to a car dealership, the salesperson says "this car costs $25,000," you say "I want to pay $21,000," she says "I like you, I want you in this car, but my boss won't let me go lower than $24,000," you say "$22,000," she says "I really want this to work out, let me check with my boss," she goes into the break room and watches TikToks on her phone for five minutes, she comes back and says "my boss is really mad at me but I talked him down to $23,500."

The boss is a crutch, an excuse. The salesperson

1. is adversarial to you — she wants to charge more, you want to pay less — but 2. wants you to feel like she's on your side, so you trust her and agree to her proposals.

The way to solve the tension is to set up some imaginary absent principal and offload all the adversarial feelings onto him. " I don't want to charge you this much," the salesperson says or implies, "it's just my awful boss; really, you and I are in this together, both trying to get this deal past him." And so you pay more than you wanted to, because you like her and feel like she's on your side, and because she has done all she can; she can't get the price any lower; that's her boss's fault.

This technique is pretty shopworn at the car dealership, and people have kind of stopped believing it, but there are better versions. There are, in the world, a lot of people who are what the financial industry would call "broker-dealers": Sometimes they act as brokers, finding buyers and sellers and negotiating a deal between them as pure agents, but but other times they act as dealers, owning stuff for their own account and buying or selling it at whatever price they can get. Sometimes they really do have some absent principal; other times, they are just trading for their own book.

It can be helpful, for these people, to create confusion about which role they are playing. For instance if you own some stuff and you want to sell it for $100, and your customer says "I'll pay $80," it can be nice, for you, to say "hang on, let me see if the seller is willing to go down to $95." And then you put the customer on hold and watch TikToks, and you come back and say "I just talked to the seller, she's not happy and yelled at me a lot, but I was able to talk her down to $96, but that's the lowest she can go." And the customer appreciates your good service and your efforts on his behalf, and feels like you and he are in this together, and agrees to pay $96. But there was no seller, or rather, you were the seller, and you just didn't want to go below $96. "The seller" on the other line was just a crutch, an excuse. But the customer doesn't know that; he thinks that you were negotiating on his behalf, trying to get him the best possible deal. He doesn't know that you were on the other side, and that you were in fact trying to get him the worst possible deal that he'd agree to.

In the financial industry this is somewhere between "frowned upon" and "a crime that you can go to prison for." For a while, there was a wave of prosecutions of bond traders who did this stuff; some were acquitted and some convicted, but some of the convictions were reversed and this behavior is, I don't know, somewhat ambiguously illegal. (Obviously not legal advice!) For instance, we once talked about a US Securities and Exchange Commission case against some Nomura traders who allegedly did stuff like this:

On March 18, 2011, Peters learned that Nomura had purchased a block of the bond JPMMT 2006-A3 2A1 at 71-08. Shortly thereafter, Peters contacted a representative of a Nomura customer ("Customer E") and falsely claimed that the bond was being offered at 75-24, implying that a third-party, and not Nomura, owned the bond. Peters then elaborated on the misrepresentation, saying that the "seller" (who did not exist) probably had "a little room" (meaning, to lower the price) but that the bond's price likely would not fall by more than a point. The Customer E representative directed Peters to "FOK" (short for "fill or kill," which is industry jargon for "last and final offer") at 74-24, to which Peters replied, "FOK worked!" By misleading the Customer E representative about the fictional [offer] from the phantom seller, Peters extracted over $117,000 in additional profits for Nomura.

Customer E there thinks that Peters is doing a good job on his behalf, advising the customer on negotiating with the seller and talking the seller down to the lowest possible price. But in fact Peters is doing a good job on his own behalf, getting the customer to pay the highest possible price (to Peters) by pretending there is some absent seller on the other side.

This trade was for somewhat thinly traded residential mortgage-backed securities, by the way, which is important. One reason that this trick doesn't work that well anymore at car dealerships, and that it doesn't work at all in the stock market, is that you need a customer who has no idea what the underlying thing is actually worth. You can't go around pretending to negotiate the price of a share of Apple Inc. stock, because the customer can just look on a screen and see its price, accurate to the penny and the second. You could go around pretending to negotiate the price of a Honda, but the internet has made car prices more transparent than they used to be. Little stubs of weird RMBS trade by appointment, and Nomura plausibly does have a much better idea what they cost than its customers do, so it can push up the price by doing a weird little pantomime negotiation.

I think sometimes about the similarities between these three businesses:

1. Journalism 2. Spying 3. Fundamental investment analysis

The basic job of many journalists and spies, and of a certain sort of analyst, is to develop personal relationships and use them to find out useful information that no one else knows, and then give that information to your customers. If you are a journalist your customers are your readers — sometimes "the public," but sometimes a rather narrower class of paying subscribers. If you are a spy your customer is your government. If you are an investment analyst, your customer might be your hedge fund (your boss and your clients), or you might be producing research for outside customers (basically, several hedge funds).

The boundaries can be porous. There are some very niche financial publications, for instance. Consider this fact pattern:

You work for a publication. You cultivate deep relationships with the employees of a publicly traded company. They tell you that the company is cooking its books, and they smuggle out corporate documents proving it. You write up your findings in a big detailed convincing report, put the headline "Company X Is a Fraud" on it, and publish it for your readers.

If you work at Bloomberg News or the New York Times, and your readers are millions of subscribers and website visitors, this is pretty clearly "journalism," and good. If you work at a firm called Specialized Stock Research and your readers are two hedge funds who each pay $1 million a year for your reports, this is pretty clearly "investment research," and regulators might have serious questions about whether it is insider trading. Insiders at a public company leaked information to you because of your long-standing relationship, and then you passed that information on to people who traded on it: That sounds a lot like a crime. [2] I wonder sometimes what the boundary is: Is there some minimum number of subscribers, or some maximum subscription price, that makes a report "journalism" rather than "insider trading"?

Similarly if your job is to work in China and find out stuff about Chinese companies and policymakers and report back what you learned to an American audience, you might be a spy (if the audience is the American government) or a journalist (American newspaper readers) or a due diligence consultant (American investors). But in each case your activities will be kind of similar, and subject to misinterpretation:

U.S. public companies generally have codes of ethics, which they make public. A company's code of ethics says that its executives and employees are supposed to act ethically, sets some guidelines about what counts as ethical or unethical behavior, and has some procedures to enforce those guidelines.

Why do companies have codes of ethics? Part of the answer is that the code of ethics is a management tool. The company's directors and officers want its employees to act ethically, for whatever reason (personal morality, management of legal and reputational risk, etc.). So they have a set of policies telling employees what not to do, and the employees read the policies and know what not to do, and if they do it the company can fire them.

Another part of the answer is that the code of ethics is an advertising tool. "We are an ethical company, see, we have a code of ethics," the company can say, to potential shareholders or customers or employees. And then those potential shareholders or customers or employees can read the code and say "oh yes you are ethical" and support the ethical companies and avoid the unethical ones.

A third, most obvious part of the answer is that having and publicizing a code of ethics is essentially required by law. U.S. Securities and Exchange Commission rules created after the Sarbanes-Oxley Act require a public company "to disclose whether it has adopted a code of ethics that applies" to its senior officers, and, if not, explain why not; the rules also require the company to make the code of ethics public. In theory I suppose you could just about satisfy this requirement by adopting a code of ethics that says "we will try to act ethically when appropriate" and leaving it at that,[2] or by publicly disclosing "we do not have a code of ethics because we generally trust our senior officers to act ethically when appropriate," but I feel like you'd get some pushback for either of those approaches. Also listing standards for the stock exchanges have further requirements for codes of ethics, including that they apply to employees (not just senior officers) and contain an enforcement mechanism; saying "we don't have a code of ethics and here's why" is not an option under these rules.[3]

So if you are a public company you have to write a code of ethics and make it public, and it has to be good enough to meet your listing requirements. But those requirements are pretty general and leave a lot of room for different approaches. So you might ask, in writing a code of ethics: How good should it be? Should it require your employees to be just barely ethical enough, or should it hold them to a very high standard?[4]

There are obvious reasons to make the standards high and specific. As a management tool, there are advantages to telling your employees to be very ethical: That will minimize legal and reputational risk, plus it is, you know, the ethical thing to do. As an advertising tool, the advantages are even more obvious: If you are trying to impress shareholders with your code of ethics, you will impress them more if it's very ethical.

This last point is particularly salient these days as so many investors are focused on environmental, social and governance issues; having a good code of ethics is a good way to respond to ESG investors' demands. If your investors say "we care about diversity," you can say "so do we, see, our code of ethics says that everyone has to respect diversity," and the investors will be happy. The SEC requires you to tell shareholders about your code of ethics, so you might as well use the opportunity to tell the shareholders what they want to hear.

But there are also obvious reasons to make the standards low and generic. As a management tool, for instance, sometimes you might want to have the flexibility to prioritize profits over ethics. (Not you , of course, but someone might!) Also, if you have very high ethical standards, sometimes your employees might violate them, and then what? It is all well and good to write on a piece of paper "we have zero tolerance for lying," but then when your extremely effective head of sales gets caught in a little lie do you have to fire her?

But the biggest problem with a strict and specific code of ethics is that everything is securities fraud. If someone at your company does something bad and the stock goes down, your shareholders will sue, claiming in essence that you didn't tell them that you were doing the bad thing. Technically, though, securities law does not require companies to disclose every bad thing; for the most part it penalizes active lies, not passive omissions. So the shareholders will not say "you didn't tell us about the bad thing"; rather, they will say "you actively lied to us, saying or implying that you were not doing the bad thing." Codes of ethics are very helpful to the shareholder plaintiffs here, meaning that they are dangerous for the company, and the more strict and detailed they are the more dangerous they are. If your code of ethics says "executives are expected to act ethically where appropriate," and your chief executive officer is revealed to be a sexual harasser and the stock drops, you can say "well that vague statement couldn't possibly have induced anyone to buy our stock" and maybe win the shareholder lawsuit. If your code of ethics says "we have zero tolerance for sexual harassment of any kind and we hold everyone accountable immediately," then it will be easier for shareholders to argue that they were deceived.

Basically everyone knows that if you work at a financial institution, and your employer gets sued or investigated by authorities for something you did, your emails and electronic chats will be turned over in the course of litigation, and the person suing you will get all the records of you saying "hahaha lets rip these muppets's faces off" or whatever, and that will be read back to you in court and you'll be like "it was a joke?" and the jury will all glare at you. That is how litigation works in the U.S.: Each side gets to ask the other side to produce all of its internal communications concerning the trade, and then there is a lot of wrangling and a lot of legal bills, and then the communications get turned over, and each side gets to mine the other side's chats and emails for embarrassing evidence. And every financial professional knows this at some level, but they forget it from moment to moment, which is why those emails and chats keep getting written and produced in discovery and read in court.

Fine! But what is less obvious is that, if you don't work at a financial institution, if you are just a person, and you get sued personally by someone in your social circle whom you don't particularly like, you might have to turn over all your emails and group chats about that person in discovery? This particular story is about a writer named Sonya Larson who wrote a short story that takes some elements from the life and personality of another writer named Dawn Dorland who was in a Facebook group with her. Things escalate, Dorland sues Larson for copyright infringement, and Larson sues Dorland for defamation. And this happens:

The litigation crept along quietly until earlier this year, when the discovery phase uncorked something unexpected — a trove of documents that seemed to recast the conflict in an entirely new way. There, in black and white, were pages and pages of printed texts and emails between Larson and her writer friends, gossiping about Dorland and deriding everything about her — not just her claim of being appropriated but the way she talked publicly about her kidney donation.

What a terrifying paragraph! The lesson here is either (1) don't gossip about your frenemies by text or email or (2) arrange your life so that you never sue, and are never sued by, the people you talk trash about in texts and emails. (Or for that matter the people who talk trash about you in texts and emails — reading this stuff can't be any fun either.) I think for most people option (2) will be easier.

The internet contains a lot of sites that publish unverified negative information about people, search-engine-optimized "gripe sites" about people who cheat on their partners or do other bad stuff. The internet also contains lots of "reputation management" companies that promise to remove posts about people from gripe sites: If you pay the reputation management company thousands of dollars, it promises to scrub negative information about you from the gripe sites.

There are obvious synergies: If you run a gripe site, and I run a reputation management company, we can enter into an arrangement where you can increase my sales (by publishing slander about people, and running ads for my reputation management company next to the slanders) and make my job easier (by taking down the slanders when I ask you to), and I can provide you with revenue (by paying you a cut of my fees when you take down the slanders).

This synergy is so obvious that, the New York Times reports, the norm in the industry appears to be for the gripe sites to be affiliated with the reputation management companies. The synergy is also … I mean, is it extortion? It's extortion-esque, right? It has obvious similarities to extortion? Pleasingly the Times asked a reputation manager this question, and she, uh:

Ms. Glosser charges $750 or more per post removal, which adds up to thousands of dollars for most of her clients. To get posts removed, she said, she often pays an "administrative fee" to the gripe site's webmaster. We asked her whether this was extortion. "I can't really give you a direct answer," she said.

Yeah, no, I can see how it would be hard for her to give a direct answer.

I don't understand why there isn't more of this:

Following the release on April 1 of a news release titled "Goldman Small Cap Research Publishes New Research Report on RocketFuel Blockchain, Inc.," the penny stock surged by as much as 335% in four days. Several lines down is a notice that the research firm, which accepts payment for reports, "is not in any way affiliated with Goldman Sachs & Co."

And the report's subject, formerly known as B4MC Gold Mines Inc., and before that as Heavenly Hot Dogs Inc., doesn't appear to have any revenue and maybe not even a product, based on litigation about a patent that expired. The report was written by an analyst who, while he appears not to have lit the world on fire at more-established firms, has an auspicious name: Rob Goldman.

There are 9.8 million users on Reddit's Wallstreetbets forum. There are about 40,000 Goldmans in the U.S., or about one for every 9,000 Americans; if Wallstreetbets were exclusively U.S.-based you'd expect it to have about 1,100 Goldmans. It's not, but even if it were only 10% U.S. you gotta figure at least 100 Goldmans. If you're a Goldman picking stocks and publishing your "due diligence" on Wallstreetbets, why not write it up as a "Goldman Equity Research Note" instead? Won't that make the stock go up more? Guess what, there are over 12,000 Sachses in the U.S.; find one and team up!

We talked a few years ago about a trader named Morgan Stanley who worked at Morgan Stanley until he left in 2018. "What if he left to found his own boutique advisory firm," I asked. "What if he's calling it Morgan Stanley & Co.?" He could probably make some stocks go up!

We talk all the time about ticker confusion, in which a stock goes up because it has a name or ticker that sounds like another company or product. You can extend that arbitrarily: A stock can go up because it is endorsed by a person or firm that sounds like another person or firm. Change your last name to Musk, have a son,[7] name him Elon, buy some Dogecoin for his college fund, put out a press release saying "Elon Musk puts 100% of his net worth into Dogecoin," who can say you are lying?

But there is a deeper conceptual mistake here. The point of "representations and warranties"—the factual promises that a company makes in deal documents—is, largely, to force disclosure. The way it works is that the buyer sends an investment agreement to the seller, and the agreement says "Seller promises it has no legal violations," and the seller says, well, actually, we have a few parking tickets, and it discloses those violations to the buyer, and the final agreement says something like "except as disclosed on Schedule X, Seller has no legal violations." The buyer asks the seller to make the representation not because it expects the seller to be totally clean—not because it expects the representation to be completely true—but because the representation will focus the seller's mind and force it to disclose anything that might be trouble. For this to work you need some baseline level of trust; it works in normal situations, but not so much in frauds. The seller will always represent something like "our public financial statements accurately represent our financial condition"; perhaps it will qualify that by telling the buyer about open questions that its auditors have raised about a few debatable matters of accounting policy. But it will never get that draft representation and reply "oh actually funny story all of our financial statements are fake." Faking the financial statements is the hard part! Once you've done that, signing a representation to a potential investor saying "our financial statements are not fake" is just routine. If someone reputable—like, say, the FT—tells you that a company is cooking its books, and you are considering a big investment in that company, you can't go to the company and be like "we'll give you a billion dollars if you promise that you're not cooking the books." Once you are asking about specific allegations of fraud, you can't just take the company's word for it! You've got to satisfy yourself that the spreadsheet doesn't exist!

We have talked a lot about the differences between legal and practical corporate control. There is some theoretical hierarchy in which the employees answer to the chief executive officer and the CEO answers to the board and the board answers to the shareholders, but there is also the practical reality that the company is a bunch of people in some locations doing stuff, and if those people stop listening to the people above them in the hierarchy—if they lock the door to keep the shareholders out—then the legal rights may not matter that much. "The night watchman controls the company, sort of," I like to say, "if he can change the locks overnight and not let the managers and directors and shareholders in the door the next morning." We have also talked a few times about the Chinese version of this, which involves the corporate seal, or "chop." You need the chop to validate documents, and so in practice whoever has the chop controls the company. What is pleasing about the chop is that it conveys purely symbolic, theoretical control—it's not a lock on the front door, it's not an army of loyal employees, it's just a stamp—and yet it is also a physical object that you can literally put in your pocket or try to wrestle from someone else.

Anyway here's a good Wall Street Journal article about chops, and about the recent controversies at Chinese companies that have (maybe?) fired their CEOs but whose CEOs have hung on to the chops. For instance:

According to the company, Mr. Li left with almost 50 official ink-stained Dangdang chops stuffed into a shoebox which he vowed not to part with until he found justice."I will have sole custody of the chops, tying them to my belt during the day and keeping them under my blanket during the night," Mr. Li announced to his 5.4 million followers the next day on the Chinese social-media service Weibo.

And:

Though chop-hostage crises have long been a source of corporate drama in China, the sudden spate of high-profile cases has prompted a number of companies to seek out legal advice and custodianship over their seals, says Vivian Mao, a partner at professional services firm Dezan Shira & Associates, whose offices across China include special "chop rooms" where the prized rubber stamps are kept under lock and key.

It is the modern equivalent of a magic amulet. If you control a company, you do so as a purely social fact: A bunch of people who work there will treat you as the boss, a bunch of customers will treat you as their counterparty, the legal system will treat you as a controller. Everything that you think gives you control—share certificates and board resolutions and a big desk—is just a symbol of those intangible social facts. But if you concentrate enough symbolism in one more or less arbitrary physical object, that physical object will become almost as good as the social fact itself, and you'll end up sleeping with it under your pillow.

The traditional view is something like: In an open market with a lot of competing firms, consumers will generally pay low prices, because if one firm charged high prices consumers would just switch to the other firms. "Pricing power," in this view, is virtually synonymous with "monopoly power": The only way a firm could charge high prices is if there are no viable competitors.

If you were really good at price discrimination, though, this might not be true. Like:

You run a hardware store. There's another, equally good hardware store down the block. Price tags do not exist: If anyone wants to buy something from you, they ask you the price and you tell them. You are extremely good at reading people. If they ask you "how much does this hammer cost," and you can tell by looking at them that they are savvy about hammer prices and willing to walk a block to the other store, you will tell them a competitive price. If they ask you "how much does this hammer cost," and you can tell by looking at them that they have plenty of money, are insensitive to price and don't know there's another hardware store nearby, you will smoothly say "that hammer is $50" and they'll pay you.

Is that an antitrust violation? I feel like the traditional answer is "no, of course not": You are not a monopolist, there's another competitor nearby, you are just good at business. On the other hand, if the purpose of antitrust regulation is to keep consumer prices low, there's something a bit unsettling about this: You don't have monopoly power, but you do have the power to charge supracompetitive prices, which is kind of the bad thing people are worried about.

In some sense it is obvious that the FX market would be automated: It trades around the clock, currencies are fungible and there are many fewer currencies than there are stocks. It took longer than stocks largely because stocks trade on public exchanges, while currencies were historically traded directly with banks in more fragmented and opaque ways. But "currency markets are now home to around 90 different trading venues, up from just 20 in 2012," and enough of them are electronic that if your goal is "buy 50 million pounds quietly" you can probably trust that to an algorithm rather than a human's gut instinct for markets:

RBC Bluebay Asset Management, for instance, relishes the ability to hide sizable trades from other players by using algorithms that 'slice and dice' their execution. ...

"It's better for risk — I want everything to be less touched, less keyboards stroked," said Stuart Campbell, who leads fixed income trading at the asset manager. "In the FX world, you can pretty much trade any size through algos, there's less and less need for me to pick up the phone to do a big block trade."

The "buy quietly" algorithm is apparently named Chameleon:

At BNP [Paribas SA], the three algorithms all have different characteristics. Clients can use Viper when they want to be aggressive with their trades and get out of risky positions quickly. Chameleon, on the other hand, is better for executing larger transactions and allowing them to slowly dribble into the market without creating larger gyrations.

Iguana was the final algorithm that BNP built. It was created for when clients know they want to execute a certain trade over a specific time horizon, but they aren't sure when within that window would be the best time to place the trade.

A dumb simple model of artificial intelligence companies is:

1. It would be good to develop good AI (AI that helps humans), but bad to develop bad AI (AI that kills or enslaves humans). 2. If you try to build good AI, there is some risk of building bad AI instead (your robot tricks you into thinking that it's nice, then enslaves you), so you have to be very very careful. You can't move too fast; you have to check carefully, at each step, to make sure that your robot is not secretly evil. 3. Company A is formed by idealistic AI researchers who want to create good AI. They work together well for a while. 4. Disagreements develop. Some researchers at Company A say "we need to work faster to build good AI, because if we don't, someone else will come along and build bad AI first instead." Others say "no, we can't work faster, that would compromise our ability to check that the robot is not evil." 5. The first group wins the argument, for reasons. [5] 6. The people who lose the argument, who are genuinely worried about bad AI, quit Company A in outrage and go start Company B, with the goal of carefully and safely creating good AI. 7. They work together well for a few months. 8. Disagreements develop at Company B. Some researchers say "we need to work faster to build good AI, because otherwise Company A will build bad AI first. That's why we quit, after all." Others say "no, we can't work faster, that would compromise our bad robot checks. That's why we quit, after all." 9. The first group wins the argument, for the same reasons as in Step 5. 10. The people who lose the argument quit and start Company C. 11. This keeps repeating: Company C eventually splits over similar tensions, but also Company A and Company B can themselves keep dividing as some people want to move faster than others. 12. Eventually all the AI researchers are very finely sorted by aggressiveness, so that Company Z is full of purists who are too cautious ever to build anything at all, while Company A is full of people who are like "actually being enslaved by robots would be pretty cool."

This is not accurate in all respects — sometimes the second group wins the argument for a weekend! — but it is an intuitive model that helps to explain stuff like this:

For the past several months, the question "Where's Ilya?" has become a common refrain within the world of artificial intelligence. Ilya Sutskever, the famed researcher who co-founded OpenAI, took part in the 2023 board ouster of Sam Altman as chief executive officer, before changing course and helping engineer Altman's return. From that point on, Sutskever went quiet and left his future at OpenAI shrouded in uncertainty. Then, in mid-May, Sutskever announced his departure, saying only that he'd disclose his next project "in due time."

Now Sutskever is introducing that project, a venture called Safe Superintelligence Inc. aiming to create a safe, powerful artificial intelligence system within a pure research organization that has no near-term intention of selling AI products or services. In other words, he's attempting to continue his work without many of the distractions that rivals such as OpenAI, Google and Anthropic face. "This company is special in that its first product will be the safe superintelligence, and it will not do anything else up until then," Sutskever says in an exclusive interview about his plans. "It will be fully insulated from the outside pressures of having to deal with a large and complicated product and having to be stuck in a competitive rat race."

OpenAI was founded to build artificial general intelligence safely, free of outside commercial pressures. And now every once in a while it shoots out a new AI firm whose mission is to build artificial general intelligence safely, free of the commercial pressures at OpenAI.

A standard story in the modern tech industry is that every entrepreneur, venture capitalist, etc., was totally focused on crypto in 2020, and is totally focused on artificial intelligence in 2024. The "pivot to AI" is a running joke. It's a joke in part because these things seem unrelated: The skills required to build artificial intelligence, the problems that it solves, the potential uses, the actual real-world uses, are all so totally different from those in crypto. The "pivot to AI" can feel like just arbitrary chasing of hot buzzwords.

But a tech executive once pointed out to me that in fact crypto and AI are deeply related, and in fact the crypto boom (and bust) paved the way for the AI boom. The connection is chips. If you want to mine cryptocurrency, you need a lot of graphics processing units, the specialized computer chips that were previously sold mostly to computer gamers. And if you want to build a large language model, you need a lot of the same GPUs. So the crypto boom created a huge demand for GPUs, which led to GPU makers — by which I mean mostly Nvidia Corp. — scaling up their production of GPUs. And then the crypto bust created a huge glut of GPUs, because crypto miners no longer needed them, so companies that wanted to build LLMs could easily acquire lots of GPUs to train their models. That led to a transformative improvement in the power of those models. And now we are in an AI boom, with enormous demand for those chips. But crypto got us there.

I think it is conventional wisdom that this story has worked out better for Nvidia than for absolutely anyone else: It is the principal supplier of shovels in two of the greatest gold rushes of our time.

One way to think about the artificial intelligence business is:

1. Everybody, by now, has an intuitive understanding of how new software products are created in the US. New ideas in software come from visionary entrepreneurs who can work pretty cheap. You need a couple of engineers, some desks at a WeWork, some laptops, some energy drinks, a modest cloud-computing budget. You build the thing, you try to find product-market fit, and if it works you scale rapidly. The marginal cost of distributing one more copy of your app, or serving one more instance of your social media website, is basically zero. If your thing takes off, it can take off quickly, and it's all profit. 2. Everything in US tech finance is oriented around that understanding. Talented tech workers want to be founders, because founding your own company is the way to fame and riches in tech. Venture capital firms invest in risky early-stage software companies, because (1) those companies don't need that much capital to figure out if their idea works, and (2) if the idea does work it will return many times the investment. 3. Generative AI … maybe does not work like that? It is extremely capital-intensive, by which I mean that you need a very large cloud computing budget to build and train an AI model that will do anything at all. And then scaling it is also quite expensive; you need a ton more computing power to serve each new customer. Building an AI model is more like building a car than it is like building Facebook.

If I asked you in the abstract "I have a potentially lucrative and important business idea, but it requires like $10 billion of startup capital and does not scale cheaply like software, how should I finance it," your first answer might not be "venture capital." You might say something like "well this sounds like a big industrial project, what you should do is go get a job at a big industrial company with a ton of money, and start a division there that will do this project." And if I said "well it's a tech idea," you'd say "ah, even better, get a job at Google or Amazon or Alphabet, they have absolutely tons of money, more than they know what to do with, they can totally fund your $10 billion project, no problem. Is it a virtual reality headset by any chance?"

But the problem with AI is that it is , mostly, made in the Bay Area by tech-industry types, so it does default to the startup mode, so you do have startups running around building AI. But to fund their billions of dollars of cloud computing costs, they

1. take billions of dollars of investment from cloud computing companies (Microsoft, Amazon, Alphabet), 2. take a lot of that investment in the form of cloud computing capacity rather than money, and 3. probably have some sort of understanding with those companies that there will be some commercial relationship between them, so that for instance Microsoft has rights to include OpenAI models in its software.

It is a Silicon Valley-style compromise between "all new software must be built by startups" and "actually giant companies with tons of money and smart employees and complementary capabilities probably do have some advantage in building this particular expensive thing."

Two ways to use a computer to generate trading signals would be:

1. Think about subtle characteristics of a company that might be good or bad for that company. Develop a hypothesis — "executives who say 'I' on earnings calls are bad narcissists, but executives who say 'we' on earnings calls are good inclusive leaders" — and then use a computer to crunch the data and evaluate the hypothesis. Take the hypotheses that are good — the signals that turn out to work — and program them into a trading model, which uses the signals to buy and sell stocks. 2. Just ask a computer "is this company good or what," and if the computer says "yeah it's good" you buy the stock.

The advantage of the first method is that it is comprehensible; you can, at some level, explain your strategy, because you have reasons for every signal. Also those signals are more likely to be robust, less likely to be just statistical artifacts, if there is some explicable reasoning behind them.

The advantage of the second method is, what if the computer is smarter than you? What if it sees subtle patterns that you miss?

You could have a model of investment analysis that is like:

1. Part of the job is about looking at financial statements, calculating ratios, and figuring out which companies make a lot of money, which are cheap, etc. 2. The other part of the job is meeting with corporate executives, shaking their hands, getting a sense of their body language and their character, and deciding if they are good people who run a good company or bad people who don't.

There is a quantitative analytical part, and a part about personality. Intuitively a computer should help with the first part. You can use a calculator to compute the ratios. You can use Excel. You can use some more sophisticated software system to get investment signals from millions of financial data points.

And then you can say "still, I have to meet with management and shake their hands, because this is not a business of pure quantitative data; there is a human component, and no computer can judge the firmness of a CEO's handshake." Or can it? The Financial Times reports:

The idea that audio recordings could provide tips on executives' true emotions has caught the attention of some of the world's largest investors.

Many funds already use algorithms to trawl through transcripts of earnings calls and company presentations to glean signals from executives' choice of words — a field known as "Natural Language Processing" or NLP. Now they are trying to find further messages in the way those words are spoken.

"The idea is that audio captures more than just what is in text," said Mike Chen, head of alternative alpha research at Robeco, the asset manager. "Even if you have a sophisticated semantic machine, it only captures semantics."

Hesitation and filler words tend to be left out of transcripts, and AI can also pick up some "microtremors" that are imperceptible to the human ear.

Robeco, which manages over $80bn in algorithmically driven funds, making it one of the largest quants, began adding audio signals picked up through AI into its strategies earlier this year.

Three points here. The first is that if you are an algorithmic fund, you will just on principle resist having a workflow that is like "have an analyst listen to the conference call and write up her impressions of the executive's confidence," because that sounds dumb and fuzzy and subjective and labor-intensive and just not how one runs a quant fund. But if you can have a computer listen to the conference call and write up its impressions of the executive's confidence, fine, good, that's alpha.

The second is that mmmaybe the computer is better at it? "Microtremors"? Like maybe humans are good at fooling humans with confident misdirection, but the computers can't be fooled so easily?

The third is that this is sort of modeled as an iterated game in which:

1. Executives try to trick investors. [3] 2. Investors acquire computers that can spot the tricks. 3. Executies adapt to be able to trick those computers. 4. Investors get new computers. 5. Etc.

Natural language processing of earnings calls is old hat now, which means not only that it's not a competitive advantage (because every fund does it) but also that it doesn't work as well (because executives are now scripting themselves for the robots):

"We found tremendous value from transcripts," said Yin Luo, head of quantitative research at Wolfe Research. "The problem that has created for us and many others is that overall sentiment is becoming more and more positive . . . [because] company management knows their messages are being analysed."

Multiple research papers have found that presentations have become increasingly positive since the emergence of NLP, as companies adjust their language to game the algorithms.

But now the robots listen to the calls, instead of just reading them, so they are not fooled by language choice; they can hear those microtremors. Now the executives have to refine their voices to fool the robots:

Just as companies have tried to adapt to text analysis, Pope predicted investor relations teams would start coaching executives to monitor voice tone and other behaviour that transcripts miss. Voice analysis struggles with trained actors who can convincingly stay in character, but replicating that may be easier said than done for executives.

One move is to get acting training. But clearly the better move, for executives, is:

1. Get a chatbot to write your earnings presentation, and responses to analyst questions. 2. Get a robot to read it for you in a soothing and convincing way. 3. Then the investors' robots will listen to it and be like "oh yes this CEO is very good, very confident, I like the cut of this CEO's jib."

Just cut out the human element everywhere.

I think of artificial intelligence in finance as having two main approaches. One is: You apply artificial intelligence to financial data. You get some neural nets, you get some data, you train the neural nets on the data, they spot predictive patterns in the data, those patterns generate trade ideas, you do them, you hope they make money.

The other is: There are general-purpose large language models that can, in certain domains and with certain constraints, produce text that a smart human might have written. Why not use them to do the work that a human investment analyst would do? Train them on some corpus of language, including earnings calls and 10-Ks and finance textbooks and Warren Buffett's annual letters but also, like, Twitter and Moby-Dick , and then type in the little box "recommend five stocks that will go up a lot, and give your reasons," and see what they come up with. If it's persuasive, buy the stocks. If it's not, yell at the chatbot, in the little box, until it does a better job. Or type "explain what the Fed's decision yesterday means for financial markets" and get a long nuanced report that informs your investment decisions. You make the investment decisions — not the chatbot — but the chatbot's work helps support them. The chatbot is an analyst, one who is cheap and tireless and broadly informed about the world, but also one without a ton of domain-specific expertise, with weird and unpredictable gaps in its knowledge, and with a propensity for making stuff up. It's not the most reliable analyst! You wouldn't let it trade on its own! But it could, with careful supervision, help.

The problem with the first form of AI is that you have to have a lot of expertise — at building AI models and collecting data — to have a real shot at using it successfully. Also it has a tendency to produce "black box" investments, where the AI knows why it is buying the stuff it is buying, but you don't, and the AI can't tell you. "I am using 35,000 signals each with a weight that shifts as market conditions change, don't worry about it," the AI tells you, and you're like "fine I guess." And maybe it works great forever and you get rich, and maybe the AI is just overfitting to recent events and it blows up.

Whereas the ChatGPT model, like, you can just get that online, and type your question in the little box, and ChatGPT tells you its reasons for recommending whatever it is recommending, and you can read them and decide if they are persuasive or not. It's a very human-scale way to use AI in investing.

The way a public company's quarterly earnings call generally works is that it puts out a press release with the earnings information and then its chief executive officer and chief financial officer get on a call with analysts. The CEO and CFO give an introduction to the call, describing the quarter's highlights, and then the analysts ask questions and the executives answer them.

Here is an experiment you could do. You take the earnings release, the company's previous financial statements and the introduction to the earnings call, and you feed them all into a ChatGPT large language model. Then, you take the analysts' questions on the call, and instead of having the CEO and CFO answer them, you let ChatGPT do it. How would ChatGPT do?

You'd hope the answer would be "poorly." The analysts, after all, have (hopefully) read the earnings release and listened to the introduction; they know all that stuff. They are asking the executives questions to go beyond what has already been said, to clarify or fill in details or add color or explain the drivers of the numbers. All ChatGPT knows is what is already public knowledge; it can't fill in any details. (Or, it can, but just by making stuff up.) Intuitively, asking questions of a chatbot trained on the already-available information should not add any new information.

On the other hand, there are some earnings calls where the CEO and CFO don't add much new information either: Analysts ask a bunch of questions, and they respond in generalities or by referring to what they have already said. For some companies it is not obvious that a robot would do a worse job than the actual executives.

Lots of fun possibilities. But the most immediate way in which ChatGPT is going to be securities fraud is the usual "everything is securities fraud" way:

1. ChatGPT is going to be disruptive to some number of businesses and industries. 2. Some companies will lose money because ChatGPT disrupts their business. 3. This will be bad, for them, and their stocks will drop. 4. Every bad thing that happens to a public company can be characterized as securities fraud: "You didn't sufficiently warn us about the bad thing, so we bought the stock thinking it was good, but then the bad thing happened and the stock dropped, so we were defrauded."

ChatGPT risk factors are starting to be included in securities offering documents, and the risks are starting to be realized:

Chegg Inc. plummeted 42% after warning that the ChatGPT tool is threatening growth of its homework-help services, one of the most notable market reactions yet to signs that generative AI is upending industries.

The company, which offers online guidance for students taking tests and writing essays, also gave revenue and profit forecasts for the current quarter that fell well short of analysts' estimates. Chegg makes much of its money from subscriptions, which start at $15.95 a month, a revenue source that's in peril if students see AI chatbots as an alternative to paying.

The impact of ChatGPT, an OpenAI tool that surged in popularity last year, began to be felt this spring, Chief Executive Officer Dan Rosensweig said in prepared remarks accompanying Chegg's first-quarter earnings Monday.

And I tell you what, when I see that a public company has announced bad news and its stock dropped, I look for the lawsuits. We are early yet — the stock dropped yesterday — but lawyers move fast; I have not yet seen any lawsuits filed, but at least two law firms have announced "investigations" of Chegg and are looking for clients.

At this point the lawsuits seem a bit far-fetched: "You should have warned us months ago that artificial intelligence would hurt your business" is unfair given how quickly ChatGPT has exploded from nowhere to become a cultural and business phenomenon. But now everyone is on notice! If you are not warning your shareholders now about how AI could hurt your business, and then it does hurt your business, you're gonna get sued.

We have talked a few times about the US Securities and Exchange Commission's crackdown on banks that use anything other than "official channels" to do business: If you text a client from your personal phone, or send her a WhatsApp message, that will get you and your bank in trouble. Not that you texted her about doing crimes, I mean, but sending perfectly innocent businesslike communications over unofficial channels will get you in trouble. You're still allowed to talk about business in person, over lunch, but give it time. I wrote earlier this month:

In like five years, technology — and the SEC's interpretation of the rules — will have advanced to the point that banks will get fined if their bankers talk about business with clients on the golf course. "You should have been wearing your bank-issued virtual reality headset and recorded the conversation," the SEC will say, or I guess "you should have played golf in your bank's official metaverse, which records all golf conversations for compliance review, rather than on a physical golf course." The golf course is an unofficial channel! No business allowed!

Well, similarly. If you want to get advice from a robot about how to invest — or if you want the robot to help you write a presentation for clients — then you had better communicate with the robot using official channels! Typing in the ChatGPT box isn't an official channel, so it's not allowed.

Leveraged loans are strange in that (1) they are a large, important, frequently traded asset class, (2) they are kind of like high-yield bonds, which trade and settle in a pretty normal way, but (3) for various historical and legal reasons they do not settle like bonds; instead they can take two weeks to settle and sometimes you have to use a fax machine. Putting stock trading on the blockchain might add some efficiency, but putting leveraged loans on the blockchain would add a ton of efficiency. Also millions of individuals trade stocks, while a relatively small pool of banks and investors trade leveraged loans, so it is just a bit easier to get everyone to agree to migrate them to the blockchain. Leveraged loans were the lowest-hanging blockchain fruit, and people talked constantly about moving them to the blockchain.

Now it is 2022 and here is Bloomberg's Paula Seligson with " Old-School Leveraged Loan Market Steps Closer to Ditching Faxes":

The $1.38 trillion U.S. leveraged loan market is nearing an innovation that could finally shift back-office operations to a centralized system and away from investors having to manually track their positions -- a process that can still include the occasional fax.

Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. on Wednesday unveiled the name of the new platform that will let lenders access data across their portfolios in one place and said that Credit Suisse Group AG, one of the top arrangers for leveraged loans, has joined the portal.

Called Versana, the platform will formally launch around the middle of this year with term loans, and then soon add revolving credit facilities and other services, said the company's Chief Executive Officer Cynthia Sachs. …

Every loan has one bank that serves as the administrative agent and provides back-office record keeping. They notify lenders on a range of changes that can occur, such as an interest payment, a company paying down debt early and amendments to the legal documentation.

But those notifications are not standardized, and investors often have to track a hodgepodge of messages from a number of different banks. If there is a discrepancy, an investor has to call up, email or instant message the bank to sort out why, for example, the cash flows in their portfolio don't match their expectations.

No mention of blockchains! A centralized system! To be fair this is for administrative notices, not settlement, but you get the idea. "We should have a nicer and more logical way to track leveraged loans by computer; these faxes are dumb," people have thought for a long time. In 2017 they expressed that sentiment by saying "everything will move to the blockchain." Now they just build a computer system.

At some level of generality, every big bank has roughly one zillion contracts that all say "the Interest Rate for any period shall be Libor plus the Spread," or something that means the same thing. And due to the demise of Libor (the London interbank offered rate) and its replacement by SOFR (the Secured Overnight Financing Rate) or some other regulator-approved benchmark, those contracts all need to be edited to say "the Interest Rate for any period shall be SOFR plus the Spread plus the Other Spread."

When I describe it like that the obvious solution is to write a teeny little computer program to find every instance of the first expression and replace it with the second expression. But this is not in fact the solution. The main problem is that there a lot of different ways to write the first expression. "For any Semiannual Period, the Interest Payable shall be defined as the sum of (i) the Credit Spread plus (ii) the Relevant Libor" would say the same thing in somewhat different words in a different order. Also, though, some of these contracts are, like, blurry scanned PDFs. And anyway you can't just unilaterally rewrite the contracts; you have to call up the counterparties and have them sign off on the changes — or you have to parse another section of the contract to see if it gets rewritten automatically and, if so, how.

So the traditional solution is to hire battalions of lawyers to do that, which is enormously expensive for the banks and honestly not all that fun for the lawyers either. Imagine being a first-year law-firm associate on that job. You'd spend like the first three years of your career getting real real real real good at revising Libor contracts, and then when you were done your only skill would be permanently obsolete. Oops!

So the correct solution is to write a large computer program to find every instance of the first expression — but with artificial intelligence — and replace it with the second expression. You know, write a program that can read all the contracts and figure out which sentences mean "the Interest Rate for any period shall be Libor plus the Spread" and replace all of them with parallel sentences that mean "the Interest Rate for any period shall be SOFR plus the Spread plus the Other Spread" but use all the correct defined terms. And then I guess email them to the counterparty for signoff.

It is fun to imagine a world in which mergers and acquisitions were similarly automated. If you were the chief executive officer of a public (or private!) company, and you wanted to sell, you could push a button and a computer would tell you "the bid price for your company is $8 billion" or whatever. And then you'd hit the "okay sell" button, and some automated market maker — some pool of cash attached to that computer — would wire you $8 billion and take over your company. And then the market maker would resell it a second later for $8.2 billion to some long-term strategic buyer who is in the market for a business like yours. And all the matchmaking and valuation work of modern M&A — bankers building deep personal relationships with CEOs and flying around the country pitching deals, 60-page board decks full of valuation models, 100-page contracts full of closing contingencies, all-night negotiations, fights about cultural fit and the name of the combined company, etc. — would all be sort of smushed into the automatic market-maker model.

This would be funny! It will be a bit of world-building in my science-fiction finance novel set in the year 2264. But it is not going to happen now, or in 10 years, or probably in 50 years. The facts about whole companies are too complicated and fuzzy and difficult to observe for a computer to price confidently, and companies trade so infrequently that any random errors could destroy the business model. Plus the capital required for this business model — billions and billions of dollars for each trade — would be too much for a business of five programmers and a computer. Finance slowly grinds toward this ideal, but it may never actually get this far.

A couple of readers emailed to point out that … this actually happens a little bit? Here's a company called OpenStore, which Bloomberg described in June as "a startup that makes automated purchase offers to small e-commerce businesses." (It's from the people who brought you OpenDoor, which, like Zillow, tries to do that with houses.) If you run a storefront on Shopify Inc., a computer can pretty much make you a price without a whole lot of extensive in-person negotiation or due diligence. To the extent that businesses of the future are not so much "big factory makes widgets and then a team of hard-charging widget salespeople fan out and build personal relationships with widget buyers" but rather "some cloud servers, an API and a Stripe account," automated business purchasing actually seems feasible. It's not that a computer will be able to understand all the idiosyncratic personal and physical features of a business, it's that those features might get sanded away.

The syndicate desk—a longtime fixture at banks across Wall Street where IPOs and other large stock sales are priced and allocated to investors—has long clung to traditional ways of doing business like phone orders and scribbled pieces of paper, even as other businesses go digital. ...

Ben Batory, head of Franklin Equity Group Trading at Franklin Templeton, said for decades he and his team have kept track of how many shares they asked for in IPOs—as well as how many they received and at what price—on loose sheets of paper. He and his counterparts at other firms talk of calling multiple bankers on a deal to make sure their orders are recorded correctly. And then they wait. The morning after an IPO prices, a banker calls them, tells them how many shares they got, at what price, and what percentage of fees they owe to each of the dozen or so underwriters. It is up to Mr. Batory, or someone in his shoes, to keep track of it all.

"All these things are ripe for error," he said. "There can be five deals a day, and you need to get the amount right, get the commission right, and it's all chicken scratch on a piece of paper on my desk. It's incredibly challenging."

Would you believe that the solution is to have some sort of website where customers can type in how many shares they want, and then the banks could look at the order book and decide how many shares to allocate to each investor, and then the investors could just see on the website how many shares they got and how much they had to pay? Seems too easy, doesn't it? Like if it were as simple as that someone would have just done it, right? Ha well anyway:

Capital Markets Gateway LLC has set out to change that. Backed by Franklin Templeton, Fidelity Investments, Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley, among others, CMG was launched in 2017 by former bankers at Robert W. Baird & Co. …

When the system is up and running, buy-side firms—of which nearly 100 are signed up—will be able to see what deals are pricing when, what the terms are and digitally enter their orders with lead bankers, so long as they have an existing relationship with them.

Once IPOs and other offerings are priced, instead of waiting until the following morning to learn via a phone call if they received any allocation, fund managers can find out electronically that same evening.

This is a form of a general problem in antitrust. Sometimes competitors in an industry will want to get together to agree not to do something that would be bad for the industry, or for the world. This is tricky to do, as an antitrust matter, because it is generally illegal for a bunch of competitors to get together to agree to keep supply down or prices up, or to agree not to give customers certain features. Often agreeing to hold off on doing something bad on the world can look like an agreement to restrict supply.

So for instance if you work at an artificial-intelligence company, and a customer comes to you and says "hey would you build me an evil AI that will enslave humankind, I'll pay you a lot of money," you might say no. But you might worry that your competitors would say yes, and then they'd get a lot of money and you wouldn't. So you might want to get together with all your competitors and agree that, even if a customer asks very nicely and offers a lot of money, none of you will ever build an evil AI that will enslave humankind. But is that an agreement in restraint of trade? Are you colluding to restrict the supply of AIs that customers want (evil enslavement AIs)?

Here is a fun paper from last July by Cullen O'Keefe of OpenAI about "Antitrust-Compliant AI Industry Self-Regulation":

Of interest here is a hypothetical and potentially desirable horizontal agreement ("Agreement") between AI engineers (or those working for labs aiming to produce AGI) not to produce unsafe A(G)I. …

There is a colorable argument that an Agreement would correct a market failure (namely, information asymmetry). AI engineers are much better-positioned than their clients to know whether AI they produce is safe. Thus, an Agreement would be analogous to the ethical canon at-issue in California Dental : it would regulate informational asymmetries in the professionals' market.

Note that the market failure is not the externalized risk to the public from unsafe AI. Under California Dental , the procompetitive benefits of the Agreement must accrue to the consumers.

If the above arguments are correct, then California Dental dictates that the Agreement would be subject to rule-of-reason review. The defendants would then have to show that its procompetitive effects outweigh its anticompetitive effects.

That is, you can't have an industry rule saying "no evil enslavement AIs" just because you don't want to enslave humanity; the rule has to be justified on the grounds that you know better about what the customer wants (non-enslavement) than the customer does.

One lesson you could take away from this is that antitrust law is sort of generative of other forms of government regulation. If everyone in the AI business thinks there should be a rule against evil AI, it is risky for them to just get together and agree on it. But if some government agency regulates AI, then all the people in the business can lobby that agency to make a rule about it. (Similarly, if everyone in the taxi industry thinks that there should be safety regulations, or minimum-price regulations , it's better for them to lobby a taxi commission to make those rules than to agree on them themselves.) It is tricky for industries to self-regulate, because self-regulation might look like collusion, so they have to ask the government to regulate instead.

Aladdin is BlackRock Inc.'s risk-management and portfolio-construction and a-little-of-everything-else technology platform (it stands implausibly for "asset, liability, debt and derivative investment network"), which BlackRock licenses to pretty much every other investing firm you can think of:

Vanguard and State Street Global Advisors, the largest fund managers after BlackRock, are users, as are half the top 10 insurers by assets, as well as Japan's $1.5tn government pension fund, the world's largest. Apple, Microsoft and Google's parent firm, Alphabet — the three biggest US public companies — all rely on the system to steward hundreds of billions of dollars in their corporate treasury investment portfolios.

And so there is a fun recurring hipster sort of worry in financial circles—the quotes above are from an article in the Financial Times yesterday; here's another version from three years ago—that if every investor is using the same software for risk management, they will all manage the same risks in the same way. There are conventional mainstream ways of thinking about portfolio construction and risk, and if everyone thinks those ways then the market will be a little less diverse and robust, and those ways of thinking are reified by everyone using the same software. I am not overwhelmingly impressed by this worry—the conventional ways tend to be fairly well grounded in theory and experience, they are reified by market custom and social practices and academic training as well as by software, and of course giant index-y investors are going to herd—but, sure, I see the point. I'm sure that if you're a certain sort of contrarian it is satisfying to say "we don't use Aladdin like everyone else; we use a proprietary astrological approach to construct our portfolio." The FT article hits two other themes that I like to talk about around here. One is that financial companies increasingly want to be tech companies, in this case in a straightforward literal way:

Aladdin's income, locked up in steady, multiyear contracts, diversifies BlackRock's income away from the fees it charges on assets, which dip during a market downturn. "It's the tech subscription model that investors love," says Kyle Sanders, an analyst at Edward Jones. "It's not sensitive to the market."

And my first reaction to the GPT-2 VC bot was "fine great but get back to me when this bot is generating startup ideas." Venture capitalists tweet aphorisms as a hobby, but their job is to invest money in startups that become successful, and (to a much lesser extent) to not invest money in startups that become worthless. An AI bot that could mine the public writings of successful venture capitalists and learn to pick companies from their writings would be something. But then I thought about it for a bit—well aware, as I did so, that I was taking a silly Twitter joke too far—and realized: Wait, no, maybe that's not actually the job? Private markets, still, don't work quite the same way as public ones. You could very easily have a model of venture capital in which tweeting gnomic wisdom is more important than picking the right investments. In this model, the job of a venture capitalist is not mainly to differentiate good companies from bad ones, but to be offered investment opportunities in good private companies in the first place. The VC's source of value comes from marketing herself to founders; in a world where capital is abundant and world-changing ideas are rare, the most important source of value for a private investor is not discrimination but access. And one way to get offered good investment opportunities is by being a thought leader on Twitter. Actually this is almost conventional wisdom? Here is Tyler Cowen on "Why is VC Twitter so peculiar?" He quotes a reader advancing the argument that "as capital supply increases, the importance of differentiation on other axes increases. VCs have a growing incentive to personally market their product." Anyone can give a startup money; a Twitter philosopher has the added advantage of being able to give it wisdom. Here is Alex Danco on the importance of "Social Capital in Silicon Valley." And I quoted it yesterday too, but Byrne Hobart wrote the other day that the main components of venture-capital alpha are "dealflow and judgment," and that "typically outsiders overweight judgment ('did you know it was going to be big?') and underweight dealflow (there are lots of companies that everyone thinks will be big, but only Sequoia gets to say so with a check)." He writes: "Having an abundant supply of loose ties in a tech-adjacent space is a source of persistent VC alpha." Ties don't get looser, more abundant and more tech-adjacent than "thousands of people like my aphorisms on Twitter." So I am willing to embrace this as an investing strategy. Make yourself a bot that writes good tweets, that can produce aphorisms at about the level of a successful and very online venture capitalist. Tweet those tweets under your name and picture. Raise investor money on the basis of your thought leadership. Notice which founders of hot startups follow your bot on Twitter. DM them and set up meetings. Get the bot to supply you some aphorisms for the meetings, too. Close the deal with a mix of basic friendliness and the aphorisms. Your stock-selection skills will be more or less random, but if you do the tweets well enough your dealflow might be good enough to make you rich. For the experience. Obviously I am kidding? I think? Maybe? I never know anymore. The standard view of automation and artificial intelligence in finance is that it will come first for the technical, quantitative, evaluative parts of the industry, but will only increase the value of soft skills in high-touch human-facing roles. Quant hedge funds won't need stock analysts but will still need managers to raise money for the robots to invest; machine-learning tools will take over junior investment bankers' jobs running merger models but won't replace senior investment bankers advising CEOs on how to negotiate the merger. It is fun to think that there might be cases where the quantitative financial logic is too hard for a robot, but the soft human skills are both valuable and relatively easy to automate.

Our study provides the first comprehensive analysis of the properties of investment recommendations generated by "Robo-Analysts," which are human-analyst-assisted computer programs conducting automated research analysis. Our results indicate that Robo-Analysts differ from traditional "human" research analysts across several dimensions. First, Robo-Analysts collectively produce a more balanced distribution of buy, hold, and sell recommendations than do human analysts, which suggests that they are less subject to behavioral biases and conflicts of interest. Second, consistent with automation facilitating a greater scale of research production, Robo-Analysts revise their reports more frequently than human analysts and also adopt different production processes. Their revisions rely less on earnings announcements, and more on the large, volumes of data released in firms' annual reports. Third, Robo-Analysts' reports exhibit weaker short-window return reactions, suggesting that investors do not trade on their signals. Importantly, portfolios formed based on the buy recommendations of Robo-Analysts appear to outperform those of human analysts, suggesting that their buy calls are more profitable.

That is from the abstract of "Man versus Machine: A Comparison of Robo-Analyst and Traditional Research Analyst Investment Recommendations," by Braiden Coleman, Kenneth Merkley and Joseph Pacelli of Indiana University. Here is Bloomberg's Vildana Hajric with more on the study; she adds:

Whereas traditional analysts actively work on maintaining relationships with company management, robots aren't beholden to the same conventions. Their calls may not get the same pop as humans' at first, but the recommendations can generate "substantial returns for individual investors," they said. ... Out of the total pool of outstanding robo-analyst recommendations, more than 30% represented buy ratings compared with 47% from traditional analysts (the overall number of outstanding recommendations from traditional analysts was five times the robots'). About a quarter of recommendations from the machines fell into the sell category, compared with 6% from humans.

If what you are looking for in an investment analyst is someone to tell you which stocks to buy because they have sound fundamentals and will go up in the medium term, the robots seem to be better than the humans. Obviously some people want that. Amateur hobbyist investors who pick individual stocks might want some professional support for their decisions, for instance. On the other hand if you are a professional investor you might want that a little, but mostly you'll be looking for something a bit different. (It is, after all, your job to pick the stocks to buy.) If you are doing deep fundamental research, you will be less interested in the analyst's conclusions than in, say, what she says about her meetings with the company's management. Or you might just want the analyst to invite you to those meetings so you can meet management yourself. Robots don't (yet) meet with managers or provide corporate access. "Traditional analysts actively work on maintaining relationships with company management" not just because they are humans bound by social conventions and the strong desire to be liked, but also because it is what their investing clients want and reward them for. Of course not all professional investors are doing deep fundamental research or meeting with management. Some just want a trade. An analyst who can move the stock price by 5% in a day by announcing a new buy recommendation is ... interesting … to a professional investor. Sometimes in simple ways: You're a client; you see the recommendation as soon as it comes out; you buy immediately; other, slower, retail investors pile in and the stock goes up; you take a profit. Sometimes in more fraught and complicated ways: You're a client; you have regular conversations with the analyst in which you bounce ideas off each other; in the course of those conversations you make the case for a stock you own; she eventually comes around and publishes a buy recommendation; the stock goes up; you take a profit.[1] The robots are bad at that, both because their recommendations do not move stocks as much as the human analysts' recommendations do, and because they don't have regular phone conversations with investors. (Being robots.) All the helpful customer-service-y things that human equity research analysts do, things that are key parts of their jobs, things that are the main value they offer to their professional-investor clients, the robots just skip. "Robot Analysts Outwit Humans on Investment Picks, Study Shows," is the Bloomberg headline, and that is true as far as it goes, but the authors of the paper are a bit less enthusiastic:

Overall, our evidence paints a textured picture of the role of Robo-Analysts in modern capital markets. On the one hand, their reports appear to offer some value to traditional investors, as they are less biased and revised more frequently. In addition, our portfolio analyses suggest that their buy recommendations generate abnormal returns that are higher than those issued by traditional analysts. On the other hand, their sell recommendations do not appear to be profitable. In addition, we expect that traditional analysts still likely add significant value through their softer product offerings, which are unavailable to common investors. In sum, automation appears to lead to an improvement in the aggregate quality of research available to individual investors, but it is unlikely that this approach to research can meet all of the objectives of traditional brokerage house services.

Oh right: "Their sell recommendations do not appear to be profitable"! The robots' buy recommendations outperform, but the sell ones don't:

For sell recommendations, however, we find no evidence to indicate that Robo-Analysts' recommendations are incrementally more profitable than human analysts. If anything, our results indicate that portfolios based on Robo-Analysts' sell recommendations generate positive, instead of negative, abnormal returns. This result is consistent with Robo-Analysts' focus on providing a more balanced distribution of recommendations potentially leading them to over-correct traditional analysts' bias by over-issuing sell-recommendations. Alternatively, Robo-Analysts' may simply invest fewer resources in generating profitable sell calls, given that their client base (i.e., individual investors) is less likely to take short positions. Regardless, our evidence suggests that individual investors can benefit from following Robo-Analysts' buy recommendations, which is likely the most relevant signal for this class of investors.

It is often considered a scandal, a fraud, an indication of conflicts of interest, that only 6% of human analysts' recommendations are sells. Surely, the assumption goes, you should sell as many stocks as you buy. But … why? Most stocks go up most of the time. Most investors are long-biased. It is not at all obvious that there should be as many sells as buys.[2] And in fact the robots correct the humans' biases—they don't care about being liked, about buttering up companies in order to get more access, etc.—and it makes them do a worse job.

No, the thing I am going to explain to Congress is that almost 30% of Pfizer Inc.'s stock is held by Vanguard Group, BlackRock Inc., State Street Corp., Capital Group Cos. and Wellington Management Group. All of those are giant institutional investment firms that own shares of hundreds or thousands of companies, and those are just Pfizer's biggest holders; lots of investors lower down the list are also huge diversified institutions. If Pfizer finds a coronavirus vaccine and distributes it as widely as possible—even at cost, even below cost, even for free, even at an enormous loss—it will make its owners richer by many many billions of dollars. BlackRock, for instance, owns about $16 billion of Pfizer stock. If Pfizer went to zero—if it bankrupted itself, selflessly producing and distributing vaccines—BlackRock (really its clients) would lose $16 billion. BlackRock owns about $2.9 trillion of other stocks; if a coronavirus vaccine allowed businesses to reopen and normal economic life to resume, and as a result those other stocks went up by 1 percent, that would more than make up for bankrupting Pfizer.

For BlackRock, I mean. BlackRock would be happy with that tradeoff, as would its clients, as would Vanguard and State Street and, in all likelihood, a majority of Pfizer's shareholders, many of whom are diversified investors who own a lot of companies that aren't Pfizer and are struggling. Presumably Pfizer's executives would be sad about it. Right now they have prestigious jobs where they get paid a lot; if Pfizer went bankrupt then they would be embarrassed and probably stop getting paid. And they're the ones who set the prices. But there is a trade there, you know? That is the thing that I want to explain to Congress. The shareholders, in some loose sense, own the company; in some loose sense, Pfizer's executives are getting paid with the shareholders' money; in some loose sense, the shareholders are the executives' bosses. If the shareholders were to call up the executives and say "look, if you find a working vaccine and give it away for free, we will give you a bonus pool of one billion dollars to share with each other and your scientists," then … presumably that would be an incentive? Like, the executives would think "if we find this vaccine and make a big profit I'll probably get like a $17 million bonus, but if we find it and make no profit I'll definitely get like a $100 million bonus," and they will have strong incentives to (1) find it and (2) give it away. Econ, like, 101.5, really.

One way to think about this, if you're Congress, is that we've got a whole great big economy, and a vaccine will be very very good for the economy as a whole, and what you want is to find some mechanism to transfer some of that value—enough to incentivize vaccine research and development and production—from the rest of the economy (the households and restaurants and retailers and everyone else who will benefit, economically, from a vaccine) to the people researching and developing and producing the vaccine. You want the people who benefit from the vaccine and are happy about it to send some money to the people who make the vaccine, so that those people will be happy to make the vaccine.

There's a super traditional Econ 101 way to do that, which is pricing; the people who make the vaccine can charge a lot of money to the people who want the vaccine. There are problems with this method, which I will not dwell on here because Congress is obviously well aware of them. (Some people don't have the money to pay for the vaccine, etc.)

All I am saying is that now there is a new way! Now the whole great big economy is knitted together not only by pricing in product markets but also by common ownership of all the stocks by the same investors, and so you can think of all of the companies—Pfizer, American Airlines, Carnival Cruises, The Gap, whoever—as divisions of one giant company, and the one giant company has an executive committee (Larry Fink and the other heads of big investment firms), and the executive committee can tell the divisions (Pfizer, etc.) what to do and how much to charge, and if the giant company's executive committee says "we are going to have our Pfizer division try to find a vaccine and give it away as a loss leader to improve the performance in our other divisions" then, you know, fine, that's how divisions operate, that's how corporate hierarchies go, it's fine. It's not quite like that—there is no giant company, there is no hierarchy—but it is kind of like that, it is enough like that that you ought to start thinking about it, that you ought to think of giant public corporations not as acting on their own pure selfish self-contained profit motives but as part of a vector of interests of their diversified investors, and that you could maybe use that. "Sure, pharmaceutical executive, you say you want to make a big profit on this drug, but what if we asked your owners what they want?"

The point is that the SEC'scrackdown on crypto has included cases against nonfungible tokens, because some nonfungible tokens are, in the SEC's view, securities. Not all of them. I would say the rough breakdown — not legal advice! — is:

1. If you sell an NFT that is, like, "here is a unique work of art that exists on the blockchain, and that might go up or down in value based on people's tastes and demand for blockchain art," then that's not a security. That's a work of art. 2. If you sell an NFT that is, like, "here are 10,000 numbered tokens, and they are all part of some blockchain project, and we've got a team managing that project and thinking of licensing opportunities to make some money, and if you buy one of the tokens you will effectively be a co-owner of the project and share in some way in the money that it makes," then that is pretty obviously a security — it's "an investment of money in a common enterprise with profits to come solely from the efforts of others," the US legal standard — and the SEC will be mad about it.

But many  NFT projects are both. Why do people buy Bored Ape Yacht Club NFTs? Clearly  some people like Bored Apes as artistic objects and cultural signifiers: For a while, if you were a venture capitalist, it was cool to have a Bored Ape as your Twitter profile picture, so there was demand for them as art objects and symbols of club membership. But also the Bored Ape sponsors were constantly doing stuff: "Bored Ape clothing lines, movie deals and video games were all on the table," and you could rationally have bought a Bored Ape as a bet on future cash flows from their efforts.

Or Mann mentions Stoner Cats, an NFT project that the SEC did  shut down. (The project had to "destroy all NFTs in its possession or control," as part of its settlement.) We talked about it last year, and, like Mann, I was skeptical that the Stoner Cats were securities. They were partly pictures of cats, partly complicated concert tickets, and, yes, partly investments in the founders' plan to make an animated web series about cats. You cannot really untangle those things. The SEC's view is apparently that even being a little bit  of an investment in a common enterprise makes a series of NFTs a security, but I am not sure that is right. If you buy a Damien Hirst spot painting, part of what you are buying is a pretty picture that you can look at, but much  of what you are buying is a small informal share in the continuing success of Damien Hirst's efforts to market his artistic project. If he does a good job of making himself famous and in-demand, then you can resell your spots for a lot of money; if not, not. Nobody thinks those paintings are securities, yet.

This is true in a deeper sense. In many cases, the essential attribute of a crypto token is liquidity: What you want, often, is a token that trades a lot, because your goal for the token is to trade it a lot. Real-world utility, a sensible business model, acceptance in real transactions, etc., are all less important than just trading , if you think of crypto as a toy market for traders to play with. If a token trades a lot at a high price, that in itself justifies the price, because that is all that is asked of a token: It doesn't need to have a good underlying business or cash flows; it just has to trade a lot at a high price.

And so Jump was, for a while, critical to the crypto economy, because it was a big market maker, so it could ensure that tokens would trade a lot. Since that was what created value, Jump could make tokens valuable. In exchange for that service, token creators would give Jump some of the tokens, and Jump would then have an incentive to make them valuable:

Token projects will lend market makers a large supply of tokens so they can kickstart trading. Some firms also negotiate a call option, which gives the market makers the right to buy a chunk of the tokens for a steep discount if the project goes well. Selig says that the inverted structure in crypto—where market makers work with token projects, rather than exchanges—makes some sense, given projects' need to spur trading activity. It also creates dynamics that would never be allowed in TradFi. While crypto market makers still make money off the trading spreads, the massive windfalls often come from those lucrative call options.

For a firm like

Man, what a crazy time the crypto boom was. It really did teach a generation of young financial traders that they could build perpetual motion machines: You make a token, you trade it, that makes it go up, the value comes from you trading it , you can do no wrong, you get rich, "unlimited upside with no real financial risk." One token that Jump made valuable was Luna, which brought the whole thing down. [5]

One appeal of cryptocurrency is that it might be a better  form of currency than traditional currencies. Cryptocurrencies, the argument goes, can do stuff that traditional currencies can't do: They can be transferred peer to peer without any intermediaries, they can be carried in electronic form without a bank account, they can be "programmable money," they can be elements in smart contracts.

But another appeal is that it might be worse than traditional currencies. I am not kidding, and this is not a trivial appeal! It is not hard to imagine use cases in which "currency, but worse" is what you want: You want a currency that is more restricted or more contingent than dollars. Giving your kids an allowance of 10 AllowanceBucks — dollars, but they can only be spent on age-appropriate goods — might be better than giving them an unrestricted $10. Or part of the case for central bank digital currencies is that they could have negative interest rates: "dollars, but 1% of them vanish every month." That's worse than a dollar! For you, I mean. But the essential fact of currency is that it represents a claim on somebody else: A dollar in your hands represents an obligation of society to give you $1 worth of stuff. A slightly worse currency represents a slightly weaker obligation, and sometimes that's what you want. Fine-tuning a financial system might benefit from having some currencies that are more  powerful and useful than dollars, but also some that are less  powerful and useful.

Okay fine I'm partially kidding; here's a press release I got:

JUNE 16 - Werewolf Coin, a cryptocurrency that can only be used during the full moon, publicly launched today.

A project by an anonymous artist, Werewolf Coin can be transferred for 24 hours before each full moon and for 24 hours after each full moon. Astronomically, a full moon refers to the moment when the Moon is exactly 180 degrees away from the Sun.

The cryptocurrency can be minted on https://werewolfco.in, which also features a lunar calendar.

I cannot think of any actual reason this would be better than regular money.

Here's how I think of it. First, staking. Ethereum is a cryptocurrency network; people do transactions on Ethereum, but rather than some centralized agency (a bank, etc.) keeping the ledger of transactions, the ledger is kept in a decentralized way by lots of computers that run on the network. The way that this works is roughly that people broadcast their proposed transactions on the network, and every 10 seconds one computer on the network (the "proposer") writes down a list of recent transactions in order, and the other computers on the network (the "validators") vote to approve that list (a "block"), and if they all agree then the block is enshrined in the permanent ledger (the "blockchain"). We talked about this system last week, because some guys kind of hacked it.

The computers that get a vote on this — the proposer and validators — are those with a stake in the network, those with an economic incentive to make sure that it works. Specifically, they are "stakers": People deposit some Ether, the currency of Ethereum, with the network, to get these voting rights. And then if they do bad stuff — propose fake lists, forget to vote, etc. — they lose some of their deposit, which is called "slashing." But if they do good stuff — if they reach consensus on their blocks — they get "staking rewards," in the form of additional Ether, which intuitively come from transaction fees paid by people who want to do transactions on Ether. These rewards are, crudely speaking, proportional to the amount of Ether that the stakers deposit; they tend to be expressed as an annual percentage yield. This morning Coinbase tells me that the rate is about 2.54%.

All the stuff about keeping ledgers and voting sounds pretty active, but it doesn't have to be. It is all algorithmic and done by computers. And so there is a marketplace in which, essentially, (1) I run computers to do the validating stuff, (2) you lend me your Ether to stake, (3) I collect the staking rewards from the validating and (4) I pass most of them on to you. You, here, are just a passive saver; you put your Ether into an account with me and get paid interest. The work of maintaining the Ethereum ledger is distributed among the holders of Ether, and the rewards of that work are also distributed among the holders, but those holders naturally delegate the work to people with more interest in doing it.

If you hold Ether you don't have to be involved in any of this — "about 27% of the all outstanding Ether is staked," reports Shen — but it is kind of free money? If you hold dollars, you don't have to put them in a high-yield savings account or a money market fund, but for a lot people that would make sense. Ethereum staking rewards, to many Ether holders, look more or less like bank account interest.

Sometimes there are profitable trades, but not that often. Sometimes someone is looking to sell 100 widgets at $20 on the American Widget Exchange, and someone else is looking to buy 100 widgets for $21 on the National Widget Exchange. And so you can buy on the AWE and sell on the NWE and make an instant $100 profit. But only one person can do that. Once you buy on the AWE and sell on the NWE, the window is closed.

Who gets to do the trade? The most intuitive answer, in most cases, is "whoever does it first." If you see the same thing trading for two different prices on two different exchanges, and I don't, and you send in the orders to the exchanges before me, then you do the trade and I don't. For most human-scale trades, this makes sense and is easy to administer and feels basically fair.

The US stock market mostly does not operate at human time scales, and there these intuitions break down. In the stock market, often, one algorithm spots trade opportunities a microsecond before another algorithm, and people get mad about that. They worry that this microsecond-scale competition between algorithms is socially wasteful, and they worry that it is unfair to people with worse algorithms. They think "yes, fine, the first person to see a trade should get to do it, within reason , but there's no social benefit to slicing it that fine." They propose things like "frequent batch auctions," where everyone who sees the same trade within (say) a second of each other gets to compete on price to do it, rather than competing on time down to the microsecond.

Crypto, however, has a different problem. Time in electronic stock markets is maybe too continuous; the timeline of a stock exchange can be sliced much more finely than the human brain can comprehend. But time in crypto is oddly discrete. Time in crypto is measured in blocks. Intuitively, people submit orders to do transactions on a crypto blockchain, and then periodically a batch of those transactions is enshrined in the official ledger of that blockchain. In Bitcoin, a block contains roughly 10 minutes' worth of transactions; in Ethereum, it's seconds.

So intuitively, Ethereum transactions happen in big simultaneous bunches every 12 seconds. But the bunches can't really be simultaneous: If there is one rare nonfungible token for sale, and two people want to buy it, only one of them can. One transaction has to be first. So the transactions within a block are ordered ; they happen in sequence. But they are not necessarily ordered by time.

How does the blockchain decide which transactions to record, and in what order? In Ethereum, the answer is: with money. People who want to do transactions on the Ethereum network pay fees to execute the transactions; there is a flat base fee, but people can also bid more — a "priority fee" or "tip" — to get their transactions executed quickly. Every 12 seconds, some computer on the Ethereum network is selected to record the transactions in a block. This computer used to be called a "miner," but in current proof-of-stake Ethereum blocks are recorded by computers called "validators." Each block is compiled by one validator, selected more or less at random, called a "proposer"; the other validators vote to accept the block. The validators share the transaction fees, with the block proposer getting more than the other validators.

The block proposer will naturally prioritize the transactions that pay more fees, because then it will get more money. And, again, the validators are all computers; they will be programmed to select the transactions that pay them the most money. And in fact there is a division of labor in modern Ethereum, where a computer called a "block builder" puts together a list of transactions that will pay the most money to the validators, and then the block proposer proposes a block with that list so it can get paid.

And so if you see 100 widget tokens trading for $20 on one Ethereum decentralized exchange, and 100 widget tokens trading for $21 on another Ethereum decentralized exchange, you can buy them at $20 each and sell them for $21 each and make $100. But if I also see that arbitrage, I will also put in those orders. Which of our trades will execute first? Whoever pays more in execution fees. How much should I offer to pay? Oh, you know, it's a competitive auction. So roughly $99. The validators should get most of the money from the arbitrage. This is called "MEV," for "miner extractable value," though now Ethereum doesn't have miners and the acronym stands much less informatively for "maximal extractable value."

What are the chances that both of us discovered the same arbitrage within 12 seconds of each other? Well, pretty good, in a competitive market with a lot of arbitrageurs. But also, traditionally, when we want to do these transactions, we submit our orders publicly to the Ethereum network. (To the "mempool," the name given to the place where orders reside before they are included in a block.) Everyone can see the mempool. So if you are a clever speedy arbitrageur, watching a bunch of decentralized exchanges for mispricings, you might see a mispricing and submit your arbitrage orders. And if I am a clever speedy front-runner , watching the mempool for arbitrage trades, I would submit the same trades a second or two after you, and pay more to execute them. And then I get to do the arbitrage and you don't.

But if I am a clever speedy front-runner, I don't even have to wait for arbitrage trades. Let's say you are not a clever arbitrageur, but just a person who really likes the Shiba Inu token on the Ethereum blockchain. You submit a huge order to buy SHIB on a decentralized exchange. That will, quite predictably, push up the price of SHIB. If I see that order, I can just jump ahead of it: I can pay a bit more in transaction fees to get my trades to execute first, and then I can buy the SHIB tokens ahead of you and then sell them to you for a profit, all within the same block.

That seems kind of rough on you? This sort of trade is sometimes called a "sandwich attack": I see your order to buy SHIB, and I sandwich it between my order to buy SHIB (before you do, at a lower price) and my order to sell SHIB (after you do, at a higher price). And people talk about "generalized front running" as a strategy:

A generalized front-runner bot will search the mempool for profitable transactions, then copy the transaction and replace the sender address with their own, then increase their bid (gas price) to price + x to be included in a block first front running the original searcher.

I am giving a simplistic and somewhat old-fashioned description of MEV, and modern Ethereum has a whole, like, institutional structure around it. There are private mempools, where you can hide transactions from bots. There is Flashbots, "a research and development organization formed to mitigate the negative externalities posed by Maximal Extractable Value (MEV) to stateful blockchains, starting with Ethereum," which has things like MEV-Boost, which creates "a competitive block-building market" where validators can "maximize their staking reward by selling their blockspace to an open market," and MEV-Share, "an open-source protocol for users, wallets, and applications to internalize the MEV that their transactions create," letting them "selectively share data about their transactions with searchers who bid to include the transactions in bundles" and get paid.

Basically, transaction data on Ethereum is informative, and the value of that information (in making profitable trades) is quantifiable, and there are cutthroat auctions among people who want to use that data to make their own trades, and the people doing the transactions that create the data can themselves get paid for their data.

Crudely speaking there are two sorts of crypto tokens. There are fungible tokens, like Bitcoin and Ether and Tether and Solana, which have approximately cash-like properties: If a thing costs two Bitcoins, it doesn't matter which two Bitcoins you use to pay for it; any two Bitcoins are just as good as any other two Bitcoins. And there are nonfungible tokens, NFTs, like Bored Ape Yacht Club, which have approximately art-object-like properties: Each Bored Ape is different, and some — based on their rarity or aesthetics or provenance — are worth much more than others.

Intuitively, fungible tokens are indistinguishable coins, while NFTs are unique images. But really neither of those things is true. Really they are both entries in detailed permanent transaction ledgers. An NFT, for example, isn't the little drawing of the monkey; the NFT is simply a numbered entry in a ledger that points to the drawing of the monkey. I once wrote that "an NFT consists of a series of numbered tokens, and the thing that makes it an NFT is that it has a different number in its tokenId field from the other tokens in its series."

Meanwhile a fungible token like Bitcoin is not a numbered entry in a ledger; there is such a thing as "Bored Ape Number 3" but there is no such thing as "Bitcoin Number 3." But there is a permanent immutable computer ledger containing every Bitcoin transaction, which means that you could, sort of, trace the ledger back to find what the third Bitcoin was and who holds it now. More generally, you could, if you wanted to, treat Bitcoins as completely nonfungible. You could trace back the history of any Bitcoin, or fraction of a Bitcoin. And then you could say things like:

"I am willing to pay more for old Bitcoins, ones that were mined in like 2009, than I will for new Bitcoins, ones that were only mined in 2024." "I am willing to pay more for Bitcoins with cool provenance, like ones that were once owned by Satoshi Nakamoto or used to pay for the 2010 Bitcoin Pizza, than I will for regular old Bitcoins with no fun history." "I am willing to pay less for Bitcoins with a troubled regulatory history, like the ones that were stolen in the Bitfinex hack, than I will for Bitcoins with a clean regulatory history."

Bitcoins are fungible simply because it is standard convention among Bitcoin users to treat them as fungible, but they are distinguishable from one another, and if you wanted to discriminate among Bitcoins you could. People mostly don't, but the last thing on that list — "try not to accept Bitcoins that have been stolen or are otherwise of interest to US law enforcement" — does have some traction. Some Bitcoins really are less valuable than others.

The basic mechanics of a stablecoin are:

1. You send $1 to a stablecoin issuer. 2. It sends you back one stablecoin, which represents $1 on the blockchain. 3. The issuer uses your $1 to buy Treasury bills that pay like 5% interest. 4. You don't get the interest.

When interest rates were lower, this was a basically sensible proposition: Stablecoin holders could get a crypto token representing a dollar, which helped in their crypto trading, and they missed out on a little interest, but not much. When interest rates are 5%, being a stablecoin issueris a great business, but owning stablecoins makes less sense. Why not keep the money in the bank and get interest?

The straightforward solution is of course for the issuers to pay interest to their depositors, but this is made harder by US securities law. Is a non-interest-bearing stablecoin a security subject to US regulation? Mmmmmmmaybe, but the US Securities and Exchange Commission doesn't seem all that interested in pushing that theory. Is an interest-bearing stablecoin a security subject to US regulation? The SEC is definitely interested in pushing that theory — it sues crypto businesses for offering interest all the time — and it has a pretty good argument. The argument is "a thing that takes your money, promises you back $1, invests it in Treasury bills and pays you the interest is a money market mutual fund , which is totally a thing that the SEC regulates."

A pretty standard story in crypto is:

1. Crypto in general, and Crypto Project X in particular, are building something. Each crypto project is working to achieve some vision of the future of finance or communications or media or wireless networking or whatever, and crypto collectively — the aggregate of those projects — is moving toward some loosely shared vision of a future of decentralized ownership, censorship resistance, etc. 2. By buying tokens of Crypto Project X, you are betting on the success of whatever they are building: If the thing succeeds, the tokens will be worth more than you paid for them. 3. Probably the people building Crypto Project X are selling its tokens to raise money to build the thing, or doing something that rhymes with that. [5]

This is not the only story in crypto; there is another common story that goes like "someone created some tokens as a joke and now they are worth billions of dollars." But the one I laid out above is important. For one thing, it describes a lot of big crypto projects. Also, though, it would be hard to care about crypto if it wasn't trying to build something. "Dogecoin is a joke and if you buy it it might go up" is, I think, a very interesting fact about modern finance, but you'd feel silly devoting your life to it. Read Write Own: Building the Next Era of the Internet is the name of venture capitalist Chris Dixon's book about crypto, and if you are a venture capitalist "the next era of the internet" is a better thing to back than "a joke about a dog."

The problem with this story, though, is that Crypto Project X's tokens sure sound like they are securities under US law. A security is "an investment of money in a common enterprise with profits to come solely from the efforts of others," and what I laid out above — Crypto Project X is a group of people building a thing, they raise money by selling tokens, and you buy tokens hoping to make money if their thing succeeds — is that.

US securities law exists mostly to prevent swindling in the sale of securities. This creates several problems for crypto:

1. Some crypto projects are in fact swindles, and securities law is bad for them. 2. The main way that the law prevents swindles is by requiring disclosure by securities issuers, and the disclosure rules are not well adapted to crypto, meaning that even a non-swindle crypto project will have a hard time registering its tokens and complying with US law. 3. The law empowers the US Securities and Exchange Commission to regulate securities, and the SEC hates crypto and does not do anything to make registration easy or even possible. 4. Most critically, perhaps, the law also regulates securities exchanges , and it is hard for a crypto exchange to register with the SEC as a securities exchange. So the SEC can go after crypto exchanges for illegally listing crypto tokens that are securities.

I think there are roughly four ways to make a stablecoin, a crypto token that has a stable value of $1:

1. A dollar-backed stablecoin: You put in $1, you get a stablecoin, the issuer puts the dollar somewhere safe and promises to give it back to you in exchange for the stablecoin. 2. An overcollateralized stablecoin: You put in $2 of Bitcoin or whatever, you get a $1 stablecoin, the issuer puts your Bitcoin collateral somewhere safe and promises to give it back to you in exchange for the stablecoin. 3. An algorithmic stablecoin: No, bad. [5] 4. A stablecoin of pure will: You list a token on a crypto exchange, its name is like "Stable Value Dollar Coin," and the marketing materials say "the point of Stable Value Dollar Coin is to always be worth a dollar." And then you just hope that people will pay a dollar for it, because you told them to.

I am not aware of any important examples of No. 4, but I feel like it lurks in the back of the mind of a lot of crypto. A lot of crypto tokens, after all, have value only through collective adoption. One way to encourage that adoption is to get people to think that the token's value is unbounded: You buy Dogecoin because you think Dogecoin will go to the moon, and if enough people buy it then it will. Another way to encourage that adoption, though, is to associate  the token's value — even in just a loose meme-y way — with something else valuable. If you name your crypto token after Elon Musk's dog, or the Greek letter omicron, then maybe it will go up when Musk's dog or omicron are in the news. I once proposed that a way to put private-company stocks on the blockchain would be to issue tokens with the names  of those private companies, and just sort of casually hope that people will buy the tokens when they think positive thoughts about the companies.

The US has about a dozen stock exchanges. Each stock trades on each stock exchange. Every so often the price of a stock on one exchange will be slightly lower than the price on another exchange. Books have been written about this fact, and people have made long and lucrative careers from it.

But we are talking about small differences in the grand scheme of things. If I were to tell you "Apple Inc. stock has been trading at $174 per share on the NYSE Arca exchange for the last hour, but it's been trading at $175 on Nasdaq the whole time," you would not believe me; that is barely even a coherent sentence. For one thing, there are rules to prevent that. But also, I mean, this stuff is all on computers, and these prices are all visible, and there are people who have lucrative careers noticing any differences. If Apple was trading at $174 on Arca and at $175 on Nasdaq, those people would buy it on Arca and sell it on Nasdaq, making a risk-free instantaneous profit. And so many of them would do this so quickly that the prices would more or less instantly converge.

Again, at a certain scale — for the arbitrageurs who make a career of this stuff — this is not true ; there are milliseconds when you can buy at $174.99 one place and sell at $175 another place and make a quick profit. But at human scales it is true enough; there are not hours when you can buy at $174 one place and sell at $175 another.

But that's only true because there are a lot of those arbitrageurs with a lot of capital and fast computers, and because a lot of technological and regulatory work has gone into making sure that all of those arbitrageurs can connect to all the stock exchanges and see their prices and move their capital quickly to whatever exchange has cheap stock for sale. You could imagine a different system. You could imagine a system where NYSE Arca is downtown and Nasdaq is in midtown and you have to take a horse and buggy between them to trade, and you can't use the phone, and there's just one of you; then maybe prices would diverge by dollars for hours. That's not too hard to imagine — it was roughly true 100 years ago, though stocks traded on fewer venues back then — but it does not really reflect our modern computerized markets.

And then there's Bitcoin!

The price of Bitcoin against Tether's USDT stablecoin fell to as low as $8,900 on BitMEX late Monday, while the largest cryptocurrency was trading above $66,000 on rival venues. The price of Bitcoin on the exchange quickly recovered and has been trading in-line with the rest of the market since.

A spokesperson for BitMEX said the company investigated the incident and found evidence of "aggressive selling behavior involving a very small number of accounts that exceeded expected market ranges," adding that its systems had operated normally and all user funds are safe.

BitMEX is "investigating potential misconduct by traders on our Bitcoin-USDT Spot market," the exchange said in a post on the X social-media platform on Tuesday. The exchange does not employ internal market makers and the orders to sell Bitcoin "were simply too big and frequent for independent market makers and other traders to react to," according to the same post. The incident had no impact on BitMEX's derivatives markets and no liquidations were triggered by it, the post added.

The best guess appears to be that this was one big whale, or perhaps a few, dumping Bitcoin steadily over a few hours:

"Someone just dumped 400+ BTC over 2 hours in 10-50 BTC clips on the XBTUSDT pair on Bitmex eating 30%+ slippage. They must've lost $4m+ at least," pseudonymous crypto community member "syq" wrote. "I'm guessing that they're done (for now?). Total volume so far is just shy of 1,000 BTC over 3.5 hours with a low of $8,900. Now BitMEX have disabled withdrawals," they added.

The exceptionally low prices did not persist uninterrupted for hours at a time or anything, but there seems to have been a pretty intense 10-minute period of low prices, and in any case each time this whale dumped 10 to 50 Bitcoin at a time, it got prices far lower than the prints on any other exchange.

And, you know, if I were making markets in Bitcoin on Coinbase, and I noticed that Bitcoin was selling for $8,900 on BitMEX, I would simply get myself over to BitMEX and start bidding, like, $9,000 for Bitcoin. That's free money!

Why didn't anyone? Part of the answer is probably that they did; this gap eventually closed, though from BitMEX's posting it seems that the gap closed more because the whale stopped selling than because anyone stepped in to buy.

But another part of the answer is that crypto exchanges are fundamentally different businesses from stock exchanges. In the US, if you buy stock on a stock exchange, you don't send the money to the stock exchange. You send the money to the seller (and the seller sends the stock to you) through a clearinghouse; there's one main clearinghouse for all US stock trades, and every exchange and broker is hooked up to it. If you are an arbitrageur looking to buy $100 million worth of stock, you don't have to park $100 million at each of the 12 exchanges so you can trade on whichever one has the lowest price. You park $100 million at your one brokerage firm, and the broker handles settlement for you wherever you actually execute the trade. [1]

In crypto, it is the norm for exchanges to hold your money for you. One thing that this means is that there is a long and comical history of exchanges losing or stealing that money. Another, related thing that it means is that traders have to evaluate the credit risk of exchanges: You do not want to deposit $100 million on an exchange that will go and lose or steal it. [2] There is high-stakes credit due diligence each time you start trading on a new exchange. Also though there is just an operational issue: Even if an exchange's credit is impeccable, if you want to be in a position to buy $100 million of Bitcoin on that exchange, you have to deposit $100 million on that exchange, which means putting it there and not elsewhere.

BitMEX's post about the flash crash says: "Yes, we are investigating potential misconduct by traders on our Bitcoin-USDT Spot market (Did you even know we offer Spot trading?)," with a little side-eye emoji in that parenthetical. The point is that BitMEX's spot markets are not very important, to BitMEX or its customers or spot Bitcoin traders generally. BitMEX is "The OG Exchange for Crypto Derivative Trading" and reports relatively tiny amounts of spot trading relative to its derivative markets. If you are a market maker trading Bitcoin for dollars (or USDT), you are probably thinking about using your capital and technology efficiently to make markets on Binance and Coinbase and half a dozen other big spot Bitcoin exchanges. BitMEX's spot market might be a bit of an afterthought. And if Bitcoin goes on a drastic sale on BitMEX for 10 minutes, you might not have time to get there and buy it.

Probably the strongest case for crypto is that cryptocurrencies meet a real need for people who live in countries with unstable currencies and weak financial and legal institutions. If keeping your money in the local bank means that your money might lose all its value because of inflation, or be seized by the government, then you will want to keep your money somewhere else. Keeping it on the blockchain — in Bitcoin, in other cryptocurrencies, or in stablecoins pegged to the US dollar — arguably solves both your problems. The government probably can't take your money if it's on the blockchain, and it can't inflate away the value of your money if it's in Bitcoin or dollars. There are other ways to store your money that are stable and hard to find — diamonds, etc. — but crypto is probably easier to hide, transfer, sell and spend than most of them.

On the other hand, there is no particular reason for your government to like this. For one thing, it is rude to the government to say "the institutions and currency here are bad so I'm putting my money in Bitcoin." For another thing, if the government wants to seize your money or whatever, it will be annoyed if you make that difficult: You may see "weak financial and legal institutions," but the government sees "legitimate enforcement of our laws against improper currency transactions." Also, though, if everyone decides to get out of the local banks and into Bitcoin, that is going to create problems; it will drive down the local currency and make the banks weaker.

The crypto maximalist reply is probably "tough luck, government, there's nothing you can do about it, code is law, the blockchain is a technology that overthrows censorship." There are two main problems with that reply:

1. The "$5 wrench attack": If your money is stored in a secure, decentralized, censorship-resistant cryptographic blockchain, that's super, and the government probably can't just seize it by pressing a button, but the government probably can throw you in jail until you cough up your password. 2. On-ramps and off-ramps: Turning your local currency into crypto, and turning crypto back into spendable money, probably involves going through a crypto exchange. A crypto exchange is probably a big centralized company with a corporate charter, a money-transmitting license, banking relationships and human executives. It has some surface area that is vulnerable to government pressure, and if the government doesn't like all its citizens getting into crypto, it will probably put some pressure on the exchanges.

The way the stablecoin business works is:

1. You send $1 to a company (the stablecoin issuer), and it sends you back a token representing "one dollar, but on the blockchain." 2. If you want your dollar back, you can (probably) give the issuer back the token and get back the dollar. [7] 3. The issuer invests your dollar and earns interest.

In a zero-interest-rate environment, the issuer didn't earn much interest, but it earned some, and it kept it: You were so grateful to be able to hold a dollar on the blockchain, and rates were so low, that you didn't worry about earning interest. (Also, when crypto was booming, you could invest your stablecoin into some crypto lending protocol that would probably pay you 20% interest, so the issuer didn't need to pay you anything.)

In a 5% interest-rate environment, the issuer earns way more interest, but it's awkward for them not to pay you any. You can get 4% or 5% interest in an insured bank or a regulated money-market fund; why should you get zero from some weird crypto startup?

You might expect there to be a straightforward market-driven move to stablecoin issuers paying interest, but there are complications. One is that stablecoins are largely trading instruments, tools for trading crypto and making payments, and so liquidity and usefulness are more important than yield. The biggest stablecoins (Tether, etc.) have the most liquidity and utility, so crypto traders are not going to abandon them for some smaller weirder tokens that pay interest, so there's not much pressure on them to pay anything.

The other complication is that a stablecoin that pays interest is pretty clearly a security under US securities laws, so if you wanted to issue one in the US you'd have to register it with the SEC, and you don't want that and the SEC doesn't want that. "We'd love to pay you interest, but if we did we'd get in trouble with the SEC" strikes me as not a bad excuse for a stablecoin issuer: It happens to coincide with the issuer's own economic interests, but it's also probably true.

There is a well-known strategy, in financial markets, of trading ahead of index rebalances. The idea is: You know that on Date X, Stock Y will join Index Z. You know that a lot of index funds are indexed to Index Z, and they will have no choice but to buy Stock Y on Date X. So you buy Stock Y before Date X, knowing that you will have someone to sell it to on Date X. Joining the index will bring in a whole new source of demand for the stock: not just people who have looked at the stock and decided they like it, but a new class of fundamentals-insensitive passive investor who will buy it just because it is in the index. So you buy it first, to sell to them.

There are ways for this to go wrong. You could get the stocks or weightings wrong, for one thing, or the trade could just get too crowded: If index funds will need to buy $100 million of Stock Y on Date X, and 10 different hedge funds each say "ah I know that there'll be $100 million of demand for Stock Y, so I'll buy $50 million of it now," then there's $500 million of supply for $100 million of demand and the price will go down on Date X.

Or I suppose you could mess up by miscounting the number of indexed investors. You could say "there's $10 billion of assets indexed to Index Z, and Stock Y will be 1% of the index, so that's $100 million of demand," but if you're wrong and there's only $5 billion of assets indexed to Index Z then there'll be less demand than you think. This does not seem like a major source of error. People have a decent idea of how much money is in, like, S&P 500 index funds.

A reader emailed to point out that this isn't necessarily the whole story. If you are the first person to offer "Bitcoins in a pot," people will put Bitcoins in your pot, and GBTC does have $29 billion of Bitcoins. And those Bitcoins have appreciated in value: Most of them were put in the pot at considerably lower Bitcoin prices than today's $46,000-ish, and Grayscale stopped putting new Bitcoins in the pot in 2021. If you bought GBTC shares in 2019, or most of 2022 or 2023 for that matter, your shares are worth much more than you paid for them.

This is good for you, generally, but it is a tax problem: If you sell your GBTC shares, you'll have a big gain and have to pay taxes on it. If you just keep those shares, you don't pay taxes (yet). That is a reason not to sell.

Soon, probably, you will have your choice of Bitcoin ETFs. They will all be about the same, and you might prefer to buy one with 0.2% fees rather than one with 1.5% fees. But if you already own shares in Grayscale's Bitcoin trust when it converts to an ETF, the math isn't so simple. If you sell the Grayscale ETF and buy a cheap one, you will save on annual fees — but you'll probably pay a lot of taxes on your gains. [4] Paying 15% or 20% capital gains taxes on 50% or 80% gains on your GBTC shares might look a lot more expensive than paying an extra 1.3% per year in fees.

Or people in crypto have spent years arguing that decentralized autonomous organizations are a new and better way to organize economic activity, never seen before. (This is wrong and they are general partnerships, but never mind.) But there are also sometimes arguments that DAOs are a way around securities regulation: If some crypto project (a decentralized exchange, a lending platform, whatever) is run by a DAO rather than by a company, then it is more robust to regulation; regulators can't fine the DAO or arrest its leaders, because it is decentralized and computerized and thus resistant to government interference.

My guess is that this is partly correct: Some decentralized crypto projects really do run as more or less autonomous code on distributed blockchains and really can't be shut down by an SEC order. [4] But there do seem to be a lot of $5 wrench vulnerabilities in crypto, where "decentralized autonomous organization" is a fancy way of saying "Discord page for voting on stuff," and the SEC can find the Discord's administrator and say "hey we can make your life bad if you don't shut down this DAO" and the administrator shuts it down and everything was a lot less decentralized and autonomous and organized than people thought.

Last month the SEC shut down a DAO:

The Securities and Exchange Commission [Dec. 22] announced that BarnBridge DAO, a purportedly decentralized autonomous organization, and its two founders, Tyler Ward and Troy Murray, will pay more than $1.7 million to settle charges that they failed to register BarnBridge's offer and sale of structured crypto asset securities known as SMART Yield bonds. The Commission also charged the respondents with violations stemming from operating BarnBridge's SMART Yield pools as unregistered investment companies. To settle the SEC's charges, BarnBridge agreed to disgorge nearly $1.5 million of proceeds from the sales, and Ward and Murray each agreed to pay a $125,000 civil penalties.

"The use of blockchain technology for the unregistered offer and sale of structured finance products to retail investors runs afoul of the securities laws," said Gurbir S. Grewal, Director of the SEC's Division of Enforcement. "This case serves as an important reminder that those laws apply to all who wish to access our capital markets, regardless of whether they are, or purport to be, incorporated, decentralized or autonomous."

Reading the SEC order, it is a little puzzling how BarnBridge could have settled the case. It's a DAO? Did it, like, take a vote? Apparently not; apparently the SEC got to the founders and the founders shut it down:

In July 2023, Ward and Murray took steps to close investments in a second version of SMART Yield that had launched in January 2023, after BarnBridge DAO had stopped offering investments in SMART Yield Pools described in this Order. Ward and Murray also canceled a new product launch, limited access to Discord, Github, and other platforms used by BarnBridge DAO, and stopped development of further securities using the BarnBridge protocol.

So not that decentralized or autonomous.

I don't really get the case for a Filecoin ETF? The Financial Times reports:

Some cryptocurrency funds run by the world's largest crypto manager are trading at as much as eight times their underlying value amid an unprecedented buying frenzy. ...

The mania has spread to a host of private trusts operated by Grayscale. The company's Filecoin Trust is trading at $34.25, 721 per cent above its net asset value of $4.17, having hit a premium of more than 1,000 per cent in November.

Its trust tracking solana, the third-largest cryptocurrency after bitcoin and ether, is at a premium of 302 per cent, while those investing in chainlink, livepeer, lumens and Decentraland's mana token are priced at between twice and four times their NAV.

"It's absurd. I feel the investor doesn't really understand what they are getting into," said Bradley Duke, chief strategist of ETC Group, which runs more than $1bn in European-listed crypto exchange traded products.

"I wouldn't know what [investors] could be thinking buying at these prices," said Bryan Armour, director of passive strategies research, North America, at Morningstar. "A lack of understanding can easily be part of it."

The funds can only be traded via the over-the-counter "pink sheets" market, where secondary trading in pre-existing shares takes place. Shares cannot be redeemed, while new shares can only be created if Grayscale carries out a private placement exercise, meaning there is no arbitrage mechanism to bring prices back in line with the underlying holdings.

To be clear, these Grayscale trusts are not ETFs, because you can't create or redeem them; if they were ETFs they probably wouldn't trade at those crazy premiums. (You'd go buy a ton of Filecoins and give them to Grayscale to get back trust shares, etc.) But Grayscale's biggest trust is the one tracking Bitcoin; it has traded at a discount for a long time, but that discount has closed significantly now that everyone expects the trust to convert into an ETF (and thus allow redemptions). That optimism has been good for the price of Bitcoin too, and for the prices of crypto generally, and also apparently for the prices of Grayscale altcoin trusts.

Bitcoin is a popular financial asset, "digital gold," a possible diversifier for retail and institutional investors. Filecoin is … the payment currency for a peer-to-peer file storage system? Why would you buy it in a pink-sheet wrapper? The Grayscale Filecoin Trust is tiny (half a million dollars under management), but owning Filecoin that way is (1) less useful and (2) vastly more expensive than owning it directly.

A stablecoin is a way to hold US dollars (or euros, etc.) in a way that is convenient for crypto. You buy cryptocurrencies on some crypto blockchain and hold them in some crypto wallet; a stablecoin is a cryptocurrency on a crypto blockchain in a crypto wallet, but it is worth a dollar.

People want this for two main reasons. One is that if you trade a lot of crypto, you will sometimes close positions — you will buy some crypto and then, later, sell it — and the natural way to close a position is into dollars. You measure your profits and losses in dollars, you pay your rent in dollars, so you effectively trade between crypto and dollars. And if you are doing a lot of that, you will find that holding dollars in the form of stablecoins is more convenient and efficient than holding dollars in the form of a bank account (or money-market fund, or pile of $20 bills). Your stablecoin-dollars live on the blockchain and are instantly transferable for crypto within the crypto system; your regular dollars live in a bank that might be slow or fussy about transferring them to a crypto exchange. The stablecoin is a way to keep all of your trading within the crypto system, but without always being exposed to crypto prices.

The other, almost unrelated reason is that there are people who find the crypto financial system more accessible than the regular US dollar financial system. People in countries with fragile banking systems, people in countries with high inflation, but also various kinds of criminals, all might say "I would rather keep my money in crypto than in a bank." These people are not trying to trade frequently or speculate on crypto; they just want to hold their money somewhere safe, and for whatever reason that is not, for them, a bank. But cryptocurrencies are volatile, while US dollar-linked stablecoins mostly aren't. So "I would rather keep my money in crypto than in a bank, but in dollars" is a reasonable thing for these people to think.

Another important thing about stablecoins is that they mostly don't pay interest. The main mechanism of a stablecoin is that you deposit dollars with a stablecoin issuer, they give you back a stablecoin (a token on the blockchain), and they put the dollar into a bank account (or Treasury bills, or Chinese real estate commercial paper, or whatever). And they keep the interest and you don't. In a world of zero interest rates that was fine. In a world of 5% short-term interest rates it makes being a stablecoin issuer insanely lucrative. But also the customers notice.

The basic mechanism of a lot of decentralized finance projects is a Ponzi scheme with some fairly standard complexification:

1. You invent a token, BoxCoin or whatever, [7] and sell it to people. 2. People who own BoxCoin get paid a yield — "APY," for "annual percentage yield," is the standard term — in BoxCoin , or perhaps in some related crypto token. 3. Like, you know, every 12 hours you get 10% more tokens or whatever. 4. People are like "look at how high the yield on BoxCoin is, I'd better get some." 5. They buy it, and the price goes up. 6. Now the yield looks even better: Now you have 100 BoxCoins worth, like, 2 cents each, but in 12 hours you'll have 110 BoxCoins worth 3 cents each. What a yield!

The trick is … I mean, it is all a trick … but one trick is to hype it up and get people to buy BoxCoins, so that yield looks like an actual monetary yield rather than just the proliferation of worthless numbers, and the other trick is to get people not to sell BoxCoins, because if they sell it all collapses.

We have talked about this so many times. This is, for instance, Hex. It is Terra and Luna. It is, perhaps most beautifully, OlympusDAO, whose trick to stop people from selling was to explain to them, in winkingly pretentious game-theoretic terms, that if everybody bought and nobody sold then they'd all make money, but if they sold they'd all lose money. "(3, 3)" was for a while an important crypto meme. I cannot adequately express how insane 2021 was.

Anyway SafeMoon's trick was that if you sold your SafeMoon tokens, the SafeMoon protocol would take a 10% "tax." Thus buying was good and selling was bad, which kept a floor on the price. (For a while.) Half of the 10% tax was used to pay the yield on the other tokens: If you sell your tokens, you pay 10%; if you hold your tokens, you get half of the money that the sellers pay. This creates a further incentive to hold, and the yield that makes the whole thing attractive. This was called "reflection"; SafeMoon's whitepaper said:

[T]he reflect mechanism encourages holders to hang onto their tokens to garner higher kick-backs which are based upon a percentages [sic] carried out and dependent upon the total tokens held by the owner. In theory, with the manual burn function … even a small holder at the beginning could potentially walk away with big money at the end of the token's lifespan.

The other half of the 10% tax was allegedly stolen by the developers, which is why they are in jail now.

The normal way for a venture capital firm to invest in a startup company is something like this. The startup is a corporation, and it issues stock, and the VC firm (through one of its funds) buys the stock. The VC firm might get a seat on the startup's board of directors, and might have some say in running the startup. But the startup is a separate company. If it is doing bad stuff, the VC firm could lose the money it invested in the startup, but it will not ordinarily get in trouble for the startup's actions. When startups like Theranos and FTX collapsed in scandal, the VC firms that bought their stock were treated as victims of the scandals, not co-conspirators.

And then the way the VC firm makes money is by eventually selling their stock, when the startup goes public or is bought by a bigger company.

In the crypto boom, VC firms discovered a different way to invest in startups. The startup would be a crypto project, and it would issue tokens, and the VC firm would buy the tokens. The tokens might have some governance rights: The crypto project might be a DAO, a decentralized autonomous organization, whose token holders get to vote on what it should do.

But there is another problem with the token approach, which is that, while these tokens might be functionally stock, and while the SEC thinks (and courts might agree) that they are therefore securities, they are not literally stock, and these crypto DAOs are not literally corporations. Specifically, they are not incorporated. Nobody filed a form with the Delaware secretary of state to incorporate the crypto DAO as a corporation. (This is not always true, and for instance Wyoming has a special statutory flavor of DAO limited liability company, but it is often true.)

This seems like a small technicality, but one important benefit that you get, from filling out a form and paying a fee to incorporate a corporation, is limited liability. If you have a business entity that is not incorporated, then it is often, by default, a general partnership. Which means that the investors who fund and participate in running it are, arguably, general partners. Shareholders of a corporation are not generally liable for the corporation's actions, but general partners of a partnership generally are. For instance, they might be liable for its unregistered sales of securities.

Or that is a theory. Late last year, some holders of Compound DAO's COMP tokens sued the venture capitalists backing Compound for unregistered securities sales. The idea is:

1. "Compound is a business that allows users to borrow and lend crypto assets, in much the same way that a traditional bank allows customers to borrow and lend traditional currencies." It is a big player in decentralized finance, letting people borrow and lend using smart contracts rather than centralized intermediaries. 2. Compound is governed by a DAO, and "Compound DAO is governed by the holders of a security called COMP." 3. Compound issued some COMP tokens to its early investors and founders. It issues others to people who use the Compound smart-contract protocol: If you deposit or borrow on Compound, you can earn COMP tokens. ("This is an example of a strategy called 'yield farming' or 'liquidity mining,' which Compound essentially pioneered," says the complaint. We have talked about yield farming before.) 4. COMP trades publicly on crypto exchanges: If you use Compound and get some tokens, you can sell them for cash, and people do. 5. "Nine people control at least 51.56% of the COMP currently issued," including the co-founders of Compound and venture capital firms including Bain Capital Ventures, Polychain Alchemy, Andreessen Horowitz and Paradigm. 6. Those people and firms are general partners of Compound, liable for any bad stuff that it does. 7. One arguably bad thing that Compound does is list the COMP token on crypto exchanges, where people can buy it. 8. The plaintiffs in this case bought some COMP on the exchanges — not from Compound or its venture investors — and are now suing, arguing that this was an unregistered sale of securities and that the venture capitalists are responsible for it.

The VCs moved to dismiss the complaint, and last month a federal judge denied their request, finding "that there are sufficient allegations against each of the Partner Defendants to allow the Securities Act claim to go forward at this juncture." "The Partner Defendants have 'reserved' their right to contest whether Compound DAO is a general partnership or whether any of them are general partners in that or a related partnership," he wrote, but I guess it's not a great sign, for them, that he calls them "the Partner Defendants."

If Compound was doing an unregistered sale of securities, then it could be liable for those investors' losses. If Compound is just a pot of crypto in decentralized finance, then that liability might not be worth much. But if Compound is a general partnership, and its partners are big VC firms, then they might be liable for the losses.

This theory is not unique to this case, and we talked last year about a US Commodity Futures Trading Commission action against a crypto thing called Ooki DAO, also arguing that its voting token holders could be general partners.

I remember the days of crypto optimism in 2021. One thing that crypto enthusiasts and venture capitalists liked to say was that crypto was a new way of organizing human economic behavior, that crypto would enable a new "Web3" in which technology was organized collectively and belonged to its users instead of being owned by big corporations. This could seem pretty cynical, as VC firms often owned big stakes in (the tokens of) these web3 projects.

But also it was just a big factual mistake! Crypto and DAOs and web3 were not a new way of organizing human economic behavior; they were an old way, the general partnership. They were a technological step backward: Ages ago, lawyers and financiers and governments figured out a new way to organize human behavior, the corporation, which allowed people to pool their capital in a new venture in ways that limited

There are three classic problems that you might encounter if you try to use Bitcoin to pay for goods and services. The first problem is that your Bitcoins might go astray: Bitcoin transactions are irreversible and involve sending money to long complicated addresses, and people are constantly trying to steal them. So if you send someone Bitcoin to pay for something, there will probably be a typo in the address and the person won't get it and you'll have to send it again and your first payment will just be permanently lost.

The second problem is that Bitcoin is very volatile, and even people who accept payment in Bitcoin tend not to denominate it in Bitcoin. So if you send someone $100 worth of Bitcoin to buy a $100 thing, the price of Bitcoin might drop 10% while you're sending it, and then they'll say "you only sent me $90" and you'll have to top them up with more Bitcoin.

The third classic problem is that, if you are using Bitcoin to pay for goods and services, there is a good chance that you are paying for something illegal, and Bitcoin payments are traceable. So if you send someone $16,000 worth of Bitcoin to buy a $16,000 thing, (1) some of your money will go missing in transit, (2) the Bitcoins you send won't be worth $16,000 and you'll have to send some more, and (3) the $16,000 thing was a murder and now you are in prison.

At a very high level, the way banking works is:

1. People have money and would like to earn interest on it. 2. They put the money in the bank, which lends it to other people, who do stuff — run businesses, buy houses — with the money and pay interest to the bank. 3. This funds economic activity, and over time, the economy mostly grows. There are more people, more productivity, more stuff. If I take $100 from you and use it to buy a house or start a business, and I promise to pay you back $110 with the proceeds of my house or business, there's a pretty good chance that I will be able to do that, that the thing I buy now will be worth more later. I invest the $100 in productive enterprises, those productive enterprises pay off $120, I pay back the loan with interest and have $10 left over for myself. 4. Obviously sometimes this doesn't work — my business fails, my neighborhood gets cheaper — but the successes should outweigh the failures, and if banks are diversified and well capitalized they'll be fine and can pay back their depositors. 5. Occasionally the whole system overreaches — all the banks decide, at once, to bet all their money on home prices going up — and the bet goes wrong and there's a financial crisis.

Broadly, banking is a levered bet on economic growth , and the bet is risky but usually pays off.

How does crypto banking work? I think there are three broad ways to conceive of it:

1. "Crypto" and "banking" simply don't go together. The strict view of some early crypto adopters is that crypto is an alternative to the leverage of traditional banking. Traditional banks hold your money for you and use it to make levered bets on economic growth, and that is risky, and if you don't like it you can use crypto. You hold your money for yourself, nobody is making any bets with it, everything is transparent and on the blockchain, there are no intermediaries, there is no hidden leverage or risk of financial crisis. It feels quaint to me to even type this, but I think this view was pretty influential in the early days of crypto. 2. Crypto banking is just like regular banking, a levered bet on economic growth: There are crypto firms, quasi-banks, that hold people's cryptocurrency for them and pay them interest, and they use that crypto to invest in productive enterprises that grow the economy and return enough to pay the interest. They lend out crypto to people who want to start businesses or buy homes or open factories. Anything is possible! I know from experience that if I write "you don't hear much about people borrowing crypto to start real-world businesses or buy houses," someone will email me to say "I have a firm that lets people borrow crypto to buy houses on the blockchain." But … I mean … not so much? 3. Crypto banking is purely financial, a levered bet on the size of the crypto market. There are crypto firms, quasi-banks, that hold people's cryptocurrency for them and pay them interest, and they use that crypto to invest in more crypto. They lend out crypto to hedge funds that want to make levered bets on crypto, and as long as crypto prices generally go up those hedge funds will make enough money to pay back the loans with interest and get rich themselves. But nothing productive is happening with these money flows; people are buying tokens but not doing any activity that makes anyone better off in the real world. Crypto prices go up because people speculate on crypto, so there is more money in crypto, so it is easier to borrow more money to make more levered bets on crypto, so prices keep going up, etc., until a slight breeze blows it all over and there's nothing left.

I don't want to say that that Version 3 is entirely right. Obviously some of the money that flowed into crypto produced some stuff that is still used. The market capitalization of all crypto, which peaked at over $3 trillion in late 2021, is about $1 trillion now, a huge crash but still a lot of residual value.

But I do think that Version 3 basically explains the crypto credit bubble and crash of 2022. Everyone in crypto wanted to pay, and receive, interest, but nobody who was paying that interest even considered investing in productive real-world businesses. And so a group of crypto hedge funds sprang up that would go to crypto quasi-banks and say "we would like to do leveraged speculation on crypto" and the quasi-banks were like "great, perfect, please take all of our money," and the hedge funds would take all the money and use it to buy, like, Luna, and then Luna went to zero and the hedge funds were vaporized and so were the lenders.

In November 2022, after FTX went bankrupt, Binance, the biggest crypto exchange, announced an "industry recovery fund" to do bailouts for crypto. Changpeng "CZ" Zhao, Binance's founder, tweeted that the fund would "help projects who are otherwise strong, but in a liquidity crisis." As Bloomberg's Emily Nicolle writes today, the plan was to "pull together some of the industry's biggest names and raise at least $1 billion to finance promising startups which, due to forces outside their own control, were strapped for cash.

At the time, I found this plan puzzling, because I had never heard of a crypto project that was "otherwise strong, but in a liquidity crisis." I asked: "Has there ever been a pure liquidity problem at a crypto firm?" Crypto project that got hacked and lost all its money? Sure. Crypto project whose founders ran off with all the money? Sure. Crypto project whose money was all in magic beans that turned out to be worthless? Sure.

But crypto project that had lots of good long-term assets that it could not sell or finance quickly, and that was therefore driven into bankruptcy despite having lots of value? I mean? I suppose it is still technically possible that that describes FTX, but only by accident. (It gambled customer money on, among many worse things, a stake in artificial intelligence startup Anthropic that has gone up a lot in value since FTX went bankrupt.) I just kind of do not think that that is how crypto works. Compared to traditional financial assets, crypto is unusually good at being liquid (it all trades on computers around the clock) but unusually bad at being solvent (it often turns out to be worthless). A fund set up to solve liquidity problems in crypto won't end up doing much.

People have thought about this question! Like, this is very much a central thing that traders and trading firms worry about. The standard starting point is the Kelly criterion, which computes a maximum bet size based on your edge and the size of your bankroll. Given the intern's bankroll of $100, I think Kelly would tell you to put at most $10 on this bet, depending on what exactly you mean by "this bet." [7] Betting $98 is too much.

I am being imprecise, and for various reasons you might not expect the interns to stick to Kelly in this situation. But when I read about interns lining up to lose their entire bankroll on bets with 1% edge, I think, "huh, that's aggressive, what are they teaching those interns?" (I suppose the $100 daily loss limit is the real lesson about position sizing: The interns who wipe out today get to come back and play again tomorrow.)

But I also think about a Twitter argument that Bankman-Fried had with Matt Hollerbach in 2020, in which Bankman-Fried scoffed at the Kelly criterion and said that "I, personally, would do more" than the Kelly amount. "Why? Because ultimately my utility function isn't really logarithmic. It's closer to linear." As he tells Lewis, "he had use for 'infinity dollars'" — he was going to become a trillionaire and use the money to cure disease and align AI and defeat Trump, sure — so he always wanted to maximize returns.

But as Hollerbach pointed out, this misunderstands why trading firms use the Kelly criterion. [8] Jane Street does not go around taking any bet with a positive expected value. The point of Kelly is not about utility curves; it's not "having $200 is less than twi

Tether's spokeswoman is making the same point here: Tether isn't making these loans because it wants to, because it thinks they are a good financial decision for Tether. Tether is making these loans to support its borrowers. Somebody out there — crypto exchanges or trading firms, etc. — has some collateral (presumably volatile cryptocurrencies) and wants to borrow dollars (in the form of Tethers), and Tether Holdings is the cheapest and most available lender they can find. Somebody in crypto needs money to buy (or keep holding onto) their crypto, and Tether will provide the money, secured by the crypto, not because that's a good deal for Tether but because Tether is being a good citizen of the crypto ecosystem and supporting its counterparties.

Tether's borrowers are big crypto investors looking to get financing for their crypto collateral, and if they ran out of liquidity they would need "to sell their collateral at potentially unfavorable prices, which could result in losses." If big crypto firms get margin calls and have to dump their assets, that will drive down the prices of crypto assets. Lending them money is not just good for them, it's good for the crypto ecosystem broadly: It prevents fire sales that might drive down prices.

We have talked about Tether's lending activity before. One common form of crypto-skeptical conspiracy theory in recent years goes something like this: "Tether is a form of self-sustaining fractional reserve banking for crypto, and it dynamically prints Tethers in order to prop up crypto prices. At the margin, cryptocurrencies are not purchased by real people putting new dollars into the crypto system, but by crypto hedge funds buying crypto using freshly printed Tethers."

Non-fungible tokens have a similar story, but much more so. I do not fully understand the appeal of, like, Bored Ape Yacht Club. But it's something like:

1. There is a limited collection of digital images of apes, each of which is associated with a numbered crypto token. 2. You can buy one of the numbered tokens and then you "own," in some not-really-worth-thinking-about way, the associated image of an ape. 3. You can use the ape as your Twitter profile picture, [5] and other people who also "own" apes can see your profile picture and be like "ooh, you own an ape too, cool cool." 4. Of course anyone can use the ape as their Twitter profile picture — buying the token and downloading the digital image are entirely separate transactions — but to the people in the club those people will look like phonies and poseurs; to be in the club you need not just the picture but the token. 5. Maybe also you like the picture of the ape? You like the aesthetic? It's like buying a cool article of clothing or bag or whatever; you feel good wearing it (as your Twitter profile picture) and other people in the know also think you are cool. 6. The club can have real-life meetups or whatever, where owning the token is your admissions ticket. 7. Also other people might want these benefits, the supply of apes is limited, and maybe you can buy an ape and then sell it to someone else for more money and get rich quick. 8. Celebrities and influencers can be enticed into this whole thing, and if they go on TV saying "I own a Bored Ape and I love it, look how bored it is" maybe the price of your ape will go up. 9. Etc.

It's a combination of quasi-art collection and quasi-club membership and very 2021 crypto price speculation.

Let's say you want to make an animated web series about cats. Not just any cats, though: The exciting twist in this series is that these cats smoke marijuana. [1] You care a lot about this idea, and you want the production to be perfect. You want to hire an amazing cast; you want celebrities like, I swear I am not making this up, Ashton Kutcher, Mila Kunis, Seth MacFarlane, Jane Fonda, Chris Rock and, of course, Vitalik Buterin (as Lord Catsington). That takes money.

To raise the money, you go out to investors on the internet and say "hey, this series is gonna be amazing, I've got a great team and relationships with big celebrities, we're gonna do sequels for ages, get in on the ground floor of a new entertainment franchise that is basically the next Marvel or whatever, but with cats who enjoy marijuana." And then you sell shares in the production, entitling investors to a share of the money you make. You sell these shares on the internet, to anyone who shows up, without bothering to check if they are " accredited investors."

That is, I think, fairly obviously a securities offering? And you will get in trouble if you sell the shares to the public and do not register the sales with the US Securities and Exchange Commission.

But let's change the hypothetical slightly. Let's change how the shares work, in the following three ways:

1. You don't call them "shares." Call them "tokens." 2. You don't actually promise holders any of the money you make. You say "if this series is a big hit and spawns years of sequels, the value of these tokens will go up." Why will they go up? Oh, I don't know, why does anything go up? In 2021 you could just do this; you could say "the tokens of this project will go up if the project is popular," even if holders of the tokens are not entitled to any of the project's revenue. 3. Each token comes with a picture of one of the cats attached.

Is that a securities offering? Man, I don't know. There are arguments both ways:

Yes: Look, this is raising money to finance a project by selling bits of the project to investors who hope to earn a speculative return. That is just classically a security, "an investment of money in a common enterprise with profits to come solely from the efforts of others." From the investors' perspective, this trade is the same as selling shares. No: There is no actual direct promise of profits! The tokens come with pictures of cats! They are just art, man! This is like Walt Disney raising money to make Mickey Mouse cartoons by selling drawings of the mouse! Sure those drawings will be worth more if Mickey Mouse is a huge hit and spawns an animation and theme-park empire, but any artist's work will be more valuable if the artist becomes famous, and that doesn't make the art a security.

We have talked about this issue before. The SEC very much takes the view that this sort of thing is a securities offering, and last month it brought an enforcement action against a company called Impact Theory LLC that raised $30 million by selling non-fungible tokens to fund, I don't know, some sort of incomprehensible crypto project. Today it came for Stoner Cats:

The Securities and Exchange Commission today charged Stoner Cats 2 LLC (SC2) with conducting an unregistered offering of crypto asset securities in the form of purported non-fungible tokens (NFTs) that raised approximately $8 million from investors to finance an animated web series called Stoner Cats.

According to the SEC order, on July 27, 2021, SC2 offered and sold to investors more than 10,000 NFTs for approximately $800 each, selling out in 35 minutes. The order finds that both before and after Stoner Cats NFTs were sold to the public, SC2's marketing campaign highlighted specific benefits of owning them, including the option for owners to resell their NFTs on the secondary market. In addition, the order finds that, as part of the marketing campaign, the SC2 team emphasized its expertise as Hollywood producers, its knowledge of crypto projects, and the well-known actors involved in the web series, leading investors to expect profits because a successful web series could cause the resale value of the Stoner Cats NFTs in the secondary market to rise. Further, the order finds that SC2 configured the Stoner Cats NFTs to provide SC2 a 2.5 percent royalty for each secondary market transaction in the NFTs and it encouraged individuals to buy and sell the NFTs, leading purchasers to spend more than $20 million in at least 10,000 transactions. According to the SEC's order, SC2 violated the Securities Act of 1933 by offering and selling these crypto asset securities to the public in an unregistered offering that was not exempt from registration.

"Regardless of whether your offering involves beavers, chinchillas or animal-based NFTs, under the federal securities laws, it's the economic reality of the offering – not the labels you put on it or the underlying objects – that guides the determination of what's an investment contract and therefore a security," said Gurbir S. Grewal, Director of the SEC's Division of Enforcement. …

Without admitting or denying the SEC's findings, SC2 agreed to a cease-and-desist order and to pay a civil penalty of $1 million.

It also promised to "destroy all NFTs in its possession or control." I don't want to think about that. There was a time when you could probably record a video of yourself deleting an NFT and sell that video as an NFT, but that was very 2021.

I am not that sure that these pictures of cats were securities? I see where the SEC is coming from: The Stoner Cats people were clearly raising money from investors to fund a project, and they were not selling the cats to discerning art collectors. From the SEC order:

Each Stoner Cats NFT was associated with a unique still image of one of the characters in the Stoner Cats web series, with different expressions, apparel, accessories, and backgrounds, resulting in a multitude of NFTs. Purchasers could not choose their NFT in the offering, but instead received a random allocation.

And:

While purchasers may "own" their particular Stoner Cats NFT, SC2 specifically reserved all commercial rights to the underlying intellectual property, including the images of the characters.

And clearly at least some people were buying the cats for speculative purposes: "At least 20% of the Stoner Cats NFTs purchased in the offering were resold in the secondary market before the first episode of the Stoner Cats series aired," and "investors were also told that 'the more successful the show, the more successful your NFT' will be."

On the other hand, one benefit of buying the cats is that you could watch the show: "Investors were told that the Stoner Cats NFT was analogous to a 'ticket' and that 'if people don't appreciate it, you can take that ticket and sell it.'" A concert ticket is not a security! Even if the concert is sold out and you can resell your ticket for a profit! And there don't seem to have been any promises to share the profits of the project: People seemed to think that the tokens would go up in value due to some combination of (1) general crypto enthusiasm and (2) maybe people would want to watch the show and would buy the tokens to do so. They were speculative investments , sure, but that doesn't make them securities.

Also I feel like the requirement that you have to own an NFT to watch the show makes the NFT in some sense the opposite of a share of stock? There is a natural limitation on the economic value of the franchise if only a few thousand token holders can watch it: Each token can be more valuable, but that value comes from exclusivity, not from the show being a big general hit. There was no source of revenue other than the tokens.

The basic story is:

1. There is obviously demand for a Bitcoin exchange-traded fund, a thing that you can trade on the stock exchange and hold in your brokerage account that gives you exposure to the price of Bitcoin. If you could make that, people would buy it. 2. The easy way to make that would be to create an ETF that holds a pot of Bitcoins, issues shares of the pot, and allows arbitrageurs to exchange Bitcoins for shares and vice versa. That is roughly the way, you know, stock and bond ETFs work, and it is good and straightforward. 3. However, in the US, the Securities and Exchange Commission has adamantly opposed this method — the spot Bitcoin ETF — due to some combination of weird concerns about manipulation on crypto exchanges plus, I think, a general philosophical desire not to make it too easy for retail investors or traditional institutions to buy crypto. 4. You need SEC approval to list a new ETF, the SEC has not approved any spot Bitcoin ETFs, so there aren't any in the US. 5. So some people came up with a clever workaround, the Bitcoin futures ETF, where they raise a pot of money and use it to trade Bitcoin futures on regulated commodity exchanges. The ETF shares represent a claim on those futures rather than on a pot of Bitcoin. 6. That's pretty good — the futures prices track Bitcoin prices pretty well — though there's some tracking error and it's more expensive than just sitting on a pot of Bitcoins. 7. Crucially, the SEC has approved Bitcoin futures ETFs: They trade only regulated futures listed on US commodity exchanges, so the SEC can't really complain that their markets are manipulated. [3] 8. So there are, in the US, Bitcoin futures ETFs but not spot Bitcoin ETFs. 9. Grayscale Bitcoin Trust, a pot of Bitcoins that is not an ETF, has sued the SEC, demanding that the SEC let it turn its pot of Bitcoins into a spot Bitcoin ETF. 10. Last month, Grayscale won its case in court. It is not an ETF yet — the SEC still has some cards to play — but it will probably become one. 11. This is good for Grayscale (which gets to convert into an ETF), though it has some downsides (fees for ETFs are generally a lot lower than the 2% Grayscale charges). 12. It is very good for other big ETF firms that can now get into the spot Bitcoin ETF game. BlackRock Inc., for instance, has one in the works. 13. It is very bad for the people who made Bitcoin futures ETFs. What a good idea they had! A clever workaround to a regulatory impediment, something that let investors get, like, 90% of the benefits of a Bitcoin ETF while threading the needle of SEC approval. In a world without spot Bitcoin ETFs, the Bitcoin futures ETF was a desirable product, though also something of a niche product; you were never going to get everyone comfortable with its complexities. Still, good workaround. But more or less pointless now, if everyone can buy a simple cheap spot Bitcoin ETF instead.

I hesitate to say this, but when I think about derivatives-based ETFs outside of crypto, I tend to think of three main use cases:

1. Commodity ETFs are often futures-based, because it's hard for an ETF to actually hold a big stash of gold or wheat or whatever, [4] so a commodities ETF will trade futures instead. Probably this is part of the reason that there is no US spot Bitcoin ETF — probably the SEC worries a little about Bitcoin custody — but it seems like a solvable problem for Bitcoins in a way that it isn't for wheat. 2. If you want to do a short ETF — one that bets that the price of some asset will go down — you probably have to do that with derivatives. 3. If you want to do a levered ETF — one that goes up $2 or $3 for every $1 the underlying asset goes up — you probably have to do that with derivatives too.

The US generally accepted accounting for Bitcoin is that it can go down, but not up: If you are a corporation and you buy some Bitcoins, then the Bitcoins are reflected on your balance sheet at their cost, but you test them every quarter for impairment. If the price has gone down, the Bitcoins are impaired: You reflect their lower value on your balance sheet, and you take a loss on your income statement. If the price has gone up, you don't reflect the higher value on your balance sheet or take a gain in income. (If you sell the Bitcoins at a higher price, you do have a gain in income.)

Accounting is, by default, conservative, and if you come to an accountant and say "we have invented a new sort of digital asset, how should we account for it," this is what they will come up with. If you have invented a new sort of magic bean, an accountant's first guess will be:

1. The beans are probably worth what you paid for them. 2. If you say that the beans' value went up since you bought them, you're probably lying. 3. If you say that the beans' value went down since you bought them, you're probably right.

And so you get this sort of accounting for Bitcoin.

This is a very appropriate reaction to a new thing, so you see why Bitcoin got this accounting. But by now there is a big liquid market for Bitcoin and if you say that the value of your Bitcoins went up, and you point to their trading prices on a bunch of big crypto exchanges, at this point your accountants will believe you.

So the accounting is changing:

The Financial Accounting Standards Board voted to set a new rule on cryptocurrency accounting and disclosure, changes companies holding these assets have argued more accurately reflect their financial condition. ...

The FASB, which sets accounting standards for U.S. public and private companies and nonprofits, on Wednesday voted unanimously to adopt a new standard that would require businesses to use fair-value accounting for bitcoin and certain other crypto assets. Companies and accountants have repeatedly rallied for this change, as it would allow them to recognize losses and gains immediately, and treat digital assets as they would some financial assets instead of as indefinite-lived intangible assets.

Public companies' financial statements will have to disclose their crypto assets, separating them from intangible assets like patents and trademarks, on a quarterly and annual basis. Private companies must do the same in whichever financial reports they compile. Businesses will have to include gains and losses on their crypto assets in their net income.

The rule is set to go into effect for 2025 annual reports for calendar-year public and private companies, which can adopt the changes early.

I do not think that the weird accounting is, like, the main impediment to all of corporate America shifting its working capital from dollars into Bitcoins. But the accounting is annoying, and companies that own have a lot of Bitcoin will grumble about it a bit in their securities filings. ("Any decrease in their fair values below our carrying values for such assets at any time subsequent to their acquisition will require us to recognize impairment charges," says Tesla Inc., "whereas we may make no upward revisions for any market price increases until a sale. For any digital assets held now or in the future, these charges may negatively impact our profitability in the periods in which such impairments occur even if the overall market values of these assets increase.")

Now, though, if you are a public company and you buy Bitcoin and the price of Bitcoin goes up, you have income. That might make it a bit more attractive to buy Bitcoin.

Grayscale Bitcoin Trust is a pot full of Bitcoins managed by an investment firm called Grayscale Investments LLC, part of Barry Silbert's Digital Currency Group. Shares of the trust trade publicly under the ticker GBTC, and you can buy them in your brokerage account. New shares can be created by handing Grayscale a pile of Bitcoins and getting back new GBTC shares. For a long time a lot of people did this — it was called, somewhat misleadingly, the "Grayscale arbitrage" — because GBTC traded at a big premium to the actual price of Bitcoin, and so it now has about $16 billion worth of Bitcoin. But that premium collapsed (in part because everyone kept doing the trade), and as of early last week GBTC traded at about a 25% discount to the value of its pot of Bitcoins.

An odd feature of GBTC is that you can't take the Bitcoins back out: You can create new shares by giving Grayscale Bitcoins, but you can't get back the Bitcoins by handing back your shares. The pot can grow, but it can never shrink, so the discount persists.

If you read those two paragraphs and thought "wow I bet Grayscale charges a lot of money to manage that pot" then congratulations, you are qualified to work in financial services. Grayscale charges a lot of money to manage that pot. GBTC investors complain about it, but what are they gonna do? They can't take their money out! They can sue — they have sued — but for the most part GBTC looks like a perpetual fee bonanza for Grayscale. It charges 2% per year, on a pot of $16 billion, to just, like, hold onto the pot. Very lucrative.

Grayscale has bigger plans, though. Specifically it wants to convert GBTC into an exchange-traded fund. If GBTC were an ETF, then it is plausible that:

1. People would be able to take Bitcoins out. 2. This would collapse the discount, and GBTC would trade more or less in line with its net asset value. 3. Therefore people wouldn't take their Bitcoins out, but in fact would put more in, and the GBTC ETF would use its brand name and first-mover advantage to become even bigger. It would become the main way for ordinary investors to own Bitcoin.

Points 1 and 2 there seem like straightforward consequences of converting to an ETF. Point 3 is more of a gamble. Maybe everyone will pile into a more efficient Grayscale Bitcoin ETF. Maybe they won't.

Grayscale wants to be an ETF, the US Securities and Exchange Commission kept rejecting its applications for not very compelling reasons, Grayscale sued and last week it won in court. It's not an ETF yet, and things could go wrong, but they are trending in the right direction ETF-wise.

We talked about the court case last week, and several readers emailed me to ask: Did Grayscale want to win this case? The math is kind of:

1. If GBTC is not an ETF, then it has a perpetually locked-up pot of $16 billion of Bitcoins, paying it 2% per year forever. 2. If GBTC becomes an ETF, then (1) everyone can take their money out, (2) other Bitcoin ETFs will start to compete with it, (3) ETFs compete largely on fees and (4) come on, no other passive ETF charges anywhere close to 2%.

Grayscale winning this case kills its golden-goose fee stream. The optimal approach for Grayscale, a lot of people have long assumed, was to talk a lot about how aggressively it was fighting the SEC to become an ETF, in order to appease investors who want to collapse the discount, but to never actually win the case. If you win the case you lose the fees.

There are two ways to run a Bitcoin exchange-traded fund:

1. You could raise money from investors, park it in cash or Treasuries, and trade cash-settled Bitcoin futures listed on a US commodities exchange. The futures would periodically expire, paying off whatever Bitcoin is worth at the time, and you would roll the proceeds into new futures to keep your Bitcoin bet active. The ETF would roughly track the price of Bitcoin, because the futures pay off based on the price of Bitcoin, but there would be some frictional costs from rolling the futures and some tracking error. 2. You could raise money from investors, use it to buy Bitcoins, and keep the Bitcoins somewhere safe. Then you'd have Bitcoins, and the price of the ETF would track the price of Bitcoin. If it didn't, arbitrageurs could deliver Bitcoins and get back ETF shares, or deliver ETF shares and get back Bitcoins, just like any normal stock index ETF.

It seems to me that Approach 1 is, you know, fine and interesting, but Approach 2 is strictly better: It's simpler for the ETF manager to do, simpler for investors to understand, and has less friction and tracking error. My one quibble with Approach 2 is that you really do have to keep the Bitcoins somewhere safe, and there is a long, long, long history of people in crypto finding exciting new ways to lose their cryptocurrency, but I think that in 2023 "buy Bitcoins and don't lose them" is the sort of thing that you can expect a regulated financial institution to manage.

But in fact the US Securities and Exchange Commission has approved Bitcoin futures ETFs (Approach 1) and repeatedly declined to approve spot Bitcoin ETFs (Approach 2), for reasons that have never really made much sense to me. Essentially the SEC worries that the spot Bitcoin market is the Wild West, someone might manipulate it, and if they did then the price of the Bitcoin ETF would be manipulated. Whereas Bitcoin futures trade on the Chicago Mercantile Exchange, a US commodities exchange regulated by the Commodity Futures Trading Commission; that market is presumably free of manipulation, so a Bitcoin futures ETF can rely on it.

I like to explain crypto initial coin offerings by saying that "they're like if the Wright Brothers sold air miles to finance inventing the airplane," so here's another old-timey analogy for non-fungible token offerings. Imagine that one day in the boom times of the 1920s a young animator named Walter Disney shows up at the stock market one day looking to raise money for his new company. "I am going to make a fortune making movies and theme parks," he says, "and I am giving you the opportunity to invest early. I'm not selling you shares of my company, though; I'm selling something even better. Here's a drawing of a mouse. If you give me $1 million, I will use it to build a movie studio and theme-park empire, and the mouse will feature prominently in that empire, and you will get the royalties from that mouse. Here's a dog, and a duck, and some nephew ducks. Same deal, though the nephew ducks are cheaper."

Obviously that would, in hindsight, have been a good investment. What kind of investment would it have been? Would it have been like buying art? Would it have been like buying intellectual property? Or would it have been like investing in a speculative business? The mouse is a picture of a mouse, like art, but he's valuable if Disney builds a film and theme-park empire and not if he doesn't, like stock.

You could expand it. "I have drawn 101 dalmations," he might go on. "They all look like, you know, dalmations. You can buy any one of them, and get the royalties from that dalmation, and use that dalmation in any spinoff intellectual property you want. Dalmation 43 has diamonds on her collar; Dalmation 81's ears are in sort of a sassy pose; maybe those dalmations are worth more, I dunno, what'll you pay me for them?"

If you buy a stock on Monday morning for $100 and it closes that afternoon at $101, then you have a one-day return of 1%, which is an annualized return of roughly 1,100%. On Tuesday, you can go out to potential investors and say "hello I am an incredibly skilled investment manager, I have achieved an 1,100% annualized return so far this year, invest with me," and maybe they will. If the stock keeps going up 1% every day, then in a year it will be worth $1,227.40 and your investors will be thrilled. What are the chances of that? Not zero, I guess. But pretty low.

Oh, I'm kidding, you can't do this:

1. People are not that dumb, and no one is going to "annualize" a one-day return, get a huge number, and believe it. Stocks go up, and they go down. If your investments go up 1% in a day, that doesn't mean that they will go up 1,100% in a year. They'll only go up 1,100% in a year if they go up 1% every day, and that's a hard streak to maintain. 2. Whether or not anyone believes you, you will get in trouble with the regulators if you market your fund this way.

Except in crypto! In crypto, if you buy some crypto and it goes up 21% in three weeks, you can advertise a 2,700% annualized return, and people will believe you? I guess? You will still get in trouble with regulators however:

The Securities and Exchange Commission [yesterday] announced charges against Titan Global Capital Management USA LLC, a New York-based FinTech investment adviser, for using hypothetical performance metrics in advertisements that were misleading. The SEC also charged Titan with multiple compliance failures that led to misleading disclosures about custody of clients' crypto assets, the use of improper "hedge clauses" in client agreements, the unauthorized use of client signatures and the failure to adopt policies concerning crypto asset trading by employees.

According to the SEC's order, for a period ranging from August 2021 to October 2022, Titan, which offers multiple complex strategies to retail investors through its mobile trading app, made misleading statements on its website regarding hypothetical performance, including by advertising "annualized" performance results as high as 2,700 percent for its Titan Crypto strategy. The order alleges that Titan's advertisements were misleading because they failed to include material information, for example, that the hypothetical performance projections assumed that the strategy's performance in its first three weeks would continue for an entire year.

From the complaint:

Titan did not disclose in the advertisements that the 2,700 percent annualized return was based on a purely hypothetical account in which no actual trading had occurred, that this annualized return had been extrapolated from a period of only three weeks (from August 10, 2021 to August 31, 2021), that the hypothetical return for this three-week period was calculated at twenty-one percent, that the projected 2,700 percent annualized return was based on the assumption that the Titan Crypto strategy would continuously generate a twenty-one percent return every three weeks for an entire year, or Titan's views as to the likelihood that this assumption would bear out. The advertisements also did not disclose whether the hypothetical projection was net of fees and expenses.

NiftyApes, an NFT lending protocol backed by Coinbase and Variant, is the first to bring Seller Financing to the world of NFTs. …

The seller lists an item for sale on an NFT marketplace that has integrated the NiftyApes SDK and sets financing options (either custom or pre-made) including price, down payment, duration, and interest rate. …

The NFT is transferred to a neutral NFT seller financing escrow smart contract which has been audited by Quantstamp and Sherlock ensuring a secure transaction. …

Immediately after clicking "Buy," the buyer becomes the delegated owner of the NFT and can start using it. … Such use cases include giving the buyer immediate access to token gated Discords, airdrops, and more. …

The buyer makes payments until the purchase is paid in full. Once the seller financed purchase is fully paid, the NFT ownership is transferred out of the escrow contract to the buyer's wallet.

If the buyer fails to make a payment, the seller keeps all the payments made and can reclaim the NFT to sell again.

A buyer initiates the purchase by making a down payment on the NFT and agreeing to the payment terms set by the seller.

Still, one important point about Judge Rakoff's opinion is that he agrees with Ripple, Terraform, most of the crypto industry and Judge Analisa Torres (the Ripple judge), and disagrees with the SEC, about whether tokens are themselves securities:

XRP, as a digital token, is not in and of itself a "contract, transaction[,] or scheme" that embodies the Howey requirements of an investment contract. Rather, the Court examines the totality of circumstances surrounding Defendants' different transactions and schemes involving the sale and distribution of XRP.

He just concludes that all of those sales were securities offerings.

I don't know what to make of that. Judge Rakoff was deciding a motion to dismiss in a particular case, not trying to make broad crypto law for every case. But what if this is the law?

1. Crypto tokens are not securities. 2. Crypto issuers who sell those tokens to fund their projects are doing securities offerings.

What would that mean for crypto exchanges? The action right now in SEC crypto enforcement is largely against exchanges, arguing that they are running illegal securities exchanges and should stop. But if the tokens themselves are not securities, does that mean that the exchanges are entirely off the hook? Or, if the issuances of "token plus totality of circumstances" are securities offerings, does that mean that when the tokens start trading they are trading along with the totality of their circumstances, and are thus securities? If you buy an XRP or a Luna (Terra's token), are you just buying a digital token, or are you expecting "the profitability of the cryptoassets" from "the managerial and technical skills that would allow the [issuers] to maximize returns on the investors' coins"?

Here is an economic system, or a system anyway:

1. I make up a crypto token called MattCoin. I can issue an unlimited amount of MattCoins, since I made them up. 2. I sell them to people for money. 3. You can use MattCoins to make term deposits, with me: You can give me back your MattCoins and I will keep them for some specified time period (say, a year), and at the end of the period I will hand them back to you with interest. 4. The interest is paid in MattCoins. 5. The interest rate is high, say, 38% per year. 6. This is the only thing you can do with the MattCoins. They're not useful for payments, they don't run smart contracts on a blockchain, all you can do is trade them on crypto exchanges and deposit them for a 38% yield paid in kind.

So you pay me $100 for 100 MattCoins, you deposit them with me for a year, and at the end of the year I give you back 138 MattCoins.

At the end of the year, how much would you expect your 138 MattCoins to be worth? I think the main options are [1] :

1. $138. You put in $100 for 100 MattCoins, meaning that they are worth $1 each, and in a year you get back 138 MattCoins. If they are still worth $1 each, then 138 MattCoins are worth $138. 2. $100. You put in $100 for some MattCoins, absolutely no economic activity happened , and in a year you get back 138 MattCoins. This is like a stock split: You had 100 shares of a pot worth $100, now you have 138 shares of a pot worth $100, each share is worth less but the pot hasn't changed. 3. $0. You put in $100 for some MattCoins, absolutely no economic activity happened or will ever happen , in a year you get back 138 MattCoins, but I keep the $100 and you don't get to exchange your 138 MattCoins for real money again. There is not actually a pot with $100 in it; I just took the $100! You put in $100 and got back a pile of magic beans that are not redeemable for anything. The pile grew bigger over the year, but it remains worthless. 4. More than $138. You put in $100 for 100 MattCoins, those MattCoins offered a 38% yield, other people see that 38% yield and said "I want some of that," they buy some MattCoins, the price of MattCoin rises, still other people see the rising price and say "ooh I want some of that ," the price rises further, it's a virtuous cycle, eventually each MattCoin is worth like $10,000 and your 138 MattCoins make you a millionaire.

I think that Answer 3 is the standard answer that traditional financial analysis would give you: You bought an electronic token with no cash flows ever, so it's worth zero. I am drawn to this traditional analysis, but it has not really worked all that well for understanding crypto.

I think that Answer 4 is the standard answer that crypto would give you. This is a completely accepted mechanism of crypto finance: You have some token, the main thing that the token does is generate more tokens, you call those additional tokens "yield," people are attracted to the yield, they buy the token and its price goes up. The "yield" does not come from any economic activity in the real world ; it just comes from printing more tokens. "Ponzinomics," people sometimes say. Loosely speaking, this is the thought process behind crypto "Ponzicoins" like OlympusDAO and Wonderland. Loosely speaking, it is the thought process behind many algorithmic stablecoins like TerraUSD. Loosely speaking, it is the thought process that Sam Bankman-Fried once described to me on Odd Lots: "You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that's gonna replace all the big banks in 38 days or whatever. Maybe for now actually ignore what it does or pretend it does literally nothing. It's just a box."

People got mad at me about this. The main objection goes something like this:

1. XRP is never itself a security. It is just some computer code, "little more than [an] alphanumeric cryptographic sequence," as the court says, citing another crypto case. 2. Sometimes, when Ripple sold XRP, those sales were "investment contracts" under the US Supreme Court's Howey test: They were "an investment of money in a common enterprise with profits to come solely from the efforts of others," because the whole transaction that Ripple did with its investors — institutional investors who bought XRP in direct over-the-counter trades with Ripple — feels like an investment contract. 3. Other times, when Ripple sold XRP, they were not, because the whole transaction just occurred anonymously, on an exchange, so there were no direct arrangements with the buyers and no expectation by the buyers that Ripple would make efforts to make XRP profitable.

The analogy that everyone in crypto likes to use is "the oranges in Howey were not securities." (Howey, which we discussed on Friday, is the Supreme Court case that created the test for an "investment contract": W.J. Howey Co. sold people some orange groves along with management services, promising to split the orange profits with the buyers; the Supreme Court found this to be a security.)

I think that this is wrong. You can eat an orange. XRP is not an orange; it is purely an abstract creation of Ripple, whose value comes entirely from the entrepreneurial efforts of Ripple. Nobody bought XRP to eat it. Nor did anyone buy XRP just because they like owning "alphanumeric cryptographic sequences." There are two reasons you might buy XRP:

1. You want to use XRP. XRP is the currency of the XRP blockchain, developed by Ripple's founders to facilitate cross-border payments and banking services. My understanding is that, in its decade of operation, Ripple has not gotten all that far in signing up banks for this payment network, but XRP is a functioning cryptocurrency with a blockchain that does transactions, and this is a possible reason for buying XRP. (It is certainly a possible reason for buying other cryptocurrencies, like Ethereum, that are regularly used to pay for transactions on widely used blockchains.) There is essentially no discussion of this possibility in the opinion, though, and I do not think that anyone is pounding the table for the view that a lot of the people buying XRP on exchanges were doing so in order to facilitate bank transfers. (If anything, the over-the-counter buyers would include banks who want to actually use XRP — but some OTC buyers explicitly disclaimed the possibility of using XRP. [1] ) 2. You think that the price of XRP will go up. Why would it go up? Well, the possibilities include (a) "general cryptocurrency market trends" (in Judge Torres' words) and (b) Ripple succeeds in building a widely used payments network, which makes XRP more valuable.

Judge Torres concludes that Ripple's institutional buyers of XRP bought it for Reason 2(b): Ripple told them that it would make XRP more valuable:

Based on the totality of circumstances, the Court finds that reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple's efforts. From Ripple's communications, marketing campaign, and the nature of the Institutional Sales, reasonable investors would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP.

Fine. But my contention is that these sales did not consist of (1) XRP plus(2) some set of contracts promising that Ripple would use the money to increase the value of XRP. They consisted only of XRP. [2] Institutions did not enter into a contract — like the contract in Howey — in which Ripple promised to manage a grove of XRP for them and give them the proceeds of their success. They just bought XRP. The XRP, and the way in which Ripple advertised it , was itself a bet on Ripple's entrepreneurial efforts.

And my second contention is that this is exactly as true in all respects for the retail buyers who bought XRP from Ripple on crypto exchanges. Like the institutional buyers, they were buying a speculative asset that would go up or down, in the long run, exclusively due to Ripple's entrepreneurial efforts. They might not have had as sophisticated understanding of these mechanisms as the institutional investors, but "retail investors are under-informed and confused" has never in the past been a reason to deny them the protections of the securities laws.

Let's say that Ripple succeeds wildly and XRP becomes the linchpin of a global payments network. Then the XRP that Ripple's institutional investors bought would go up, and they would have a good return on their investment. The return on investment would come exclusively from the increasing value of their XRP: They had no other contracts with Ripple, nothing else that would entitle them to any return outside of their XRP. The XRP, for them, is the "security"; it is the speculative instrument that they invested money in hoping to get a return from Ripple's efforts.

But that is exactly as true, in exactly the same way, for the retail investors who bought XRP on the exchange. Those retail investors are in complete commonality with the institutional investors; they bought the same thing and have exactly the same exposure to exactly the same risks. If Ripple succeeds wildly, a person who bought 100 XRP from Ripple on the exchange will get exactly the same benefit as the institution who bought 100 XRP from Ripple directly. If XRP is a security in the hands of that institution, because it was "an investment of money in a common enterprise with profits to come solely from the efforts of others," then I think it is a security in the hands of the exchange buyer: same money, same enterprise, same profits from same efforts of same others.

And my third contention is that they bought them for the same reasons. Sure sure sure: Some retail investors who bought XRP on the exchange from Ripple did not actually see Ripple's advertisements, its website, its white paper, its Reddit posts, its YouTube videos, or the other public statements in which Ripple said that it would work to increase the value of XRP, the public statements that Judge Torres thought made XRP a security with respect to the institutional investors. But it would be very strange indeed if nobody did, if everybody bought XRP solely because they liked alphanumeric sequences. Surely Ripple's widespread advertising of XRP as an

Statistically speaking, almost nobody who has ever bought Meta Platforms Inc. stock bought it from Meta. Between its founding in 2004 and its 2012 initial public offering, Facebook (as Meta was then called) raised about $2.9 billion by selling stock to venture capitalists. That IPO raised about $16 billion, though only about $6.8 billion went to Facebook; the rest went to early investors who sold their own stock in the IPO. Facebook did another stock offering a year later, raising another $1.5 billion for the company; it has never sold stock since then. So over the last two decades, people have invested about $11.2 billion in Meta by buying its stock.

That is a drop in the ocean compared to the amount of Meta stock that people buy from each other on the stock exchange. People bought $9.5 billion of Meta stock yesterday. The day before, they bought about $11.2 billion of Meta stock: as much in one day as Meta sold in its whole history. Last year about $1.6 trillion of Meta stock traded; the year before it was only a little less. In the entire history of Meta, on the order of 0.1% of all the money spent to buy Meta stock went to Meta; in the last nine years, the percentage is exactly 0%.

It is conventional to say that if you buy a share of Meta stock, which closed yesterday at $313.41, you are "investing in Meta." But what does that mean? It does not mean that you are giving $313 to Meta to use to buy computers or pay workers; your $313 does not go to Meta at all, but to whoever else had the share of stock before you did. It does not mean that you get a check for your share of Meta's profits: Meta has enormous profits and has never paid a dividend. (Meta does do stock buybacks, in which it voluntarily buys back shares from time to time, but I suppose it could just as well buy Apple Inc. shares; nothing about Meta's propensity to buy Meta shares seems to make those shares an "investment in" Meta.) It does not mean that you get a say in the management of Meta: Mark Zuckerberg owns super-voting shares and can make all the decisions himself. It does mean that if someone acquires Meta in a merger, you will get your proportionate share of the merger price, but Meta is an $800 billion company so that seems unlikely.

And yet buying a share of Meta stock does seem, practically speaking, to be a way to bet on Meta's success. The stock goes up when Meta has good news and down when it has bad news; the stock does behave like an investment in Meta. And I think that that is not pure wishful thinking or confusion on the part of the stock market; there are norms and fiduciary duties and expectations that, for instance, if Meta makes a ton of cash and has no business need for it, it will spend the cash on buying back stock, and will not spend it on building giant glass houses for Mark Zuckerberg or whatever. The company has certain obligations to its shareholders, and though those obligations are not exactly "share the profits with the shareholders," that is sort of how the market interprets them.

Also, Meta did sell stock. Ages ago, and not very much of it compared to the current trading volume, but it did. And part of the deal , when it sold that stock, was that the buyers would eventually be able to resell it. The deal — not spelled out, but the background to all stock offerings like this — was "give us money today, and we'll give you some stock, and if all goes well the stock will go up 100x and you will be able to resell it on the stock exchange to someone else for billions of dollars." If you buy Meta stock today, you might be buying it from someone who bought it from Meta all those years ago, and who is now cashing out. Probably not. But you are certainly buying it from someone who bought it from someone who bought it from someone who bought it from … etc. … someone who bought it from Meta all those years ago. All the stock came from Meta, originally. You are not giving Meta any money, today, when you buy Meta stock. But by a sort of financial backward induction, you are making it possible for someone to have given Meta money years ago. If you and people like you weren't around to buy Meta stock in 2023, nobody would have bought Meta stock in 2008.

In the US, there are securities laws that apply to Meta and other companies that issue stock to the public. They generally have to register their sales of stock, filing a registration statement with the US Securities and Exchange Commission with details about their business and finances. They generally have to file annual and quarterly financial reports with the SEC so that the public can get updates on their financial results. If they lie in those reports, they can be sued for securities fraud. You can avoid many of these requirements (though not the fraud ones) by not issuing stock to the public, by only selling it to rich people and institutional investors rather than letting everyone buy your stock: The securities laws are mostly to protect public retail investors, and there are fewer disclosure requirements for sales to sophisticated institutional investors.

The simple story for why those rules exist is that in, like, the 1920s, a lot of people started very shady companies and raised a lot of money by selling stock with bad and misleading disclosures. And so the securities laws were created to say "no, if you want to sell stock, you have to do this disclosure, so people can know what they are buying and sue you if you lie."

That story does not really apply to Meta Platforms in 2023. Meta has not sold stock in ages. "We are not asking anyone to give us money for our stock," you could almost imagine Meta saying, "and it just trades on an exchange totally disconnected from us. Why should we have to file all of these reports and get sued for all our misstatements, just because some people still want to trade this stock that we sold a decade ago? Maybe in 2012 we looked like one of those shady 1920s issuers, and the SEC needed to keep an eye on us and make us disclose everything about our finances to raise money, but that doesn't apply now, not because we were shady then and aren't now, but because we were raising money then and aren't now."

But Meta doesn't say that, in part because it does care about its stock price — in particular, a lot of its executives' wealth happens to consist of Meta stock — and in part because that is absurd. The rule is that if you go public you are a public company, and if your stock trades publicly you stay a public company until it stops trading. (For instance, because somebody — a bigger company, a private equity firm, Elon Musk — buys all the stock.) Facebook files quarterly reports now because, by a sort of financial backward induction, that makes it possible for it to have raised money years ago. That's the deal of being a public company.

The US Securities and Exchange Commission is cracking down on crypto, and the theory of the crackdown is:

1. Almost every cryptocurrency is a "security," under US law, meaning for our purposes roughly that almost every crypto token is a "scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter": Teams promote crypto projects, and people invest in those projects hoping that the teams' efforts will work out, etc. 2. Every crypto exchange that lists those tokens is a "securities exchange," and if it is not registered with the SEC as a national securities exchange (and it isn't) then it is breaking the law.

Both elements of the theory are controversial: Crypto exchanges and promoters argue that their tokens are decentralized utility tokens, not at all like securities, and it is not in fact the case that every platform for trading securities is required to register with the SEC as a national securities exchange. Your broker's trading app is not an exchange, for instance. Even a venue that matches buyers and sellers of securities — a dark pool, say — is not necessarily a "securities exchange"; it could be an alternative trading system, subject to a different sort of SEC registration with somewhat softer requirements.

Another objection that you sometimes see to the SEC's crackdown is that it commits the SEC to extreme positions outside of crypto. "Tokens are like airline miles or Starbucks gift cards or artworks or collectibles, and if you crack down on crypto exchanges for trading them, then you need to crack down on online platforms for trading Starbucks cards," etc. I do not want to evaluate the merits of that objection, but here is this:

The Securities and Exchange Commission [yesterday] announced settled charges against RSE Markets Inc. for operating as an unregistered exchange by maintaining and providing a marketplace and facilities that brought together purchasers and sellers of securities, specifically equity interests in "collectible assets" such as valuable cars and watches.

The SEC's order finds that, between July 1, 2018, and November 20, 2021, RSE operated the Rally Platform, consisting of the RallyRd.com website, the Rally App, and trading functionality, for retail investors based in the United States to purchase and sell securities. Secondary market trading for these securities occurred exclusively on the Rally Platform within trading windows provided by RSE. RSE used an algorithm to match orders based on price and time priority, calculated a final clearing price at which matched orders would execute, and required matched buyers and sellers to provide confirmation of their willingness to transact at the final clearing price. According to the SEC's order, the trading interests that RSE accepted were firm orders, as demonstrated by representative data showing that almost all matched trading interests were confirmed and executed. Despite these facts, and RSE marketing the Rally Platform as a stock exchange, the company neither registered the Rally Platform as a national securities exchange nor operated it pursuant to an exemption from such registration.

"If a crypto token is a security then a share of a watch is a security," might be one objection to the SEC's crackdown, and the SEC's answer is "oh sure, a share of a watch is absolutely a security, and we sued the watch-share exchange and won." Well, settled. Rally agreed to pay a $350,000 fine, which is a very small fine in the scheme of things, but a very valuable precedent for the SEC.

Well, that strikes me as a fairly manageable problem. Crudely oversimplifying, the rule in the US is that if you sell securities to accredited venture capitalists and they immediately turn around and dump them on retail investors, that's bad, that's a public offering of securities and you and the VCs get in trouble. But if you sell the securities to VCs and lock them up for a year, and at the end of the year the VCs dump them on retail, that's fine, that's allowed: You sold the securities under an exemption from registration (just to the VCs), and they sold the securities in a regular secondary-market transaction that doesn't need to be registered.

Again I am oversimplifying the rule, but it is Rule 144, and it is kind of the standard for how crypto-offerings-that-might-be-securities are conducted in the US these days: You sell to VCs with a long lockup, so that the securities offering is exempt. Also it probably helps with trading. The Wall Street Journal reports:

A small brokerage firm thinks it has a blueprint to bring crypto trading into the regulated market.

Prometheum's plan involves the use of an exemption that U.S. regulators created 50 years ago to permit trading of shares that were restricted, such as those given as compensation to a corporate insider or sold to an early investor. The exemption is used daily in the stock market to sell millions of shares.

It has never been used in crypto, however, which developed as an unregulated alternative to Wall Street that still doesn't have a federal market overseer. Prometheum, a six-year-old startup with no digital-asset trading revenue, has cast its lot with regulators hoping to move crypto onto regulated exchanges and brokerages. ...

Finding a registered broker who wants to trade crypto assets still doesn't make the tokens themselves free to be traded. That is because their sale was never registered, making their resale restricted just like the shares given as compensation to CEOs or public-company directors.

Prometheum says the exemption, known as Rule 144, is one way to solve that. ...

Some securities lawyers question whether Rule 144 can be used to trade cryptocurrencies that have been trading on crypto exchanges that don't follow SEC rules. Meeting the exemption's requirements, including proving that the seller held the asset for at least a year, can be difficult to establish in crypto where trading was meant to be anonymous, said David Adams, an attorney at Goodwin Procter LLP.

"Any broker-dealer that embarks down this path is going to be under incredible scrutiny," Adams said. "Just because you are approved…that does not mean that goodwill will necessarily continue if you start to list some crypto assets or tokens that the SEC" doesn't agree with, he said.

This is not quite as simple as "even if crypto tokens are illegal securities offerings, if you wait a year they become more legal," but that is a little bit what is happening here.

This problem comes up because "customer money" is a fuzzier concept in crypto than it is in traditional banking or securities brokerage. When you send dollars to a crypto exchange and use them to buy Bitcoins, and you look at your balance on the exchange's website and it says "1.57 Bitcoins" or whatever, you tend to think that those Bitcoins belong to you. Frankly the exchange would probably prefer that those Bitcoins belong to you, for marketing and legal reasons.

But the situation is not particularly clear, and it does seem more likely that the exchange owns the Bitcoins, and just owes you an unsecured debt: If the exchange doesn't have enough money to pay back all its creditors, you may not get back all your Bitcoins. "Because custodially held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors," says Coinbase Global Inc., controversially but correctly. And in fact lots of crypto businesses have gone bankrupt in the last year or so, and it does seem like the legal result is mostly that the coins belong to the crypto businesses and the customers are unsecured creditors. Which might mean that they would have to share with the SEC.

Anyway this is all a bit fanciful, but also a bit not. In April the SEC sued Bittrex Inc., a crypto exchange, for operating an unregistered securities exchange. Bittrex responded by, among other things, shutting down its US business and putting it into bankruptcy. But all of the customer money is there and accounted for, and Bittrex asked the bankruptcy court to let it process customer withdrawals normally. The Petition newsletter reports:

The debtors filed a motion seeking entry of an order authorizing them to honor withdrawals of crypto by customers. Interestingly, the debtors stated: "there may be a dispute between the Debtors and their customers as to who owns the cryptocurrencies deposited by customers and stored in the Debtors' wallets. The Debtors believe that they own the cryptocurrency assets. But, the proposed treatment, where customers will be permitted to withdraw cryptocurrencies equivalent to 100% of the cryptocurrencies they deposited as a distribution (subject to complying with information requests to ensure that all governmental rules and regulations are satisfied) avoids the expense and delay of litigation concerning ownership of those assets, while still providing customers, the vast majority of which are individuals, the ability to receive a 100% distribution by withdrawing the cryptocurrencies."

That is: The customers technically have an unsecured claim on their crypto assets, which are technically owned by Bittrex. But there's plenty of money and not much debt so it's fine, Bittrex will just give them their crypto back anyway.

Except that the SEC is still suing Bittrex, and presumably expects to extract a large fine. And so the question arises: Can Bittrex give its customers back all their money, or does it have to hang on to some of that money to potentially use to pay SEC fines? While the bankruptcy judge did sign the order allowing Bittrex to give its customers their money back, the order explicitly said that it would not

prohibit the Debtors, any liquidating trustee, plan administrator or any creditor, including the United States, from recovering from any customer the value of any cryptocurrency assets or fiat currency such customer receives that exceeds the distributions provided by the plan, if such general unsecured creditor or subordinated creditor is not paid in full, and, in such event, the entry of this Order shall not constitute collateral estoppel or res judicata of any customers' entitlement to cryptocurrency assets or priority under any federal or state law.

That is: If the SEC is not paid in full on whatever fines it ultimately extracts, it can go after Bittrex's customers for the amounts they withdrew. As Petition says "Soooooo…customers can withdraw their crypto but that crypto is subject to a potential clawback in favor of the regulators? FUN!!" Again this is all a bit fanciful, and I cannot really imagine the SEC suing Bittrex's customers for withdrawing their money. But it's keeping the option open.

I think even a year ago it was possible to imagine the traditional financial system learning something from crypto. Crypto built its own financial system that does things differently from traditional finance. For instance:

1. Crypto exchanges have websites and are open to everyone. If you want to buy Bitcoin, you don't have to go to a brokerage firm to send your order to the crypto exchange: You just go to the exchange yourself, deposit some money there, and put in a buy order. Crypto cut out layers of middlemen and let everyone trade on the same exchanges. There was something egalitarian about this; everyone traded on a level playing field, instead of the US stock market's system of retail brokers routing their customers' orders to wholesalers who pay for order flow. 2. Crypto exchanges also run their own clearinghouses, keeping custody of assets and settling trades, and they use real-time, objective, automated margining systems rather than the traditional fuzzy margining of traditional finance. FTX, Sam Bankman-Fried's crypto exchange, was a big proponent of this, and we talked about its proposal last year. I thought it was cool! Traditional finance involves a lot of unsecured credit risk , while crypto was building a system that was much more based on real-time collateral ; Bankman-Fried argued, rather compellingly, that the crypto approach might be safer. 3. We have talked a lot about "tokenomics," the idea of giving people who use a system (say, a crypto exchange) some financial stake in the system (say, a token that gives them a share of the exchange's fee income). This has some securities-law problems, and some Ponzi-ish elements, and some wrong-way risk, but it also has a real appeal: It is a way to build network businesses from a cold start, a clever way to solve a business problem 4. Blockchain blockchain blockchain. I have never really understood why keeping track of stock ownership (or real estate, etc.) on a blockchain was better than keeping track of it in a centralized database run by a trusted intermediary, but people sure talked about it a lot.

And, you know, I guess it is still possible to imagine traditional finance adopting these (or other) ideas from crypto. It is harder though. A year ago it seemed like FTX's plan was to expand out from crypto, to prove that its approach was better than that of traditional exchanges, to take over the trading of stocks and commodities and whatever, to bring the structure of crypto finance to the assets of traditional finance. Not anymore, man! The odds of a crypto exchange taking a lot of market share in US stock trading anytime soon are really, really low.

All of those lessons from crypto seem bad now:

1. Having crypto exchanges hold customer money, instead of keeping it at brokerages, seems bad after FTX (and a long line of previous crypto exchanges) misplaced the customers' money. 2. Same with FTX's margining system, which turned out to just give all of FTX's customer money to its affiliated trading firm. 3. The problem with tokenomics is that the US Securities and Exchange Commission thinks, correctly, that all of these tokens that convey a financial stake in the system are securities, and so have to be registered with the SEC, which is very hard for crypto platforms to do. All of these tokens seem to be illegal, or at least legally very dicey, in the US. 4. Everyone stopped talking about blockchain, and stock exchanges that excitedly announced their blockchain plans in 2017 have quietly dropped them.

Meanwhile traditional finance is like "ugh, fine, we'll do crypto, but in a normal way." Bloomberg News checks in on EDX markets, which is as traditional as can be except it trades Bitcoin:

A new crypto exchange backed by firms including Citadel Securities, Fidelity Digital Assets and Charles Schwab Corp. said it's gone live, a move that could reshape the digital-asset landscape amid heightened US scrutiny of the sector.

EDX Markets, an institutional-only exchange announced in September 2022, will offer trading in four cryptocurrencies: Bitcoin, Ethereum, Litecoin and Bitcoin Cash. Unlike existing crypto platforms such as Coinbase Global Inc. and Binance Holdings Ltd., it offers a "non-custodial" model, meaning that it doesn't hold clients' digital assets during trading. Instead, EDX is working with a third-party custodian, according to Chief Executive Officer Jamil Nazarali. …

"We believe crypto is here to stay, but for it to evolve as an asset class it needs to adopt the rules and investor protections that exist in traditional finance," Nazarali said in an interview. "The message we've got from our investors is that this creates an even bigger space for us."

The Wall Street Journal adds:

EDX says its approach draws on standard practices in traditional, regulated financial markets and differs in key ways from how crypto exchanges typically operate.

One major difference: EDX is a "noncustodial" exchange, meaning it doesn't directly handle its customers' digital assets. Instead, EDX runs a marketplace where firms agree to execute trades of coins and dollars, using its platform to agree on prices. Then the firms move crypto and cash between each other to settle the trades. Later this year, EDX plans to launch a clearinghouse to facilitate the process of settling trades, but even then it plans to use third-party banks and a crypto custodian to hold customer assets. …

Unlike most crypto exchanges, EDX won't directly serve individual investors. Instead, it expects that retail brokerages will send investors' orders to buy and sell digital coins to its marketplace.

The stock market operates under a similar model, in which investors don't directly access the New York Stock Exchange or Nasdaq, but instead submit orders through brokerages such as Fidelity and Schwab. …

An institutional-only exchange in which retail orders are intermediated by brokers, [1] clearing and custody that are separate from the exchange, listing only non-security tokens, no hype about blockchain. This is a way to trade crypto while almost completely rejecting the crypto financial system. This is bringing the structure of traditional finance to the assets of crypto finance. Traditional finance learned nothing from the crypto financial system except that it didn't work. Which is a useful lesson.

The way the US stock market works is:

A retail broker (Robinhood, Fidelity, etc.) has a website, where you can put in an order to sell stock. They send the order to a market maker (Citadel Securities, Virtu, Jane Street, etc.) who buys the stock from you. The market maker goes to a stock exchange (the New York Stock Exchange, Nasdaq, etc.) to sell the stock to another market maker or to an institutional investor.

This is not exactly right, [5] but it is a good rough intuition. Trading with retail customers is lucrative, and somebody who operates a retail-customer-facing website will want to monetize that fact; in the US stock market, that means selling the retail order flow to a market maker. Meanwhile there are public stock exchanges where institutions and market makers can trade with each other.

The way the crypto market often works is the same except:

A crypto exchange operates the website for retail customers, and the exchange for market makers and institutional investors. Also it often quietly operates the market maker who trades with the retail customers.

That might cover various things — the internal trading team might do proprietary directional trading and/or institutional market making on the exchange — but I read it to say mostly "facing Crypto.com's retail customers is lucrative, so Crypto.com does that itself, and when it trades with those customers it ends up with positions that it has to lay off on the institutional exchange." That's kind of how the stock market works except that in stocks the retail broker, the market maker and the exchange are three separate entities. In crypto they are all the same.

A core concept in the crypto financial system is the box. This is not an official term or anything, but it's how I think of it; the term comes from something that Sam Bankman-Fried said to me on a podcast. Here's how it works:

1. You start some project or business or blockchain or whatever. 2. You issue a token for the project. The token may or may not have some sort of claim on the cash flows of the project, or some governance rights over it, but in any case it is the token of the project, and its price will fluctuate based on people's perception of the project, their expectations for its future, its actual success, etc. The price of the token will reflect the value of the project in some loose way. 3. You give yourself a lot of the token. 4. You multiply the trading price of the token (which reflects the market value of the project) times the number of tokens that you have (which is probably large, since you made up the token and can give yourself as much as you want), and you get a large dollar number. 5. You probably cannot sell your tokens for that large dollar number: If you dumped all your tokens at once, confidence in the project would fall, supply would swamp demand, the price of the token would collapse and you probably wouldn't get very much money for your stash. 6. But you can turn the tokens into money in other ways. You can borrow against them; if you say "hey I have $10 billion of tokens" some crypto lender might give you a $5 billion secured loan. 7. More broadly, you can say "I am a billionaire, what with my $10 billion of tokens," and people will tend to trust you more and give you more economic opportunities because you're a billionaire. If you put in a bid to buy a mansion or a sports team or whatever, people will take you seriously because you have $10 billion (of tokens). If your bid is successful, a bank will probably lend you the money to buy the mansion or sports team. The loan will not necessarily be secured by your $10 billion pile of tokens, but the bank's credit decision will probably be like "this person has $10 billion, she's good for this loan." 8. And people will be more willing to deal with your project — or business or blockchain or whatever, the thing that started all of this — because there's $10 billion behind it. "I will trade on this crypto exchange without worrying about it getting hacked, because if it gets hacked surely it will make up my losses, because it has $10 billion."

This is not something that crypto invented, or that is limited to crypto. Lots of people found regular companies, issue stock of those companies, keep a lot of stock for themselves, and either explicitly borrow against that stock (margin loans, etc.) or at least point to their huge pile of stock as proof that they are rich and leverage that wealth to buy other things. Carl Icahn has margin loans against his Icahn Enterprises stock. Elon Musk has margin loans against his Tesla Inc. stock; also, though, he was clearly able to get financing to buy Twitter Inc. (not secured by his Tesla stock) because banks were like "yeah, this guy's rich, we'll lend him money even if we think that the Twitter deal is kind of a dog."

Nor is any of this really wrong ; I am not necessarily describing a fraud or a mistake or anything. It just sort of depends on what the project is? The problem is that a lot of stuff in crypto is a pure confidence business: Tesla makes cars, and if people lost confidence in its stock there would still be cars, but many crypto projects just make crypto trades, and if people lost confidence in their crypto trades there'd be nothing left. It is a very wrong-way risk; the pile of money safeguarding your business evaporates in exactly the circumstances that your business is in trouble.

The other problem is that at least some people in crypto were very self-aware of this dynamic. It is one thing to start a car company, issue stock to finance factories, keep stock for yourself as the founder, get rich on paper, and then borrow against your vast stock wealth to finance a rocket company or whatever — each decision there is plausibly about building a real business. It is another thing to think "hey I'm gonna issue some tokens because if I can get people to buy them I can borrow a lot of money and walk away from the mess." There is adverse selection there. I am not saying everyone in crypto thought that. I am just saying that Sam Bankman-Fried explicitly described that thought process to me as a general feature of crypto, and look how that worked out.

The most classic cases of the box are:

Terra was a blockchain, it issued tokens (called Luna), the tokens went up, and it used them to collateralize billions of dollars of a stablecoin called TerraUSD. Confidence in Luna dropped and billions of dollars of TerraUSD vanished in like a week. FTX was Sam Bankman-Fried's crypto exchange, Alameda Research was his crypto trading firm, FTX issued tokens (called FTT, though there were also some other "Samcoins" called SRM and MAPS and stuff), and Alameda used them to collateralize billions of dollars of loans — from outside lenders, and later from FTX, using its customers' money. Confidence in the tokens dropped, Alameda went extremely bankrupt, and billions of dollars of FTX customer money vanished in like a week.

One feature of the box is that you can sort of earn your way out of it. If your project is successful and makes a lot of money, or if it is successful enough to allow you to sell a lot of your tokens over time, you will end up with a lot of actual money, dollars or whatever that you own free and clear. And then when people say "I trust this person because she has $10 billion" they will be, in some more robust sense, correct. The people running Terra understood this, and built up a war chest of non-Luna money (Bitcoin, dollars, etc.) to back TerraUSD. They just didn't do enough of it before confidence collapsed.

I have a model of Adam Neumann that goes like this. There was a bubble for a particular sort of tech startup, one that scaled very quickly and used lots of buzzwords and had big ambitions and bad unit economics and raised tons of money from SoftBank Group Corp. Adam Neumann saw that bubble and said "well, I should be on the other side of that." The other side of that bubble was not shorting a bunch of tech startup stocks: That's risky, and anyway you couldn't really do it because the bubble was in tech startups with no publicly traded stock.

No, the other side of the bubble was starting a startup, and making it the most egregious imaginable example of the bubble. Scale the fastest, talk the most nonsense, have the worst unit economics and raise the most money by bro'ing down the most with SoftBank's Masayoshi Son. Neumann incinerated many billions of dollars of SoftBank's money, and got paid something like a billion dollars to stop. What a great trade! He and his family will be wealthy for generations because he timed the startup bubble right, but also because he structured the trade right. The trade is not quite "go long startups" or "go short startups"; the trade is "other people want to get long this bubble, so stand in the way of their money."

I should say that I do not think that this model is accurate, in the sense that it does not correctly describe what Adam Neumann subjectively thought he was doing. I find it useful, though, because it does describe what he was doing. Why is Adam Neumann rich? Because SoftBank made a mistake that involved spending $10 billion to build a $400 million company, and Adam Neumann was there to take the other side of that mistake.

If you spotted a gigantic crypto bubble in the late 2010s and early 2020s, how would you play it? Two obvious wrong answers:

Short crypto. You'd have gotten carried out, multiple times. Long crypto. This is better — the George Soros "When I see a bubble forming, I rush in to buy" approach — but still risky (the bubble did pop) and sort of analytically unsatisfying.

And a pretty good answer:

Take out absolutely bajillions of dollars of non-recourse loans to buy as much crypto as you can, selling enough along the way — and putting the proceeds somewhere your creditors can't get them — to make yourself dynastically wealthy. [1] Borrow $1 billion to buy $1 billion worth of crypto. If that turns into $2 billion of crypto, pay off your loans, take the extra $1 billion and bury it in your backyard, and do it again. If you do it again and it turns into $0 of crypto, walk away from your debts, dig up your backyard and buy yachts.

The Adam Neumanns of the crypto bubble might have been Kyle Davies and Su Zhu, the founders of Three Arrows Capital. Three Arrows, or 3AC as everyone calls it, is usually called a "crypto hedge fund," but that name is not really accurate. Typically a hedge fund raises money from investors, invests it, gives the profits to investors and takes a cut. But 3AC does not seem to have invested much money for outside investors.

Instead 3AC invested using its partners' capital and immense oceans of leverage from crypto lending platforms. This leverage was provided with very little in the way of due diligence or negotiation or often even collateral. And 3AC was very clear-eyed and thoughtful about identifying this part of the bubble. The bubble was not just "people buy crypto and it goes up"; it was specifically "people invest a lot of money in crypto lending platforms, which promise a high rate of interest but have nowhere good to lend their money, so we will just borrow all their money from them, pay them interest, and use the money to make insanely risky crypto bets. If they pay off, we buy yachts; if they go bust, we don't pay them back and sail away on our yachts." This worked for a while and made the 3AC guys rich, and then it stopped working and made 3AC's lenders bankrupt. But the 3AC guys took money off the table along the way, and they will be wealthy for the rest of their lives. A bunch of crypto lending platforms had too much money and wanted to do something dumb with it. 3AC provided the dumb thing to do with it, and took a large fee for that service.

Are stablecoins securities? A typical stablecoin — Tether, Circle's USDC, Binance's BUSD, etc. — works like this:

1. You give $1 to a company; it gives you back a crypto token (the stablecoin). 2. The company presumably puts the $1 somewhere safe — a bank account, Treasury bills, something like that — though there is certainly room for hijinks here, and your legal rights are not necessarily great. 3. The company promises to give you back the $1 on demand. 4. The company presumably earns interest on its investments, which makes this a nice business, for it. 5. The company mostly does not pay you interest on your stablecoin.

This is a little loose, but accurate enough for our purposes. [2] Does that make it a security? The US Securities and Exchange Commission says, eh, sort of:

Using prongs of the so-called Howey test—a court precedent that gives conditions under which something can be considered a security—the SEC alleged in its Binance complaint that BUSD buyers participated in a common enterprise with Binance, which did "earn returns through various forms of capital deployment." It also said that Binance marketed BUSD's "profit-earning potential," including a reward program that the SEC said "promised interest payments to BUSD investors merely for holding BUSD."

Notably, the SEC said an expectation of profit for BUSD investors derived from these rewards, which it described as "the potential for direct, interestlike payments made by Binance, in part from the proceeds of deploying BUSD investors' capital."

This may be a key argument for the SEC, since it must confront the contention that stablecoins aren't expected by buyers to appreciate in value but instead to stand-in for a dollar, euro or other traditional currency and intended to be used for things like payments or storing value.

Ehh? Mainly, when we talk about whether cryptocurrencies are securities, what we are talking about is the Howey test. US securities law says that various things, including any "note, stock, ... bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share [or] investment contract," are securities. "Investment contract" is the vaguest of those terms, so when the SEC argues that something weird and novel is a security, it usually argues that it's an investment contract. And the Howey test says that an investment contract is "an investment of money in a common enterprise with profits to come solely from the efforts of others."

But a stablecoin is obviously not that, because it does not promise profits. (Sometimes crypto exchanges offer an interest-bearing account where the exchange will pay interest on your stablecoin accounts, and the SEC has argued that those accounts are investment contracts, but that doesn't make the stablecoin itself a security.)

My view is that a stablecoin is probably not a security and the SEC is wrong about BUSD, but I don't hold that view strongly. I do think, however, that if BUSD is a security, it's not because it's an "investment contract." Look at the list of securities. Is a stablecoin "evidence of indebtedness," or a "note"? I mean, kind of? The stablecoin issuer's promise to redeem the stablecoin for $1 is not quite the same sort of legally binding promise you'd find in a bond debenture, but at the same time stablecoin investors obviously expect the thing to be redeemable at least in some indirect way; if investors didn't treat the stablecoin as debt then it wouldn't work. And "evidence of indebtedness," marketed broadly to retail investors, is a security.

I don't know! I used to talk a lot about my laws of insider trading, of which the most important was probably No. 2, "don't insider trade by buying short-dated out-of-the-money call options on merger targets." More generally, if you have inside information about some news that is about to come out about a company, the most efficient way to trade on that news is usually to buy short-dated out-of-the-money options on the company: The options will be cheap, and if the stock moves a ton in the next few days they will pay off a lot. You can turn a little bit of money, say $86,500, into a lot of money, say $2.6 million, which is hard to do with more linear bets like buying or shorting stock.

Which is why I said that you shouldn't do it: This trade is so good that it's the first place the authorities look for insider trading. And it looks bad! There are so many insider trading cases where the authorities say not only "this guy bought short-dated out-of-the-money call options on a merger target and made a bundle of money in three days," but also "and he has never traded options before in his life, and in fact had to Google 'what is call option' before placing the order." If your first ever options trade makes you a ton of money immediately on big unexpected news, that just looks really suspicious.

But one weirdly important market trend in the last few years is that everyone is buying short-dated out-of-the-money options all the time now. Here's a Bloomberg story from March titled " 'Degenerate Gambling' in Zero-Day Options Thrills Retail Traders," and another one titled " Zero-Day Options Boom Is Turning Wall Street Trading On Its Head," and one from May titled " Zero-Day Options Are Reordering the Way the Stock Market Behaves." Here is a Financial Times story from last December titled " Big traders flock to US equity options with fleeting lifespans." Much of that is about index options trading, but the meme-stock boom also involved a lot of very short-dated single-stock options bets. It is fun to gamble! Short-dated options are a satisfying way to gamble: You put in a little money, you either lose it or win a lot of money, and you find out fairly quickly. And so they have become very popular.

But because they are popular, their value as a signal is much lower. If your first ever options trade makes you a ton of money immediately on big unexpected news, that looks suspicious. If your thousandth short-dated out-of-the-money options trade makes you a ton of money immediately on big unexpected news, that was bound to happen eventually.

The US Securities and Exchange Commission began cracking down on crypto in 2017. At the time, there was a vogue for what were called ICOs, initial coin offerings, in which some crypto company or project would raise money by selling crypto tokens to public investors. The ICO promoters — the people behind the crypto project — would put out a white paper describing their project and promising brilliant innovations and huge profits, and they would sell a bunch of tokens for money. There would generally be very little in the way of disclosure or investor rights. For promoters, the ICO was attractive because it was a way to raise a lot of money from enthusiastic and gullible retail investors without following securities laws. Many, many, many ICOs turned out to be complete vaporware, either frauds or functionally indistinguishable from frauds.

For the SEC, the ICO was obviously illegal: These tokens were obviously securities, and the ICOs were obviously unregistered securities offerings. (Also, many of them were frauds.) And so the SEC started bringing enforcement actions against ICO promoters, basically making them give the money back and promise not to do it again, and the ICO boom quickly fizzled.

The SEC, I think, learned three lessons from this experience:

1. Almost all crypto tokens are securities. 2. Winning (or settling) cases against crypto projects for doing illegal securities offerings is pretty easy. 3. Especially when they are also frauds.

The crypto industry also learned some lessons from this experience. The "ICO," as an initialism, went away, but crypto projects kept selling tokens to raise money. But a new set of best practices emerged that more or less conceded the SEC's point that selling tokens to raise money to build a project is a securities offering. Startup crypto projects largely stopped selling tokens to public retail investors in the US: They might sell to retail investors in more crypto-friendly jurisdictions, but in the US they would only sell to accredited institutional investors, crypto hedge funds and venture capitalists. (Under US securities laws, private offerings to institutional investors are exempt from registration requirements.) The venture capitalists would sign a lockup, agreeing not to sell their tokens for some period of time. (Under US securities laws, selling securities to a venture capitalist who immediately turns around to dump them on the public is treated as a public securities offering, but if the VC holds the securities for at least a year, she can sell them freely. [1] )

The project might do what is called a SAFT, a "simple agreement for future tokens," in which the VC pays the crypto project now and gets back a contract promising delivery of the project's tokens in, say, a year. The theory here is that the SAFT fundraising is a securities offering — the crypto project is selling investment contracts for cash — but the underlying tokens are not securities; the tokens are just a form of currency for use in the crypto project. They are, in crypto lingo, "utility tokens"; people buy them not as speculative investments in a business but to use them to do crypto-y stuff.

I have sometimes explained ICOs by saying that "they're like if the Wright Brothers sold air miles to finance inventing the airplane." Raising financing from investors to build a speculative new technology feels like a securities offering , so ICOs are securities offerings, but actually existing airline miles are not securities: They are a loyalty program, a way to pay for an airline seat. The SAFT concept is a way to embody this difference: Selling the tokens before the project exists is a securities offering, but once the project is running and the tokens are useful, the tokens are just tokens, not securities. And so the SAFT might say that the VC pays now to get tokens in the future, and the SAFT actually delivers the tokens when the project is up and running and the tokens are useful. [2]

The SAFT is not the only way to do it, though; even if the tokens are always securities, selling them in private placements to VCs and locking the VCs up for a year is more or less a way to comply with securities laws. Broadly speaking, the US securities laws regulate mostly public sales of securities, widespread sales to retail investors; private placements to big investors are less regulated.

The US securities laws define a "security" to include, among other things, any "stock," "certificate of interest or participation in any profit-sharing agreement," "preorganization certificate or subscription," "transferable share," "investment contract," [or] "voting-trust certificate." The most general term there is "investment contract," and the US Supreme Court explained it in a famous 1946 case called SEC v. W.J. Howey Co.:

An investment contract, for purposes of the Securities Act, means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise. Such a definition … permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of "the many types of instruments that, in our commercial world, fall within the ordinary concept of a security." … It embodies a flexible, rather than a static, principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits. …

The investors provide the capital and share in the earnings and profits; the promoters manage, control, and operate the enterprise. It follows that the arrangements whereby the investors' interests are made manifest involve investment contracts, regardless of the legal terminology in which such contracts are clothed. …

The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.

This has become the "Howey test," and courts ask whether there is (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) to come solely from the efforts of others. The SEC has argued, at least since 2017, that most crypto enterprises fit this description.

For instance, consider Solana. Solana is a blockchain that runs crypto applications; its native token is called SOL. Here's the SEC's explanation of Solana [6] :

"SOL" is the native token of the Solana blockchain. The Solana blockchain was created by Solana Labs, Inc. ("Solana Labs"), a Delaware corporation headquartered in San Francisco that was founded in 2018 by Anatoly Yakovenko ("Yakovenko") and Raj Gokal (Solana Labs' current CEO and COO, respectively). According to Solana's website, www.solana.com, the Solana blockchain is a network upon which decentralized apps ("dApps") can be built, and is comprised of a platform that aims to improve blockchain scalability and achieve high transaction speeds by using a combination of consensus mechanisms.

According to Solana's website, SOL may be "staked" on the Solana blockchain to earn rewards, and a certain infinitesimal amount of SOL must be "burned" to propose a transaction on the Solana blockchain, a common function for native tokens on blockchains that constitutes a method for cryptographically distributed ledgers to avoid a potential bad actor from "spamming" a blockchain by overwhelming it with an infinite number of proposed transactions.

Solana Labs sold SOL tokens to raise money to build the Solana ecosystem:

Solana Labs stated publicly that it would pool the proceeds from its private and public SOL sales in omnibus crypto asset wallets that it controlled, and that it would use those proceeds to fund the development, operations, and marketing efforts with respect to the Solana blockchain in order to attract more users to that blockchain (potentially increasing the demand for, and therefore the value of, SOL itself, given the need for those who wish to interact with the Solana blockchain to tender SOL). For example, in connection with the 2021 private sale of SOL, Solana Labs stated publicly that it would use investor funds to: (i) hire engineers and support staff to help grow Solana's developer ecosystem; (ii) "accelerate the deployment of market-ready applications focused on onboarding the next billion users into crypto"; (iii) "launch an incubation studio to accelerate the development of decentralized applications and Platforms building on Solana"; and (iv) develop a "venture investing arm" and "trading desk dedicated to the Solana ecosystem."

The Howey test:

1. Did investors invest money? Yes, SOL was sold for money, to raise funding to build Solana. [7] 2. Was there a common enterprise? Yes, Solana is an enterprise ; it is a blockchain ecosystem that competes with Ethereum and Cardano and so forth, that tries to attract users. 3. Is there an expectation of profits? Yes, people bought SOL hoping that it would go up, and it did. 4. Do the profits come from the efforts of others? Yes, SOL went up because its promoters and developers built Solana into a popular blockchain, as they said they would, increasing the demand for SOL.

These are often close questions. Most big crypto blockchains are to some extent decentralized; Solana's growth depends not only on the efforts of Solana Labs but also on the efforts of third-party users and developers who like using it. [8] With some crypto tokens, it is plausible to argue that people buy the tokens not as an investment with an expectation of profits, but rather to pay for transactions on the blockchain; the SOL token is the "gas" that people use to run programs and transactions on the Solana blockchain, and if you buy SOL as a pure "utility token" then it is arguably not a security. Most crypto tokens have both utility and speculative-investment aspects, muddying the analysis a bit.

You might think that the natural reaction to "crypto companies keep collapsing and losing everyone's money" would be "well then don't invest in crypto," but instead it is "do invest in crypto, but only through like Charles Schwab," okay. Also some of crypto's vision of the future of financial services — like crypto exchanges that combine the functions of exchange, clearinghouse, custodian and retail brokerage — seems bad these days:

The infrastructure being built by large institutions is markedly different to the crypto industry's original structure. Wall Street executives are keen to separate business units such as trading from custody, as a way to reduce risk and potential conflicts of interest.

The collapse of Sam Bankman-Fried's FTX exchange and trading firm Alameda Research, which were closely entwined, has brought those concerns to the fore.

Custody, where assets are stored securely to protect funds from hacks or theft, has emerged as the most straightforward way for traditional finance groups to grow their crypto presence.

"I don't want my custody to be run by the same person as my exchange," said Michael Safai, co-founder of trading firm Dexterity Capital, adding that the extent to which some companies did not separate such functions "isn't appealing, and it's even a bit unsettling".

And:

As the smoke clears, some executives see two markets developing; a shallower, retail-facing one with wide discrepancies between buying and selling prices, and a deep institutional one, where prices are more competitive.

Usman Ahmad, chief executive of Zodia Markets, said that, as the crypto industry developed, it "may lead to a disparity of spreads between institutions and retail [and lead to] institutions paying a tighter spread in a more liquid market".

"It is going to be a two-tier structure with Binance being the face of retail," said Chhugani.

That is the opposite of the stock market (where retail investors pay lower spreads), though I suppose it is a lot like the traditional foreign exchange market (where corporate customers got competitive rates and retail customers got fleeced at airport currency exchanges). But it does fit the model of "institutions want to bet on the continuing popularity of the casino, but not at the casino."

The idea of the most popular ("fully backed," non-algorithmic) stablecoins is:

1. You give some company $1. 2. It promises to give you back the $1 when you want it. [1] 3. That promise lives on the blockchain; it can be traded on the blockchain, and it represents $1 on the blockchain.

This description is very, very close to the standard story of banking: You put one paper dollar in the bank, you get back a receipt saying you've got $1 in the bank, and you can use that receipt for $1 in the bank to transact with because it is a dollar. Your money in your bank account is not a claim on money, not an IOU for money; your money in your bank account is money. A stablecoin is money , in the specific context of some blockchain.

However, two other things that bank accounts have are:

1. Branches, tellers, customer service, compliance, stuff like that; and 2. Interest — not all of the time, and not so much over the past decade, but in an environment of high interest rates it becomes reasonable to expect to get paid interest on at least some of the money you keep in the bank.

Stablecoins can be like three guys in an undisclosed location who provide good customer service to a dozen big counterparties and have an inscrutable website for everyone else. And they tend not to pay interest.

This was a minor omission when banks also tended not to pay interest, but as rates have gone up, stablecoins seem like an incredibly good business to be in? You have a giant pile of money, you can park it somewhere quite safe and earn like 5% interest, you pay $0 of that interest to your depositors, you pay not very much more than $0 of that interest to your compliance department, you do not have much in the way of operating costs, and you collect 5% of a giant pile of money basically for having come up with this idea a few years ago. Of course the downside is that if crypto was a low-interest-rates phenomenon eventually people might lose interest in crypto and the demand for stablecoins would dry up. But Tether is fine I guess?

Tether's latest reserves report shows roughly $79.4 billion of Tether stablecoins outstanding, backed by "at least" $81.8 billion of assets, for an excess of $2.4 billion, or, roughly speaking, a capital ratio of about 3%. When we talked about Tether a year ago, that ratio was 0.2%. A 3% capital ratio for a bank with mostly very safe short-term assets like Treasury bills would be pretty normal [2] ; a 0.2% capital ratio for any sort of bank at all is hair-raising. Tether has gone from alarmingly thinly capitalized to reasonably well capitalized over the past year, because it is a pile of money invested in short-term money-market instruments and rates have gone up a lot. Now Tether earns a lot of interest — it earned more than half of its excess reserves last quarter — and it puts that interest in the bank, and that means it has more than enough money to pay back all the Tethers out there.

Well, no, I mean, it doesn't put the interest in the bank ; it puts it in Bitcoin. (Or it puts 15% of it in Bitcoin.) Still, currently, that is all house money:

"Every single token in the market is and would remain fully backed even if the bitcoin price were to go down to zero tomorrow," [Tether Chief Technology Officer Paolo] Ardoino said in an email. "Tether could distribute the entire amount invested in bitcoin to its shareholders, and the peg to USD will not be affected. In such a scenario, Tether would still have $1B of excess reserves."

The ideal way to run Tether, for the people running Tether, would be:

Have like $80 billion of Tethers outstanding. Put $80 billion into the safest possible stuff, short-term risk-free instruments, Treasury bills and reverse repos with strong counterparties collateralized by Treasuries. Earn like $4 billion of interest on that stuff?? Put $1 billion of the interest into more safe stuff, just to be safe. Put $1 billion of the interest into crazy stuff, to try to grow your assets and make more profits. Pay yourself $2 billion of bonuses, you've earned it.

Here is a story that you could tell about crypto in 2020 and 2021. Interest rates, in the US, in traditional finance, were very low. If you had some money and you wanted to earn a yield on it, and you put it in the bank, you'd earn roughly 0% interest, and you'd be sad. Crypto found a solution to this. The solution was that crypto platforms — exchanges, lending programs, etc. — would take your money and lend it to absolutely wild leveraged degenerate crypto traders, who would pay high interest rates on that money so they could gamble with it. For a while crypto mostly went up, the gamblers mostly made money and paid their interest, and you could get, like, 18% yields on bank-account-ish-looking crypto accounts. And then this system, which was as dumb as it sounds, collapsed, and crypto platforms like Celsius and Voyager and BlockFi went bankrupt.

This system collapsed for a number of reasons, but probably one of them was that the Federal Reserve raised interest rates, which reduced the value of speculative assets like crypto. But there is a bright side to that, for crypto, which is that now if you are a crypto platform and you want to attract deposits by promising to pay interest, that is much easier. You can take your customers' money and buy Treasury bills yielding 5% and pay them 4% and keep the difference, instead of taking your customers' money and flinging it into crazy leveraged gambling and losing it and going bankrupt. This is not, I suppose, "crypto," in some relevant sense, but you do it on the blockchain, blah blah blah, it's crypto enough. The Wall Street Journal reports:

"The high-yield DeFi app era is over," said Sidney Powell, chief executive of decentralized lender Maple Finance.

As of Tuesday, one of the biggest DeFi platforms, Aave, was offering a 30-day deposit rate of only around 2% for the two largest stablecoins, cryptocurrencies pegged to the dollar.

Maple Finance is among a host of crypto firms seizing on the higher yields and relative safety offered by U.S. government bonds. Last week, the company launched a product that will earn interest equivalent to a one-month Treasury bill minus a fee on deposits—offering a yield of about 3.4%.

This is how the product works: non-U.S. accredited investors can deposit USD Coin into the "cash management pool" and receive tokens that represent their ownership in exchange. The pool then issues a loan to an entity managed by crypto hedge fund Room40 Capital, which will invest customer deposits in one-month Treasury bills.

Is this product better than a money market fund? Well! The money market fund (1) seems to pay higher interest and (2) does not involve LENDING YOUR MONEY TO CRYPTO HEDGE FUND ROOM40 CAPITAL to buy Treasury bills. But this product does have the advantage of being cryyyyyyyyyypto:

Proponents of these new products say they appeal to big crypto investors who want to keep stablecoins on hand for fast trading and earn a return on idle cash.

Of course, traders can always sell their stablecoin holdings and park them in Treasury bills directly without taking the risk of going through a third party and paying a fee.

But where is the fun in that. In the olden days, crypto paid higher yields than traditional finance, to compensate people for taking enormous amounts of risk. Now it pays lower yields than traditional finance and, uh, well. To be fair, Maple explains that "assets are held in standalone single purpose vehicle, custodied by a regulated prime broker and Lenders have full recourse over all assets."

Elsewhere in investing crypto stablecoin assets in Treasury bills:

Franklin Templeton says its money-market fund that records share ownership on a blockchain is seeing inflows from crypto-related entities in the aftermath of the shuttering of several industry-friendly banks.

Total assets in the Franklin OnChain US Government Money Fund (FOBXX), which was launched in 2021 and became publicly available last year, have increased to around $270 million. The fund uses the Stellar blockchain network to process transactions and record ownership. The fund invests in US government securities, cash and repurchase agreements and doesn't hold any cryptocurrencies. …

The fund even has a digital token called BENJI that represents shares of the funds. One share of the fund is maintained at one dollar. The tokens are currently not transferable between fund investors, but executives at the asset manager said that bringing utility to the token is on the roadmap of the firm.

We talked about this fund back in 2019, and I love it, though I still wish that they called the token a "Benjamin." One way to think about the BENJI is that it is a stablecoin that is worth a dollar, lives on the blockchain, is invested in safe assets by a regulated entity and (unlike most stablecoins) pays interest. Another way to think about the BENJI is that it is just a normal government money market fund, except that the people promoting it say "blockchain" a lot, so if you are a crypto investor you will feel better about giving it your money.

Now, these are not really rules about stock exchanges; technically the rules are about securities, not stocks. If you run an exchange-like thing for trading securities — stocks, bonds, options, etc. — you have to register with the SEC.

There are crypto exchanges in the US. They operate as exchanges (venues for bringing together buyers and sellers), and also often as clearinghouses (they move tokens from sellers to buyers [1] ). They are not generally registered with the SEC as securities exchanges (or ATSs, or clearinghouses). They offer trading in crypto tokens. Some of those tokens — Bitcoin, Ether — are not securities. [2] But the SEC takes the view — in speeches, in various enforcement actions — that almost all of them are securities.

This means that most crypto exchanges that operate in the US are probably, in the SEC's view, breaking the law. I assert this pretty confidently based on my reading of the SEC's whole vibe, but the SEC has not really come out and said it directly, by, you know, bringing enforcement cases against crypto exchanges. It has come close. Last year it brought an insider trading case against a former Coinbase Global Inc. employee, accusing him of insider trading some tokens that Coinbase listed; the SEC claimed that these tokens were securities, and I tweeted "This is a weird way for the SEC to say that Coinbase is running an illegal securities exchange?" Last month the SEC sent a Wells notice to Coinbase, basically telling Coinbase that it is going to bring charges against it for operating an illegal securities exchange. But not yet.

Today the SEC brought charges against Bittrex Inc. for allegedly operating an illegal securities exchange:

The Securities and Exchange Commission today charged crypto asset trading platform Bittrex, Inc. and its co-founder and former CEO William Shihara for operating an unregistered national securities exchange, broker, and clearing agency. ...

Since at least 2014, Bittrex has held itself out as a platform that facilitated buying and selling of crypto assets that the SEC's complaint alleges were offered and sold as securities. From 2017 through 2022, Bittrex earned at least $1.3 billion in revenues from, among other things, transaction fees from investors, including U.S. investors, while servicing them as a broker, exchange, and clearing agency without registering any of these activities with the Commission.

Here is the SEC's complaint, which is straightforward. Bittrex is an exchange (and a broker, and a clearinghouse). It lists a bunch of tokens. Some of them, in the SEC's view, are securities. "For purposes of prevailing on the Exchange Act claims set forth herein, the SEC need only establish that Bittrex transacted in a single crypto asset security," says the complaint, but then it goes on to list six crypto tokens that the SEC is pretty sure are securities.

Here again the argument is straightforward and familiar. The US Supreme Court has said that a "security" includes "the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." Lots and lots of crypto projects raised money from investors by promising to build some sort of profitable product or ecosystem on the blockchain. The SEC cites some of them.

Algorand is a blockchain protocol founded by Silvio Micali. The Algorand blockchain uses a consensus algorithm it calls "pure proof-of-stake," in which each user's ability to influence the choice of a new block is proportional to its stake (number of tokens) in the system.

"ALGO" is the native token of the Algorand blockchain, and has a maximum supply of 10 billion ALGO minted at the launch of the Algorand network. Because ALGO is the native token of the Algorand blockchain, those utilizing the Algorand blockchain need to hold (and potentially stake) certain amounts of ALGO.

The Algorand Foundation Ltd. (the "Algorand Foundation") conducted an initial ALGO token sale on or about June 19, 2019, selling 25 million tokens at $2.40 per ALGO, raising approximately $60 million. …

The publicly available information disseminated by Algorand, Inc. and the Algorand Foundation led ALGO investors to reasonably expect to profit from Algorand, Inc.'s and the Algorand Foundation's efforts to grow the Algorand protocol, which would in turn potentially increase demand for, and therefore the value of, the ALGO token itself. …

The Algorand Foundation described "Governance" as a way for investors to make investment returns on their ALGO purchases—stating it is "a decentralized program which allows Algo holders to vote on the future of Algorand" and "the best way to earn rewards for holding Algo, with APY% of 10.02% - 14.05% seen in previous periods." …

The Algorand, Inc. and Algorand Foundation websites tout their teams' technical experience and expertise in the areas of cryptography and business development. For example, Algorand, Inc.'s website states: "Blending technical mastery and professional stability, the Algorand team consists of internationally recognized researchers, mathematicians, cryptographers, and economists along with proven business leaders from global technology companies."

None of this stuff even sounds particularly bad. But the bones of it are:

Algorand (and lots of other crypto projects) raised money from investors to build its project. The investors expected to make money from their investment in this enterprise. They expected to make this money because of "the efforts of others": The team promoting the project (and raising the money) was also going to build it, and the investors were hoping for a return because they thought the team would do a good job.

That's just stock. There's a blockchain, sure, and the mechanics of how ALGO tokens participate in the upside of the Algorand blockchain are somewhat different from the mechanics of how META shares participate in the upside of Meta Platforms Inc. But basically, the SEC says, this is stock: You invest money in a team that is building a tech project, and if the project works out you get rich. Bittrex was offering this stock on its exchange. So it should have registered as a stock exchange.

Bitcoin transactions are public, preserved forever and pseudonymous. In 2012, this meant that Bitcoin was a pretty good way to do crime. If you sold some drugs for Bitcoin, the buyer would send Bitcoin to a string of numbers representing your address, and then you'd be able to send the Bitcoin to a crypto exchange to turn it into dollars, and law enforcement would have no way to catch you because they didn't understand Bitcoin. "The money went to the blockchain," the police would shrug, and that would be that.

In 2023, it means that Bitcoin is frankly kind of a bad way to do crime: If you steal some Bitcoin, law enforcement and blockchain analysis firms will be able to trace the movements of that Bitcoin forever, and any crypto exchange will do some know-your-customer checks and get your photo ID before letting you cash out, and so when you turn your proceeds into cash the police will show up at your house with a detailed permanent immutable public record of every transaction that you did, starting with the theft and ending with the withdrawal to your bank account.

Also, though, it means that in 2023, Bitcoin is retrospectively a bad way to have done crime in 2012. All those transactions you did when you stole Bitcoins or sold drugs are preserved forever, and if the police are bored they can just go back and look at old blockchain transactions and catch old crimes. I suppose they have statutes of limitation to worry about, but otherwise, it seems very convenient for the police to have a permanent public record of all the crimes.

Government investigators exploit a feature of bitcoin and many other digital currencies: Every transaction is stored forever in blockchain's online ledger and open for anyone to see. Since Mr. Zhong's heist, authorities and private firms have compiled the equivalent of a blockchain address book to aid the IRS, Federal Bureau of Investigation and state and local authorities investigating cybercrimes. The blockchain-analytics company Chainalysis Inc., based in New York, said it has mapped more than a billion wallet addresses, separating out legitimate and questionable holdings and identifying the exchanges where the cryptocurrency is converted to cash.

"If there's one thing the blockchain does really well, it preserves evidence perfectly," said Jonathan Levin, a pioneer cryptocurrency sleuth and one of the founders of Chainalysis.

Look there have always been sports collectibles. Mostly they have been, you know, balls and jerseys and stuff, actual equipment, though the baseball card market is large and longstanding. But I suppose the innovation of crypto and non-fungible tokens was to discover that you could just create an arbitrary number of things, call them collectibles, convince people that they have some meaning, and then sell them for money. Ooh you can buy a rookie's game-worn MLB Debut patch, don't you kind of want to?

The argument that TRX — Tron's token, sometimes called Tronix or just Tron — is a security under US law strikes me as quite straightforward. The test is the Howey test, which says a security is "the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." Tron did an initial coin offering in 2017 to raise money to build its blockchain ecosystem, selling TRX to investors as an investment in that ecosystem:

On or about August 22, 2017, Sun and the Tron Foundation posted Tron Whitepaper Version 1.7 (the "TRX Whitepaper") on the internet. The TRX Whitepaper explained that "TRON is a blockchain-based decentralized protocol that aims to construct a worldwide free content entertainment system with the blockchain and distributed storage technology." The TRX Whitepaper further explained that Tron's protocol allowed users to publish, store, and own data, and to participate in "a decentralized content entertainment ecosystem."

Additionally, the TRX Whitepaper stated that the Tron Foundation was established "to operate [the] TRON network." …

The TRX Whitepaper also promoted the profit potential for investors in TRX. For example, it stated: Purchasers of TRX could "share [in] dividend growth "; Tron's ecosystem was designed for TRX "holders who [are] optimistic about TRON on a long-term basis "; "those who hold and lock [TRX] for [the] long[-term] will be rewarded"; " [l]ong-term investment " was "critical;" "stakeholders enjoy . . . sustainable growth "; and " [l]ong-term holding of stakeholders [would] be the benchmark in the ecosystem and better lead the development of the ecology." (Emphasis added.)

The TRX Whitepaper also promoted the executive team whose efforts would supposedly lead to TRX's success. For example, the TRX Whitepaper listed Sun as the "Founder and Chief Executive Officer" and highlighted Sun's prior experience working for another crypto asset company, stating that the "market value of [the company] has exceeded ten billion US dollars."

Does that sound like a security to me? Sure, yeah. But it was not registered with the SEC, and it is illegal to broadly market and sell a security to US investors without registering it. Did Tron sell to US investors? Ehh sure kind of:

On or about December 15, 2019, Sun retweeted a post from another individual, which stated that investors in the United States could trade TRX "pretty much everywhere, especially with a VPN." Sun's retweet announced, "[w]e will make $TRX available for all [U.S.] users! More options are on the way!" Sun and the Tron Foundation worked with crypto asset trading platforms to made TRX widely available for trading by investors in the United States, who can still trade TRX on at least four U.S.-based platforms.

A key idea in derivatives is no-arbitrage pricing. Let's say that the price of some metal is $100 today, and you think it will be $300 in three months. What should be the price of a futures contract on that metal with delivery in three months? The wrong answer is $300. Let's say you bid $300 for that contract. I will sell you that contract. I will buy the metal for $100 today. I will put it in my garage. In three months, I will deliver the metal to you, and you will pay me $300. I have made $200 of free money.

I mean, not free, I had to use some space in my garage. In practice the futures price will differ from the spot price for various reasons (interest rates, storage costs, etc.). But none of those reasons, generally, are "I think the price will be higher in the future." If you think the price will be higher in the future, you can buy it now, and wait.

Similarly the price of Bitcoin for delivery in three months is not exactly the same as the price of Bitcoin for delivery today, again for reasons of leverage and interest and contract mechanics and storage costs. The CME Bitcoin June 2023 futures contract price was about $28,575 at 10 a.m. today, whereas spot Bitcoin was about $27,975. You can, and people do, buy Bitcoin and sell futures and pocket the $600ish difference to pay for storing Bitcoin for three months. But this has nothing to do with where you think Bitcoin will be in three months; this is just no-arbitrage pricing.

The Grayscale Bitcoin Trust is a pot that contains Bitcoins. Shares of the trust — each representing a share of ownership of the Bitcoins in the pot — trade publicly on OTC Markets like shares of stock. If you have some Bitcoins and want shares of the pot, you can go to Grayscale Investments LLC — which runs the trust — and give them your Bitcoins, and they will give you back shares in the pot. If you have shares of the pot and you want some Bitcoins, however, you can't go to Grayscale and ask for the Bitcoins back. The pot is one-way. Bitcoins can come in, but they cannot leave.

This is suboptimal product design for customers, but it is very very good product design for Grayscale. As an asset manager, it is just good business to run a pot of money that can increase (when people put in Bitcoins) but not decrease (they can't take them out). [1] Grayscale has got all these Bitcoins in the pot — about $14 billion worth — and, as the manager of the pot, it gets to charge fees on the money in the pot. The fee is 2% per year, so Grayscale collects about $280 million a year for sitting on its giant pot of Bitcoin. Grayscale also has a Grayscale Ethereum Trust, the same idea but for Ether; that has $4.7 billion of Ether in the pot and a 2.5% annual fee.

These trusts became a famous widowmaker trade in crypto; name any high-profile 2022 crypto bankruptcy, and you will probably find a reference to Grayscale in its bankruptcy filings. The situation is that early on (the Grayscale Bitcoin Trust was created in 2013), owning Bitcoin directly was a pretty off-putting proposition for a lot of people — you had to be fairly technically savvy to hold Bitcoin directly, or you had to own it on an exchange that would probably rob you or get hacked — so owning shares in a pot of Bitcoin in your brokerage account was pretty attractive. Ordinary investors who wanted Bitcoin exposure without a lot of hassle wanted to buy Grayscale shares, so those shares traded at a premium: If the pot had $12 of Bitcoin per share, the shares might trade at $15.

So big crypto trading firms like Three Arrows Capital and Alameda Research would do the Grayscale arbitrage trade: You buy $12 million of Bitcoin, you deliver it to Grayscale, you get back 1 million shares of the Grayscale Bitcoin Trust and you sell them for $15 million, collecting the premium. It wasn't quite as easy as that, though; for securities-law reasons, you had to wait a while (originally a year, more recently six months) between when you got the shares and when you sold them. If the price of Bitcoin went down in that time, you'd lose money. An alternative trade was to borrow $12 million of Bitcoin, deliver them to Grayscale, get shares, wait and sell them. Then you had no exposure to Bitcoin prices; if the price of Bitcoin fell by 50%, then you'd only get $7.5 million for your Grayscale shares but you'd only have to pay $6 million to buy back the Bitcoins you borrowed.

So the arbitrage firms did this trade as a very levered bet, borrowing a bunch of dollars or Bitcoins to do the trade and collect the Grayscale premium. The results were:

lots of Bitcoin got locked up in Grayscale's pot; lots of Grayscale Bitcoin Trust shares were created; lots of big crypto arbitrage firms had huge levered bets on the Grayscale premium.

Over time, it became easier for ordinary people to hold Bitcoin in other ways. Crypto exchanges (mostly) became a bit safer and less likely to rob you; crypto self-custody became a bit easier. Regular retail brokerages got into the crypto business. Bitcoin futures started trading on regular futures exchanges, and Bitcoin futures exchange-traded funds were approved. The demand for Grayscale shares waned, but the supply grew as all these arbitrage firms were doing the Grayscale trade. The results were:

By 2020, the Grayscale premium collapsed and became negative: Now Grayscale Bitcoin Trust shares trade at a discount to the value of the Bitcoin in the pot; Three Arrows and Alameda, which had made levered bets on the premium, went bankrupt, as did lots of the platforms (FTX, Voyager, Celsius, etc.) that were lending them money or Bitcoins to do the trade [2] ; People stopped doing the Grayscale arbitrage trade: Since Grayscale shares were now trading at a discount, there was no reason to give Grayscale Bitcoins to get back shares, and no one has done so for two years; but The Bitcoins that were already in Grayscale's pot — $14 billion at current prices — stayed there. No Bitcoins are coming in anymore, but none are going out either.

As of yesterday, the closing price of a Grayscale Bitcoin Trust share was $11.77, versus a net asset value per share of $20.33, a discount of 42%. The Ethereum Trust discount is 55%.

Now, to be fair to Grayscale: I said that this product design — Bitcoins can come into the pot but never come out — is bad for customers but good for Grayscale, but in fact Grayscale doesn't like this product design either. Grayscale has been asking the US Securities and Exchange Commission for years to approve the conversion of the trust into an exchange-traded fund. If the trust becomes an ETF, then it will have the same creation/redemption mechanics as most other ETFs: Arbitrageurs can hand Grayscale Bitcoins, get back shares, and sell them immediately; or they can hand Grayscale shares, get back Bitcoins, and sell them. That should lead to a price for the shares that closely tracks the net asset value of the pot of Bitcoins: If the shares trade at a premium, arbitrageurs will deliver Bitcoin and get shares to sell, but if they trade at a discount arbitrageurs will buy shares to deliver to get back Bitcoin. At today's prices, closing the discount would create about $6 billion of value in the Bitcoin trust and about $2.6 billion of value for the Ethereum one.

In principle, Tether, the big stablecoin issuer, has an extremely simple business model:

1. People give it dollars. 2. It gives them back Tether stablecoins, or "USDT." Each USDT is meant to be worth $1, and the exchange rate is one USDT for one dollar. If people give Tether $10,000, it gives them back 10,000 USDT. 3. Tether keeps the dollars somewhere safe, presumably earning interest on them, which it uses to pay operating expenses and executive salaries and so forth. 4. If people want their dollars back, they can give Tether USDT and get back dollars, again one-for-one.

As of its most recent … auditor-related thingy? … Tether had about $67 billion worth of assets backing about $66 billion of Tether tokens, though that was in December 2022 and it has grown since then.

This is, in principle, a very simple and attractive business, but Tether has found it hilariously difficult as an operational matter. In principle the way you do this business is you have people wire you the dollars, and you send them their USDT (on the blockchain), and you keep the dollars in a bank account or money-market fund or Treasury bills or whatever earning like 4%, and if people want their dollars back you wire them the dollars, and meanwhile you're earning like $200 million a month on the float and life is good.

But in practice what seems to happen is that people go to their banks and are like "I would like to wire Tether $1 million to buy stablecoins" and the banks say "no." And then Tether goes to banks and says "we would like to deposit the $67 billion backing our stablecoins" and the banks say "no." And then people go to Tether and say "I would like you to wire me back $1 million for my stablecoins" and everyone's banks say "no." I am exaggerating, but the basic fact of Tether's life seems to be that a lot of the financial intermediaries — banks, brokers, auditors — who would normally be thrilled to work with a $67 billion pot of money, for some reason, aren't. So Tether has to do this very simple banking business in a very complicated way.

There are three basic ways for a stablecoin to work:

1. Some centralized stablecoin issuer sells one stablecoin for $1. It takes the dollar, puts it in a bank account, uses the interest on the bank account to pay for its operational costs, and promises to redeem each stablecoin for $1. This is the simplest approach, but is more centralized than some people in crypto like, and it requires you to trust the stablecoin issuer, which is maybe not always a great idea. This is how Tether (probably) works, as well as other big stablecoins like USDC and BUSD. 2. Some stablecoin smart contract lets you deposit $2 worth of Bitcoin or Ethereum or whatever as collateral, and gives you back one stablecoin as a loan. The stablecoin is meant to be worth $1. You can repay the loan at any time and get back your collateral. If the collateral drops in value while the loan is still outstanding, there is some sort of liquidation mechanism — margin calls, basically — designed to protect the value of the stablecoin. This one is more crypto-y, in the sense that it can be done with decentralized immutable code rather than some bank that you trust. But it is also less crypto-y in the sense that it is, like, fractional reserve banking? This business of slicing risky claims to engineer a safe tranche that is (you hope) always worth a dollar feels like what the traditional financial system does, sometimes with bad results. But anyway this sort of thinking is what is behind MakerDAO's DAI stablecoin. 3. Same as No. 2, except that instead of depositing Bitcoin or Ether or whatever, you deposit $2 worth of some token made up by the person who made up the stablecoin. "I will sell you a thing that will always be worth $1," some impresario says, "because it can always be exchanged for $1 worth of bleebits, and I can print as many bleebits as I want, because they are just a thing I made up. So I can always pay you $1 worth of bleebits, the math is unassailable." This is a real thing that people keep trying, generally with hilarious results. The most hilarious was Terra — there, the stablecoin was called TerraUSD (or UST) and the bleebits were called Luna — but it is a well-known source of chaos. The problem is that some guy just made up the bleebits! If the bleebits are worth $0.01 each, then he can give you 100 bleebits for your stablecoin and the math checks out. If they're worth $0.005 each, he can give you 200 bleebits, fine. If they're worth zero dollars because they are just a thing that he made up , you have a divide-by-zero error. In practice what happens here is that (1) people think the bleebits are valuable, (2) money piles into the stablecoin, (3) somebody looks down and realizes there's nothing there, (4) they sell the stablecoin for bleebits and dump the bleebits, (5) the price collapses, (6) death spiral.

The thing to notice is that Stablecoin 2 and Stablecoin 3 are not that different. Bitcoin is also a thing that someone just made up. It's just that the person who made up Bitcoin is not the same person who made up MakerDAO; the stablecoin uses a somewhat uncorrelated asset as collateral. In Stablecoin 3, the collateral for the stablecoin is basically "confidence in the stablecoin," and when that fails there's nothing left.

In general, in the US, most people have the mostly correct sense that if someone scams some money out of their bank account, they can call their bank and the bank will put it back. The intuitive process is roughly:

1. Someone scams you into sending them money from your bank account. 2. You call your bank and say "I was scammed, my transfer of $2,000 last Thursday was a fraud," and provide some details. 3. Your bank looks at where the money was sent and calls the recipient bank — the scammer's bank — to say that the transaction was a fraud. 4. The recipient bank takes the money out of the scammer's account and sends it back to your bank, which puts it back in your account.

This is not a completely accurate description of the process or anything, and there are various imperfections; in particular, knowing this risk, the scammer might sensibly move the money out of the recipient account as soon as she gets it. She might move it among a bunch of banks to obscure its provenance, or she might move it to a bank in a less regulated jurisdiction to avoid having to give it back, or she might take it out of the bank in $100 bills before you notice that you were scammed. [2] But broadly speaking bank transactions are reversible: Banks are regulated entities that keep lists of who has money, and if the lists get messed up due to fraud or hacking then people at the banks will try to fix them.

In crypto, things are … I don't know …. different-ish? A little different? Philosophically, crypto has an ethos of irreversible transactions and immutable code; when crypto platforms are hacked the hackers will sometimes boast that they were just doing what the code allowed them to do. But practically:

1. Crypto transactions are really traceable, in many ways easier to trace than transactions in the regular banking system: Blockchain transactions are public and immutable, and removing crypto from the system by turning it into $100 bills or real estate or bank deposits is often challenging. 2. The code mostly isn't that immutable: In some bits of crypto, somebody probably has the ability to block or freeze transactions, to modify smart contracts, or even to send crypto from one address to another without the permission of the person holding it. This isn't true of every bit of crypto — it's not true of the Bitcoin blockchain, say — but you just need to find the right bit. 3. In practice the people who have the ability to block or freeze or reverse transactions might be susceptible to the same sorts of appeals as a banker would be. "We were defrauded and that's unfair, look at the evidence" might work. Or: "Look at this court order we got." Or: "If you don't stop this fraud you will be a criminal accessory to money laundering." Those sorts of appeals.

Are the hats "securities," under US law? The relevant definition is the Howey test, which says that something is a security if "there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." Here I think the analysis would go like:

1. You invested money, by putting money into your account to buy hats. 2. There is a common enterprise, in the sense that you and everyone else are giving the money to QuestCo, playing MattQuest and trading hats on the QuestCo-controlled market. 3. There is possibly an expectation of profit, in the sense that you might be buying the hats because you think the price will go up. This one is fuzzy, I think: Maybe you buy a hat because you think that it looks nice on your character. But if QuestCo is going around telling everyone, like, "buying MattQuest hats is a great way to fund your retirement, they have gone up by 18% every quarter" or whatever, then that sounds like an expectation of profit. [1] 4. The profits are derived from the efforts of others, in the sense that QuestCo is in charge of developing and promoting the game, and the hats.

So, I mean, I dunno, maybe. If the hats are securities, then QuestCo has to register them with the US Securities and Exchange Commission — meaning that it has to provide a lot of public disclosure, including risk factors, audited financial statements, and management discussion of its business — if it wants to sell them to the public in the US. [2] You might be interested in that disclosure! For instance, if you are about to transfer a million dollars into your QuestCo account to fund a hat-buying spree, you might want to take a look at QuestCo's audited balance sheet and see how much money it has. If the balance sheet is like "LIABILITIES: $100 million in customer hat accounts; ASSETS: some imaginary hats," you might worry. You might think thoughts like: "Wait, if they owe customers $100 million, do they actually have $100 million in cash?" Or like: "Wait, if I put my $1 million into QuestCo, and then do some profitable hat trading and end up with $3 million, will I actually be able to cash it out?" [3] The hats are an investment in QuestCo in the sense that you give QuestCo money, and then you wait, and then you hope it will give you back your money, so having some disclosure about its financial circumstances would be useful.

Roughly speaking the way the US stock market works is that all of the stocks are in one place. The place is called DTC, the Depository Trust Company, which in some sense owns almost all of the stocks. If you own a stock, what you own is an entry on a list at your brokerage, saying that you are entitled to some of the stocks that it is holding onto for clients, and what your brokerage has is an entry on a list at DTC, saying that it is entitled to some of the stocks that DTC is holding onto. (And what DTC mostly owns is entries on lists at all the companies, or their transfer agents, saying that it owns the stocks that those companies issue.)

One thing this means is that when I buy some stock from you, the way we settle that transaction — the way you actually deliver the stock to me — is by updating DTC's list. We tell DTC about the transaction, it increments the stock in my account (really my broker's, who increments my account) and decrements the stock in yours. This is far more efficient than if, for instance, you owned your stock in the form of paper stock certificates, and to settle trades you had to courier those certificates over to me, which is pretty much how things worked in the olden days.

Another thing this means is that DTC is an extremely important weird market utility, highly trusted and so heavily regulated. "DTC is a member of the U.S. Federal Reserve System, a limited-purpose trust company under New York State banking law and a registered clearing agency with the U.S. Securities and Exchange Commission," says its website, on the same page that also mentions that it holds $87 trillion worth of securities.

The way the crypto market works is a bit different. One way for crypto to work is that there is a blockchain, a decentralized ledger maintained by thousands of independent nodes, and you can own some Bitcoin on the blockchain, and you and I can agree on a trade in which I send you some dollars (by wire transfer or Venmo or whatever) and you send me some Bitcoin on the Bitcoin blockchain. How do we meet each other and agree to that trade? You could imagine some sort of exchange — like US stock exchanges — that allows us to post orders to buy and sell crypto, and if our orders cross — if I want to buy and you want to sell — then we are matched with each other and then settle up using Venmo and the blockchain. This can work in some sort of informal way (like, a message board for us to meet and negotiate trades), or in modern crypto you can have decentralized exchanges built on smart contracts where trades and settlements all occur on the blockchain. [1]

But practically speaking the way that a lot of crypto works is more like the stock market: There is some central intermediary, much like DTC, that holds onto a lot of crypto for a lot of investors; we can call it the "depository." The investors agree on a trade — you agree to sell me some Bitcoin — on an exchange, and then we settle that trade by updating our accounts with the depository. There are some differences, though:

1. The depository is normally also the exchange: If you and I are trading on Coinbase, Coinbase is holding onto our crypto for us and updating its ledger when we agree to a trade on its exchange. This is different from the stock market, where the exchanges — NYSE and Nasdaq and so forth — are separate from DTC. 2. There is normally one depository per exchange: If you have some Bitcoin on Binance, and you and I agree on a trade on Coinbase, you can't just instantly send me your Binance Bitcoins to settle that trade. Each exchange has its own depository, unlike in the US stock market, where you and I can agree a trade on NYSE or Nasdaq or wherever and then settle up using DTC. 3. The exchange is … I mean … less trusted by US regulatory authorities than DTC is? To be clear, DTC is very trusted by US regulatory authorities; it is a centerpiece of modern securities markets. Crypto exchanges range from, you know, "not quite as trusted as DTC" to, uh, well, much worse than that.

Interest earned on bank accounts, certificates of deposit and corporate bonds is subject to income tax in the year it's generated, according to the Internal Revenue Service. Typically, that's a fairly straightforward process: Banks and other institutions send out 1099 forms listing the taxpayer's interest income, which is then used when determining overall obligations for tax season.

But in a quirk of last year's crypto collapse, investors are now receiving tax bills for money locked up on platforms like Celsius and Voyager Digital, which have frozen customer withdrawals as they undergo bankruptcy proceedings.

It could hardly come at a worse time for crypto investors. Not only have digital asset prices plunged in the wake of FTX's collapse, but inflation, high housing costs and rising interest rates are also making it more difficult for everyday people to afford regular expenses — let alone taxes on investments they've likely lost.

To oversimplify a lot, Ethereum is a global distributed computer system. People can run programs — smart contracts, crypto exchanges, etc. — on the Ethereum system, which is a sort of virtual computer whose state is maintained by thousands of independent nodes. Anyone can run programs on Ethereum, though you have to pay transaction fees — called "gas" — to run your program. The fees are paid in Ether, the currency of the Ethereum system. There is a system for validating Ethereum transactions, for making sure that all the nodes of the distributed virtual computer agree on what programs have been run and what the results were. This system involves people — called "stakers" — depositing 32 Ether and then running computer programs to validate the transactions. In exchange for doing this, the stakers get paid in Ether; effectively they get a share of the fees that people pay to run programs on the computer that they help maintain.

What does this make Ether? Well, it is a little bit of a lot of things:

1. Ether is a way to pay for computer time: You get Ether to pay to run programs on the Ethereum system, or you get paid Ether for running those programs. Ether is like an arcade token, or like a Starbucks card or airline miles, a limited-use form of money that can be used to pay for a particular service. In crypto this idea is called a "utility token," a cryptocurrency that you need to pay to use some crypto project. 2. Ether is kind of like money more generally — you can use Ether to pay for lots of stuff that is not Ethereum transaction fees — and the staking mechanism is a way to earn interest on your money. Staking is sort of like a … bank account? A bond? But decentralized; the "issuer" of the bond is the Ethereum system rather than a particular company. 3. Ether is kind of like stock in the Ethereum system. If a lot of people want to use Ethereum to run programs and do stuff, then the value of Ether will go up. And owning Ether sort of gives you — through the staking mechanism — a share of the profits. Sort of.

I don't want to insist on any of these things. Ether is the crypto token of the Ethereum system; it's a crypto thing; it's not exactly anything else, though it has some of the properties of various other things.

The standard way that a stablecoin works is:

1. There is some crypto entity, the stablecoin issuer. 2. Regular people give it their dollars. 3. It gives them back a stablecoin, a crypto receipt saying "we owe you one dollar" that can be used as a dollar on some crypto blockchain.

Is that a security? I actually think the answer is no; that to me reads like it is not "the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." (There is no expectation of profit. [5] ) But that is just my opinion, and this is close enough to being a money-market mutual fund (a security!) that a lot of people think the answer is yes.

Also, consider what I said above about what sort of disclosure you would want: If you give your dollars to a centralized stablecoin issuer, what sorts of disclosure should that issuer have to give you? Is the answer "it should give you the same disclosure about its own finances that a public company would give its investors in a registered securities offering," or is it "nothing"? You are pretty clearly an unsecured creditor of the stablecoin issuer, [6] and if the stablecoin issuer is in fact stealing all the dollars — or investing them in risky ventures, etc. — then that is bad for you and you'd want to know about it. In fact there is a history of stablecoin issuers being comically bad at releasing audited financials, and sometimes not being as fully backed by safe assets as you might like.

Also, again, I think it should be relatively easy to register a stablecoin with the SEC. This is not some decentralized autonomous project with characteristics totally different from regular securities offerings. It's just a money-market mutual fund, and people register those all the time.

A basic idea in crypto is that things can be simultaneously (1) lucrative and (2) a joke. Like if someone pitched you on Dogecoin as an investment opportunity, you would say "well what is good about Dogecoin," and they'd say "it has a picture of a dog," and you'd say "what," and they'd be like "ha ha ha," but also Dogecoin does have a $12 billion market capitalization. For a while its price would go up whenever Elon Musk tweeted about it. Was he kidding? Just the wrong question. I once wrote:

One question that is never worth asking about anything related to cryptocurrency is, "is this a joke?" Essentially everything in cryptocurrency is simultaneously serious and a joke. This is partly explained by the history of crypto—crypto is Extremely Online, and everything Extremely Online is both serious and a joke—but it is also something essential to its nature. If I told you that there was a vast oil reservoir in my backyard, that would be either true or not true. Oil is a real physical substance; you can look at it and touch it and burn it as fuel. But if I told you I had a vast stash of Mattcoins, and proposed to give you some for a sandwich or a yacht, we would be on less solid ground. Whether the Mattcoins are a valuable currency exchangeable for sandwiches and yachts, or just a joke I made up, is a social fact; it depends on what you think about Mattcoins, and perhaps on whether you find them funny. Crypto is a form of collective storytelling; its truth or falsity does not depend on externally verifiable facts in the world but rather on people's attitudes toward it. It's a parody if you think it's a parody, but if you think it's real then it's real.

Here I want to be a bit speculative, and I also want to write in all caps: NONE OF THIS IS LEGAL ADVICE. But if you have a certain sort of mind, you might notice a potential legal arbitrage here. The arbitrage is:

1. You intentionally sell people a worthless thing, for real money, which you keep. 2. If anyone complains — if you get sued or arrested — then you say you were kidding. (But you keep the money, which after all is a crucial element of the joke.) 3. You kind of were! And kind of weren't!

Again! I am not recommending this as a strategy! I am just observing certain patterns in the world! But for a while during the initial-coin-offering boom there were a lot of ICOs that explicitly said things like "we are offering a token that is worthless, so we can have money," and, you know, I hope they had good lawyers.

The basic idea in — I'm so sorry — DeWi is:

Someone starts a project to provide wireless service everywhere, but with crypto. The way it works is that you can get some sort of hardware device from the project, and you plug it in to your home electricity and internet, it provides a wireless signal, and people who are near you can connect to the internet using your device. And then — this is the crypto part — they pay for using the coverage you provide, and you get paid for that coverage, in the project's crypto tokens.

Why don't they just pay in dollars? Why don't you just get paid in dollars? Well! Because, as I have said a few times before, the basic premise of a lot of crypto is that every product is simultaneously an investment opportunity. The day that this project — Pollen, Helium, whatever — launches, (1) nobody is providing service on its network and (2) nobody is using its network. The project is only good if it achieves scale and network effects: You'll only provide service if people use the network, and you'll only use the network if people provide service. It's hard to incentivize people to start.

Crypto — or, more specifically, the crypto boom that sort of ended last spring — was a way to solve this problem. Instead of "buy our device and start providing wireless coverage, and if a lot of people do that then people will use the coverage, and then maybe one day they'll pay you," it was "buy our device and start providing wireless coverage, and we'll give you lots of tokens , and if this thing takes off then the tokens will be valuable and you'll be able to buy an island, for providing this wireless coverage in the early days of our network." It was a way to turn this possibly useful service into also a Ponzi scheme: You get rich if more people come into the project after you. But if more people come into the project after you, then it will actually provide a useful service (wireless coverage), and maybe the economics will work out. It's a little bit of Ponzi to bootstrap a real business with network effects.

Is lending your Bitcoins a security?

Oh, sure, yes, absolutely. The rule in the U.S. is that an "investment contract," meaning "the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others," is a security, and generally can't be sold to the public without registering it with the Securities and Exchange Commission, delivering a prospectus with audited financial statements, etc. A Bitcoin lending program — in which (1) a bunch of people pool their Bitcoins, (2) some manager or smart contract lends those Bitcoins to borrowers who pay interest, and (3) some or all of the interest is paid back to the people in the pool — is pretty straightforwardly an investment contract and thus a security.

This is easy stuff. People in crypto don't like it, but that's because they are wrong. More specifically, they have an intuition like "if a crypto platform pays you interest on your crypto deposits and uses them to make loans, that is like a bank account, and a bank account is not a security." [1] But that's because IT'S A BANK ACCOUNT. Like:

Securities regulator: Your Earn product is a security and needs to be registered with us.

Crypto platform operator: That's ridiculous, Earn is just like a bank account, that's not a security.

Banking regulator: Hi! I couldn't help overhearing. Did you just say that YOU WOULD LIKE US TO REGULATE YOU AS A BANK?

Crypto platform operator: [screams, dives out window]

As I wrote in 2021:

Coinbase obviously does not want to be regulated as a bank; it does not want to be subject to bank capital requirements (which require essentially 100% equity capital backing Bitcoin positions) or prudential regulation by bank regulators who like crypto about as much as the SEC does but have even more tools to crack down. You think the SEC is being annoying about not issuing formal guidance! A bank examiner could just call you up and say "we don't think owning Bitcoin is a good idea, get rid of it," and then where would Coinbase be?

Here is the SEC's complaint, which comes to a brisk 22 pages. The main argument that this is a security is on pages 13 to 19. Under the Securities Act of 1933, the definition of "security" includes a bunch of different things, but the two that are relevant here are a "note" and an "investment contract." There are two Supreme Court cases — Reves v. Ernst & Young and SEC v. W.J. Howey & Co. — that decided what makes an investment a "note" or an "investment contract" under this law. The SEC summarizes Reves :

A note is presumed to be a security unless it bears a strong resemblance to instruments that are not securities, which courts determine by examining four factors: (1) the motivation of the parties; (2) the plan of distribution; (3) the expectations of the investing public; and (4) the availability of an alternative regulatory regime that "significantly reduces the risk of the instrument" for investors other than the securities laws, "thereby rendering application of the Securities Acts unnecessary."

Here, publicly marketing Gemini Earn as an investment to hundreds of thousands of retail investors probably makes it a security. The "alternative regulatory regime" stuff is basically the point that bank accounts are not securities: If Gemini Earn were subject to banking regulation, then it might not be a security, but that is not the case. The SEC says:

Although Gemini is registered with [New York State Department of Financial Services] as a New York limited purpose trust company, NYSDFS did not have oversight over Genesis. Gemini publicly stated that Gemini Earn does not operate like a traditional bank account, is not protected by a governmental program, and is not backed by Gemini itself. In a February 2021 press release launching Gemini Earn, Gemini stated that "Gemini Earn is not a depository account. . . . Loans are not insured by Gemini or any governmental program o

At some level, if you were offering 8% interest rates on a crypto savings product last year, you were involved in delusion. You were not paying 8% on crypto deposits because you were lending them out at 10% to homeowners who needed mortgages. Those crypto deposits were not funding real-world activity that yielded 10% cash flows. Fundamentally, those crypto deposits were part of a credit bubble, and they were used to fund various bets on the continued growth of crypto markets. When the total value of crypto markets quadrupled in a year — as it did in 2021 — then the people making those bets could very easily pay 10% interest to their lenders and still make a lot of money themselves, and everyone was happy. When the total value of crypto markets fell by two-thirds — as it has since its peak in 2021 — then the people making those bets went bankrupt and their lenders lost money and froze withdrawals.

During the boom, nobody characterized things this way: Those 8% interest rates came from "yield farming" or "arbitrage" or "staking" or "DeFi liquidity provision" or whatever. But now things are clearer, and fundamentally the yields came from bets on crypto going up. The advertising was basically that customers could get safe 8% yields on their crypto (or stablecoin) deposits. The asterisk — "these rates are safe as long as crypto keeps growing, but if it contracts we'll have to shut down withdrawals and you might lose your money" — was not quite spelled out.

Also there was a chain of delusion here: Some crypto lending platforms offered 8% yields to retail customers and then took the money and bet it on a bunch of random tokens going up, but most platforms had some intermediate steps. You take deposits from retail customers, you lend them to an institutional lending firm, it lends them to a market-neutral arbitrage trading firm, and the arbitrage trading firm turns out to just be betting on a bunch of random tokens going up. In that situation, if you are running the retail platform, you have some deniability. "I trusted my customers' money to a stable institutional firm that promised me safe returns; I can't believe that they just invested it in risky crypto bets!" I mean! What did you think they were doing? Why did you think those 8% yields were safe? Still, maybe you deluded yourself as well as your customers.

If you think things like this, one thing that you might want to do is bet against cryptocurrencies by selling them short. And betting against Tether seems particularly attractive, for two reasons:

1. Tether just kind of makes people mad in ways that other cryptocurrencies don't. 2. A key feature of Tether is that it can't go up. If you think Bitcoin will go to zero, so you short Bitcoin at $17,000, and you are wrong and Bitcoin goes to $67,000, you have lost $50,000, oops. But if you think Tether will go to zero, so you short Tether at $1, Tether will not go to $2. If you are wrong, Tether will stay at $1: If Tether works perfectly, then it will be a successful stablecoin and always worth a dollar. If you bet against it and you're wrong, you won't lose money. I mean, you'll pay some funding cost on your bet, but the bet can't really move against you. There is asymmetric upside.

This is obvious stuff and people keep noticing and wanting to bet against Tether, and then often they think about it for a bit and change their minds. Bloomberg's Annie Massa and Katherine Burton report:

A handful of hedge funds are now turning their focus back to the $66 billion stablecoin, which they warn could be the next crypto catastrophe — one that would make the implosion of Bankman-Fried's FTX exchange look small in comparison.

Fir Tree Capital Management and Viceroy Research are among the firms shorting Tether, according to people familiar with their wagers — positions they've held for months, waiting to cash in on their bets.

But:

The short is hardly straightforward. Valiant, a San Francisco-based hedge fund, made the trade earlier this year, but backed away and made it out unscathed, according to people familiar with the matter. The fund would consider shorting Tether again if it could do so without risking collateral, the people said.

Philippe Laffont's Coatue Management and other funds looked at the trade and also passed due to counterparty risk, according to people familiar with the matter.

"I'm not short Tether – I haven't found the vehicle," said Andrew Left, founder of Citron Research, a short seller. "If someone showed me a way to do it with Goldman Sachs as a counterparty, I'm in."

The problem is that if you want to short Tether, you have to borrow Tether to sell it. If you want to borrow Tether, you will probably have to post collateral: You borrow $100 million of Tether, and you give your lender back $150 million or $100 million or $50 million of collateral, Treasury bills or Bitcoins or whatever, as security for the Tether loan. You can borrow Tether from Tether — the entity that issues Tethers does seem to lend out new Tethers against various sorts of cryptocurrency collateral — or from someone else, some crypto exchange or crypto hedge fund or lending platform that has a lot of Tethers and wants to make some money by lending them.

The problem is that you are posting collateral to your Tether lender, and do you trust them? In the state of the world where Tether goes to zero, are you getting your collateral back? From a crypto exchange or crypto hedge fund or crypto lending platform? Or from Tether itself? Tether is widely regarded as being central to the functioning of the levered crypto financial system, and a bet against Tether is a bet on the collapse of that system generally. If the system collapses, you're not getting your collateral back.

Or you can bet against Tether by shorting Tether futures on some crypto exchange. [1] FTX, for instance, offered Tether futures, before it went bankrupt last month. You can see the problem here. The problem is that it went bankrupt last month. More generally, though, it's the same as the problem in the previous paragraph: If Tether goes to zero, the crypto exchange where you shorted Tether futures might not still be around to pay out your bet.

So in round numbers the way to make a $100 million bet against Tether is (1) you take $100 million of your own money, (2) you park it with some crypto counterparty to borrow 100 million Tethers, (3) you sell those Tethers, (4) Tether goes to zero, (5) you buy back the Tethers for $0, (6) you go back to your counterparty and say "here's my 100 million Tethers, can I have my $100 million back," and (7) your counterparty is just a smoking crater and your $100 million is gone. Being short Tether is a lot like being long Tether.

The thing about Celsius, Voyager and BlockFi — and to an extent FTX — is that of course they were lending out their customers' money. That was the business they were in; if you are parking your crypto at a crypto shadow bank and getting 8% interest, it's because the shadow bank is doing something (something risky!) with your crypto to earn that 8% (plus its own profits). The thing with Tether is that there's like $65 billion outstanding, it pays no interest and one-month US Treasury bills yield like 3.8%. People do not give Tether money in order to earn interest on it; they give Tether money in order to get back USDT to use for crypto transactions. If you were Tether, you could just park their money in the safest and most liquid possible investments and earn billions of dollars of revenue that you get to keep. This is a very good and easy business. You don't need to do anything else. When people call you up for loans, instead of evaluating their collateral and creditworthiness and negotiating good documentation and having a prudent risk management and monitoring system, you could just say "no we're good" and buy Treasuries and sleep well on your giant pile of money.

And that is, as far as I know, mostly what Tether does; it reports that about 58% of its assets are in US Treasury bills. But 9% are in secured loans, and those secured loans apparently take the form not of "people give Tether dollars for USDT, and Tether lends those dollars to businesses secured by collateral" but rather "people borrow USDT directly from Tether by posting cryptocurrency collateral."

Ever since Tether has existed, there have been pretty vocal Tether skeptics. In the early days the main form of skepticism was that Tether was not really backed one for one by dollars, that Tether was doing something weird with its dollars. This seems to have been mostly untrue — most of the dollars were there most of the time — though also definitely a bit true; in the past, Tether definitely shipped some of its money out to its affiliated crypto exchange for dodgy reasons. And even today Tether makes a lot of noise about how transparent it is without actually being transparent; it publishes attestations of its assets and liabilities that fall frustratingly short of being audited balance sheets. Still it seems reasonably likely that, these days, Tether's money is mostly where it says it is, and where it says it is is mostly in Treasury bills and other pretty safe stuff.

Instead, the main form that Tether skepticism takes these days is … I am not sure I can entirely capture it, but the basic flavor of it is:

The price of Bitcoin (of crypto generally, etc.) seems to be set by an exchange rate between dollars and Bitcoins. People have dollars and use them to buy Bitcoins, which makes the price of Bitcoin go up. Or people trade their Bitcoins for dollars, etc. But really the demand for Bitcoin is largely people trading USDT for Bitcoin. Tether is the instrument that sets the price of Bitcoin. That seems fine if you think of Tether as "people put dollars into a box and get back an equal number of USDT that are fully backed by those dollars." But really — the skeptics say — Tethers are printed out of thin air in order to keep up the price of Bitcoin.

This theory of course converges with "Tethers are not fully backed by dollars," but its emphasis is different, not "Tether got the dollars and misplaced them" but rather "Tether is a form of fractional reserve banking in which Tethers are created by buying Bitcoin instead of the reverse."

I do not propose to evaluate this theory further except to say: Doesn't that Journal story sound a bit like that? I mean here is a story you could tell:

1. You have 1,000 Bitcoin worth about $17 million. 2. You want to buy more Bitcoin, but you do not have any dollars. 3. You go to Tether and say "hey give me 17 million USDT, in exchange I'll put up 2,000 Bitcoins as collateral." 4. Tether is like "sure that's the business we're in" and hands you 17 million USDT. 5. You use that 17 million USDT — notionally worth $17 million — to buy 1,000 more Bitcoin. 6. Now you have 2,000 Bitcoin. 7. You post the 2,000 Bitcoin as collateral to Tether for the loan, which is now overcollateralized with liquid collateral ($34 million worth of Bitcoin). 8. More USDT have been created to buy Bitcoin, but no new dollars have come into the system.

Maybe this is fine, no problem, just margin lending. But if your concern is "Tethers are printed out of thin air in order to allow people to buy crypto without putting any actual dollars in," then this might make you nervous.

At its core, the vision of crypto is about finding a better way to keep a list of who has money. Society has, over the centuries, evolved some decent ways to keep those lists. There are banks, and your money consists mostly of deposits at banks, and the banks keep lists of who has money. In the olden days they would keep the lists on paper, but in modern times they keep the lists on computers. At a high level, their processes are easy to describe: My bank keeps a record of how much money I have, and when I send money to you my bank decreases the money in my account and tells your bank to increase the money in your account. In practice there are ways for this process to be messy and complicated and error-prone. My bank and your bank might run on different systems and have different views of the world, and information and transactions can be delayed, and our transaction might have to happen quickly and with imperfect information, and then later there might have to be a tedious manual reconciliation process where my bank double-checks to make sure I actually had the money in my account, etc. Banks are in a lot of businesses, but one business that they're in is the technological business of keeping track of the money and making sure that it moves reliably to where it's supposed to go.

And then crypto came along and promised, among other things, better list-keeping. When I send crypto to you, we do it on the blockchain, a distributed database that keeps a record of who has how much crypto. The blockchain is trustless and decentralized: Instead of relying on a bank to get it right, we can be sure that the code of the blockchain gets things right. It is censorship-resistant: No one makes ad hoc decisions about what transactions to allow or forbid; all transactions that meet the open public requirements go through. It is immutable and public: If I send Bitcoin to you, I can't take it back, and everyone can verify that you have it and I don't. There are costs to this — the blockchain is kind of a slow database, and the Bitcoin blockchain wastes a lot of energy — but it keeps a good list.

One thing that this was supposed to do was disrupt banks: If we can send money to each other on the blockchain, who needs banks? But the banks also saw some advantages to this technology. If there was some distributed database that provably contained each transaction in the right order, then a lot of the manual messy error-prone business of banks could be simplified. Instead of you and me agreeing to a trade over the phone, and then our back-office staffs getting together to figure out the details of what we actually traded, everything could happen in real time on the blockchain. In a perfect world, all of the systems at all of the banks would have access to the same single distributed ledger, instead of all keeping their own slightly different lists and struggling to reconcile them.

People sometimes assume that I am a sort of antagonist to Bankman-Fried, in part because he has sometimes said things in our talks that are … let's say surprisingly candid. Most notably, people keep bringing up an Odd Lots podcast from last August in which I asked him to explain yield farming. His explanation starts:

You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that's gonna replace all the big banks in 38 days or whatever. Maybe for now actually ignore what it does or pretend it does literally nothing. It's just a box. So what this protocol is, it's called 'Protocol X,' it's a box, and you take a token. You can take ethereum, you can put it in the box and you take it out of the box. Alright so, you put it into the box and you get like, you know, an IOU for having put it in the box and then you can redeem that IOU back out for the token.

And at some point I interject:

I think of myself as like a fairly cynical person. And that was so much more cynical than how I would've described farming. You're just like, well, I'm in the Ponzi business and it's pretty good.

And he replies:

So on the one hand, I think that's a pretty reasonable response, but let me play around with this a little bit. Because that's one framing of this. And I think there's like a sort of depressing amount of validity. …

So you've got this box and it's kind of dumb, but like what's the end game, right? This box is worth zero obviously. … But on the other hand, if everyone kind of now thinks that this box token is worth about a billion dollar market cap, that's what people are pricing it at and sort of has that market cap. Everyone's gonna mark to market. In fact, you can even finance this, right? You put X token in a borrow lending protocol and borrow dollars with it. If you think it's worth like [not] less than two thirds of that, you could even just like put some in there, take the dollars out. Never, you know, give the dollars back. You just get liquidated eventually. And it is sort of like real monetizable stuff in some senses. And you know, at some point if the world never decides that we are wrong about this in like a coordinated way, right? Like you're kind of the guy calling and saying, no, this thing's actually worthless, but in what sense are you right?

If you were a salesperson at a big investment bank in August 2008, it might have been a good idea to call up some hedge funds and say "hey, we are hearing some bad things about Lehman Brothers. Do you feel safe with them? Might be a good time to move your accounts over here." The hedge funds might have believed you — you would have been correct! — and moved their accounts to your bank. You would have done more business and made more money. At the end of the year, you could go to your boss and say "I won all these accounts from Lehman, give me a big bonus."

And then your boss, if she was smart, would have fired you.

If you were the chief executive officer of a big investment bank in August 2008, and your subordinates were doing that sort of thing, how would you have felt about it? Three possibilities are:

1. Good: They were being aggressive about winning business, and winning more business is good. 2. Bad: Investment banking is a genteel business, and badmouthing a competitor is rude. 3. Very bad: The banking system was in perilous shape, and doing anything to undermine confidence in the system — like, for instance, spreading rumors that a competitor was collapsing — would have negative effects on your bank. If Lehman failed, or even looked likely to fail, you might be next. Better to prop up confidence in your competitors than to tear them down. Not all the time! In good times, sure, compete fiercely. But in a crisis, be extremely polite.

I think actual attitudes in 2008 were a mix of all three, but among smart investment bank CEOs the third attitude was very prominent. In 2008, the job of an investment bank was not to win market share; it was to stay alive. And staying alive was not a zero-sum game; each bank was more likely to stay alive if its competitors did. The way to stay alive was not by convincing everyone that you were better than the competition. The way to stay alive was by convincing everyone that everything was fine, that the system was fine. Bad news for one bank was bad news for everyone.

Oh, no, I'm kidding, you know how this joke goes. This is the hoary old joke about how "market capitalization," in crypto — and really in stocks, too — is fake, or at least potentially fake. It goes like this:

Anyone can make up a cryptocurrency and "print" as much of it as they want, trivially, for free. So I can make up Mattcoin, create 5 trillion Mattcoins, and give them all to myself. Then I sell you one Mattcoin for $1. You pay me $1 for a Mattcoin because you're my friend, or because it's funny, or because I asked you to and Venmo'd you $5 and told you to keep the change. (Or, it being crypto, "you" are just another anonymous wallet that I created myself, and I sell myself one Mattcoin for $1 in two different wallets.) Now the last reported trading price of Mattcoin is $1, you have one Mattcoin "worth" $1, and I have 4,999,999,999,999 Mattcoins "worth," in round numbers, $5 trillion. Huzzah, market cap.

This joke generally ends with one of two punchlines:

1. Obviously Mattcoin isn't worth $5 trillion and this is all stupid, a reductio ad absurdum of reported crypto market caps; or 2. Now I tell people that Mattcoin really is worth $5 trillion. "Look at this fast-growing Mattcoin ecosystem," I tell them, "it is already worth $5 trillion, but you can still get in at a good price, I'll sell you 1 million Mattcoins for just $300,000, that's a huge discount." Take some fake sales, add some internet hype and sales patter, and see if I can turn them into real sales.

The second punchline is called "market manipulation." The first punchline is just "look how dumb this is."

There are two main approaches to running a crypto exchange in 2022:

1. You set up a centralized exchange in some country. You form a corporation, the corporation runs the exchange, it opens accounts and holds crypto for customers, and you try to be a good corporate citizen. You follow the country's laws as much as possible, and you lobby to change the ones you don't like. Exactly how regulated you are (and how much lobbying clout you have) depends on the country, and this approach encompasses both "incorporate in the US and beg the Securities and Exchange Commission for permission to do anything at all" and "incorporate in a small island nation, buy its political system and do whatever you want." Both have pluses and minuses: The buy-an-island approach gives you a lot of flexibility and probably nice weather; the US approach gives you access to a lot of customers and, arguably, the confidence-boosting value of US regulatory oversight. 2. You set up a decentralized exchange with no legal entities at all, or at least none that run the exchange. The exchange consists of smart contracts that run permanently on some blockchain; people can interact with the exchange in a purely decentralized, permissionless way. You might try to avoid personal criminal liability by not coding or advertising the exchange in a way that is going to get you obviously arrested by US authorities, or alternatively by being anonymous and staying away from the US. But even if you do get arrested, the exchange is open and decentralized and hard to shut down. It exists not in a corporate entity but in code on a decentralized censorship-resistant blockchain.

I have suggested in the past — very much without giving legal advice! — that the second approach, empirically, works: US regulators abstractly, and sometimes concretely, do not like the idea that decentralized finance is insulated from regulatory oversight, but in practice it seems to be kind of true. [7] The exchanges that are most subject to regulation are the ones that pick up the phone when regulators call. If you don't have a phone number, they can never call you.

One other thing. I have called BAYC an "entity," which is a nice generic term, but it appears to call itself a DAO, a decentralized autonomous organization. There are some advantages to calling your entity a DAO rather than a corporation. For one thing, shares of stock of corporations are obviously securities subject to SEC regulation, while governance tokens of DAOs are … also obviously securities subject to SEC regulation, I think, and the SEC thinks, but some people seem to disagree. So you can say "what, it's a DAO, governance tokens, not stock, no securities here," and maybe someone will believe you. For another thing, it is good marketing: The people buying your DAO governance tokens believe in a future of crypto and decentralization, and they'd be disappointed to buy shares of stock in a corporation. They want some "decentralization" branding on their shares, so you give it to them.

But there is also a big disadvantage to calling your entity a DAO rather than a corporation. A corporation is a particular sort of legal entity that has one key feature, which is limited liability. If you own shares of a corporation, you are not generally responsible for (1) the debts of that corporation or (2) its crimes. (If you are also an executive and you do the crimes, you are responsible, but simply being a shareholder does not make you responsible for the actions of the corporation.) This is a special feature of corporations (and some other entities like limited liability companies or limited partnerships), and corporations have to take affirmative steps (file incorporation documents, pay fees, etc.) to get this protection.

If you don't do that — if you just get together with your buddies and start a business without incorporating it — then you don't get those protections. Instead, you have the default form of business organization, just a group of people doing a business without paperwork, which might be called a "general partnership" or an "unincorporated association." A general partnership does not have limited liability. If your partnership incurs a debt — if one of your partners borrows money on behalf of the partnership and then loses it — then you are responsible for it. If the partnership does crimes, you might get in trouble.

This is why people, in traditional business, tend to do the paperwork to form corporations (or limited liability companies, limited partnerships, etc.). In crypto business, some combination of libertarianism, naivety, we're-doing-stuff-no-one-has-seen-before exceptionalism, and a desire to evade securities laws leads people to avoid that paperwork. And then you have a DAO with no paperwork, which is a general partnership, and oops.

And so last month the US Commodity Futures Trading Commission brought an enforcement action against a decentralized finance platform called bZeroX and a DAO called Ooki DAO, and said:

The Ooki DAO is an unincorporated association comprised of holders of OokiDAO Tokens ("Ooki Tokens") who vote those tokens to govern (e.g., to modify, operate, market, and take other actions with respect to) the bZx Protocol (which the Ooki DAO has renamed the "Ooki Protocol").

The CFTC's view is that just buying governance tokens doesn't make you a general partner in the DAO, but buying those tokens and voting them does. As one CFTC commissioner said in dissent:

Under the Commission's definition, [a token holder who votes] has now become a member of the unincorporated association and (possibly unknowingly) assumed personal liability and is subject to CFTC sanctions for any violations of the [Commodity Exchange Act] by the Ooki DAO.

It is possible that DAOs are just the worst of all worlds: Their tokens are similar enough to corporate shares to be subject to securities laws, but different enough to create unlimited liability for their holders.

I say "crypto exchanges" because, historically, crypto exchanges have been leaders in the business of keeping custody of crypto assets. But now crypto custody is increasingly the business of traditional financial institutions. And I guess the question is: Wouldn't it be very, very funny if Bank of New York Mellon Corp. gets hacked and loses its customers' Bitcoin?

The nation's oldest bank said it would begin receiving clients' cryptocurrencies on Tuesday, becoming the first large U.S. bank to safeguard digital assets alongside traditional investments on the same platform.

BNY Mellon won the approval of New York's financial regulator earlier this fall to begin receiving select customers' bitcoin and ether starting this week. The bank will store the keys required to access and transfer those assets, and provide the same bookkeeping services on those digital currencies that it offers to fund managers for their portfolios of stocks, bonds, commodities and other assets. ...

Money managers have long relied on BNY Mellon and other custody banks for an array of vital, if humdrum, back-office functions such as tracking changes to the value of their assets. Founded by Alexander Hamilton more than two centuries ago, BNY Mellon is the world's biggest custody bank.

Until now, fund managers would have had to custody their digital currencies with a crypto specialist. BNY Mellon said it is the first of the eight systemically important U.S. banks to store digital currencies and allow customers to use one custody platform for both its traditional and crypto holdings.

"We are excited to help drive the financial industry forward," Robin Vince, BNY Mellon's president and chief executive, said in a statement.

It probably won't happen, right? The point of doing crypto custody with BNY Mellon, as opposed to "a crypto specialist," is that you are expecting the security, regulation, and not-being-hacked-too-much of traditional finance. Still you might worry: BNY Mellon's pot of crypto will be as attractive to hackers as any crypto exchange's pot of crypto, and it might have less experience and expertise in securing crypto than "a crypto specialist" would. The question is whether being hacked constantly is a feature of crypto exchanges, or just a feature of crypto.

Colloquially you can say that you have Bitcoin "on" a hardware wallet or other computer storage device, like the guy in Wales who threw his in a garbage dump and keeps getting publicity for his schemes to dig it up. But really the hardware wallet just stores your private keys to one or more Bitcoin addresses, and having those on a hardware wallet doesn't stop you from also storing them somewhere else — on another hardware wallet, in your iPhone notes app, on a Post-it note, by memorizing them (or by memorizing a seed phrase that can be used to generate the keys), etc. The lesson for the government is that if you arrest someone for Bitcoin crime and you seize his hardware wallet, you have not seized his Bitcoin; you have just seized a hard drive, and he — or his brother, or anyone else — might have other ways to access the Bitcoins. The way you seize the Bitcoins is by getting his private keys — from the hardware wallet, or by asking him, or whatever — and then transferring them to an address that you control, where you can be pretty sure that he and his friends do not have the keys.

Here is a weird tension in marketing crypto tokens. If you run some crypto-y project, and it issues a token, and the token is not actually useful for doing anything on your crypto-y platform, one thing that you can do is go around saying "this token has no cash value and will not appreciate, this is for pure entertainment purposes only." Another thing you can do is go around saying "this token is going to be hugely valuable as our crypto project takes off, buy it now and it will go up."

The problem with the first approach is that if you consistently and clearly say "this token is worthless," probably no one will buy it. (This is not always true — people might buy tokens for a meme, or for aesthetics — but it is a risk.) The problem with the second approach is that if you say "this token represents a bet on the success of our business venture," then it is probably a security under traditional US securities law, and the US Securities and Exchange Commission will sue you for securities fraud unless (1) you have registered the security or exempted it from registration (you haven't) and (2) you are telling the truth about your business venture (are you?). The first approach won't make you any money; the second approach will get you in trouble.

There are various artful ways to split the difference. One rough one is:

1. You consistently say, in boilerplate, "this token has no value and is not an investment." 2. You go around doing podcast interviews where you are like "what a great business we have, we keep making more money, oh there is also a token, how about that." You don't say that the token represents a bet on the business, but you vaguely imply it. 3. You do a lot of wash trading, where you buy the token from yourself and then sell it back to yourself, at ever-increasing prices, creating the impression that its value is going up.

And then you have not quite said that it's an investment, so it's arguably not a security, but maybe you have gotten enough people interested in it that you can sell it to them and get some money.

I am not saying that that will work, or that it is a good idea, but it is an idea. Here's an SEC enforcement action from yesterday:

The Securities and Exchange Commission today announced charges against The Hydrogen Technology Corporation, its former CEO, Michael Ross Kane, and Tyler Ostern, the CEO of Moonwalkers Trading Limited, a self-described "market making" firm, for their roles in effectuating the unregistered offers and sales of crypto asset securities called "Hydro" and for perpetrating a scheme to manipulate the trading volume and price of those securities, which yielded more than $2 million for Hydrogen.

The SEC's complaint alleges that starting in January 2018, Kane and Hydrogen, a New York-based financial technology company, created its Hydro token and then publicly distributed the token through various methods: an "airdrop," which is essentially giving away Hydro to the public; bounty programs, which paid the token to individuals in exchange for promoting it; employee compensation; and direct sales on crypto asset trading platforms. The complaint further alleges that, after distributing the token in those ways, Kane and Hydrogen hired Moonwalkers, a South Africa-based firm, in October 2018, to create the false appearance of robust market activity for Hydro through the use of its customized trading software or "bot" and then selling Hydro into that artificially inflated market for profit on Hydrogen's behalf. Hydrogen allegedly reaped profits of more than $2 million as a result of the defendants' conduct.

They gave the tokens away for free (including to themselves), and were careful-ish about not advertising them as an investment. From the SEC complaint:

Hydrogen and Kane publicly marketed Hydro as a so-called "utility" token on the company's website and its social media pages and channels, initially claiming that it would function as an "API key" within Hydrogen's existing non-blockchain API business. However, at no point during the Relevant Period, including during the offers and sales of Hydro, could the token be used within Hydrogen's existing non-blockchain API. ...

While Hydrogen and Kane worked to have Hydro listed on crypto asset trading platforms, the company fielded numerous questions on its social media pages and channels from Hydro recipients and purchasers about the token's value and whether and when Hydrogen expected the token's price to increase.

At Kane's direction, Hydrogen created a set of scripted responses to these questions, being careful not to expressly state that the Hydro token would increase in value.

But instead they allegedly created that impression through trading:

Kane began selling the company's Hydro through crypto asset trading platforms in May 2018, but soon after learned that selling a significant volume of Hydro would depress the token's price and hinder his efforts to raise much-needed capital for Hydrogen. As a result, in October 2018, Kane privately hired and directed Ostern and his company, Moonwalkers, a self-described "market maker," to manipulate Hydro's trading price and volume so that the company's Hydro sales would be more profitable. Moonwalkers did so by creating the false appearance of robust Hydro trading and artificially propping up the token's price.

Specifically, at Kane's direction, Ostern used a customized trading bot (a computer program that automates trades) to sell the company's Hydro through Kane's personal trading accounts on crypto asset trading platforms. Among other manipulation tactics, Ostern placed and canceled both buy and sell orders at random increments to artificially inflate the Hydro token's trade volume and price, thereby enabling sales of the company's Hydro to be more profitable.

Ostern provided Kane and Hydrogen with regular updates on his market manipulation efforts. For example, on October 11, 2018, just days after the Hydro market manipulation began, Ostern told Kane that he was "starting off slow, trying to keep the sell pressure minimal until [he could] build enough capital to really get the market moving upward" and indicated that they would "have plenty of excuses to pump price and sell into the FOMO [fear of missing out] guys down the road." Two weeks later, Ostern told Kane about his "volume shenanigans" on a popular, high-volume crypto asset trading platform, and bragged that it had taken his bot "about 3 seconds" to generate the illusion that "a million" Hydro tokens had been bought and sold—"[a]round half" of which Ostern admitted was "fake."

"The name 'Moonwalkers,'" explains the SEC, "derives from the expression 'going to the moon,' which is used by crypto enthusiasts and issuers to describe the potential significant appreciation in price or value of crypto assets," terrific. You walk a token to the moon with fake trading I guess.

This didn't really work, I don't think, in that the SEC brought the case, but I want to highlight the thought process. If (1) the token is absolutely valueless and has nothing to do with any operating business, and (2) you say that clearly and consistently, then you have a decent argument that it is not a "security." The "Howey test" of securities law says that something is a security if it involves "the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others," and if you consistently say "there's no enterprise, there'll be no profits, and we'll make no efforts" then you can argue that your token is not a security.

If you then also hire someone to do a bunch of spoofing and wash trading in your token, that's bad , and somebody (the Commodity Futures Trading Commission? prosecutors?) might go after you for fraud , but the SEC won't go after you for securities fraud because the fraud that you are doing is not to a security. If your model i

The idea of a blockchain is that you want to do bank transfers without a bank. You want people to be able to do transactions, and have them confirmed, and have there be some canonical agreed list of the transactions, but you don't want to trust some central party to do it.

At a high level, the blockchain solution is to confirm transactions by letting everyone keep a copy of the transaction ledger. And then the official ledger is based on consensus among people who have some demonstrated stake in the system. What that has often meant in practice — what it means in Bitcoin and what it originally meant in Ethereum — is "proof of work." What you do is, you buy a bunch of computers, and you set them to work solving meaningless math problems, and whoever solves the most math problems the fastest gets to confirm a block of Bitcoin transactions, and they are rewarded with some newly minted Bitcoins and then everyone starts over solving more math problems to confirm more transactions. Buying the computers, and paying for the electricity to run them to solve the math problems, demonstrates your commitment to Bitcoin: It would be crazy to spend all that money on computers and electricity to confirm fake transactions, which would undermine the value of Bitcoin and thus of your investment. [1]

This is called "mining": You spend money on computers and electricity, and then you are rewarded with newly created Bitcoins. And there are people, and publicly traded companies, who are in the business of Bitcoin mining and thus of maintaining the Bitcoin network. The inputs are electricity and the outputs are Bitcoin.

This was a clever innovation and has some important benefits. It lets you have a ledger that is maintained by people with incentives to do the right thing — people you can trust — without knowing who they are. There is no pre-approved list of people who are allowed to maintain the Bitcoin ledger; anyone who buys enough computers and electricity can participate. It is permissionless. But because they have to buy all those computers and electricity, they have good incentives to maintain the ledger in a good way.

But there are some problems. The biggest is that it uses a ton of electricity solving pointless math problems, which seems wasteful both in environmental terms (you're emitting a lot of carbon to generate all that electricity) and also in economic terms (the Bitcoin system is effectively paying utility companies a lot of money to maintain its ledger). Developers of later blockchains realized that, if the point here is to have transactions confirmed by people with a demonstrated stake in the system, there are easier ways to demonstrate a stake in the system. [2] Most simply: If you have a lot of Bitcoins, you will want Bitcoin to be valuable, and so you will want to confirm transactions honestly in order to keep Bitcoin valuable. Instead of proving that you have an economic stake in the system by spending a lot of money on computers and electricity, you could prove that you have an economic stake in the system by spending a lot of money on Bitcoin. If you have a lot of Bitcoin, that proves that you care about Bitcoin, so you get to participate in confirming transactions.

Well, that is not how Bitcoin works, but it is how Ethereum works starting, uh, today-ish. Bloomberg's Olga Kharif and David Pan report:

Ethereum is about to get a makeover. The popular crypto network that runs Ether, the world's second-most-valuable digital currency, could morph as early as Sept. 14 into a configuration that shakes up the entire crypto universe.

The long-anticipated software change, "the Merge" to crypto fans worldwide, will lower Ethereum's energy use by 99%, silencing critics who dislike the blockchain for its electricity consumption—enough to power Finland for a year by one estimate. …

Ethereum's new process will rely instead on what's called proof of stake. It consumes very little power, because it doesn't depend on miners. It does require entities called validators to put some skin in the game in the form of Ether coins. Staking, or putting coins in the pot, gives large Ether owners the right to add a block of transactions to the ledger; they're rewarded with new Ether when they do so. All Ether tokens will now pay interest when placed into staking wallets. The software upgrade is called the Merge because the existing Ethereum blockchain will combine with a parallel network that's been running for almost two years to test the proof-of-stake concept.

If you have a lot of Ether, you can stake them and be a validator and confirm transactions and get rewarded with additional Ether. Or, if you have a smaller amount of Ether, you can delegate them to a validator: You hand them over to some validator that you trust, and that validator can stake them and confirm transactions and get rewarded with additional Ether and give you some of them. In practice, it is natural for big crypto exchanges like Binance, Coinbase and Kraken to be in this business: They are holding on to people's Ether for them anyway, and they have a big economic interest in Ether working well, so they might as well stake customers' coins, validate transactions, and share the staking rewards with their customers.

The economic model here is a bit different from the Bitcoin proof-of-work model. In that model, professional miners basically buy electricity and turn it into Bitcoins. In this model, professional stakers, or their customers, basically buy Ether and turn it into more Ether. You take your Ether, you lock it up in an account at a financial services firm for a while, and your Ether grows by some steady percentage. You know: like interest.

But there are also a lot of places in securities law where the rules are a little bit vague and you are operating a little bit on the cutting edge and the best practice is to pick up the phone and call the SEC staff and say "hey what do you think about this?" Sometimes this is fairly formalized: The SEC staff issues "no-action letters" (you send them a letter saying "is it okay if we do this," and they send back a letter saying "if you do that, we probably won't sue you," which is almost as good as them saying "yes") and "telephone interpretations" (you call them up and ask "is it okay if we do this," they say "sure seems fine" or "no that's bad," and then they write down the question and answer so other people with the same question don't have to ask it again). These are places where the rules are unclear, or they are clear but applying them as written would create bad results, so the solution is to ask the SEC "is it okay if we do this" and they just tell you.

Sometimes it's less formal. Your lawyer calls an SEC lawyer and has an informal chat about the issues raised by whatever you've got cooking, and the SEC staff raises some concerns, and you work to address those concerns, and eventually the SEC staffers say "yeah this seems fine now" and you do it. And, as you'd expect, these sorts of informal contacts tend to work better for certain sorts of people. If you are a big firm who can hire good lawyers (perhaps ones who used to work at the SEC), that's good. If you are a big incumbent who has a reputation for knowing what you're doing, and a lot to lose if you mess up, that's good. If you're a couple of 20-somethings with no track record, it might be hard to get the SEC to take you seriously, and they might be suspicious of what you're up to.

Many things in crypto are (1) on the cutting edge of securities regulation and (2) done by a couple of 20-somethings with no track record. So the offer of "come in and chat with the SEC" is less appealing to them than it would be to, you know, Goldman Sachs Group Inc.

"A basic premise of Web3," I once wrote, "is that every product is simultaneously an investment opportunity":

If you sign up for a Web3 social network or chat room or trading venue or let's-buy-the-Constitution lark, you will get some of that project's tokens, which will entitle you to use the project's app or exchange or Constitution, and which will give you some notional say in the decentralized governance of the project. Also the tokens will appreciate in value if the project takes off and more people want to use it. It's as if being an early user of Facebook or Uber also automatically made you a shareholder of Facebook or Uber, and when those services got huge you got rich.

This has good points and bad points:

The good thing is that Web3 and crypto have solved the cold-start problem for network-effects businesses. It is hard to build a social network or a marketplace or a ride-sharing app or lots of other businesses, because those businesses are useful mainly if they have a lot of users, so they are not very useful for their first users. But if you add a crypto token, the first users get the most tokens, so they stand to get the richest, so there is a lot of incentive to join early — which means that lots of people join quickly and it becomes useful. "The basic idea," Andreessen Horowitz partner Chris Dixon once tweeted, is that "early on during the bootstrapping phase when network effects haven't kicked in, [you] provide users with financial utility via token rewards to make up for the lack of native utility." The bad thing is that every project is simultaneously a Ponzi scheme, and it is hard to know if people are using the project because they get utility out of it or because they hope to dump their tokens on future suckers.

Here, though, the point that I want to make is that this situation — every product is an investment — also has good points and bad points as a matter of securities regulation:

The good thing is that if you are a venture-capital firm investing in Web3 or decentralized-finance projects, or a crypto exchange listing their tokens, you can say "what, no, this is a product, not a security." The bad thing is that if you are the US Securities and Exchange Commission and you want jurisdiction over all of DeFi and Web3, you can say "all of these things are securities, not products."

And you're both right! Everything is both. That is the economic innovation of crypto and DeFi and Web3, making everything both the currency of a project and equity in that project.

Here's a speech that SEC Chair Gary Gensler gave today:

Of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities. Offers and sales of these thousands of crypto security tokens are covered under the securities laws. … In general, the investing public is buying or selling crypto security tokens because they're expecting profits derived from the efforts of others in a common enterprise. ...

Some in the crypto industry have called for greater "guidance" with respect to crypto tokens.

For the past five years, though, the Commission has spoken with a pretty clear voice here: through the DAO Report, the Munchee Order, and dozens of Enforcement actions, all voted on by the Commission. Chairman Clayton often spoke to the applicability of the securities laws in the crypto space.

Not liking the message isn't the same thing as not receiving it.

Investors are following crypto projects on social media and scouring online posts about them. These tokens have promotional websites, featuring profiles of the entrepreneurs working on the projects.

It's not about whether you set up a legal entity as a nonprofit and funded it with tokens. It's not whether you rely on open-source software or can use a token within some smart contract. These are not laundromat tokens: Promoters are marketing and the investing public is buying most of these tokens, touting or anticipating profits based on the efforts of others.

Therefore, investors deserve disclosure to help them sort between the investments that they think will flourish and those that they think will flounder. Investors deserve to be protected against fraud and manipulation. The law requires these protections.

This just strikes me as uncontroversially, straightforwardly true as a matter of standard US securities law, and I always wonder what people think they are doing here. "The test," the famous Supreme Court case says, "is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others." If you're buying tokens to bet on the success of some crypto ecosystem or DeFi protocol or Web3 project — and if the project's promoters are selling those tokens to raise cash to develop the ecosystem or protocol or project — what else could it be?

In cryptocurrency markets, broadly, people like to exchange volatile cryptocurrencies (Bitcoin, Ether, etc.) for dollars, but they are particular about what flavor of dollars they want. Some traders will want to send out Bitcoin and get back actual U.S. dollars in their bank accounts. Most professional crypto traders do not, for various ease-of-settlement, staying-in-the-crypto-system and/or regulatory reasons. They prefer to get paid in stablecoins, dollar-denominated tokens that live natively on some crypto blockchain. They will sell you Bitcoin and get back Circle's USDC or Binance's BUSD or Tether's USDT or some other dollar stablecoin.

This creates the annoying practical difficulty that crypto exchanges will list trading pairs like "Bitcoin/USDC" and "Bitcoin/USDT," and if you want to trade a Bitcoin for dollars you will have to choose which flavor of dollar you want. And the liquidity will be divided: Some people will bid one flavor of dollars for Bitcoin, and other people will bid another flavor of dollars; some people will offer to sell Bitcoin for one flavor of dollars, while others will offer Bitcoin for a different flavor. And the people who bid USDC will not trade with the people who offer for USDT.

And sometimes there is some reason for this: Someone won't trust Tether, or won't be able to get USDC, or whatever. Often, though, everyone is more or less indifferent between flavors of dollars; they just want to trade Bitcoin for dollar-ish things or dollar-ish things for Bitcoin. But because there are different flavors of dollar in the crypto world, the liquidity is fragmented.

The basic situation with Tether is that it claims to be 100% backed by safe assets. Actually it claims to be about 100.3% backed: For every $1 of Tether outstanding, there are about $1.003 of assets that Tether keeps in a box. But Tether is notoriously secretive about what it keeps in the box. Whereas a typical money-market fund will list the exact dollar amount and CUSIP of every instrument that it owns, Tether discloses broad categories of securities; whereas banks and money-market funds have audited accounts, Tether is perpetually months away from the audit that will finally solve all of its problems.

And plainly Tether is not always 100%, or 100.3%, backed by very safe assets. For one thing, even its current "reserves breakdown," as of June 30, 2022, says that 8.36% of its assets are in "Other Investments (Including Digital Tokens)," and digital tokens sometimes lose value. If Tether's "other investments" lost 10% of their value, then Tether would no longer be fully backed: Each Tether was backed by $1.003 of assets, but if 8% of its portfolio lost 10% of its value then it would be backed by only $0.995 of value. Cryptocurrencies lose 10% of their value all the time. Also there is some historical record of Tether counting risky loans — to its affiliate Bitfinex, to busted crypto lender Celsius — as part of its assets. So far those loans seem to have been paid back in full, so it's fine I guess, but with just a 0.3% equity cushion there is not much margin for error.

The interesting question with Tether is: Let's say that you knew, definitively, that Tether "broke the buck." Some of its not-so-safe assets didn't pan out, and each Tether turned out to only be backed by, say, 97 or 98 cents of assets. In the world of money-market funds — or of regulated banks — that would be a disaster; that would be insolvency and a bank run and the end of the fund and a possible systemic crisis. Investors put their dollar in expecting that they could always get exactly $1 back, and if they find out that they can't then they'll race to get their $1 while they still can, and the fund will be forced to liquidate its holdings and further drive down their prices and leave investors with big losses that they were not expecting.

In the world of stablecoins … I don't know? It is not obvious that the same intuitions apply. The point of a stablecoin is not mainly to be a secure claim on $1 of assets in a bank account. The point of a stablecoin is mainly "to grease the rails of the roughly $1 trillion cryptocurrency market," by being the on-blockchain form of a dollar. We talk somewhat frequently about stablecoins that are openly backed by nothing but overcomplicated confidence in their own value; to be fair, we mostly talk about them when they are crashing to zero, but still. The thing that makes a stablecoin worth a dollar is primarily that big crypto investors treat it as being worth a dollar, that they use it as a medium of exchange and a form of collateral and value it at $1 for those uses. Being backed by $1.003 of dollar-denominated safe assets helps with that, but being backed by $0.98 of dollar-denominated assets might be good enough?

One way of putting this might be that Tether is "too big to fail," that the people who use it have incentives to continue treating it as being worth $1 even if it never to gets around to proving that it has assets worth $1 per Tether. Another way of putting it is that people don't worry too much about the "backing" of the US dollar itself; a dollar buys a certain amount of goods and services because of broad social acceptance rather than any reserve of gold in a vault somewhere. If enough people believe that a Tether just is a dollar in the crypto world, maybe that's enough to make it true.

I feel like when I was a youngster the warning you got about short selling was "if you short a stock, you have unlimited risk, because the stock can go to infinity, but limited upside, because the stock can't go below zero." The classic retort is "I've seen a lot of stocks go to zero, but I've never seen one go to infinity."

A more fundamental problem is that short selling is sort of necessarily leveraged. If you buy a stock for $100 with your own money, and it falls to $0.01, you can hold on to the stock, no problem: You'll never get a margin call, because you never borrowed money; you'll never need to put up more than the original $100. And then if it recovers to $200 you make money. But if you short a stock at $100, you have to post collateral with your stock lender, and if the stock goes to $500 then you have to post more collateral, and if you can't you get liquidated. So if you're like "I've got $20 million to bet that Luna is going to zero," you're right, but it doesn't help.

Loosely speaking, there are two sorts of cryptocurrency platforms. There are centralized platforms, which are owned by shareholders (founders, employees, venture capitalists, etc.) and managed by managers. The managers set the policies and try to attract deposits (of money and cryptocurrency) from customers and then make decisions about how to invest those deposits. If the investments make money, the customers get paid some agreed-upon yield, and the platform (and its equity investors) keeps any profits that are left over. If the platform becomes popular and successful and widely used, and if its investments work out well, then its shareholders get rich. This is roughly how many traditional finance businesses work too.

Then there are decentralized platforms. These are in some sense owned by their users (customers, depositors, borrowers, etc.), though generally that means that the users get a cryptocurrency token with some economic and governance rights rather than a share of equity. There might be some managers, but the holders of the governance tokens can replace them or change the platform's policies. There is a Discord channel. If the platform is investing customer money, the customers, as holders of governance tokens, might get to vote on what to invest in, and the profits (or losses) of the investment flow directly to the customers. If the platform becomes popular and successful and widely used, and if its investments work out well, then its users — at least the early users, the ones with a lot of tokens — get rich. This form of organization is at least a somewhat new phenomenon, a genuine innovation of crypto.

Don't take those last two paragraphs too seriously; I am oversimplifying and abstracting a lot here. But I think that directionally there is something to this: There are manager-run shareholder-owned centralized platforms that interact with users as customers, and there are token-driven decentralized platforms that interact with users as customer-owners.

I mean … they'll … buy them back … at $1? Like that's the point? Of Tether? What are we doing here? Like if you see a stock go from $10 to $100 and think "hahaha this is a great short" and short it at $100, one thing that might happen is that there might be a short squeeze and the stock might go to $400 and stay there. If that happens, (1) you will have to buy it back at $400 and lose tons of money, and (2) the people who own the stock will say things like "yes!" and "haha gotcha" and "this is exactly what we wanted." But if you see Tether trading at $0.9988 and you think "hahaha this is a great short" and short it at $0.9988, it seems implausible that there will be a short squeeze and Tether will go to, like, $2. The point of a stablecoin is to be worth $1! If Tether goes to $2, the people who own it will say things like "what?" and "oh dear" and "this is not supposed to happen." It's not a useful stablecoin if it trades very far from $1. If you are short Tether and it stays near $1, you will lose money, because you are paying money to borrow Tether and short it. But you're losing a little money every day; the problem is not, like, you sold it at $0.9988 and now you have to buy it back at $1.00. That costs you $0.0012!

Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don't have to worry about them. Money in a bank account simply is money ; you don't have to analyze your bank's financial statements before opening a checking account. The short-term senior debt of financial institutions is "information-insensitive."

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don't get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn't safe. But the basic mechanics of seniority mostly work pretty well.

But they are in a sense unnatural. If you started a bank in the state of nature, and the bank had equity investors who were smart and rich and concentrated and heavily involved in the running of the bank, and then the bank took a lot of money from dispersed retail depositors who didn't pay a lot of attention and just wanted their money back and had no real idea about the running of the bank, and then the bank ran into trouble, you might expect the equity investors to say "well we'll take whatever money is left and stiff the depositors." And you might not expect the depositors to be very effective at fighting back. And so the equity investors might in practice be senior to the depositors, in this state-of-nature bank. As they effectively were at Terra.

Of course if you started a bank in the state of nature nobody would give you any deposits. The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don't think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don't have to; that is the point of those requirements.

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn't always.

A DAO, or a decentralized autonomous organization, is like a corporation except that:

1. Instead of having annual meetings with highly circumscribed ways for shareholders to submit non-binding proposals to management, the DAO has a continuous Discord chat where shareholders can submit proposals anytime they want, and those proposals can concern core functions of how the company is run, and the shareholder vote on those proposals is at least kind of binding on management. 2. All the shareholders are really into crypto.

And so one thing that happens is that a DAO can enter into a contract, meaning that the managers of its legal entity can sign a contract binding that legal entity to do something, and then someone in the Discord chat can say "nah I don't like that contract," and then the Discord chat can vote to reject it, and then … uh … I dunno? I think under traditional legal principles, if the officers of a legal entity sign a contract binding that legal entity to do something, a later vote by a Discord chat to reject the contract doesn't carry much weight. But I think a lot of people who are really into crypto would disagree.

Here's some DAO stuff:

On May 20, Honey Barrel, whose online bio describes them only as a "vanquisher of non-frens," woke up and chose chaos. They're a member of Merit Circle DAO, a decentralized autonomous organization worth over $370 million that loans non-fungible tokens to people who play crypto games but can't afford the buy-in, according to crypto research startup DeepDAO. In a 2,000-word post on the Merit Circle DAO forum, Honey Barrel proclaimed that certain Merit Circle investors weren't pulling their weight.

Their solution? Break the contract with the investor in question, Yield Guild Games, return its money, and show the world that DAOs aren't to be messed with. In the normal startup world, one angry blog post would have gotten lost in the depths of tech Twitter. But in the DAO world, where anyone who holds a token gets a say in the group's future, the post lit a fire.

The proposal from Honey Barrel—an average, albeit vocal member of the organization—threatens to usher in a new, distinctly investor-unfriendly era in the DAO world. Because if one DAO breaks its legal contract with an investor, what's to stop others from doing the same? For venture capital firms that have put millions into DAOs—including giants such as Andreessen Horowitz, Union Square Ventures, Sequoia Capital and Paradigm—the ripple effects could be existential.

The proposal passed. The DAO voted to kick one Merit Circle investor — Yield Guild Games — out of the DAO. YGG had bought its tokens from Merit Circle Ltd. (the legal entity connected to the DAO) for about $0.03 each; they were trading at about $1 at the time of the proposal. Merit Circle's management team, who presumably understood that "refund money to investors who aren't pulling their weight" isn't really a thing, took this proposal as obliging them "to renegotiate the terms of the financial agreements made between the DAO and Yield Guild Games"; they negotiated an agreement with YGG to buy them out at $0.32, a 10x return on their investment but still well below market value, and got the DAO to approve that. (Here is a useful Twitter thread from Tim Connors.) Merit Circle and YGG put out a rather peeved joint statement:

The proposal singled out one early stakeholder on the basis that it had not provided enough value in relation to how many tokens it held. Merit Circle Ltd does not agree with this view. Yield Guild Games added value in many different ways although they were not often called upon to do so. They were also one of the first ones to post their transparency & accountability thread to share and create a dialogue with the community.

After taking in the proposal and observing the community's feedback, Merit Circle Ltd reached out to Yield Guild Games. Yield Guild Games worked with Merit Circle Ltd in the hopes of helping Merit Circle Ltd find a workable solution to appease their community whilst honoring the SAFT that Merit Circle Ltd had signed.

We both recognized the arbitrary nature of the MIP-13 proposal and the danger a precedent like this could set for the Merit Circle DAO and the industry as a whole if agreements are not upheld and investors are not respected. The chosen tool was too crude and did not do justice to prior agreements.

The divergence between the prior agreement and the DAOs proposal would have likely led to legal action against Merit Circle Ltd. While the legal question is one that could probably be argued at length, both parties agreed it was better to settle. This would spare both parties from a costly, time-consuming, legal process with uncertain outcomes. None of the parties had to settle, but both parties chose the constructive path to help Merit Circle mo

We have talked a few times recently about how people borrow money to do leveraged trading in decentralized finance, and how it differs from leveraged trading in traditional finance. One key difference is:

1. In traditional finance, if you have borrowed money to buy some stocks, and the stocks have gone down, your broker will call you up and say "hey could you post more collateral." Ideally you post the collateral and everything is fine. Sometimes you don't, and your broker sells the stocks at hopefully a high enough price to pay off your loan. But sometimes you say "sorry, I can't post any more collateral today, but I can try tomorrow," and your broker gives you another day. 2. In decentralized finance, if you have borrowed money (stablecoins) to buy some crypto, and the crypto has gone down, a robot sells your crypto at hopefully a high enough price to pay off your loan, automatically and without bothering to call you.

I have mostly emphasized that the traditional approach can be more generous to you, the borrower: Sometimes you don't pay back your loan, but your broker gives you more time. Why would the broker do this? Well, you might be a good customer, and the broker won't want to make you mad. Or you might be a big fund, and the broker will think "sure this position is undercollateralized but all in all they're good for it." Or you might be so big that the broker will think "if I liquidate this position it is going to crash the market and cause a systemic crisis, whereas if I just give them another day to pay maybe everything will be fine."[2]

Or you might say "sorry, can't make a margin call right now, I'm on vacation with limited cell service" and your broker might say "ah we've all been there" and give you another week. (True story: Once, when I was a banker, I sent a Brazilian client a large margin call. They said "it's Carnival, sorry, try us next week." I gulped and waited. It worked out fine!)

The crypto robots don't do any of this sort of thinking. They just look at the collateral, look at the position, and if the collateral is too low they liquidate. The crypto system is often stricter, which is good (less buildup of systemic risk) and bad (harder to sleep).

On the other hand, the traditional approach can also be stricter. Sometimes your stocks haven't gone down, and your broker calls you up and says "hey we are changing our margining requirements and would like you to post more collateral." And if you say no, the broker will (eventually) liquidate your position.

Why would the broker do this? Well, there might be a new risk manager at your broker, and she might want more collateral. Or volatility might have gone up and your broker's model now demands more collateral. Or your stocks might have gone up , and your broker might say "this position is so big that we need to manage the risk more strictly." Or your broker might have heard a rumor that you are in financial trouble. Or your broker might have heard a rumor that a bunch of other investors are in trouble, so it is tightening up collateral across the board. Or something else.

Can your broker do this? Does your contract with your broker allow them to just call you up for more collateral? The short answer is, sure, probably; brokers are good at protecting themselves. The longer answer is that you are all embedded in a fuzzy system of repeat players and you cannot ignore your broker's demands forever, even if your current contract favors you. If your broker asks you for more collateral then, in the long run, your choices are (1) post more collateral or (2) find another broker; either of those approaches accomplishes the broker's essential goal of reducing its risk exposure.

This is actually an element of the Archegos Capital Management story: When Credit Suisse Group AG called Archegos for more collateral, it was not because Archegos's stocks had gone down; they had gone up , and Credit Suisse took a closer look at its margin provisions and realized they were not great, so it called up Archegos and asked to change those provisions. Archegos said "we'll get back to you" and then imploded, oops. But the basic story is that Credit Suisse tried to adjust its margin provisions on the fly to address newly salient risks, and Archegos was at least in theory willing to work with Credit Suisse on that.

Meanwhile in decentralized finance, if you wake up one morning to realize that a whale has built up a huge position in an increasingly volatile market, and that your margin provisions are not adequate to protect you if you need to close the position, what do you do? I mean … kind of the same sorts of ad hoc things that you'd do in traditional finance, but you get a lot more grief for it.

Solend is a DeFi lending platform on the Solana blockchain. It … discovered? … that it has one "whale" client who has borrowed a huge amount of stablecoins from Solend to fund a position in Solana's native SOL token. If the price of SOL falls too far, the Solend smart contract will automatically start liquidating the whale's position in a way that will apparently overwhelm market liquidity, crater the price of SOL and cause huge losses for Solend and its own depositors (the people who put up the stablecoins that Solend is lending to the whale). CoinDesk reports:

The anonymous wallet at the heart of the crisis had deposited 95% of Solend's entire SOL pool and represented 88% of USDC borrowing. But Solend's single-largest user came dangerously close to a massive margin call with SOL's cratering price. If SOL hit $22.30, the protocol would automatically liquidate up to 20% of the whale's collateral.

To avoid this, Solend decided to amend the smart contract to let Solend's team take over the whale's position and start liquidating it in over-the-counter transactions before it hits the margin trigger. To do this, it put the proposal to a vote of its decentralized autonomous organization; from Solend's blog post:

Any action we take (including inaction) has a set of trade offs to consider. There is no perfect solution. With that in mind, the action we believe would result in the best outcome is as follows:

Enact special margin requirements for large whales that represent over 20% of borrows. If a user's borrows amount to over 20% of all borrows for the Main Pool, a special liquidation threshold of 35% is required. This policy will go into effect upon approval of the proposal.

Grant emergency power to Solend Labs to temporarily take over the whale's account so the liquidation can be executed OTC and avoid pushing Solana to its limits. This would be done via a smart contract upgrade. Emergency powers will be revoked once the whale's account reaches a safe level.

The proposal passed, but in a hasty way that led to lots of objections, so they walked it back: Solend introduced another proposal to rescind the first one, and then a third to create new position limits to mitigate this risk in a more mechanical way.

I suppose you could conclude something along the lines of:

1. In traditional finance, this stuff is managed through a combination of contractual remedies, background legal and equitable principles, and fuzzy relationships and reputations. 2. In decentralized finance, people like to say that "code is law": Everything is supposed to be transparent and deterministic; smart contracts specify exactly what happens in every case. 3. Code is not law. Sometimes the smart contracts do not cover the cases you end up caring about, or they do, but not in the way anyone wants. 4. Nothing else is law either, so you make things up from scratch.

Well! At FT Alphaville, Alexandra Scaggs has a fun post about oracle latency. A large crypto wallet owns a lot of Ethereum, funded by borrowing, and as the price of Ethereum dropped the account became undercollateralized and should have been liquidated. But it wasn't. Scaggs:

On Wednesday morning, the price of ether fell below the implied liquidation price. At the time that was said to be around $1,015.

So what happened? Why didn't the account get liquidated?

As the above tweet explains, it was an issue of "oracle update latency". … At risk of oversimplification, an "oracle" is essentially a data feed that helps smart contracts perform their function. In this case a service called chainlink puts prices on the blockchain so Aave's smart contracts can use them to operate.

This isn't the futures market, and updating prices on-chain is expensive. So they aren't refreshed in real time. Instead, chainlink updates the on-chain prices when the "off-chain" data deviates by 0.5 per cent or more from the latest update, or every hour.

When ether fell to around $1015, it would have triggered a sizable liquidation if it had met the criteria for the price to go on-chain.

But it didn't. It wasn't a large enough move compared to the price recorded in the prior on-chain update, and it didn't last for an hour. So instead of getting blown out of around $250mn in ether, the account got to live another day.

I dunno. Seems fine? "We check the prices every hour, and if you're undercollateralized at any hourly update we'll liquidate you" is kind of a reasonable thing for a broker to say. As a way to handle financial-market risk, it's just fine; the lender takes an hour of price risk, which is a lot less than lenders take in a lot of traditional financing businesses. Still it's not a particularly, like, futuristic thing for the broker to say? In the stock market, traders have computers that can check the price many times each millisecond. In crypto, the computers are famously slow and expensive, so checking the price every hour is the best they can do.

But I also think that often the way crypto works in practice is to take the problems of the banking system and make them much worse. If you don't like the financial system making leveraged speculative bets with your deposits, you might find yourself putting your money in some entirely unregulated crypto bank whose entire purpose is to make leveraged speculative bets with your money. Maybe that will work out great for you? I guess the good news is that if it works out poorly, the losses won't be socialized in quite the same way they were in 2008. The Federal Reserve and the US government are not going to bail out some crypto lending project. You'll just lose your money.

Here is Alex Mashinsky, the founder of crypto banking thingy Celsius Networks LLC, quoted in a Bloomberg Businessweek article from this January:

Mashinsky told Bloomberg Businessweek that Celsius is able to pay such high yields because it passes along most of its earnings to its users. He said it's the traditional financial system that's ripping people off by taking their deposits, using them to make money, and then claiming it can only pay tiny interest rates. "Somebody is lying," Mashinsky said. "Either the bank is lying or Celsius is lying."

This schtick works:

In testimonials posted last year on Twitter as part of a contest in which customers shared their "Celsius Story," many said they had entrusted Celsius with their life savings. One said he took out home equity and cashed in his work pension and his savings for his kids' education to put the money into the company's accounts. Another said it let him quit his job to move closer to his kid. One entry read: "I don't trust the banking system, but I trust #Celsius."

As that article explains, the basic idea of Celsius is that you can deposit your cryptocurrencies with Celsius — essentially, lend them to Celsius — and it will pay you a pretty high interest rate, or an even higher interest rate if you'll accept payment in its own CEL token. Or you can borrow cryptocurrencies from Celsius and pay it interest. Think about possible explanations for how Celsius could offer a higher interest rate on deposits than your local bank:

1. The bank is lying. 2. Celsius is lying. 3. Celsius is making riskier loans than your bank, which carry higher interest rates. Functionally, if Celsius is lending out cryptocurrencies, it is lending them to crypto speculators who want to make leveraged bets on those currencies. In particular, if it is lending out Bitcoins or other volatile cryptocurrencies, it is lending them to people who want to short those cryptocurrencies; if it is lending out stablecoins, it is lending them to people who want to get leveraged long volatile cryptocurrencies. Making leveraged speculative bets on volatile assets with limited trading histories is riskier than, you know, lending people money to buy houses, and so it carries a higher interest rate, which Celsius can pass on to its depositors. But it also means that those deposits are riskier: If Celsius doesn't get paid back, you are in trouble. 4. Much of banking regulation reduces the interest that banks can pass on to its depositors. If a bank has $100 of deposits and can lend out money at 5%, it can't just lend out $100 at 5%, collect 0.1% for its trouble and pass on 4.9% to depositors. A bank has capital requirements, meaning that if it has $100 of loans it will need to have, say, $10 of equity capital that requires some economic return, reducing the amount that can be passed on to depositors. It has liquidity requirements , meaning that if it has $100 of deposits it can't put them all into long-term loans; it has to keep some of the money in cash in case any depositors want their money back. It pays fees to the government for deposit insurance. Prudential regulators examine the bank and make sure its mix of business isn't too risky, which makes it less lucrative.

As we know from 2008, there are strong incentives, at a bank, (1) to fund as much of your business as possible with cheap deposits (that is: to be very levered), (2) to put as much money as possible into lucrative business rather than keeping it in the cash drawer, and (3) to choose risky lucrative businesses over safe boring businesses. But there are constraints on banks to stop them from going too far in that direction. One important set of constraints comes from regulation: Capital and liquidity and prudential regulation prevent banks from gambling too much with depositors' money. Another important set of constraints comes from transparency and reputation: Banks have to produce audited financial statements explaining, in some detail, what they are doing with their money; if the stuff they are doing is too weird then they'll have a hard time raising more money. Those constraints are imperfect! 2008 happened! People get mad at banks a lot! Still, the constraints exist.

Look, I think the economics of play-to-earn video games are self-evidently bad. If you are earning money, it has to come from somewhere , and what is Axie Infinity selling other than the gameplay itself? If 10% of players earn money by making the game more fun and exciting for the other 90% of players, who pay for a good experience, that's fine, and there is a long history of multiplayer games with economics like that, where most people play for fun but some people have the paid job of making the game more fun for everyone else. But if the game is advertised as a "play-to-earn" experience, as a route out of poverty, etc., then everyone is playing to make money from each other, which is only sustainable by constantly adding more new players, and it is a pure Ponzi.

But I also think that this is a standard, deep move in web3 economics. We have talked about this before. Traditional web platforms have "network effects" where a thing is more valuable the more people use it; this creates incentives to join the big platforms. But web3 platforms have "token effects" where early adopters get a lot of tokens that represent a sort of equity in the platform; this creates incentives to join platforms early. So web3 projects tend to have two related components:

1. A decentralized distributed system that (you hope) does something useful, and 2. A token that enables you to use the system and that goes up in value when the system becomes more popular.

The attraction of any web3 project, early on, will be a combination of those two things: You get to use a thing that you think is good, and also the early adopters will get rich if it takes off. In a frenzied crypto boom, the Ponzi element — the prospect of getting rich if the thing takes off — will tend to dominate, and most people will be in most projects for the money, not for the utility of the underlying thing. But eventually that has to flip ; Ponzis can't work forever. If your project gets established enough, if it offers real utility, if people are buying tokens to do the thing that it does rather than to speculate on the tokens going up, then you can transition from Ponzi economics to just regular old economics. People will buy the token because they can use it to do useful stuff, not because they hope more people will pile in and they can sell it for a profit.

This flip will probably happen gradually over time, but it might be crystallized in a broad market crash, and then you might go around saying things like "sometimes having to flush out people who are just in it for the money, that's just the system self-correcting," and that will make sense. I am not sure it does here.

A weird model for US cryptocurrency regulation would go like this:

1. Virtually all cryptocurrencies are securities, and sales of them to US retail investors are securities offerings under US law. Not literally all of them — Bitcoin is not a security — but many modern crypto projects are of the form "we will sell millions of dollars' worth of some token in order to fund our efforts to build a platform, and then the token holders will have an economic share in the growth of that platform." That looks like equity to me, and also I think to the US Securities and Exchange Commission. 2. Virtually none of those sales are registered with the SEC, making them illegal securities offerings. 3. The SEC has about a five-year backlog to notice, investigate, and sue the people who do those offerings.

This is a weird model because five years is just a lifetime in crypto. It's one thing for someone to do an offering of $10 million of some crypto token to build a project, and then the SEC calls them up and says "nope, give the money back." That's fine, you just give the money back. It's another thing for someone to do an offering of $10 million of some token to build a project, and build the project, and grow into a huge business, and do a series of follow-on offerings, and then the SEC calls them up after five years and says "this is all illegal."

Maybe it's fine? If you sell securities illegally, the main punishment is that you have to buy them back at the price you sold them for. If you run a short-lived scam that fizzles out, that is an expensive punishment; you have to give back all the money. If you run a hugely successful business that happens to have started with an illegal securities sale, it is not so expensive: If you sell your tokens for $1 and now they're worth $20, no one will take you up on your legally mandated offer to buy them back at $1.

Arguably this is a good regulatory model? The SEC lets everyone sell tokens illegally, and then the tokens that work out work out, while the ones that don't work out have to give the money back?

The US Commodity Futures Trading Commission is in the business of approving futures contracts on cryptocurrencies. The way these futures generally work, in the US, is that they are cash-settled. If I buy a Bitcoin future from you with a strike price of $30,000, at maturity we do not "physically settle" (where I give you $30,000 and you hand me a Bitcoin); instead, we just exchange cash for the difference. If at maturity a Bitcoin is worth $32,000, you pay me $2,000; if it's worth $27,000, I pay you $3,000.

To do this sort of cash settlement, you need a reliable reference price for Bitcoin: We need to cash settle against some official price of Bitcoin. Particularly back when Bitcoin futures were just getting started, US regulators worried that the markets for Bitcoin were too opaque and manipulated to generate a reliable official price; the SEC still won't approve spot Bitcoin exchange-traded funds because of worries like that. But the CFTC eventually did approve some cash-settled Bitcoin futures products because it got comfortable that the underlying markets for Bitcoin were good enough.

Last Friday the CFTC sued Gemini Trust Co. for allegedly lying about how good those markets were, as part of its efforts to get a Bitcoin futures contract approved in 2017:

The complaint alleges that from approximately July 2017 to around December 2017, Gemini, directly and through others, made false or misleading statements of material facts, or omitted to state material facts, to the CFTC during an evaluation of the potential self-certification of a bitcoin futures contract by a designated contract market (DCM). The proposed bitcoin futures contract was to be settled by reference to the spot bitcoin price on the relevant day as determined by an auction held on Gemini's digital asset trading platform (Gemini Bitcoin Auction).

According to the complaint, Gemini, directly and through the DCM, provided information to the CFTC concerning Gemini's trading platform and the Gemini Bitcoin Auction, and certain statements and information conveyed or omitted by Gemini were false or misleading with respect to, among other things, facts relevant to understanding whether the proposed Bitcoin Futures Contract would be readily susceptible to manipulation.

A non-fungible token is, at a minimum, a bit of code that lives on a blockchain that you can "own." When I put it like that it isn't very appealing. When I add that the code can point to a web server that hosts a JPEG image, it … doesn't sound that much more appealing? You "own" the JPEG in some very specific blockchain-y sense, but you don't actually own it, and anyone else can look at it or download it.

But this is dumb and trivializing, and really what an NFT is is a symbol of membership in some sort of online (or offline) community. The best and most valuable NFTs offer their owners real social benefits; owning an NFT in a popular series like CryptoPunks or Meebits gives you a sense of community, perhaps some intellectual-property rights, and a way to socialize with like-minded, uh, venture capitalists.

Owning an NFT in the Bored Ape Yacht Club series gives you a particularly valuable social experience: You get to have your Bored Ape stolen and then complain about it online, which lets you feel a sense of kinship with Seth Green and a bunch of venture capitalists who have also had their Bored Apes stolen.

The basic philosophical difference between the traditional financial system and the cryptocurrency system is that traditional finance is about the extension of credit, and crypto is not. That is an exaggeration in various ways, but I think that it is essentially true.

So consider the simplest aspects of these systems. Like money: A US dollar is, essentially, an entry on the ledger of a bank, representing that bank's debt to you. Basically every dollar that you own is someone else's debt to you. A Bitcoin is not. A Bitcoin is an entry on the decentralized ledger of Bitcoin; there is a fixed supply of Bitcoins; owning a Bitcoin is like owning a gold nugget; no debt is involved.

Or take trading. Every time you trade a stock, in the US, there is an extension of credit. You and I agree on a trade on Wednesday, and we actually settle — I give you the money and you hand over the stock — on Friday. In the meantime, there is credit risk: If I disappear you don't get your money; if you disappear I don't get my stock. The traditional financial system deals with this risk through layers of intermediation, trust and collateral requirements: My broker makes sure I'm good for the money, a clearinghouse demands collateral from my broker to make sure it's good for the money, etc. (And there is a plan to change this "T+2" settlement to "T+1," so we exchange the cash for stock on Thursday instead of Friday, reducing the credit risk.) Meanwhile in the crypto system the paradigmatic trades occur on the blockchain: You and I agree on a trade on some decentralized exchange, and I send you my stablecoins and you send me your crypto at the same time the transaction is agreed; the trade and settlement are simultaneous.

Many advocates of crypto like this; they think that crypto's philosophical uneasiness with credit is good. Money without debt — without fractional-reserve banking — is sounder, less inflationary and safer, they argue; trading with instant settlement is clearer and more logical and safer than trading with delayed settlement and credit risk.

But whether you like it or not this difference is deeply baked into the mechanics of crypto. In some sense the entities of traditional finance are people and companies, and their counterparties can make credit decisions based on thick sets of information about them. Your bank can look at your credit report and payment history before giving you a credit card; an investment bank can consider a hedge fund's track record and prospects of future business and risk-management protocols — and how much the bank's salesperson likes the hedge fund's manager — before extending it a margin loan. Also if you default on your credit card the bank can sue you and make the whole rest of your life difficult; if the hedge fund defaults on a margin loan the bank can blackball its manager from future business. In crypto the entities are blockchain addresses, and they are thinner.[1] You set up a wallet, you have a private key, the wallet interacts with other wallets, you don't know the names of the people who own those wallets, they don't know your name, and only what happens on the blockchain is relevant to any of your or their decisions. The bank knows where you live; the blockchain does not.

Still, credit is kind of an important part of a financial system? People want to borrow money to do stuff. Sometimes this is normal business or personal stuff: People want to borrow money to start a business or build a factory or buy a house or whatever. If crypto is going to displace or compete with the traditional financial system, it will need to find ways to do that sort of lending. This seems to me like a hard and rather unsolved problem in crypto, and I don't think a lot of people are taking out mortgages from the blockchain.[2]

But credit is also a very useful aspect of many forms of trading. People like to do trades that involve credit. Some people like to buy financial instruments (stock, cryptocurrencies, etc.) on margin: They put up some money of their own, borrow some money from their broker, and buy more stock than they can currently pay for. Or they like to do derivatives trades (swaps, futures) that have that basic profile: You put up a little bit of money to get exposure to a larger amount of some financial instrument. Or they like to trade options, which involve an extension of credit: If I sell you a call option on some stock, then I owe you the stock (in some circumstances), and you have to trust that I will actually be able to deliver it.

The crypto system is able to extend that sort of credit. That's relatively easy. Margin loans and futures and options are all forms of leverage that are (1) secured (2) by traded collateral and (3) subject to margin calls. If you buy $200 worth of stock with $100 of your own money and $100 of margin loans from a broker, the broker will feel fairly safe: It has $200 worth of stock to cover its $100 loan. If the stock goes down to $140, the broker will feel less safe, and will demand that you put up some more of your own money. If you don't do that quickly, the broker will sell the stock — perhaps for $120 — and pay itself back, no problem. (If the stock goes down to $80 quickly, that is a problem, but these are understandable problems and the broker will set the margin levels so that it is comfortable with the risk.)

And because crypto trades 24 hours a day, seven days a week, and is very tech-forward, crypto is pretty good at this sort of thing. All sorts of crypto trading platforms offer leverage like this: You can put up a little bit of money to buy a lot of exposure to some cryptocurrency, and the platform monitors the value of the cryptocurrency, and if it goes down the platform sells the cryptocurrency you own to repay its loan. And this can all be done automatically, 24/7. It is tricky because lots of crypto stuff is very volatile, and there is limited trading history, but it is all sort of in the category of solvable math problems. No thick sorts of credit extension are required: The trading platform doesn't have to know where you live or have a good personal rapport with you; everything can be automated and done "on-chain," based solely on the blockchain's knowledge of your crypto wallet.

In the traditional financial system, very few things work like this. One thing that mostly does is a margin account at a retail stock brokerage: If your stock declines, you will get a margin call, and if you don't post margin within a defined and fairly tight time frame your broker will sell the stock, and this really might all be done by a computer in a pretty formulaic way. But if you have a big enough account — if you are a big hedge fund or family office — it doesn't work that way. When Credit Suisse Group AG decided that Archegos Capital Management did not have enough collateral in its margin account, a Credit Suisse representative called Archegos and asked it to post more collateral, and Archegos said, sorry, we are really busy this week, let's discuss next week. In theory Credit Suisse could have liquidated Archegos's positions, but in practice that would have been rude, so it didn't. Credit Suisse did not extend credit to Archegos based on some defined formulaic function of the value of its collateral; Credit Suisse extended credit to Archegos based on some fuzzy holistic relationship-based function of how much business it hoped to do with Archegos, how much the Credit Suisse people liked the Archegos people, how its traders felt about the collateral, when its risk committees had meetings, stuff like that.

But that's not even the main reason I'm bullish. The main reason is that a lot of crypto projects look a lot like securities, under US securities law, and are generally sold to US retail investors without registration with the US Securities and Exchange Commission. Under former chair Jay Clayton, the SEC regularly went after crypto projects for doing unregistered securities offerings; under current chair Gary Gensler, it does less of that.

But the basic remedy for doing an unregistered securities offering is that you have to buy the securities back at the price you sold them for. As long as cryptocurrencies mostly go up, this is not too big a worry: If you sell a bunch of SecurityCoins for $10 each, and they go up to $20, nobody is going to demand that you buy them back for $10. But if they go down to $0.06, everyone will, and it might be easier for them to prove that the coins were securities than it is to prove that you were doing fraud.

We have talked a few times recently about Terra, the blockchain ecosystem whose algorithmic stablecoin blew up earlier this month. One model of Terra goes like this:

1. Terra is a company. Not really — it's a decentralized finance ecosystem, a blockchain, a bunch of independent developers working on diverse projects — but let's just pretend for a minute. (In fact there is a company-ish thing called Terraform Labs which helps run Terra, and another company-ish thing called Luna Foundation Guard that keeps some of Terra's money, but here I want to conceive of Terra as a whole as sort of a distributed company.) 2. The Luna token, which powers the Terra blockchain and is the currency of its ecosystem, is the equity of Terra, the stock in the Terra company. 3. The TerraUSD stablecoin (or UST), which was supposed to always be worth a dollar, and which maintained that peg by being exchangeable for $1 worth of Luna at market prices, is the debt of Terra. Like bonds of the company, or like deposits of a bank.

This model has a lot going for it. UST, certainly, looks like debt: You buy a UST for a fixed amount ($1), and you expect to get back that fixed amount ($1), and while you hold it you earn interest. (For a while, you could get 19.5% interest on UST in the Anchor protocol, a part of the Terra ecosystem.) It was advertised as a safe investment, a way to participate in the Terra ecosystem with a guarantee of getting your money back.

Luna, meanwhile, looks like equity. It has no fixed value; it went up as optimism about Terra grew, and went down as Terra imploded. Luna could go to zero if Terra failed, or it could go to the moon if Terra became the world's dominant financial system. There was no floor and no cap on Luna's value (unlike UST, which was floored and capped at $1); it was just worth some fraction of the future value of the Terra ecosystem.

There are some implications of this model. One implication is that you might think: Wait, if these coins are the debt and equity of a company, aren't they securities? If they are securities, and they were sold to US investors, aren't they required to be registered with the US Securities and Exchange Commission? If they are securities that were sold broadly to the general public and then lost almost all of their value, shouldn't the SEC investigate? If big US crypto trading firms and venture capitalists were buying huge piles of Luna from Terra's promoters and dumping them to retail buyers on exchanges while also talking up Terra, making billions of dollars for themselves while they "cash[ed] out on the backs of retail," weren't those big investors breaking US securities laws? Weren't they underwriters of an unregistered securities offering, and shouldn't they have to buy those coins back from those retail bagholders at the prices they paid? These seem like good questions! Some of the answers might be "no" — Terra is not actually a company, and while Luna and UST are like securities it is not obvious that they are securities — but I think they're good questions. I will not pursue them further here but, you know, something to think about. If you work at the SEC for instance.

Here I want to talk about a different implication. Like I said, Terra blew up this month. The price of Luna fell from over $100 in March to a tiny fraction of a penny today, and through the workings of UST's algorithmic peg, trillions of near-worthless Luna were issued to UST holders who were trying to get out. Meanwhile UST, which was supposed to always be worth a dollar, traded as low as 5 cents.

If Terra were a company, you might describe this situation as a bankruptcy. And there would be reasonably well-understood procedures for what happens to the debt and equity in a bankruptcy:

1. If there's money around, it goes to paying off the debt. 2. If there's not enough money to pay off the debt, then the equity is extinguished; all the equity holders get nothing. 3. If the equity is zeroed and there's something left over — if there's some valuable business that can be run as a going concern — then the debt holders get it. They get equity in the new, post-bankruptcy entity, to compensate them for not getting paid back. 4. Generally that new entity will need to pay managers, maybe raise new money, etc., so the old debt holders won't own 100% of its equity: The managers, new investors, etc., will get some, as an incentive to keep working at this business that is now owned by its creditors. 5. But in general the old equity holders won't get much of the new company, and usually they'll get none of it.[1] The debt holders will have absolute priority over the equity holders; they need to be made whole before the equity holders get anything.

You could apply that thought process to Terra. Terra went bankrupt , in the sense that its value is not enough to support all of the debt claims (TerraUSD) against it. But Terra still has some value , in the sense that there is a blockchain ecosystem that Terra impresario Do Kwon and other people are trying to keep alive. In theory, at least, people used (and could still use) Terra as an ecosystem for building decentralized applications, transferring money, creating a new financial system, etc.; the price of Luna reflected people's optimism in Terra as a platform for building those things. Then UST had a death spiral, which should certainly undermine your confidence in Terra — its main app was an algorithmic stablecoin, which worked terribly — but might not totally eliminate it. "What we should look to preserve now is the community and developers that make Terra's blockspace valuable," tweeted Kwon, shortly after the death spiral, and I guess some people agree with him.

If Terra is a company, then the developers and community and apps are in a sense its employees and projects, and those projects might have positive value even if the company was washed away by debt. In a classic bankruptcy, the creditors would be handed control of the company: The employees would keep working, the projects would keep happening, but now the profits would go to the creditors instead of the old owners.

But in a … crypto bankruptcy? … there is no guarantee of that. There is no guarantee of anything. Everything is being reinvented from scratch. There are some proposals, and there's a vote of Terra validators — sort of an indirect vote of Luna holders — and then something does or doesn't happen. Here the proposal was to start over with a new blockchain, abandoning TerraUSD, and it was approved. The new blockchain will have a new Luna token: again, roughly "equity" in the new blockchain. And just as in a bankruptcy, New Luna will be distributed to some combination of (1) claimants on the old blockchain, tha

I feel like the sophisticated answer here is something like, "Sure, it would be a house." Like I think that what is interesting about the idea of a "non-fungible token" is the possibility of linking some non-fungible thing in the real world, or some non-fungible slice of some real-world thing, to some transferable digital representation. And there is a strand of crypto thinking that is like "we are going to build a new financial system that will take over the entire job of financing and paying for the real world," and in this vein you need to think about ways to represent real economic activity. You want ways to digitize ownership of houses and factories and the contents of particular shipping containers and stuff like that.

And a lot of people who come to crypto with this way of thinking are like, well, we'll start by building out the digital primitives first, and then we'll figure out ways to associate them with real-world objects. So we'll figure out a way to build and trade non-fungible tokens, starting with tokens that are just empty nonsense, but then once we have that technology, we can work on trading tokens that are not empty nonsense. So one day instead of getting the title to your house through some archaic title registry where you have to go down to the basement of a courthouse and leaf through ancient paper documents and figure out if there are liens on the house, it will all be on the blockchain and home sales will be easy and you can own a fraction of a home and get a mortgage instantly, etc., etc., etc. And I am not saying that I expect all that stuff to happen in the near term, but it is at least an interesting vision for something, and the concept of "non-fungible token" is part of it.

And that is more or less this. You have some class of not-quite-fungible things in the real world, reservations for particular dates in particular rooms of particular hotels. People want reservations mostly for normal consumption reasons, not for unhinged speculation, but (1) their plans might change, etc., so they might want to be able to resell them and (2) sure I guess you could speculate on the future price of hotel reservations, why not. So it is good to create a liquid secondary market for reservations: It is better for buyers than an alternative of nonrefundable reservations (because they can resell if their plans change), it is better for hotels than an alternative of freely refundable reservations (because they get certainty of income), and, who knows, it might attract a new class of buyers (hotel-room speculators, high-frequency hotel-room market makers, whatever).

Of course the hotels could just offer nonrefundable-but-transferable reservations; if I reserved a room and then sold it to you, we could call up the hotel and tell them that you're coming in my place. But this could be an administrative hassle for the hotel; better for the hotel if some third party keeps track of the reservation, runs the marketplace, and just tells the hotel who is going to show up. Also having a third-party platform do it makes it easier for people to trade reservations across different hotels. You can cancel at one hotel and book at another, or maybe you are doing a complex arbitrage trade where you get long an ocean-view suite and hedge your risk by shorting three parking-lot singles, I don't know.

Of course you could build a trading platform for hotel reservations, sign up hotels and customers to use it, and skip the entire concept of an "NFT." (Like StubHub, which is a platform for trading tickets , not NFTs "of" tickets.) The platform could keep a centralized database of reservations (by arrangement with the hotels), you could trade by going through the platform, you don't need a blockchain. But there are some commonly asserted advantages to a blockchain that might be relevant here. If the hotel reservations are NFTs on a blockchain instead of just entries in Pinktada's database, then in theory other people could build competing trading platforms for the same reservations, or you could sell your reservation-NFT off the platform. Or competitors could act as market makers on Pinktada's platform and be able to compete on equal terms. An open permissionless decentralized blockchain might be good for hotel-room liquidity, which I suppose is the goal here.

Here is a cryptocurrency insider trading scandal that I would like to see:

1. There is some crypto project that does something. People work together to build something that adds value to the world, and there are tokens that represent some form of economic interest in that project. If the project succeeds and the underlying product is widely used and beloved, the tokens will be valuable; if the project fails, the tokens will be worthless. 2. Something good happens at the project. A trial version of the product works really well, some regulatory approval is received, some big business decides to use the project, whatever: Some event occurs that materially increases the probability that the project will succeed and, thus, that the token will be valuable. 3. After the event happens, but before it is publicly announced, some insider of the project buys a bunch of tokens. 4. Then the event is announced publicly, the tokens go up, and the insider gets rich from her well-timed token purchases.

There is nothing particularly novel or interesting about this; this is just insider trading. Just normal insider trading. Happens at companies all the time: A company has good quarterly earnings or a good drug trial or lands a big customer or whatever, an insider buys stock, the news comes out, the stock goes up, totally normal stuff. Illegal stuff! But normal.

Here is the crypto insider trading scandal that I actually see, repeatedly:

1. There is some crypto project. Maybe it does something, but this is irrelevant to the discussion. 2. What is relevant is market depth: If you can sell the project's token to more people, then it will be more valuable. In particular, if it is listed on one of the big cryptocurrency exchanges, the price will go up, because more people will buy it, independent of any considerations about what the token actually does or whether the project will ultimately succeed. 3. The project's token gets listed on a big exchange. 4. While the listing is being considered, but before it is publicly announced, somebody — presumably an insider of the project or of the exchange — buys a bunch of tokens. 5. The token lists on the exchange, the price goes up, and the insider gets rich from her well-timed token purchases.

In a sense this is novel and interesting because crypto tokens are (at least sometimes) not securities, everything happens vaguely offshore, and the law of insider trading in this area is underdeveloped and arguably unclear. It is also interesting because the insider trading tends to occur on public blockchains, which means (1) everyone can see the concentrated well-timed trades right before the listing event but (2) you can't necessarily tie the wallet doing those trades to the actual person involved (to see if it's an insider, etc.). But the inside information is always fundamentally about the exchange , not about the project. The core inside information is never "the fundamental value of this token has increased," always "we can sell this token to more people." It is a dispiriting sort of insider trading.

Look, this exists in traditional finance. There was a fun 2020 case against an S&P Global Inc. manager who allegedly traded on inside information about what stocks would be added to indexes; information about liquidity and demand can be material, just like information about the actual business. But this is rare; most of the material information about stocks is information about the business. In crypto it is the reverse.

Two weeks ago an algorithmic stablecoin called TerraUSD (or UST) blew up, incinerating tens of billions of dollars of market value. The idea of an algorithmic stablecoin is that it should always be worth a dollar because of an arbitrage mechanism in which one stablecoin can always be exchanged for a number of units of some other crypto token — for TerraUSD, it was called Luna — with a market value of $1. If that other token (Luna) is worth $100 or $10 or $1 or $0.10, that works fine; if the stablecoin trades below $1, you buy it for $0.97 or whatever and redeem it for some Luna that you can sell for a dollar, making an arbitrage profit and pushing the price of the stablecoin back to $1.

The problem is twofold. One is that, if people want to redeem a lot of the stablecoin, the algorithm will print a lot of the other token (Luna), which will tend to drive down the price of that token, which might undermine confidence in the stablecoin, which might lead to more redemptions, which will lead to more printing, which will drive down the price, etc., in what is called a "death spiral." This is a very well-known problem that long predates crypto; companies have for years issued bonds that are convertible into fixed dollar amounts of stock, which are called "death-spiral convertibles" and have the same problem. The other problem that is more specific to crypto is that the other token — Luna — is just made up, and its value is tied to confidence in the stablecoin. If a death spiral starts, there is nothing to underpin the value of that token, so it can go to zero fast. Luna was trading in the $80s in early May; it's at about $0.0002 today. TerraUSD is below 7 cents.

I want to emphasize here that:

1. This problem is extremely, extremely well known. 2. Algorithmic stablecoins have death-spiraled in the past in extremely public and predictable ways. 3. Lots of people loudly predicted that TerraUSD would death-spiral in exactly this way. 4. It did.

But I guess we're gonna keep going until we get it right. Or until we get it wrong a bunch more times: ... Look I don't actually think this is impossible. When we first talked about TerraUSD last month, I liked the idea of the Luna Foundation Guard and its pool of money. The point is that you build up a valuable algorithmic stablecoin on a wave of investor confidence, and then you use that value to build a sort of foreign-exchange reserve fund. You can print Luna for free, so if people value Luna you should print a bunch of it and exchange it for things that (1) people also value and (2) are uncorrelated to Luna. You buy $10 billion of Bitcoin or Ethereum or Treasury bills or gold or whatever and, if the stablecoin goes down, you spend some of that reserve fund to buy the stablecoin and prop up the price. If you build a big fund and show a willingness to deploy it, then no one will doubt your stablecoin, so you won't have to spend the fund, so your other token (Luna, Tron, whatever) will appreciate, so it will all work in a self-sustaining way. "The basic structure of the trade," I wrote, "is (1) Ponzi, (2) acceptance, (3) diversification, (4) permanence."

I don't think this strategy is crazy! I mean, of course it's crazy, but I do think it could work. (Does it … sort of … describe the history of fiat currency?) It's just, you know, if you slip up on the way to permanence, you vaporize tens of billions of dollars. And it's extremely easy to slip up, because in the early going the only thing underpinning the value of your stablecoin is confidence in your system. And people keep slipping up.

One popular theory of contagion is about stablecoins. Not algorithmic stablecoins, which try to be worth a dollar without holding any dollars, and which can crash to zero with surprisingly little impact on anything else, but "backed" stablecoins like Tether and USD Coin, which try to be worth a dollar by holding roughly $1 of dollar-denominated financial assets (commercial paper, Treasuries, bank deposits, etc.) for each $1 of stablecoins they issue. If there is a run on one of those stablecoins, then they will need to sell their underlying assets, which, if the coins are big enough, could cause the prices of those assets to go down.

When we discussed this, I wrote that "at a high level you could argue that Tether is one of the more important crypto projects in terms of having an effect on the real economy," just because it purportedly buys so much commercial paper, meaning that it effectively lends billions of dollars to (presumably non-crypto) companies to fund their operations. On the other hand, lots of people have their doubts about Tether, in part because it bizarrely refuses to disclose much about its holdings, and because there is curiously little evidence about what Tether — which seems to be one of the world's biggest buyers of commercial paper — actually buys.

In that vein, here is a new paper by Sang Rae Kim at Yale on "How the Cryptocurrency Market is Connected to the Financial Market":

The cryptocurrency market is connected to the traditional financial market through reserve-backed stablecoins. A one standard deviation ($320 million) increase in the issuance of major stablecoins (Tether and USD Coin) on a given day results in a 10.7% increase in the commercial paper issuance quantity, a 20 basis point decrease in the commercial paper yield, and a 15 basis point decrease in the Treasury yield the following day. This shows that the exponential growth of stablecoins created an excess demand for short-term money-like safe assets such as commercial paper and Treasury. I also explore the fiat cryptocurrency market's effect on the commercial paper market. A one standard deviation increase in the market capitalization growth of major fiat cryptocurrencies (Bitcoin, Binance Coin, and Ethereum) on a given day results in an 11.9% decrease in the commercial paper issuance quantity, a 20 basis point increase in the commercial paper yield, and a 18 basis point increase in the Treasury yield the following day. This result suggests that investors exchange stablecoins for fiat cryptocurrency when the fiat cryptocurrency market is doing well, lowering the demand for stablecoins and thus commercial paper.

Don't worry too much about the details there. The point is that Medjedovic did a couple of individually irrational transactions (buying UNI tokens for much more than the market price, selling Sushi tokens for much less than the market price) in order to manipulate the contract to give him more money. Is that market manipulation? Sure, I dunno, why not; if you do that in the US stock market then the Securities and Exchange Commission will at least look into it. A hallmark of market manipulation is doing an individually irrational trade in one place in order to make money somewhere else. That isn't a definition of market manipulation — it is not illegal to do irrational trades — but it is a rough guide to recognizing market manipulation.

On the other hand he didn't do this in the stock market, the precedents here are slim, and, as he says, he "interacted with the smart contract according to its very own publicly available rules." The subjective meaning of the smart contract and the objective code of the smart contract were different. I think it is possible for a judge — or for you and me — to know what the subjective meaning was, to conclude "whatever the smart contract actually allows, it wasn't supposed to allow this." As a former lawyer and a traditional finance guy, I am used to that idea and not bothered by it. But in the crypto world there are still, even now, code-is-law types who think that the only thing a smart contract could mean is what it says. In the crypto world, it is not at all clear that Medjedovic did anything wrong.

Even ignoring the blockchain stuff, though, this is kind of a weird case: The borrower admittedly (1) borrowed money (2) secured by his ape and (3) did not pay it back on time, so the lender seized the ape. Seems fine! But the borrower's claim is effectively that he was supposed to have more time to repay the loan, that the combination of their past dealings and their ongoing negotiations for a new loan made it unfair to hold him to the deadline at the last minute.

The thing that it reminds me of most is actually Greensill and Bluestone. Greensill Capital was nominally in the business of providing short-term financing to companies secured by their accounts receivable. Company X sells $10 million of widgets to Company Y on credit, Company Y promises Company X to pay within 60 days, Company X sells that receivable to Greensill for $9.9 million or whatever, that sort of thing.

Greensill did a weird extension of this where it started financing companies' prospective receivables. Greensill would say to, for instance, coal producer Bluestone Resources Inc.: "Hey, you'll probably sell $10 million of coal to Company Z someday , so we'll lend you $9.5 million now, secured by that future receivable." Sixty days later, if Bluestone had not sold any coal to Company Z, Greensill would just roll the loan, charging a bit of interest and extending the loan for 60 more days. It would do this even if Bluestone had no relationship at all with Company Z; it would do this for years.

For Bluestone, this felt like a long-term unsecured loan; this was money that Bluestone kept for years, not linked to any particular cash flows. But technically it was a very short-term loan. Greensill could decide at any time not to roll it over, and then Bluestone would have to come up with cash on short notice. But Bluestone got used to rolling over the loans, and was not prepared to come up with the cash on short notice. And then Greensill imploded, and Greensill's liquidators called up Bluestone for the money, and Bluestone got very aggrieved and sued Greensill, saying in effect "this short-term loan was really a long-term loan, so you can't ask for your money back." This kind of worked for Bluestone, and I guess it worked for this ape owner too.

In 2008 the prices of some structured credit products built out of subprime U.S. mortgages went down, and as a result there was a global recession and millions of people lost their jobs. If you had asked a normal person in 2007: "How would it affect your life if it turns out that investors have mispriced the super-senior risk in synthetic collateralized debt obligations built out of subprime mortgage tranches," that person would have said "I have no idea what you are talking about, but I can't imagine how that collection of words would affect me." But it did. Loosely speaking, the mechanism was that the people (often banks or shadow banks) who owned subprime CDOs (1) also owned other stuff and (2) had borrowed money to buy that stuff. When their CDOs collapsed, they had to sell other stuff to pay off their debts, which drove down the prices of other stuff, which led to broad market contagion, which destroyed a lot of wealth, which reduced economic activity, etc. Meanwhile the banks had lost money and were more risk-averse and less able to lend, which also reduced economic activity. And so normal people lost their jobs because of contagion from some weird financial asset that they hadn't even heard of.

If you asked a normal person, you know, two weeks ago: "How would it affect your life if the prices of some monkey JPEGs and algorithmic stablecoins crash," I think most people would reasonably have said "I do not own a monkey JPEG and do not aspire to own one, so this will not affect me at all." My guess is that they would have been right. My guess is that the real world is not too affected by the crypto world, and that if crypto prices crash there will not be a ton of contagion in the rest of the financial system. But I think it is, at this point, debatable. Crypto has at least started to work its way into the real financial system. Some traditional investors also own crypto; if their crypto goes down they might have to sell regular stuff. Some public companies are exposed to crypto (because they are crypto exchanges, because they have levered crypto holdings, etc.), so your boring old index fund might go down when crypto goes down.

Ten years ago, if you had waved a magic wand and every cryptocurrency went to zero, not much would have happened. A few oddballs experimenting with a newfangled money called Bitcoin would have seen their experiment fail. "Oh well, that was cool for a while," they would have said.

Five years ago, if every cryptocurrency went to zero, a lot of people would have lost a lot of money. But they would mostly be crypto people: Some individuals and some hedge funds that bought crypto would lose their money. The contagion to the real financial system would have been small. Lamborghini dealerships would have a rough year. But most people would barely notice.

Five years from now, if every cryptocurrency goes to zero … well, I don't know what the next five years will be like, but a plausible story (as of last week anyway!) is that there will be continuing integration of crypto into the real economy. More crypto companies will be big and important and intertwined with other companies; their stock will be in the indexes and they will borrow money from banks and use their own money to finance real businesses. More traditional investors will own crypto, and will make levered bets on crypto, and if those bets blow up they will naturally sell more liquid traditional assets, causing contagion from crypto markets to stock and bond markets. Crypto platforms will be used for real economic activity; ordinary people will invest their savings in those platforms, and those investments will be used to finance real, non-crypto business activity. You'll get your mortgage from a decentralized finance platform or whatever.

This is a very bullish story for crypto; in this story, broad institutional adoption and growing utility will be good for the popularity, and prices, of crypto. And then if there's a break in crypto — if there's a run on a stablecoin, if there's a rug-pull in a popular DeFi project, if all the apes gone — that break will naturally spread to the broader financial system, and that will be a sign of crypto's success. Ideally there would not be a lot of breaks; that would also be a sign of success. But a sign of failure would be if crypto projects keep blowing up and nobody outside of those projects notices. That would be a sign that crypto isn't good for anything, that it cannot provide benefits to the real world. If crypto can be good for the real world, then crypto prices going down should be bad for the real world.

An "algorithmic stablecoin" sounds complicated, and there are a lot of people with incentives to pretend that it is complicated, but it is not. Here is how an algorithmic stablecoin works[1]:

1. You wake up one morning and invent two crypto tokens. 2. One of them is the stablecoin, which I will call "Terra," for reasons that will become apparent. 3. The other one is not the stablecoin. I will call it "Luna." 4. To be clear, they are both just things you made up, just numbers on a ledger. (Probably the ledger is maintained on a decentralized blockchain, though in theory you could do this on your computer in Excel.) 5. You try to find people to buy them. 6. Luna will trade at some price determined by supply and demand. If you make it up on your computer and keep the list in Excel and smirk when you tell people about this, that price will be zero, and none of this will work. 7. But if you do a good job of marketing Luna, that price will not be zero. If the price is not zero then you're in business. 8. You promise that people can always exchange one Terra for $1 worth of Luna. If Luna trades at $0.10, then one Terra will get you 10 Luna. If Luna trades at $20, then one Terra will get you 0.05 Luna. Doesn't matter. The price of Luna is arbitrary, but one Terra always gets you $1 worth of Luna. (And vice versa: People can always exchange $1 worth of Luna for one Terra.) 9. You set up an automated smart contract — the "algorithm" in "algorithmic stablecoin" — to let people exchange their Terras for Lunas and Lunas for Terras.[2] 10. Terra should trade at $1. If it trades above $1, people — arbitrageurs — can buy $1 worth of Luna for $1 and exchange them for one Terra worth more than a dollar, for an instant profit. If it trades below $1, people can buy one Terra for less than a dollar and exchange it for $1 worth of Luna, for an instant profit. These arbitrage trades push the price of Terra back to $1 if it ever goes higher or lower. 11. The price of Luna will fluctuate. Over time, as trust in this ecosystem grows, it will probably mostly go up. But that is not essential to the stablecoin concept. As long as Luna robustly has a non-zero value, you can exchange one Terra for some quantity of Luna that is worth $1, which means Terra should be worth $1, which means that its value should be stable.

All of this is, I think, quite straightforward and correct, except for Point 7, which is insane. If you overcome that — if you can find a way to make Luna worth some nonzero amount of money — then everything works fine. That is the whole ballgame. In theory this seems hard, since you just made up Luna. In practice it seems very easy, as there are dozens and dozens of cryptocurrencies that someone just made up that are now worth billions of dollars. The principal ways to do this are:

Collect some transaction fees from people who exchange Luna for Terra or Terra for Luna, and then pay some of those fees to holders of Luna as, effectively, interest on their Luna holdings. (Or pay interest on Terra, creating demand for Luna that people can exchange into Terra to get the interest.[3]) Talk about building an ecosystem of smart contracts, programmable money, etc. on top of Terra and Luna, so that people treat Luna as a way to use that ecosystem — as effectively stock in the company that you are building and ascribe a lot of value to it.

These things reinforce each other: The more fees you collect and distribute to Luna holders, the more big and viable your ecosystem looks, so the more highly people value it, so the more Luna they buy, so the more activity you have, so the more fees you collect, etc.

But there is no magic here. There is no algorithm to guarantee that Luna is always worth some amount of money. The algorithm just lets people exchange Terra for Luna. Luna is valuable if people think it's valuable and believe in the long-term value of the system that you are building, and not if they don't.

The danger here is that Point 7 never goes away. Any morning, people could wake up and say "wait a minute, you just made up this all up, it's worthless," and decide to dump their Lunas and Terras.

If people decide to dump their Lunas then the price of Luna goes down.

If people decide to dump their Terras — "wait," you say, "there's an algorithm; the price of Terra can't go down." If people decide to dump their Terras, then the price of Terra goes down from $1 to like $0.97, and arbitrageurs step in, buy Terras for $0.97 and exchange them for $1 worth of Luna.

Yeah. Well. The problem is that if people lose confidence in this system, they decide to dump both Lunas and Terras. Someone sells some Terras. Arbitrageurs step in, buy Terra for $0.99, and exchange it for $1 worth of Luna. Luna is at, say, $40, so each Terra gets you 0.025 Luna. Then the arbitrageurs sell their 0.025 Luna in the market, which drives down the price of Luna, which is falling anyway. Someone else sells some Terras, but now Luna is at $20, so each Terra gets 0.05 Luna, which arbitrageurs sell, and now Luna is at $10, so each Terra gets you 0.10 Luna, which then get sold, so Luna goes to $5, so each Terra gets you 0.2 Luna, etc. There is no natural stopping point for this process because Luna is just a thing you made up , and because it represents essentially confidence in your ecosystem, and as the price of Luna crashes that confidence ebbs away. And so eventually Luna trades at $0.0001 and you exchange one Terra for 10,000 Luna and you try to sell them and there are no buyers and so no one wants to arbitrage the price of Terra and so the price of Terra falls below $1 and everyone gives up on the stablecoin and the ecosystem and everything and it all goes to zero.

The technical term for this is a " death spiral." Fun fact, that term is also used for something called "death spiral financing" or a "death spiral convertible" in traditional finance, which works exactly the same way. A "death spiral convertible" is a bond of a company that converts into stock of that company at a floating exchange rate, so that each $100 bond converts into $100 worth of stock at whatever the market price is. If the stock is at $40, each bond converts into 2.5 shares, worth $100. If the company's profits are good and the stock price is stable, no problem. But if the company is running out of money and can't pay back the bond, then the stock drops, one bond converts into lots of shares, selling the shares pushes the stock down more, converting another bond produces even more shares, which get sold and push the stock down more, until eventually the stock is at $0.0001 and each bond converts into a million shares and there are no buyers for those shares and it's all worthless.

I guess it is time to talk about algorithmic stablecoins again. Terra, or UST,[1] is an algorithmic stablecoin whose price is maintained by an arbitrage relationship with another cryptocurrency, Luna. One UST is supposed to be worth one US dollar, and one UST can always be exchanged for a floating quantity of Luna with a market value of $1. If a UST is trading at $0.99, you can buy it for $0.99 and then exchange it for $1 worth of Luna, making an instant profit. If it is trading at $1.01, you can buy $1 worth of Luna (for $1) and use it to buy a UST worth $1.01, making an instant profit. Because of this arbitrage relationship, while the price of Luna can fluctuate, the price of Terra should always be $1: If it trades above or below $1, people will exchange Terra for Luna or Luna for Terra until the price of Terra gets back to $1.

When we talked about Terra last month, I wrote:

On first principles this is insane. It relies on [Luna] always being worth something. If [Luna] trades at $0.01, you can print 10 million of them and buy 100,000 [Terra] and push the price up. But if [Luna] trades at $0.00, you can print infinity quadrillion of them and you're still not gonna be able to push up the price of [Terra]. If [Luna] is worthless, it cannot be used to support the price of [Terra]. And because you just made it up , there is no particular reason for [Luna] to be worth anything, so there is no particular reason for [Terra] to be worth a dollar. If I made up [Luna] and [Terra] on my computer and said to you "I will give you the number 10 billion in this Excel spreadsheet if you give me 1 million U.S. dollars," you would say no, and if I raised my offer to 400 quadrillion you would not change your mind.

Nonetheless! It works? The rough intuition here is that there is a lot of demand for stablecoins; there is particularly a lot of demand for Terra because Terraform Labs, the entity that created Luna and Terra, essentially pays 19.5% promotional interest on UST deposits. People want a stablecoin that is worth a dollar, so they are inclined to treat Terra as though it's worth a dollar, which makes it worth a dollar. They buy lots of Luna to turn into Terra, which means that the price of Luna goes up, which means that there is plenty of valuable Luna to support the price of Terra, which means that Terra is robustly worth a dollar.

The basic thing that makes Terra valuable is confidence in it. The essential source of this confidence is ... just sort of recursive social belief? If you think that everyone else will treat Terra as worth a dollar, then you will treat it as worth a dollar, and you won't sell it for $0.90 in a panic, which means that it won't go down to $0.90, etc. But if you think that everyone else will treat Terra as worth zero, then you will dump it as fast as you can at whatever price you can get, which means that it will go down below $0.90, etc.

Also there is an algorithm, but it is a complicated cloak thrown over these basic social facts. If one Terra goes down to $0.90, the arbitrage mechanism — you exchange one Terra for $1 worth of Luna, and then sell your Luna into the market for $1 — just doesn't work. You exchange one Terra for $1 of Luna, but confidence in Luna is also falling, and the market is being flooded with Luna as people try to do this arbitrage. So the $1 worth of Luna you received is no longer worth $1, and then the next person who redeems Terra gets even more Luna and has to sell even more of them, which drives the price down more, which increases the amount of Luna being issued, etc., in a "death spiral." There is no particular floor on this process, and it can go until everything is worth zero.

However! As we discussed last month, Kwon and the Luna Foundation Guard did a smart thing. During the virtuous cycle of Terra's existence, as its market capitalization grew and as Luna became more valuable, they used their valuable Luna to buy a bunch of Bitcoins. Luna is a creature of Terraform: If you lose confidence in Terra you will simultaneously lose confidence in Luna, and being able to exchange one Terra for infinity bazillion Luna will not do anything to prop up the price of Terra. But Bitcoin is an entirely separate thing. Terraform made up Terra and Luna, but somebody else made up Bitcoin. If people lose confidence in Luna and Terra, Bitcoin will still be valuable.

And so the LFG bought a bunch of Bitcoin and promised to use it to defend Terra's peg to the dollar. If one Terra goes down to $0.90, instead of turning Terra into Luna and selling them in a death spiral, the LFG can buy Terra for $0.90 and pay for it in Bitcoin. If the LFG has enough Bitcoin, and if Bitcoin's price holds up, then it can defend the peg and keep the price of Terra close to $1.

The point is that you print a lot of Luna when Luna prices are high and exchange them for Bitcoin. And then if Luna prices fall, you can use the Bitcoin to buy Terra and keep it at $1, avoiding a death spiral.

The way a gold mining company works is that it digs gold out of the ground and then sells it for money. Then it uses the money to, like, buy shovels and pay workers and pay dividends to shareholders. It would be a bit weird for a gold mining company to dig up the gold and then keep all of it forever. The gold mining business, as a business, consists of both digging and selling.

In general if you buy stock in a gold miner you are often betting on the price of gold: The mining company will probably make more money if the price of gold goes up. Sometimes miners hedge their gold production, though, selling gold futures (or buying put options, selling calls, etc.) to reduce the impact of future gold prices on their earnings. Some shareholders will like this, while others will prefer miners that are more levered to the price of gold.

Meanwhile I guess if you buy shares in a Bitcoin mining company you really want to bet on the price of Bitcoin. And while a Bitcoin miner's earnings are related to the price of Bitcoin, the relationship is not as direct as it is with a gold miner: Bitcoin miners do not actually sit on top of reserves of Bitcoins that belong to them; they compete with other miners to mine a global pool of Bitcoins. So apparently it is normal for Bitcoin mining companies to dig up their Bitcoins and not sell them? Just write some covered calls instead?

Publicly traded miners very much embrace the HODL, or "hold on for dear life," mantra, hoarding tokens to make their stock more appealing to investors seeking exposure to Bitcoin's gains. But these firms have major expenses; grinding through cryptographic puzzles to spawn new coins takes pricey computer hardware and giant power bills.

Instead of selling Bitcoin to raise money, firms like Marathon Digital Holdings Inc. are selling Bitcoin call options to wring money out of their holdings, turning to a yield-generating strategy deployed throughout conventional finance.

"Bitcoin miners are some of the most voracious yield seekers in the market today," said Joshua Lim, head of derivatives at New York-based brokerage Genesis Global Trading, which offers options overwriting strategies to the industry. …

Public miners have been on the lookout for yield-generating strategies to fund their rapid expansion without issuing new shares or debt.

I … I mean … gold miners and oil companies solve this problem by digging up the gold or oil and then selling it, but the crypto financial industry is more innovative.

Let me give you sort of like a really toy model of it, which I actually think has a surprising amount of legitimacy for what farming could mean. You know, where do you start? You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that's gonna replace all the big banks in 38 days or whatever. Maybe for now actually ignore what it does or pretend it does literally nothing. It's just a box. So what this protocol is, it's called 'Protocol X,' it's a box, and you take a token. You can take ethereum, you can put it in the box and you take it out of the box. Alright so, you put it into the box and you get like, you know, an IOU for having put it in the box and then you can redeem that IOU back out for the token.

So far what we've described is the world's dumbest ETF or ADR or something like that. It doesn't do anything but let you put things in it if you so choose. And then this protocol issues a token, we'll call it whatever, 'X token.' And X token promises that anything cool that happens because of this box is going to ultimately be usable by, you know, governance vote of holders of the X tokens. They can vote on what to do with any proceeds or other cool things that happen from this box. And of course, so far, we haven't exactly given a compelling reason for why there ever would be any proceeds from this box, but I don't know, you know, maybe there will be, so that's sort of where you start.

And then you say, alright, well, you've got this box and you've got X token and the box protocol declares, or maybe votes by on-chain governance, or, you know, something like that, that what they're gonna do is they are going to take half of all the X tokens that were re-minted. Maybe two thirds will, two thirds will offer X tokens, and they're going to give them away for free to whoever uses the box. So anyone who goes, takes some money, puts in the box, each day they're gonna airdrop, you know, 1% of the X token pro rata amongst everyone who's put money in the box. That's for now, what X token does, it gets given away to the box people. …

So, you know, X tokens [are] being given out each day, all these like sophisticated firms are like, huh, that's interesting. Like if the total amount of money in the box is a hundred million dollars, then it's going to yield $16 million this year in X tokens being given out for it. That's a 16% return. That's pretty good. We'll put a little bit more in, right? And maybe that happens until there are $200 million in the box. So, you know, sophisticated traders and/or people on Crypto Twitter, or other sort of similar parties, go and put $200 million in the box collectively and they start getting these X tokens for it.

And now all of a sudden everyone's like, wow, people just decide to put $200 million in the box. This is a pretty cool box, right? Like this is a valuable box as demonstrated by all the money that people have apparently decided should be in the box. And who are we to say that they're wrong about that? Like, you know, this is, I mean boxes can be great. Look, I love boxes as much as the next guy. And so what happens now? All of a sudden people are kind of recalibrating like, well, $20 million, that's it? Like that market cap for this box? And it's been like 48 hours and it already is $200 million, including from like sophisticated players in it. They're like, come on, that's too low. And they look at these ratios, TVL, total value locked in the box, you know, as a ratio to market cap of the box's token.

And they're like '10X that's insane. 1X is the norm.' And so then, you know, X token price goes way up. And now it's $130 million market cap token because of, you know, the bullishness of people's usage of the box. And now all of a sudden of course, the smart money's like, oh, wow, this thing's now yielding like 60% a year in X tokens. Of course I'll take my 60% yield, right? So they go and pour another $300 million in the box and you get a psych and then it goes to infinity. And then everyone makes money.

We talked yesterday about algorithmic stablecoins, in which a made-up crypto token is used to maintain the value of another crypto token at exactly $1. In particular we talked about TerraUSD, whose price is maintained by trading with another cryptocurrency called Luna, and about how Terra is diversifying its "foreign reserves," as it were, by buying Bitcoin and other cryptocurrencies. The idea is that as Terra has gotten big, it can buy other cryptos to defend its peg to the dollar, instead of relying on the value of Luna. I wrote: "The basic structure of the trade is (1) Ponzi, (2) acceptance, (3) diversification, (4) permanence."

This is a common way for algorithmic stablecoins to go, but there are other possibilities. For instance you could have a backed stablecoin (where each $1 stablecoin is backed by $1 in U.S. dollar bank accounts), or an overcollateralized stablecoin (where each $1 stablecoin is backed by, say, $2 worth of Bitcoin). And you could bop along doing that for a while, and everyone could be satisfied that it's always worth a dollar, and then you could transition it to being an algorithmic stablecoin. Keep $1 on hand for every coin until everyone treats your coin as being worth a dollar, and then start keeping $0.90 on hand, then $0.80, etc., keeping enough money to defend the peg but not enough to fully redeem every coin in every scenario.

This is more or less the strategy of another algorithmic stablecoin called Frax, whose founder Sam Kazemian emailed me yesterday:

I can see why you didn't include us as Frax goes against your entire narrative of (1) Ponzi, (2) acceptance, (3) diversification, (4) permanence since we start out at 100% collateralization and slowly have gone down to ~85% so far. Our own structure is 1.) not-ponzi, 100% backed normal bank 2.) acceptance, slowly unbacking 3.) permanence 4.) THEN finally ponzi like the Fed/USD. And go figure, FRAX has not lost its peg a single time.

Honestly one of the best reader emails I've ever received. And, yes, I suppose a plausible history of traditional banking would go something like "first backed, then accepted, then Ponzi."

Here is how an algorithmic stablecoin works. You invent two tokens, call them Dollarcoin and Sharecoin. You list them on the crypto exchanges. Sharecoin trades for whatever price is determined by supply and demand. It might be $0.01 per Sharecoin, or $1, or $100, who knows. But Dollarcoin is supposed to trade at $1. If it trades at $0.99, you have some automatic process in which you print more Sharecoins and use them to buy Dollarcoins until it is back to $1. If it trades at $1.01, you have some automatic process in which you print some more Dollarcoins and use them to buy Sharecoins until it is back to $1. The result is that Dollarcoin is firmly pegged to the dollar. The process is sometimes compared to algorithmic central banking, where the central bank maintains the value of the currency (Dollarcoin) by adjusting its supply.

On first principles this is insane. It relies on Sharecoin always being worth something. If Sharecoin trades at $0.01, you can print 10 million of them and buy 100,000 Dollarcoins and push the price up. But if Sharecoin trades at $0.00, you can print infinity quadrillion of them and you're still not gonna be able to push up the price of Dollarcoin. If Sharecoin is worthless, it cannot be used to support the price of Dollarcoin. And because you just made it up, there is no particular reason for Sharecoin to be worth anything, so there is no particular reason for Dollarcoin to be worth a dollar. If I made up Sharecoin and Dollarcoin on my computer and said to you "I will give you the number 10 billion in this Excel spreadsheet if you give me 1 million U.S. dollars," you would say no, and if I raised my offer to 400 quadrillion you would not change your mind.

On second principles, though, it's fine? I guess? Someone just made up Bitcoin, too, and it's worth a lot of money now. Also Dogecoin, etc. "I'll make up a digital currency out of thin air and try to get people to buy it, and they'll buy it and it will be an enduring store of value" is now a perfectly plausible and repeatable proposition.

You probably dress it up a bit. The way you dress it up will generally be with some sort of Ponzi-ing, because that is the main way for self-contained crypto projects to create value these days. You say "hey if you deposit Dollarcoins we'll pay you a 20% yield in Sharecoins," or "if you stake Sharecoins we'll give you a 20% yield in Sharecoins," or whatever, and the interest rate on this — the rate at which people are given new Sharecoins created out of thin air — is high enough that people get excited and do it for a trade, even if they understand that it's all made up.

The desired end state is, I think, that if you do this for like a decade and Dollarcoin becomes deeply integrated into a booming crypto economy, then everyone just accepts that it's worth a dollar and you don't have to work that hard to defend the peg. And so Sharecoin also keeps its value and the whole system maintains itself. You Ponzi your way to widespread acceptance, and then you maintain the value mostly through the widespread acceptance, not through the algorithmic peg mechanism.

On the other hand, this equilibrium feels quite unstable. Dollarcoin and Sharecoin are, in a fundamental way, correlated. One day people might wake up and say "wait you just made up this whole thing, what the heck, I am selling." And they'll sell their Dollarcoins, driving down the price of Dollarcoin and requiring you to print more Sharecoins to defend the peg, but they'll also sell their Sharecoins, driving down the price of Sharecoin and making it harder for you to defend the peg by printing Sharecoins. And as the price of Sharecoin goes down and the peg gets less stable, more people will lose confidence and sell, making it harder to defend, etc., in a self-reinforcing death spiral.

This happens a lot! We talked last year about Titanium, a partially algorithmic stablecoin, which had itself a nice death spiral.

One way out of this is just to power through and hope for enduring widespread acceptance; if nobody attacks the peg you don't have to defend it. But another way out is, once you have fairly good acceptance and your tokens are worth a lot of money, you diversify the peg defense mechanism. Instead of saying "we have a limitless pool of entirely made-up Sharecoins, and we will spend Sharecoins to maintain the price of Dollarcoin at $1," you say "we are a small country on the Continent of Crypto, and we have a central bank, and our central bank maintains foreign reserves, and we will spend those reserves to maintain the price of Dollarcoin at $1." You print some Sharecoins while the printing is good, you use them to buy like a billion dollars worth of Bitcoin, and then if Dollarcoin goes to $0.99 you can spend some Bitcoins to buy Dollarcoin and push up the price.

The advantage of this is that Bitcoin is not correlated to your project, to Dollarcoin and Sharecoin. I mean, it probably is, both in the sense that Bitcoin, Dollarcoin and Sharecoin all reflect some general "faith in crypto" and in the sense that the more Bitcoin your project owns the more correlated you are to Bitcoin. But if people woke up tomorrow and said "wait you just made up Dollarcoin and Sharecoin," they would not necessarily lose confidence in Bitcoin, because someone else made that up. Bitcoin is not an intrinsic part of your project the way Dollarcoin and Sharecoin are, and your Bitcoin holdings will maintain value in states of the world where Sharecoin does not. So you have more robust ammunition to defend the peg, so the peg is more robust.

And then you are off to the races, your Dollarcoin becomes more widely used, your Sharecoin's price goes up, you use it to buy more Bitcoin and Ethereum and whatever else is good in crypto and eventually U.S. Treasuries and gold bars and all the other stuff of central banking. And maybe one day a Crypto George Soros attacks your peg and you have to spend a lot of Bitcoin and gold defending it, and maybe you fail, but you are working with real tools instead of just stuff you made up. You used the stuff you made up to buy the real tools.

Here's a good Wall Street Journal article about algorithmic stablecoins:

The esoteric topic of algorithmic stablecoins has become more mainstream with the startling rise of TerraUSD, the most popular such coin. …

Here's how TerraUSD works. If its price dips below $1, traders can "burn" the coin—or permanently remove it from circulation—in exchange for $1 worth of new units of another cryptocurrency called Luna. That reduces the supply of TerraUSD and raises its price. Conversely, if TerraUSD climbs above $1, traders can burn Luna and create new TerraUSD. That increases supply of the stablecoin and lowers its price back toward $1.

In other words, the collective efforts of traders seeking to make quick arbitrage profits should keep TerraUSD within a relatively tight band around $1. Luna effectively acts as a shock absorber for TerraUSD, buffering volatility in TerraUSD.

Launched in 2020, TerraUSD has mostly maintained its dollar peg—except during bouts of heavy volatility such as last spring's big crypto selloff. TerraUSD dropped below 92 cents on May 23, 2021, according to data provider CoinMarketCap. …

TerraUSD is the brainchild of Do Kwon, a South Korean crypto developer. A spokesman for Mr. Kwon's company, Terraform Labs, said he was unavailable for an interview.

During the past three months, Mr. Kwon has sought to allay concerns about TerraUSD losing its peg by funding a multibillion-dollar reserve of bitcoin and several other cryptocurrencies. The reserve is intended to act as an additional backstop against a severe drop in TerraUSD.

Mr. Kwon has also argued that it is unlikely TerraUSD's liquidity will vanish because of all the activity on the coin from numerous trading and lending projects.

Here's a trade you can't do:

1. Find a small publicly traded bank. Say it's a bank with $10 billion of assets, with an equity market capitalization of $1 billion. (These are realistic numbers; the market value of a bank's stock will generally be much lower than the value of its assets, because most of those assets are in effect owed to its depositors.[8]) 2. Buy 51% of the stock for $510 million or whatever. 3. Vote out the board, vote in a new board and make yourself the chief executive officer. 4. Take the $10 billion in the vault and send it to yourself, making $10 billion on your $510 million investment. 5. Smirk "what, I own the bank, I take the money, that's how it works."

That's not how it works, you can't do this,[9] if you did do it you would go to prison, but you'd be stopped well before that point. But in its outlines it is a tempting and elegant trade, and we have talked about variations that work a little better. (The guy we talked about did go to prison, though he did get the money first, so his version worked only a little better.)

The basic idea of the trade is that there exist in the world some very large pots of money — banks, insurance companies, asset managers, etc. — that are controlled by relatively small companies. It takes a smaller amount of money to buy control of the company, and then you get to decide what to do with the larger pot of money that the company manages. In the world of traditional finance, this is a well-known problem, and those pots of money tend to be very carefully regulated to guard against some opportunist taking control of them on the cheap and draining the money from the pot.

In crypto, etc. etc. etc. etc. etc. you know how this is gonna go. Here's Anthony Lee Zhang on Twitter:

Beanstalk, a moderately popular new algo-stable protocol, just got attacked for $80M

This one is a very interesting hack: rather than exploit a bug in the code, it was a "governance attack". My understanding is that holders of beanstalk equity token holders can vote on changes to the protocol: literally, chunks of code that are added to the protocol

The way an algo-stable works, there's an equity layer and a debt (stablecoins) layer, and possibly a bunch of reserves, so the equity layer effectively has control over a bunch of "stuff" that the protocol owns

Hence, a fairly simple attack:

1\. Propose a piece of code to the protocol that says "send the entire treasury to my address A"
2\. Buy a bunch of equity tokens and vote the change in
3\. Send the entire treasury to your address A

And here is CoinDesk's summary:

The attacker took out a flash loan on lending platform Aave which enabled them to amass a large amount of Beanstalk's native governance token, Stalk. With the voting power granted by these Stalk tokens, the attacker was able to quickly pass a malicious governance proposal that drained all protocol funds into a private Ethereum wallet.

Various crypto pots of money are controlled by governance tokens, and the market capitalization of the governance token is often a lot lower than the value in the pot, for basically the same reasons that the market capitalization of a bank is generally much lower than the value of the bank's assets. And the governance token can, by majority vote, decide what to do with the pot. (Sometimes — many pots are better designed than this!) And in crypto, you can often do a series of transactions as a single integrated transaction, in which you take out a flash loan to buy all the governance tokens, vote the governance tokens to give yourself the pot of money, use some of the pot to repay the flash loan and keep the rest for yourself — all at once. And so someone did.

Again: You could do exactly this trade with a bank , instead of a stablecoin, if banks were stupidly designed. But they are not!

[8] This is obvious to banking people but perhaps not to everyone: The way a bank works is that it takes deposits (and owes money back to depositors) and uses them to make loans, buy bonds, etc. A bank with $10 billion of assets might have $9 billion of deposits and $1 billion of equity value. It has $10 billion of stuff, it owes $9 billion back to depositors, so there's $1 billion left over, which belongs to its shareholders. The point is just that banks are very leveraged; they fund most of their assets with deposits, so the assets are worth way more than the equity value of the bank.

[9] Among other things because they don't keep the deposits in cash in the vaults, etc., though that is not actually as big an obstacle as it seems. The trick is to sell the bank's $10 billion of assets, lend the $10 billion to yourself instead, and use it to buy yachts. That trick also does not work, though, usually.

If you do some crime and get a lot of Bitcoins for it, and the authorities want to seize your Bitcoins, can they? There is a crypto-libertarian answer that is like "no, the blockchain is not subject to any nation's jurisdiction, it uses secure cryptography, if you hold your coins in your own wallet then they are safe from encroaching despotism," etc. But then there is the practical answer that:

1. If you hold your coins at a regulated exchange, sure yeah the authorities can probably get a warrant and seize your Bitcoins. 2. If you hold your coins in your own wallet but you write down your private key in, like, your phone's notes app, and it backs up to the cloud, then the authorities can probably get your cloud provider to give them access to your notes and read the key and use that to seize all your Bitcoins. (This happened to the alleged Bitfinex hack launderers.) 3. If you write your private key on a scrap of paper, the authorities can search your house until they find it and seize all your Bitcoins. 4. If you memorize your private key, or just write it down somewhere really safe, then they can arrest you and throw you in jail until you tell them what it is, and then seize all your Bitcoins.

Here are Ellen Milligan and David Voreacos on authorities seizing Bitcoins:

To start, investigators have to learn to recognize a crypto wallet and then how to obtain the private key, or seed phrase, to unlock it. Months after the $10 million hack of the GateHub platform in 2019, French investigative judge Pascal Latournald and his colleagues held and interrogated a suspect for the better part of 48 hours before he gave up the code that unlocked $2 million in Bitcoin. The exhausted suspect, hoping for leniency, revealed he'd written it on a slip of paper inside a cookbook in his parents' living room in southern France, according to an officer involved in the investigation who spoke on the condition he wasn't named.

U.S. agents have discovered seed phrases hidden on a gum wrapper, inside a TV instruction manual, and on tiny pieces of paper stuffed in a suitcase in a closet, says Tigran Gambaryan, who was a special agent for the IRS's criminal investigation arm for a decade before joining crypto exchange Binance in September.

Yeah. There is a vein of crypto libertarianism that imagines that you can have money that is immune from the claims of society, but that's only really true if the rest of your life is immune from the claims of society. If you live alone on a faraway island and have a lot of weapons then sure right maybe the authorities can't seize your Bitcoins. (Though you also can't use your Bitcoins to, like, order pizza delivery.) But if they can toss you in jail until you cough up your Bitcoins, then the Bitcoins aren't doing that much for you.

No it didn't, come on. Imagine borrowing, like, $1 million of Bitcoin for 30 years to buy an apartment, and then paying back $50 million as Bitcoin appreciates. Imagine being the lender and locking up your Bitcoins for 30 years at 5% or whatever. Obviously this is not a "30-year mortgage in Bitcoin." It's a 30-year mortgage in dollars, secured by the apartment, and also secured by some Bitcoins for novelty value:

Crypto mortgages are structured much like traditional mortgages and are lent out to home buyers in dollars but are meant to appeal to people who have large crypto holdings they don't want to convert to dollars.

These mortgages require additional collateral in the form of a cryptocurrency, and the agreements allow the lender to take ownership of the home and the additional collateral in the event of default. If the value of crypto falls, the borrower may have to put up more crypto or other collateral.

A non-fungible token is basically a receipt saying that you have bought it. You have bought what? The receipt. Sometimes something else occurs — the receipt points to a digital image file hosted on a web server, or somebody burns a work of art before selling you the receipt, or whatever — but fundamentally the NFT consists of the receipt. This receipt generally lives on a decentralized computerized database associated with some cryptocurrency, but artists came up with the idea of selling a receipt for money and calling it art long before the invention of the blockchain. Yves Klein is a particularly good one and you can buy one of his NFTs now:

Auction house Sotheby's said it expects to fetch up to $551,000 for an unusual item -- a receipt for a piece of invisible art by French artist Yves Klein.

Sotheby's said Klein sold numerous pieces of imaginary art, which he dubbed Zones of Immaterial Pictorial Sensibility, in exchange for a weight of pure gold, and he would issue receipts to the buyers.

The receipt up for auction April 6 is dated Dec. 7, 1959, just a few years before the artist's death in 1963. …

"Some have likened the transfer of a zone of sensitivity and the invention of receipts as an ancestor of the NFT, which itself allows the exchange of immaterial works," the auction catalog states. "If we add that Klein kept a register of the successive owners of the 'zones,' it is easy to find here another revolutionary concept -- the 'blockchain.'"

Yes, right, keeping a list in a notebook is basically the blockchain, why not.

Like, Tether is a digital token that is supposed to be worth a dollar. (It is also the name of the entity, Tether Ltd., that issues Tethers.) It is in fact worth a dollar: It trades on exchanges for very close to a dollar, with very limited volatility. It is backed by a pool of liquid dollar-denominated assets, or says it is anyway. Institutional customers can redeem Tethers for dollars, from Tether Ltd., one for one.

You might believe — lots of people believe! — that Tether is backed by bad commercial paper and that it will break. A big commercial-paper issuer will default, Tether (which keeps its holdings very secret) will turn out to own a lot of its paper, and so Tether will have fewer dollars than it has issued Tethers. Customers will panic and redeem their Tethers, forcing Tether to sell more bad commercial paper at fire-sale prices and driving down the price of its commercial paper; ultimately each Tether will be worth much less than a dollar.

If you do believe this then in some sense the trade should be easy? Like, if you wanted to borrow dollars, betting that a dollar would somehow turn out to be worth 40 cents, you could do that pretty cheaply. (I realize this makes no sense.) Borrow $100 million for a year at, you know, 3%. (The one-year Bloomberg Short Term Bank Yield Index, representing unsecured borrowing costs of a big bank, is about 1.46% today.) That costs you $3 million. If it crashes to 40 cents, you only have to pay back $40 million, so you make $57 million of profit; if it doesn't, your loss is capped at $3 million. (It's never going to be worth more than a dollar.) Asymmetric trade!

Interest rates to borrow Tether are … higher? Tether is in some ways a substitute for the dollar, but not in the sense that you can borrow a ton of it at dollar interest rates to bet that it will drop.

Or, sure, find someone to sell you puts. How much should someone charge to sell you, say, a one-year put on Tether struck at 90 cents? (If Tether is above 90 cents for the whole year, you get back $0; otherwise, you get back the difference between 90 cents and the price of Tether when you exercise the put.) Tether has as far as I can tell never traded below 90 cents. Its realized volatility is nearly zero, because it is a stablecoin. Option pricing models suggest that the price of that put is, like, "free." But of course the bet, when you buy a put on Tether, is that past performance does not reflect future performance, and that when people really understand Tether its stability will disappear.

There is a relevant story from Nassim Taleb. Here is how I have previously summarized it:

In 1992, a trader "needed to buy quantities of out-of-the-money puts on the sterling, calls on the [Deutsche] mark, struck 10% outside the official government band. The customer was a conspiracy theorist fund manager who believed in the imminent breakup of the [pre-euro European] monetary order." The trader called a few large dealers for quotes and got two answers. One dealer, a former pit trader, "told him that they were reluctant to show a price, 'because the strike is outside the band' and the options were 'too risky.' They would accommodate him if necessary, but at very expensive implied volatility and only for a moderate amount." Another dealer, "a graduate of a prestigious European school of engineering," "literally laughed at him. 'But Zey are outside the band, if I am not mistaken,' he was told. 'How many do you vant? I can sell you all you need. You should give your money to charity instead.'" The European Monetary System broke up. One of those dealers kept his job.

If you want to buy puts on Tether, then:

1. Some people will charge you a lot of money for the puts. If you trade with them, it will be expensive. 2. Other people will charge you very little money for the puts. If you trade with them, and Tether in fact crashes, how sure are you that they'll be around to pay out? The problem with betting on disaster is that when you win there has been a disaster.

I know this is normal now, this is just life in 2022, this ship has sailed. Still, imagine telling a federal judge "see, my cartoon ape is vastly more valuable than Justin Bieber's because it is in the top 14% rarity, so please award me millions of dollars of damages against the exchange that negligently allowed someone to buy my ape for 0.01 ETH." "What is an ETH," the judge might reasonably ask. "The ape is a computer image, what does it mean that someone else possesses it, or that it is rare," the judge might reasonably ask. "Why can't you just right-click and save it, then you'd have your ape back," the judge might reasonably ask. "Who is Justin Bieber," the judge might reasonably ask.

"What do you mean that you are the rightful owner of Bored Ape #3475 when the blockchain shows definitively that it was transferred out of your wallet to someone else, who now demonstrably owns it," you or I (not the judge) might reasonably ask, but that ship has also sailed. Everyone understands now that:

1. NFTs are a kind of property. 2. Possessing those NFTs on the blockchain — having them in your crypto wallet, having the private keys that allow you to transfer them — is not the same thing as ownership of that property, though it is an important indicator of ownership. (Just as possessing a bicycle is generally a good sign that you own it, but not definitive proof; "you stole my bicycle, give it back" is a coherent sentence, as is "you stole my NFT, give it back.") 3. Outside authorities — OpenSea and other centralized intermediaries, but also U.S. federal courts — can decide who owns an NFT, even if the blockchain says something different. 4. For most practical purposes, what the outside authorities say about ownership matters more than what the blockchain says.

All of that seems fine, really, but the path by which we have arrived here is strange. The idea of crypto was to create a sort of property that could be evidenced through code, where ownership was decentralized and permissionless rather than intermediated through some traditional authority. And it worked , and NFTs became worth millions of dollars, which made them far too valuable to be subjected to the uncertainty of decentralized permissionless ownership. And so now if someone takes your apes on the blockchain, you can try to get them back in federal court. "Why is this my problem," the judge might reasonably ask.

Here is a dumb model of financial regulation. There are two general ways for authorities to regulate financial activities. Call one "rulemaking." A regulator thinks about some financial things, decides how they should work, solicits comments from industry participants and the general public, and writes a rule explaining in some detail how things will work. After that, everyone who does those things knows what the rules are and what things they are and are not allowed to do.

Call the other "regulation by enforcement." The regulator doesn't spend much time writing specific new rules, but just relies on some general old rules saying things like, you know, "don't use an artifice to defraud." What that means can be unclear and, more to the point, if the regulators decide to go after you for using some artifices, your life will be unpleasant even if you ultimately win. Knowing this dynamic, the regulators can use enforcement actions to decide and declare what is and is not allowed. Everyone goes around doing things, and then some of them get sued by the regulator and have to pay a bunch of money to settle the lawsuits. Everyone watches those lawsuits, and each lawsuit tells everyone a bit more about what is and is not allowed. If the regulators sue someone for doing X, and you're also doing X, you stop doing X. "Don't do X" has become a rule without any rulemaking. The first person to get sued for X didn't know that that was the rule, though, and gets in trouble and has to pay a fine.

One way to think about this is that it is unfair: That person didn't know X was against the rules, why should she get in trouble? Often though it does not feel that unfair, because X probably does look pretty bad; it probably was at least arguably against some general rule like "don't use any artifices." It's a little random that this person got in trouble for doing X, but it's not like she was totally innocent either. The people who get fined were in some gray area; they didn't know that what they were doing was not allowed, but they had some notice that it might not be allowed.

But another way to think about it is that regulation is expensive, and regulation by enforcement is a way to make the industry pay for regulation. In rulemaking, the regulator has to put a lot of expensive effort into figuring out what should be allowed; this is particularly hard when a lot of novel activities are going on, and there is a risk that the regulator will get it wrong, miss things, move too slowly, etc. In regulation by enforcement, the industry has to put a lot of expensive effort into figuring out what is not allowed, and the risk of missing things is on the industry; the regulator gets to focus its attention on what is actually happening and what it wants to prevent rather than theoretical generalities. More concretely, each time the industry gets a little more clarity — each time it learns a new X that is or is not against the rules — it pays a big fine. "Fines are a cost of doing business," people complain about financial regulation, but perhaps sometimes it is more like "fines are a cost of figuring out what the rules are." The regulators will tell you what the rules are, but one at a time, and for $10 million per rule.

If you have $10,000 in your bank account, and thieves hack into your account and drain all of the money, and you go to your bank and establish that that's what happened, and the hackers get away successfully, what will the bank do? The three main theoretically possible answers are:

1. The bank will give you the $10,000 back and eat the loss. 2. It won't, and you will eat the loss. 3. The bank will give you some of the money back, and you will split the loss.

Which one it chooses will be determined mostly by regulation and somewhat by how effectively you complain, but none of that is the point here. The point is that what will not happen is:

4. The bank will say "Well the dollars are gone, but we can credit you with 10,000 Theft Bucks, enjoy!"

I am not even sure I know what that sentence means. But let me try. A bank is a system of computers that keep lists of people who have stuff. For the most part, your entry on the list shows how many U.S. dollars you have at the bank. There is an important sense in which this entry means "the number of U.S. dollars that the bank has to pay you when you ask," but there is a more important sense in which it doesn't. Most people's primary interaction with their bank is not withdrawing paper money ; for most people, the number next to their name on the bank's list simply is the number of dollars that they have. If they want to spend those dollars, they do it by sending electronic messages telling the bank to decrement the number next to their name and increment the number next to someone else's name; the dollars never leave the banking system's computers, never become paper money, always remain numbers on lists. The number on the list is not the number of dollars that the bank has to give you if you ask; it is the number of dollars that you have already. "Dollars" are entries on the bank's list.

The bank controls the computers, so it is a little tempting to say that it could put any number it wants next to your name. It can't, though, for important reasons of regulation and tradition and, you know, the whole banking system would crumble if the bank just made up numbers arbitrarily. Well, it would crumble if the bank just made up numbers of U.S. dollars. U.S. dollars are very important and widely accepted and there is a huge financial and regulatory apparatus built up around the function (banking) of keeping lists of them. But the bank could make up other numbers on other lists. The bank could say "every time you use an ATM we will give you 10 loyalty points," and then it could keep a list of customers and their loyalty points, and then one day it could say "also we'll give you 20 loyalty points every time you smile at a teller" without any particularly serious implications for the banking system.

And so you could just about imagine discovering that your account was hacked and that your $10,000 is gone, and going to the bank and saying "hey your list says I have $0 but I should have $10,000," and the bank saying "well your entry on that list of dollars was decremented to $0 using the established procedures of banking, and we cannot reverse those procedures because that would mess everything up, but we will write another list, not of dollars, but of something else — call it Theft Bucks — that we just made up, and we can put 10,000 next to your name on that list, does that help?" And you will say, no, it absolutely does not, because dollars can be used to pay rent and buy sandwiches, while Theft Bucks are a thing that the bank made up just now.

But this is because there is a very stark binary, in traditional banking, between dollars , which are money, and other stuff , which is not. Move this bank into the world of cryptocurrency and the situation gets much hazier. Crypto tokens can be created arbitrarily, in a sense all of them are money, in another sense none of them are, and there is a continuum between the ones that feel a lot like money and the ones that don't. If you have an account at a crypto exchange and it contains 10,000 Shiba Inu tokens, and a thief drains your account and you complain to the exchange and the exchange says "sorry about that, the SHIB are gone — immutable blockchain and all that — but to make it up to you we will create a brand-new Lost Dog token and give you 10,000 of them," does that help? Maybe? The Shiba Inu tokens were worth a somewhat arbitrary and variable amount of money based on speculative interest, and the Lost Dog tokens will also be worth a somewhat arbitrary and variable amount of money based on speculative interest. Context clues here suggest that the Shiba Inu tokens are worth more , and have more general interest, while the Lost Dog tokens are just nonsense and won't be worth much, but, I mean, are the Shiba Inu tokens not nonsense?

We talked yesterday about the Bitfinex hack. In 2016, Bitfinex, a cryptocurrency exchange, was hacked; thieves made off with 119,754 Bitcoins. At the time this was a $71 million haul. When I wrote about it yesterday, though, it was a $5.3 billion haul, as Bitcoin went up about 7,000% over the past six years. (As of this morning it's a $5.4 billion haul.) We talked about it yesterday because the Justice Department arrested two people for allegedly trying to launder the money, and managed to recover at least 94,636 of those Bitcoins, worth $4.2 billion at yesterday's price. And the Justice Department has promised to give the Bitcoins back to the victims of the hack.

The simplest way to interpret that is that if you had 10 Bitcoins in your Bitfinex account in 2016, worth about $6,000,and they went missing, then now the Justice Department will give you 8 Bitcoins (it recovered about 80% of the missing Bitcoins), worth about $360,000. From 2016 until now you had an asset — Missing Bitcoins — that appreciated by about 6,000%, which is a worse performance than actual Bitcoins but much better than, you know, the S&P 500. Owning Bitcoins stolen from Bitfinex was an incredibly good trade. Here's Bloomberg's Olga Kharif:

David Silver, a lawyer who specializes in financial and cryptocurrency-related fraud, said since the seizure was announced Tuesday he's received dozens of calls from individuals saying they lost money in the 2016 online heist and they want to get their coins back. Twitter has been whipped into a frenzy as well, with posters asking how to claim lost crypto. Justice Department officials said they plan to establish a court process for victims to reclaim the stolen digital assets, which have since surged in value.

But there are other ways to interpret it. Bitfinex, in particular, has other views. Bitfinex's views are, approximately, "we gave you 119,754 Theft Tokens to make up for your 119,754 stolen Bitcoins, so you are fine and those Bitcoins are ours now." Kharif:

Bitfinex considers that it's made investors whole, and said in a statement that it will "follow appropriate legal processes to establish our rights to a return of the stolen Bitcoin." If Bitfinex and users start off on a collision course, the legal battle would likely be protracted.

"The world has changed dramatically since 2016, and everyone is going to lay claim to this newfound bag of Bitcoins," Silver said. …

At the heart of Bitfinex's argument is a long-ago token distribution. After the attack in August 2016, when a hacker made away with more than 119,000 Bitcoin, Bitfinex allocated losses of more than 30% to all customer accounts. It then created and credited BFX tokens to customers at a ratio of one for every $1 lost. Within eight months, all holders had those tokens redeemed, or had exchanged them for iFinex capital stock. During that time, Bitcoin's price had nearly doubled, according to Bloomberg data.

Bitfinex also created another coin named Recovery Right Token, or RRT, for holders that had converted their BFX tokens into iFinex shares. In case the stolen Bitcoins were ever

Classically, the idea of money laundering is that, when you do crimes, it is often hard to spend your ill-gotten loot. If you steal a sack of cash from a bank and try to buy a car with it, people will get suspicious. This is particularly true of stolen Bitcoins: Spending Bitcoins mostly requires converting them into dollars (or euros, or gold, or non-fungible tokens, or something), which mostly requires going through a cryptocurrency exchange. So you want to take your suspicious loot and filter it through the legitimate financial system until it comes out in a respectable bank account that you can use to buy stuff.

Governments want to prevent this, and so regulated financial institutions — especially banks, but in recent years also especially legitimate cryptocurrency exchanges — have know-your-customer/anti-money-laundering (KYC/AML) compliance programs where, if you walk into a bank with a large sack of cash and say “I’d like to deposit this please,” they ask you questions like “who are you” and “where did you get this money.” If the answer is “I stole it from a crypto exchange” they will call the cops, so you have to lie (which is a crime), and also they might check (so you might get caught).

Here is how the Justice Department summarizes the laundering here:

The criminal complaint alleges that Lichtenstein and Morgan employed numerous sophisticated laundering techniques, including using fictitious identities to set up online accounts; utilizing computer programs to automate transactions, a laundering technique that allows for many transactions to take place in a short period of time; depositing the stolen funds into accounts at a variety of virtual currency exchanges and darknet markets and then withdrawing the funds, which obfuscates the trail of the transaction history by breaking up the fund flow; converting bitcoin to other forms of virtual currency, including anonymity-enhanced virtual currency (AEC), in a practice known as “chain hopping”; and using U.S.-based business accounts to legitimize their banking activity.

“In a methodical and calculated scheme, the defendants allegedly laundered and disguised their vast fortune,” said Chief Jim Lee of IRS-Criminal Investigation (IRS-CI).

But if you read the complaint, what is striking is how little of the money actually got laundered. Certainly a lot of effort seems to have gone into laundering. But the thing is that if you are a TikTok rapper and you walk into a bank and say “hello I’d like to open an account in which to deposit the proceeds of my TikTok rapping” and the bank says “sure okay” and you say “here is my first deposit of $4.5 billion” you’ll be in jail that afternoon. You gotta launder slow.

If you buy a book, and you read it, and you don't want to read it again, you can sell it. You own the book that you bought so it's yours to do what you want with. On the other hand, you can't scan the book, upload it to the internet, and sell thousands of electronic copies at $1 each. You don't own the contents of the book; you don't own the intellectual property. You own the physical printed copy of the book. In the U.S., this is called the "first-sale doctrine."

Similarly if you buy sneakers you can resell them. You can also wear them. They'll probably have some brand on them, like a Nike swoosh. If someone sees you wearing the sneakers they might say "hey cool shoes are those Nikes" and you can say "they sure are, they're the new Air Jordan 420s" or whatever and they might say "oh wow those are ultra rare and cool" and you can be like "I know."

What if you tried to separate out that rare coolness from the shoes? What if you, like, advertised that you would let people take pictures with your rare Nikes to post on social media? I am not an intellectual property lawyer but I feel like eventually Nike Inc. would get annoyed. You own the shoes, sure, but Nike owns the intellectual property. You can resell the shoes, but the brand belongs to Nike.

My basic model of Web3 is that any Web3 project consists of (1) the ostensible project plus (2) a Ponzi scheme. (We have discussed this mainly here and here.) If you do a thing in a Web3 project, you get some tokens, and then if more people do it the tokens become more valuable; you are rewarded for doing the thing to the extent that new investors put money in after you. Mostly this strikes me as bad! However! If you take a worthy but not especially sexy distributed project and add, like, a little bit of Ponzi to it, maybe that is something? At the New York Times, Kevin Roose writes about Helium:

On a basic level, Helium is a decentralized wireless network for "internet of things" devices, powered by cryptocurrency.

The network is made up of devices called Helium hot spots, gadgets with antennas that can send small amounts of data over long distances using radio frequencies. These hot spots, which cost roughly $500 apiece and can reach 200 times farther than conventional Wi-Fi hot spots, share their owners' bandwidth with nearby internet-connected devices — like parking meters, air-quality sensors or smart kitchen appliances.

Anyone can use the Helium network, although most of its users so far are companies like Lime (which has used Helium to keep tabs on its connected scooters) and the Victor mousetrap company (which uses it for a new line of internet-connected traps). …

Helium, which was founded in 2013, didn't start off as a crypto company. Its founders originally tried to build a long-range, peer-to-peer wireless network the old-fashioned way — by persuading people and businesses to set up hot spots and stringing them together. But they struggled to get enough participants, and the network stalled. …

So the company tore up its old business model and settled on a new one. Instead of building its network itself, Helium would make it fully decentralized and let users build it themselves by buying and connecting their own hot spots. Participants would be paid in crypto tokens, and they'd get to vote on proposed ideas for changes to the network. If the price of those tokens rose, they'd make even more money, and set up even more hot spots.

"This," writes Roose, "is one of crypto's superpowers — the ability to kick-start projects by providing an incentive to get in on the ground floor." The more people who join the project after you, the more money you make. Ordinarily a network benefits from network effects, and you should join a network that a lot of people already use. But crypto networks benefit from "token effects," and you should join a network that a lot of people will use in the future. There is some guesswork involved there of course, and some incentive for hype. ("A cardinal rule of Helium's 140,000-member Discord chat server is that you're not allowed to discuss token prices," notes Roose, which should reduce hype.)

Incidentally this is sort of a nice metaphor for the fact that an apparently huge source of alpha in crypto consists of:

1. There is a mistake. 2. People notice the mistake and try to correct it. 3. Because crypto is all open-source and on the blockchain, you can see them trying to correct it. 4. Because crypto effectively conducts auctions to decide whose transactions go first, you can jump ahead of them in line and exploit the mistake before they can correct it.

The attempts to correct the mistake are what tip off the exploiters. The classic "Ethereum is a Dark Forest" story is an example of this: Someone noticed a flaw in a smart contract, but any effort to correct it would tip off arbitrage bots who would front-run it. We talked the other day about a bug in OpenSea that caused some people to sell their non-fungible tokens for less than they were worth under old, un-canceled listings; the obvious fix when this was discovered was to cancel your old listings, but people who tried to do that also got front-run.

Anyway I guess the point is that if you get into trading and building market infrastructure in crypto, some days the money will vanish and you'll have to stump up $300 million to cover customer losses and maintain confidence in your market, and it will be worth it. That's a good sign for how lucrative it is on the other days.

A less obvious risk of stablecoins is that they might be too stable. A stablecoin is, among other things, a substitute for putting money in a bank. Banks are generally very safe places to put money, but they are not perfectly safe. There can be runs on banks; banks can fail. For most U.S. retail bank accounts this is not a very salient problem, since they are backed by government deposit insurance, but many large institutional pools of money (corporate cash accounts, money-market funds, etc.) park their money in short-term bank instruments and are sensitive to risk. If a bank gets riskier, it will lose deposits. And if a stablecoin is so stable that it is safer than a bank, then banks generally will lose deposits.

Why is this a risk? Well, banks do useful stuff. Classically, they take people's deposits and lend them out to other people to start businesses and buy homes. The provision of credit by banks helps the economy grow. More to the point, the withdrawal of credit by banks hurts the economy, and the risk here is wrong-way. If people get nervous about banks and pull out all their money to put it in safer stablecoins, then (1) that will probably happen at a time when the economy is shaky and (2) that will definitely make the economy shakier. The bulk of the response to the 2008 financial crisis involved preventing runs on banks, because those would have made all of the problems of the crisis much worse.

I suspect that this worry — that stablecoins might be too safe — is not at the top of most people's minds. This is not the main problem with actually existing stablecoins! It sounds a bit silly, as I type it. But it does seem to be top of mind for U.S. banking regulators, particularly for the Federal Reserve. This is probably because in some sense the Fed's introduction to stablecoins came from people pushing the Fed to launch its own stablecoin. A Fed-issued stablecoin — the usual term is CBDC, "central bank digital currency" — would indeed be perfectly safe, a pure dollar on the blockchain, safer than any bank account. And the Fed has not been interested, in part for these sorts of crowding-out reasons. But the Fed has also rejected a proposal to allow a "narrow bank," meaning a bank that issues super-safe deposits backed solely by reserves at the Fed, for similar reasons. And when U.S. financial regulators put out proposals on stablecoin regulation, they were ostensibly focused on safety, but the proposals also very quietly called for banning ultra-safe Fed-backed stablecoins and requiring stablecoins to be issued through regular banks.

I have to say I have no idea how cryptocurrency investments are regulated under U.S. securities law right now. Back in the late 2010s, there was a wave of crypto projects that were called "initial coin offerings," and the U.S. Securities and Exchange Commission fairly quickly came to the conclusion that those were all illegal securities offerings, and the wave came to an end. This was controversial, and I am not sure it was entirely correct, and I occasionally wrote columns that were sympathetic to some of these ICOs. And of course there were a ton of ICOs and so a lot of them fell through the enforcement cracks. But surely most ICOs were illegal securities offerings, and there was a rough intellectual consistency to the whole thing. The SEC thought ICOs were bad, and it killed them.

But then the crypto world moved on to other things, many of which — particularly in "decentralized finance" — kind of look like ICOs. Two crypto stories caught my eye today. One is a Bloomberg story about big crypto firms that pay interest on crypto deposits:

The U.S. Securities and Exchange Commission is scrutinizing cryptocurrency firms Celsius Network, Voyager Digital Ltd. and Gemini Trust Co. as part of a broad inquiry into companies that pay interest on virtual token deposits, according to people familiar with the matter.

The SEC enforcement review focuses on whether the companies' offerings should be registered as securities with the watchdog, said the people, who weren't authorized to speak publicly. The firms are able to pay customers rates higher than most bank savings accounts by lending out their digital coins to other investors, a practice that the SEC and states including New Jersey and Texas have said raises concerns about investor protection.

Now, I think that the SEC is probably right to be concerned here, and these offerings probably are securities under traditional readings of the rules, though there's an argument the other way. And there is a certain consistency in that regulators have gone after other firms offering similar crypto-interest accounts. And of course this is just a review, nothing is final, Gemini et al. are not in trouble. So I have no real complaints here; the SEC should take a look at stuff that might violate its rules.

And these are large companies that do seem to care about following regulation. Gemini ran a silly ad campaign calling itself "the regulated cryptocurrency exchange" and saying "the revolution needs rules." And look at these little descriptions from that Bloomberg article; these sound like real companies:

Celsius, which has $18.1 billion in deposits, incorporated in the U.K. in 2018 but last year said it would move its headquarters to the U.S. amid regulatory uncertainty. The private company recently raised money from investors including Caisse de Dépôt et Placement du Québec, Canada's second-largest pension fund, valuing Celsius at more than $3 billion.

Gemini's crypto exchange was launched in 2015 by Cameron and Tyler Winklevoss, the twins who famously feuded with Mark Zuckerberg over the founding of Meta Platform Inc.'s Facebook. The firm's "Gemini Earn" crypto accounts pay interest of as much as 8.05%, which the firm says it earns by partnering with third party borrowers whose risk it vets.

New York-based Voyager, which also runs an exchange and had $7 billion in assets under management in November, is listed on the Toronto Stock Exchange and had a market value of about C$1.7 billion ($1.35 billion) as of mid-day Wednesday.

A fourth name for the list is Coinbase Global Inc., a $38 billion U.S. public company, which wanted to do a crypto lending product and was told by the SEC to knock it off before it even started. And, sure, right. These are big important companies that try to comply with the law, and the SEC calls them and says "under our interpretation of our precedents you are not complying with the law," and so they change their behavior to comply with the law while also, of course, lobbying the SEC to change the rules to allow the things they want to do. All normal stuff, though normal stuff at the cutting edge of legal and financial developments, so nobody is quite sure what the right answers are.

The other story is about … well, see, there's a billion-dollar Ponzicoin called Wonderland, which as of about 11 a.m. today was advertising an annual percentage yield on staked deposits of EIGHTY-THREE THOUSAND, SIX HUNDRED EIGHTY-SEVEN POINT FIVE PERCENT (83,687.5%), and it is in the news today because one of the pseudonymous people running its treasury is allegedly a famous convicted serial scammer who previously co-founded Quadriga CX, which was the biggest Canadian crypto exchange before it collapsed in an exit scam in which the other co-founder apparently stole most of the money and may or may not have faked his death.

Man, come on. Read that sentence. If you were an SEC enforcement lawyer and you had the choice of (1) calling up the "revolution needs rules" guys to tell them that under SEC precedents interest-bearing crypto accounts paying 8.05% have to be registered as securities or (2) looking into the very popular billion-dollar Ponzicoin run by an exit scammer that is offering an 83,000% APY to U.S. investors … just … what are we doing here?

What is the difference between Gemini and Wonderland? I think two critical differences are:

1. Wonderland is hilariously riskier and less compliant than Gemini in every respect. 2. Gemini answers the phone when the SEC calls.

There is a certain drunk-under-the-lamppost element to current U.S. crypto regulation. If you incorporate a company in the U.S. and walk into the SEC's office and ask "hey what are we allowed to do," the answer is "almost nothing." If you just launch the wildest thing in the world pseudonymously, call it "decentralized," and advertise eye-popping investment returns to U.S. investors, then, I mean, I don't want to give you legal advice, but look around.

Or we talked yesterday about stablecoins. Specifically we talked about the fact that Facebook Inc. (now Meta Platforms Inc.) announced in 2019 with enormous fanfare that it was going to launch a stablecoin and work closely with all of the relevant regulators blah blah blah, and it went to the Federal Reserve and said "what do we need to do to launch a stablecoin," and the Fed said "you must bring me the egg of a dragon and the tears of a unicorn," and now the Facebook stablecoin is shutting down. One of the largest companies in the world devoted millions of dollars to figuring out how to launch a stablecoin and concluded that it was impossible. It is demonstrably not impossible! Tether did it! Tether has a hugely successful stablecoin! Tether does not care at all about working closely with all of the relevant regulators! That's why!

Of course this is very much part of the point of decentralized finance projects like Wonderland (though not Tether, which is hilariously centralized): They are decentralized, there is no legal entity for the SEC to go after, people participate under pseudonyms and blockchain addresses rather than legal names, etc. And they are often "trustless" in the loose sense that some amount of their activity is governed by open-source code, transparent blockchains and mechanical operations of smart contracts, though in practice they often involve some amount of trusting individuals (like the Quadriga guy!) to manage some aspects of the project (like Wonderland's treasury!).

There is perhaps a legal argument, under securities law precedent, that this stuff combines to make them not a security: The expectation of profit in Wonderland comes from the explicit mechanics of the project, not from the efforts of a management team. This argument strikes me as very weak but not completely absurd. But there is also a practical difficulty of enforcement: You can't find the people or entities to sue, you can't make them give b

A share of Microsoft Corp. stock trades for about $300. That price goes up and down, but at any given minute during regular trading hours if you want to sell a share of Microsoft stock you're going to sell it within a few pennies of the last trading price. If you tried to sell a share of Microsoft for $100 you'd have a hard time doing it. If you called your broker, or went into your broker's app, and said "sell Microsoft for $100," you'd get back an instant confirmation saying "congratulations you sold Microsoft for $300."

There are many people in the stock market who would describe themselves as being in the business of buying underpriced stocks, but they don't mean it literally. They mean that they pay $300 for stocks that trade for $300 because they think those stocks will eventually trade for $500. They don't mean that they pay $100 for stocks that currently trade at $300. That's not a business.[1] You could write an algorithm saying "if anyone is selling Microsoft for $100, buy it," but that would not work. In all likelihood you'd never buy a single share. And if you did, that would mean that either (1) it was a "clearly erroneous" trade and the stock exchange will reverse it or (2) something horrible has happened to Microsoft and you paid $100 for a stock that's now worth $80.

Meanwhile in the market for, like, baseball cards, or Caravaggios, it is entirely possible to wander into a garage sale and buy an object for far less than its market value. The objects are unique, the markets are not transparent, the sellers might not be sophisticated, and there are plenty of opportunities for a well-informed buyer to underpay a poorly informed seller. On the other hand for all of those reasons it is also very difficult to write an algorithm saying "if anyone is selling a Caravaggio for $100, buy it." That's a good algorithm! But hard to implement on a computer.

A famous function of brokers in traditional finance is not answering the phone when the market crashes. This has various benefits and costs. If you are a customer and the market is going down and you see that and panic and decide to sell everything, you will call your broker, and she will not answer her phone. You will be unable to sell everything. This may protect you from selling at the bottom (though it may make things worse for you if this is not in fact the bottom), and will definitely protect the market from you adding your sales to the general march downward. On the other hand if you bravely decide to step in to buy the dip, your broker's failure to answer the phone not only costs you money (if you correctly time the bottom) but also prevents you from stepping in to stabilize the market; if brokers don't answer when buyers call then the crash gets worse.

There is also the issue of margin calls. In general, if you have a trade on using money that you borrowed from your broker, and your broker calls you for more money, and you call her back, she will answer that call, because she does want your money. But in particularly frantic market conditions she may not — because she has too much else going on, or because she has preemptively liquidated your position rather than waiting for you to post more money. And that too may drive the market lower.

Of course this is all old-timey stuff and modern markets are considerably more technically advanced; the role of stabilizing markets by not answering the phone has been taken over by Robinhood having its app and website break (and also not answering the phone). Even that approach feels a bit dated, though, and with the rise of crypto and blockchains and decentralized finance there are new, cutting-edge, cryptographically elegant ways for trading not to work:

Solana, one of the largest blockchain networks, was hit by instability during a turbulent week for cryptocurrencies. ...

The issue experienced by validators that use their computing power to help verify the network was caused by excessive duplicate transactions, according to a notice on the Solana website dated Jan. 22. Engineers have released version 1.8.14, which "will attempt to mitigate the worst effects of this issue," the notice said. It added that more improvements are expected to come out in the next eight to 12 weeks, and many of those features are being "rigorously tested."

"Solana mainnet beta is experiencing high levels of network congestion," the notice said. "The last 24 hours have shown these systems need to be improved to meet the demands of users, and support the more complex transactions now common on the network."

And:

Solana's network logjam has had ramifications across the crypto-ecosystem. Not only does it make it difficult for a retail market participant to, for instance, sell a Solana-based NFT, it also slows down large DeFi traders and forces them to work around the network. "Slows everything down," one trading executive said.

For large traders moving tens of millions, they have to move activity over-the-counter and agree to settle once the chain is working. "Agree on a price now and settle later... CEXes are still working so you still have price discovery," an executive at a derivatives trading desk noted.

Others traders complained about not being able to top off a leveraged position in Solana on a decentralized venue — meaning, add to their position before risking liquidation.

Here is a very important one; let's call it the "Web2 version":

1. You start a platform business. 2. You charge a fee of $2 per transaction. 3. You go to venture capitalists and raise some money. 4. You use the money to pay people, say, $3 per transaction to use your service. You pay them $3 per transaction and they pay you back $2 in fees. They keep $1. Free money! 5. You get a lot of users, because everyone wants to use a service that pays them to use it. 6. Now you have the good things: Lots of (real) users, lots of revenue, fast growth. 7. You do have one bad thing, which is that you lose money on every transaction. 8. That's fine! "Customer acquisition costs are high right now," you (and your investors!) say, "but they will come down as the platform matures and achieves scale." 9. You go to some more venture capitalists and raise a ton of money on that premise. Or you go public on that premise. 10. You stop paying people to use the service. 11. Maybe Step 8 was right! Maybe by this time your users are so dependent on the service, and the service is so good, and the network effects are so powerful, that they keep using it once you start charging them to use it instead of paying them to use it. And then your service is a huge success and you're a billionaire. 12. Or maybe it was wrong, the service dies, the venture capitalists lose their investment and you get to keep whatever cash you took out and do this again in a year as a battle-hardened repeat founder.

The Web2 version of the trade is central to the story of the last decade in the U.S. tech industry. We sometimes called it the "MoviePass economy," the idea that venture capitalists would subsidize consumers' lifestyles because they valued customer growth above everything else (including profitability). Or there's the term "blitzscaling," the idea that by throwing enormous quantities of money at a company in a network-effects business you can make it the dominant player and then pivot to profitability. There is no single outcome to these stories, no simple lesson to take from them. Sometimes it's the outcome in Step 11 above: User acquisition costs decline with scale and network effects, you jack up the price, and the unprofitable fast-growing subsidized service becomes profitable. Other times it's the outcome in Step 12. MoviePass went hilariously bankrupt.

One way to characterize the Web2 version is that instead of trading with yourself , you got your investors to trade with you. You generated volume on your platform from your investors , indirectly, by taking their money (the investment in Step 3) and turning it into revenue (the customer subsidy in Step 4). A dollar of investment capital can be turned into revenue, and then sold to new investors at a multiple of that revenue. This is arguably good for your (early) investors. They want a higher valuation. They are happy for you to turn their money into revenue. They hope that you will turn it into long-term stable recurring revenue (Step 11). But if you just turn it into fake revenue, then maybe they can still sell their shares to the next sucker before it collapses.

There are a lot of people in the world and almost all of them would prefer to pay lower taxes rather than higher taxes. But there is a small category of people who are intensely interested in paying higher taxes. There are people who will walk into a casino with a sack of cash, buy $1 million of chips at a table, carry them directly to a cashier, cash the chips out for $1 million, declare $1 million of gambling income to the IRS and pay taxes on it.[5] Of course they don't have $1 million of gambling income in this scenario: They walked in with $1 million and walked out with $1 million, their gambling income is zero. Why call it gambling income? Because once you declare $1 million of gambling income and pay taxes on it, you can use what's left over to buy houses and cars and college tuition and stuff. Whereas before they declared it as gambling income, when it was just cash in a sack, it was … probably it was the proceeds of selling illegal drugs, though there are other ways to end up with $1 million of questionable cash in a sack. If you buy a house with cash in a sack it is going to raise questions.

This is called "money laundering," and the essential component of money laundering is generating fake taxable income. If you take $13,800 out of your (legitimate, previously taxed) bank account, and you use it to buy cryptocurrency in a wallet that you tell your accountant and the IRS about, and you then use that cryptocurrency to buy a Meebit, and then you take $50 million out of your sack of illegal money, and you use it to buy cryptocurrency in a wallet that you don't tell your accountant about, and then you use that cryptocurrency to buy the Meebit from your declared wallet, and then you take the $50 million of cryptocurrency out of the declared wallet and put it back in your (legitimate) bank account, and then you write the IRS a check for $20 million saying "ah I've been selling NFTs, what fun I have had, but I have to pay the IRS my fair share," then … I am obviously not going to give you advice on crime but it's possible you've got something there? Like, nobody has any idea what a Meebit is worth, so this string of outlandish numbers is somewhat plausible? It's possible that some number of NFT wash trades have a purpose other than pumping up volume on NFT platforms?

Most people think of images and digital art when they think of NFTs, but NFTs generally do not store that data on-chain. For most NFTs of most images, that would be much too expensive.

Instead of storing the data on-chain, NFTs instead contain a URL that points to the data. What surprised me about the standards was that there's no hash commitment for the data located at the URL. Looking at many of the NFTs on popular marketplaces being sold for tens, hundreds, or millions of dollars, that URL often just points to some VPS running Apache somewhere. Anyone with access to that machine, anyone who buys that domain name in the future, or anyone who compromises that machine can change the image, title, description, etc for the NFT to whatever they'd like at any time (regardless of whether or not they “own” the token). There's nothing in the NFT spec that tells you what the image “should” be, or even allows you to confirm whether something is the “correct” image.

So as an experiment, I made an NFT that changes based on who is looking at it, since the web server that serves the image can choose to serve different images based on the IP or User Agent of the requester. For example, it looked one way on OpenSea, another way on Rarible, but when you buy it and view it from your crypto wallet, it will always display as a large [poop] emoji. What you bid on isn't what you get. There's nothing unusual about this NFT, it's how the NFT specifications are built. Many of the highest priced NFTs could turn into [poop] emoji at any time; I just made it explicit.

The NFT does not by itself convey ownership of the underlying thing in either a legal or practical sense. It conveys ownership in some more metaphysical sense: If you buy a Bored Ape Yacht Club NFT, then the people who are part of the BAYC NFT community will treat you as the owner of your ape. This is essentially a social fact and can be true even if the immutable code of the blockchain says that you don't own the ape, because you were hacked or whatever. The technology is a scaffolding on which to hang a social system, but the social system is what does or does not convey “ownership” in a meaningful sense.

Also the technology is totally centralized? Marlinspike goes on:

After a few days, without warning or explanation, the NFT I made was removed from OpenSea (an NFT marketplace). ...

What I found most interesting, though, is that after OpenSea removed my NFT, it also no longer appeared in any crypto wallet on my device. This is web3, though, how is that possible?

A crypto wallet like MetaMask, Rainbow, etc is “non-custodial” (the keys are kept client side), but it has the same problem as my dApps above: a wallet has to run on a mobile device or in your browser. Meanwhile, ethereum and other blockchains have been designed with the idea that it's a network of peers, but not designed such that it's really possible for your mobile device or your browser to be one of those peers.

A wallet like MetaMask needs to do basic things like display your balance, your recent transactions, and your NFTs, as well as more complex things like constructing transactions, interacting with smart contracts, etc. In short, MetaMask needs to interact with the blockchain, but the blockchain has been built such that clients like MetaMask can't interact with it. So like my dApp, MetaMask accomplishes this by making API calls to three companies that have consolidated in this space.

For instance, MetaMask … displays your NFTs by making an API call to OpenSea. ...

All this means that if your NFT is removed from OpenSea, it also disappears from your wallet. It doesn't functionally matter that my NFT is indelibly on the blockchain somewhere, because the wall

I can say words like "we should put real estate title registries on the blockchain," but actually doing that requires getting lots of local jurisdictions and courts and banks and mortgage companies and title insurers and real estate agents to coordinate around some particular blockchain solution; it is an enormous social coordination problem and seems exhausting.

But you can sidestep it by just pretending. Instead of digitizing ownership of Olive Garden franchises, with the right to hire and fire employees and collect cash flows and the obligation to maintain food-safety standards and take out the trash, you can digitize pretend Olive Garden franchises, digital receipts associated with pictures of Olive Garden franchises. "They're in the metaverse!" or whatever. Instead of selling an NFT that conveys ownership of my house, I could sell an NFT "of" my house, which conveys nothing except itself. (Or: Anyone else could sell an NFT of my house.) "If I buy the NFT of your house do I get your house?" No, you get the NFT of my house. "Why would I want that?" I don't know.

Well. If you sold an NFT of my house, could I … stop you? Could I go to court in the real world and say "stop selling my house in the pretend world"? I don't know! Presumably your defense would be, like, "selling your house in the pretend world doesn't affect you at all, so why shouldn't I be able to do it?" Selling virtual claims on real property seems … just … strange, I don't know.

On the other hand selling virtual claims on intellectual property seems more obviously actionable. If I make an NFT "of" a painting and sell it on a crypto platform, the actual artist who did the painting seems to have a real complaint that I am violating her copyright. Perhaps she can't do much about the immutable code of my NFT on the blockchain, etc., but she can (1) sue me for money in a regular court and/or (2) send legal threats to the main NFT trading platforms asking them to delist my NFTs.

My broader point here is that the system of stock ownership runs on different rails from the system of crypto ownership. For instance, it is pretty unusual, in the U.S., to actually own stock in your own name. Most stock is owned in the name of a thing called "Cede & Co.," a "nominee" for the Depository Trust Co., the big U.S. stock clearinghouse. And then DTC keeps a list of the brokers who "really" own its shares, and those brokers keep their own lists of the customers who "really" own their shares. So if you buy a share of stock through your broker, what you own is a notation in the broker's database saying that you are entitled to one share, and what the broker owns is a notation in DTC's database saying that it is entitled to one share. DTC/Cede, meanwhile, actually owns the share, which is to say that Cede owns a notation in the issuer's transfer agent's database saying that it is entitled to one share. Actual share ownership — "record" ownership — means being on the transfer agent's list.

This can seem like a rickety system, though it mostly works pretty well. (There are some gaps!) In the long run it is an obvious improvement over the prior system of, like, everyone owned paper stock certificates and had to cart them around to settle trades and if you lost your certificate you were out of luck. But the DTC system is decades old at this point and it is not hard to imagine a simpler system. Sometimes the people who go around imagining simpler systems imagine blockchain -based systems. "We'll have one ledger of share ownership, and [the big banks and brokers][DTC][an open system of crypto miners] will maintain that ledger reliably," is the thinking there.

But here we are in the actual world of 2022, where most people own stock through their brokers. This creates problems for bividends. When a company pays a cash dividend, it pretty much wires the money to DTC, which wires the money to brokerage firms, which deposit the money in their customers' accounts. But owning crypto is still sort of fraught for brokerages and DTC: There are regulatory custody obligations and capital requirements for holding crypto yourself, and you can't deposit crypto in a customer account unless you let your customers hold crypto in their accounts , which is sort of a momentous decision for an old-school retail brokerage.

So if a company said "we're going to pay a dividend in Bitcoin" it … kind of … wouldn't … work? Like, it would have to send the Bitcoins to DTC's Bitcoin wallet, and DTC would have to send them to the brokerages' wallets, and some of them would not have wallets and would get pretty upset. For that matter a lot of investors would get pretty upset: If you run a stock mutual fund, you might invest in the stock of BTCS, but your mandate might not allow Bitcoin investing, you might not have a Bitcoin wallet, and you might have trouble complying with your own custody obligations.[1] So a Bitcoin dividend would cause a lot of havoc for the intermediaries in the financial system.

We talked last month about Web3, the new name for crypto-based internet services. "A basic premise of Web3 is that every product is simultaneously an investment opportunity," I wrote:

It's as if being an early user of Facebook or Uber also automatically made you a shareholder of Facebook or Uber, and when those services got huge you got rich. ...

What sort of incentives does this create to spend your time making good products? Not none! But … attenuated, no? If you could spend a day optimizing the color scheme and messaging mechanics of your social network, or instead optimizing the payoff structure of the tokens, which one creates more value? If every product is also an investment, will the product engineers be mostly financial engineers?

The pitch here is not, you know, about the technical skills of the people building the DeFilm streaming platform, or about their aesthetic judgment in movies, or even about their marketing skills. The pitch here is that there are a bunch of speculative assets, because that is what Web3 is.

CryptoPunks and Bored Apes are both NFTs pointing to digital images of characters (punks, apes). If you buy one, you get a certificate on a blockchain corresponding to a particular punk or ape. You can download a picture of your punk or ape to use as your Twitter profile picture or whatever, but so can I; the NFT does not by itself represent ownership in any traditional sense. If you buy a Bored Ape from the company that makes Bored Apes (or, now, in the secondary market), that company will also license some intellectual property rights to you so that you can, I don't know, sell T-shirts with your ape on it, or "build a blockchain-based game," sure. You "own" the ape image in some sense that approximates traditional legal ownership of intellectual property. Meanwhile if you buy a CryptoPunk from the company that makes CryptoPunks (or, now, in the secondary market), you get a much more limited license, and the company retains the copyright and can commercialize the punks itself.

We talked the other day about Non-Fungible Olive Gardens, a (parody) online community that allows people to basically pretend that they own Olive Garden franchises. Each token corresponds to an individual Olive Garden in a purely hypothetical, joking way. This is how most NFTs work: You own the NFT, the NFT corresponds to some online or offline thing, and you don't own the thing. What I said about NFOGs is that this is a funny little pretend game, but that the interesting idea for NFTs is to try to make them correspond to real-world things:

It does seem like the trading-digital-primitives part is pretty well established right now, but we are perhaps a bit stalled at the tricky part of linking them to real-world assets. I can say words like "we should put real estate title registries on the blockchain," but actually doing that requires getting lots of local jurisdictions and courts and banks and mortgage companies and title insurers and real estate agents to coordinate around some particular blockchain solution; it is an enormous social coordination problem and seems exhausting.

Putting intellectual-property rights on the blockchain is probably a bit easier than putting real estate on the blockchain. The apes aren't exactly real-world assets, but it's a start.

The "(3, 3)" meme is a sort of casual adaptation of game-theory payoff notation. The idea is that if you sell your OHM that is bad for you (you don't own OHM any more) and bad for everyone else who owns OHM (your selling pushes down the price of OHM); if everyone sells, that has a payoff of "(-3, -3)." But if you buy OHM and stake it, that is good for you (you get more OHM) and good for the other OHM holders (your buying pushes up the price of OHM); if everyone stakes, that's "(3, 3)." The ordered pair represents payoffs for you and for the other player in this game; the numbers are arbitrary.

Also OHM pays a comically large interest rate (in OHM) to holders who stake their OHM. Currently it has an annual yield (again, in OHM) of around 5,200%. Higher than the lira!

When I first read this explanation in the OlympusDAO documentation, I laughed and laughed. "Well yes right," I thought, "the way a Ponzi scheme works is that early 'investors' get rich as long as later investors keep buying more." Sure, (3, 3). "If we all keep buying this thing its price will go up and we will be rich" is absolutely the main financial theme of 2021, but it is an irreducibly silly theme and I would be embarrassed to formalize it with game theory.

A basic premise of Web3 is that every product is simultaneously an investment opportunity. If you sign up for a Web3 social network or chat room or trading venue or let's-buy-the-Constitution lark, you will get some of that project's tokens, which will entitle you to use the project's app or exchange or Constitution, and which will give you some notional say in the decentralized governance of the project. Also the tokens will appreciate in value if the project takes off and more people want to use it. It's as if being an early user of Facebook or Uber also automatically made you a shareholder of Facebook or Uber, and when those services got huge you got rich.

At the Wall Street Journal this weekend, Christoper Mims wrote about "Jack Dorsey and the Unlikely Revolutionaries Who Want to Reboot the Internet":

What if, to take but one example, users of social networks collectively owned them, or at least could vote on how they were run and what kind of speech they allowed? And what if similar questions could be asked of just about any tech company whose primary product is software and services—whether financial, cloud computing, or even entertainment-related? ...

The answers are taking the form of services and apps that are the first outlines of what their creators hope will someday eat the internet completely: a distributed, democratically ruled "Web 3.0" or "Web3" that will rise like a phoenix of 1990s-era Web 1.0-idealism from out of the ashes of the corporation-controlled Web 2.0 that all of us currently inhabit.

For instance:

DeSo—which, confusingly, is simultaneously a not-for-profit foundation, a blockchain and a cryptocurrency token, but explicitly not a traditional for-profit corporation—is in many ways typical of the form. The idea behind DeSo is that everyone should be able to create their own social media service, but also that they could be interconnected in ways that, say, Facebook and Twitter would never be—including shared accounts and other shared data.

"The thesis behind DeSo is that if you can mix money and social, you can create new ways for creators to monetize," says Nader Al-Naji, founder and head of the DeSo foundation. "Instead of creators monetizing from ads, they can monetize from DeSo coins."

DeSo has created a new cryptocurrency (named DeSo) that, for example, could be used to "tip" other users for their posts, replacing likes with actual money—or at least DeSo tokens that can be traded for dollars on the usual cryptocurrency exchanges. Like other next-generation cryptocurrencies, inspired by Ethereum, these tokens also can store the data that actually makes up a social network, such as the text of posts .... This dual function illustrates the inspired weirdness that is Web3: If money can become code, then money can be way more than a means of exchange; it can also do anything that other software can do.

This core insight, a sort of E = mc² equivalence between money and software, is why true believers in Web3 think it could have such a huge impact. Suddenly every activity humans engage in, from buying and selling a house to liking a post on social media, can be made part of a token-based financial system of a scale and complexity that makes today's look like an antique.

I think that what is interesting about the idea of a "non-fungible token" is the possibility of linking some non-fungible thing in the real world, or some non-fungible slice of some real-world thing, to some transferable digital representation. And there is a strand of crypto thinking that is like "we are going to build a new financial system that will take over the entire job of financing and paying for the real world," and in this vein you need to think about ways to represent real economic activity. You want ways to digitize ownership of houses and factories and the contents of particular shipping containers and stuff like that.

And a lot of people who come to crypto with this way of thinking are like, well, we'll start by building out the digital primitives first, and then we'll figure out ways to associate them with real-world objects. So we'll figure out a way to build and trade non-fungible tokens, starting with tokens that are just empty nonsense, but then once we have that technology, we can work on trading tokens that are not empty nonsense.

It does seem like the trading-digital-primitives part is pretty well established right now, but we are perhaps a bit stalled at the tricky part of linking them to real-world assets. I can say words like "we should put real estate title registries on the blockchain," but actually doing that requires getting lots of local jurisdictions and courts and banks and mortgage companies and title insurers and real estate agents to coordinate around some particular blockchain solution; it is an enormous social coordination problem and seems exhausting.

But you can sidestep it by just pretending. Instead of digitizing ownership of Olive Garden franchises, with the right to hire and fire employees and collect cash flows and the obligation to maintain food-safety standards and take out the trash, you can digitize pretend Olive Garden franchises, digital receipts associated with pictures of Olive Garden franchises. "They're in the metaverse!" or whatever. Instead of selling an NFT that conveys ownership of my house, I could sell an NFT " of " my house, which conveys nothing except itself. (Or: Anyone else could sell an NFT of my house.) "If I buy the NFT of your house do I get your house?" No, you get the NFT of my house. "Why would I want that?" I don't know.

See, I feel like the sophisticated answer here is something like, "Sure, it would be a house." Like I think that what is interesting about the idea of a "non-fungible token" is the possibility of linking some non-fungible thing in the real world, or some non-fungible slice of some real-world thing, to some transferable digital representation. And there is a strand of crypto thinking that is like "we are going to build a new financial system that will take over the entire job of financing and paying for the real world," and in this vein you need to think about ways to represent real economic activity. You want ways to digitize ownership of houses and factories and the contents of particular shipping containers and stuff like that.

And a lot of people who come to crypto with this way of thinking are like, well, we'll start by building out the digital primitives first, and then we'll figure out ways to associate them with real-world objects. So we'll figure out a way to build and trade non-fungible tokens, starting with tokens that are just empty nonsense, but then once we have that technology, we can work on trading tokens that are not empty nonsense. So one day instead of getting the title to your house through some archaic title registry where you have to go down to the basement of a courthouse and leaf through ancient paper documents and figure out if there are liens on the house, it will all be on the blockchain and home sales will be easy and you can own a fraction of a home and get a mortgage instantly, etc., etc., etc. And I am not saying that I expect all that stuff to happen in the near term, but it is at least an interesting vision for something, and the concept of "non-fungible token" is part of it.

Meanwhile there is another strand of thinking that is like "human life takes place increasingly online, and whereas people used to get meaning out of being seen promenading in the plaza in fancy clothes, now they get meaning out of being seen promenading on Twitter with fancy Bored Ape avatars, and we are finding ways to create artificial scarcity and gradations of status there and sell those gradations for a lot of money." And here, I mean, I see the point of "human life takes place increasingly online," but I do not really see the point "so I have spent $20,000 on a pixelated JPEG of an ape to use as my Twitter avatar because people will think that's cool." It's possible that I am just not cool, though! In 10 years maybe everyone will spend thousands of dollars on their avatars and only crusty weird nerds will be like, "No, I will just wear a burlap sack to promenade in the plaza, it keeps the wind out, that's all I need."

In traditional finance, there have been long boring controversies over high-frequency traders getting microsecond advantages over regular traders by paying for direct feeds of stock-exchange data, paying to colocate their servers near the stock exchanges' data centers, paying for high-speed fiber-optic lines between exchanges, etc. The idea is that there are sometimes brief dislocations in stock prices, or brief arbitrage opportunities where the price of something on one venue does not match the price on another venue; being the first to capture those dislocations is profitable, and trading firms will pay for advantages that make them faster. Sometimes they will pay the exchanges , for fast data or fast connections, and people with slower connections find that unfair.

Decentralized finance does not get rid of those sorts of conflict; it just renders them explicit and creates a market for them. Instead of a tier of high-frequency traders paying a stock exchange a monthly fee for fast connections to its matching engine, it's as if a stock exchange auctioned priority on every trade to the highest bidder. If a stock is trading at $10.01 on one exchange and at $10.02 on another exchange, whoever gets there first can buy it for $10.01 and sell it for $10.02 and make an instant penny of profit. Knowing that, the first exchange could just say "whoever pays the most to the exchange to buy the stock gets it," and it would run a little auction, and some high-frequency trader would bid, like, $0.0095 to be first, and would make $0.0005 of profit and the exchange would get $0.0095. And when I type numbers that small, you can probably see why this particular approach is not common in equity market structure.

Meanwhile in crypto every transaction does work this way, and there is an auction market for transaction priority, and sometimes the trade is "buy a 75 Ether NFT for 0.75 Ether," and the right amount to pay for that opportunity is, you know, 73 Ether or whatever, and paying 8 Ether for it is an absolute bargain.

This is called "Miner Extractable Value" in the literature, people talk about it a lot, and the term was apparently coined in a 2019 paper titled (with reference to the Michael Lewis book about traditional equity market structure) "Flash Boys 2.0: Frontrunning, Transaction Reordering, and Consensus Instability in Decentralized Exchanges":

We observe bots engage in what we call priority gas auctions (PGAs), competitively bidding up transaction fees in order to obtain priority ordering, i.e., early block position and execution, for their transactions. PGAs present an interesting and complex new continuous-time, partial-information, game-theoretic model that we formalize and study. We release an interactive web portal, this http URL, to provide the community with real-time data on PGAs.

We additionally show that high fees paid for priority transaction ordering poses a systemic risk to consensus-layer security. We explain that such fees are just one form of a general phenomenon in DEXes and beyond---what we call miner extractable value (MEV)---that poses concrete, measurable, consensus-layer security risks. We show empirically that MEV poses a realistic threat to Ethereum today.

Our work highlights the large, complex risks created by transaction-ordering dependencies in smart contracts and the ways in which traditional forms of financial-market exploitation are adapting to and penetrating blockchain economies.

I think a general tendency in crypto, and particularly in decentralized finance, is that it replaces other forms of social organization — companies, governments, trust, etc. — with markets and incentives. Here we have an instance of crypto replacing the concept of time priority with markets. Whoever is first to a trade gets to do the trade, but there is an auction for who gets to be first.

But actually you don't need to get into the metaphysics of NFTs to do this; this is just regular finance. Right now Howells has some sort of claim to those lost Bitcoins. That claim is not worth 8,000 Bitcoins or anything close to it, because:

1. Nobody has possession of the hard drive; it's somewhere in the dump. 2. Actually you can't be 100% sure it's even in the dump? Maybe a seagull carried it away, or everyone's memory of throwing it in the dump is wrong, I don't know. 3. The town of Newport, which runs the dump, has emphatically denied his requests to dig up the dump to find the hard drive and doesn't seem likely to budge on that. 4. Even if you did find it in the dump, it might have decayed to the point where his private key is not recoverable. 5. Even if the town authorities change their mind, he digs up the dump, he finds the hard drive, it works, his key is on it, and he recovers the 8,000 Bitcoins, many of those Bitcoins have been promised to someone else at this point: "He met with potential investors, and eventually made arrangements with two European businessmen who agreed to support a recovery operation. Howells would get only about a third of the proceeds. He had hoped for a much higher sum; the money was his, after all. He recalls being told, 'James, that's not how it works.'" (Also: "he made a public offer to give Newport a twenty-five-per-cent cut of the proceeds" if they approved his dig.) 6. It is not clear to me what his legal ownership of the hard drive is; if I snuck into the dump at night, found the hard drive myself and took it, could anyone demand it from me? It was thrown away; who owns it? Or if I formed my own consortium of diggers and promised Newport a 50% cut of the proceeds, and Newport let me dig, would Howells have any claim to stop me?

Still! Howells's murky contingent residual claim — "if I get permission to dig up this dump and if I find this hard drive and if we find the Bitcoins on it and after I pay off everyone else, I'll have some Bitcoins left" — seems like it might be valuable? It is somewhat better than a lottery ticket. There is some imaginable future — he certainly imagines it, and he's convinced some people to back him financially — where he actually digs up the hard drive and gets (some of) the Bitcoins and his stake is worth, you know, $120 million. If there's a 5% chance of that happening then that chance is worth like $6 million. Maybe someone would pay him $3 million for a 50% share of his claim? He's got a potentially valuable asset, which, by the rules of finance, means that he's got an actually valuable asset. Why not sell it? Isn't that better than hanging on to it obsessively?

I say sometimes that crypto is about rediscovering all of financial history in rapid succession, and this week we are covering activist investing and the separation of ownership and control:

SushiSwap, the decentralized cryptocurrency exchange that started with a scandal, is facing a crossroads as infighting among developers has investors seeking to reorganize the supposed autonomous organization.

Two large owners of Sushi tokens, which gives holders governance rights over how the protocol operates, submitted a proposal to restructure the project that may be considered for adoption as early as this week. The plan suggests establishing a more formalized entity to manage the effort, and checks and balances to ensure the proper spending of funds.

SushiSwap was supposed to be "a community-built open-source ecosystem," in which users could trade directly with each other, without intermediaries, and make operational decisions. But it turned out to be largely controlled by a handful of mostly anonymous developers, who sometimes bypassed community votes and have been seeking to increase their compensation. The discord has led to the trading of accusations of extravagant spending and self-enrichment without community approval or oversight, and the quitting of the exchange's chief technology officer Wednesday.

"It is physically impossible for every decision a DAO makes to go to a public vote," Jeff Dorman, chief investment officer of crypto investment firm Arca, which is one of the sponsors of the restructuring proposal, said in an interview. "We are using Sushi as a microcosm for what all DAOs should look like in the future."

Yes no look corporations learned all of this a few decades ago? If you have a company, it answers to its shareholders, and each share gets one vote blah blah blah. But the shareholders are busy and often passive and there are a lot of them and they're not gonna vote every time the company buys a pencil, so in practice they will need to delegate authority to a smaller group of directors, who will then delegate particular decisions to some hierarchy of executives and workers. And there will be some sort of legalistic control by the shareholders, and the shareholders will get to ratify big decisions and maybe propose big decisions of their own.

The whole "decentralized autonomous organization" concept has from the beginning struck me as very odd. That's … a … corporation? I wrote about an early DAO, called "The DAO" (later famously hacked), back in 2016:

All of this is trivially replicable using old-fashioned governance structures. Berkshire Hathaway would look a bit like the DAO if, instead of leaving things to Warren Buffett, all of its shareholders got to vote on every investment decision. When I put it like that you can probably see why this structure has not been super popular so far. But who knows!

Now it is popular, but we are still in early days. Eventually DeFi will figure out the benefits of (1) centralized executive decision-making and (2) carefully constructed investor checks on those decisions.

How can a physical artwork become an NFT," asks Felix Salmon at Axios, but of course Money Stuff readers know the answer. "By lighting it on fire," is the answer. We call this the "object-fire-token-money" cycle of non-fungible tokens, and it is the absolutely standard approach. Crypto mascot Brock Pierce explained NFTs to a guy by lighting the guy's painting on fire. Some comic-book artist apparently burns an original painting every month to make NFTs. Some DeFi platform burned a Banksy painting to make an NFT; later the guy behind it gave an interview under the pseudonym "Burnt Banksy." You buy the work of art, you light it on fire, and then you sell an NFT representing the now-incinerated work of art.

You might object that this is very stupid. I will not argue with you. In particular, if you are the person doing this process, you might ask, well, why do I have to burn up the work of art? What if I bought a painting, sold NFTs representing whatever-an-NFT-represents of the painting, and then also hung the painting on my wall? Who could object? The people buying the NFTs would still have the NFTs, which are digital tokens representing … nothing; they would own just as much nothing whether or not I actually burn up the painting. This way, I get the money from selling the NFTs, plus I get to keep the painting.

Salmon goes on:

The art market globally sees volume of about $60 billion per year, almost all of which is trade in physical objects. Art-world insiders including former Christie's co-chair Loïc Gouzer are on the lookout for ways to monetize physical paintings without necessarily giving up physical ownership of them.

There are some traditional ways to monetize a thing without giving up ownership of the thing. Borrowing against it is popular, for instance, but then you have to pay back the money. I think that you should read "monetize" here to mean "sell." Art-world insiders are on the lookout for ways to sell paintings without necessarily giving up physical ownership of them. Well, of course they are, aren't they? If you could sell a painting and also keep it, you would have both the money and the painting. That seems strictly better than having only the money or only the painting.

Salmon continues:

Gouzer said he spent $12.9 million at Sotheby's in May to buy a Banksy painting estimated at $3 million to $5 million. He's now showing the work at Art Basel Miami Beach under the aegis of Particle, a company that intends to turn the work into 10,000 NFTs "within the overarching structure of collective ownership."

I think you should read "within the overarching structure of collective ownership" to mean "with absolutely no collective ownership whatsoever":

The NFT owners will not have significant collective ownership of the physical painting. That would require Particle to register as a securities issuer. ...

As Particle managing director Harold Eytan told Axios, "NFTs are changing the way that people perceive ownership." Value drivers in the NFT world aren't based in contract law, they're based in community and consensus. So long as enough people believe that they're going to own a piece of a Banksy, they can trade on that belief.

Sure, right, yes, if someone thinks that you're selling them something valuable, they will give you money for it. And if you aren't in fact selling them something valuable then … well the point is to get them to give you the money.

So who will get the painting?

Particle claims that it "has chosen to legally destroy" the work by donating it to a non-profit called the Particle Foundation, which pledged never to sell the work. There is no legal destruction, however.

Yes! Yes! Yes! "I will buy a painting, and then I will turn it into an NFT by lighting it on fire, and then I will sell you the NFT, except that when I said 'lighting it on fire' I actually meant 'hanging it on my living room wall.'" Not that lighting it on fire made any more sense! Still!

I love this so, so much; I cannot stress enough how much I love it. Some rich guy will buy a multimillion-dollar painting and then you can just buy shares of The Fact That A Rich Guy Has A Painting. Do you have the painting? No, he does. But you have the NFT. Come on.

I am kidding a little bit — the foundation "will exhibit works," sure, and I suppose the guy is not literally going to hang it on his wall. "Museums could do something similar with their permanent collections, says Gouzer," the idea I suppose being that instead of asking for donations museums could, like, auction off tradable donation receipts? But I am not kidding much. We talked in September about a Bohemian prince who was auctioning off NFTs to restore his family's various castles. He keeps the castles, but if you buy an NFT, you get to pay for the upkeep of the castles and the restoration of the art on the walls. That's a great deal, for him. Why shouldn't art-world insiders get to sell their art and also keep it?

The basic innovation of crypto is the production of artificial scarcity. The original Bitcoin white paper addresses the problem: Sure, anyone can type numbers on their computer, but is there a way for a community to allocate numbers on your computer in a way that makes them demonstrably scarce? If there is, then you can call those numbers "money" and they can be valuable. I am being a little annoying, but this was obviously a real innovation and did in fact help make Bitcoin very valuable.

The rest of the crypto world continued applying that same process. Most non-fungible token projects address the problem: Sure, anyone can limitlessly reproduce JPEGs on the internet, but is there a way for a community to allocate ownership claims to JPEGs in a way that makes them scarce? The answer is … not really, no, in the sense that anyone can still right-click and save the JPEGs underlying most of the popular NFT projects. And yet the answer is also "sort of," in the sense that NFT communities tend to respect the allocations of ownership claims; they act like the JPEGs are scarce — the NFTs, the ownership claims, are scarce — and so they have value. And so some NFTs sell for lots of money.

Basically it is easy, using blockchain technology, to create scarce claims. You could I suppose use this technology to create scarce claims to scarce resources: You could put, like, housing deeds or shares of corporate ownership or cargo-container manifests on the blockchain. This would — people have argued for years — have benefits in terms of efficiency and legibility and tradability. It would create value by improving the processes by which real-world assets are transferred and allocated. Classic financial-services stuff. Nobody talks that much about this anymore.

Instead, people like to use blockchain technology to create scarce claims to abundant , or infinite , resources. There is absolutely no shortage of JPEGs, they are infinitely reproducible more or less for free, but that means — or meant — that you couldn't become a millionaire by having good taste in JPEGs. But now people can create a unique non-fungible token representing ownership of a JPEG and use it as a status symbol or a speculative asset. Nobody will pay you for a number in your computer's memory, but people will pay you for a scarce number in your computer's memory.

It is an interesting economic question whether this artificial production of scarcity could actually create value. Arguably abundance is more valuable than scarcity? Arguably this is all … terrible? Here is Ryan Broderick on crypto, Web3, right-clicking on NFT JPEGs, etc.:

The best overall articulation I've seen so far of why Web3 is so hated by many online subcultures right now was from @nicodotgay, the Twitter user behind the right-click mosaic. They explained in a follow-up tweet that they weren't anti-NFT for ecological reasons. "The real issue is that they represent an attempt to re-impose artificial scarcity on culture," @nicodotgay tweeted. "'Digital scarcity' is an anti human evolution ideology that imposes board game-like rules which serve no purpose than to preserve the game itself - to hide the internal contradictions of capitalism that become painfully obvious in an area of culture that has overcome scarcity."

But the other way to put that is that people do seem to enjoy status-competition and gambling games, they get some value out of them, and artificial scarcity allows them to play a lot more of those games, thus increasing human happiness, or something. There is a new abundance of scarcity.

The classic Ronald Coase model of the firm is that firms exist to optimize transaction costs. Some transactions occur in the market using the price mechanism, but it would be a pain to hire a new group of freelancers and negotiate their pay every time you want to do a new project, and so in practice companies exist with permanent salaried employees who can be told to do new projects without going through new market transactions. One promise of the internet was that it would reduce transaction costs: Technology makes it easier for buyers and sellers of goods and services to coordinate with each other, so they don't need the coordinating abilities of the firm. In recent years this has led to a surge of interest in non-firm ways of coordinating behavior, from gig-economy platforms (lots of people drive for Uber, but are not employees of Uber) to the Web3 projects that Davidson writes about to decentralized autonomous organizations in which people pool together to make joint decisions without a corporate management structure.

On the other hand, these days those projects tend to be built on crypto, which introduces huge new artificial transaction costs to mess it all up. Here is a Motherboard article about the people who donated $40 million to ConstitutionDAO, failed to buy the Constitution, and now can't get their money back because it will all be eaten up by transaction fees:

In its "how to donate" video, a member of ConstitutionDAO recommended that donors add "recommend adding about $150 to $200 more than you'd like to contribute" to their donations to pay gas fees, which are transaction fees on the Ethereum network. Motherboard contributed a small amount of money to the project to see how this would play out in practice. Here is how it worked:

ConstitutionDAO accepted only ether, the token on Ethereum. For someone to convert USD to $PEOPLE tokens, the process had several steps. First, we had to buy Ethereum on an exchange (we used Coinbase). We bought $200 worth of Ethereum. Coinbase took a $3 fee. Then, we had to send the Ethereum from Coinbase to a MetaMask crypto wallet. To do this, we had to pay a $12 network fee. Then, we had to send the Ethereum from MetaMask to Juicebox. So-called "gas" fees vary wildly and depend on how busy the Ethereum network is at any given moment and the complexity of the transaction. Right now, gas fees on Ethereum are very high, and a highly complex operation could end up costing hundreds of dollars in fees. In our case, we paid a $75 gas fee to contribute roughly $75 to the project. Of the initial $200 we bought in ETH, $90 was eaten up in fees simply to donate to ConstitutionDAO. …

In order to get a refund, we have to do this in reverse, basically. And so to get our ETH back from Juicebox, we would have to pay gas fees again, meaning essentially the entirety of the amount invested would be wiped out. …

Interactions with the Juicebox contract on the Ethereum blockchain reveal numerous instances of people getting their money back only to have it significantly reduced by fees or wiped out entirely. Here's someone transferring .011 ETH ($46) out and paying .015 ETH ($63) in fees, meaning they ended up paying $18 for their $0 refund. Here's someone else getting .018 ETH ($76) refunded and paying .0175 ETH ($74) in fees, so they got $2 back when all was said and done.

The basic idea of a stablecoin is that it is a cryptocurrency that lives on the blockchain and is always worth one U.S. dollar. (Or one euro, or some other pegged unit of account.) The simple way to do a stablecoin is to have the issuer sell stablecoins for one dollar each, and put the dollar somewhere safe. Then when a stablecoin holder wants her dollar back, the stablecoin issuer has it, and can give it to her.

This is the way that some stablecoins work. They put the dollars into Treasury bills or bank accounts at reputable banks or whatever, somewhere safe. Other stablecoins work differently. A popular way to build a stablecoin is with senior claims on volatile cryptocurrency. But arguably the leading way to build a stablecoin is a variant on the simple approach: The issuer sells stablecoins for one dollar each and puts the dollar somewhere not safe. Then, when you ask the issuer where it's keeping your dollars, it says "ooh sorry no that's a big secret but trust us, it's somewhere real good."

This … look, I don't know man, maybe that's fine, but it makes people nervous. U.S. financial regulators are particularly nervous and have proposed new rules for stablecoins. The gist of the proposed rules is that only regulated banks will be allowed to issue stablecoins. We have talked about these rules, and I have pointed out that they are strange. In particular, these rules are stricter than the rules for traditional finance. In traditional finance, you can start a money-market fund that takes your dollar, puts it into Treasury bills or bank certificates of deposit or whatever, and promises to give you the dollar back when you want it; that would not be regulated as a bank. But in crypto, under the proposed rules, that would have to be a bank.

But here is a memo from Davis Polk & Wardwell LLP that points out something even stranger: Under the proposed rules, it would be impossible to do stablecoins the good simple way. If you wanted to set up a stablecoin under these proposed rules, you'd need to do it in a bank. So you set up Stablecoin Bank Corp. You issue $1 billion of stablecoins and invest the money in $1 billion of extremely safe stuff, Treasury bills expiring tomorrow or whatever. And then the banking regulators would come to you and say: No, this doesn't work, if you have $1 billion of Treasuries you need $40 million of equity; that is a central rule of bank capital regulation, that you need equity alongside your deposits. And then as you issue more stablecoins you have to raise more equity, and it is hard to get a decent return on equity if you're investing in only the very safest things. So you are forced to reach for yield, to buy riskier things with higher yields in order to make a return on equity — you know, like banks do. Davis Polk:

By recommending that Congress require all stablecoin issuers to be IDIs [insured depository institutions, i.e. banks], the Report would effectively require all stablecoin issuers to engage in fractional reserve banking and effectively prohibit them from being structured as 100% reserve banks (i.e., narrow banks) that limit their activities to the issuance of stablecoins fully backed by a 100% reserve of cash or cash equivalents.

The reason is that IDIs are subject to minimum leverage capital ratios that were calibrated for banks that engage in fractional reserve banking and invest the vast portion of the funds they raise through deposit-taking in commercial loans or other illiquid assets that are riskier but generate higher returns than cash or cash equivalents. Minimum leverage ratios treat cash and cash equivalents as if they had the same risk and return profile as commercial loans, commercial paper and long-term corporate debt, even though they do not. Unless Congress recalibrated the minimum leverage capital ratios to reflect the lower risk and return profile of IDIs that limit their assets to cash and cash equivalents, the minimum leverage capital ratios would make the 100% reserve model for stablecoin issuance uneconomic and therefore effectively prohibited. It is puzzling why the PWG, FDIC and OCC would recommend a regulatory framework that would effectively require stablecoin issuers to invest in riskier assets and rely on FDIC insurance rather than permitting stablecoins backed by a 100% cash and cash equivalent reserve.

We have talked previously about the Fed's hostility to " narrow banking," the idea of a bank that would just take deposits and park them in reserves at the Fed. This is a perfectly safe form of banking, but it is not a traditional form of banking; traditionally, banks take deposits and use them to make longer-term loans to businesses and consumers and homeowners. The Fed seems to like traditional banking, the kind where banks use deposits productively (but riskily); it does not like narrow banking, the kind where banks just park deposits somewhere safe. If stablecoins have to be banks, they will have to be risky: They will have to have equity capital, which will cushion stablecoin users against the risk of loss, but they'll need to buy assets that create that risk of loss. The dream of a stablecoin as a narrow bank, where it issues dollar-denominated crypto assets and backs them with dollars deposited at the Fed, won't work.

Again, this is weird! Again, it is not the rule in traditional finance, where narrow banks are disfavored but Treasury money-market funds are fine. But the rules seem harder for crypto.

There is a breed of Japanese hunting dog called a Shiba Inu. You might know it from Doge, a meme of a dog who talks funny; Doge is a Shiba Inu. There is also a cryptocurrency called Shiba Inu. (Often abbreviated/tickerized as SHIB.) This is distinct from Dogecoin, another cryptocurrency that is also based on Shiba Inus.

Shiba Inu, the cryptocurrency, is "based on Shiba Inus" in the sense that its name is "Shiba Inu" and some of its branding involves Shiba Inus, but that's it. Shiba Inu the cryptocurrency is not redeemable for Shiba Inus the dogs. There is not a fixed exchange ratio between the cryptocurrency and the dog; arbitrageurs do not keep the prices of the cryptocurrency and the dog in line. Nor does the cryptocurrency represent some sort of claim on the cash flows of the dogs, or on the cash flows of intellectual property related to the dogs, etc. Nor do the dogs generate the cryptocurrency. Nor is the cryptocurrency issued or governed by a collective of dogs. The cryptocurrency is sort of inspired by the dog but that's it. Nothing flows from the cryptocurrency to the dogs, or from the dogs to the cryptocurrency.

And yet:

With virtual life increasingly indistinguishable from everyday reality, it makes sense: Just as the price of dog-inspired cryptocurrencies Dogecoin and Shiba Inu coin have exploded, so has demand for—what else?—living, breathing shiba inus.

While Dogecoin, the cryptocurrency created from a meme back in 2013 using the image of a shiba inu, enjoyed a burst of popularity this summer, it was recently overtaken in market value by the slightly less creatively named Shiba Inu coin. In classic crypto style, it sounds like a joke but is immensely valuable, with investors pushing up its price almost 800% in the past month, even though a coin still costs a tiny fraction of a cent.

At the same time, shiba inu breeders across the U.S. say they're seeing more business than ever since cryptocurrency trading brought the Japanese hunting dogs into the limelight.

Credit Elon Musk, crypto godfather and the richest man in the world, for some of that rocket-ship-emoji action. His recent tweets of his new shiba inu puppy, Floki, ignited speculation that he'd invested in Shiba Inu coin himself, sending its price rallying and even sparking the creation of more dog coins with the name "Floki" involved. Robinhood users are calling on the brokerage to list Shiba Inu coin—it already allows trading in Bitcoin, Ethereum, Dogecoin, and Litecoin—a petition to that effect has more than 450,000 signatures.

There is — I'm sorry, I'm so sorry — there is an arbitrage between the Shiba Inu coin and actual Shiba Inus. When the stock of the dog goes up (because Elon Musk gets one) people race to buy the coins. When the coins go up, people race to buy the dogs.

I wrote a few weeks ago:

I confess that I am inspired by NFTs, and I guess by Tether, but also by the SHIB cryptocurrency, which, through the awesome power of pure nonsense, seems to track something like "how much attention are people online paying to Elon Musk getting a Shiba Inu?" When Musk tweets about getting a Shiba Inu dog, SHIB goes up. Is it worth more? Is there a robust arbitrage mechanism to ensure that the price of SHIB tracks the cuteness of Musk's Shiba Inu? Does SHIB confer any ownership rights to Musk's dog? Are there cash flows from the dog that are securitized into SHIB? No, absolutely not, it is nothing, it is a pure online joke, but when Musk tweets about his Shiba Inu people are like "oh I remember that there's an online joke token about this" and they buy SHIB and it goes up. It has a market capitalization of $10 billion. It's up 216% this week because of a Musk tweet. This isn't my fault! I don't make this stuff up! This is a real thing that is happening!

All I am saying is that if I sold you a crypto token that was called "StripeCoin" and I said "this is a token on the stock of Stripe" you might say — because you are reading Money Stuff, etc. — you might say "wait how is the value of the token linked to the value of Stripe" and I would say "hahahaha it absolutely isn't." But my hypothesis is that not everyone is as skeptical and literal-minded as you are, and some people would just go buy StripeCoin when they had nice thoughts about Stripe and sell StripeCoin when they had sad thoughts about Stripe and buy a whole lot of StripeCoin when Stripe went public, and it would at least directionally end up being a sort of a proxy for Stripe stock. And everyone would get what they came for, which is a convenient way to gamble on people's feelings about Stripe.

Here are three sentences that I found on the internet:

SQUID implements an innovative anti-dump mechanism where buying in the market will release selling credits at a rate of 2:1.

The maximum amount of SQUID that can be sold is half of the total buying value in the pool. When the credit in the pool is depleted, you can't sell any more.

That is an innovative anti-dump mechanism! Whenever stocks or cryptocurrencies go up, someone will half-joke that the explanation is "more buyers than sellers." If you just build into the design of your cryptocurrency that there always have to be twice as many buyers as sellers, it will always go up.

Obviously that sentence makes no sense, and SQUID — the Squid Game Token — did not always go up during its short life. Well, actually it did — "It surged more than 230,000% in the past week to $2,861.80," says Bloomberg News — until its anonymous developers apparently stole all the money; then it went down. The whole thing is so stupid and overdetermined that I cannot bear to write about it; if you lost money on SQUID you should just come to my house and give me your wallet because you should not be allowed to use money anymore. "New Squid Game Cryptocurrency Launches as Obvious Scam," reported Matt Novak at Gizmodo last week, before it crashed, listing red flags like "Netflix's Squid Game is the most popular streaming show in the world right now, so it makes sense that scammers would use the name without permission," and "the website for the Squid Game crypto even includes a fake endorsement from billionaire Elon Musk," and "the single largest red flag is the fact that people can put money in, but can't take it out." According to the now-disappeared white paper there was purportedly a mechanism to take money out by (1) spending a lot of SQUID coins to play a game, (2) winning the game, (3) collecting some other related cryptocurrency and then (4) being allowed to sell your SQUID freely if you had that currency. But, come on, instead they just stole all the money.

I do, however, want to talk about that anti-dumping mechanism, which I love. It is a basic fact about financial markets that if lots of people want to buy an asset and nobody wants to sell it, the price will go up. (Strictly, if nobody wants to sell it, there will be no trades and no price, but if very few people very reluctantly sell it then there will be some trades and the price will go up.) In general this is sort of an epiphenomenon of some more fundamental reason that people want to buy it. "More buyers than sellers" is a joke , a non -explanation; if someone asks you why Tesla stock went up and you say "more buyers than sellers" you are just being annoying and obtuse.[5]

But in modern crypto and meme-stock markets this basic fact has been distilled into a fundamental belief, free of any underlying reason. "If we all buy this thing and don't sell it, the price will go up, and then we'll be rich" is a belief that is … sort of logical? … and that can be applied to anything. "If we all buy GameStop Corp. stock," etc.; there the belief went by the name "diamond hands." "If we all buy Bitcoin," etc.; there it goes by the name "HODL." There is a new generation of crypto stuff like Olympus DAO, where it goes by the name "(3,3)," a vague wave in the direction of game theory: "(3,3) is the idea that, if everyone cooperated in Olympus, it would generate the greatest gain for everyone (from a game theory standpoint)." "Cooperate" in that sentence just means buying a lot and never selling.

This belief has a basic mechanical problem, which is that if you all buy the thing and don't sell it and become rich, you can't actually use your riches without selling the thing. Sometimes this takes the shape of a pump and dump: People buy the thing, it goes up, they get rich on paper, they try to cash out, it crashes, some of them are left holding the bag. Sometimes, though, it takes the shape of, like, mass adoption and stable wealth? If you bought a lot of Bitcoins at $2 you are very rich now and you can probably cash out enough wealth to buy a yacht without really affecting the price of Bitcoin. Bitcoin just kind of made it.

The weirdest thing that I think about is that GameStop might also have kind of made it? If you got rich on GameStop you can sell your GameStop stock and be rich and the price might be unaffected either by your selling or by the underlying cash flows of GameStop the company. That is much weirder than Bitcoin because GameStop is a company. But the point is that when I say that this belief can be applied to anything, I also mean that it might work for anything. Like, why not, mass societal adoption of GameStop as a store of value, stranger things have happened though I cannot actually think of one.

SQUID did not make it, obviously. But its marketing is instructive. The marketing was "people can buy it but they can't sell it." Skeptics, correctly, interpreted this as a mark of a scam. But it was marketed as a good thing , an innovative way to design a coin that would always go up because people would buy and not sell it. There is a lot of demand for that!

I don't want to say that stablecoins are the hot new thing in crypto now, or that they are a new and interesting way to do anything. A stablecoin is a cryptocurrency that is supposed to always be worth a dollar. There are various ways to do that. The main ones are a "backed stablecoin," where you sell stablecoins for $1, put the $1 in the bank, and stand willing to buy the stablecoins back with the $1, and an "overcollateralized stablecoin," where you issue senior claims on $20,000 worth of volatile crypto to support $10,000 of stablecoins.[1]

There is nothing particularly new about these approaches. A backed stablecoin is something very close to a money-market mutual fund, in which you take money from investors, put the money into safe short-term interest-bearing investments, and promise to redeem the investors at $1. (Typically money-market funds pay interest and stablecoins don't, which makes stablecoin issuing a good business to be in.) I wrote once about a Franklin Templeton money-market fund that might one day live on the blockchain; what I wrote was that Franklin Templeton was "launching a stablecoin." Because that's what it is.

An overcollateralized stablecoin, meanwhile, is very close to a short-term (redeemable-on-demand) senior claim on a volatile asset or pool of assets. There are lots of things like that. The main short-term funding market in modern finance is the repo market, which consists basically of risk-free-ish overnight senior claims on bonds and other assets; those assets tend to be a lot less volatile than crypto but on the other hand the haircuts are smaller. Or there is — or at least, was — asset-backed commercial paper, a form of short-term, money-like obligations secured by a pool of mortgage-backed securities; this performed poorly in 2008, and ABCP, like CDO, became one of the bad initialisms of the financial crisis.

An important mechanism to remember is:

1. You create a new cryptocurrency, WashCoin. 2. You mint a trillion WashCoins and put them in your crypto wallet along with $2 of Ethereum. 3. How much are your trillion WashCoins worth? I mean, zero dollars, right? 4. You open another crypto wallet and put another $1 worth of Ethereum in it. 5. You send the $1 of ETH from the second wallet to the first in exchange for one WashCoin. 6. The next day, you send $2 of ETH from your first wallet back to the second in exchange for that one WashCoin. 7. Now the trading price of a WashCoin is $2, so its total market capitalization is $2 trillion, up 100% in the last 24 hours. 8. You still own 100% of the WashCoins and nobody has paid you anything for them. 9. But, now that the market cap is $2 trillion and soaring, somebody might.

Is this legal? In the stock market , no, of course not; it is "wash trading." Is it legal in the crypto market? I dunno man, it's crypto. Does this describe all of crypto? No, of course not, Bitcoin trading is pretty much all independent economic activity and very little wash trading at all. Does it describe … a certain amount … of crypto? Yes, absolutely. If you see that a ridiculous non-fungible token sold for $500 million, should you just assume that the buyer was also the seller? Probably!

One point here is that if CryptoPunk 9998 is worth $500 million, then other CryptoPunks are also worth a lot. But also other , non-CryptoPunk NFTs are more attractive, because if CryptoPunks are so valuable then that process might repeat. And Ethereum is more attractive, as a platform for buying NFTs. And other cryptocurrencies are more valuable, because look how quickly Ethereum's ecosystem developed, maybe that can be repeated. Everyone who is already in the broad crypto ecosystem benefits when stuff in crypto gets more valuable, because that entices new people into the crypto ecosystem and makes all of the stuff more valuable.

You could tell a story in which this leads to a wash-trading dynamic even among arm's-length counterparties without coordination: If you sell me one CryptoWolverine for $1, and I sell it to someone else for $2, and she sells it to someone else for $3, then we have collectively pumped up the value of the ecosystem that we are all invested in; it is in each of our personal interests to overpay for stuff so that the rest of our stuff is worth more. But not by $500 million. That's probably just regular wash trading.

If you buy shares of an S&P 500 index exchange-traded fund, what does the fund do with your money? There is a technical answer about in-kind creation and authorized participants that I am going to ignore here to just say: The fund takes your money and uses it to buy shares of the 500ish stocks in the S&P 500. If you slice open the S&P 500 ETF, you will find a bunch of stocks. It owns stocks. When you own shares of the S&P 500 ETF, you own a portion of the big pot of stocks that it owns.

If you buy shares of a Bitcoin ETF, what does the fund do with your money? Again I will ignore technical creation mechanics. Also of course this is a trick question, you cannot (in the U.S.) buy shares of a Bitcoin ETF, Bitcoin ETFs do not exist. But soon they will, Bloomberg's Katie Greifeld, Vildana Hajric and Benjamin Bain report:

The Securities and Exchange Commission is poised to allow the first U.S. Bitcoin futures exchange-traded fund to begin trading in a watershed moment for the cryptocurrency industry, according to people familiar with the matter.

The regulator isn't likely to block the products from starting to trade next week, said the people, who asked not to be named while discussing the decision. Unlike Bitcoin ETF applications that the regulator has previously rejected, the proposals by ProShares and Invesco Ltd. are based on futures contracts and were filed under mutual fund rules that SEC Chairman Gary Gensler has said provide "significant investor protections."

So what will the Bitcoin ETF do with your money? The answer is:

1. It will put about 30% of the money into a collateral account at a U.S. registered commodity futures exchange, to collateralize positions in cash-settled Bitcoin futures. The futures exchange will presumably hold the collateral in bank accounts or Treasury bills or whatever. 2. It will put about 70% of the money into money-market securities, Treasury bills or high-grade commercial paper or whatever.

Basically if you slice open the Bitcoin ETF you will find a bunch of (U.S. dollar) cash equivalents. Plus a cash-settled bet with a futures exchange that the price of Bitcoin will go up. If Bitcoin goes up, the ETF will get more cash to plop into money-market securities. If Bitcoin goes down, the ETF will have to sell some of those securities to hand over some cash. If Bitcoin doubles, the ETF's cash will more or less double; if Bitcoin goes to zero, the ETF's cash will more or less disappear.

The ETF holds a synthetic Bitcoin: cash, plus a derivative to make that cash go up and down with the price of Bitcoin. Somebody is manufacturing that synthetic Bitcoin for the ETF. Probably that someone is an arbitrage trader on the futures exchange, and probably the main ingredient it is using to manufacture the synthetic Bitcoin is a real Bitcoin. The trade is roughly:

1. The arbitrageur gets together $60,000 and buys one Bitcoin on a Bitcoin exchange, keeping it in custody on the exchange or in the arbitrageur's own Bitcoin wallet. 2. The arbitrageur sells one cash-settled Bitcoin future on a registered futures exchange, posting $20,000 of collateral with the exchange to ensure that it will pay up on the bet. 3. If the price of Bitcoin goes up, the arbitrageur has to put more cash into the futures exchange to margin its position. The value of the Bitcoin it holds goes up, but that doesn't necessarily generate any cash; it's not going to sell the Bitcoin. 4. If the price of Bitcoin goes down, the arbitrageur gets some cash out of the futures exchange. The value of the Bitcoin it holds goes down, but that doesn't necessarily cost it any cash; it's not going to sell the Bitcoin.

If you put $60,000 into a Bitcoin ETF, it will post about $20,000 at the futures exchange to collateralize one synthetic Bitcoin, and will keep the other $40,000 in cash earning a bit of interest. Meanwhile the person selling it the synthetic Bitcoin has to put up about $80,000 to (1) buy the actual Bitcoin and (2) post margin at the futures exchange itself. That $80,000 isn't free; you have to pay the arbitrageur for the use of its balance sheet.

Also, the person selling the synthetic Bitcoin has to keep custody of the real Bitcoin it uses to manufacture the synthetic Bitcoin. This is a problem that has become easier over time, but it is still not entirely trivial; there is a lot more high-stakes remembering of passwords in the Bitcoin world than there is in the traditional financial system. This also costs money.

So the people manufacturing the synthetic Bitcoins for the ETF will charge for that service: They have to put up $80,000 of cash and then do a lot of hard password-remembering to keep their Bitcoin, while the ETF only has to put up $20,000 of cash and take the relatively pleasant credit risk of a registered U.S. commodity futures exchange. So if you buy a synthetic Bitcoin — as the Bitcoin ETFs plan to — you have to pay more for it than you would for a regular old Bitcoin:

In recent days, the annualized premium on CME bitcoin futures prices over bitcoin's spot value was 15%, compared with about 7.7% on average over the first nine months of the year. Traders can make those returns by buying spot bitcoin and shorting the futures contract because the two prices will converge in the future, said Noelle Acheson, head of market insights at crypto lender Genesis Global Trading Inc. She chalks the gap in the premium up to institutions rushing to buy bitcoin futures in expectation of the ETFs' approval. …

But futures-based ETFs are vulnerable to divergences in the prices of the futures and the underlying assets they track—in this case bitcoin, which is notoriously volatile.

ETFs may also lag the performance of bitcoin if it keeps rising. Longer-dated bitcoin futures have tended to trade above short-term contracts, a market dynamic known as contango. This can lead to lower returns for funds as they pay to roll over monthly contracts.

"A lot of people really don't understand how futures work," said Kathleen Moriarty, an ETF lawyer, of individual investors.

The basic way that futures work is that you are paying someone else to store your Bitcoins for you, which is expensive.

Why not just store the Bitcoins yourself? Really there are two questions there:

1. Why doesn't the ETF just store the Bitcoins itself? You give the ETF $60,000 and, instead of spending that on money-market securities and futures margin, it just goes out and buys a Bitcoin. 2. Why not just store the Bitcoins yourself? Don't give the ETF anything; just pay $60,000 to someone with a Bitcoin and get the Bitcoin.

The answer to the first question is essentially that the SEC is probably about to approve futures-based Bitcoin ETFs, but seems to be considerably more skeptical about "physical" Bitcoin ETFs, ETFs that would actually hold Bitcoins. This is, I suspect, mostly a matter of regulatory legibility: Bitcoin futures trade on registered U.S. futures exchanges, and if weird stuff happens on those exchanges U.S. regulators have lots of power to investigate and intervene; Bitcoins themselves trade in lots of different places, many of them not subject to much U.S. regulatory oversight. Also physical custody of Bitcoins does seem to be an issue that the SEC worries about, and if an SEC-approved physical Bitcoin ETF forgot its passwords and lost all of its customers' Bitcoins that would be really, really, really, really … let's not kid ourselves, it would be hilarious, but it would be really upsetting for the SEC. Whereas an ETF that just holds a pot of money-market instruments and some regulated exchange-traded futures is, you know, fairly normal.

Speaking of weird stablecoins:

Tether will pay $41 million to settle a U.S. regulator's allegations that it lied in claiming each of its stablecoins was backed by fiat currencies.

From at least June 2016 through February 2019, Tether misrepresented to customers and the cryptocurrency market that it maintained sufficient U.S. dollar reserves to back every token, the Commodity Futures Trading Commission said in a Friday statement. Since its 2014 launch, Tether had claimed that its coins were pegged to fiat currencies and "100% backed by corresponding" assets, the CFTC said.

Here is the CFTC's announcement. It is not much new if you followed the New York state case against Tether a couple of years ago, but that case was wild and if you didn't follow it you should go ahead and read the CFTC one. We have talked recently about Tether's reserves, which remain interesting, but overall my impression is that Tether in 2021 is a model of probity and transparency compared to Tether in 2017. From the CFTC order:

In contrast to Respondents' statements, Respondents did not at all times hold sufficient fiat reserves in the Tether Bank Accounts to back USDt tokens in circulation for the substantial majority of the Relevant Period. Indeed, for the time period of September 2, 2016 through November 1, 2018, the aggregate amount of fiat currency held by Tether in the Tether Bank Accounts was less than the corresponding USDt tokens in circulation on 573 of 791 days, meaning that, contrary to Respondents' representations, the Tether Reserves were "fully-backed" by fiat currency reserves held in the Tether Bank Accounts only 27.6% of the time. Instead, at various times, Tether maintained some of the Tether Reserves in bank accounts other than the Tether Bank Accounts. Tether represents that, at times, it also included receivables and non-fiat assets among its counted reserves; and further represents that Tether has not failed to satisfy a redemption request for tether tokens. ...

On June 1, 2017, there were at least 109,844,263 tether tokens in circulation; by July 1, 2017, there were at least 214,852,881 tethers in circulation; by August 1, 2017, there were at least 319,398,873 tether tokens in circulation; and, by September 15, 2017, there were at least 442,481,760 tether tokens in circulation. During this same time, the amount held in the GC Trust Account never exceeded $61.5 million.

At various times during the Relevant Period, Respondents relied upon unregulated entities and certain third-parties to hold some of their funds, including Tether Reserves, and for a period of time commingled Tether Reserves with funds belonging to Bitfinex and/or Bitfinex customers. In aggregate, during the Relevant Period Tether and Bitfinex's assets included funds held by or received from third-parties pursuant to at least 51 different arrangements, only 22 of which were documented through loan agreements, trust agreements, or other formal contracts.

Basically in the early days of Tether (and also possibly now?), it was pretty hard for a newish stablecoin to get a smooth straightforward banking relationship with a large regulated bank, and so as cash came into Tether it was reduced to, like, finding people on the street and saying "hey could you hold onto this giant bag of cash for us?" And mostly the people do seem to have held on to the cash and given it back to Tether on request — though not quite always! — but it is not the sort of thing that looks great to a regulator.

On Thursday I talked at some length about a way to manufacture a stablecoin — a cryptocurrency that is always worth a dollar — out of no ingredients other than Bitcoin (or some other volatile cryptocurrency). The recipe is fairly simple:

1. You get a Bitcoin. 2. A Bitcoin is worth $55,000. 3. Maybe tomorrow it will be worth, like, $52,000, or even $45,000. 4. But it won't be worth less than, say, $25,000. 5. So you issue (say) 25,000 stablecoins, each worth $1, collateralized by the Bitcoin. 6. Someone has to put up the other $30,000 to buy the Bitcoin (along with the $25,000 from selling the stablecoins). This person is left with the residual claim on the Bitcoin, i.e., once the 25,000 stablecoins are paid back at a dollar, the residual claimant gets whatever the Bitcoin is worth above that. If Bitcoin goes to $100,000, the residual claimant ends up owning $75,000 worth of Bitcoin after paying off $25,000 worth of stablecoins (and makes a $45,000 profit). If Bitcoin goes to $30,000, the residual claimant ends up owning $5,000 worth (and losing $25,000). If Bitcoin goes to $20,000 the residual claimant is wiped out and the stablecoins are no longer stable but what are the odds of that.

My point here was, one, to explain that this basic approach — tranching of a risky asset into junior and senior claims — is the main move in traditional finance, and that combinations and variations on this move are most of what the financial system does. Two, I wanted to explain some of the advantages and disadvantages of this approach compared to the other main method of making a stablecoin, which is to sell 25,000 dollar stablecoins for cash and put the $25,000 you raise into a traditional dollar bank account (or, more realistically, use it to buy safe dollar-denominated assets like commercial paper or Treasury bills). The main advantage of the Bitcoin-based approach (call it an "overcollateralized stablecoin") is that it manufactures stablecoins out of pure crypto, without too much of an interface with the traditional banking system; if you don't trust banks to hold your dollars, this seems preferable. The main disadvantage is that it manufactures stablecoins out of pure crypto, without any actual dollars; if you don't trust Bitcoin to hold its value, this seems worse.[1]

My third point was that Tether, the biggest and weirdest and most controversial stablecoin, mostly seems to be the other kind of stablecoin, call it a "backed stablecoin," the kind with money in the bank. It advertises that all of its coins are backed at least 1-for-1 with safe dollar assets. But in fact a (small but interesting) fraction of those "safe dollar assets" are in fact secured loans to crypto companies, secured specifically by cryptocurrency. Tether is mostly (it says) in the business of getting dollars, issuing stablecoins, and putting the dollars in the bank (or Chinese commercial paper), but it is also a little bit in the business of getting dollars, issuing stablecoins, and using the dollars to fund levered Bitcoin positions.

But I neglected to mention that there are a number of stablecoins that are explicitly, entirely in that business, stablecoins that just are overcollateralized stablecoins. The most famous is probably Dai, the stablecoin of MakerDAO. "The Maker Protocol, also known as the Multi-Collateral Dai (MCD) system, allows users to generate Dai by leveraging collateral assets," says its white paper. And:

Dai is generated, backed, and kept stable through collateral assets that are deposited into Maker Vaults on the Maker Protocol. A collateral asset is a digital asset that MKR holders have voted to accept into the Protocol.

To generate Dai, the Maker Protocol accepts as collateral any Ethereum-based asset that has been approved by MKR holders. MKR holders must also approve specific, corresponding Risk Parameters for each accepted collateral (e.g., more stable assets might get more lenient Risk Parameters, while more risky assets could get stricter Risk Parameters). Detailed information on Risk Parameters is below. These and other decisions of MKR holders are made through the Maker decentralized governance process.

And:

When a user deposits ETH or any supported ERC20 token into the Maker platform as collateral, Dai is created and loaned to the user at a collateral-to-loan ratio of 66%,[2] which increases the supply of Dai.

One thing I will say about this is that it is way more transparent and straightforward than the picture I tried to paint of Tether as sort of doing some amount of complicated transformation of Bitcoins into dollars at some unspecified level of overcollateralization. This is just a decentralized platform automatically transforming Ether into dollars at a specified level of overcollateralization with clearly defined procedures for making sure the collateral is sufficient and for liquidating if it isn't.