October 24, 2019
I spent most of this week in Washington, in part filming an interview with IMF managing director Kristalina Georgieva. "Axios on HBO" airs at 6pm ET/PT on Sunday.
- In this week's 1,829 words (a 7-minute read): Exchange monopolies; WeWork; international noncooperation; mistrust in business; and much more.
- Please tell your friends about Edge! They can sign up very easily at edge.axios.com.
1 big thing: The case for exchange monopolies
Exchanges matter. Exhibit A: In the end, it was the Chicago Mercantile Exchange that dealt the final death blow to the theory, published in Vanity Fair, alleging President Trump or his associates had somehow been trading major geopolitical news by buying and selling e-mini contracts on the futures markets.
- Impartial observers including myself and futures expert George Pearkes poured cold water on the theory as soon as it came out. But journalists sniping at one another rarely settles anything.
- The CME press release settled everything. "CME Group regularly monitors its markets for suspicious activity," it said. "As it relates to the Vanity Fair article published on October 17, 2019, regarding activities in the E-mini S&P 500 futures contract, the allegations about the trading activity are patently false."
- CME would know, because it has a monopoly on e-mini trading. There are various different e-mini contracts, but all of them are traded only on the CME.
The big picture: The CME, host to trillions of dollars' worth of trades, needs to be trusted by thousands of counterparties around the world.
- As such, it's in the exchange's own best interest to ensure that, in the words of the Vanity Fair headline, no "hanky-panky" is going on. It's CME itself, rather than any regulator, that's best placed to do so.
- Regulators can't hope to keep up with the volume and sophistication of these markets. Only the exchanges themselves have the wherewithal to track every trade and ensure there are no shenanigans.
- Mattli has a provocative yet compelling thesis: That the U.S. stock market was much better regulated before 2005, in the years when the New York Stock Exchange had monopoly power and self-regulation had teeth. Since then, the number of exchanges has risen to 23; NYSE market share has dropped to 12%; and the NYSE no longer has the ability or the inclination to police the entire market.
- Without the NYSE keeping a watchful eye on trading, the entire stock market has been overrun by predatory high-frequency traders. Far from enforcing a level playing field, the exchanges are incentivized to give the HFTs every conceivable advantage. The algobots provide most of the exchanges' volume and liquidity, after all.
- The losers: Big institutional investors, accounting for the lion's share of the money that Americans have invested in the stock market, are the biggest losers. No one exchange has sufficient liquidity any more to absorb large trades, which are the only trades that big investors really want to do.
- The winners: Individual retail investors probably come out on top from this deal, but it's the high-frequency traders who are by far the biggest winners. Even on the rare occasions that they are caught in unlawful exploits, they generally suffer de minimis consequences. The occasional fine does them no reputational damage, and pales in comparison to the profits they can make.
The bottom line: While the CME, with its monopoly, does a good job of staying on top of the e-mini contract in particular, it can't effectively regulate today's ultra-sophisticated cross-border arbitrageurs.
- In order to do that, it would need to merge with stock and futures exchanges around the world.
- That would violate any number of global antitrust laws, but it might be less bad than the status quo.
2. WeWork never learned from Jeff Koons
Some flywheels are broken, and can fall apart astonishingly quickly. This week's WeWork news provides a prime example — one that will be very familiar to millionaire pop artist Jeff Koons.
- The flywheel is one of those concepts you come across a lot in business and strategy circles, especially as applied to Amazon. Jeff Haden does a great job of describing the model here, but at heart it's any virtuous cycle.
- Medium has a very simple flywheel, for instance, where readers pay money to writers, who can write more as a result, attracting more paying readers, and so on.
The most dangerous flywheel is one where a rising share price is a core component of the virtuous cycle.
- Many high-flying tech companies, including Amazon and Palantir, use their rising share price as a key talent-retention mechanism. Without it, they find it much harder to attract the qualified engineers they need to continue to grow.
WeWork, however, used its rising share price as much more than just a recruiting tool. Its breakneck growth created enormous losses, and its shareholders were OK with those losses if and only if they were seeing even greater gains in the share price. When the value of a company's shares rises by $10 for every extra $1 it loses, then it's natural for shareholders to want to lose as much money as possible.
- WeWork's erstwhile flywheel: Its rising share price attracts ever-greater investment rounds, which fund ever-greater losses, which fuel ever-faster growth, which feeds back into the rising share price.
The now-scuttled IPO was supposed to be WeWork's biggest investment round of all, which would ratify the company's largest-ever valuation.
- When public market investors balked, the flywheel fell apart. There was no money to cover the company's losses any more — WeWork reportedly couldn't even afford to fire staffers because it didn't have the cash to make severance payments.
- Suddenly, losses were bad rather than good, and the valuation of WeWork crashed, like an electron jumping down a series of energy levels.
Jeff Koons could have told WeWork CEO Adam Neumann what to expect.
- He, too, used the rising values of his work as a key component of his business model, as I explained in 2014. He would sell unmade work, run out of money, and then ask the buyer for more. The buyer would cough up the extra cash just because the secondary-market value of the still-unmade work had risen so much in the interim.
- When the works stopped rising in value, the scheme stopped working. Koons has now laid off most of his staff and faces multiple lawsuits from buyers who haven't received the work they paid for.
The bottom line: There's a fine line between a virtuous cycle and a Ponzi scheme. Whether you're issuing shares or sculptures, it's extremely foolish to count on them appreciating in value whenever you need them to do so.
3. International noncooperation
What's been less remarked on is that we're seeing social breakdown between countries as well. (Brexit, of course, probably finds itself in both camps.)
The IMF, celebrating its 75th birthday, held its 150th semi-annual meeting this week.
- It had one main job: Finalize the Fund’s 15th quota review.
- How it works: Each of the 189 member countries pays a certain amount of money as its quota, and that money is then lent to members in need. The higher your quota, the more you can borrow — and the more voting power you have at the board level.
- The IMF's board and management were very clear on the importance of increasing quotas by this week's deadline. The review would strengthen the Fund financially, and would also help it better reflect the reality of economic power in the 21st century, with China and India in particular getting a larger say.
- Yes, but: The review failed. The 15th quota review is dead. Now the process starts all over again, with hopes that the 16th quinquennial review will do better. The main reason for the failure was "stiff resistance from the United States," per Reuters.
Meanwhile, the EU summit in Brussels this week was also a failure.
- It had one main job: To decide whether or not to admit North Macedonia and Albania into the union. It failed. Both countries remain in limbo, with no indication of when their fate might be decided.
- EU leaders also failed to set a long-term budget.
The bottom line: The era of international consensus and cooperation seems to be over.
- Even last year's much-vaunted capital increase for the World Bank happened only because the Bank persuaded the Americans that it was the last-ever such increase, and that it would never again ask them for more money.
- No multinational institution is strengthening, and most are weakening. That's going to continue for the foreseeable future.
Bonus: One international bright spot
4. Mistrust in business grows
Americans' trust in big business eroded sharply over the past year. That's one of the key messages in the latest survey from JUST Capital, a nonprofit that tries to get businesses to align their values with those of ordinary Americans.
By the numbers: When asked if they trusted or mistrusted large companies, "trusted" won in 2018, but "distrusted" won in 2019. And when asked whether large companies have a positive or a negative effect on society, again the results swung dramatically from positive to negative.
5. Blood money
If you want a prime example of why Americans mistrust business, look no further than the Future Investment Initiative, the lavish conference (aka "Davos in the desert") that will take place later this month in Saudi Arabia, sponsored by the crown prince who ordered the murder of Jamal Khashoggi.
- Yesterday, I revealed the list of companies scheduled to be represented at the conference, often at CEO level.
- The list of American companies alone is extremely long, and includes Goldman Sachs, Citigroup, JPMorgan, Morgan Stanley, Bank of America, Mastercard, State Street, Raytheon, Dow, Atari, Magic Leap, BlackRock, Pimco, Blackstone, Lazard, and many more.
Go deeper: The full draft program is here.
6. A very well deserved Nobel
Economics shouldn't really be called the dismal science, because, most of the time, it's not much of a science at all. There are precious few experiments, and almost no economic theories are falsifiable.
This year's winners, however — Esther Duflo, Abhijit Banerjee, and Michael Kremer — are true scientists. Their theories are based on large-scale field experiments, often using randomized controlled trials. Which shouldn't be revolutionary, but is.
- Indian cookie company Amul celebrated the win with a wonderful advertisement featuring Duflo (the youngest ever winner of the economics Nobel) and Banerjee (who is Duflo's husband). "Nobel abhi jit gaya" is a pun on Banerjee's name, of course; it translates to "just won a Nobel."
7. Coming up: Boeing’s CEO heads to Washington
Why it matters: Muilenburg will face lawmakers for the first time since the crashes. The company is under more scrutiny than ever from lawmakers, regulators and airlines.
8. Building of the week: The Rubjerg Knude lighthouse
The 75-foot tall Rubjerg Knude lighthouse, in northern Denmark, was built in 1899, on a cliff some 200 feet above sea level. Its light, originally powered by an on-site gasworks, could be seen from ships 26 miles away.
- Despite originally being built 650 feet from the sea, coastal erosion meant that it was only 20 feet from the coast earlier this week, when it was carefully moved 263 feet inland.
- The lighthouse had long since lost any utility: Winds had blown surrounding sand dunes so high that it was sometimes impossible to see the lighthouse from the sea at all.
- The move, which cost about $750,000, should save the popular tourist attraction for another 20 to 40 years.
Finally, you might be interested in what William Cohan, the author of the Vanity Fair story, is saying in the wake of the CME statement. He pointed me to what he said to Vox, which basically boils down to "I was merely asking questions."
- He also said that regulators should examine the trades, without specifying which regulators, or how they would be better placed to do such an examination than the CME itself.