July 02, 2022
One of the things we've learned over the past year is that people who claim to be "trading" any given market are nearly always just making big bets that it will go up. That certainly seems to be the case in crypto.
- In this week's newsletter (1,374 words, a 5-minute read): Where that leaves the crypto world; how well your financial adviser thinks you'll do in the future; what happens when the rich stop intermarrying; and much more.
1 big thing: Crypto's systemic stress test
Crypto is facing a crisis moment — and its ecosystem is proving much less capable of reacting in a way that's predictable and fair than the dollar-based system generally does when firms implode.
Why it matters: There will always be institutions that take on too much risk or that end up insolvent. A well-functioning system will swing efficiently into action in such cases, while a chaotic system will spiral into ever-greater troubles.
The big picture: Much of the current crypto winter is a function of two familiar markets phenomena — failed arbitrages and commingling of customer funds.
- Both were seen in the 2011 implosion of MF Global, the small brokerage that was taken over by Jon Corzine after his stints running Goldman Sachs and New Jersey.
- Of note: MF Global's clients ended up getting all their money back. So did creditors of Lehman Brothers. Even Madoff depositors are almost whole. In each case, a robust legal system worked exactly as it was designed.
Driving the news: This crypto down cycle is being driven by "levered long" trades getting unwound. As in many previous market implosions — LTCM springs to mind — such trades are often associated with arbitrage plays.
- The idea is to use borrowed money to buy item X, which should be worth the same as item Y, at the same time as shorting item Y. Then when the two prices converge, you make a profit.
- Trades that have blown up have included ones saying that 1 Terra should be worth 1 dollar, or that 1 stETH should be worth 1 ETH, or that the share price of GBTC should be worth the same as the value of the bitcoin in that fund.
Between the lines: The borrowed money that funded such trades came not from arbitrageurs (they were the borrowers) but rather from depositors who are now rushing to get their money back from shops like Celsius and BlockFi.
- Flashback: MF Global customers will remember the feeling. Their money was used to cover losses on an ill-starred arbitrage play involving European sovereign bonds.
What's new: Crypto is a wild west by comparison. There's no established jurisprudence surrounding the seniority of depositors; indeed, there's not even any consensus on which jurisdiction companies should be incorporated in, and therefore which governing law should be used.
- Lehman Brothers was often described as being "too interconnected to fail." Perhaps crypto shops like Three Arrows Capital were in a similar position.
My thought bubble: Billionaire Sam Bankman-Fried of FTX is trying to play a role akin to that played by John Pierpont Morgan during the panic of 1907, before actual institutions were created to stem bank runs. His fire-sale potential acquisition of BlockFi pointedly puts depositors first, but that kind of individual intervention is hard to scale or institutionalize.
Bonus: GBTC goes the wrong way
Historically, the only easy way of owning bitcoin as part of a retirement fund was to buy GBTC, an investment trust from Grayscale that effectively works as a listed wrapper for bitcoin.
- Partly for that reason, GBTC — the box owning the bitcoin — usually traded at a premium to its net asset value — the value of the bitcoin inside the box. More recently, however, it's been trading at a discount.
- Anybody making the mean-reversion trade — that GBTC would bounce back towards its net asset value — has suffered massive losses of late, especially if they've been using leverage.
2. Your investments won't do as well as you think
Financial advisers' bullishness is reaching new and ever more unrealistic levels, even as the stock market pulls back from its recent excesses.
Why it matters: Advisers are already doing a bad job managing their clients' expectations. But it turns out their own instincts have also been skewed by the long bull market of the past decade.
By the numbers: Every two years, Natixis polls 2,700 financial professionals across 16 countries, and asks them for the annual returns — above inflation — that their clients "can realistically achieve in the long term."
- This year, answers ranged from 6.2%, in the UK, to 14.9%, in Colombia.
- U.S. advisers were near the bottom of the range, at 7.0%, but that number has been rising steadily: It was 6.7% in 2020, 6.3% in 2018, and 5.9% in 2016.
Be smart: Markets have been performing uncommonly well over the past 10 years, but even during these halcyon times they haven't done as well as advisers expect them to do over the long-term future.
- A good proxy for the typical portfolio of an adviser's client is the Morningstar Moderate Target Risk index, which "represents a portfolio of global equities, bonds, and traditional inflation hedges, and seeks approximately 80% exposure to global equity markets."
- That portfolio has risen by 4.2% per year, in real terms, on average, over the past 10 years — a full 2.8 points behind advisers' current long-term expectations.
- The Morningstar index's returns have consistently run a point or two behind advisers' expectations — but the size of the current gap is unprecedented, and the best real-world returns, in 2020, are still lower than the lowest adviser expectations, in 2016.
The big picture: Advisers' clients have expectations that are off the charts. Surveyed last year, they said that they expected long-term real returns of 17.5% per year — numbers that would put them in the top tier of legendary hedge fund managers.
The bottom line: Clients' expectations are filtering back into the expectations of the advisers themselves.
- After all, given the choice between an adviser promising higher returns and one promising lower returns, it's rational to expect clients to gravitate towards the higher number.
3. What happened when the rich stopped intermarrying
When Queen Victoria's mother and husband died in quick succession, the result was a significant expansion of public education in England.
- That's the conclusion of what is easily my favorite economics paper of the year so far, from Marc Goñi of the University of Bergen in Norway.
How it worked: The 1860s were a high point for assortative mating within the English elite. The peerage, in particular, "was likely the most exclusive elite ever to exist," writes Goñi: "unusually small, exclusive, and rich."
- The mechanism for maintaining that small ultra-elite group was the London Season — a series of balls where the eligible offspring of the peerage would meet and match.
- Invitations were extended only to families of the highest social status, and attendance was very expensive, meaning you needed to be well-born and rich to participate.
What happened: When the Queen went into mourning, the Season was effectively canceled for three successive years (1861–1863). As a result, posh rich daughters failed to meet posh rich men, and married commoners instead.
- Peer–commoner intermarriage rose by 40%; titled women married husbands 44 percentile ranks poorer in terms of family landholdings.
- Such marriages caused real harm to the daughter's brothers and even fathers. Her brothers were 50% less likely to enter parliament; her family's prestige fell; and she was much less likely to become the kind of terrifying matriarch so familiar to readers of PG Wodehouse.
The bottom line: Constituencies that were no longer represented in parliament by the local peer were much less likely to oppose the introduction of state education — which eventually became law in the 1870s.
- Assortative mating eventually bounced back and is still going strong. British matchmakers Gray & Farrar, for instance, with their minimum fee of £15,000, boast of having "the connections and network to attract the right people for the right people." They're not a fully-fledged London Season, but they're trying hard to replicate its results.
4. The death of coupons
Coupons are disappearing fast, partly because almost no one uses them any more. Redemption rates are now running at about 0.5%, down from more than 1% in the early 2010s and more than 3.5% in the mid-1980s.
- What they're saying: “It's hard to pinpoint exactly if and when print coupons will become extinct, but they're definitely on that path,” Kristin McGrath, savings expert with RetailMeNot, told Axios' Kelly Tyco.
5. The end of the money boom
Some good news for anybody who thinks that inflation is caused by the expansion of the money supply: That expansion rate is now back down to its pre-pandemic levels.
6. Trade diplomats are people, too
Worthy of your time: Faces of Trade Diplomacy, the brainchild of Maastricht University's Clara Weinhardt.
- It's a lovely project of portraits and short interviews of individuals participating in the latest round of multilateral negotiations at the World Trade Organization in Geneva.