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Payments, Not Promises

By Peronet Despeignes

As the world stumbles through what might yet evolve into yet another crisis of no-confidence in the global financial system, it might soon prove helpful to remember a couple lessons from the last few.

Over the past eight years since the eruption of the 2007-2008 global financial crisis, and over the last 14 years since the tech bubble implosion and over the last 18 years since the Asian financial crisis, we’ve learned, re-learned and re-re-learned that a lot of what we thought about the financial markets just wasn’t true. We learned that, when push comes to shove, and we check to see who has our back in the financial arena, there might not be anyone there.

We’ve learned that some banks and financial markets might not be secure. Never mind the soothing words from policymakers or the crisp images on glossy prospectuses and annual reports of stoic Greek columns and well-put-together, friendly-looking, clear-eyed financial advisers with dapper threads, chiseled jaws and rimless spectacles. We’ve all learned that, at any given time, much of Wall Street (or London’s Square Mile or Shanghai’s Pudong district or Hong Kong’s, well, entirety) might not be a paragon of probity, integrity or adherence to rock-solid rules. Even the value of the very currency we use to buy things and survive is built on sand and could evaporate tomorrow.

More than thirty years of recurring financial crises have taught many of us that many of the assurances and guarantees in financial markets are backed by nothing more than smiles and poll-tested platitudes, Don Draper style. In fact, much of the 2007-2008 crisis was the direct result of many institutions not having the funds to back their promises and their bets.

We’ve learned (or re-learned) that financial markets are managed by humans who, like the rest of us, are deeply flawed, limited in their knowledge and awareness of the future (and even the present) and too often self interested at the expense of the people for whom they claim to work. The last item on that list is what causes or worsens many of the other problems.

Economists call it the principal-agent problem, and boy is it a problem. It matters especially when funds are held in reserve or some other form of fiduciary trust by a third party, as is the case with various forms of insurance, derivatives and other financial arrangements.

On Augur (and more generally on Ethereum, the next-generation peer to peer distributed ledger and decentralized application network upon which Augur is built), agreements would be enforced by automated, open-source code (pre-programmed digital robots, basically) operating across a transparent system — a system that, like bitcoin (and more generally, like much of the Internet), has no central point of failure, control or censorship and once up and running is hard to erase, shut down or for an individual to otherwise muck up.

There is no counterparty risk that agreements will be broken by banks with help from their lawyers, or by insurance companies or other entities who don’t really have the funds to meet agreements for which they were paid. Funds aren't held in custody by an individual or bank - they're held by an algorithm that reliably and dispassionately follows pre-set, transparent "if-this-then-that" orders in real time.

Since the start of the global financial crisis (which in some ways never really eneded), there has been the recurring threat of counterparties fully or partially backing out of agreements to pay holders of credit default swaps. These are supposed to work as insurance against defaults. They’re supposed to pay holders when a default happens.

Well, a default happened. In Greece. I mean, the last one. In 2011. The counterparties who had the obligation to pay up when Greece essentially defaulted started playing footsie with the original terms after the fact. Some of these parties were the same groups who benefited when this “insurance” had rocketed in value in the period leading up to the big bang as people made a mad dash for protection.

Talk about changing the rules in the middle of the game... heck, at the end of the game... gosh, after the end of the game, actually. People were counting on that insurance against disaster.

The problem is that it is not entirely clear what constitutes
default in the case of a country like Greece, and the definition can change overnight, which isn’t fun if you just spent $100 million buying [these credit-default swaps as insurance].
In fact, it turns out that the people who decide what constitutes default are an industry board made up largely of the same banks that sell the credit default swaps — firms like Goldman Sachs and JPMorgan Chase & Co. This board recently decided that if Greece forces its bond holders to take a so-called “haircut” on Greek bonds — a deal that will lower the value of Greek bonds — it will not be considered a default and the people who bought the swaps will not get paid.

Say what? The Los Angeles Times article goes on to report:

Jason DeSena Trennert, a founder of Strategas Research
Partners, is one of many people who have cried foul, saying that the system exposes the degree to which the big banks get to write the rules of the financial game, and then change those rules when they might get hurt. In a new note to clients, he uses a school-yard analogy to make his point:
"Yesterday Johnny insisted that the ball that bounced off of
Dominic’s book bag was a goal. Today, on defense, he swears that it hit the post. One might think that after 20 years of education and socialization, Johnny, now a Managing Director in structured products at FancyPants & Co. and living in a co-op off Park Avenue, might have developed a greater sense of fair play. Sadly, as we are finding out in the post-financial modernization world, he has not."

Now, that just isn’t right… and it gets worse.

Let's travel a bit further back in time to 2008. AIG, the "insurance" giant which had sold – and supposedly backed – massive amounts of credit-default “insurance” against “subprime” mortgage loans risked going under (and taking much of the U.S. financial sector with it) because the “insurance” giant lacked reserves to pay up when the subprime market started to implode around the start of the financial crisis. People were calling on their credit “insurance.” AIG just didn’t have the funds to pay them all.

If AIG hadn’t accepted a government bailout, it would have ended up in bankruptcy and shareholders “would have been wiped out,” said Edward Liddy, who was caretaker CEO at the time.

Now, you shouldn’t have to worry that the very risk-avoidance tools you’re buying – to minimize your exposure to risk – have risks of their own. Risk of the contract being reneged on for the very reason you bought it. Risk that you’ll be subjected to a “heads they win, tails I lose.” Risk that “banks” aren’t really banks with – like, ya know? – funds. Risk that “insurance” isn’t really insurance. Risk that you’re doing business with a pin-striped Potemkin Village.

This kind of risk has distorted the derivatives market ever since, significantly undermining its vital role as a form of risk management in the modern global economy, probably making many parts of the market smaller than they would otherwise be and other parts bigger than they should be.

There's an awful lot of misallocation of scarce resources (and risk) going on out there. Maybe that's one reason why growth of the global economy, in productivity and of average wages has been unusually subpar the past few years (I hope to get a chance to write more on that topic later).

Ben Heller, a portfolio manager at New York hedge fund Hutchin Hill Capital, which owns both Greek bonds and CDS, said these kinds of instruments aren’t doing the job they were meant to do. He said that until the problem is fixed, he “will not use CDS as a hedge against
credit exposures anymore.”

...and who could blame him?

Imagine an open decentralised market. Imagine one people could have 100% confidence in. Confidence that it would not “break.” Confidence it could not be rigged or gamed. Confidence that agreements couldn’t be broken or reneged on. Confidence that there was little or no counterparty risk. Confidence that all contracts would remain enforced by cryptographically secured, automated processes – not by “she backs me" / "she backs me not” human discretion.

Today we have a (pre-Augur) market effectively closed to many who could really use it (like farmers in Argentina or Kenya who’d like to hedge against the weather when the market becomes wide and deep enough) and inadequate to many using (or choosing not to use) it now, like Mr. Heller. That means the potential market might ultimately be huge and hugely underserved.

On an algorithm-enforced prediction market run on a decentralised bitcoin-like network everything is out in the open for the entire world to see (including all the code that runs it) and contracts have to be digitially funded and held in custody by the algorithms to be activated and enabled. Funds aren’t released until a completely disinterested program dispassionately executes the preset terms and conditions for releasing them. The funds are padlocked into the network by consensus and cryptography until that happens.

The Greek and AIG credit-default swap fiascos showed that, at key moments, when billions of dollars are at stake, humans err and humans fail. Insurance might not really be insurance and banks might not be banks. That does not happen on an automated system designed to run beyond human discretion and control after agreements have been "signed."

Payments, not promises. Funds, not fluff. Escrow, not Jell-O.

No fractional reserves, no leverage, no naked shorts, no IOUs. No empty promises. No counterparty risk. No "whoops, sorry for your loss." No Potemkin Villages. Oh, and sorry, Popeye fans: no “I’ll gladly pay you Tuesday" Wimpys.

A shorter version of this article ran as an opinion piece in VentureBeat.
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