“In my view derivatives are financial weapons of mass destruction, carrying dangers that, while now dormant are potentially lethal.” Warren Buffet
What are SMIs?
Self-managed investments (SMIs) are a new class of financial product. They can be considered a reinvention of the hedge fund model. Their primary purpose is to enable investors to once again diversify their portfolios. The collapse of Lehman Brothers on 15th September 2008 showed the dependent nature of the current financial system. When the value of one asset and one institution are dependent upon other assets and institutions diversification has all but disappeared.
Second, because SMIs are deliberately structured as silos of value outside the current financial system, they are also a means of diversifying away from the systemic risk of the system collapsing.
SMI’s have other benefits. These include:
• No fees. Unlike a traditional hedge fund that typically charges 2% management and 20% performance fees, there are no fees associated with SMIs. Once the asset has been purchased, the investor is independent of any further reliance on the issuer.
• Increased Access. Because investors self-manage the value of the asset rather than relying on a third party, SMI assets are generally not classed as securities. This makes them available to a wider range of people than many traditional investments.
What does “self-managed” mean?
SMIs are self-managed in the sense that investors are responsible for both the value of the asset and for keeping that value pegged to a particular price.
For example, Bitcoin Enhanced is the first SMI to be created. The purpose of its CBE token is to track the returns of a simulated Bitcoin long/short investment strategy. These simulated returns are published on the website as the Target Price. The simulated nature of the strategy means there are no underlying Bitcoin or Bitcoin futures. It is this exclusion of underlying assets and their associated counterparties that keeps CBE tokens independent of the financial system.
Instead of underlying assets to establish the value of the tokens, token holders are expected to do this. There is no reason to purchase the CBE token except to trade at the Target Price. Therefore all token holders have the same vested interest for trading to take place at this price.
Market-driven price discovery
The value of the CBE token is determined by buyers and sellers on the Waves exchange. Like any other market mechanism, this is where price discovery takes place. The issuer of the token, in this case, Forecast Services Limited plays no role in either supporting the price on the exchange or as a provider of liquidity.
The entire point of an SMI is for investors to have access to assets that do not depend on other assets or institutions for their value. The way this is achieved is by returning to the fundamentals of finance and the ability of investors to create and manage this value themselves.
A return to what works
The overwhelming majority of today’s assets are derivatives in the sense that their value depends upon the value of other underlying assets. It is this dependence that has created the fragility of the current financial system.
SMIs not only enable investors to return to diversification as the tried and tested bedrock of sound risk management, but are themselves a return to the basis of what creates value — people.
Physical assets such as commodities and property have value because people give them value. Follow any derivative back and there will be an asset whose value has been self-generated by people. SMIs return to this fundamental basis of all finance by giving back the function of value creation to investors.
SMIs have the need to maintain parity between, in the case of Bitcoin Enhanced CBE tokens, the Target Price and the traded price on the Waves exchange. Today ETF’s and stablecoins maintain parity by the active management of supply. The asset manager, or their appointed representative, has an unconditional commitment to purchase or sell the asset at the parity price. This commitment ensures the parity price is maintained.
The major problem with this active management of parity from the investor’s point of view is that it ties the asset into the financial system through the use of counterparties such as the asset manager’s agent (often a large bank) and the use of the underlying asset.
With SMIs parity is self-managed by buyers and sellers. In this SMIs draw upon the basis of the Gold Standard itself.
Gold demonstrates people’s ability to maintain parity
Gold has been the asset of choice to provide stability to currencies because of the stability of its own value. This has made it ideally suited as a means of exchange where stability is of first importance. But what gives gold its parity — the same value year after year? The most likely answer is the expectation and needs of people to have a stable means of exchange.
SMI’s use the same expectation as their primary parity mechanism. The purpose of, say, the CBE tokens is to trade at the Target Price. Therefore any token holder has both the expectation and self-interest to trade at this price. While this natural and passive approach to parity is likely to mean the assets trade in a wider band to the peg than an actively managed mechanism they do so without exposure to the systemic risks of the financial system.
Bitcoin Enhanced also uses quantitative measures to limit supply: new tokens can only be issued if the price on the exchange is equal to or greater than the Target Price. The CBE token is also hard capped at 4 million.
Risks of SMIs
Because SMIs hold no underlying assets there is no recourse if the system fails. While equities, hedge funds, ETFs and other asset classes can also fail, their link to underlying assets means that some value may be recoverable. The independence of SMIs precludes this recourse.
Like other assets SMIs are market driven. This means that if there are no buyers their value can fall, potentially to zero.
Further, the passive mechanisms for maintaining parity are likely to mean a wider band of peg to a reference price than the active mechanisms employed today by ETF’s and stablecoins. This does not mean the peg mechanism is not functioning but simply that it has a wider range of tolerances.
Why consider an SMI?
SMI’s represent a return to principles of finance that have demonstrated their effectiveness for hundreds of years. Price is a human artifact created by buyers and sellers. Gold demonstrates that buyers and sellers can keep the price at a given peg.
Because they hold no underlying assets SMI’s enable diversification to again function as the bedrock of sound portfolio management.
While SMI’s do carry their own risks these are not the same risks associated with other asset classes embedded in the financial system. Hence their ability to re-enable diversification.
The mechanisms employed by SMIs remind us that price is a human artifact and that ultimately people are the sole creators of value.