Self-Managed Investments (SMIs) — A Return to What Works

Photo by M. B. M. on Unsplash

This article suggests a new asset class, Self-Managed Investments (SMIs) have the ability disrupt the financial system. The system they disrupt t is inherently fragile posing unacceptable levels of risk for investors and misery for much of the world’s population without a stable currency.

As independent silos of value SMIs restore diversification as the cornerstone of sound investing. The same independence builds a more stable financial environment.

SMIs achieve these goods by returning to the foundation of finance, namely that people, and only people are the creators of monetary value.

Building an Internet of Finance

SMI’s are independent silos of value.[1] Like the routers, servers and cables that make up the Internet, they are self-sufficient. This means that if one SMI fails its loss does not jeopardize the entire system. How long would the Internet last (and who would use it) if it collapsed each time a server or router failed? Yet this is exactly the way the current financial system is built.

A Fragile System of Dependencies

Today the vast majority of financial products are derivatives.[1] This means that their value depends upon the value of an underlying asset. For example, the value of a Milk Futures contract depends on the value of the quantity of milk being sold at a future date.

Because banks and other institutions buy and sell these derivatives, the value of these institutions depends upon the value of the other institutions they trade with. This is because their partners hold (or are counterparties to, or are part of the chain of dependencies back to) the underlying asset. The fragility of the system is the result of these dependencies — if one institution goes down they can all go down in a classic domino effect or like the unravelling of a sweater.

[1] https://www.visualcapitalist.com/worlds-money-markets-one-visualization-2017/

15th September 2008

This was exactly the cause of the panic on 15th September 2008 when Lehman Brothers failed.[3] The US government and others around the world stepped in with trillions of dollars of bailouts and the guarantee of bank deposits because the collapse of one bank was jeopardizing the entire system.

Because there has been no fundamental change to the financial system since then its dependencies, and hence vulnerability still exist. If you do a Google search for “next financial collapse” a list of the current most likely triggers can be found.

Unquantifiable Risk

If investors could remove themselves from this risk of systemic collapse they would. The risk is unquantifiable in its dimensions and affects the vast majority of assets. Only assets that are valued in themselves such as commodities, property and some crypto-assets such as Bitcoin function like SMIs in that their value is independent of the system.

Death of diversification

Second, the dependencies created by derivatives have destroyed diversification as investor’s most effective means of managing risk. Risk for an investor is reduced by holding a portfolio of assets whose value is not connected to the value of other assets. However in a world where the value of most assets depends on the value of others, genuine diversification has vanished.

Creating Independence

SMI’s are not exposed to the risk of the financial system collapsing. They also restore diversification by providing assets whose value is not part of the system of dependences. This independence is achieved by not holding underlying assets as a derivative would.

Instead, SMIs give the responsibility for their value, and their peg to a reference price to token holders themselves. This is what “Self-Managed” means — token holders are the creators of value and responsible for the maintenance of that value to a given peg.

For example, Bitcoin Enhanced is the first SMI. Its CBE token has the purpose to track the Target Price of returns from a simulated long/short Bitcoin trading strategy published on the website. Because the strategy is simulated, no Bitcoin or Bitcoin futures are actually traded and no counterparties or underlying assets are involved. The SMI remains outside the financial system.

Without underlying assets what gives the CBE token its value? The only reason to purchase a CBE token is to trade at the Target Price. Thus token holders have the incentive to do this. This combination of self-interest and expectation gives the tokens their value as they are traded on the Waves exchange. The same forces maintain their value at the Target Price.

In contrast, derivatives have active mechanisms to establish their value and maintain it at a specified price. For example, the SPDR Gold Trust EFT (GLD) holds gold bullion in vaults in London as the underlying asset that guarantees the value of its shares traded on the NYSE. Second, the trust appoints a trustee, in this case, Bank of New York Mellon Asset Servicing, to daily buy and sell shares as needed to maintain parity of the Trust’s shares with the price of gold. This active parity approach works yet comes at the cost of being part of the dependencies of the financial system through the use of counterparties and underlying assets.

Invention of the Blockchain

SMIs are made possible by the invention of the blockchain, itself a response to the fragility of the financial system seen during 2008. Bitcoin Enhanced uses tokens created on the Waves platform. The distributed ledger of the blockchain keeps account of each person’s ownership of the token outside any centralised authority or the need for counterparties. If the Waves organisation or Forecast Services Limited, the issuer of the tokens, no longer existed, token holders could still trade and track ownership as long as at least one full node of the Waves blockchain remained.

How SMIs Work

The invention of Bitcoin not only gave SMIs the distributed ledger of the blockchain. Bitcoin also provided a clear example of the ability of people to create value for themselves. Without the usual trappings of government institutions, impressive buildings, laws and the penal system, people choose to give value to a piece of crypto-graphic code.

This was not the first time this value creation process has occurred. Like language and law money is a human artefact. Bitcoin helped to remind us that people are the sole creators of monetary value.

The Creation of value by Governments and Central Banks

This ability includes the value created by governments and their central banks.

To expand the money supply the Federal Reserve enters the dollar amount into the Liabilities side of its balance sheet. This is an ex-nihilo act — creating out of nothing.

With this newly created money it can purchase, for example, US Government Bonds. It places the purchased bonds on the Asset side of its balance sheet.

The net effect is that the government has new money to fund its debt and the Federal Reserve owns assets (government bonds) as collateral against the money it has just created.

[1] https://medium.com/datadriveninvestor/discover-self-managed-investments-smis-ad333c9b9cac

[2] https://www.visualcapitalist.com/worlds-money-markets-one-visualization-2017/

[3] https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008

A simplified balance sheet for the Federal Reserve after creating ex-nihilo $500 million

However, the important part of this value creation process is generally overlooked. It is only because people expect and believe in the value of the money created that it has value at all. Inflation is what happens when this belief begins to be lost. Indeed inflation can be considered a form of default by a government when people stop believing it can pay its debts.

Monetary value held by a derivative, Central Bank, Bitcoin, or an SMI is the product of the belief and expectation of people. There is no other method for value to be created. This means the SMI approach is not new. It is simply the explicit use of the value generation process to return finance to its basic principles and restore diversification as the bedrock of investing.

Maintaining a Peg

Not only do SMIs expect token holders to create the value of the token, but also to maintain that value relative to some external price. In the case of Bitcoin Enhanced, the external price is the Target Price of the simulated long/short Bitcoin trading strategy.

As we have seen derivatives such as the GLD EFT use an active parity mechanism where a trustee has an unconditional commitment to buy and sell any outstanding shares in the market at the parity price. This has the effect of maintaining the peg because people feel confident they can always trade at this price.

However, the more passive approach of expectation and need can also maintain a peg. For example during the autumn of 1923 Germany was in the depths of hyper-inflation. As an interim solution before the release of the rentenmark the government issued a number of Gold Loan Bonds to be used as a means of exchange or as collateral for other currencies. These notes had no more underlying assets backing them than the hyper-inflating mark. Nor was their supply adjusted to maintain their value. However, they were accepted by the population and indeed held their value. The reason was one word printed on the notes: “wertheständig” (stable-value). [1]

The example illustrates the ability the stated purpose of an instrument, here printed directly on the note, to achieve price parity — in this case a stable price.

Gold

The most compelling example of a peg mechanism based on expectation returns us to the very basis of the financial system. From at least 1772 B.C. gold has been the primary means of exchange and store of value for the majority of the world’s finances. The reason for this is that gold has maintained a constant value. This consistency of value (a peg from one year to the next) enabled the Gold Standard to function in Holland, Britain, the United States and most of the world during the 19th Century. By enabling their currencies to the exchanged for gold, the currencies shared gold’s stable value.

Much has been written about the gold and the Gold Standard, but the fundamental question has seldom been asked: why has gold had a stable value (peg) for thousands of years?

The most likely answer is that people expect, need and believe that gold maintains its value and so it does. Like the creation of monetary value itself people also have the ability to maintain parity at a given value.

A peg created from expectation may in practise have more variability than an actively managed commitment to trade at a given price. However the process is inherent to the basic principles of finance and there is no reason to suppose a wider range of price variability would not achieve similar ends with the benefit of enabling the asset to remain outside the dependencies of the current financial system.[2]

The Hedge Fund Model Reinvented

One way to view SMIs is as a reinvention of the hedge fund model. Both can actively trade in markets to produce returns for investors. In the case of SMIs the trades are simulated.

SMI’s can also function as currencies. A new Gold Standard currency could be created by pegging the value of a blockchain token to the price of gold.

While hedge funds charge clients a fee such as 2% management and 20% performance for their services, the sponsor of an SMI earns through seigniorage as it sells tokens. For a medium to long term position the on-going fees of a hedge fund can produce significantly lower returns for investors than the one-off initial payment for a SMI token.

On the other hand, the great advantage of holding underlying assets in a hedge fund is that investors generally have re-course to at least some value if the fund performs badly. Under the SMI model poor performance is likely to render the value of the tokens worthless.

While a hedge fund has on-going obligations to its clients, the sponsor of a SMI has no further obligation to the token holders once the token has been sold. The difference between the two approaches can be considered as the difference between a relationship of dependence and one of self-reliance. An investor depends, and has claims upon a hedge fund. In contrast an SMI investor buys into an independent system of value where they share the responsibility of maintaining the value of the system along with other token holders. The reason why they take on this responsibility is so that they reduce the peril of financial collapse from their portfolio and are again able to diversify as the primary means of managing risk.

Another benefit of the self-generated value of an SMI is the lighter regulatory environment. While hedge funds are highly regulated and fall under the securities laws of most jurisdictions, SMIs are likely to operate outside these laws. This is because the issuer of the token plays no part in the value creation process. The value is entirely the product of token holders. This lighter regulation gives more people access to SMIs than traditional hedge funds.

[1] Constantino Bressciani-Turroni, The Economics of Inflation pp. 341–354 abstracted in The Institute of Economic Affairs 1976.

[2] https://medium.com/@simonpaige/four-ways-to-achieve-price-parity-in-financial-instruments-60507c4233fe

Comparison of SMIs with traditional Hedge Funds

A Return to What Works

Like the story of the Emperor’s New Clothes it is sometimes difficult to see what is staring one in the face. SMIs are a response to a financial system inherently unstable because of the pervasive dependencies upon which it is build. These dependences represent an unacceptable level of risk to the investor and have removed diversification as the bedrock of sound investment practise.

The response is not the invention of a new, more elaborate scheme. Instead SMIs return to the basis of finance: people are sole creators of value and people can maintain a peg. By purchasing SMIs investors consciously take on the responsibility of value-creation. Control returns to those who originate value. In doing so investors remove the single greatest risk in their current portfolio and rebuild diversification as their most trusted ally.