Your Route to Financial Freedom

In my last post I hope I have shown that it does not matter what investments you have made. If they remain part of the financial system you are still exposed to the unlimited risks of that system. In this post we are talking about how to de-risk your investments. This means diversifying away from the risk of the financial system collapsing.

The key is understanding the difference between asset-based instruments and belief-based instruments.

You want to invest in belief-based instruments such as currencies, property, commodities or some blockchain tokens such as Bitcoin Enhanced. The reason is that the value of these financial instruments does not depend on the underlying value of another asset. This means they are not so much part of the chain of dependence that has created fragility in the economic system.

Have a read and post any questions you may have. We are talking here about nothing less than financial freedom.

There are two kinds of physics, fermion physics and boson physics. Fermion physics has to do with the particles that make up matter. Boson physics has to do with superconductors and the zero-point field. Because all the particles that make up matter draw their energy from the zero-point field, for example the energy that keeps electrons spinning, fermion physics is a derivative of boson physics.[1]

A similar situation exists in finance. In finance there are two classes of instruments, asset-based instruments and belief-based instruments. Asset-based instruments are those that derive their value from another instrument that already has value. Belief- based instruments are those whose value is self-generated by users who believe they have value. Because all asset-based instruments derive their value from other instruments that already have value, and because belief-based instruments are the only form of instrument where value is self-generated, asset-based instruments are derivatives of belief-based instruments.

The distinction between asset and belief-based instruments has implications for the investor and for the future stability of the financial system as a whole.

Belief-based Instruments

Belief-based instruments are the creative act of people. A barrel of oil weighs around 175 kilograms (225 pounds). This weight is an inherent attribute of the oil. However, the price of oil is the product of people believing that the oil has value. Unlike weight, value is not an inherent attribute of the barrel of oil.

For the same reason, the Californian Gold Rush began on 24th January 1848 because the native Indians saw little or no value in the nuggets lying in the stream beds. Value was not inherent in the gold nuggets, its value was the product of the belief of the prospectors. 
 
 Value can also leave belief-based instruments. On the Polynesian island of Yap, there are large round stones with holes in them. They were a form of money that people no longer believe in. Now they are just stones again. Like oil and gold, the value the stones held was not inherent in the stones but generated by the people who used the stones as money.

[1] https://en.wikipedia.org/wiki/Boson

Asset-based Instruments

Once the belief-based approach has given monetary value to something the currency, seashells, or precious metals become a financial asset that can serve to give value to asset-based instruments. These are generally termed securities. They include:

· debt securities

· equity securities

· managed investment products

· derivatives.

In each case, the value of the financial instrument is derived from another asset that is already accepted as having value.

A bond provides interest in a currency that already has value. A futures contract is based on the expected future value of an underlying asset, whether that asset is a currency, commodity or carbon emission credit.

All asset-based financial instruments are derivatives in the sense that their value is derived from referencing another asset that is already accepted to have value. Follow the “value-chain” back and it will always end in a belief-based instrument — one where value has been self-generated by people’s belief in its value.

The test to determine what kind of asset a financial instrument is requires asking the question: “Does this instrument have value itself or does its value depend upon another asset whose value is already accepted?”

Features of Belief-based Instruments

People give value to many things — food, housing, personal safety, children, relationships and health to name but a few. Many of these are monetised and have become belief-based financial instruments. The largest categories of these belief-based instruments are commodities, real estate, and currencies.

The importance of this class of instrument is shown by the 2014 estimate of the global size of some of these markets:

· Silver $14 billion

· Commercial Real Estate $7.6 trillion

· Gold $7.8 trillion

· Broad money[1] $80.9 trillion[2]

The currency markets are by far the largest markets in the world, both in size and liquidity. The 2016 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange spot markets averaged $1.7 trillion per day in April 2016.[3] The same survey also demonstrates the ability of belief-based instruments to provide the foundation for asset-based instruments: while $1.7 trillion of actual currency was traded each day, $3.39 trillion of asset-based instruments including forwards, swaps and options were also traded.

The difference between these two classes of financial instruments is of particular interest for the investor in the areas of regulation, risk, and new products.

Regulatory Implications

Securities laws are focused on asset-based instruments. In the United States, the Howey Test is used as a standard means of establishing whether an instrument is a security. The test has four components. The instrument must pass all four if it is to be classed as a security.

  1. It is an investment of money
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party[4]

For example, a term deposit is a security. Money is placed with a bank and interest is paid by the bank on the money deposited. The money deposited already has value, there is an expectation of profits (interest) and these are generated by the efforts of the bank, not the depositor.

The fourth clause of the test, the need for any profit to come from the efforts of a promoter or third party specifically excludes belief-based instruments. The value of these does not depend on the efforts of anyone except the instrument holders themselves.

This difference in the way the two classes of instrument are regulated was reiterated in June 2018 when Jay Clayton, the chair of the US Securities and Exchange Commission (SEC), said that the crypto-currency Bitcoin was not a security.[5] The “coins” of Bitcoin are pieces of cryptographic code whose ownership can be tracked in a decentralised manner in what is called a “blockchain”. Because Bitcoin operates outside of any government mandate the value given to the coin — currently above $6,000 — is clearly only the product of people’s belief in the coin and what it represents.

Outside the United States, financial regulators are also focused on asset-based instruments. For example in New Zealand, as mentioned above, there are four categories to a financial product:

· debt securities

· equity securities

· managed investment products

· derivatives.

In each case, the category has to do with products where the value of the product depends upon another asset that is already deemed to have value.[6]

While there are other laws in relation to belief-based instruments such as fair trading requirements and the issuing and managing means of payment, in general belief-based have lighter regulatory requirements than asset-based instruments.

[1] Including coins, banknotes, money market accounts, saving, checking and term deposits.

[2] https://money.visualcapitalist.com/all-of-the-worlds-money-and-markets-in-one-visualization/?link=mktw

[3] https://en.wikipedia.org/wiki/Foreign_exchange_market

[4] https://consumer.findlaw.com/securities-law/what-is-the-howey-test.html

[5] https://cointelegraph.com/news/sec-chairman-jay-clayton-says-bitcoin-not-a-security-most-icos-likely-are

[6] https://fma.govt.nz/compliance/offer-information/offers-under-the-fmc-act/who-needs-to-comply/

Risk Implications

Belief-based instruments can suffer a catastrophic loss of value if people lose confidence in the instrument. The most obvious examples of these are the hyper-inflation of currencies. In a study of 590 “dead” currencies the primary factors causing the loss of value were hyper-inflation, war, and political change.[1]

However, there are other ways belief-based instruments can lose value. If a bug was found in the code that runs Bitcoin its value would likely disappear overnight. Technological change, as in the case of the stone money on the island of Yap can also remove value.

Because the value of asset-based instruments is derived from underlying assets it may be assumed that these assets are more robust in the sense of carrying less risk than belief-based instruments. However, the opposite is actually the case.

It is clear that different asset-based instruments carry different levels of risk. For example, a term deposit is seen to have less risk than investing in the S&P500 tracker fund. In turn, this fund is seen to have less risk than investing in the equities of emerging countries. Yet, as a group, all asset-based instruments are exposed to the risk of systemic institutional failure.

The problem with asset-based financial instruments is their interconnectedness. The ease with which new products can be built from existing instruments already accepted as having value has spawned a financial system with two critical flaws:

· Every aspect of the system is connected to every other aspect of the system means that the failure of one institution can precipitate catastrophic failure in the system itself

· The extent of the risk of this interdependent system cannot be quantified. I.e. the risk is unknown and unlimited.

For example, while the 2014 amount of broad money in the world was estimated at $80.9 trillion, a high-end estimate of the value of all derivative contracts was 1.2 quadrillion.[2] The authors qualify this with the words: “The truth is no one really knows the size of the market.”

The dependency of financial institutions on each other through asset-based instruments and the unquantifiable nature of the risk were the causes of the 2007–2008 General Financial Crisis (GFC). The Wikipedia entry, not known for exaggeration, describes the event:

“It began in 2007 with a crisis in the subprime mortgage market in the United States and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008.[5] Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally.[6] Massive bail-outs of financial institutions and other palliatives monetary and fiscal policies were employed to prevent a possible collapse of the world financial system. “[3]

Steve Eisman, one of the people who saw the crisis coming, described the situation like this:

“’There’s no limit to the risk in the market,’ he said. ‘A bank with a market capitalization of one billion dollars might have one trillion dollars’ worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!’ The failure of, say, Citigroup might be economically tolerable. It would trigger losses to Citigroup’s shareholders, bondholders, and employees — but the sums involved were known to all. Citigroup’s failure, however, would also trigger the payoff of a massive bet of unknown dimensions from people who had sold credit default swaps on Citigroup to those who had bought them.’”[4]

The “unknown dimensions” quoted be Eisman are the dependencies of other institutions on, in this case, Citigroup. That is to say, financial institutions — banks, governments, insurers, investment firms, are all dependent upon each other to maintain themselves and the scale of this dependence cannot be known in advance of collapse. Much of this mutual dependence is the result of asset-based instruments. It is both this dependence and the inability to know its scale that represents the risk of systemic institutional failure.

By way of contrast, the Internet is also an interconnected system. But in this case, because one server, router or cable of the Internet is NOT dependent upon another, the interconnectedness of the system creates resilience. If one server or router or cable should go down, information is re-routed to its destination.

Belief-based instruments do not carry the same risk of systemic institutional failure because their value does not rely on another asset. There are therefore fewer dependencies. A barrel of oil or a Bitcoin is still likely to have value if the institutions of the current financial system collapse. The universe of belief-based instruments functions more like the Internet. If one asset fails another is able to take its place.

[1] https://trader2trader.co/2012/11/28/list-of-590-dead-currencies-demonetized-r-i-p/

[2] https://money.visualcapitalist.com/all-of-the-worlds-money-and-markets-in-one-visualization/?link=mktw

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

[4] Michael Lewis The Big Short, page 263.

Product Implications

Asset-based instruments continue to proliferate as people find ways to create new instruments. However, as we have seen this also extends the unlimited risk associated with these products based on their dependence on other assets already accepted as having value.

Innovation has also been taking place with belief-based instruments. With the development of the blockchain new currencies have been launched that people have invested with value. Along with Bitcoin, these include Litecoin, Monero, Dogecoin, and many others. In each case, the value of the coin is self-generated by the coin holders.

These belief-based innovations have stayed in the category of currencies where, since 1972 when the US dollar left the gold standard, all instruments are belief-based. However, one crypto-currency has demonstrated the possibility of developing a new category of belief-based investment products. This would be a departure for belief-based instruments. These products would enable investors to participate in the gains of, for example, traditional hedge funds or tracker funds without exposure to the unquantifiable risks these asset-based instruments carry.

The crypto-currency is Tether. The purpose of the Tether coin is to be pegged to the value of the US dollar. In order to achieve this, each Tether coin is backed by a US dollar and can be redeemed for the fiat currency at any time. As the below graph illustrates Tether is successfully achieving its purpose of staying pegged to the dollar’s value.

The price of Tether compared to the USD since September 2017. Source: https://www.tradingview.com/symbols/USDTUSD/

However, for most of 2018 media reports have claimed that the Tether coin is NOT backed by US dollars.[1] This would mean that Tether’s peg to the US dollar is not due to an underlying asset. Instead, parity with the dollar has been a function of people’s expectation that the coin is pegged to the dollar. In other words, Tether is not an asset-based instrument but a belief-based instrument. Furthermore, Tether demonstrates that belief-based instruments can track a specific stated value.

This ability of belief-based instruments to track a specific value opens the way for belief-based investment products. Part of what people believe in can be for the product to track specific values. 
 
 For example, rather than having to invest in a futures contract to participate in the returns of Brent Crude oil, a blockchain token could be created whose purpose was the track the price of the spot Brent Crude market. An advantage of this approach would be that investors would not be exposed to the risks of the asset-based approach. As the value of the token would be self-generated investors would also not be subject to the legislative requirements of securities.

Bitcoin Enhanced, a project I am involved in, is applying this belief-based methodology to a long/short Bitcoin strategy.[2]

From a macro perspective, the development of belief-based investment instruments could reduce the current unlimited risk posed by the derivatives market. Each token would be a self-referential pricing system. As such if a token failed there would be no domino effect. The losses associated with the failure would be quantifiable and limited to the amount invested. Any repercussions for the financial system as a whole would be limited to this loss.

The approach opens many other possibilities for new product development. For example, governments could issue their own token that tracked the consumer price index of the country. People could buy and hold the token as a means of saving. Currently saving as a form of investment is no longer possible in most countries because of the inflationary nature fiat currency management.

[1] For example: https://en.wikipedia.org/wiki/Tether_(cryptocurrency)

[2] https://bitcoinenhanced.io/

Summary

All financial instruments ultimately depend upon what people believe has value. Price is a human creation unlike physical attributes such as the weight of a barrel of oil.

However financial instruments can also be subdivided into two broad classes: belief-based instruments and asset-based instruments. This classification of instrument is useful because both classes have unique attributes that can have an important impact on investment decisions. In particular, the regulation of securities is focused on asset-based instruments. These instruments also carry an unlimited and unquantifiable risk of systematic intuitional failure that many investors would want to diversify away from.

Both classes continue to expand their product range. With the experience of the crypto-currency Tether, belief-based instruments have now shown that they can track a given published price. This opens the way for the development of investment products that do not carry the systemic risks of asset-based instruments such as traditional hedge funds or derivatives. The development of such products could help reduce systemic risk for the financial system as a whole.