Considering Safe Havens From A Systems Perspective: Risk Versus Resilience
By Andrew Gillick on ALTCOIN MAGAZINE
Here we look at the interdependent risks built into financial markets and consider the resilience of gold and bitcoin as safe havens within that complex system. In the second part of the article, we look at trust eroding in money and the changing narratives of value.
When considering a safe haven it is important to consider what are we protecting against: known high-probability risks within a system, or low-probability high-consequence systemic risks that are highly interconnected with others? We should consider the difference between risk and resilience in our strategies and assets and look at the whole market from a systems perspective.
In today’s extraordinary environment many so-called market axioms are being violated: stocks and bond prices rallying together, gold and the US dollar strengthening, volatility shocks, and many other atypical events are becoming more frequent. In trying to bring stability and control to naturally and spontaneous systems, from financial markets to the natural world, we have been compounding risks and exacerbating the consequences. The frequency of these ‘atypical’ market events may suggest it's nearing a tipping point.
Complex dynamics is the study of nonlinear systems that are considered out of equilibrium; they are whole systems made up of many complex interactions between different parts and difficult to predict. Financial markets are made up of complex human interactions, personality types and biases, are complex systems — although complexity theory is the opposite of today’s prevailing economic and financial models which are all premised on equilibrium equations.
Financial markets share the three characteristics of complex dynamical systems, as defined by the Stockholm Resilience Centre: (i) highly unpredictable, due to their non-linear relationships / interactions. (ii) contagio effect, things can spread very quickly and (iii) modularity, although the whole system is well-connected parts of the system are more connected within than between, which may help its resilience.
Using forest fires as an example of complex dynamics, in spite of our success at reducing their frequency the size and devastation caused by forest fires has actually increased over the years. What has since been discovered is that human interference in suppressing the frequency of forest fires has actually resulted in more acres of forest being lost to fire.
The primary reasons for this are the lack of diversity in pine forests that are planted for their timber efficiency but lack resilience and because preventing fires allows invasive species, which grow faster, to outcompete the more resilient species, which are the older slower-growing species. This makes the forest less resilient to recovering from fires and the cycle continues.
Risk Versus Resilience
When considering a safe haven it is important to consider what are we protecting against: probable known risks within a system or low-probability high-consequence systemic risks?
What then is a systemic threat? According to the International Risk Governance Center they arise when “systems […]are highly interconnected and intertwined with one another”, and disruption in one area triggers cascading damage to other nested or dependent nodes. A system is less resilient to these systemic threats the more closely interconnected it is with other systems.
The loss of resilience in the financial system can be seen in the declining central bank interest rates since the 1980s as the rate has failed to recover its former strength after each recessionary shock.
Before the end of the gold standard in 1971, the Feds Fund rate (blue line) and Federal debt (red line) moved in largely in sync, keeping the government’s debt margin relatively steady, and both FF rate and debt generally came down during recessions. Since then the government has been free to increase money supply and rates and debt have moved in opposite directions as the government has increased the govt debt margin to the point where it is effectively monetizing its debt for free.
Just as forest fires are a regenerative process that clears out dead wood and leaves only the most resilient trees which increases overall resilience, our economic system is comparable. Because a true reset has been avoid for several decades time it has been falsely supported QE, bank bailouts it has resulted in many ‘zombie companies’ be even larger. It is due to this that we must resilience in our safe haven for the 21st century.
Although the terms are sometimes conflated there is a fundamental difference between the two. While risk on the more probable risks before the event occurs, the system’s theory considers the resilience of how well a system prepares, adapts and recovers from high-impact shocks that are entwined in other complex systems. Resilience is risk preparedness, risk absorption, and risk adaptation to black swan events, or in other words ‘threat agnostic’.
On the other hand, risk management strategies such as hedging, safe havens, diversification or options strategies can be effective for relatively known/probable risks.
Market Systemic Risk And Loss Of Resilience
In the legacy markets, there is growing concern that passive investing and exchange-traded funds (ETFs) have created bubbles and distortions in equities, all but eliminating price discovery and falsely suppressing volatility, the threat has even been likened to collateralized debt obligations (CDOs), the derivatives that precipitated the GFC.
The latent risks of these ETFs is that the institutions which create, underwrite, and custody them are all counterparties to each other for many other derivatives they have on their books. In other words, the fund management industry is highly interdependent and has grown ‘too big to fail’.
The eight largest asset management shops in the US have amassed $22t in assets under management, up from $8t in 2006, according to research by asset manager Fasanara Capital. This can be partly attributed to the positive feedback loop of rising asset prices led by trend-following funds and managers, resulting in a highly correlated and concentrated level of risk in global stock markets and particularly in the asset management industry.
We find that, over recent years, measures of market diversity and resilience fell in lockstep with measures of entropy, all the while as size rose to record levels. Entropy in the ETF market decayed at an average rate of 4.5% per year in the last ten years, and its trend-line has almost reached 2008 levels.
— Fasanara Capital
In 2014, the Financial Stability Board (FSB), the international body which monitors the global financial system, recommended that fund and asset managers be designated as “global systemically important financial institutions” due to the size of the sector. Such a categorization would have involved more regulatory oversight but after strong lobbying by the industry the designation was not applied.
The FSB also warned of a “liquidity mismatch” between fund investments and redemption — essentially ETFs create an illusion of liquidity for assets as the number of funds has far outgrown the number of stocks underlying them and the ability to sell (or redeem) them during a mass sell-off.
Bitcoin’s relative autonomy from the wider financial system should make it a safe haven from shocks emanating from that system as there are weaker connections that would result in cascading shocks. While bitcoin has its own native risks, they are largely independent from the financial system.
Bitcoin As Portfolio Resilience
What characterizes a resilient system is its ability to absorb shocks but also to quickly adapt to the new equilibria after a system regime change. We argue Bitcoin’s ability to bounce back from a Black Swan event, such as that experienced in 2008, something unforeseen, is also more adaptable than gold as it has many 21st century qualities — natively digital, portable, divisible, provides a platform for other software and programs to be built upon. In short, because it is a ‘programmable asset’ it is malleable enough to build new utility into and on top of.
If data is the oil of the new economy then Bitcoin, as perhaps the world’s most secure and expensive data network, it has appeal to developers and tech entrepreneurs who are building the apps and software of the new internet (Web 3.0).
Rather than being mere ‘digital gold’, bitcoin has become perhaps the most resilient, valuable information and data system in the world. We argue Bitcoin will be more adaptive and resilient regime changes in the 21st century as it is natively digital, fungible, liquid, portable, data privacy and evolution of the internet, traits we believe are more desirable and will become more valuable than the aesthetics of gold jewelry.
As such it is a feature that bitcoin has no ETF, central bank and little institutional exposure as this reduces its cross-ownership, interconnections with other parts of the financial system which should increase its resilience in the event of a systemic shock.
Gold’s Interdependencies In The Financial Markets
Gold, on the other hand, is highly interconnected to the ‘legacy’ markets as it is owned by central banks and throughout investor portfolios, public and private, through dozens of derivatives funds and ETFs — and as we will argue can backfire as safe haven strategy.
Gold funds are wrappers around a risky asset which introduces many more intermediaries between the buyer and the asset than if one was to buy the asset outright. For example, the value of the largest gold ETF, the SPDR Gold Share (GLD), depends largely upon physical gold held in vaults in London, and systemically important financial institutions, the fund vendor State Street Global Advisors, the trustee Bank of New York Mellon, and HSBC as the custodian of the gold. If any of those major (highly interdependent) institutions were to fail the value of funds shares could go to zero.
Also, no two funds are constructed in the same and ETFs can either be fully-backed by the physical asset (GLD) or a mix of paper and physical. The fully-backed model has some obvious obstacles, there is only so much free-floating gold supply that can be bought but an unknown amount of demand for the gold fund, which can introduce price dislocations between the spot and the fund’s NAV (which is ordinarily brought back in line by arbitrageurs). The fund can only grow to such a size before it distorts price.
Why then do most people buy gold? It’s hard to argue that it’s for its perceived scarcity, after all, a large swathe of investors will never need or want to own physical gold but simply hold a paper derivative as a portfolio instrument.
With hundreds of gold derivative products (ETFs, ETNs, futures, options etc.) gold is also firmly ensconced in the global derivatives market which, at a conservative estimated, has a capitalization around $544t, and, at an upper estimate, $1.2 quadrillion. For comparison, all the world’s stock markets have a capitalization of around $80tr and all the gold in circulation (187,200 tonnes according to the World Gold Council) has a cap of $10tr, at a price of $1,500 per ounce.
The sheer size of the derivatives market has compounded systemic risk as it has increased the interdependence of the world’s major financial institutions which have a role in issuing, insuring, underwriting, and holding custody of the derivative products, making them counterparties to the same risky assets they hold on their books. When systems are highly interdependent it increases the node connectivity which increases cascading effects emanating from a system blow up.
In the tumultuous months leading up to the Lehman Bros collapsed in 2008 and the global financial crisis gold dropped sharply for almost an entire year, presumably due to people liquidating positions and covering margin calls and selling by large institutions including central banks — a cascading effect.
At the onset of the GFC in early 2008, gold (XAU/USD) initially sold off and declined over 40%, not what would be expected of a ‘safe haven’ asset at the beginning of a crisis.
Even though gold made a strong recovery in the years after the GFC, its reversal also coincided with a strong recovery in the S&P index, although not as dramatic.
Although most assets correlate during a market panic, this coinciding crash and recovery in both gold and the SPX over such a long time-frame suggests gold wasn’t acting alone as a safe haven but benefited from a broad lift in liquidity from quantitative easing which, in turn, lifted confidence.
Whether this pattern will repeat in the next recession or be even more accentuated is unclear but it is an example of the unreliability of gold as a safe haven when it is so intrinsic to the system it is meant to be protecting against.
Trust Is Eroding In Money
As money is a promissory note we can use it as a proxy for trust in a system. If interest rates are the price of money (for which return you are willing to lend it) then negative and zero rates have the effect of diminishing trust rather than bolstering it. Using the ‘alternative money’ narrative of gold its price can be viewed also as the breakdown of trust in legacy money.
Despite its reputation as protection against inflation, since the Great Depression, the annual return on gold has been 3% after inflation, compared to 8% for the Dow Jones. The narrative of gold as a safe haven against market turmoil is also an enduring one in investment folklore, most likely a legacy from middle ages when, in times of war, gold was used in trade rather than the paper money issued by kings who were prone to be killed leading to a regime change and default on the notes.
Stock markets in the largest gold producing countries US, Canada, Australia are at or near all-time, housing prices are also at all-time highs in these countries and the price of gold is at multi-year highs against their respective currencies (while the same currencies weaken in USD terms). Despite narratives of strong economies today the rally price of gold doesn’t reflect inflation protection but signals a breakdown of trust in money, politics, and economics.
Source: Gold Charts R Us
In the first six months of the year, central banks bought a record $15.7b in an effort ‘to diversify’ from USD which signals distrust among central banks, just as the turnover of gold coins increased during times of war and distrust in monarchies.
A Changing Narrative Of Money
The paradigm of value or the digitization of value. Rather than money reverting back to a hard-backed standard, money is becoming globalized and it is unlikely there will ever be a return to a ‘gold standard’.
The margins on the cost of money production have been widening for central banks over the decades as the Treasury has diluted the content of metal (silver and nickel) in coins and even changed the standard of the printed paper money. In 2018 the Federal Reserve printed $243m of USD at a cost of $800m — or 0.3% of the face value.
Gold is held by all central banks as a form of non-sovereign base money as it is the one true globally accepted unit of settlement.
When fiat money is fully digitized and central banks issue their own digital currency the cost and ease of money production will be slashed again. This could allow for even greater fiscal spending that proponents of Quantitative Easing and Modern Monetary Theory (MMT) advocate.
Monetizing government debt as per the proposition of MMT would be entirely more plausible and even logical with a central bank digital currency (CBDC) as the government would have real-time data on all economic activity.
The concept of value is undergoing a paradigm shift as a new generation native to the world of digital value emerges as the dominant global demographic: Millennials and Gen Z. This cohort grew up with the internet, online banking, credit cards, Magic The Gathering cards and gaming virtual currencies and this new generation of consumers perceives value very differently from other generations and has an even more abstract concept of value.
This generation will shape the future of money and perhaps define the next reserve currency. In the early 20th century a global narrative emerged that rather than having currencies pegged to gold as a reserve currency (the gold standard) that they should be backed to both gold and silver. The premise being that a gold peg hindered economic growth as countries couldn’t expand the money supply beyond what value of gold they held and often the peg had to be dropped, especially in times of war. A gold-silver combo would be more flexible and allow for more monetary expansion.
Bimettalism For The 21st Century: Bitcoin And Gold
The concept of ‘bimetallism’ arose in the 1890s which called for a monetary-based on both gold and silver, rather than just the gold standard that prevailed for centuries. This term rose in frequency particularly after the 1893 depression, as the tie to a scarce physical asset limited the amount of money and credit supply needed to lift economies out of the trough.
A similar spike in interest has emerged with search terms for bitcoin since 2012, driven certainly by price speculation but also amid other narratives: calls for a new autonomous financial and monetary system autonomous, financial sovereignty, anarcho-capitalism, debt-free money, and ‘digital gold’. And its narratives continue to evolve the longer it exists.
However the narrative for a largely debt-free alternative economy is perhaps the strongest as we approach unprecedented corporate, personal and sovereign debt levels and as the probability of a systemic threat rise.
Just as the calls for bimetallism arose during the late 29th-early 20th centuries, a period of many wars in Europe and US, the some of the ‘macro drivers’ for bitcoin have been geopolitical turmoil, Brexit and Trade War headlines, etc. Narratives spread the same as any epidemic and if so could the interest in bitcoin and fear of geopolitics reach epidemic status in confluence and would Bitcoin emerge as a safe haven for the 21st century?
Conclusion: Preparing For A Regime Change
It is also important today that we consider ‘regime changes’ today from a systems perspective as the build-up of passive investing bubbles, cross-ownership of assets and high correlations between markets add to systemic threats. A regime change occurs in a system after reaching a tipping point that triggers an abrupt change of state to a new equilibrium in the system.
There are many tipping points lurking in the global financial system as the global sovereign debt bubble (as well as climate costs) comprised of $14 trillion in negative-yielding bonds is uncharted territory.
Rather than being mere ‘digital gold’, bitcoin has become perhaps the most resilient, valuable information and data system in the world.
Every year the bitcoin network exists it grows in resilience as it is constantly under attack and adapting to those new threats with updates to the base code and there are numerous features in its decentralized design that prepare it for systemic shocks. This is the opposite trend to the financial system as a whole.
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