Some folks are suggesting that a bitcoin ETF is absurd because it doesn't fit with Bitcoin's original ethos. On the contrary, I think it's a nice snug fit.

It would be a misunderstanding of bitcoin's history to assume that it was the idealism of cypherpunk-ism that gave birth to the Bitcoin movement. Bitcoin would never have got off the ground without a massive amount of old fashioned greed. In bitcoin-speak, this greed usually goes by the term number-go-up, and it was crucial from the start. The new bitcoin ETFs are certainly not cypherpunk, but they are very much in the founding spirit of number-go-up.

One of the main goals of the 1990s cypherpunks, if you recall, was to create anonymous digital cash. And while bitcoin certainly has some roots in cypherpunk ideals, the ethos of number-go-up clashes with the dream of digital cash: after all, an asset with a volatile price makes for an awful medium of exchange. Before long, number-go-up had drowned out the cypherpunks.

I recall walking into Montreal's Bitcoin Embassy in 2014, which was located on the busy intersection of St-Laurent and Prince-Arthur. I had already been researching and writing about bitcoin for a few years, but decided to play it dumb to see how the folks at the Embassy would approach the task of teaching a newbie about bitcoin. Instead of preaching to me about how to make a bitcoin payment from my own self-custody wallet, the ambassador walked me over to a large screen showing bitcoin's price. "Look, it's rising," he said in awe.

That, in short, sums up bitcoinism. Like 1980s televangelism with its gold-plated cowboy boots, mansions, private jets, and a dose of God on the side, bitcoin is all about the price chart with a small helping of cypherpunk ideology.

Number-go-up has always required getting ever more people into the game. Bitcoin, after all, is itself sterile. Unlike a publicly-traded business, it doesn't generate a stream of improving profits, so the only way for its price to keep rising is to recruit more players, much like a pyramid or a chain letter. From the early days, getting access to traditional financial and banking infrastructure has been crucial to making this recruitment process go as smoothly as possible.

Docking bitcoin to the existing financial edifice began in 2010 with the first bitcoin exchanges, which hooked into the crucial global bank wire systems like SWIFT, as well as local wire systems like the Federal Reserve's Fedwire system and Europe's SEPA system. These integrations were key to pumping the initial rounds of money into the game, and pushing the number above $1, and then $10, $100, and $1000.

Later on, bridges to the Visa/MasterCard debit card and credit card networks brought an even tighter fusion between bitcoin and the regular world, more inflows, and more number-go-up. The addition of bitcoin purchases to mobile payment apps like PayPal and Cash App came after. Viewed in this context, ETFs are nothing new, really; they only represent the next coupling between the two worlds.

As for regular old finance, it isn't complaining. The task of players like Visa is to generate profits – they want nothing more than to add new products like bitcoin to the list of products they already connect. The curious result is that no chain-letter style product has ever gone as mainstream as bitcoin has.

Now that bitcoin ETFs exist, number-go-up demands even more linkages to traditional finance and banking. What's next? One possibility: expect the bitcoin community to lobby for federally-chartered banks to be allowed to offer bitcoin products alongside savings deposits and retirement accounts. Banks offering bitcoin to their retail client base may seem inconsistent with bitcoin's more cypherpunk-y dreams of replacing the banking system, but on the contrary: its hard to imagine a more fantastic recruitment tool for number-go-up.

I'm hearing all sorts of silly projections about how big the U.S. market for a physical crypto ETFs will be, and how their eventual approval will drive new bitcoin demand and pump its price into the stratosphere.

To date, the Securities and Exchange Commission (SEC) has refused to give its permission to a physically-backed crypto ETF. As such, the main way for U.S. investors to get exposure to exchange-listed crypto products has been to buy the Grayscale Bitcoin Trust or Grayscale Ethereum Trust, which are closed-end funds, and lack the many of the nice features of an ETF.

Luckily, we already have a good idea about what market demand for physical crypto ETFs looks like. Canada has allowed these products since 2021. According to the Canadian Securities Administrators (CSA), our version of the SEC, the combined value of all listed crypto financial products was C$2.865 billion as of April. Almost all of that (C$2.289 billion) is comprised of physical bitcoin and ether ETFs, with a small contribution from close-end funds and futures-backed products.

Source: CSA

Applying the rule of 10 to this number, the implied total value of all U.S. exchange-listed crypto products, both physically-backed ETFs, futures-backed ETFs, and closed-end funds, comes out to C$28.65 billion, or US$22 billion. The rule of 10 is based on the idea that Canada's population is a tenth the size of the US's, and since Canadians and Americans are quite similar, just multiply Canadian data by ten to get U.S.-equivalents.

The Grayscale Bitcoin and Ethereum Trusts, worth US$13.7 billion and US$3.5 billion respectively, are likely to convert into ETFs if the SEC allows it, so US$17.2 billion of this US$22 billion in theoretical headroom for total U.S. exchange-listed crypto products is already taken. That leaves another US$4.8 billion in theoretical as-yet unused capacity. 

This is hardly a game changer, folks.

If the eventual approval of physical crypto ETFs unleashes US$4.8 billion in potentially new crypto demand from U.S. investors, that is tiny relative to the US$900 billion combined value of bitcoin and ether. And keep in mind that this US$4.8 billion may not necessarily represent new investor buying power, since the introduction of physical ETFs could simply cannibalize existing demand by pulling crypto holders away from storing crypto on exchanges like Coinbase, or from owning it physically.

Back in 2018 I wrote about the controversy over the constant stream of bitcoin ETF denials emanating from the Securities and Exchange Commission (SEC). And my conclusion then was: "further rejections likely." My conclusion in 2023 is the same. Even with Wall Street-giant Blackrock entering the scene with a proposed Nasdaq-listed iShares Bitcoin ETF, nothing has changed: a bitcoin ETF probably probably won't get approved.

The FT says that the big difference this time around is that Blackrock will enter into a "surveillance-sharing agreement with an operator of a United States-based spot trading platform for bitcoin." It's pretty clear that this agreement will be with Coinbase, the U.S.'s largest crypto market.

This may sound convincing, but the idea that Blackrock is the first potential bitcoin ETF issuer to enter into surveillance-sharing agreement with a U.S. exchange is wrong. It's an old tactic, one that hasn't worked to-date.

When the Winklevoss twins famously tried to launch their bitcoin ETF on the Bats BZX exchange many years ago, part of their (modified) proposal involved BZX entering into a surveillance-sharing agreement with the Gemini Exchange, a U.S. crypto exchange. But the SEC didn't see this as adequate in 2018, so it's not apparent to me why that approach would be adequate now.

Let's back up. Why surveillance sharing agreements?

I got into this in more detail five years ago, but here's a quick explanation. When an exchange lists an ETF, particularly a commodity-based one, that ETF is typically underpinned by some sort of commodity, say lumber or copper, that gets traded on another exchange (or set of exchanges). The SEC believes that a mutual agreement to share information between the relevant exchanges is key to preventing fraudulent and manipulative acts. For example, if one exchange serves as a venue for trading bananas, and another exchange wants to list a banana ETF, the SEC will only approve said ETF if the listing exchange shows that it can monitor the underlying spot banana exchange to catch manipulators, the end goal being to protect investors.

The Winklevoss's earlier attempt to prevent manipulation through surveillance sharing with Gemini wasn't deemed sufficient by the SEC, for two reasons. Gemini was neither significant (i.e. "big relative to the overall market"), nor was it regulated as a national exchange.

Fast forward to 2023. In its proposal, Blackrock is essentially swapping out Gemini with Coinbase, by having Nasdaq, the exchange that will list the iShares Bitcoin ETF, share surveillance with Coinbase. But unfortunately for Blackrock, nothing has changed. First, much like Gemini, Coinbase isn't a regulated exchange. Secondly, Coinbase isn't all that big in the global scheme of things, especially compared to global titan Binance, an offshore exchange. So I doubt that a surveillance sharing agreement with Coinbase will get Blackrock's proposal over the line. 

A second tactic that Blackrock is using to get SEC approval is to establish another surveillance sharing agreement with a regulated futures exchange, one that offers bitcoin contracts. As I explained in my 2018 article, this is how the massive SPDR Gold ETF got approved a few decades ago. When trading in a commodity occurs informally, say via over-the-counter markets (as it does with gold), and it's not possible for an exchange that lists an ETF to ink surveillance sharing agreements, then the SEC may accept an agreement with a futures exchange as a substitute, in SPDR's case the NYMEX exchange.

In Blackrock's case, it has chosen to have Nasdaq, the exchange on which it will list, mutully share information with CME futures exchange, which lists bitcoin futures.

At first blush, Blackrock seems on the right track. The CME ticks the "regulated" column, unlike Coinbase. What about the "significant" column? The CME's open interest of around $1.5-2.0 billion is about half of Binance's $3-4 billion in futures open interest (and just a small fraction of the $10 billion combined total of Binance and all other unregulated offshore exchanges), so I'm not sure how the CME will qualify as big enough. (I get this data from The Block.) Put differently, if you wanted to manipulate the price of bitcoin using futures, you'd probably be able to do a fine job of it via Binance's futures market, and so Blackrock's surveillance sharing agreement with the CME just won't be all that effective.

In any case, this particular gambit has been tried before, and it hasn't worked. A parade of ETFs have tried to use a CME surveillance sharing agreement as their ticket to SEC approval, many using in-depth statistical analysis showing why the CME qualifies as "significant," and none have convinced the SEC, so it's not evident why Blackrock is special.

If Blackrock's iShares Bitcoin ETF isn't going to get approved, what needs to happen to get a bitcoin ETF over the line?

In my opinion, the unregulated offshore market needs to die. Much of crypto price discovery (and thus potential manipulation) occurs in offshore markets, both on the spot and futures side. Given the logic that the SEC has used up till now, Binance needs to go bust, and kosher venues need to take its place, before a U.S. bitcoin ETF get approved, because it's only then that a majority of bitcoin trading will migrate to venues that tick both the SEC's "regulated" and "significant" requirements.

The global rise in interest rates is finally beginning to percolate into the stablecoin sector. One of the effects of this rise is that centralized stablecoins like USD Coin and Gemini Dollar, which by default pay 0% to holders, are introducing backdoor routes for paying interest to large customers. (See my tweets here and here).

In the case of USD Coin, Coinbase refers to interest as a "reward." Gemini calls it a "marketing incentive." But less face it: they're really just interest payments.

The links I provide are the only public evidence of stablecoins doling out interest, but you can be sure that behind closed doors, large issuers like Circle/Coinbase, Gemini, and others are offering their largest customers -- in particular exchanges like Binance and Kraken -- the same deals.

Stablecoin issuers are offering interest to select customers because of the inexorable pressure of competition. After hovering near 0% for much of the last decade (see chart above), interest rates have ramped up to 3% in just a few months. Issuers hold assets to back the stablecoins that they've put into circulation, and now these previously barren assets are yielding 3%. That means a literal payday for these issuers. In the first quarter of 2022, for instance, Circle (the issuer of USD Coin) collected $19 million in interest income after making just $7 million the quarter before. In the second quarter of 2022, interest income jumped to $81 million. I suspect the third quarter tally will come in well above $150 million.

However, if they don't share at least some of this juicy reward, issuers risk having their customers flee to alternatives that do offer interest, like Treasury bills or corporate deposit accounts. And then the amount of stablecoins in circulation will shrink, eating into issuers' revenues.

And thus, we get to a world where Gemini is promising incentives and Coinbase rewards.

Alas, while large stablecoin holders may be benefiting from this trend, small holders of stablecoins are being ignored. They don't get to share in these sweet flows of interest income. Even folks with old-school U.S. savings accounts are being paid 0.17%!

Small stablecoin holders need to unite. By working together through a StablecoinDAO, their bargaining power vis-a-vis the big stablecoin issuers improves. They may be able to negotiate the same interest payments from Circle and other issuers that large stablecoin customers are getting.

For a good example of strength in numbers, take a look at the phenomenon of high-interest savings ETFs in Canada. Corporate customers of Canadian banks get far better interest rates on chequing deposits than retail customers do. A high-interest savings ETF manager bridges this divide. They collect money from retail customers, invest the proceeds in banks at the corporate rate, and then share the superior return with thousands of retail ETF unit holders.

A StablecoinDAO would work along the same lines as a high-interest savings ETF. People would deposit their stablecoins -- USD Coin, Gemini Dollar, Binance USD, USDP, Tether, Dai -- into a smart contract. In return they'd get a new stablecoin called, say, UniteUSD, which would be redeemable on demand into any of the DAO's underlying stablecoins. UniteUSD itself would be useful. It could be used for purchases, deposited into smart contracts, or traded on decentralized exchanges and whatnot.

StablecoinDAO would have the authority to swap one underlying stablecoin out with a new one. That potential threat would give the DAO the necessary leverage to negotiate interest payments. "Hey Circle, if you don't pay us 1% then we're going to shift the DAO's holdings over to Binance USD, your competitor." As a nuclear option, the DAO could threaten to buy short-term government debt.

The interest that the DAO receives would be funneled back to UniteUSD holders. 

In sum, that's how interest rates finally filter through to small stablecoin owners.

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A few random afterthoughts about stablecoins and interest payments, in no particular order:

* A version of StablecoinDAO may already exist... in the form of MakerDAO, a decentralized-ish bank that issues Dai stablecoins. Think of MakerDAO as an organizing device for small stablecoin customers to extract interest from stablecoin issuers. These small holders deposit their stablecoins (USD Coin, USDP, etc) into MakerDAO smart contracts and receive Dai stablecoins in return, which are convertible to any of these underlying stablecoins on a 1:1 basis. MakerDAO negotiates with issuers for interest payments, sluicing this interest back to Dai owners.

* Some tricky regulatory issues arise when retail customers are promised a return. If StablecoinDAO were to pay interest on UniteUSD, then UniteUSD might be deemed to be a security, and thus StablecoinDAO would have to register with a securities agency. This could doom StablecoinDAO, or at least make things very difficult for it. (Remember, when PayPal used to pay interest to customers? It did through an SEC-registered money market mutual fund.)

* StablecoinDAO would become a stablecoin black hole: all other stablecoins would quickly get sucked up into it. Why? In a world where USD Coin and USDP can only pay 0% to small stablecoin holders, but depositing said coins into StablecoinDAO means earning 2%, then every small holder will deposit their funds into StablecoinDAO. The DAO would inhale the big stablecoins -- USD Coin, Binance USD, Tether, etc -- right out of circulation, leaving UniteUSD as the dominant stablecoin.

* As competition forces large issuers to share the interest they earn, this will have implications for the finances of those very issuers. Circle, the issuer of USD Coin, envisions being profitable in 2023, as the table below illustrates:

Source: Circle Q2 2022 financials [link]

A big part of Circle's estimates are based on higher flows of interest from the assets that it holds to back USD Coin. What this table isn't accounting for is the concurrent pressure to share interest income with USD Coin holders, both large and small ones, which threatens Circle's 2023 projections.

I executed one of the oddest financial transactions of my life earlier this week. I did Norbert's Gambit.

These days a big chunk of my income is in U.S. dollars. But since I live in Quebec, my expenses are all in Canadian dollars. To pay my bills, I need to convert this flow of U.S. dollars accumulating in my account to Canadian dollars.

Outsiders may not realize how dollarized Canada is. Many of us Canadians maintain U.S. dollar bank accounts or carry around U.S. dollar credit cards. There are special ATMs that dispense greenbacks. Canadian firms will often quote prices in U.S. dollars or keep their accounting books in it. I suppose this is one of the day-to-day quirks of living next to the world's reigning monetary superpower: one must have some degree of fluency with their money.

Anyways, the first time I swapped my U.S. dollar income for loonies I did it at my bank. Big mistake. Later, when I reconciled the exchange rate that the bank teller had given me with the actual market rate, I realized that she had charged me the standard, but massive, 3-4% fee. In an age where the equivalent fee on a retail financial transaction like buying stocks amounts to a minuscule $20, maybe 0.3%, a 3-4% fee is just astounding. But Canadian banks are an oligopoly, so no surprise that they can successfully fleece their customers.

So this time I did some research on how to pull off Norbert's gambit, one of the most popular work-a rounds for Canadians who need to buy or sell U.S. dollars. From a moneyness perspective, Norbert's gambit is a fascinating transaction because it shows how instruments that we don't traditionally conceive as money can be recruited to that cause. The gambit involves using securities listed on the stock market as a bridging asset, or a medium of exchange. More specifically, since the direct circuit (M-M) between U.S. money and Canadian money is so fraught with fees, a new medium--a stock--is introduced into the circuit (like so: M-S-M) to reduce the financial damage.

To execute Norbert's gambit, you need to move your U.S. dollars into your discount brokerage account and buy the American-listed shares of a company that also happens to be listed in Canada. For instance, Royal Bank is listed on both the Toronto Stock Exchange and the New York Stock Exchange. After you've bought Royal Bank's New York-listed shares, have your broker immediately transfer those shares over to the Canadian side of your account and sell them in Toronto for Canadian dollars. Voila, you've used Royal Bank shares as a bridging medium between U.S. dollar balances and Canadian ones.

These days, Norbert's gambit no longer requires a New York leg. Because the Toronto Stock Exchange conveniently lists a wide variety of U.S dollar-denominated securities, one can execute the gambit while staying entirely within the Canadian market. In my case, I used a fairly liquid Toronto-listed ETF as my temporary medium of exchange, the Horizon's U.S. dollar ETF, or DLR. I bought the ETF units with my excess U.S. dollars and sold them the very next moment for Canadian dollars.

Below I compare how much Norbert's gambit saved me relative to using my bank:


Using the ETF as a bridging asset, I converted US$5005 into C$6465, paid $19.90 in commissions, for a net inflow of $6,445.10 Canadian dollars into my account. Had I used my bank, I would have ended up with just $6265, a full $180 less than Norbert's gambit. That's a big chunk of change!

What is occurring under the hood? Norbert's gambit is providing a retail customer like myself with the same exchange rate that large institutions and corporations typically get i.e. the wholesale rate. Because there is a market for the DLR ETF in both U.S. dollar and Canadian dollar terms, an implicit exchange rate between the two currencies has been established. Call it the "Norbert rate". Large traders with access to wholesale foreign exchange rates set the Norbert rate by buying and selling the DLR ETF on both the U.S. and Canadian dollar side. If any deviation between the Norbert rate and the wholesale exchange rate emerges, they will arbitrage it away. Small fish like myself are thus able to swim with the big fish and avoid the awful retail exchange rate offered by Canadian banks.

This workaround is called Norbert's gambit after Norbert Schlenker, a B.C-based investment advisor who it to help his clients cut costs. Says Schlenker in a Globe & Mail profile:

"In 1986 I moved down to the States, and while I was there I needed to be able to change funds from U.S. dollars to Canadian and vice-versa, and I had a brokerage account in Canada. It came to me that I could use interlisted stocks to do this."

Thanks, Norbert!

But using stock as money isn't just a strange Canadianism. Back in 2014, I wrote about other instances of stocks serving as a useful medium-of-exchange. During the hyperinflation, Zimbabweans used the interlisted shares of Old Mutual to evade exchange controls, lifting them from the Zimbabwe Stock Exchange to London. Earlier, Argentineans used stocks (specifically American Depository Receipts) in 2001 to dodge the "corralito". But I never imagined I'd use this technique myself to skirt around Canada's banking oligopoly!

Blair Ferguson. Source: Bank of Canada

Passive investing is eating Wall Street. According to 2015 Morningstar data, while actively managed mutual funds charge clients 1.08% of each dollar invested per year, passively managed funds levy just a third of that, 0.37%. As the public continues to rebalance out of mutual funds and into index ETFs, Wall Street firms simply won't be able to generate sufficient revenues to support the same number of analysts, salespeople, lawyers, journalists, and other assorted hangers-on. It could be a bloodbath.

Here is the very readable Eric Balchunas on the topic:

Because when an inv switches from active to passive, it basically means a 70% drop in revenue for industry. #DOLrule https://t.co/HntHyDi3rJ

— Eric Balchunas (@EricBalchunas) April 7, 2016

Any firm that faces declining profits due to narrowing margins can restore a degree of profitability by driving more business through its platform. In the case of Wall Street, that means arm-twisting investors into holding even more investment products. If Gordon Gecko can get Joe to hold $3000 worth of low margin ETFs then he'll be able to make just as much off Joe as he did when Joe held just $1000 in high margin mutual funds.

How to get Joe to hold more investments? One way would be to increase demand for ETFs by making them more money-like. Imagine it was possible to pay for a $2.00 coffee with $2.00 worth of SPDR S&P 500 ETF units. Say that this payment could occur instantaneously, just like a credit card transaction, and at very low cost. The coffee shop could either keep the ETF units as an investment, pass the units off as small change to the next customer, use them to buy coffee beans from a supplier, or exchange them for a less risky asset.

In this scenario, ETF units would look similar to shares of a money market mutual fund (MMMF). An MMMF invests client money in corporate and government debt instruments and provides clients with debit and cheque payments services. When someone pays using an MMMF cheque or debit card, actual MMMF shares are not being exchanged. Rather, the shares are first liquidated and then the payment is routed through the regular payments system.

Rather than copying MMMFs and integrating ETFs into the existing payment system, one idea would be to embed an ETF in a blockchain, a distributed digital ledger. Each ETF unit would be divisible into thousandths and capable of being transferred to anyone with the appropriate wallet in just a few moments. One interesting model is BitShares, provider of the world's first distributed fully-backed tracking funds (bitUSD tracks the U.S. dollar, bitGold tracks gold, BitCNY the yuan, and more). I wrote about bitUSD here. Efforts to put conventional securities on permissioned blockchains for the purpose of clearing and settlement are also a step in this direction.

Were ETFs were to become a decent medium of exchange, people like Joe would be willing to skimp on competing liquid instruments like cash and bank deposits and hold more ETFs. If so, investment managers would be invading the turf of bankers who have, until now, succeeded in monopolizing the business of converting illiquid assets into money (apart from money market mutual fund managers, who have tried but are flagging).

Taken to the extreme, the complete displacement of deposits as money by ETFs would get us to something called narrow banking. Right now, bankers lend new deposits into existence. Should ETFs become the only means of payment, there would be no demand for deposits and bankers would have to raise money in the form of ETFs prior to making a loan. Bank runs would no longer exist. Unlike deposits, which provide fixed convertibility, ETF prices float, thus accommodating sudden drops in demand. In other words, an ETF manager will always have just enough assets to back each ETF unit.

Two problems might emerge. Money is very much like an insurance policy—we want to know that it will be there when we run into problems. While stocks and bonds are attractive relative to cash and deposits because they provide superior returns over the long term, in the short term they are volatile and thus do not make for trustworthy money. If we need to patch a leaky roof, and the market just crashed, we may not have ETF units enough on hand. Cash, however, is usually an economy's most stable asset. So while liquid ETFs might reduce the demand for deposits, its hard to imagine them displacing traditional banking products entirely.

A fungibility problem would also arise. Bank deposits are homogeneous. Because all banks accept each others deposits at par and these deposits are all backed by government deposit insurance, we can be sure that one deposit is as good as another. And that homogeneity, or fungibility, means that deposits are a great way to do business. ETFs, on the other hand, are heterogeneous. They trade at different prices and follow different indexes. Shopkeepers will have to pause and evaluate each ETF unit that customers offer them. And that slows down monetary exchange—not a good thing.

Somewhat mitigating ETF's fungibility problem is the fact that the biggest ETFs track the same indexes. On the equity side, three of the six largest ETFs track the S&P 500 while on the bond side, the two largest ETFs track the Barclays Capital U.S. Aggregate Bond Index. Rather than just any ETF becoming generally accepted media of exchange, the market might select those that track the two or three most popular indexes.

In writing this post, I risk being accused of blockchain magical thinking—distributed ledgers haven't yet proven themselves in the real world. All sorts of traditions and laws would have to be upended to bring the world of securities onto a distributed ledger. Nevertheless, it'll be interesting to see how the fund management industry manages to squirm out of what will only become an increasingly tighter spot. Making ETFs more liquid is an option, though surely not the only one.

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PS. Here is the blogosphere's own Tyler Cowen (along with Randall Kroszner) on "mutual fund banking" in 1990:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

With the rise of ETFs and blockchain technology, the modern version of mutual fund banking would be something like distributed ETF banking described in the above post,

Would it make sense for firms to try to slow down their equity structure?

Equity markets are made of two classes of participants. The minority consists of long-term investors who, like Ulysses, have 'tied themselves to the mast' and would rather fix things when a company runs into problems than sell out. The majority is made of up rootless speculators and nihilistic indexers who cut and run the moment the necessity arises.

Because their holding period is forever, the long-term investor class does all the hard work of monitoring a company and agitating for change. Keeping management honest is the only recourse they have to protecting their wealth. Speculators and indexers are free loaders, enjoying the same upside as investors without having to contribute to any of the costs of stewardship.

How might long-term investors be compensated for the extra expenses they incur in tending the garden?

One method would be for a firm's management to institute a slow/fast share structure. The equity world is currently dominated by the fast stuff, shares that can be bought and sold in a few milliseconds. A slow share is a regular share that, after having been acquired, must be "deposited" for, say, two years. During the lock down period the shareholder enjoys the same cash dividends as a fast share but they cannot sell. Only when the term is up can the slow share be converted back into a fast share and be got rid of. The illiquidity of slow shares is counterbalanced by a carrot; management makes a promise that anyone who converts into slow shares gets to enjoy the benefit of an extra share down the road i.e. a stock dividend. So a shareholder with 100 fast shares who pledges to lock them in for two years will end up with 101 fast shares once the lock-up period is over.

The investor class, which until now has received no compensation for their hard work, will quickly choose to slow down all their shares and enjoy the biennial stock dividend. Feckless speculators and indexers, unwilling to stay tied down for two years, will keep their fast shares and forgo the dividend. After all, the S&P's constituents could change at any moment, so an ETF/index fund needs to be able to cut and run. And a speculator's trend of choice could reverse at any moment.

By the way, ETFs and index funds aren't the only asset type that I include in the fast money category. Also qualifying are the huge population of funds that claim to be "active" but are actually "closet" indexers, as well as all those funds that say they are engaging in 'investing' but are really just speculators. Given the possibility of sudden redemption requests, they need the flexibility that liquid fast shares provide.

As the slow/fast share structure goes mainstream, the benchmark to which market participants are compared, the S&P 500 Index, will evolve into two flavours, the Fast S&P 500 and the Slow S&P 500, the former including the fast shares of the 500 index members while the latter includes only the slow. The Slow S&P will, by definition, show better returns than the Fast S&P, since slow shares enjoy stock dividends at the expense of fast shares. Nihilistic indexers and rootless speculators will choose to benchmark themselves to the lagging Fast S&P. Active investors with a genuine long-term bias, most of whom will choose to own slow shares, will compare themselves to the better-performing Slow S&P.

Mass adoption of fast/slow share structure could change the complexion of the very combative active vs passive investing debate. Passive investors have typically outperformed active investors after fees, largely because they have been able to freeload off of the stewardship of long-term investors. With a new structure in place, buyers of passive indexed products would—by definition—begin to underperform the average long-term active investor. This is because the dual share structure obliges the passive class to compensate long-term investors for their efforts.

I suspect that the adoption of a fast/slow share structure would increase the size of the investor class. After all, with a long-term investing mentality now being rewarded, those on the margin between the investing class and the mass of speculators/indexers will elect to slow down their shares. Once they have lost the ability to cut & run, the only way to protect their wealth will be through constant surveillance of management and a more activist stance. This is a good thing since long-term shareholders are better stewards of capital than short-term ones. In general, share prices should rise.

On the other hand, as more shares are locked down, market liquidity will suffer. Will the increase in stock prices due to improved stewardship outweigh the drop in prices due to a much narrower liquidity premium? If I had to guess, I'd say yes. Which means that even feckless indexers and speculators should support the subsidization of long-term investors.

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Addendum: This isn't a new idea. Read all about loyalty-driven securities here.
Disclaimer: I consider myself to be 50% speculator, 25% indexer, 25% investor. But I'm trying my best to boost the last category.

John Bogle, father of passive investing

With fees as low as 0.10%, passively managed ETFs are one of the cheapest ways to get exposure to equities. Not bad, but here's a financial product that would be even cheaper for investors: an equity deposit. I figure that equity deposits would be so cost efficient that rather than charging a management fee, investors would be paid to own them.

To understand how equity deposits would work, I want to make an analogy to bank deposits. Think of an equity ETF as a chequing account and an equity deposit, or ED, as a term deposit. In the same way that chequing deposits can be offloaded on demand, an ETF can be sold whenever the owner wants, say on the New York Stock Exchange or NASDAQ. Equity deposits, like term deposits, would be locked in until their term was up up. Issued in 1-month, 3-month, 1-year, 3-year, and 5-year terms, EDs would replicate a popular equity index like the S&P 500.

Given that both ETFs and EDs track the same index, and both provide the same dividends, the sole difference between the ETF and the ED is their liquidity. A commitment by an investor to an ED is irrevocable (at least until the term is up) whereas an ETF allows one to change one's mind.  ETFs represent liquid equity exposure; EDs are illiquid equity exposure.

An investor might buy an ED rather than an ETF for the same reason that they might prefer term deposits to a chequing account; they are willing to sacrifice liquidity for a yield. For a trader with a holding period of a few minutes or hours, an ED would be an atrocious instrument. On the other end of the spectrum, long-term buy-and-hold investor would be perfect candidates for substitution from ETFs into EDs. Come hell or high water, investors following a buy and hold strategy have pre-committed themselves to owning equities till they retire. As such, they don't need the permanent liquidity window that ETFs provide. Now if that window were provided free of charge, then investors may as well buy ETFs. But liquidity doesn't come without a cost, as I'll show below. Which means that long-term investors who own ETFs are paying for a worthless feature.

Better for a buy and hold investor to slide a portion of the portfolio that has already been dedicated to ETFs into higher yielding 5-year EDs, rolling these over four or five times until they retire. In doing so, investors get a higher return while forfeiting liquidity, a property they put no value on anyways.

How is it that an ED can provide a higher return than an ETF? Here's how. Once investors' funds have been irrevocably deposited into a 5-year vehicle, the manager buys the stocks underlying the S&P 500. Next, the manager offers to lend this stock to various market participants, either short sellers looking to make a quick buck or market makers who want to replenish inventories. These loans, which are quite safe due to the fact that the borrower provides collateral, earn a recurring stream of interest income which the ED manager shares with the ED investor. This return should be high enough to more-than counterbalance management expenses such that on net, ED investors end up earning an extra 0.25% or so each year rather than paying 0.10-0.50%.

But wait a minute, why don't ETFs do the same thing? Why don't they lend stock and share the income with ETF investors? Actually, they already do. And in some cases, ETF managers are already providing investors with more in lending income than they are docking them to manage the ETF. See the screenshot below from an iShares quarterly report:



The iShares Russell 2000 ETF, which has a net asset value of around $25 billion, provided investors with $34.58 million in stock lending income in the six months ended September 30, 2015, well in excess of advisory fees of $27.85 million.

So yes, ETFs can and do earn stock lending income, but my claim is that an ED manager following an equivalent index would be able to earn even more from lending out stock. To understand why, we need to think about how stock lending works. Stock loans are usually callable, meaning that the lender, in this case the ETF, can ask for a return of lent stock whenever they want. Callability is terribly disadvantageous to the borrower, especially a short seller, as they may have to buy back and return  said stock when they least want to, say during a short squeeze. In order to protect themselves, a short seller will always prefer a non-callable stock loan, say for 1-year, then a callable one, and will be willing to pay a higher interest rate to enjoy that protection.

ETFs and mutual funds are not in the position to provide non-callable stock loans because ETF and mutual fund units can be redeemed on demand by investors. For instance, if performance lags a mutual fund manager may start to experience large redemption requests. To meet those demands, the manager needs the flexibility to recall lent stock and quickly sell it. As for ETFs, units can be redeemed when authorized participants submit them to the ETF manager in return for underlying stock. So an ETF manager is limited in their ability to lend out stock on a long term basis lest they are unable to fulfill requests from authorized participants. Because ETFs and mutual funds can only lend on a callable/short-term basis they must content themselves with a correspondingly low return on lent stock.

As one of the only actors in the equity ecosystem with a long-term pool of pre-committed stock-denominated capital, an ED manager is in the unique position of being able to make non-callable term stock loans. Put differently, redemption of EDs is distant and certain, so only an ED structure allows for the perfect matching of long term assets with long-term liabilities. This means EDs should enjoy superior stock lending revenues, more than offsetting the costs of running the ED.

Say that an ED can beat an ETF by around 0.5% a year thanks to its superior stock lending returns. That doesn't sound like much, but compounded over a long period of time it grows into a large chunk. For instance,  If you invest $2000 each year for 25 years in an ETF that earns 8%, you end up with $157,900. Place those funds in an ED that returns 8.5% and you end up with $170,700. That's a pretty big difference.

EDs don't exist. But if they did I'd probably sell a significant number of my ETFs and buy EDs. I could imagine putting 20% of my savings in a 5-year S&P 500 ED, for instance. What about you?

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PS: Feel free to torture test this idea in the comments
PPS: It is very possible that this product already exists.
PPPS: The devil is in the legal details.

Related posts:

An ode to illiquid stocks for the retail investor 
A description of the moneyness market 
If your favorite holding period is forever 
Beyond Buffett: Liquidity-adjusted equity valuation 
Liquidity as static 
No eureka moment when it comes to measuring liquidity

John Maynard Keynes and Harry Dexter White, who contributed to the design of the Bretton Woods system

David Glasner's piece on the gold standard got me thinking about the Bretton Woods system, the monetary system that prevailed after WWII up until the early 1970s.

There are many differences between Bretton Woods and the classical gold standard of the 1800s. My claim is that despite these differences, for a short period of time the Bretton Woods system did everything that the classical gold standard did. I'm using David's definition of a gold standard whereby the monetary unit, the dollar, is tied to a set amount of gold. This linkage ensures that there can never be an excess quantity of monetary liabilities in circulation—unwanted notes will simply reflux back to the issuer in return for gold. When most people criticize Bretton Woods, they say that it lacked such a linkage.

A narrowing redemption mechanism

For a gold standard to be in effect, a central bank's notes and deposits have typically been tied down to gold via some sort of redemption mechanism. In the days of the classical gold standard, central banks didn't discriminate; the right to redeem was universal. Whether black or white, big or small, male or female, you could bring your notes or deposits to a central bank teller and have them be converted into an equivalent quantity of gold coin. Any unwanted notes and deposits quickly found their way back to the issuer.

After 1925, the world adopted a narrower redemption mechanism; a gold bullion standard. Economist and trader David Ricardo had recommended this system a century before as a way to reduce the resource costs of running a gold standard. Gold coins were withdrawn from circulation, and rather than offering to redeem notes and deposits in coin, the monetary authorities would only offer bulky gold bars. This excluded most of the population from redemption since only a tiny minority would ever be wealthy enough to own a bar's worth of notes.

It might seem that this narrowing of the redemption mechanism compromised the gold standard. After all, if too many dollars were created by a central bank, and these fell into the hands of those too poor to redeem for bullion bars, than the excess might remain outstanding rather than refluxing back to the issuer.

But consider what happens if a free secondary market in gold is allowed to operate. Unable to send excess notes to the central bank, less wealthy gold owners can sell them in the free market. This would drive notes to a discount relative to their official price, at which point large dealers will buy them and bring them back to the central bank for redemption in bars, earning arbitrage profits. The free market price is thus kept in line with the central bank's redemption price. So as long as the wealthy and not-so wealthy are joined by a market in which they can exchange together, then a narrower redemption mechanism needn't impinge on the proper functioning of a gold standard.

Anyone who has toyed around with ETFs will know what I'm talking about. Despite the fact that a gold ETF limits direct redemption to a tiny population of investors (so called authorized participants), the price of the ETF will stay locked in line with the market price of gold. Authorized participants earn profits by arbitraging differences between the ETF and the underlying, thus maintaining the peg on behalf of all ETF owners. You don't need many of them; just a few well-heeled ones.

When authorized participants don't do their job

The U.S. narrowed the gold redemption mechanism even further when, in 1934, Roosevelt limited redemption to foreign governments. As long as foreign governments and the public were joined by a market, then excess notes could be sold to these governments and returned to the U.S. for gold at the official price. The free market price and the U.S.'s official price would converge and a gold standard would still be in effect.

Things didn't work that way. After it entered WWII, the U.S. continued to buy and sell gold to governments at $35, but gold traded far above that level in so-called free gold or premium markets in Zurich (see chart below), Paris, Beirut, Macau, Tangiers, Hong Kong, and elsewhere. The existence of premium markets continued through the 1940s and well into the 1950s.

While private dealers have incentives to engage in arbitrage, national governments are driven by political motives. Governments no doubt could have earned large profits by buying gold from the U.S. at $35, shipping it home, and selling it in their domestic free gold markets at $45 or $50, but they chose not to, most likely to avoid raising the ire of American officials.

The monetary system in the 1940s and 1950s was a malfunctioning ETF. For various reason the authorized participants (ie. foreign governments) were not arbitraging differences between the price of the ETF and the underlying, and the ETF was therefore wandering from its appropriate price.

With the redemption mechanism compromised, the supply of U.S. monetary liabilities in circulation could exceed the demand, the result being that the market price of dollars sagged to a discount to their official price. Bretton Woods, with its multiple prices for gold, was not a gold standard, at least not yet.

The London gold market

It was only in 1954 that the so-called "free gold" price in Zurich and elsewhere finally converged with the official price of $35. This happened more by accident than purposeful arbitrage conducted via the redemption mechanism. On the supply side, the Soviets were bringing large supplies of "red gold"  to sell on free markets while the South Africans were diverting more gold away from official buyers in order to earn wider margins. At the same time, the end of the Korean War was reducing safe haven demand.

Source: The Economist

Once parity between free gold prices and the U.S. official price was established, the London gold market reopened for business. London had always been the largest gold market in the world, far eclipsing Paris, Zurich, and the rest. Its re-opening had probably been delayed for face-saving reasons. Given that the Brits and the Americans effectively ran the world's monetary system, they could safely ignore premium markets in Zurich and Paris. But the existence of a British gold price in excess of the official price would have been embarrassing. Upon the market's reopening, British authorities limited the ability of locals to buy on the market (they could freely sell) but put no restrictions on the ability of foreigners to participate in the London gold market.

From the time it opened in 1954 to 1960 the London price was well-behaved, staying locked in line with the official price. In October 1960, however, speculators took over control of the London gold market and sent the price of gold to an intraday high of $40, well above its official price of $35. Rather than arbitraging the market by buying from the U.S. Treasury at $35 and selling in London at $40, foreign central banks stepped aside.

The London gold pool

The authorities' response to the 1960 gold crisis is what finally turned Bretton Woods into a real gold standard, at least in my opinion. While the U.S. had ignored premium markets in the 1940s and early 50s, they couldn't ignore a premium market in their own backyard. At the behest of the U.S., the London gold pool was formed. Under the management of the Bank of England, the pool assembled a gold war chest with contributions from the U.S., U.K., Germany, Holland, France, Italy, Belgium, and Switzerland. Whenever gold rose above $35.20, the pool sold gold on the London market in order to keep the price steady. When it fell to $34.80, it bought in order to support the price. The existence of the pool was never officially declared, but everyone knew it was in operation and had the task of setting the London gold price.

This effectively created a functioning gold standard. Before, the only mechanism connecting the public's excess dollars with the U.S.'s gold was the somewhat unpredictable predilection of foreign governments to buy that excess and exercise the right to return it for redemption. Now the public could deal directly with the U.S. government by selling on the London gold exchange to the U.S.-led London gold pool, which guaranteed a price of at least $35.20.

And as the chart below shows, the pool worked pretty well for the next few years, keeping the price of gold in a narrow range. However, the devaluation of the British pound in 1967 and the departure of the French from the gold pool shook confidence in the $35 peg. The system imploded in March 1968 when a steady jog into gold accelerated into an all out run. Rather than continue to bleed gold to speculators, the London gold pool disbanded and the price of gold in London shot up to over $40, well above the official price of $35.20.



But from 1961 to 1968, the world pretty much had a gold standard. Or, put differently, thanks to the opening of the London gold market and the arming of the London gold pool, the world's monetary system between 1961 and 1968 did pretty much everything that the  gold standard of the 1800s did. After 1968, the U.S. dollar slid back into its earlier Bretton Woods pattern of having more than one price in terms of gold; the $35 official price and the "free" London price. This was no gold standard. When Nixon famously dismantled the already-narrow redemption mechanism in 1971, most of the damage had already been done.

Ted Nasmith, An Unexpected Morning Visit

"Why not just get a mortgage and buy the place rather than throwing money away on rent?" That's what people often say to folks like me who rent rather than buy. This post is my response.

Let me start off by saying that I'm neither a housing bear nor a bull. I have no idea which way Canadian real estate prices are going to go. My decision to choose renting over ownership has to do with other factors.

I don't have enough resources to buy a house or condo without getting a mortgage. Those who tell me I'm throwing my money away on rent and should buy are implicitly counseling me to take on a lot of leverage. Let's pretend that I'm comfortable accepting that level of debt. Why should I purchase a home with the borrowed funds and not buy some combination of the Vanguard Total World Stock ETF and the Total International Bond ETF?

To favor a home over the Vanguard ETF option is to assume that the risk-adjusted total return on the home exceeds that of the ETFs. Let's unpack this comparison a bit. ETFs provide a return that is purely pecuniary; some combination of price appreciation, interest, and dividends. Homes also provide a pecuniary return—they can appreciate in value. But a home is special. In addition to the pecuniary return, it simultaneously offers a non-pecuniary return, namely shelter. We can't eat in an ETF, or sleep in it, or entertain friends in it, but we can do these things with a house.

The total return on a home should be about equal to ETFs. Markets are competitive, after all, so if one asset offers an excess return, people will compete to harvest those gains, eventually arbitraging them away. Thus the total expected dividends, interest, and price appreciation from an ETF should be about equal to the sum of a home's expected price appreciation and the value of the shelter it provides. Shelter is a sizable service. This means that a home's expected life-time price appreciation needn't be very large to attract buyers. So an ETF's expected return will exceed a home's potential for price appreciation by a significant wedge. This wedge is the extra pecuniary return on ETFs held.

How big is the wedge? We can try to get a feel for it by looking at long term data. Using numbers compiled by Robert Shiller, I've calculated annualized real returns (i.e. adjusted for inflation) for both U.S. homes and equities going back to 1890. I don't have data that would approximate the Vanguard Bond ETF, and I don't know of any comparably long Canadian data series.


Equities, as represented by the S&P, have provided a real return of 6.5% per year including  price appreciation and reinvested dividends. Shiller's U.S. housing price index has yielded a much smaller 0.35% annualized real return over the last 120 years. Even if we omit the brutal credit crisis years of 2006-2015, U.S. homes still only provide a 0.54% return.

So when anyone boasts that unlike me they're not wasting money on rent, I accuse them of throwing away the extra wedge they could be earning by owning Vanguard ETFs.

Anyone who borrows to harvest the extra wedge on ETFs is left with a problem, however. They can't just sleep on the street, they need to acquire shelter. We're all born with a short position in housing. And that means giving up part of the excess wedge to a landlord. How much of this wedge? Again, since markets are competitive, my bet is that pretty much all of the wedge will have to be forfeited. If there was a significant chunk left over, everyone would choose to rent, driving rents higher until returns had equalized. At the end of the day, there probably aren't significant excess returns to be harvested by either home ownership or renting/investing in ETFs.

There are a few other stylized facts that colour the rent versus buy decision. Buying and selling a home will set you back thousands of dollars in transaction costs whereas it costs less than $25 to buy and sell ETFs. Secondly, a Vanguard ETF can be sold in a few seconds; a home can take weeks. Lastly, it costs just a few basis points to maintain an ETF (think management fees) whereas a house can cost thousands to keep in shape. To compensate for all these drawbacks (which are sizable), a home must offer a pretty high expected return.

What ultimately tips me towards the ETF option is the opportunity for diversification. Leveraging up on a single asset exposed to one street in a single city is a gamble. The two Vanguard ETFs, on the other hand, offer global exposure to thousands of different businesses, both large and small. Between renting and buying, renting seems to me to be the more prudent approach. I'm no gunslinger.

Which leads me in a meandering way back to Robert Shiller, specifically his derivatives markets for home prices. I'd certainly reconsider the home ownership route is if I could hedge away some of the risk of housing price declines, say by swapping out exposure to changes in the price of my home for a more diversified return. Most attempts to create housing derivative markets have failed, so until we have a futures market in housing prices, give me ETFs.