Banking on the Future


Quote of the Day

The lack of money is the root of all evil.

Mark Twain

Lydia’s Revolution

Lydia’s round, copper coins became ubiquitous and were in rampant circulation. The new money instilled greater confidence in trade and commerce. At first, the Cave Village had been transacting by barter – this meant trying to find a suitor for the goods you had to offer in every transaction. It was very cumbersome; not every watermelon grower needed eggs at the same time the poultry farmer needed watermelons. Immediately after the massive pebble hyperinflation of 97,985 BC, Cave People resorted to using things with more limited supply such as rare shells, feathers and rare antelope hides (buck-skins). Interestingly, buck-skins or hides were a luxury and regarded as a symbol of wealth on every continent. They represented a “big kill” or supreme power.


Skin in the Game

Indeed, it would later be found that that an Asian warrior leader, named Temujin (which translates as “iron”), was on the verge of slaughter by his main rival. In an act of desperation, he persuaded another, larger, rival clan leader, Togrul, to side with his forces by offering him a rare animal skin; a sacred black sable fur. Temujin made a huge gamble – Togrul could have killed him on the spot, as was commonplace – but such was the value of the fur, and thus the gesture, Togrul agreed to side with him. Togrul had skin in the game. Because of this turning point, Temujin went on to become, what some regard, as the greatest warrior ever to walk the Earth. His conquests created the largest land empire ever known to mankind. His calligraphers and scribes would document his deeds in detail, but local history books would later refer to him as simply the “Great Ruler”, or “Genghis Khan”. He and his sons were as promiscuous as they were ruthless, to this day it is thought that 1 in every 200 people are descended from him… and all this changed the course of history, just for one piece of animal skin. Such was the value of this ancient exchange medium. It’s amazing what an animal skin can buy you.

But animal skins were a common currency throughout history. In Africa, animal skins were a major trading utensil. In America, Native Indians used buck-skins as currency – a term which would later be abbreviated to “buck”, the American slang for a dollar.


Back in Asia, in a post-Ghenghis world, animal hides were becoming old hat, as modern, sophisticated fabrics were conveyed over trade-routes, like the “Silk” Road. The use of round metal-disc currency was taking preference over animal hide. It is tempting to think coins were made circular to save on metal. Actually, because the manufacturing process involves striking (whacking with a great big hammer), the way the metal bulges and spreads makes it easier to manufacture in circles. Also it’s more practical and durable both for the vessel carrying the coins (no sharp or jagged edges) and the coin itself (no corners which chip and break). Thus, in Asia, the coins were called “circular piece”, which loosely translates to “yen” in Japanese or “yuan” in Chinese and “won” in Korean.

Not to be outdone, the Europeans were also minting their own circular pieces from a precious metal called silver. In Eastern Europe the “Thaler” was a standout coin of choice. The Thaler (pronounced “Daler” in Scandinavia) derived its name from a valley or “dale” from where the silver was physically mined. Obviously, this name mutated into “Dollar” in an English-speaking accent.

But the British didn’t use Thalers or Dales. They were busy making their own silver circles. The slang alternative for the British currency was “quid”, as if to highlight the money’s exchange property (quid, a shortened version of the Latin phrase quid-pro-quo, i.e. “exchange barter for goods or services”). But there was an inherent problem with using pure silver. While it had exemplary exchange properties of money, the metal was too soft – it did not have sterling durability. Durability is one of the critical properties of a true money, as we know from our piece on the Birth of Money. Forgers knew that, by fortifying the silver with other metals, they could create a much more durable silver alloy. But the British didn’t trust each other, so a silver alloy standard was created which had 92.5% silver and 7.2% other metal, like copper. This standard was known as Sterling Silver and was used to mint the new, coins of sterling durability. As British trade grew during their own empire expansion, larger transaction sums were needed in the form of weights of Sterling Silver. A heap of the coins (240 of them to be exact) equated to a lb (a pound weight) in Sterling Silver. Thus the oldest currency still in circulation today was formed. The British Pound Sterling.


Trust, Faith, Religion and Banking

But, while, trading buck-skins was a useful alternative, the coins proved much more effective. Lydia’s idea of creating circular copper money may sound simple to us, but you see she was nearly 100,000 years ahead of her time! Importantly, Lydia’s vision was a noble one. As she accumulated wealth of her own and others, she would use her capital and the copper deposits of others entrusted to her, to create a private organisation. By using the most secure cave in the village, and then paying for it to be guarded by the fiercest dogs, she could pile all the copper into a great big vessel, a copper bank*, if you like.

Lydia understood her concept required a level of faith and trust of almost religious** proportions. She, indeed, had a position of great responsibility. Her honourable idea was that she should incentivise, or, rather, compensate each depositor for their money she had “banked” up. Compensate them, that is, for the loss of flexibility or cost of opportunity and also the risk depositors naturally assume by keeping their capital stagnant and in the hands of a single debtor (yes, I use the word “debtor”, quite deliberately), who may or may not die/default. The old Latin word “interesse” translated as compensation for loss, so Lydia would call this payment for capital deposits “interest”. This meant, when someone left copper with her for a fixed term (a guaranteed reserve), she would repay them their copper when the term matured plus a little more copper as well, as honourable compensation for the risk the depositor was taking. Interesting isn’t it? The notion that a portion of the interest one receives from depositing money at a bank is attributed to the default risk of the bank, not just the opportunity cost of time. But, that’s another story for another time, perhaps we’ll come back to it later…

How was Lydia able to pay interest on deposits? Well, she was able to do this with a neat little trick. Even if the Money Supply remained relatively stable, because she knew the terms of all her locked-in, secured deposits, she could now loan out that secure money without fear of it being recalled by the depositor. She could charge the borrowers more interest than she paid out to the depositors and thus make a modest profit in the meantime. Just for moving copper between participants! Because there was a one-for-one relationship between the savings of clients and the loans of borrowers there was almost no risk to this arrangement. Depositors could store their money in the copper bank and they could “bank on Lydia” returning that money to them, with interest when their term expired. Because the copper she held was banked up in a mound she called this institution a “bank”. A sort of savings and loans bank, was born.


*It is possible that the word bank is derived from a word meaning a “heap” or “mound” and is synonymous with the Italian word “monte”. To this day there are Italian banks with “monte” in the title. In fact, according to a friend of mine, Banca Monte Paschi, is regarded as the oldest bank in the World and has been operational since 1493. It was created to guarantee exportations from Italy to the rest of Europe. In fact, they were the first to create the concept of a “credit letter”. Payments were guaranteed by Banca Monte Paschi with special letters… people were not happy to travel with gold. The second step was the exchange of these credit letters. But this is another story … and should be told another time…

**The earliest form of banking in was the storage of wealth in “treasure houses” or special rooms, “treasuries”, located in trusted religious establishments like churches and temples. Note how so much of banking revolves around trust and faith. To this day Temple is located in the heart of London’s financial district, The City. Without getting too Da Vinci Code on you, it’s named after the Knight’s Templar who were perhaps the first “City Bankers”. Noticed how both the Federal Reserve buildings and the Bank of England buildings look like Temples? It’s an architectural shape synonymous with trust and faith.



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The Birth of Money

Quote of the Day

There are more questions than answers…

Jonny Nash

Coins in Hand

Revolution in the Air

Yes, Jonny Nash. That’s the guy that sung “I can see clearly now, the rain has gone”. Great song. But can we see clearly. I often think too much fog stands in the way of understanding the basic fundamentals of finance and economics. I don’t claim to be the smartest tool in the shed – that’s what I like reading about… the simple stuff, the stuff that I ought to be able to explain to my kids. If at any point, I hear them or even myself say “ah… I too can see little more clearly now” that’s what I call success!

It’s been a while since my last piece, it’s hard to pick things up from where we last were. This post will insult the intelligence of many, so apologies in advance. But it forms the basis of the modern, complex financial system we find ourselves in today. We are but building a journey, one step at a time, to get there we started with pebbles in the Stone Age and may end with futuristic cyber-money and crypto-currencies. Who knows?

But money all comes down to the same thing. Let’s recap a little. In my piece, Living in the Desert, I quoted El-Erian who suggested that the banking industry was going through a “Quiet Revolution”. But what on Earth is that? Surely all revolutions are, by definition, noisy affairs? Under the heavy weight of regulation, the banks, if anything are becoming more and more like “boring utilities”. But El-Erian talks of subliminal disruption akin to “Airbnb and Uber”. But those two disruptors turned their respective industries inside out in a very short space of time… all this talk of quiet revolution and uber-disruptive forces makes me wonder if there is something I’m missing…

There are times when there are more questions than answers, I certainly don’t have all the answers. But let’s go on with the journey…


A Brave Beginning – The Birth of Money

Remember that Caveman village, where some devious little Caveman called Alan inflated the pebble-based Money Supply by swamping the economy with the pebbles they were using as cash? Well, the Caveman village people learnt their lesson, they decided to use materials which were much less readily available. Throughout history all sorts of not-so-readily-available-things have been used as money or currency: exotic feathers, pretty sea shells and pearls, gems and precious stones and, of course, certain precious metals. They are precious because they are rare, that is, they are not as readily available as pebbles and stone or promises on paper. There was a specific reason for doing this, because such items could neither manufactured nor plucked out of thin air, it provided assurance that the degree to which people could corrupt the supply was also limited.

One day, one Cavewoman (let’s call her Lydia – named after one of the birthplaces of metal coinage) cogitated with deep-thinkers from other cave villages and came up with an idea to revolutionise the money-system. She would make money out of little pieces of metal, a specific not-so-readily-available metal called copper. I deliberately choose copper in my example to highlight that I’m not really a gold-buff – if only for the reason that I am not convinced why gold and silver should be favoured so much over other precious monies. The copper metal was malleable, which meant it could be cut into simple circular shapes of different sizes to signify different amounts and behold, the first true Money was invented.

Money was important because it obeyed the following rules, the attributes of money:

  1. Portable and an easy medium of exchange:- unlike those eggs, in our previous story, which kept breaking!
  2. Fungible unit of account:- a piece of copper in China is the same as a piece of copper in Belgium (when is one apple worth more than another apple?).
  3. Durable:- unlike those perishable watermelons in our previous story.
  4. Divisible:- I can cut a large piece of copper into smaller pieces of smaller value (change)
  5. Store of value:- unlike those pesky pebbles which depreciated ever-so rapidly! Indeed, if you’d kept a hunk of copper thousands of years ago, the likelihood is it would still have had relevance and value even today.

Other Cave-people laughed at Lydia’s idea. They said her idea would never work. Copper was a silly thing to use and, besides, what was to stop people using other forms of money and shunning the brown metal or reverting to barter. But humans are always looking for an easier way to do things and, for whatever reason, it just caught on. To this day the likelihood is you’ll be carrying small metal discs around in your pockets, purses and handbags… some of them pennies or “coppers”.


Currency and Inflation

The last point, #5, is perhaps the most overlooked. By physically limiting the supply of something (or by choosing a money of physically limited supply) you ensure that it remains true and maintains a certain level of value. This is what some regard as the fundamental difference between “money” and “currency”. A store of value is an intrinsic property of money, but a currency does not necessarily have this property. In the 1970’s you could have bought a jolly nice house with £15k, but if you’d kept £15k under your mattress for all those years, that would not even get you a down payment today and in Hong Kong it’s about 3 months’ rent on a tiny 2 bedroom apartment! We can talk about monies like copper, gold, silver and gems storing value for millennia, so a mere 40 years is a relatively short period of time to have your liquid assets erode by so much! Only 100 years ago a loaf of bread would cost you 3 cents, but now, even with all our fancy logistics and super-efficient manufacturing, it costs a whopping 100 cents. What happened?

But if we remember what Friedman said of inflation: it is always and everywhere a monetary phenomenon. When I go to my baker and notice that the price has gone up from $1 to $2, I could say that the price of bread is inflating in dollar terms, but my contrarian baker may say: “no Jonny, I can exchange my loaf of bread for a bag of grapes just like I have always done… the problem is with your cash, not my bread… your dollar has just gone down in bread terms“. What has happened between then and now is not a massive change in the dynamics of house-building and bread-baking (in fact the influences here, like industrial revolutions and globalisation, have been deflationary, not inflationary). But these deflationary influences have been swamped by the explosive inflation of the monetary base, which has, in turn reduced the value of… well, I was going to say “reduced the value of our money” … but you tell me… what do you think you have in your pocket or bank account: money or currency?

It’s a question I still struggle with today…


The Dawn of Modern Finance

The copper money standard in the Cave Village heralded a new era of finance and commerce. Lydia was hailed as the Queen of Finance and Economics. Cave-people flocked from miles around to pay her for advice – exchanging liquid capital (copper money) for intellectual capital (knowledge). They wanted to know what materials to buy (commodity investments) and understand the benefits of saving and investment. Lydia, the Queen of Economics, by now had irrefutable status and the highest credibility. The only thing growing faster than her power and reputation was the pile of copper in her coffers.

She was collecting huge amounts of capital, both of her own and other people’s wealth – strangers who had given it to her for safe-keeping. But what was she to do with this mountain of power, wealth and credibility?

Unbeknown to the Cave Village community, Queen Lydia had an ingenious, yet audacious, plan up her mammoth-skin sleeves. It would signal the birth of modern finance and would propel the economy forward like nothing else they had ever seen. For her, the rest of the village and the entire Neanderthal community at large, it was (to quote the great Jonny Nash) “going to be a bright, bright sunshiny day”.


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Caveman Capital

caveman money

Quote of the Day

A nickel ain’t worth a dime anymore.

Yogi Berra

Neanderthal Economics

Yogi Berra’s quote could be dismissed as low-grade witticism. But he’s not actually that far from the truth. Milton Friedman once famously said, and I quote; “inflation is always and everywhere a monetary phenomenon“. But what does all this mean, truly? We talk so much about central bank policy, government fiscal policy, the Eurozone, Chinese growth story but why? While we dedicate so much time searching for answers to impossibly complicated questions, is it not worth answering some of the “simple” questions first? I use phrases like “hair of the dog monetary policy” and the fact the Fed must inflate away bygone sins of indebtedness. But what is inflation? What is debt? In fact, what is money and how is it different to currency or capital? Most people think they know the answers to such questions; debt, money, inflation … it’s all around us.

To add some humour, I’m unashamedly re-writing an old post I made back in 2009 called “Neanderthal Economics“. I’ve written hundreds of posts, but this was one which received a very large number of hits, much to my surprise. Let’s start from the very beginning…

Imagine you’re an alien and your Zork-Mobile landed on Planet Earth a few thousand years ago when people like us were simple, crude cavemen. You took to studying the economics of a caveman village.

Now remember, inflation is a monetary phenomenon, and money is effectively a simple, efficient exchange mechanism for “capital”. I’m throwing lots of words around here but we’ll come back to them shortly.

So imagine I’m a caveman with some assets: an egg, which a friend gave me, and a patch of land which I use to grow watermelons. I’m a pretty rich guy by caveman standards! Now imagine my chicken egg is worth the same to me as one watermelon. One could argue that an egg is the money or “currency” (there is a difference but now is not the time, that’s another story for another time).

Now if other cave-people shared my opinion that eggs and watermelons were of roughly equivalent worth, I could use the egg to buy a watermelon and or, indeed, vice versa. In fact, one could argue that there is on special type of money, real money: tradeable “things” or tangible “stuff” which is exchangeable and yet at the same time has “value” away from the world of finance – like oil, wood, stone, watermelons or eggs. Of course, I’m simplifying things greatly.

As cavemen and cavewomen, descendants of our race demonstrated a differential advantage over other species by the synergies they could work through sophisticated, multi-lateral communication. One of my caveman buddies might have turned to me and said: listen, you’re really good at growing watermelons and I raise chickens, what y’ say I give you one egg for one of your watermelons every day for the next 6 lunar cycles?And behold: the World’s first bilateral currency swap was agreed. Both eggs and watermelons were considered as currencies in their own right. Two parties have agreed to exchange currency at a given rate for a given time – it really is that simple. Additionally, I don’t have to worry about subsistence any more, I don’t need to rear chickens myself. So long as I grow good watermelons I can always exchange them for eggs or, indeed, other goods and services. I can concentrate on growing watermelons, which I’m good at, and get even better at it. This is a fundamental principle upon which all modern economic societies are based.

But consider this: if the exchange coefficient of the watermelon goes up from one egg to two eggs, then we can say that the “price” of watermelons has gone up (in egg terms): it is “inflating”. Another way to express this change is to say that the “price” of eggs is “deflating” in watermelon terms – as it now takes only half a watermelon to acquire an egg.

You with me so far?

OK. Put this into a modern context: if the “price” of an egg goes from one Dollar to two Dollars we could say either that the price of eggs has gone up in Dollar terms or, perhaps more interestingly, that the price of a Dollar is falling in “egg money”. This is a little unintuitive as we don’t often think of things that way, but there is nothing wrong with it – it’s a useful thought-experiment, there is nothing wrong with thinking about transactions in this way.

Now, notice that in our egg-for-watermelon currency swap, it may be a little premature to suggest that the value of watermelon has gone up – or indeed that the value of the egg has gone down. After all, eating an egg still has the same calorific intake as it always did, it is still “backed by chickens” (that is, it still takes one healthy chicken to lay an egg) and it still takes 3 eggs to make a cake – nothing much has changed in this respect! More specifically, there may be other currencies available – what about the cavegirl in the cave next door who has apple trees? So, while the price of a watermelon has gone up in egg money, we do not know the price deviations between eggs/watermelons and other “monies” that may exist in our caveman village. Of course, if the price of eggs go down sharply in relation to all other monies or capital, there may be some substance to the expectation that the value of eggs is changing (declining), not just the price.

Similarly, in a modern context, if the “price” of a Dollar falls in relation to all other forms of capital this is the same as the price of all other monies going up with respect to the Dollar, a unit of currency. We, of course know what this phenomenon is called, when we see prices of everything going up in Dollar terms, it is called INFLATION. In a similar vein to caveman eggs: if the price of Dollars go down sharply in relation to all other monies, there may be some substance to the expectation that the value of The Dollar is changing (the value of a Dollar is declining).

The key message behind the watermelon-for-egg currency analogy is that, there are limitless choices for how we transact, there is exchangeable capital all around us. I challenge the principle that “the World is not made of money”, or that “money does not grow on trees” – at a fundamental level, this is actually incorrect. Indeed, this simple wealth-exchange of groceries was actually how capital was distributed for many thousands of years (and it still is to this day, in many respects).

Now, let’s move the story on a little…

This type of barter-trading went on for many years until, one day, Mr Watermelon got fed up of carrying a barrow-load of watermelons every time he needed to go grocery shopping and decided to come up with an ingenious “system” whereby one could just use smooth stones or pebbles to exchange for goods. Interestingly, the pebbles were not much use to anybody per se, but they did serve as a fantastically efficient (there’s that word again) medium which helped the whole cave-village lubricate the exchange of goods. I could use one pebble to buy one egg and, because I knew that an egg had a similar market worth as a watermelon, I could also use that very same pebble to buy a watermelon, or an apple… I didn’t have to wait for my counterparty to want watermelons before we could transact… the options were endless! Trading thrived, the economy of the village was booming.

Now, watermelons are inherently backed by the labour and the earth used to produce them, eggs, one could say, are backed by chickens, there’s something tangible about where the “worth” lies in an egg and a watermelon. But pebbles … well, they aren’t backed by anything really. No, the pebbles were just an integral part of “the new system”, a system for which we were making the rules up as we go along – and so, behold, the first fiat currency was born.

Things were going well until one bright spark of a caveman (let’s call him Alan) realized that there was a beach a few miles down the coast where one could acquire millions of such pebbles. If he could bring back bucket loads of these pebbles, he would be able to buy anything he wanted from anybody without having to do much work – he’d be living “the life of Reilly”(*). In fact what was to stop anybody doing this? Well, soon the word spread and quickly the cavemen found that the “price” of one egg went from 1 pebble to 2 pebbles, then 3 pebbles and then 10 pebbles … and behold…  the first bout of hyperinflation was induced.

What is interesting about this caveman inflation is that, while we may choose to measure it in terms of the price of capital goods going up. Fundamentally, it was nothing to do with the goods themselves. Inflation was about the supply of currency (pebbles) going up.. and thus the value of currency (pebbles) going down with respect to other forms of capital or money. Inflation is always and everywhere a monetary phenomenon.

Suddenly, the stone-faced Neanderthals were stuck between a pebble and a hard place. Because of sneaky Alan, Money Supply of their Monetary Base went through the roof, pebbles were everywhere – they were trash. Eventually it got so farcical that a single egg required a whole bucket full of pebbles – which kinda defeated the purpose of not carrying watermelons around in the first place. Volatility increased and pebble prices ebbed and flowed for a while, but eventually, at the extreme, cavemen lost confidence in the fiat currency and shunned pebbles as receipt for their goods. In this environment, I’d rather have eggs and watermelons than pebbles, people were literally dumping pebbles on the street, a nickel wasn’t worth a dime any more … and behold… the World’s first currency crisis was born. Eventually, the cavepeople, realised the folly of their ways, because pebbles had an unlimited supply, the entire economy was prone to manipulation, so they reverted to transacting in more “stable” currencies with limited or “predictable” supply.

(*) a particularly relevant phrase which I think is quite apt in the current circumstance. “The Life of Reilly” is a phrase that comes from late 19th century in England when the “Reilly Clan” of County Cavan in Ireland began to mint their own currency which (bizarrely) became legal tender in England. They could simply print money in Ireland and hop on a boat and spend it in England! Thus a freely spending gentleman was referred to as a man “living off his Reillys”! Thought, you’d enjoy that little inflationary tid-bit!


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Living in the Desert

Quote of the Day:

What makes the desert beautiful is that somewhere it hides a well.

Antoine de Saint-Exupery

survive the drought


Life In The Liquidity Paradox

I rather left the last few posts unfinished, so let’s wrap up. The Liquidity Paradox poses an interesting dilemma for commentators and observers like me but what does one actually do about it?

I’m by no means the leading authority on such matters but here are my suggestions to surviving the liquidity drought and making your way out the other side when the rain comes.

  1. Measure your liquidity risk. For listed securities, like shares, this is a relatively easy task, but for OTC instruments and other assets this is harder. You’ll need to be creative, but doing something is better than doing nothing.
  2. Monitor your liquidity and look for signs of liquidity drought. If you’re ahead of the curve, your chances of survival are high, but, importantly, you may even be able to exploit the situation. Again OTC instruments are hard to monitor but get creative. It is possible to, say, create a relative liquidity benchmark for a portfolio of convertibles which you can use to screen for idea generation and thus react and dynamically adjust your portfolio with. It’s not perfect, but is infinitely better than doing nothing.
  3. Collect more information on liquidity. Talking to people is one thing, but what my experience has told me is that talk is… well … all talk. You do not truly know someone until you fight them. If you want to understand liquidity you need to be “doing” not “talking”. An example of this is to have more contact at the impact-zone where transactions are happening. Give more autonomy to your trader to trade at a higher frequency. Each trade gives you 100X more liquidity information than a 1 hour phone call could.
  4. Embrace technology. It’s a moving World. OTC instruments are less transparent so is the World going to stand still? No, they will become more transparent. You need to figure out how this will happen. Hint: see Mohammed El Erian excerpt below.
  5. Use factor-based models. Liquidity is one of those risks which lurks beneath the surface. It’s not always tangible how the portfolio of your assets is correlated to seemingly subjective variables such as liquidity. This is the realm of a factor-based risk model.


A Final Word From El-Erian

Finally, a word from Mohammed El-Erian. As a person who used to trade OTC products but now manages a software unit, I almost felt he was talking to me directly. It’s not a a response you’d expect from one of the biggest fund managers in the World. Here are his thoughts on the liquidity conundrum and how it will play out.

For starters, customer expectations will evolve as the millennial generation increasingly accounts for a larger portion of earning, spending, borrowing, saving, and investing. With many of these newer clients favoring “self-directed” lives, providers of financial services will be pressed to switch from a product-push mindset to offering more holistic solutions that allow for greater individual customization. Market-communication functions will also be forced to modernize as more clients expect more credible and substantive “any place, any time, and any way” interactions.

Then there is the influence of outside disruptors. Jamie Dimon, the CEO of JPMorgan Chase, expressed it well in his 2015 shareholder letter, observing that “Silicon Valley” is coming. These new entrants want to apply more advanced technological solutions and insights from behavioral science to an industry that is profitable but has tended to under-serve its clients.

Airbnb and Uber have demonstrated that disruption from another industry is particularly powerful, because it involves enabling efficiency-enhancing structural changes that draw on core competencies and strategies that the incumbent firms lack. Many other companies (for example, Rent the Runway, which provides short-term rentals of higher-end fashion) are in the process of doing the same thing. Be it peer-to-peer platforms or crowd-funding, outside disruptors already are having an impact at the margin of finance, particularly in serving those who were previously marginalized by traditional firms or had lost trust in them.

The end result will be an industry that serves people via a larger menu of customizable solutions. Though traditional firms will seek to adjust to maintain their dominance, many will be challenged to “self-disrupt” their thinking and operational approach. And, while emerging firms will offer better services, they will not find it easy to overcome immediately and decisively the institutional and regulatory inertia that anchors traditional firms’ market position. As a result, a proliferation of financial providers is likely, with particularly bright prospects for institutional partnerships that combine the more agile existing platforms with exciting new content and approaches.

Read more at–el-erian-2015-06#2rlyClrE78dTojqr.99

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Posted by on October 9, 2015 in El-Erian, Liquidity


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All Eyes on the FED

Quote of the Day:

               “Liquidity is there in abundance when you need it the least.”



Stampeding Cattle

Bloke I know down the village grew up on a farm – like many folk around this neck of the woods. Down the pub, over a pint of Doom Bar, he told me a story about the most horrific experience he’d ever had on a farm. You see his dad had quite a big dairy farm. During milking sessions cattle would be herded into the front yard for milking and then out through the back yard after milking. But the milking facility needs to be spotless, there’s a lot of unwanted germs crawling around fresh, organic substance. So they constantly hose the place down. Unfortunately one lad was hosing so enthusiastically he splashed the light switch and shorted it. The whole place was full of water and went live at mains voltage. If you can imagine a big building, filled with water, laden with metal equipment attached to the most sensitive area of many huge animals? “My dad came running down and he got a bolt off the gate! It was carnage Jonny. You see, a stampede in a field is OK. Something startles them and they just run it off, but in a building there’s only one exit… they just ran over each other. It was carnage. We lost 12 animals that day. Worst thing I ever saw on a farm.


The Mirage of Liquidity

The big question is: how does this Liquidity Paradox relate to us today as market participants or people interested in the financial markets? Well, first, I think it’s important to understand the dynamics at the source, the cyclicality of inflows and outflows at funds. Ribalov and Shirbint’s article references Citi’s simple diagram showing what they feel is happening.

Liquidity Cyclicality

[Source: Citi Research]

When I go down to my high street bank and I ask to deposit some of my savings into the PIMCO Global Investment Grade Bond Fund, that’s an inflow to that fund. In a normal situation, capital flows through open-ended mutual funds are quite cyclical: funds flow in, causing lower yields (fewer opportunities), so they then flow out again – yielding opportunities for the next cycle. However, under the repressive regime of negative real interest rates and excessively accommodative monetary liquidity, it’s one-way traffic. Funds come in, yields of instrument drop as returns of those funds get higher, then more in-flows come in to the funds as they produce yet higher returns. You see the caption at the bottom of the Citi Research charts above: “Investors buying [securities] not on value but on inflows”.

Don’t be fooled by the mirage of liquidity when you’re parched in the desert. ZeroHedge show that while Bid-Offer spreads have decreased, it’s a misleading comfort – turnover has capitulated over the last few years. Paper is simply not moving around. What looks like a liquid market at a distance is barely trading. Some liquidity may be there on the bid side of the market now, but it is fickle, nobody needs it now – everybody is experiencing inflows and needs offers, not bids. Liquidity is there in abundance when you need it the least.


[Source: Citi Research]

One way traffic is fine when you’re in the present. But, as they say, the trend is your friend… except for the bend at the end. A problem comes if the market turns and people will head for the exits en masse. This may never happen. But if it does, it’s hard to see if the market has the mechanism, the sluice gates to accommodate the flood. Just like my mate’s dairy cows, the herd will run over itself to get to the exit first.


Why Focus on Liquidity Now?

But what might startle the market? We’re not going to hook everybody’s nipples up to the mains are we? Well, market participants have more brains than dairy cows, they’re looking for signals of how and when this flow might start to unravel and they (hopefully) secure mandates that would allow them to not only ride out a storm but profit from it. So what signals may they be looking for? Well, remember, this all starts from the repression of low interest rates. It therefore stands to reason that a rising trend in interest rates may reverse the flow and kick start the great unwinding. Now, the reality is, you might say, a 25bps hike in interest rates is not really going to change a great deal in the grand scheme of things – it barely budges the yield curve, it moves GDP by all of 0.1%, that’s so small “you can’t even measure that” according to Deutsche Bank’s chief economist Torsten Slok. But it’s more about the signal that it sends. Remember, markets are forward-looking. Given the dominance of macro factors in the market place, we’ve never been more sensitive to central bank tinkering. These days the intent of the central banks is more important than the action itself. A rate hike today signals to the market that the Fed is ready not be beholden to the value of asset prices (especially the stock market) anymore.

Which brings us to today. The largest and most important central bank of all, bank to the world’s reserve currency, the Federal Reserve has a very important meeting today and tomorrow. The Federal Open Market Committee (FOMC) is due to meet to decide what do to. Raise rates for the first time in nearly a decade or leave them as they are at 0.25%? There is no question, our economy has become so dependent on low interest rates it has brought about imbalances – we have already talked about mutations in the market place and the liquidity paradox. But will they have the mettle to raise rates this time round? Western Central Bankers have shown that, for the last 40 years (I’m not exaggerating) they’ve been beholden to the whims of the markets to the extent that they’ve almost become one and the same – remember the Greenspan Put? I’ve written some pretty scathing articles on this as have others. But these are other stories, and should be told another time… the reality is, apparently, the market is split 50/50 on the outcome of this Fed Meeting.

There are many commentators suggesting that the Fed will bite the bullet and raise rates, including my favourite American Austrian (American nationality, Austrian economic views), Jim Grant. But I don’t believe it, I think most people will get an ever-so-slight electric shock by a Fed hike. My reading tells me that common consensus is that the Fed will raise rates (a hawkish gesture) but will give dovish guidance (i.e. language to the effect that this will be very gradual so please don’t panic). I’m going to stick my neck out here and say they’ll do the opposite. They’ll bottle it, like they always have done, keep rates at rock-bottom and spew the usual mildly hawkish language. The reason is, the Fed has had doves at the helm for 3 decades, in my opinion. They talk a good inflation-fighting game, but in actual fact have become slaves to asset prices as much as economic indicators. I’m not going to be as politically pugnacious as Goldman, who suggest that recent market turmoil is the equivalent of 3 rate hikes (!?), but with the recent volatility in the markets, I think they’ll flake.

Now, price-shocks in the equity market can be absorbed and they can, conceivably, recover quickly from a large vol-spike – stampedes here have open fields to run into. But a shock in some of the OTC markets, where capital is herded and penned into a liquidity enclosure, may be the spark that causes a panic and this would not be pleasant. Just to be clear, I don’t want to sound too alarmist, the chance of this happening is pretty low. But that’s MY reason for paying attention here. The point of my piece is not really what I think, I’m not a qualified economist or theorist – you can all make your own minds up and I’m so rusty I’m almost certainly going to be wrong. The point of my three pieces is to deliver this very simple message:


Over the next 2 days we have probably the most important FOMC meeting in years – it’s what awoke me from my 3 year Blog-writing slumber.

The entire market is watching this FOMC meet.



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The Liquidity Paradox

Quote of the Day:

The market can remain irrational longer than you can remain liquid.

John Maynard Keynes

Everyone in the market loves that quote. It’s one of my favourites too. But these days the cautionary quote sends a little more chill down the spine; there is a menacing precariousness to the state of liquidity in the market place – and you don’t have to be a one-armed blackberry-picker in Somerset to know this.

Roubini’s article, The Liquidity Time Bomb, draws reference to the fact that we are in, what he calls a “Liquidity Paradox”. The paradox being thus: for all the liquidity being pumped into the global economic system, the net effect of policy meddling is that there is less, not more, liquidity in the financial markets. Roubini harks to a, frankly, awesome macro research piece by Citi’s Matt King. The piece is also highlighted in a ZeroHedge article, Nor Any Drop to Drink, which expounds the liquidity paradox with, of course, the satirical cynicism for which their blog is renown. The blogosphere is twittering and well-known market participants and commentators are regularly referring to it. This summer an FT article referencing the Citi research team’s liquidity paradox opened with the simple sentence: welcome to the desert. I really recommend opening this FT article, if only to look at the pictures – there are some fairly remarkable charts on trading volumes and market turnover.

Why should we care? Well, the argument is that this lack of liquidity leaves us open to what Matt King and ZeroHedge call “air pockets” – asset price shocks and volatility spikes. He points to some interesting trends which illustrate just how our liquidity has deteriorated – some of which I have attached below.

But why are we worried about liquidity today? One could argue there has never been more liquidity in the World. Every single central bank in the world appears, not just to be easing, but hell-bent on unconventionally aggressive money-printing measures such as ZIRP (Zero Interest Rate Policy), outlandish dovish official guidance, Quantitative Easing and Asset Repurchases and, in China’s case, outright stock manipulation and political coercion (intimidation?) with a simple objective: to increase the supply and velocity of currency in the economic system. That is; central banks and the economic authorities seek to drown us in the most liquid asset of all: cash. I could tell you why they are doing this… but that is another story… and should be told another time… (I say that quite a lot, apologies in advance)

As usual, in the beginning, the rationale is righteous; by reducing interest rates one encourages businesses to borrow and finance capex and investment, feeding positive energy back into the economy a process which self-sustains in a phenomenon Keynesian economists often refer to as The Multiplier Effect. That’s the theory, at least. Practically, however, as the real “good inflation” (wage inflation invoked by increased economic activity) fails to take hold, in true Richard Koo-Style Balance Sheet Recession, the effects of exploding the Monetary Base mutate into a new, more sinister beast. From businesses being gently enticed into investment, we find consumers (that’s us) being pressured out of the drought-lands of conventional savings, by the pain of negative interest rates* and into either fruitless consumption or prevailing asset bubbles in property or stocks – the very assets prone to over-crowding, air-pockets and price-shocks.

The comfort of liquidity is a mirage, to use my blackberry-picking paradox: blackberries, blackberries everywhere nor any fruit to pick. Despite massive amounts of liquidity in our economic system, the ripened fruit of market liquidity is superficial, illusionary in some areas and outright delusionary in others. Where it does exist, we must often overstretch to reach it. The money-printing, liquidity-flooding philosophy of our monetary authorities even spills into the geo-political arena with new saber-rattling over currency wars – a topic which have touched on many times. But that is another story… and should be told another time…

It’s hard to overlook the irony isn’t it? In a world awash with liquidity, we are fretting about illiquidity in financial markets. So what is causing this lack of liquidity? Matt King of Citi and Nouriel Roubini argue that there are three main causes:

  • High Frequency Trading: produces unnatural surges in liquidity at certain times in the day but leaves vacuums at other times of the day, distorting volume distribution. The individual computer algorithms trading securities are, of course, highly sophisticated, but the net effect is that they exacerbate “herding mentality” of the markets – this is a characteristic the markets do not need help amplifying! There is also another aspect of herding which is interesting. During herd-like behaviour, it is as though individuals (investors) lose perspective of the world outside the herd. Perhaps it is the animal herding instinct of the “safety in numbers” at play. But, consequently, we find that prices are prone to deviate from the fundamentals of “fair valuation”. The markets are prone to trade rich and, because there is less attentiveness to absolute valuation, dealers and investors alike are more likely to be on the same side of the trade (long) for longer periods of time, offering little resistance as valuations move yet higher. Greg McKenna of Business Insider, quoting Matt King, puts this more succinctly than I can in his short piece on the topic:

The problem at the moment is that, as King says, ‘Markets are liquid when they work both ways.

But markets are all heading in the one direction because central banks are creating artificial liquidity on the way into these globally uni-directional trades where ‘market participants… find themselves increasingly needing to move the same way.’


   [Source: Citi Research]

  • Prolonged extreme (accommodative) monetary policy is repressing investors out of safety. Many of the securities traded these days, like government bonds and corporate bonds (e.g. investment grade and high yield straight bonds and convertible bonds) are traded OTC. Firstly, these are inherently less liquid. This is not much of a problem, normally speaking, but the herds of investors are migrating into these OTC bond markets motivated, not by the pull-effect of tantalizing fresh pastures but, rather, the push-effect of a barren liquidity/return on “cash equivalents”. Just like I, the consumer, under the gloom of negative real interest rates, is being coerced out of keeping my money in the bank account and into precarious asset bubbles, investors used to transacting in the low volatility, very liquid, very short-term investments – such as Commercial Paper, Repos and short-term govvies – are now being coerced into using the longer, riskier OTC bond markets as their “pseudo-cash equivalents”. Note: if we’re using the word “pseudo” and “equivalent” in the same sentence we’re already a long way from sensibl
    To make matters worse, there is mismatch in the investment horizon building across the OTC bond markets, generally. Previously, long term investors, such as Pension Funds and Insurance Companies used to own large segments of the OTC bond markets. These days, though, their dominance is being dwarfed by a massive growth in mutual funds. Again, this is in part due to us, the retail investor, being forced out of an easy-access savings account and into what your bank manager may call “a managed fund”.  Either way, because these funds are open-ended – I, the retail customer, can withdraw my funds at any time. The long term investment market of OTC bonds is being dominated by funds with short term money flows. That’s a recipe for disaster, indeed, ZeroHedge say mutual funds “may be setting the stage for a veritable maturity mismatch massacre”.chart2                                         [Source: Citi Research]
  • Volcker Rule is taking the liquidity-providers out of the game. In the old days, banks, with their beefy facilitation books and prop books, which could use balance sheet and were not subject to fickle investor-flows, would add a level of objectivity to market in-flows (selling into a rising market) and a degree of cushion on an air-pocket-induced falls and outflows (buying on the dips). The Volcker Rule means this mechanism has all but vanished. The financial markets are effectively speeding down the freeway without a liquidity seat-belt.

Roubini calls it a “Time Bomb”, ZeroHedge use the phrase “powder keg” whereas commentators like El Erian have the slightly less alarmist tone pointing to a “Quiet Financial Revolution”. But what is becoming clear, is that there are asset bubbles within the financial markets which have been fueled by central planners and policy-makers (primarily our central banks) in a reaction to a financial crisis caused, in the first place, by the collapse of an asset bubble (Sub-Prime Asset-Backed Securities). A bubble which, in turn, was caused primarily by excessively accommodative stance by central planners – see a trend here? Welcome to Hair of the Dog Monetary Policy. We are suffering from the ingestion of a poison and the only cure we can think of is to drink yet more of the very same poison. The irony of the liquidity debate is not lost either – in the honorable desire to increase liquidity, we are also destroying it and creating a complex web of market distortions which is herding investors further and further from rationality.

Don’t get me wrong, investing in financial assets has yielded amazing results over the last 5 or 6 years while the cost of holding cash has been high. I have no idea how much longer this can go on for, but it can’t go on forever. The question is; how rational do you think you are? Are you tempted to jump on the next asset price gravy train? John Maynard Keynes was correct, but the real question may not be whether the market can remain irrational longer than you can remain liquid, but, rather, whether the market can remain illiquid longer than you can remain rational.


*I don’t know about you, but my bank effectively gives me negative nominal interest rates when one accounts for fees, penalties, cost, taxation and commissions. When one accounts for inflation then the “real interest rate” is harshly punitive (negative). It actually costs me to hold my money at the bank, which almost compels me to take my money out of the safety of my account and into the welcoming arms of the next potentially calamitous asset bubble. Our savings are continuously in danger of becoming what Mauldin refers frequently to as a “bug in search of a windshield”. And remember, many people think they put their money in the bank for safe-keeping, that’s what central planners would like you to believe, but try telling that to the owners of Northern Rock accounts. Upon inspection what we are actually doing is more accurately described as lending money to a bank – which then goes and churns it into a leveraged banking system via a process known as fractional reserve banking. Why did Bank of England Governor, Mervin King, hesitate before bailing out Northern Rock? What was all that hot air about “Moral Hazard”? The reality is Mervin King did not bail out Northern Rock because he wanted to help all those little old ladies who had their life-savings deposited there. Merv “the Swerv” King bailed the bank out because he had no choice – had he not done so he would not have had a banking system left to preside over…but, of course, that is another story… and should be told another time…


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Fruitless Liquidity

Blue Ocean

Quote of the Day:

“Water, water everywhere, and all the boards did shrink; Water, water everywhere, nor any drop to drink”

Samuel Taylor Coleridge [The Rime of the Ancient Mariner]

Macro Overview

High-Hanging Fruit

Despite my best efforts to remain semi-in-sync with the UK time-zone in Hong Kong, I was still jet-lagged on my return. By Sunday afternoon the wife wanted me out of the house, and she wanted me to take the kids with me. Which is fair, given my Hong Kong escapades in Hong Kong had lumbered her with them for a full week. But I had a plan. You see, our house, in the lush countryside of the West Country of England, over-looks woodland, hedgerows and fields and, from the rear of the house, I could see that the blackberries were coming into season. Now, there’s one good way to get over jetlag and that’s to get out into the open sunshine doing a task which requires physical activity but minimal thought and effort: blackberry-picking was the perfect tonic. Daughter #1 (Miya, 7yrs) was going to a birthday party, so I ventured forth into the Somerset wilderness with daughter #2 (Charlie, 5 yrs) in tow and daughter #3 (Florence, 2 yrs) on my back. But, there were fundamental flaws to my plan…

A mere 10 minutes into the expedition, things started to unravel. You see, while I was gallivanting around the convertible bond market in Hong Kong, daughter #2, had broken her wrist at school being carried (and then dropped) by daughter #1, during some school playground Tom-foolery. This meant she only had one hand to carry her blackberry-picking pot and thus zero hands with which to pick blackberries. Daughter #3, complained about not being allowed to eat all the Godforsaken fruit for all of 30 seconds before passing out en-route. But my main mistake was that I’d picked the wrong time; it was too early in the season and most of the berries were red, not black. Daughter #2, with all of five blackberries in her pot, finally capitulated after being stung by nettles one-too-many times.

The physical trauma didn’t end there. You see, I’d committed that cardinal sin of thinking that because I could see blackberries, I could have blackberries. The berries visible from our house were at the very tops of the hedges – where the sun caught them. Down in the murky shadows at ground level, though, the pickings were slim. Decisions made in jet-lag are often misguided. We managed to collect enough for a crumble, but let’s just say it was emotional.

My frustration lay in that the bushes were abundant with assets, awash with liquidity: fruit of the lushest calibre were out in force, but, where we were standing, there was no capital, no low-hanging fruit, no liquidity, no means of exchange, no velocity of trade. Thus, because our blackberry plight was relatively fruitless (perhaps that’s where the word comes from) our subsequent mechanism to manufacture goods and fuel productivity (of making a blackberry crumble and jams and other things) was looking obsolete. Indeed, the only way I could reach the sun-ripened blackberries was by taking excessive risk … and so I did. I’m 6’ 2” with a decent reach, but by wading deep into the thicket I succeeded only in waking up daughter #3, on my back, who failed to appreciate the risk/reward profile of being violently wrenched out of her deep slumber by a face full of brambles (or “grambles” as she likes to call them). It all went a bit pear-shaped and we retreated, stung, bruised and dishevelled, with the wretched morsels we had acquired…


Measureable Liquidity Supply Does Not Equal Liquidity Access

So that’s just it… the bushes in our surrounding fields are laden with fruit. Yet, for all the measureable capital liquidity (and as I wrote about in my Neanderthal Economics stories, food, such as fruit is actually a form of capital), there was nothing easily accessible. With all the will and intention in the World, as a fruit-picking organisation, the three of us could not access liquidity when and where we needed it the most, without a lop-sided risk. Liquidity, liquidity everywhere nor any drop to drink.

Our ill-fated blackberry expedition reminded me of things people had said to me in Hong Kong, the state of liquidity and valuation in our markets, and an article written by Professor Nouriel Roubini (aka Dr Doom) called The Liquidity Time Bomb. Dr Doom gets his nickname on account of his permabear-like prophecies and, dare I say it, demeanour. But remember, Roubini is known for being the guy who called the recession of 2008 in 2006, citing specifically that “the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence, and, ultimately, a deep recession”). One could say even a stopped clock is right twice a day, but to his credit, Roubini backs his proclamations with fact and chooses his moments to add emphasis. Today he is emphasizing liquidity risk in the capital markets. So that seems a good place to start…


I’m going to hit the send key now because it forces me to write the follow-up, else you’re all going to think I’ve lost my mind…

1 Comment

Posted by on September 13, 2015 in China, Hong Kong, Monetary Policy, Nouriel Roubini


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