Category Archives: Finance

If a state becomes Bitcoin-friendly, it will see a huge increase in companies

Interesting Bloomberg story: State-level regulations are coming for Bitcoin and “the devil take the hindmost”.

California and New York, home to Silicon Valley and Wall Street, are preparing to write rules of the road for entrepreneurs driving a surge of interest in Bitcoin and other virtual currencies.The outcome could determine how big a threat Bitcoin poses to established payment companies including JPMorgan Chase & Co. and Visa Inc. as well as where venture capital and talent converge to form a geographic hub for U.S. startups.“If a state becomes Bitcoin-friendly, it will see a huge increase in companies,” said Adam Ettinger, an attorney with San Francisco-based Strategic Counsel Corp., which advises technology investors. “That will mean the brightest minds working on some of the most innovative payment technology we’ve seen in awhile.”Bitcoin, a five-year-old protocol for issuing and moving money across the Internet, has gained traction with merchants selling everything from Sacramento Kings basketball tickets to kitchen mixers on Venture capitalists see promise in it as an alternative to the global payment system currently dominated by companies including Visa, Western Union Co. (WU) and large banks.


Burton Malkiel: Equities entail less risk than ‘haven’ investments


Prof. Malkiel accepted the CIO position at Wealthfront November 2012. His recommendations are now being integrated into expanded asset classes, managed by the Wealthfront software for 0.25% management fee. Of special interest to the retired cohort is what to do about the negative returns offered by bonds?

Investors have been fleeing to “safety”. US 10-year Treasury yields fell to less than 1.5 per cent earlier in June, a level not witnessed since 1946 when interest rates were pegged. German 10-year yields fell to an all-time low near 1 per cent. Some very short-term Federal rates were negative, implying that investors were willing to pay governments considered financially stable for the privilege of holding their money. Global equity markets have fallen sharply.

Investors appear to be far more concerned with the return of, rather than a return on, their money. Since 2008, more than $1tn have been moved from equity funds to bond funds. Similar shifts from equities to bonds have characterised US pension fund allocations.

But does this flight to so-called havens really provide investors with the protection they desire? Or, are bond buyers making a huge mistake that is likely to guarantee them a period of negative real (after inflation) returns? The answer is almost certainly the latter. Bonds today in countries such as Japan, Germany, and the US are more expensive than at any time in history. Bond investors face virtually sure losses and equities are as attractive as they have been in a generation.

We can illustrate the fundamental unattractiveness of bonds with the US market. The buyer of a 10-year US Treasury bond at a 1.5 per cent yield to maturity will receive a nominal return well below the current rate of inflation and below the Federal Reserve’s informal target rate of inflation of 2 per cent. Thus, even if inflation does not accelerate, long-term US Treasuries will provide a negative real rate of return. If inflation does accelerate, that real rate of return will be further reduced.

It is important to remember what happened to bond investors the last time that Treasury bond yields were at 1.5 per cent, in 1946. Bond yields remained pegged at low rates until the early 1950s to enable the government to more easily finance the debts from the second world war. Therefore, bond prices remained fairly stable. But moderate inflation reduced the real value of both coupon payments and the face value of the bonds, and bondholders lost considerable purchasing power. And that was only the beginning of the pain.


Equities are reasonably priced and are downright cheap in comparison with bond alternatives. Price-to-earnings multiples and multiples of book values are below recent averages. Dividend yields on stocks are well above bond yields. The dividend yield on AT&T stock is double that on AT&T 10-year bonds, and AT&T has been increasing its dividend at about 5 per cent per year.

Emerging market equities are even cheaper. Prior to the world-wide recession that started in late 2007, developed-market P/E multiples were 10 per cent higher than those in emerging markets. Today emerging-market multiples are more than 10 per cent below those in developed markets. And emerging markets have better fiscal balances, lower debt to GDP ratios, and younger populations.

Read Malkiel’s complete essay.

Paul Pfleiderer: Investing & Modern Portfolio Theory

Stanford prof. Paul Pfleiderer is an advisor to Wealthfront. In this article for TechCrunch he refutes some recent attacks on Modern Portfolio Theory (MPT). Recommended:

A few weeks ago, TechCrunch published a piece arguing software is better at investing than 99% of human investment advisors. That post, titled Thankfully, Software Is Eating The Personal Investing World , pointed out the advantages of engineering-driven software solutions versus emotionally driven human judgment. Perhaps not surprisingly, some commenters (including some financial advisors) seized the moment to call into question one of the foundations of software-based investing, Modern Portfolio Theory.

Given the doubts raised by a small but vocal chorus, it’s worth spending some time to ask if we need a new investing paradigm and if so, what it should be. Answering that question helps show why MPT still is the best investment methodology out there; it enables the automated, low-cost investment management offered by a new wave of Internet startups including Wealthfront (which I advise), Personal Capital , Future Advisor and SigFig .

The basic questions being raised about MPT run something like this:

  • Hasn’t recent experience – i.e., the financial crisis — shown that diversification doesn’t work?
  • Shouldn’t we primarily worry about “Black Swan” events and unforeseen risk?
  • Don’t these unknown unknowns mean we must develop a new approach to investing?

Let’s begin by briefly laying out the key insights of MPT.

(…) One of MPT’s key insights is that while investors need to be compensated to bear risk, not all risks are rewarded. The market does not reward risks that can be “diversified away” by holding a bundle of investments, instead of a single investment. By recognizing that not all risks are rewarded, MPT helped establish the idea that a diversified portfolio can help investors earn a higher return for the same amount of risk.

(…) Modern Portfolio Theory focuses on constructing portfolios that avoid exposing the investor to those kinds of unrewarded risks. The main lesson is that investors should choose portfolios that lie on the Efficient Frontier, the mathematically defined curve that describes the relationship between risk and reward. To be on the frontier, a portfolio must provide the highest expected return (largest reward) among all portfolios having the same level of risk. The Internet startups construct well-diversified portfolios designed to be efficient with the right combination of risk and return for their clients.

Now let’s ask if anything in the past five years casts doubt on these basic tenets of Modern Portfolio Theory. The answer is clearly, “No.” First and foremost, nothing has changed the fact that there are many unrewarded risks, and that investors should avoid these risks. The major risks of Zynga stock remain diversifiable risks, and unless you’re willing to trade illegally on inside information about, say, upcoming changes to Facebook’s gaming policies, you should avoid holding a concentrated position in Zynga.

The efficient frontier is still the desirable place to be, and it makes no sense to follow a policy that puts you in a position well below that frontier.


I recommend the complete article. An excellent companion article is by the father of the Sharpe Ratio, Stanford prof. William Sharpe: How to Invest In a Turbulent Market. There are many useful insights. Bill closes with this:

The equities market is around an all-time high. Should future retirees buy in now or wait for it to get cheaper?

I wish I knew whether in a year, we will look back and say that the current level of the market was an all-time high. But I don’t, and would warrant that few, if any, do. Better to assume the equities market is somewhat more likely to go up than down and act accordingly.


Matt Yglesias: Bitcoin Will Spiral Up and Down Forever

Matt Yglesias explains why the scheme will prove useless:

Tim Lee makes what is I think the strongest case for Bitcoin, arguing that it’s not just a fad, it’s a disruptive technology that can serve as a platform


But where I think the analogy breaks down is with deflation. As computers started looking more and more useful and demand for computers grew, the world started building more computers. Bitcoins are deliberately designed to represent a finite supply. So if over time more and more people want to use Bitcoins to conduct transactions of various kinds, then the price of bitcoins is going to have to rise and rise. The problem is that if the price of a bitcoin is on a steady upward trajectory, then nobody’s actually going to want to spend a Bitcoin on anything. And if everyone’s hoarding their Bitcoins, then the network is actually useless. Then, since it turns out to be useless, you get a crash. The funny thing is that once the upward spiral comes to an end, then the technological virtues of the Bitcoin platform come to the fore again. If nobody wants to hoard Bitcoins, then Bitcoin-as-platform looks like an attractive alternative to elements of the payment system. But when Bitcoin starts looking attractive again, you should get a renewed hoarding cycle.

To put it in more jargony terms, expectations about the price level will be ‘unanchored’ instead of rapidly mean-reverting, so its going to be very difficult to ever have a platform that attracts a steady user base rather than a boom-and-bust cycle.

Tim Lee: Why bitcoin is a bubble

 As I just posted, Felix Salmon says “bitcoin is a bubble…”. Tim Lee writes “Why bitcoin is a bubble“, guest-posted at Megan McArdle:

My friend Tim Lee says that critics of Bitcoin need to do a better job of explaining why bitcoins–the virtual currency that has been soaring to impressive heights–are in a bubble.  Tim writes:

When people dismiss Bitcoins because they can’t think of how they’d use it, they’re missing the fact that Bitcoin is a platform, not a product in its own right. When ordinary users started buying computers, it wasn’t because they thought it would be cool to own a computer. They did it because they wanted to do spreadsheets or word processing or email. Similarly, ordinary users aren’t going to start using Bitcoins just because it’s a cool technology. If normal users start using Bitcoin, it will be because they’re interested in gambling, or cheap international money transfers, or some other applications that hasn’t been invented yet. And Bitcoin’s intermediary-free architecture means that many more people can try their hand at building the platform’s killer app.

I haven’t written about bitcoin before, but here’s my stab at why it’s fair to say that bitcoins are frothy: eventually, the novelty will wear off, the state will get involved, and the costs will be found to outweigh the advantages.

The problem isn’t that I can’t imagine how I’d used bitcoins.  I can imagine exactly how I’d use them: to evade government surveillance of my financial transactions.  This potential use seems to have tickled the imaginations of many, many bitcoin fanciers. The problem is, the government also has an imagination. 

The reason I think that bitcoins will ultimately go away is that I think they will, like other virtual currencies before them, ultimately prove to be too illiquid.  A dollar is one of the world’s most liquid assets: it can be turned into virtually anything I want, at least if I put enough of them together.  

But bitcoins are not so liquid.  Mostly, to buy things, I need to trade them for dollars or another currency.  And that is the fatal weakness of bitcoins: at some point, to compete with dollars, it needs to enter the real economy.  And if bitcoins become a good way to avoid government surveillance of your financial transactions, then governments will find a way to choke off those entry points so that bitcoins become very illiquid indeed.  (…) 

Some of those ‘technologies’ are pretty low tech. Bitcoins are essentially electronic bearer bonds.  Readers of 1930s-era thrillers will remember that these often figured heavily in the plot: bonds which paid out to whoever happened to be physically holding the bond.  These were very useful for refugees, tax dodgers, and criminals, and anyone else who wanted to keep the government’s eyes off their finances.

But the usefulness of bearer bonds became a problem.  If your bearer bond was destroyed, you had no recourse. They also turned out to be very useful to steal, since the original owner had no way to prove their property rights.  And indeed, one source alleges that about 10% of bitcoins have been stolen at some point.

Even worse, governments found a way to shut down the issuance.  In fact, this proved surprisingly easy: the US government simply announced that interest payments on bearer bonds would no longer be tax deductible.  And voila, no one wanted to issue bearer bonds any more.

 (…) In other words, I think that governments can make it so difficult to translate your bitcoins into the real economy that most people simply won’t bother.  And the more successful that bitcoins are–the better they become established as an alternate currency–the more likely it is that rich-world governments will swoop in and make it prohibitively difficult to use bitcoins to procure real-world goods in developed countries.  At that point you’ve essentially got a novelty currency like greenstamps, which can be exchanged for only a limited supply of goods, and maybe some developing-world travel.

Given that, bitcoins seem overvalued to me.  People are betting on bitcoins as an actual substitute for money, not a novelty currency.  And while I wish the bettors luck, I think they’re facing some pretty long odds.

More Tim Lee at Megan McArdle.

On the bitcoin-as-platform concept, my friend Charles writes “Bitcoin is really a template for a whole family of shared distributed ledger systems that can potentially solve all kinds of problems without any central authority being involved.” Personally I think Charles has the best perspective on the future utility of this machinery. The “Killer App” of bitcoin may not involve bitcoin as medium of exchange.

Scott Sumner: When bitcoin crashes . . .

Scott Sumner captioned his somewhat technical “no bubble” argument “When bitcoin crashes . . .”

. . . .I predict people will say it was a bubble, even though it wasn’t. The term ‘bubble’ can mean many things, but the sine qua non of definitions includes “rejection of the EMH.” But the EMH says that bitcoin is very likely to crash. Why is this so, and why don’t people know this?

1. We know that market volatility is serially correlated. Markets that have been highly volatile are likely to remain highly volatile.

2. Bitcoin prices are super volatile.

3. The EMH predicts that expected returns are near zero. Combined with high volatility, this mean the EMH predicts that bitcoin will exhibit large price increases and large price decreases at various times in the future.


Felix Salmon on “The Bitcoin Bubble and the Future of Currency” a primer on the crypto-currency

Each time the value of a bitcoin hits a new high or a new milestone, there’s more press coverage of the phenomenon, drawing new people in, and sending the value of bitcoins even higher. Indeed, if you chart the value of bitcoins against the number of times that they’re being talked about on Twitter, you’ll see a very strong correlation. And because of the Cyprus connection, mainstream publications have a handy real-world news hook, now, with which to explain the bitcoin phenomenon.

This is actually a serious problem, if you’re trying to put together a currency, rather than a vehicle for financial speculation. If the currency of a country ever fluctuated as much as bitcoins did, it would never be taken seriously as a medium of exchange: how are you meant to do business in a place where an item costing one unit of currency is worth $10 one day and $20 the next? Currencies need a modicum of stability; indeed, one of the main selling points of bitcoin was that it couldn’t be destabilized by government institutions. But that comes as scant comfort to people watching the value of a bitcoin behave like some kind of demented internet stock during the dot-com bubble.

And just like demented internet stocks, bitcoins have seen busts as well as bubbles: in the second half of 2011, for instance, the value of bitcoins retreated from their peak around $30 each to a low point closer to $3. (Today, they’re trading above $140.)

In reality, then, bitcoin doesn’t really behave like a currency at all. In terms of its market value, it looks much more like a highly-volatile commodity. That’s by design: bitcoins were created to be the most fungible commodity the world had ever seen – to the point at which they would effectively erase the distinction between a commodity and a currency.

But is that a good idea?


 Good question. More in the longish essay by Felix Salmon at The Medium. 

James Kwak: the mutual fund company that oversees your 401(k) plan is out to get you

Economist James Kwak is now a law professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. In this piece James examines the conflict of interest between the asset management industry and the suffering 401K investor. Excerpt: 

(…) But wait, there’s more! In addition to these very real problems, 401(k) plans are generally run by the asset management industry, which (surprise!) does not always have your interests at heart.

Most defined contribution plans allow participants to select from a menu of investment options, largely mutual funds. The question is, who decides what’s on the menu? About three-quarters of the time, these decisions are made by a mutual fund company acting as the plan’s trustee.** And (surprise again!) mutual fund companies are more likely to push their own funds onto employees than other companies’ funds—despite the fact that they are legally obligated to act in the best interests of plan participants.

Although many people have suspected this all along, we now have convincing evidence from a paper by Veronika Pool, Clemens Sialm, and Irina Stefanescu aptly titled “It Pays To Set the Menu” (which was sent to me by two different readers). The paper uses a clever empirical approach. In any given year, a mutual fund may be included in 401(k) plans overseen by that fund’s sponsoring company (e.g., the Fidelity Magellan Fund may be included in a plan whose trustee is Fidelity) and also in other plans not overseen by that company. It turns out that there are many such funds.

Let’s say such a fund has a bad year. If plan trustees are acting solely in the interests of their participants, we would expect the identity of the trustee not to affect the chances that the fund is dropped from the investment menu. But that’s not the case: a poorly-performing fund is much less likely to be dropped from a menu controlled by its sponsoring fund company than from a menu controlled by a third party. Fund companies are also much more likely to add their poorly performing funds to plan menus that they control.

Much more.

U.S. government regulations for virtual currencies

This was posted by Tyler Cowen:

U.S. government regulations for virtual currencies

Here is part of one summary:

The major boon from the document for Bitcoin is this: users get off lightly. In fact, FINCEN does not intend to touch mere users of virtual currency at all; the document states, “a user who obtains convertible virtual currency and uses it to purchase real or virtual goods or services is not an MSB under FinCEN’s regulations. Such activity, in and of itself, does not fit within the definition of “money transmission services” and therefore is not subject to FinCEN’s registration, reporting, and recordkeeping regulations for MSBs.” The document also offers protection from “prepaid access” laws that regulate gift cards and the like, saying that “a person’s acceptance and/or transmission of convertible virtual currency cannot be characterized as providing or selling prepaid access because prepaid access is limited to real currencies.” Finally, even exchanges are safe from “foreign exchange” regulation, the set of rules governing businesses that offer exchange between two or more national currencies.

The regulations are here, and the pointer is from Jeff Garzik.  On the topic, there is a very good short essay by Eli Dourado.

[Marginal Revolution]