June 30, 2019


By now you’ve probably heard of Libra, Facebook’s new cryptocurrency that has changed the way the tech world thinks about cryptocurrency. We’ve seen several big name companies experiment with crypto over the past year or so, with JPMorgan and Amazon among the biggest. JP Morgan, Amazon, and Facebook provide legitimacy to the whole movement, guiding digital tokens from fringe tech nerd concept into the mainstream. No longer is the world of crypto dominated by niche smart-contract startups that your Uber driver invested in (Really, though, the number of Uber drivers I’ve met who have struck it rich in crypto is unbelievable). These are real players, ready to spend their bottomless pits of cash on high-risk, high-reward projects.

We hear a lot about world-changing new technology, especially around here in San Francisco. Libra’s white paper is another level of aspirational, promoting a new currency that will “empower billions of people”, “innovate on compliance and regulatory fronts”, ultimately creating a “more connected global financial system”. They’re setting big goals to make a splash and to show their commitment to the idea.

Of course, Facebook wasn’t the first to propose something like this. Tether shared some of the goals of Libra: fast global money transfer and stability in value. Tether has found a number of use cases in the crypto market already. But Libra aims to address some of the shortcomings of Tether, backed by one of the largest corporations in the world. If anyone has enough clout to launch a game-changing digital currency, it’s Facebook. With over 2 billion worldwide users and many people in developing countried utterly dependent on Facebook, it has immediate access to a market larger than any one country.

There are so many interesting aspects of Libra to talk about. I want to (1) address the viability of the product, and what sort of legal and regulatory requirements it’ll have to overcome in order to come to fruition. I’m also interested in (2) the global financial implications of a full-fledged successful rollout of Libra. It’ll also be interesting to (3) discuss Facebook’s plan for widespread adoption of the token, and the partnerships forged to ease that transition. I want to talk about (4) how Facebook is managing their PR in the context of the new coin, and how the Calibra organization provides an illusion to cover up Mark Zuckerberg’s ultimate plan for world domination (kidding, of course). Finally, I want to talk about (5) the implementation: how it differs from traditional cryptocurrency, how the new programming language (called Move) works and why it makes sense for this project, and what applications we can foresee built on top of a successful Libra.

It’d be helpful to acknowledge immediately that I personally am skeptical of cryptocurrency for several reasons, among which include viability, energy consumption and overall usefulness (comparing blockchain to the advent of the Internet?). But in the end it’s up for the world to decide whether this is the direction we will move in.


Facebook has already run into several issues even just after the announcement of Libra. Of course a moonshot project like this from one of the biggest tech companies in the world will turn heads, and regulatory heads in particular. Regulators have procrastinated on regulating cryptocurrency, allowing it to flourish without oversight for several years before implementing any sort of tax code. This is the nature of regulation: the trend has to gain enough traction before the government agencies bother to look at it. With Libra and the threat to upend the traditional financial system, Facebook is forcing regulatory agencies to take a serious look at crypto. Facebook couldn’t promise to “innovate on compliance and regulatory fronts” without painting a picture of a completely successful rollout. The ultimate vision was enough to get even our Congress to act almost immediately. I think the immediate regulatory scrutiny bodes well for the success of Libra, as it provides an extra layer of legitimacy for the currency: governments are taking this seriously, so you should too.

Perhaps it’s in Congress’ best interest to sound alarmist about the new currency. “We cannot allow Facebook to run a risky new cryptocurrency out of a Swiss bank account without oversight”, Senator Sherrod Brown of Ohio said.

I think there are a few things to consider in regulating Libra. First, how does crypto as an asset figure in to capital structures? What is the difference between a crypto token and a security, and what is the difference between a cryptocurrency and a fiat currency? Second, how should governments with fiat currencies react to the threat of goods and services being denominated by a digital currency? The US has an incredible amount of oversight in financial transactions all over the world, precisely because a plurality of transactions are denominated in US dollars. In a world with Libra, will Facebook (ok, Calibra) be the entity with oversight over the world’s financial transactions? Of course governments don’t like the idea of currency managed by a private organization.

In the traditional model of economics, there are essentially three different things you can own: fiat currency, commodities, and securities. Fiat currency only has value because the government says it does. This provides a useful tool for governments to interfere with the economy, allowing them to adjust interest rates, keep inflation under control, and control the supply of credit. In general, people trust the US government and the Fed to keep the dollar reasonably stable. The dollar is backed by a single entity (the US government). Commodities, on the other hand, are physical goods that are homogenous in nature and have intrinsic value based on usefulness or desirability. Fluctuations in the value of commodities follow the basic laws of supply and demand. Securities are essentially pieces of paper that give a the holder the right to a piece of some corporation/entity or some promise of it in the future.

Cryptocurrencies fall in a category of their own. Some, like Tether, function as currency - they are generally a medium of exchange (though not backed by a government: they are backed by a reserve of US dollars, which makes it a sort of currency-by-proxy). Bitcoin acts more as a commodity - the value fluctuates with demand (up to $20,000 in late 2017) and is seen less and less as a medium of exchange and more as an investment. The value of Bitcoin is derived from the difficulty of completing a proof-of-work problem as well as the overall demand. Finally, crypto startups offering digital tokens in initial coin offerings are offering tokens that resemble securities more than anything. Kin is a cryptocurrency designed to bail out a failing messaging app and will at some point become a medium of exchange on the app.

With the variety of different use cases and models for crypto, you can see the challenges that the SEC faces with regulating it. Kik’s Kin currency was in a fuzzy territory because the SEC saw it as a way to fund company operations, while Kik saw it as a medium of exchange. Since the company didn’t follow IPO regulations when ICO’ing, the SEC got involved and Kik had to make an argument for Kin as a currency.

This is all just to say that regulation of such an undefined new sphere is hard. Facebook and Calibra will have to define a new category of asset for the SEC (and regulatory agencies around the world) to regulate. These three categories need to be defined explicitly for the crypto space. Perhaps some coins should be subject to capital gains taxes. Crypto exchanges should be held to some baseline standard of security and durability such that money doesn’t get lost. ICOs should follow disclosure rules governing their IPO cousins.

In the ultimate grand vision of Libra, it exists as a medium of exchange, with which you can order your Uber or pay with Visa. In the ultimate grand vision, your Uber price is denominated in Libra, your payments online processed through Stripe are denominated in Libra, and the dollar is an irrelevant external form of exchange that you don’t care about because you buy everything online anyway. The dollar seems to fluctuate against Libra rather than the other way around, and you suddenly think “why should I even hold dollars if I buy everything online and the dollar price changes every day?” Then Libra becomes your primary form of currency and you immediately turn your direct deposits from work into Libra. Everyone else does the same thing, and suddenly no one actually wants the dollar anymore. The effect of this is that the governments that are quickest to adopt and accept Libra will see inflation as people exchange their fiat currency for Libra. The value of the fiat currency amongst the basket of currencies that backs Libra decreases. It’s in government’s best interest to stall or stop the deployment of Libra altogether. If central banks lose the ability to adjust according to the state of the economy, monetary policy as it stands today doesn’t work.

Now suppose Facebook (Calibra) owns the world’s money supply. Who governs sanctions on countries? Who allows or disallows illicit or questionable decisions? Who stops the funding of terrorist organizations? You’d think that Facebook would, but the blockchain is designed such that no one can actually control these transactions. However, if one were able to discern transaction patterns from the transaction history, validator nodes could reject certain transactions from going through. The idea of private corporations dictating the flow of money scares governments and the public alike. Accounts are tied directly to government identification. Online marketplaces could tie purchases to a particular account, allowing for price gouging and a whole new meaning to the term “surge pricing”.

Traditionally, money changing hands is associated with some sort of premium - specifically, a tax. With cryptocurrency, it could be especially difficult to enforce sales taxes. If Facebook is going to innovate in regulation to make Libra a universally accepted medium of exchange, then they will have to work with the IRS to make more clear rules on how to collect sales taxes on cryptocurrency transactions.

Facebook will have to work very closely with public financial institutions in order to realize their vision. They need to address the issues with monetary policy, fiscal policy, and securities regulation. David Marcus, the leader of the Libra project, is commited to addressing the regulatory concerns, saying: “Facebook will not offer the libra digital currency until we have fully addressed regulatory concerns and received appropriate approvals”. We’ll see how long that takes.


The impact of a widely-adopted cryptocurrency is far-reaching. First, as we alluded to before, we could see the shape of the global money supply change. We could also see Libra upend payments in the developing world. We could see effects in foreign exchange markets, where fees could be less lucrative.

To throw another buzzword in the mix, Libra is what crypto people call a stablecoin. This means that for every unit of Libra out there in the world, there will be some number of dollars/euros/pounds/yuan/yen in a bank somewhere. These are bank deposits or short-term government securities, with high liquidity and low interest. The only way to get more Libra is to buy it with fiat currency - there’s no mining in this blockchain network. If Libra is widely adopted, this could have profound implications for the banking system. We’ve already discussed some of them above.

Government debts and bank deposits aren’t generally meant to be held for the purpose of backing some other currency - they’re generally seen as a safe investment for individuals and banks. Banks can use their deposits to meet the reserve requirement, upon which they can lever up and take more risky investments. Now, if American banks were to take deposits for backing Libra, the amount of deposits would increase, allowing banks to take more risk in other ways (issuing loans for mortgages or corporations). On one hand, one may argue that banks should not be allowed to take an excessive level of risk on the basis of Libra-related deposits. On the other hand, Libra deposits could be seen as an extra insurance policy, since it seems less likely that Libra would be exchanged for dollars during a bank run (which is why Fed reserve requirements exist). However, Libra reserves will not be held at American banks, but rather overseas at Swiss banks. This could have a negative impact on reserves in the US, potentially leading to less investment opportunity for banks, and thus economic contraction. The Fed could adjust reserve requirements accordingly, at the expense of insurance for those holding their savings in American banks. Alternatively, the Fed could increase the money supply in this scenario, potentially spurring more investment. However, increasing the money supply is often not a sustainable solution, as it could lead to runaway inflation.

In addition to the effects on the banking system, Libra will have very interesting effects on payments in the developing world. In Africa, mobile payments are already mainstream, and mobile phone minutes have become a currency. Libra could be a formal version of a number of different airtime currencies, in that it is a digital form of value transfer with few fees. Facebook, as an essential part of the daily life of many living in underdeveloped countries, can easily tap its network in developing countries to build the Libra currency quickly in Africa and beyond. This level of adoption could undermine any attempt by developing countries to create their own fiat currency.

In the grand scheme of things, cryptocurrency provides a new category for corporations or governments or startups to define their own financial instruments. I’d argue there’s nothing particularly novel about this particular usage of crypto. Facebook could have simply issued a digital token that they keep track of in their own databases, put a pile of stable fiat currencies in a Swiss bank, reduced fees to zero to encourage adoption of the token, and called it a day. The only difference here is that they slapped the word blockchain on it, called it decentralized to boost trust in the token, and voilá, it becomes a part of the nebulous and unregulated space of cryptocurrencies. Perhaps the real innovation of blockain is it’s ability to get other companies to sign on to something like this - if you trust the technical whitepaper, you trust that Facebook can’t be extracting extra value out of it.


Facebook partnered with some of the biggest existing names in payments processing to add legitimacy to their project: Visa, Mastercard, PayPal, and Stripe are all signed on to the project. In addition, Spotify, Uber, Lyft, eBay, and Andreessen Horowitz are among the founding members of the Libra association. These companies, among others, each paid $10 million to join the founding members group, and optionally can set up a validator node for the Libra blockchain. What this means is that if you can collectively trust this group of organizations, you can trust the Libra blockchain. These companies also get to vote on the direction of the Libra.

The incentive for Facebook to collect this group of support is quite obvious: Facebook itself doesn’t have the best reputation on its own, and the partnerships bolster the confidence of any individual contemplating whether to use Libra. On the other hand, the incentive for companies to join the Libra Association is less straightforward - they’re making a bet on the outcome of the project, and hope to use their voice to give direction to the digital currency. The founding members will have a bigger portion of the voting share when more companies choose to join the association. They will also each receive a portion of the Libra reserve’s interest, proportional to their original investment.

Having a seat at the table allows Visa and Mastercard, for example, to keep the growth of the Libra payment system in check. So while Facebook portrays these partnerships as endorsements of their new technology, internally they could be seen as threats to the system. Existing payment processors want to have a say in how the new coin is developed. The incentive is actually similar for telecommunications systems like Vodafone, who have become major players in payments processing in developing countries. Vodafones’ M-Pesa was the original Venmo in Africa.

For Uber and Lyft, the incentive is more symbiotic. First off, Uber has recently gotten into the fintech space with its Uber Card and Uber Rewards, so this investment is another signal that they plan on expanding their footprint in fintech. Clearly these startups are following the Amazon model of growth - instead of maintaining a core business, issuing dividends and buying back equity, they choose to diversify, branching into new fields orthogonal to their core business. But Uber and Lyft process millions of transactions on their platforms every day, and so they influence the adoption of Libra. If Uber offers incentives to riders to pay with Libra, riders will open Libra wallets specifically to hail Ubers. At that point, if the consumer goes online shopping on a site that uses Stripe, they’ll start moving a lot more of their money into Libra. In the end, Uber and Lyft are probably the biggest companies with which consumers do business every day. And Uber and Lyft could well get much more than their money’s worth in interest on the reserves.

For venture capital firms like Andreessen Horowitz, the venture could be purely investment opportunity: the interest returned on Libra reserves could be well worth their $10 million investment (probably a less risky investment than other ventures). On the other hand, they could want a say in how Libra could be used in the investment and venture capital space.

The notable absence on the list of Libra partners, of course, is Amazon. Surely the idea of Amazon and Facebook working together on a project of this magnitude would draw more regulatory scrutiny than needed, and perhaps Amazon itself is working on a crypto project of its own (it did launch AWS Managed Blockchain which is a pretty good sign that it’s working on it’s own).


In the month since the announcement, Facebook has gone through quite a bit of scrutiny. David Marcus has gone through Senate testimony, AOC has criticized Facebook and likened the new coin to scrip, and Trump launched a tweet storm against cryptos in general and Facebook in particular. The value of Bitcoin has surged as interest for cryptos has increased since the announcement, but subsequently has fallen in the context of the testimony. The fact is that people still don’t trust Facebook after the never-ending feed of bad press since the Cambridge Analytica scandal.

To be continued…

May 16, 2019

Startup Funding

There’s been lots of talk recently about the coming influx of millionaires in the Bay Area. Of course, new millionaires are being minted as a result of large privately held tech companies going public. The biggest story out of Silicon Valley this year so far has been the Uber IPO. One of the biggest privately held companies of all time when it went public, Uber has long dominated the talk of “unicorns” in the tech sphere. Since Uber was founded in 2009, it seems like every new startup uses the phrase “the Uber of blank” in their investor pitch. The wave of IPOs this year include Lyft, Pinterest, Slack, Zoom, and PagerDuty. Rumors have been circulating about We Co. (WeWork), Palantir, and AirBnB going public this year, too.

So far, these IPOs haven’t been doing great - Uber dropped 17% in the two days following IPO, after pricing on the lower side of their range. Lyft has lost around a third of its value since IPO. Clearly public markets haven’t been taking to the cash burning unicorns as much as private markets have.

One attractive feature of being a venture capitalist, or an employee at an early-stage startup, is that you have considerable upside on the equity you own in the company, especially in the event of an IPO. Unfortunately, for many longtime Uber employees, the equity that they owned in the company has not appreciated in value since they joined the company. IPOs this year have not done a good job of convincing the venture capitalist or startup employee (such as myself) that the value of their investment will increase significantly with the initial public offering. I’m concerned that the appeal of investing in private companies for venture capitalists will significantly decrease with the wave of IPOs this year. Especially if IPOs continue to go as poorly as they have.

Perhaps the public markets aren’t fooled by the sparkle of buzzwords like “cloud”, “AI”, and “machine learning”. One indicator of this is the fact that one of the most successful high-profile IPO this year was Beyond Meat, a company that makes (delicious) vegan meat through a combination of plant-based materials and chemicals. They’re currently at 4x their IPO valuation, but they are definitely not tech.

Perhaps investors in the public markets don’t have 100 billion dollars to burn (most don’t). Public investors are inherently more sensitive to a billion dollars of cash burn every year. It’s pretty hard for a sales and trading intern to make a compelling pitch on a company that may never make a profit. In the private markets (or as some may call it, the “magical forest”), there’s a tendency to sell a “mission” or a “vision” rather than future cash flows. You could have a hotshot CEO that gives inspiring albeit poorly delivered speeches. There’s a way to manufacture non-GAAP metrics that make you look good (ie, adjusted EBITDA) and make you look like you’re growing. Executives out here in the Bay Area have this magical ability to hook you on an idea. CEOs are particularly good at pitching to private investors, but when the shares go public, you don’t get as much facetime with the execs. All private investors get to meet the CEO on a mission; public investors don’t. That’s one of the reasons why Lyft and Uber’s S1 filings are so filled with stories about the company vision, mission and values. There’s no financial value in that, but they’ve been selling the value to private investors for years, and it’s worked. Once these companies are public, they don’t get the benefit of the doubt. Subject to scrutiny and metrics galore, these companies don’t generate discounted cash flow models to the public markets’ liking.

Matt Levine from Bloomberg loves talking about how private markets are the new public markets, how companies like Forge are making pre-IPO shares more liquid, and how companies (in particular, big, high growth tech companies) are able to make most of the money they need in private funding rounds. This is very much thanks to huge venture capital funds, like Sequoia and Benchmark. Not to mention the questionable-at-best hand of the Saudi sovereign wealth fund and SoftBank’s Vision Fund.

There are several reasons companies choose to go public. (1) Historically, the primary reason has been to get funding from a broad investor base. (2) Going public provides liquidity to early shareholders (employees and VCs). (3) The publicity around a successful IPO can often positively impact a brand. For many private tech companies these days, the first and third reasons are not as relevant anymore, given that funding has been easy to come by in the private sphere and most of these companies are household names. Going public these days is more a rite of passage than a source of funding. Slack is going public through a direct listing over a typical IPO, because it doesn’t need publicity, cash, or dilution. At the same time, Slack’s executives must be wary of the additional scrutiny that going public brings.

So why is Slack still choosing to go public? I can imagine that large investors in Slack (Accel and Andreessen Horowitz) were pushing for the liquidity that the public markets provide, potentially in an effort to exit their positions. Completion of the rite of passage gives employees an ego boost, and a way to cash out. They better hope that it’ll go better than Uber’s, or they’ll be sending a warning sign to other companies trying to go public.

Things are looking bright in the private space, though. SoftBank’s Vision Fund somehow managed to allocate the hundred billion dollars worth of capital in just over two years, out of the expected four. This is a testament to either (a) the strength and growth opportunities available in their tech-heavy portfolio, or (b) a gross overestimation of the value of the companies they are investing in. As an engineer in the Bay Area, I am crossing my fingers that it’s the former. Their investors seem to think so too, and for good reason. The fund has already returned 45% net of fees to partners. The Vision fund is itself seeking to go public, which would provide some liquidity to its generally illiquid parts. After jumping through some legal and regulatory hoops, a public Vision Fund would look like Berkshire Hathaway, except with a growth-focused rather than a value-focused mindset. It’d provide proxy access to investment in private companies for the individual investor.

The Vision Fund is supposedly going for a round 2 of over a hundred billion dollars in capital allocation, after tapping out the first hundred billion too quickly. This’ll be a great driver for continued over-inflated startup valuations. This new Vision Fund is one (large) counterargument to the point that private investors could abandon their large-scale bets on startups in the future.

Only time (and more IPOs) will tell whether IPOs have a negative impact on private market funding. For now, things don’t seem to be slowing down. But given market volatility and trade uncertainty, I wouldn’t be surprised if venture capitalists are a little less enchanted by startup investor slide decks.

January 19, 2019

Sears bankruptcy

I’m really interested in the Sears bankruptcy proceedings because I want to know how long exactly I’ll be able to use my points on Shop Your Way. Shop Your Way is a weird rewards program held by Sears holdings, the disastrous trainwreck that is billionaire Eddie Lampert’s brainchild. This rewards program, frankly, makes absolutely no sense. You get $2 in “points” every time you take an Uber (the Uber could be $3, it doesn’t matter). Now, you’ve got to bet that Shop Your Way is on the losing side of this corporate partnership - what private tech company would go around and burn millions of dollars a day?

Honestly, I don’t know how anyone at Sears could have thought that this was a good idea. As long ago as 2014, the program has made up for three quarters of Sears’ sales. Personally, I only buy stuff on Shop Your Way when I have enough points to buy $70 worth of stuff for free with free shipping. I apologize to those in older generations who will miss the novelty of shopping at Sears, where you can actually see and feel the things you’re buying. So you can see how this brilliant scheme to get more people to shop at the dying retailer both succeeded and failed. Succeeded in that more people than would normally shop at Sears shopped at Sears, and failed in that they’re selling stuff for free. (It’s always a winning sales strategy to give away stuff for free, just ask a college student).

So there’s a whole lot out there about the corporate financial trickery that Lampert employed to keep Sears afloat for the past decade or so, while at the same time extracting as much money as possible out of the fading icon as possible for his hedge fund, ESL Investments.

Lampert bought Sears through an acquisition by Kmart for $11 billion in 2005. Before buying the company outright, he was a 15% shareholder in the company. He bought Kmart two years beforehand, and merged the two to form a relic of old time retail. Source

Sears’ sales rose for one year after the acquisition (in 2006) and subsequently declined for the next 9 years. The financial crisis in 2008 was quite close to a nail in the coffin for the fledgling company. The company lost 85% of its market capitalization, but Lampert somehow kept it alive through a corporate restructuring of massive proportions. By splitting the company into dozens of competing subsidiaries, he introduced layers upon layers of bureaucracy. Each of these subsidiaries was individually managed, had its own corporate structure, and vyed for a larger portion of an already scarce pool of resources.

This restructuring did well to drag Sears’ revenues even farther down the hole, as heads of each division would each demand high salaries, and the overhead of maintaining separate organizations weighed down on revenues.

From the late 00s to now, Sears has been on a steady cycle of “streamlining”. Despite pumping hundreds of millions of dollars into the company, Lampert was still able to shave off gains for himself. Some have argued that the way in which Lampert drove Sears into the ground indicates not poor management, but typical Wall Street greed. This is mostly evident in the streamlining cycles that Lampert put the company through in the 2010s.

The picture that comes to mind when thinking of Sears’ restructuring is of a rocket launch gone wrong, with pieces of shrapnel spinning off every ten seconds. First, Lampert spun off over 200 properties into a real estate investment trust. Sears subsequently spun off a number of brands in an effort to build a more streamlined business. Land’s End, Craftsman, and Kenmore were all spun off to shareholders. In this case, however, “shareholders” also refers to Lampert and his hedge fund ESL. So he still owns a 59% stake in Land’s End, on top of a large 43.5% stake of the REIT that holds much of Sears’ old retail space.

Lampert siphoned cash off of these spun-off assets rather sneakily (and definitely without Sears’ best interests in mind). The REIT, called Seritage Growth Properties, was now leasing its properties (formerly Sears retail stores) directly to Sears. Thus, the REIT actually made money off of the company that spun it off. In fact, this maneuver essentially allowed ESL to take cash directly from Sears’ balance sheet.

The money that Lampert lent to Sears will not all be lost to him, either. Sears put up collateral against these loans in the form of its retail property, meaning that Lampert will take control of the property if and when the loans default. So in the event of default, Lampert may even get the better end of the deal (even though he had lent the money through ESL). What’s more, much of what ESL lent Sears is secured, meaning it’s at the very top of the payback pyramid.

For the last decade or so, Lampert has been able to keep Sears alive, simply because it assets to burn in the “streamlining” process.

(As a side note, ESL and Lampert are essentially the same entity, as Lampert “owns all of ESL and makes all of its investment decisions”.)

People overemphasize the role of online shopping and Amazon in killing Sears. Sure, there was certainly a failure to adapt to a new medium of retail. In the end, what really killed Sears is poor management and misaligned incentives. What was in the best interest for the largest shareholder (Lampert) was not in line with the interests of employees (who saw their hours and pay get cut), shareholders (who saw the retailer’s assets dwindle to nothingness), or customers (who saw Sears’ appeal as a retailer drop).

Even since the bankruptcy, my Shop Your Way account still feeds me $2 in points for every Uber ride I take (I’ve heard that they’re getting rid of the free shipping, though).

A lot of weird things have happened with Sears’ debt in the aftermath of the bankruptcy. The way that the debt is settled in these situations is that there is an auction for the debt that is outstanding. This essentially answers the question of “how much do we expect (company) to pay us back for that $X we loaned them?” In default, the company has to pay back as much as it can to its debtors, an auction like this settles it.

Bring credit default swaps into the equation, and suddenly this debt auction isn’t as straightforward anymore. I’m reiterating what Matt Levine very gracefully explained in his fantastic blog, Money Stuff. Sears subsidiaries sold bonds to each other (yes, within the same company) because of Lampert’s super convoluted and unnecessarily complicated corporate structure. The bonds of one subsidiary in particular, Sears Roebuck Acceptance Corp, were supposed to be sold at auction to determine their fair value. Now, the seller of the CDS on those bonds (Cyrus Capital Partners) wants the price at auction to be high, so that they don’t have to pay out as much in CDS. So in order to minimize net losses on the CDS sale, Cyrus can go to the auction and figure out what price they’d have to buy all the bonds to minimize their net payout (CDS payout + bond auction price).

Sears, knowing that this trade existed, set up an auction of its own for the internal debt that it held. Both of the two sides stood to gain from participating in the Sears auction. The CDS holders could buy the notes and bring them to CDS auction, making it harder for Cyrus to push up the price on the debt, thereby increasing the CDS payout. Cyrus, in anticipation of this fudgery, had an incentive to buy the notes, in order to not bring them to auction. Cyrus bought the notes, handing Sears 82.5 million dollars to work with.

Lampert was the only bidder at the bankruptcy auction for Sears itself. Offering 4.4 billion dollars to keep thousands of workers employed, he made a difficult pitch to a number of weary creditors. The only thing stopping him from winning the auction outright is the bankruptcy court’s perception of his ability to bring Sears back to life. Creditors, of course, do not want to see more of the same in management from Lampert. But for many, it could very well be their best option, since if no one else can put in a viable bid for Sears’ assets, the value of their holdings becomes the value of Sears’ assets in a fire sale. Unsecured creditors (not ESL) are the most at risk here. Essentially, Lampert has to give a pitch to creditors that he can provide more value to their holdings than a liquidation could. The courts were originally unsatisfied with Lampert’s bid, given his spotty history as CEO of the company. Eventually, however, Lampert’s bid won, and as of mid-January, he has one more chance to bring Sears back to its feet.

So what happens now? More store closings, more spin-offs, and more consolidation of assets to benefit ESL and Lampert? Or a transformative magical turnaround that somehow brings Sears back to life? I’m just wondering how much longer I can get free stuff from Shop Your Way.

November 15, 2018

The Unicorn Bubble

Unicorns are particularly temperamental creatures. They are supposedly very sensitive to the environment and the conditions surrounding them.

My source here is not Fantastic Beasts and Where to Find Them, but Bloomberg.

Unicorn is one of those made-up names over the last decade that has popped up to provide some new jargon for the tech venture capital sphere. It’s a privately held startup company valued at over a billion dollars. Most are in tech and get ridiculous amounts of funding from VC firms.

There have been a number of interesting trends over the past decade in startup funding and venture capital. The amount of money poured into startups has been increasing, while the time-to-exit (the time it takes for a typical company to IPO or get acquired) has increased. Companies are waiting to get bigger before exiting.

There have been many compelling reasons for companies to stay private. The obvious one is access to capital - lots of VCs want to play every hand, for fear of missing out on the next Uber or AirBnB. If it’s easy to get access to private capital on good terms, why would a company want to expose itself to the hysteria of the market? Elon Musk and Tesla are a prime example of why a company should not go public in today’s environment. If you’re trying to change the world, you don’t want to be juggling the general public’s potpourri of differing opinions, activist investors, and conflicting perspectives. A company out to change the world should have a benevolent dictator (not sure how benevolent Musk is, but you get the point). It used to be the case that if you wanted access to capital, you put your shares out on the open market. Today, if some Saudi sovereign wealth fund or venture capital firm takes your company’s bait on changing the world for the better (and making tons of money while doing it), you’re in the money.

A lot of unicorns are out to change the world. Uber with self driving cars, (previously) Tesla with sustainable self driving cars, and Wealthfront with self driving money. (I work at Wealthfront). There’s a lot of appeal in Uber’s model. It’s sort of encouraging to young startups that there’s a company that can burn billions of dollars a year, a toxic workplace culture, and a 120 billion dollar valuation. (As a side note, I feel like people love selling their startup ideas as “Uber for [blank]”). These companies are out their to achieve some vision, and that vision is more convoluted when public investors tell them to do things. That’s why Musk got stressed out and tweeted about taking Tesla private - there’s so much less scrutiny, and for Musk in particular, less exposure to short sellers.

Over the past decade, interest rates have been extremely low, making it cheap for any bank to do more speculative investment. Venture capital is by definition speculative investing, so it’s been pretty cheap for VCs to pump money into small companies over the past decade. As rates rise, more people have more reason to be skeptical about the unicorns, and it’s less likely that they will have as easy of a time getting funding.

Assigning a value to a company like Uber is particularly difficult, because those companies are hemorrhaging money. Investors have to estimate the net discounted value of future cash flows in order to properly estimate it. For Uber in particular, this is difficult because their pitchbook is dependent on the delivery of one product: the self-driving car. As financial conditions tighten, the net value of future cash flows is discounted accordingly, since a the new future dollar value is worth less than the old future dollar value (interest rate is higher, so the discount rate is higher). Expectations for further rate increases also have an impact on the discount rate.

Another aspect of rate increases is that investors will start to gravitate towards less risky assets. For example, the Fed funds rate generally floats in tandem with yields on the overarching bond market. So if interest rates go up, bonds will give higher yields, and institutional investors will see less incentive to go after risky investments like startup funding.

A number of these companies have defied the physics of traditional valuation models. This stems from the idea that many business models in the software space come at little to no marginal cost - the vast majority of a private company’s valuation is dependent on growth. These growth estimates can come from anywhere - but they always go up and to the right. Some growth curves assume exponential user growth, some depend on regulatory restrictions to be lifted, some are drawn to match the historical growth curves of “similar companies”. Will all these growth projections come to fruition? Probably not. We can only imagine the quality of the pitchbook that Uber uses to draw the funding that it does despite its unprofitability. Perhaps we’re starting see more reasonable valuations as financial conditions tighten. It might be time for VCs to ask why the revenue charts go up and to the right at unreasonable and unsustainable rates.

November 5, 2018

Ballot measures and municipal bonds

Elections are coming up. I sat down with my roommates yesterday and perused the California General Election Official Voter Information Guide. In particular, we talked about the propositions on this years ballot, of which there are 11. A few questions came up during the conversation.

Why would the government choose to fund something with general obligation bonds versus with tax increases? How much can a federal/state/municipal government issue in debt? What decides this? What’s the difference between federal/municipal bonds in terms of investment?

There are two types of municipal bonds, as described by Investopedia. The first are general obligation bonds, bonds paid back by your future taxes. These are the types of bonds that get people riled up, the stuff that your children end up paying for. The other type of bond is a revenue bond, which is the type of bond that seemingly only municipalities can issue. A revenue bond is paid back through revenues from the projects that are built (ie bridge tolls, entrance fees to park).

Typically, revenue bonds are more risky as an investment than general obligation bonds, because there is no guarantee that the revenue paying back the bond will be consistent. Since general obligation bonds are issued by those who have the power to levy taxes, these investments are more safe.

The amount of debt a municipality can feasibly loan out depends on several factors. For example, changes in incomes, property values, and tax rates affect the rate at which loans are paid back. Detroit defaulted on its debt in 2013 due to corruption, a declining population, and a declining automotive industry. In San Francisco, a tech boom may drive future tax revenues to be higher. In fact, San Francisco revenues are higher than the majority of other major US cities, in particular thanks to the tech boom.

One thing about passing a general obligation bond issue through a referendum is that it’s very difficult to change. California in particular has a rule that requires that lows passed by referendum can only be changed through referendum. This leads to particularly convoluted and confusing ballot measures that the average American should not be expected to understand. This year, California proposition 2 was to redirect funds from a mental health services act to a housing program for those suffering from mental health issues. For the investor, this does not change the return on investment, but does change the thing you are lending for. Whether or not this ballot measure passes should be fairly uncontroversial for the investor. However, you can imagine a situation where an investor loans money in a bond issue for Tesla thinking that they can change the world by funding solar power. When Tesla turns around and uses the loan to, say, buy SpaceX, that socially conscious investor may feel cheated out of their social goodness.

In 2009, as one of many measures to dig the economy out of the Great Recession, President Obama launched the Build America Bonds program, a program in which the federal government paid 35% of the interest owed to loaners (buyers of bonds). This reduced the cost of borrowing for cities and towns, allowing for more investment on a local level.

In general, the credit risk for municipalities in the United States is fairly low - Detroit is your biggest example of municipal default, and Puerto Rico defaulted on general obligation bonds in 2016. Less than a tenth of one percent of municipal bond issues have defaulted since 1970. Recently, pension obligations are a particular source of pain for municipalities. In Chicago, pensions plans and benefits would cost over 60% of net revenues for the city. This is a significant debt burden, and the city will need to make structural changes in the future to better finance their plans going forward.

All in all, there is a limit on how much debt a municipality can issue (and a much more tangible limit than that of the federal government). On the other hand, if a city continues to develop and produce revenue (and doesn’t get locked into unsustainable cycles of debt), the debts are generally safe investments.

October 21, 2018

What is currency manipulation?

One recent piece of economic news was that China was not labeled a currency manipulator in the eyes of the United States. Since then, the RMB has dropped to its lowest level against the dollar in over a year.

The Donald has been calling China a currency manipulator since the election. Why does China want to have a weak currency? What good does it do to place a label on China as a currency manipulator? How do you manipulate currency? Is Donald right?

TL;DR: To make exports cheap. None. Adjusting the money supply. No.

China, for over twenty years, has been a net exporter of goods to the rest of the world. This was a huge part of Deng Xiaoping’s “Socialism with Chinese characteristics” policy. China would industrialize, and industrialize quickly, taking advantage of its behemoth workforce to make products for the rest of the world. Initially, it was real cheap to buy products from China because its people were still in poverty, reeling from Mao’s Cultural Revolution. The labor force was just struggling to put food on the table at home. As a result, foreign nations kept pumping money into the Chinese system. Dollars and euros and pounds (but mostly dollars) flow into the Chinese economy to purchase these goods. This, in turn, produces growth in the Chinese economy. All of these dollars are exchanged for RMB to pay workers. Since so much of this USD -> RMB exchange is happening, one would expect the normal laws of supply and demand to kick in. The price of the RMB should go up. It doesn’t.

China wants to keep its currency undervalued so that it can remain a net exporter of goods. For people in China, this means that leaving the country and buying foreign goods can be prohibitively expensive. This is one of the reasons why American-made cars are often viewed as luxury goods in China. But instead of letting their currency float, the People’s Bank of China would take the influx of dollars from trade and exchange them for RMB at a fixed exchange rate. The People’s Bank can do this essentially because they print the money. With these dollars, the PBOC can go out and buy some more US treasuries, adding to the US debt to China.

China can also control the value of its currency by selling and buying domestic bonds and adjusting the reserve ratio and discount rate. Each of these methods affects the money supply in the system, which in turn affects its forex rates.

Over the past decade, the RMB has been a mixture of a fixed-rate currency (when the exchange rate with the US was essentially flat) and a “managed float” currency. It’s a pseudo-floating currency that will occasionally see government intervention in the name of “market forces” that justify the devaluation of the currency. “Market forces” refer to the failure to meet ambitious growth targets of 6-8% over the year. In order to meet those growth targets, the government did the logical thing and spurred on the economy by reducing interest rates and devaluing the currency. This is at least somewhat justified. China, as an export-driven economy, needs to maintain growth by providing competitive prices on goods. On the other hand, it is very artificial, leading Chinese people to be more dependent on the domestic economy and less able to purchase foreign goods.

As China continues to devalue the currency, Chinese goods continued to be cheap, leading to more foreign inflows. This inflow of foreign money puts upward pressure on the yuan, and so China needed to infuse more yuan into the money supply. This cycle feeds itself, leaving the PBOC in a bit of a pickle today.

In labeling China a currency manipulator, pretty much nothing actually happens. Any review that the Treasury will conduct under the new label would have been done anyway. For Donald, it’s fulfilling a campaign promise. For the rest of the world, it’s stoking more tensions that don’t need to exist in the first place.

The trade war over the last several months has caused a depreciation in the value of China’s currency, as China makes its goods cheaper to compete in the American market with the tariffs. This only devalues the RMB even more.

In 2015, the IMF announced the addition of the RMB to the reserve currency list. At the same time, it wasn’t yet fully ready to embrace the yuan. Neither are investors - the fact that PBOC policy influences the value of the yuan as much as it does means that investors and governments are wary of keeping their money in yuan. In a normal economy, keeping yuan would be fine, because the value of the RMB would rise against other currencies. But with the depreciation in value of the RMB combined with a slowdown in growth of the Chinese economy, many are not interested in keeping the RMB. As you find in any country/corporation, laws of big numbers come into play - you can’t sustain 6%+ of growth year over year forever. More recently, China has been coming to terms with this fact, and as a result need to reconsider the structure of the economy.

Even Chinese individuals are trying their best to get money out of yuan. The Chinese government imposes a $50,000 USD foreign exchange outflow quota for individuals. For wealthy Chinese families, this is only a small barrier in getting their money out of RMB. Many will use their quotas in combination with extended friends and family’s quotas to go invest in foreign real estate, bonds, and other markets. Fraudulent papers and accounts can also be used to transfer money out of yuan.

As a side note, the sentiment on the RMB is another reason why wealthy Chinese often turn to real estate - one of the few investments with firm value and growth projections that coincide with Chinese growth targets.

As Chinese investors and companies look outside China for investment opportunity, the demand for the yuan decreases, putting downward pressure on the value. In order to prevent a complete collapse of the currency, China began digging into their forex reserves. This means selling dollars and buying yuan, to increase the supply of the dollar and reduce its value against the yuan. This is propping RMB up in value. Donald says that the RMB is undervalued. In reality, it’s probably overvalued right now.

Suppose the PBOC just went hands off on the RMB right now, letting it float. No outflow quotas, no money supply manipulation, no selling of USD reserves. Market forces would decide the value of the RMB. As a result of China’s slowing economy, we could see the RMB plummet in value. This would likely send a shock through the Chinese economy. But at some point, the PBOC can’t sustain this much longer.

China needs to come to terms with the fact that it can no longer focus on an export-driven economy. They’ve progressed admirably through the stages of industrialization and development, and need to start acting like a grown-up. They need to let their currency float properly, open markets up to both inflows and outflows, and allow Chinese people to participate in the global marketplace. In the long term, this is the only way to ensure that China maintains some amount of growth sustainably.

Here is a cool infographic on how the (downward) currency manipulation works.

October 19, 2018

Monetary policy for dummies

News alert: Fed expect to increase rates to up to 3% within the next year.

What does this mean? Donald says it’ll ruin the economy and that the Fed is the “biggest threat” to his… presidency? Legitimacy? Economic policy?

Why does Donald want interest rates to stay low? Rates have stayed low since 2009, when rates were lowered to close to zero and held there for almost a decade. Monetary policy in the US even went as far as using quantitative easing to spur negative interest rates in the early 2010s. As the economy started to make a bit of a comeback, Fed chair Janet Yellen pretty much continuously hinted to the financial world about higher rates. Finally, in 2016, some moves were made to push the rate up. And since then, the Fed has been consistently poking and prodding financial institutions, ensuring that they are on their toes for the next rate hike.

Let’s start from the beginning. Interest rates represent the cost of borrowing money. The benchmark or target interest rate in the United States (the rate that all these articles are talking about) is a goal number for the federal funds rate. This rate is the rate at which banks loan money to each other to meet reserve requirements. A minimum reserve requirement is the amount of cash that a bank needs to hold at the Fed in order to remain compliant with the Fed and the government.

So every depository institution (bank) in the US needs to hold a certain percentage of their deposits in reserves. Throughout the day, a bank will receive funds and pay funds, leaving a certain amount left at the end of the day. If they are not able to meet the reserve requirement at the end of the day, a bank can borrow either directly from the Fed or from other financial institutions with a surplus in reserve funds. The rate at which the the bank borrows from the Federal Reserve is called the Fed discount rate, while the rate at which the bank borrows from other banks is the Fed funds rate.

So how does the Fed manipulate this rate? There are three knobs that the Fed can twist in order to manipulate the fed funds rate.

  1. Open market operations
  2. Fed discount rate
  3. Reserve requirements

First, open market operations. Open market operations are purchases and sales of government securities on the open market. In particular, the Fed buys and sells government bonds on the market in order to inject or remove money from the economy. When the Fed is buying, they are introducing more money into the market. In exchange for whatever government bonds that a commercial bank is holding, the Fed will deposit cash into that institutions’ reserves. This increases the bank’s lending power because they have more in reserves to meet their minimum reserve requirement. Since the banks have more to lend, their interest rates decrease (more supply leads to less expensive borrowing). This is expansionary monetary policy.

Quantitative easing is an extreme version of open market operations (OMO). When rates hit zero, other methods are needed in order to spur the economy on, since people would be unwilling to make deposits if their money simply dwindles in the account. Instead of limiting buybacks to short term government loans, the Fed moved to purchase mortgage-backed securities and longer term securities as well, injecting as much cash into the reserve system as possible to increase money supply.

On the other hand, if the Fed is selling on the open market, they are removing money from the market, decreasing lending power of institutions, and thus increasing the cost of borrowing. This is contractionary policy.

Second, the fed discount rate. The Fed sets its own interest rate on overnight loans to banks. This price on borrowing is set as a competitor to overnight loans between banks. Thus, there is pressure on banks to move their overnight rates with the federal discount rate. If the discount rate goes down, the cost of borrowing decreases, and so more money is flowing through the economy. This spurs economic activity and growth. This is a expansionary policy. If the discount rate goes up, the cost of borrowing from the Fed discount window goes up, and so other banks can afford to charge a higher rate for their overnight loans, thus disincentivizing banks to lend too much. Money flow slows down, and we have a contractionary policy.

Third, reserve requirements. The Fed sets reserve requirements on the amount of cash that banks need to hold against their liability position. This reserve will sit in a Federal reserve branch. Currently, reserve requirements depend on the size of a bank’s net deposits, and range between 3 to 10 percent. If a bank holds three thousand dollars in deposits when the reserve rate is 3%, this means they are permitted to loan up to $100,000. If the reserve rate is increased, banks have to ensure that more cash is on hand relative to their liabilities, which means they have less money to lend. Less money to lend leads to more expensive loans, which means less money is flowing through the market. This is a contractionary procedure.

On the other hand, if the reserve rate is decreased, banks are able to loan more money, which means they can lend at a lower rate, which in turn means that interest rates decrease. This is an expansionary policy.

So low fed funds rate = expansionary policy, while a high fed funds rate = contractionary policy. All of the methods above are really just controlling the supply of money in the economy. Pretty much all interest rates out there are in some way correlated with the fed funds rate. Mortgages, student loans, PLOCS, HELOCS, auto loans, and credit card APRs all move in tandem with the fed funds rate.

So why does Donald not approve of the potential for rising rates? Any sitting president would disapprove of the Fed raising rates, because the purpose of raising rates is to slow down the economy when it becomes to overheated. On the other hand, the president’s job is to tell people that the economy is doing absolutely fantastic, thanks to your vote.

There are several reasons why the Fed want to raise rates. The past few years have seen quite a solid bull run in the markets. This bull run seems a bit artificial, given the low cost of borrowing still in the market. A rate hike would force investors to reevaluate how much of the growth over the past several years was spurred on by loose monetary policy, and how much of it was true growth. It’s been a long time coming for a market correction and we’re seeing the effects of this reevaluation this year, in February market-wide and more recently in tech.

Another reason to raise rates it to provide breathing room for the next recession. One of the best tools we have to curb recession is the target interest rate, and if we can’t push it down, the only option is often last-resort techniques like quantitative easing. The Fed won’t want to inflate their balance sheet again with more meh holdings (no one wanted the mortgage-backed ones in 2009 anyway), so they’d probably like to stick to more traditional monetary policies.

There is also a concern about runaway inflation when it comes to low interest rates. When there is a larger money supply, the prices of goods increase, which means individuals have less purchasing power. One issue with the economic recovery over the last decade has been a decrease in purchasing power for consumers. Though prices of goods have been increasing, wages have not kept up with the pace. A higher interest rate will help curb inflation, in theory allowing wages to catch up to prices. Given today’s very low unemployment rates, demand is high in the labor market, which should (in theory) push up the price of labor (wages). The problem we are seeing now is that that is not happening, which indicates that we need to stop focusing on growth at breakneck pace. Historically, wage inflation lags behind price inflation, which is why rapid price inflation is not good.

Yes, rates should be increased, and no, it won’t look good on paper. But as China has shown recently, rapid economic growth is unsustainable for extended periods of time, and the Fed needs to keep the markets in check somehow. This is the best way to do it.

I get a lot of information from Investopedia.