Money Stuff: Don’t Forget Your Bitcoins

tHe fUtUrE oF mOnEy The New York Times has a hilarious story about people who forgot their Bitcoin passwords: Of the existing 18.5 million Bitcoin, around 20 percent — currently worth around $140 billion — appear to be in lost or otherwise stranded wallets, according to the cryptocurrency data firm Chainalysis. Wallet Recovery Services, a business that helps find lost digital keys, said it has gotten 70 requests a day from people who want help recovering their riches, three times the number of a month ago. Bitcoin owners who are locked out of their wallets speak of endless days and nights of frustration as they have tried to access their fortunes. Many have owned the coins since Bitcoin's early days a decade ago, when no one had confidence that the tokens would be worth anything. "Through the years I would say I have spent hundreds of hours trying to get back into these wallets," said Brad Yasar, an entrepreneur in Los Angeles who has a few desktop computers that contain thousands of Bitcoin he created, or mined, during the early days of the technology. While those Bitcoin are now worth hundreds of millions of dollars, he lost his passwords many years ago and has put the hard drives containing them in vacuum-sealed bags, out of sight. "I don't want to be reminded every day that what I have now is a fraction of what I could have that I lost," he said. Honestly I could read these stories all day. Here is a fact about me: I did not mine Bitcoin in the early days, so I do not now have thousands of Bitcoin that are now worth tens of millions of dollars, so I do not, for instance, own a $25 million plot of oceanfront land in Barbados, as one person in this article does (even after losing some of his Bitcoins). I admit that I occasionally envy the people who bought Bitcoin early for nothing and are now billionaires and retired. One thing that soothes this envy is reading about people who bought Bitcoin early for nothing and are now theoretical centimillionaires but lost their private keys and can't access the money. I may have no Bitcoins, but at least I haven't misplaced a fortune in Bitcoins. Here's someone else who lost some private keys: "Even sophisticated investors have been completely incapable of doing any kind of management of private keys," said  Diogo Monica, the co-founder of a start-up called Anchorage, which helps companies handle cryptocurrency security. Mr. Monica started the company in 2017 after helping a hedge fund regain access to one of its Bitcoin wallets. A hedge fund! If you're a person who bought some Bitcoins and lost the password then, oops, that's tough for you, and we'll all have a laugh about it. But if you are a professional investing firm who bought some Bitcoins with your investors' money and held them as a fiduciary for those investors, and then lost the password, then you probably can't be a professional investing firm anymore. That's not good. And yet it is in a way understandable. If you are a hedge fund and you buy some stock, you will not spend even a moment worrying about losing the stock. That is an entirely solved problem in 21st-century finance. You will have a custodian who holds the stock for you, but it's not like the custodian is keeping stock certificates in a vault that might burn down. The custodian has an account with the Depository Trust Company, the stock is all on computers (like a blockchain!), there are a lot of backups and redundancies, and in practice stock does not just go missing. We talk occasionally about weird anomalies in this system, places where the system briefly loses track of where some bits of stock are supposed to be, but they are all temporary and marginal. Nobody misplaces billions of dollars of stock forever. Nobody misplaces 20% of all the stocks in the world forever, come on.[1] A hedge fund that is used to that system may be unprepared for the Bitcoin system of, like, write down your password and don't lose it, or etch it on metal plates and bury it in the backyard, that sort of thing. You are used to a custodian keeping track of your assets for you; you are used to the system working in a calm and sensible way; you are used to mistakes being corrected; you may not be up for the high-stakes challenge of maintaining the physical security of your digital assets. Note that the anecdote about the hedge fund is from 2017. In recent years, as institutional investors have gotten more into cryptocurrency, a lot more attention has been paid to custody. This past December, the U.S. Securities and Exchange Commission put out a statement on custody of digital assets, laying out how broker-dealers should act when they are custodians of digital assets (like Bitcoin) for their customers. The guidance talks about things like deciding if the digital asset is a security and examining the asset's blockchain to make sure it works well, but there is also a long paragraph about not losing the password.[2] It's a very important part of cryptocurrency custody, not losing the password. The institutional Bitcoin market is moving in the direction of SEC-regulated custodians keeping track of funds' Bitcoins for them. The retail Bitcoin market also involves a lot of trusted and increasingly regulated intermediaries; if you buy Bitcoin on Robinhood the thing to remember is your Robinhood password, not the private key to your Bitcoin wallet, which Robinhood holds for you. Of course there are Bitcoin futures and trusts, which are ways to get economic exposure to Bitcoin while letting someone else—hopefully someone responsible and regulated—remember the password for you. And there are proposals to go further, to issue depository receipts on Bitcoin that will essentially allow it to function like the current system for stocks: A big central financial intermediary can hold all the Bitcoins, and everyone can open an account with the intermediary, which will keep track of their Bitcoins for them. The basic tension in Bitcoin is: Bitcoin is at its core about rejecting the traditional financial system and replacing it with something different, something trustless and disintermediated. Instead of relying on banks to hold and transfer your money for you, your money lives on a blockchain and you have direct access to it.  But most of what actually happens with Bitcoin is about rediscovering financial history and re-creating the traditional financial system from scratch. And so on the one hand much of the value proposition of Bitcoin is that it will replace traditional banks and brokers; on the other hand, a lot of the people who actually buy Bitcoin are desperate to put their Bitcoins in a bank because, you know, the alternative is often so stupid. One more story from the article, about a guy who misplaced $220 million of Bitcoin:[3] Since then, as Bitcoin's value has soared and fallen and he could not get his hands on the money, Mr. Thomas has soured on the idea that people should be their own bank and hold their own money. "This whole idea of being your own bank — let me put it this way, 'Do you make your own shoes?" he said. "The reason we have banks is that we don't want to deal with all those things that banks do." Like remembering where the money is! Libor Libor, the London interbank offered rate, is an interest-rate benchmark reflecting banks' short-term unsecured borrowing costs. SOFR, the Secured Overnight Financing Rate, is an interest-rate benchmark reflecting the cost of short-term borrowing secured by Treasuries. Which benchmark you use depends on what you are doing with it. If you are a bank making a floating-rate loan, you might reasonably prefer Libor: Your own cost of funding the loan will be based on your unsecured borrowing cost, so using Libor will better match your assets and liabilities. If you are a bank looking to do an interest-rate swap, similarly, you might want to match the floating rate to your own marginal funding costs, so you might prefer to reference Libor. (Though since you do a ton of repo funding too, you might prefer SOFR.) You might expect banks mostly to prefer Libor over SOFR, and for Libor-based instruments to be more popular than SOFR-based ones. If so, you would be correct: "Average open interest in three-month SOFR futures barely topped 5% that of eurodollar contracts last month." (Eurodollar contracts are, in effect, Libor futures.) That analysis is bad, though; that is not how it works. People do not choose Libor or SOFR based on their economic needs. They choose Libor because they have always chosen Libor; Libor is the traditional interest rate for floating-rate loans and interest-rate derivatives. They choose SOFR because they are required by law to choose SOFR; the U.S. Federal Reserve has a "year-end deadline to halt new Libor contracts." These quotes are from this Bloomberg article about how the transition is going slowly. I have read lots of articles like it over the last year or two. Here: Recent high-profile milestones in the Libor transition that were expected to jump-start trading in the new instruments have delivered relatively modest boosts so far. As the Federal Reserve's year-end deadline to halt new Libor contracts creeps closer, some are beginning to express concern that the slow pace of progress could undermine efforts to ensure a smooth transition, posing a risk to financial stability. While few expect a delay similar to the one announced in November for legacy contracts that can't be shifted to SOFR, it's another example of the difficulties regulators have had in getting critical corners of the financial world on board. "We're in this classic chicken-and-egg scenario, where participants don't want to trade because liquidity is low, but there's not going to be enough liquidity unless people trade it," Thomas Pluta, global head of linear rates at JPMorgan Securities, said of SOFR derivatives. "It's increasing, but quite frankly there's an awful lot more that needs to be done for this transition to happen." Fine. I did a talk at a law school once, maybe a year or so ago. I mentioned "the Libor scandal" and people looked at me funny. It turns out they had never heard of the Libor scandal. I felt old. The Libor scandal was … maybe the most scandalous scandal in the financial industry since the 2008 global financial crisis? Libor was called " the world's most important number," but the way that it was calculated was by calling up banks and asking them what rate they could borrow at, and the banks could just make up an answer. It turned out that they often made up answers that were wrong, in order to (1) reassure investors that they could borrow more cheaply than they actually could and/or (2) affect the value of their Libor derivatives trades. So zillions of dollars of derivatives and loans turned out to have the wrong price, banks paid billions of dollars of fines, there were a lot of lawsuits, it was all quite bad.  One consequence of the scandal was that regulators decided to burn Libor to the ground and start over—with SOFR in the U.S., and with similar secured-financing-index ideas in other countries. But there are problems with that approach. One is the chicken-and-egg stuff in that block quote: If you have a gigantic liquid market based on Libor, and no market based on SOFR, it is hard to get anyone to be the first or second or hundredth person to do a SOFR trade. The other problem is that Libor, for all of its flaws, was actually designed to do the things banks want (reflect their funding costs for loans and help them manage risk), while SOFR is not.  Balanced against those problems is the fact that regulators, and everyone else, were really really mad about Libor. But that consideration was a lot more important in 2014, when the Libor scandal was fresh and regulators were starting to plan the transition away from Libor, than it is now, when the transition is going slowly and the Libor scandal is a more distant memory. (Another good reason to transition from Libor is that the eurodollar market, where banks borrow unsecured from each other in transactions that are used to set the value of Libor, has become significantly less active and important since 2008, so Libor is in some sense even less "real" than it used to be, even though now banks and the benchmark administrator take accuracy more seriously now.) I know that the deadline for Libor is approaching, but I feel like I've read these articles forever, and part of me thinks that I'll just keep reading them forever. The deadline will be delayed, the Libor market will remain big and the SOFR one will remain small, and everyone will pay vague lip service to the idea that we need to transition away from Libor even as they forget why exactly we were supposed to do that.[4] China stocks In the olden days, the atomic unit of investing was the stock. You'd decide what stocks you wanted to buy, and you'd buy them, and those would be the stocks you'd own. Each stock represented a share of ownership of a company; your investing bore some direct relationship to the companies that issued the stock. And if the U.S. government wanted to sanction a company for whatever reason, it could tell people not to invest in the company's stock, and then you'd have to sell the stock and you wouldn't own it anymore. That's all still true, I guess, in a technical sense, but these days the atomic unit of investing is increasingly the index. There are a bunch of indexes, lists of stocks that aim to reflect an entire market or sector or theme or whatever. Famously there are now more indexes than there are stocks. Lots of people invest via indexes, through index funds or exchange-traded funds or weird derivative products on indexes. They are investing passively by owning the whole market, or they are investing actively in some theme or thesis or sector or derivative structure, but they are not picking companies to own; there is no direct relationship between the investment and the companies. And if the U.S. government wants to ban a company for whatever reason, yes, sure, it will forbid everyone from investing in the company's stock, but then everyone will have to rummage around in the basement of their indexes to see if they even own the stock and find a way to get rid of it. Recently the U.S. government forbade U.S. citizens from owning some Chinese stocks because, according to the executive order, the Chinese government "exploits United States investors to finance the development and modernization of its military" through those stocks. A lot of rummaging ensued. For instance:  Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co. will delist 500 structured products in Hong Kong, filings show. The city is the world's largest market for such contracts with more than 12,000 of them, according to Hong Kong Exchanges and Clearing Ltd. Products being pulled include warrants and callable bull/bear contracts on the benchmark Hang Seng Index, the Hang Seng China Enterprises Index and China Mobile Ltd. The $14 billion Tracker Fund of Hong Kong managed by State Street Global Advisors Asia Ltd., the island's most actively traded ETF, won't make new investments in companies covered by the ban after saying it's no longer "appropriate" for U.S. investors. If you are buying a callable bull/bear contract on the Hang Seng Index, it seems pretty safe to say that you are not doing it to finance the development and modernization of the Chinese military. Those contracts are complicated exchange-traded barrier options written by big banks. If you buy them, you're not giving your money to the Chinese military; you're giving it to a big bank (or, more likely, to another trader on the exchange, who got it from another trader, etc., who got it from the bank). The banks aren't giving their money to the Chinese military; they may or may not own shares of the underlying stocks to hedge the contracts, but if they do they presumably bought them on the exchange too. The link between buying callable bull/bear contracts on the Hang Seng Index and financing the Chinese military is real enough—buying the contracts affects the price of Hang Seng stocks, the forbidden Chinese companies are among those Hang Seng stocks, lowering their cost of capital helps them raise more money to do projects, those projects allegedly support the military, etc.—but it's a long chain of causation. Also: Even if banned companies comprise a small fraction of a widely followed index, the sanctions could force money managers to shift billions of dollars out of products linked to that index. It's one reason why MSCI, FTSE Russell and S&P Dow Jones Indices have all adjusted their equity gauges to remove banned companies like China Mobile. Hang Seng Indexes Co. said Friday that it has no plan to change its benchmarks for now, though it will monitor "market developments" closely. When a company in an index is banned (for U.S. investors), and U.S. investors own products (funds, ETFs, derivatives) that track the index, there is a weird inefficiency. Two things can happen: The U.S. investors can dump their index-tracking products, or The index administrators can dump the companies. Both solutions are over-broad. In the first, the U.S. investors are effectively selling all the companies in the index, not just the banned ones. In the second, all indexed investors, not just U.S. ones, have to sell the banned companies. The efficient solution would be for (only) U.S. investors to dump (only) the banned companies, but since the atomic unit of investing is now the index, that is hard: You don't just own stocks, so you can't just sell them. We talked last week about direct indexing, which is like index investing except (1) you buy all the stocks in the index directly, instead of buying an index-tracking product like a fund, and (2) you don't have to buy all the stocks in the index; you can add or delete a few if you want. As index investors deal with deleting a few stocks from the index due to sanctions, that approach might sound more appealing. Things happen The Hertz Maneuver (and the Limits of Bankruptcy Law). Intercontinental Exchange's Cryptocurrency Venture to Go Public Through a SPAC. Commodity traders profit from blockbuster year of market chaos. City of London Warned EU Market-Access Decisions Will Take Time. Deutsche Bank to Pull Back From Business With Trump and His Company. Commerzbank warned BaFin about Wirecard in early 2020. Online Platform eToro Called in Leveraged Crypto Trades When Bitcoin Price Peaked. Ex-Credit Suisse chief Tidjane Thiam to launch blank cheque vehicle. Automotive tech start-ups take wild ride with Spacs. Tyson, Pilgrim's Agree to Settle Some Chicken Price-Fixing Claims. Dutch officials seize ham sandwiches from British drivers. The Great Gritty. Cate Blanchett wins permission for meditation room at her 'haunted' £4.9m Sussex mansion despite discovery of bat colony. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] Or we talked last week about the time that Citigroup Inc. sent $900 million to some hedge funds by accident. Citi then called the hedge funds and asked for the money back. It got about half of the money back. The rest is being held by hedge funds that argue, with slim but not no justification, that they're entitled to keep it. Citi went to court to get it back. A court will decide, and then the money will go to whoever is supposed to get it. Citi didn't just seal the whole thing up in a vacuum bag and say "well never mind then." When mistakes occur in the traditional financial system, you try to correct them. You don't just despair. [2] Here you go: "A fourth step the broker-dealer could take is to establish, maintain, and enforce reasonably designed written policies, procedures, and controls for safekeeping and demonstrating the broker-dealer has exclusive possession or control over digital asset securities that are consistent with industry best practices to protect against the theft, loss, and unauthorized and accidental use of the private keys necessary to access and transfer the digital asset securities the broker-dealer holds in custody. These policies, procedures, and controls could address, among other matters: (1) the on-boarding of a digital asset security such that the broker-dealer can associate the digital asset security to a private key over which it can reasonably demonstrate exclusive physical possession or control; (2) the processes, software and hardware systems, and any other formats or systems utilized to create, store, or use private keys and any security or operational vulnerabilities of those systems and formats; (3) the establishment of private key generation processes that are secure and produce a cryptographically strong private key that is compatible with the distributed ledger technology and associated network and that is not susceptible to being discovered by unauthorized persons during the generation process or thereafter; (4) measures to protect private keys from being used to make an unauthorized or accidental transfer of a digital asset security held in custody by the broker-dealer; and (5) measures that protect private keys from being corrupted, lost or destroyed, that back-up the private key in a manner that does not compromise the security of the private key, and that otherwise preserve the ability of the firm to access and transfer a digital asset security it holds in the event a facility, software, or hardware system, or other format or system on which the private keys are stored and/or used is disrupted or destroyed." [3] Though to be fair "he also managed to hold onto enough Bitcoin — and remember the passwords — to give him more riches than he knows what to do with," so I cannot gloat. [4] I am thinking here also about GSE reform. The U.S. government-sponsored enterprises, Fannie Mae and Freddie Mac, were seized by the U.S. government and placed into conservatorship in 2008, in the depths of the financial crisis. This was a novel and shocking development and it was widely assumed that, you know, *something* would happen: They'd be reformed in some way and recapitalized and returned to private ownership, or broken up, or abolished, or turned into an official government agency, or whatever you want. But instead nothing really happened, and they've been in conservatorship ever since; the terms of the conservatorship changed in a controversial way in 2012, but the basic structure—Fannie and Freddie are in limbo, not wholly owned by the government but nonetheless effectively owned by the government—stayed the same. And every few months there is a news story about how the U.S. government is going to return them to private ownership, and each time I write, " hahaha no it won't," and each time it doesn't. And each time the urgency fades. After a year of conservatorship, it is easy to say "this can't go on forever," but after 12 years … maybe it can?  Follow Us Get the newsletter You received this message because you are subscribed to Bloomberg's Money Stuff newsletter. Unsubscribe | Bloomberg.com | Contact Us Bloomberg L.P. 731 Lexington, New York, NY, 10022