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Safest Money

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Foreword

In the last few days of last week (week of March 6, 2023), Silicon Valley Bank (SVB) suffered a bank run. On Thursday alone, $42B of deposits fled the bank and on Friday, the bank was taken over by the FDIC. While not one of the big 4 banks, SVB was still a pretty big bank, somewhere in the top 20. In such a climate, where can we keep our money and be safe?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Definitions

Before we go forward, let’s get a little bit of definitions out of the way. While many people use the words “money” and “cash” interchangeably, they are actually not the same things. “Money” refers to the entire spectrum of assets that can be used to pay for stuff. Depending on the type of money, each unit of it may or may not be worth what it says it is worth.

At one end of this spectrum, is “high powered money” or “base money”, which is money that is generally assumed to be always worth its face value — $1 is $1 is $1. A small subset of high powered money is “cash”, which is generally taken in academia to be actual physical bank notes, coins, etc.

At the other end of the spectrum, is “broad money”, which is money that is only worth its face value over time. For example, a 2year(4) Treasury bond is a form of broad money — it is worth a portion of its face value (depending on current interest rates). edit: However, when the bond matures, it will be worth 100% of its face value (assuming no defaults), regardless of interest rates, so as the bond heads towards maturity, it becomes closer and closer to narrow money.

In high finance, where large sums of money are transferred regularly, broad money is often used to settle transactions, a very stark difference to what retail users are used to, on a day to day basis, where narrow money (cash) is more common.

Silicon Valley Bank

There is more than enough coverage of SVB in the media, so I will just touch on the bits relevant here.

SVB took deposits from a lot of customers and promised the customers that the money is available on demand (i.e. demand accounts). When the money changed hands from the customer to SVB, it is transformed — if you hand over $100 in bills to a bank, you are giving the bank cash, and getting in return a claim on the bank to the tune of $100. Similarly, if you transfer $1m from one bank to another bank, you are exchanging a claim on the first bank for a claim on the second bank, both to the tune of $1m.

The FDIC provides insurances to all bank accounts per account holder to a maximum of $250k. That is, assuming the federal government does not go bankrupt, the first $250k you have in a checking account at SVB is high powered money — it is (transitively) backed by the faith and credit of the US government, and so is effectively narrow money. However, anything above that limit is technically no longer high powered money at all times. Amounts above the FDIC insurance limits is high powered money only as long as the bank itself is operating, because those limits are now a “claim on the bank”, i.e. debt owed to you by the bank.

So, in our first example, the $100 in cash you hand over is high powered money. The $100 in claim on the bank you get in return is high powered money only if it is under $250k at the bank, or if the bank is operating normally.

SVB typically takes deposits from its customers and uses those deposits to invest in US Treasuries, loans to customers, or non-government bonds (1). A large portion of these investments are long term debt, i.e. broad money. And as we know, the value of broad money is generally as a discount to its face value, and is often influenced by interest rates.

And interest rates have been rising, so the value of broad money has been declining. By a lot.

As a result, the mark to market value of SVB’s assets is below the value of SVB’s liabilities (the money it owes its customers). In scenarios like this, if a lot of customers decide to pull money out quickly, SVB will be forced to sell its assets at a huge loss, and since there’s not enough assets to cover all liabilities, if all customers want their money now, some of them will not get all their money back.

Fallout

Because of SVB’s forced insolvency, all customers with balances at or below $250k should get all their money back — the FDIC is promised that the money will be accessible on Monday (3/13) in full. However, because SVB is insolvent (i.e. assets < liabilities), there is a good chance that anyone with accounts more than $250k will lose some of the money above $250k, if they want the money now.

As far as I can tell, SVB did not commit fraud, so the money isn’t missing, it’s just a paper loss due to the change in interest rates. So, with time, as the investments SVB made matures and the debts are paid back, SVB should end up making a profit — that is, assuming all customers are willing to lock up their money until all the investments mature, then everyone should get 100% of their money back, and SVB would have made a small profit as well.

Which is to say, if the customers with accounts more than $250k are willing to wait and let the FDIC slowly unwind the investments, they should be able to get back all their money, though it may take a while, possibly a few years.

The problem is that, currently, you can invest money in short term US Treasuries (one of the safest investments around) for 3.5-5% annual returns, so why would you leave money in SVB for long periods of time just to break even? Also, a large number of customers probably need the money now to make payrolls or pay their own debts, so leaving that money with the FDIC until everything is wound down orderly may not be feasible.

This dilemma is what led to the bank run, and also what likely leads to at least some customers taking a haircut on their money. I have no real insights on how bad the haircuts could be, but I’ve heard estimates from 0-50% (the FDIC is promising to make available at least 50% of money above $250k available on Monday as well).

Crypto

No modern day discussion on money can be done without touching crypto (sadly), and so I will just say this:

SVB, a bank with over $100B went bust in an disorderly manner. Anyone with accounts <= $250k will not lose a cent, but will be inconvenienced for a few days while the FDIC is working to take over. Anyone with accounts greater than $250k will get ~50% of the amounts above $250k back, and may or may not get more back over time.

FTX, Celsius, Voyager, all bank-like crypto entities went bust in the recent past. Pretty much all their customers lost access to all their money, there are various lawsuits taking place to try and recover the assets, and so far it seems like most customers will lose more than 50% of their assets, and that’s after likely a few more years of legal wrangling.

USDC, a stablecoin administered by Circle, a US crypto entity, broke its peg and is now trading at 96c to the dollar, previously having reached as low as 85c. This is simply because for reason I cannot fathom (see below), they decided to keep over $3B (BILLION) of their cash at SVB, and a large chunk of that money is now locked up by the FDIC. This is despite the fact of numerous claims of being “audited”, and that their assets are “safe”. Before the blow up, SVB’s equity base was around $12B, and USDC’s deposit $3B of unsecured assets, earning basically 0% interest, at SVB represents 25% of that equity base, alone. That $3B also represents about 7% of all USDC in circulation before the blowup. How that is “safe” is beyond me.

BTC, the original cryptocoin that did not go bust, lost ~70% of its value in the past year or so. All users maintain access to their assets, though at the new much lower valuation.

Decide for yourself which case you prefer, certainly none of it is good.

Diversifying money

It is frustrating to me, that many companies with large treasuries keep a large part of their treasury(2) in bank accounts. The most basic job of a company’s treasurer (or CFO), is literally to keep the treasury safe. I want to say a “good treasurer/CFO”, but really, any treasurer/CFO that is not a teenager playing pretend should take into account basic things like counterparty risk, diversification of assets, etc.

For both the individuals and the corporate, there are fairly simple things you can do to diversify your liquid holdings to reduce the chance of a serious, crippling financial disaster if some counterparty goes under.

The following is purely US-centric, because I’m based in the US. Also, all the efforts noted below only reduces the risk — there is no way to entirely eliminate all risk. For example, if aliens invade the Earth and just nukes the planet to little bits, there’s really not much any of the following can do to help you. Tough.

Bank accounts vs brokerage accounts

The first thing to note, is that there are 2 types of accounts you can hold liquid assets in. The first is bank accounts, including checking, savings, CDs, etc. These accounts are administered by a bank, and deposits in these accounts represents a claim against the bank (i.e. the bank owes you the money you put in). As noted above, the FDIC provides insurance to all bank accounts up to a limit of $250k.

So, for money deposited into a bank account, as long as you are under the $250k limit, you are pretty safe — the worst thing that generally can happen, is if the bank goes under in a bad way, and the FDIC needs more time to sort things out. In that case, your money may be stuck for a few days (maybe even a few weeks!), but you should get everything back reasonably quickly.

Brokerage accounts, on the other hand, are not insured by the FDIC. Instead, they are insured by the SIPC. SIPC insures all brokerage accounts up to $500k, though only up to $250k of that can be cash. You can get around the $250k cash limit by buying a money market fund (more below), because these are securities and covered up to the $500k limit, or by buying other short term US Treasury ETFs.

Note: When opening a new banking or brokerage account, be sure to check that:

  • The bank/brokerage is legitimate. There have actually been cases of scammers pretending to be small banks/brokerages and then running off with the money.
  • That the account is insured and under which plan (FDIC or SIPC). Some banks actually have brokerage arms, while some brokerages have bank arms, and it’s not always obvious which arm your assets are put under from a legal perspective.
  • Some brokerages provide 3rd party insurance on your assets above the FDIC/SIPC insurance limits. The details vary based on the brokerage, and for the most part, these insurances have not really been tested before. So while it’s better than nothing, these schemes may not end up protecting you 100%.

Now, in general, absent fraud or heavy losses (like SVB), the assets will be at the bank/brokerage even if it fails. So, the FDIC/SIPC will generally be able to return you all your assets, once they have time to untangle the whole mess, even above their insurance limits. The FDIC/SIPC isn’t going to make off with the excess assets once they pay out their insurance limits, don’t worry.

In the case of brokerages, the assets are actually held at a depositary institution (DTCC), which provides another layer of security — the brokerage going down just means that the SIPC needs to talk to the DTCC to get your assets back, and then go through the brokerages’ books to figure out who owns what. Again, this works only if there is no fraud — if the brokerage is secretly selling your assets to buy beanie babies or magic beans, then you’ll likely be out of luck. Note that DTCC only holds securities — cash you hold at your brokerage is generally held by the brokerage itself, or whatever bank arm it has.

Money market funds

If you hold your assets at a brokerage, then you have a separate choice to make — how do you keep the assets? While bank accounts only let you keep the assets in cash, brokerage accounts offer you the option of keeping it in cash or buying securities. If you want to maintain the liquidity of your cash, one good option is to buy a money market fund.

Money market funds are offered by many financial entities, including brokerages. You may have heard of, for example, the Schwab Money Fund (SWVXX), which currently has a 7-day yield of 4.48%, much higher than what most bank accounts offer. Note that just because you hold cash at Schwab, does not mean that your idle cash will be invested in SWVXX — you have to make the conscious decision to buy SWVXX!

In general, most funds (including mutual funds, money market funds, ETFs [exchange traded funds], private equity funds, etc.) have 3 components — there is the fund itself, which is a separate company and separate legal entity. There is a sponsor (also called general partner, administrator, manager, managing partner, etc.) who manages the fund, but does not actually hold the assets (i.e. they are not legally allowed to use the money for their own purposes), and finally there are the investors (also called limited partners, partners, investors, shareholders, etc.). In the case of our example (SWVXX), Schwab is the sponsor, SWVXX itself is the fund, and whoever buys shares of SWVXX are the investors.

Because of the sponsor vs fund setup, and again, absent fraud, the assets in the fund are typically safe even if the sponsor goes bust. In particular, money market funds are, by law, only allowed to invest in certain very safe short-term assets, so the chance of them breaking the buck is extremely low (in all of history, I believe only 2 funds have ever done that). Also, money market funds are not allowed to use leverage, making them even more safe.

When choosing a money market fund, be sure to pick one with reasonable yields (some have low yields because they are administered badly, others have low yields because they are tax exempt, so be sure to pick one that makes sense for you), and be very careful to pick one sponsored by a reputable sponsor. Shifty G may sound like a really cool guy, but I wouldn’t necessarily buy a fund that they are sponsoring.

Money market accounts

One thing to be very careful of, is the distinction between money market funds and money market accounts. Money market funds are separate legal entities as described above, from their sponsors. Money market accounts are typically bank accounts that invest in money market instruments (i.e. the same stuff as money market funds). So while the assets held by the money market accounts and money market funds are themselves pretty safe, money market accounts are subject to the $250k FDIC insurance limit and all the caveats discussed above, instead of the more generous SIPC $500k limits. Not to mention that because money market funds are separate legal entities, they have an additional layer of protection against the sponsor going bust.

Exchange traded funds (ETFs)

If for whatever reason you cannot invest in a money market fund in your brokerage account, you can also buy short term US Treasuries ETFs. ETFs, by their fund nature, share the same sponsor vs fund vs investor legal separation discussed above, so the assets are generally quite safe.

However, because ETFs are traded (money market funds are not traded, they are bought/sold directly with the fund), their price fluctuates. While a money market fund may have paper losses on a day to day basis, the fund generally keeps its per share value at $1, and absent fraud or serious financial issues, you will be able to redeem your shares for $1 per share. ETFs, however, are traded, and so every paper gain or loss is reflected immediately in the share price.

In general, this is fine — for a ETF that invests in very short term US Treasuries, the chance of a permanent loss is small, and the chance of a large gain or loss on a daily basis is also very small. What you’ll generally see, is that the ETF’s per share value goes up slowly over time, and then drops suddenly. Don’t panic — these drops generally are due to the ETFs paying out dividends, so the share price is decreased by the value of the dividend.

Exchange traded notes (ETNs)

If you have a brokerage account, you may have come across something called an ETN. Collectively, ETFs + ETNs = Exchange traded products (ETPs). But other than being exchange traded, ETFs and ETNs are very different beasts.

A note, in finance nomenclature, is a debt instrument — so if someone borrows money from me, one way we can denote that debt is for them to issue a note to me, indicating the amount owed. In other words, notes are a form of broad money.

And that is the clue — ETNs, unlikely ETFs, are generally NOT separate legal entities from their issuers. Instead, an ETN represents a debt that the issue has to you. So, while ETNs are generally subjected to the same $500k SIPC insurance limit, they do not really protect you very well if the issuer goes bust.

I don’t know if there are ETNs reflecting short term US Treasuries, but given the wide availability of money market funds and ETFs, I wouldn’t go anywhere near these ETNs.

WDJBD

Given this wide array of choices, what does JB do?

If you follow me on Stockclubs (disclaimer: I’m an investor in this app), you’ll know that a large chunk (over 95%) of my portfolio on display is in a money market fund. For reasons I may get to in the future, I am currently remaining liquid with some smallish option trades on the side.

That account represents 1 (out of 10+) of my brokerage accounts — In total I have 5 checking accounts, 2 savings accounts and 10+ brokerage accounts. This allows me to keep well below the various insurance limits in each of the accounts, and still remain very liquid for my purposes.

In each brokerage account, excess cash is generally held in a tax advantaged money market fund (in taxable accounts) or a regular money market fund (in tax deferred accounts), while cash in the checking/savings accounts are reduced to only just what I need to ensure I don’t miss my bills.

In effect, I have partitioned my liquid assets into multiple tiers of liquidity (for the computer science folks, think of it as multi-layer caching) — my checking accounts hold the cash that I expect to need to pay my bills due this month, plus a little bit of buffer for unexpected stuff. My savings accounts hold the cash that I expect to need for the next ~6months. The brokerage accounts hold the cash that I expect to need for investments or for the next ~12 months.

This setup gives me flexibility, while ensuring that every dollar of asset(3) is covered by applicable insurance limits. It does make things a little complicated to manage, so a good system of bookkeeping is definitely required (I use Quicken).

Footnotes

  1. While both loans and bonds are debt, they are not quite the same thing. All bonds are loans, but not all loans are bonds. The difference is similar to the difference between options and warrants or shares and units — bonds, options and shares are types of loans, warrants, units with well defined properties that are enshrined in either contracts or regulatory rules. Because of this standardization, each bond of the same tenure from the same issuer, each option of the same expiry and strike of the same underlying, and each share of the same class from the same company are fungible, and thus can be traded on a public exchange.
  2. A company’s treasury is its financial assets, managed by a treasurer (or CFO).
  3. Note that I also have private equity investments, which are not covered by any insurance at all. Can’t have it all, I guess.
  4. The first copy of this post used 30year Treasuries as an example of broad money. I was later informed that most (all?) academic endeavors generally stop at 2year for the definition of broad money. Obviously, I prefer a definition that is broader, and readers can draw their own conclusions about the narrowness of that thinking in academia. Just kidding… I made a mistake, it’s fixed. ;p

The stock market is forward looking

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Foreword

For the past few months, I have been working with my favorite financial journalist, Matt Levine of Bloomberg on a new series of podcasts that will be released all at once at a date to be announced. Here’s a sample of some choice clips.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

#1

ML: So, JB, what do you make of the Tesla stock price action today? Tesla previews some bad delivery numbers and TSLA stock is down?

JB: Yes, Matt. That’s because the stock market is forward looking. The numbers suggest strongly that demand for Tesla vehicles is drying up — the wait for a new Tesla vehicle is dropping and Tesla is still ramping up production. Soon, the legendary line of buyers may just run out and then they’ll have a huge oversupply problem.

#2

ML: We talked about TSLA stock being down the other day, but it seems the stock is up strongly today. What’s your take, JB?

JB: Well, Matt, that’s because the stock market is forward looking. Elon announced a series of price cuts, and it appears demand for their vehicles is up again, despite the ongoing supply ramp. It appears the market is pricing in a steady state of more demand and supply, leading to high growth for the foreseeable future.

#3

ML: Wow! TSLA stock just dropped 5% today after hours. What’s on your mind, JB?

JB: That’s because the stock market is forward looking, Matt. Investor Day was a dud — the market was expecting new products at lower price points to attract new customers, but Elon kept talking about their existing products and incremental improvements. The market is looking at the future, and right now, there’s not much in that future to be excited about!

#4

ML: And just like that TSLA is BACK! What’s up with that?

JB: Matt, Matt, Matty! That’s because the stock market is forward looking! The consumer spending numbers are good, so future demand for Tesla cars should be good, and the market sniffed that out.

#5

ML: So what’s the market sniffing out this time? There’s no news and TSLA is down 9%!

JB: Ah, Matt, that’s because the stock market is forward looking! The last consumer spending numbers were too good, and the market is now predicting higher inflation for longer. The Fed will need to hike harder, driving stocks down. It’s all about discounting the future, and the discount rate just went up!

#6

ML: So… TSLA is up 15%. In one day. What?

JB: We’ve talked about this Matt, the stock market is forward looking — the Fed is going to hike rates too much, and that is guaranteed to lead to a recession. The market sniffed that out, and is now pricing in the Fed cutting rates to fight the recession! Rates down, stocks up. Simple as!

#7

ML: … and TSLA is down 14% since the last episode. Any comments?

JB: Well, the stock market is forward looking, and it appears the stock market is pricing in the Fed hiking rates again after the coming recession to fight the next wave of inflation. It appears they’ll overdo the liquidity injection in the future.

#8

ML: Holy <bleep>, TSLA is up 50,000% since we started recording. What is happening?!

JB: Ah yes, the stock market is forward looking and hard at work. With the next wave of inflation so high, and the Fed forced to hike to 20%, it appears stocks will drop by 99%. With Tesla’s Bitcoin holdings, the market is pricing in Tesla buying out the entire US stock market for pennies on the dollar. TSLA is the new SPY, baby! The future is bright and the stock market sees it!

#9

ML: After the last session, I bought TSLA with all my life’s savings and now it’s down 99.99%. This podcast better work, or I’m ruined!

JB: I’m sorry Matt, but the stock market is forward looking. After Tesla buys out the entire US stock market, Elon sold a large chunk of his TSLA shares to fund SpaceX’s research. It won’t happen for another 20 years, but the market sees the future, and is pricing that in now. I’m sorry man, Elon selling stocks 20 years from now is causing you the pain, I’m afraid.

#10

ML: OK, for some reason, TSLA is up again and I’m at least at break even. What a ride!

JB: Indeed, Matt! The stock market is forward looking, and pricing in SpaceX coming up with a fast and cheap transport to Mars, leading to a whole new world of resources for humans to gather and exploit. The future is bright again!

#11

ML: Yep, down again. I’ve been meaning to ask you JB, I get that the stock market is forward looking, but why would TSLA stock go up if SpaceX discovers transport to Mars?

JB: Oh Matt, Matt, Matty… the stock market is forward looking, and it appears it thought of the same question! Tesla and SpaceX are two separate companies, duh! That’s why the stock market is correcting, it is looking forward and it sees this!

#12

ML: … words fail me.

JB: The stock market is forward looking, and it’s apparently pricing in Elon Musk attempting a private take over of TSLA 40 years from now! $420million per share, funding secured!

#13

ML: <bleep>, <bleep>, <bleep>!

JB: Ouch. Matt. The stock market is forward looking, and it appears it is pricing in space aliens attacking Earth after Elon Musk, our future lord and savior departs for Mars permanently. Earth will be in ruins Matt, your life savings is really quite insignificant compared to that. Kids will be murdered, Matt! Kids! Oh, why does nobody ever think of the kids!?

#14

ML: … And we’re back again. To the Moon! I mean, Mars!

JB: The stock market is forward looking, truly amazing! It appears in the future humanity fought off the aliens! Whew, that was close! For a moment I was worried that I may have to learn a new language.

#15

ML: Wait, is TSLA trading at $0? Is that even legal? Who is giving away TSLA shares for free?!

JB: Yep, I was afraid of this. The stock market is forward looking, and it appears it is pricing in the Sun imploding — no Sun, no plants. No plants, no oxygen. No oxygen, no life. No life, no customers. Imagine what that will do to Tesla’s ROI. Man, what a nightmare!

#16

ML: Wait, is that $8? Why is it sideways…?

JB: That’s infinity Matt. The stock market is forward looking, as always. With the Sun having imploded, all life is gone, and money is worthless. So you might as well buy TSLA shares with infinity dollars per share. I guess hyperinflation is coming after all.

Podcast details

Thank you! I hope you enjoyed the little selection of clips from our new upcoming podcast.

If you are looking for details on how to download the podcast when it comes out, or if the talk of the Sun imploding is causing you trauma, and, this is very important, if you are a financial advisor, follow these instructions in bold and immediately stop reading: Look up, smile politely and say, “I’m afraid I can’t help you”. Then show the person in front of you out of your office.

If you are looking for details on how to download the podcast when it comes out, or if the talk of the Sun imploding is causing you trauma, and I guess you can’t be a financial advisor — I think it is probably prudent for you to stop managing your own finances. Go out, find a financial advisor, show them this blog post, and they’ll know what to do.

If you are either laughing, rolling your eyes, or trying to get the last 10 minutes of your life back, and you are a financial advisor, please treat the person in front of you delicately. I think they desperately need your help.

And finally, if you are either laughing, rolling your eyes, or trying to get the last 10 minutes of your life back, and just a regular person, here’s the truth: Given any situation, it is always possible to find reasons for why it would make stocks go up, down or sideways. This is even more true if you have an arbitrary “future” point in time for which to extrapolate to.

“The stock market is forward looking” is true to some extent, but the stock market is just a bunch of people trying to outsmart each other — there is no magic. Yes, some of them are indeed very smart and have done the research. But the vast majority are just regular folks like you and I, and we’re just doing our best. So, not everything the stock market does is rational, and not everything can be explained, and sometimes the stock market moves, simply because it just wanna.

Stockclubs

There is no podcast, but if you want to see what I’m doing in one (out of 10+) of my brokerage accounts, do check out Stockclubs, an app that I’ve invested in, which lets you share your trades and see what others have shared.

Partners

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Foreword

What are you actually getting yourself into, when you buy shares of a company? Or the bonds of a company?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

History lesson

The first known business corporations were formed in 16th century England. These were mainly linked to the crown and were given monopolistic powers over certain sectors of the economy by the crown. At around the same time, partnerships between private individuals were also being developed, mostly by merchant guilds and other large private organizations(1). With time, these two models took ideas from each other and the culmination resulted eventually in the modern day corporations that we know today.

Originally, corporations were joint ventures, where every shareholder signs up for the venture by entering into a contract with each other. The contract dictates the rules of incorporation, what responsibilities each member has, and also how profits are to be split, forming the basis for the modern capital stack.

Around the early 17th century, the modern joint ventures with limited liability partners signing on via buying shares was invented(2) and that eventually evolved into the stocks and shares that we know today. Each share effectively represents a pre-negotiated fractional share of the company, and within each share class, every share was identical. This treatment allows for shares to be easily sold and traded by removing the friction of having to individually negotiate the ownership with each new investor.

Partners

When you buy shares or bonds of a company, you are, literally, entering into a financial arrangement (bonds are contracts, but shares are not quite contracts, though close) with the company — its management, other shareholders and debtholders. These 3 groups of people (management, shareholders and debtholders) have gotten together to collectively fund and run the company and its businesses, hopefully to the benefits of all parties, according to the articles of incorporation.

In fact, from a legal perspective, as a shareholder, you are literally part of the group that hires the management to run the company on your behalf.

Think about that for a minute.

While buying shares on your brokerage account feels abstract and impersonal, from legal and financial perspectives, it is not really very different from buying a part of a private company, where the contract can be negotiated in a bespoke manner. Now ask yourself these questions:

  • Would you go into business with a known fraudster?
  • Or someone who has a history of promising grandiosity, but delivering mediocrity?
  • Or someone who sells large portions of their shares while encouraging others to hold on to their shares?
  • Or people with a known history of fickle relationships with the truth?
  • Would you hire someone with the above traits to run your company for you?

And if your answer is no to any of the above, then consider if you should or would buy shares in companies that have majority shareholders or managements (collectively, “insiders”) with similar traits?

Shenanigans

While the law set by Congress and rules set by the SEC/FINRA bound what insiders of companies can do, laws and rules are, by their nature, static while human creativity is dynamic and always changing. So, while the laws and rules prevent insiders from outright defrauding other shareholders, there are still many loopholes and legal grey areas that the less scrupulous insider can exploit, often with the result of enriching themself at the expense of others.

As investors, it is paramount that we look out for such behaviors, identify the perpetrators, and refuse to enter into partnerships with them ever again. Because while in the short term we may benefit from their unethical ways, there is no telling when they may turn on us — after all, a series of spectacular returns is still 0 after an eventual 100% drop.

Footnotes

  1. Additional reading: https://www.britannica.com/topic/corporation
  2. Additional reading: https://www.britannica.com/topic/joint-stock-company

Value System

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Foreword

In this blog, we talk a lot about “value” — intrinsic value, extrinsic value, productive value, etc. What does it mean exactly, though, what is value? In this post, I try to put a definition on what I mean by “value”.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

My values

We’ve discussed in multiple prior posts about this amorphous thing called “value”, and at times, I’ve adorned it with a prefix like “intrinsic value” or “extrinsic value”, but I’ve never really defined what these mean.

The idea of “value” is ill-defined in finance, and in many cases, is simply synonymous to “price” — for example, in some states, the value of your home on which your property taxes are based, is simply the price you bought the home at, and the value of your stocks portfolio is generally defined to be the sum of the last traded price of each asset.

But in economics and finance, sometimes there is a distinction made between price and value, yet value is very often not clearly defined — certainly, if you ask 10 different economists/financial observers, you’ll likely get 11 different definitions of “value”.

So, here to make things clearer (or murkier?), I’m putting forth my own definitions of value, of which there are 4. Yes — ask 1 single JB, you’ll likely get 4 different definitions of “value”.

Intrinsic value

Intrinsic value is the value something has, because someone wants it for the thing itself. For example, a piece of bread has intrinsic value — it sustains life and affords temporary reprieve from hunger.

Extrinsic value

Extrinsic value is the value something has, because others prescribe it value beyond its intrinsic value. For example, a dollar note has very little intrinsic value — if you are desperate, you can burn it for a few seconds of heat, but that’s about it. However, a dollar has exactly one dollar of extrinsic value, because others are willing to trade you things of value for your dollar.

Productive value

Productive value is the value something has because it is able to produce other things of value. For example, a well run, profitable business has productive value — it produces goods and/or services that are valuable and which can be exchanged or sold for other things of value.

Speculative value

Speculative value is the value something has that is above and beyond all the values above. It is generally the value someone, including yourself, may ascribe to something, simply because that someone think yet another someone else may value the thing at some value beyond the values above.

Breakfast at the beach

Let’s say you are on a deserted island with no food. For whatever reasons, you have infinite dollars with you. What would you pay for a slice of bread at that very moment?

Given that the island has no other sources of food, the amount you would be willing to pay, would be somewhat commensurate with how hungry you are (time difference between now and the last time you bought bread) and how long you think rescue will come. Therefore, the intrinsic value of that slice of bread increases with time, until you buy it, at which point, it’ll drop slightly as you are sated, but start growing in value again until the next time you are hungry. It would be entirely conceivable, for you to pay $1m or even more for that slice of bread in this situation.

If, however, you are in the middle of Manhattan, with all its wonderful choices attending to all kinds of appetites, a slice of bread would very properly drop in value, to almost nothing.

So, on the deserted island, the extrinsic value of money dropped significantly, because there simply isn’t any other merchants for you to spend your money. But in Manhattan, the extrinsic value of money grew comparatively, because you are spoiled for choice.

In the opposite way, the intrinsic value of bread increases to almost infinity as you are starved for food on a deserted island, but drops to almost nothing when you are in Manhattan, surrounded by much more choices of food.

As with intrinsic value, productive value, being a derivative of the other types of value, will, too change based on the circumstances. Back on that deserted island, a magic machine that produces a slice of bread a day would be worth fortunes — you may even be tempted to give up your entire infinite wealth. But in Manhattan, most would barely pay a few hundred dollars for it.

Buffett value

Warren Buffett is often cited as having said

Price is what you pay. Value is what you get.

Warren Buffett

To put that in our value framework, “price” would be the money you hand over, i.e. the extrinsic value you give up, and “value” would be the things you get in return, the sum of the intrinsic, productive and speculative values.

While we’ve said that the exchange rates between intrinsic, productive and extrinsic values can change, the value of speculative value is entirely in the difference — If you paid $10 for something with $1 intrinsic value and $2 productive value, then you must have paid 10 – 1 – 2 = $7 speculative value for it.

Unlike the changes in intrinsic and productive values under different circumstances as we’ve discussed above, changes in speculative value are almost entirely based on changes in mindset and sentiments. It is changes in speculative value, when a stock trades $100 one moment, and $101 the next, absent any relevant news.

And that difference is key. While intrinsic, extrinsic and productive values rarely change dramatically from minute to minute or even day to day, speculative value can and do change almost continuously. If someone bought a stock at $100, someone else may see the trade and think “what do they know? I should buy at $101!”, and yet someone else may see the trade and think “what does the seller know? I should sell at $99!”.

This uncertainty, this second guessing, this random flights of fancy and random depths of despair, they are what drives speculative value, and because the reasons for changes in speculative value is so fickle and the results so extreme, it is rarely a good thing to rely solely on speculative value when you are trading assets.

Net worth

It is with this in mind that a well thought out financial plan should include some cash buffer and sources of cash flow (dividend stocks, bonds, etc.). Because while it is generally true that non-dividend paying stocks tend to increase in value faster over time, if your entire portfolio is in non-cash and non-cashflowing assets, then you will always be subject to the whims of speculative value — to the whims of how much others feel they should pay you for your assets.

And remember, you cannot eat net worth. Especially if it is ephemeral, and the market simply ascribes lower (or even negative!) speculative value to your assets right now.

StockClubs

As you may have heard from prior posts, I am an investor in StockClubs, an app which lets you share your portfolio (or part of it) with others. While it is still in heavy development, the team would greatly appreciate any feedback!

Fairness

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Foreword

Some people are born with a silver spoon in their mouths, others inherit healthy trust funds or major companies and never need worry about money in their lives. Yet others strike the lottery, or stumble upon buried treasures in their backyards. How is any of these fair?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Conversations

For the past 10 odd years, perhaps more, millennials (1) have been complaining of the short end of the stick they’ve been given, especially by the baby boomers. The gist of the complaint goes along the lines of baby boomers in power have rearranged rules and laws, such that they have benefited unfairly, for example the housing boom (which benefited boomers the most), the financial boom (again, boomers were the main beneficiaries), etc. At the same time, millennials complained that boomers have left us a pile of trouble, including global warming, geopolitical tensions, divided politics in the USA, etc.

Talking to my software engineering compatriots, many of them are completely gloomy about their future prospects, with some predicting they’ll never be able to afford a home, never be able to afford kids, get married, retire, etc. Most of them are convinced the only real way they can ever get ahead in life is to win the lottery or otherwise cheat in a “rigged game”.

Childhood

A long time ago, when I was little, around 6 or 7, my family visited a small island in Indonesia, then a third world country, and fairly poor by most standards. Upon arrival, we were swarmed by a swarm of kids, most around my age, more than a few younger. One of them made a particularly strong impression on me, an impression I remember to this day:

The kid, who was probably around 4 or 5, was running with a shallow wooden drawer strapped to his neck and balanced on his belly, filled with various sundries. He was going around, clearly asking anyone to buy something from him.

I had no need of the goods he was peddling, and I had no money anyway. But for some reason, I felt sad that this was the life of someone who otherwise was so similar to myself, and I offered him the only thing of value I had at the time — a sticker of the Teenage Mutant Ninja Turtles (2) that I was particularly proud of, and carried around with me all the time.

The child stared at me like I was mad, shook his head and eventually ran off. I couldn’t explain to him that it was a gift, that I wasn’t expecting to trade it for something — he spoke no English and I spoke no Indonesian, and that was that.

To put things in context, the most expensive thing on his drawer was a 25c (rough equivalent of local currency). I paid a friend almost double that for the sticker.

Blessings

For the vast majority of folks who were born in the USA, Canada, western Europe, the richer countries in Asia (Japan, South Korea, Singapore, etc.), the raw truth is that you’ve already won life’s first mini lottery. If you don’t have to worry about clean running water, if you can reasonably trust your doctors and leaders, if you can step out of the house in the middle of the night without reasonable fear of being harmed, then compared to the majority of the world’s population, you already have it pretty good.

If you further were born in one of the first or second tier cities, or at least in the suburbs of one, then you’ve won the second lottery. Access to life’s opportunities are disproportionately available to those who live near the centers of finance, typically the tier one and two cities.

Finally, in addition to all the above, if you were afforded the chance to attend K-12 schooling, or even better, if you had attended college, then you’ve pretty much struck the lottery. As long as you do reasonably well in school, you are almost guaranteed a decent selection of jobs.

Software engineers

Rounding back on my software engineering compatriots — I’m fairly certain that all of them make a 6 figure salary, and most make $200k or more a year, with more than a few going much higher. Even if many of them live in the San Francisco Bay Area, infamous for being one of the most ridiculously expensive places to live on Earth, it is instructive to note that those in the same area not so fortunate to work for a large tech company will be lucky to see a 6 figure salary (3).

So, yes. Life is unfair, and some people just have it easier in life. Welcome to Earth, blah, blah, blah.

But maybe let’s not rub it in other people’s faces?

A bit of light heartedness

And with that, I leave you with a little bit of light heartedness. Happy New Year!

Stocks, why’d it have to be stocks

Because this is, after all, a finance blog. On the topics of being broke, for those who want to see what crazy shenanigans I’ve been up to, and how fast I’m going broke in my brokerage account, you can follow 1 (out of 10+) of my brokerage accounts on StockClubs, an app I’ve invested in.

Footnotes

  1. Disclaimer: I’m a millennial.
  2. Don’t judge. TMNT was hot stuff back then, and TMNT stickers and Ghostbuster stickers were basically money to kids in my school.
  3. Per capita income in San Francisco Bay Area in 2021 is just under $80k. Source.

January 1, 2023: New Year’s video binge – The Global Everything Crisis

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Foreword

This is a quick note, which tends to be just off the cuff thoughts/ideas that look at current market situations, and to try to encourage some discussions.

Money & Macro Talks interviewed one of my favorite YouTubers (Patrick Boyle) about a variety of financial topics that I’ve touched on in the past. Certainly worth a listen if you are interested in finance.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Boyle, oh Boyle!

Related posts I’ve made in the past on topics discussed (in the order they are discussed in the video):

Efficient Market Hypothesis

Save Banks First

Genius level stock trader

All Money is Debt

Regulations

Price vs Value

Stock Clubs

In the vein of crises in the financial markets, I’ve recently picked up some puts on various assets for the new year. You can see part of my portfolio (1 out of 10+ brokerage accounts) with Stock Clubs, an app I’ve invested in.

December 10, 2022: Weekend video binge – Josh Brown’s End of the Year Chartapalooza!

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Foreword

This is a quick note, which tends to be just off the cuff thoughts/ideas that look at current market situations, and to try to encourage some discussions.

Just watched (really just listened) a great video summing up the year, and how investors should really think about their portfolios.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Watch this

Josh Brown’s End of the Year Chartapalooza!

For this who are too busy/lazy to watch the whole thing, here’s a little glimpse which starts at 38m 38s (direct link):

So I think there was like this widespread mental illness amongst people who were like 16 years old, men, young men, who were like 16 years old and 35 years old, where in the last couple of years, they like discovered the markets and they followed a lot of people who were unqualified to be followed, and they did a lot of things that were inadvisable, and some of those things in the early going were like working, so they kept going, or they used margin, or they graduated from buying a stock to buying a stock on margin to buying options, like the, all of that stuff had to get wiped away. Like it, it had to, it was very unhealthy, it was like this young male, toxic energy of like, you know, I don’t need to learn anything, I don’t need to listen to you, I don’t need a job, I just need to wake up and trade shit on my phone.

…

And it hasn’t been replaced by anything, there’s like a vaccum now. What are these people doing? We know they are not trading. Look at Robinhood, common stock, look at Coinbase, we know they are not trading, that’s the one thing we know for sure. We don’t know how many of them started reading books, god forbid, and like actually learning about investing and actually, like, came to the ephiphany that like people have done this before?

…

So, it’s fine, it’s fine though, like because nobody comes into this smart, and you have to lose money to learn how to not lose money, like, it’s, it’s a progression. So we don’t know what’s gonna take its place, I don’t think, erm, that somebody’s gonna go from crypto to 60/40 indexing, it’s probably going to be a step in between and maybe that’s like the value stock rally now. Maybe that’s like people realizing like oh you mean you can buy like an oil stock, and they don’t make semiconductors, and it, stuff actually goes up?

…

It’s not a smart vs dumb thing, it’s like you have to do this for a while, to understand how it works, and what the stakes are. So, er, I don’t know where the puck goes next, but we’ll see if we get a wizened class of investors out of this.

https://www.youtube.com/watch?v=L6fC1r_QsLE&t=2318s

December 6, 2022: Stocks are cheap?

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Foreword

This is a quick note, which tends to be just off the cuff thoughts/ideas that look at current market situations, and to try to encourage some discussions.

I keep hearing people say that stocks are cheap, because they are 10, 20 (or in some cases 90)% below their peaks. Are they though?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Bovine Stool

For the sake of decorum, let’s say I have a pile of, ahem, bovine stool. Let’s just call it BS for short.

OK, I have a pile of BS. It’s a pretty big pile. Are you willing to pay me $1m for it?

No?

What about $500k! It’s 50% off from peak!

Would you buy my BS for $500k?

Last offer, $100k, 90% off! Yes?

EMH

One criticism I hear of the example above, is some form of EMH style argument — Markets are efficient/smart/sortof-efficient/whatever, so if you buy at this temporary dip, you’ll make a lot of money.

Cool, if markets are efficient/whatever, what makes you think it was efficient then, and not efficient now?

Or, maybe, it will be efficient after your favorite stock drops another 50%?

Summary

Just because something is selling for X% less than it used to, doesn’t mean it’s on discount for X%.

It could very well mean that it’s still overvalued by Y% (Y > 0), and waiting a bit will get you a better price. If your entire thesis is that “Stock Z has dropped X%”, so it must be cheap, then I suspect over the long run, you’ll be very disappointed in your portfolio performance.

To be clear, I’m not saying stocks are overvalued (or undervalued) right now. I’m just pointing out that comparing a stock’s current price vs its prior price at some point in time, and ignoring everything else, makes no logical sense.

Regulations

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Foreword

AML, KYC, MIFID, RegNMS, RegT, SEC, CFTC, FinCEN! Regulations and regulators! If you’ve ever worked in finance, you’ll know that the alphabet soup of regulations and regulators that need to be followed is long and overwhelming. Do we really need all of these?!

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Cost of regulations

If you’ve ever worked in a financial company, you’ll know that other than legal, there is a compliance department, whose job, it seems, is solely to make your life miserable. “Can I do this?”, “No”. “How about this?”, “Hell, no”. “What can I do?”, “I’ll get back to you in a month. Or year.”

And to rub salt into the wound, compliance folks do not come cheap. Every large bank spends millions to possibly even billions every single year for compliance related reasons, or, in cases where there is a compliance lapse, for fines. All of these costs are directly the result of regulations mandated by regulators. And like all costs to a business, all these are directly or indirectly paid for by clients.

Which means, yes, you are getting a lower interest rate from your savings account, in part, because some of the gains are taken by the bank to pay for compliance. You are paying a higher fee (either directly or via spreads) when you trade stocks, because the broker needs to take part of your profits to pay for their compliance. You are paying a higher mortgage rate, because, you guessed it! The mortgage company needs to pay for compliance.

Is it really worth it? What about a world without regulations?

Road to Alabama

Let’s say you are driving in a car, on the way to Alabama (1). This is the new world, a freer world, a world where there are no rules. Street signs? Nope. Traffic laws? No, siree. Speed limits? LOL. You get the idea.

How would you drive? On the right side of the road? Is the right side still the right side? There are no rules!

How fast would you drive? What if you drive too slowly for someone in a fancy car and they decide to just bump you off the road? Again, no rules!

How do you navigate a roundabout? Go straight through over the middle? Turn left? Or right? NO RULES!

Would you even dare to drive?

Confidence

Let’s say you have $100k, and you need to stick it somewhere. Somewhere safe, so not your mattress. What would you do?

Would you give the money to your next door neighbor Blair, and ask them (nicely) to take real good care of it and leave it at that?

Would you give the money to your local loan shark? After all, Cameron seems to be really good with money!

Would you put the money in the bank?

I’m guessing most people would say the bank, and the next question is… why?

Insurance

One of the reasons why folks tend to choose the bank for largish sums of money, is because of the FDIC insurance. If the bank goes under, or there is fraud and the money is lost, or pretty much anything else, the FDIC, an agency backed by the full might of the US Government, will make you whole. It may take a few days or even weeks for them to sort out the mess, but you can be sure that you’ll get your money back. In full.

Are you confident of getting your money back from your Blair? Or Cameron the loan shark? What if they just laugh in your face when you ask nicely to get your money back? Who you gonna call (2)?

Now, how does FDIC insurance works? Why would the FDIC subject itself to this? What if the banks just collectively decide to defraud the entire nation, take all the money and go live in the Bahamas with their slightly scandalous college room mates?

Well, that’s where regulations come in. The FDIC is playing a statistics game. They know that regulators regularly conduct checks on the balance sheets of banks, and that if anything goes wrong, certain folks at the banks are personally liable and may very well spend the rest of their days in jail. Now, bankers make a lot of money, especially if you are at the top of the food chain in a big bank. Like, a lot, a lot. But a lot of money is really only useful if you actually get to spend it freely — it’s really no fun spending money whilst in jail. So there is just that amount of incentives for bankers, and thus banks, to toe the line.

Yes, not all bankers and banks will toe the line. Some will think they can get away with it, and maybe they can! And some other banks are just unlucky and make bad bets. Like, who would have thought calls on AMC would go to 0? So some banks go under, and the FDIC pays out for those banks. But because the vast majority of banks don’t go under, collectively, the FDIC manages to stay afloat by collecting a small premium from every bank, and directing those premiums to bail out customers of the banks that do go under. Insurance, at work.

And the thing that gives the FDIC that confidence? The thing that allows this statistics game they play? Regulations. Regulations which detail what banks can and cannot do with your money. Regulations which mandate banks keep a minimum amount of liquidity (float), and regulators which conducts checks to make sure the banks are following the rules.

Confidence, again

Other than insurance (and also for insurance, because this is something FDIC, SIPC, other insurance companies depends on), is the fact that by putting down regulations, and setting out what a bank and broker can or cannot do with customer money, it dramatically reduces the surface area of shenanigans that bankers and brokers can do.

Yes, some of the more creative ones will still do stupid things. And some of the less scrupulous ones will just laugh at the regulations and do whatever anyway. But the vast majority of them will know where the line is, and while they will push ever so hard against the line, they will likely not actually cross it (by too much).

Because of that self policing, confidence in the economy and the financial system blooms. Businesses can operate, because they know that when they are approved for a loan, their interest rates won’t magically jump 20% tomorrow. Savers can bank, because they know the banks won’t bet it all on red in Vegas. Investors can leave their cash in their brokerage accounts, because they can be sure that the money is likely there, as opposed to being used to buy magic beans or to fund the CEO’s lavish lifestyle (3), and even if the money is lost, the SIPC will make them whole (4).

And this confidence in the system, this ability to know how others will act, and what to expect, these regulations, they allow the modern world to work.

All regulations are equal, but some regulations are more equal than others

That’s not to say that all regulations are good. While most of them come from a good place, a lot of regulations are reasonable, and many regulations are simply needed for the world to even work, there are, clearly, some regulations which were either poorly thought out, or designed with less than altruistic concerns.

Which is not great, certainly, but welcome to Earth, population 8billion (5), where humans fail, and there’s a lot of us around to fail. Get used to it.

The whole point of having ongoing lawmakers is because we know that laws and the rules borne of those laws are not always good or right, and very often become obsolete over time. And the whole point of democracy is so that lil’ ol’ us get at least a bit of a say in how and what the lawmakers do and legislate. If every law and rule was perfect and will always remain perfect, then there’s really no point to having an ongoing government, is there?

So yes, things break sometimes, but hopefully, over time the bad bits will get replaced with somewhat better bits.

But claiming that we should do away with all regulations, because of 1 or 2 bad ones, is simply naïve.

Footnotes

  1. To bring granny a basket of fruits and cakes. In your red car. What else could it be?
  2. Ghostbusters! The answer is, always, Ghostbusters! With the exclamation mark.
  3. OK, fine, bank/brokerage CEOs get paid a lot of money. So maybe some of that. But not all of it.
  4. Currently up to a maximum of $500k, of which at most $250k can be in cash.
  5. Yea, that just happened, in the Philippines, apparently.

All Money is Debt

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Foreword

What is money? What is debt? How are they related?

Some people get all twisted out of shape calling fiat money “debt”, and that only gold or bitcoin or silver or whatever is real “money”. But is that really right?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Debt

Let’s start with the easy one. What is debt?

The Cambridge dictionary defines debt as “something, especially money, that is owed to someone else, or the state of owing something“. That’s fairly clear, ain’nit?

Island adventure

Let’s do a little thought experiment. Let’s say a bunch of people, including you, are on a remote island. None of you know each other, none of you have reasons to trust each other. But for your little society to work, and for everyone’s lives to improve, you need to work together, because it simply isn’t feasible for one person to do everything well — division of labor generally tends to yield much better results for everyone.

One day, one of the strangers, Alex, did a favor for you — they built a little fire pit for you, out of rocks they carried down from a nearby mountain. Your specialty is foraging berries, but Alex already had their meals today, and berries don’t keep long. How can you repay Alex?

One way, is for you to give Alex a token, a symbol of the value you owe them, for their work in constructing the fire pit. This token can be a cowrie shell, a pretty rock, a piece of leaf you scribble a mathematical puzzle that only you can solve, etc., pretty much anything — Anything that both you and Alex agree to recognize as an accounting measure of what you owe Alex.

Now, let’s say you and Alex settle on using cowrie shells — they are hard enough to find that neither of you are concerned about the other using newly found cowrie shells to deceive the other, and the shells are pretty enough that you wouldn’t mind keeping them just for their own sake. Further, let’s say that the rest of the group of strangers feel the same — that cowrie shells are rare enough, and valuable enough in their own right, so that everyone starts offering, and accepting, cowrie shells for goods and services bought and rendered.

Well, congratulations, you’ve just invented money — the cowrie shells are, essentially, money.

As you can see, money is, at least in this case, just a means to measure how much each person is owed by the collective body — the rest of the island (world). It is a physical manifestation of the debt that the rest of the world owes you. Nothing more, nothing less.

Intrinsic value

“Hold on there!” someone will be shouting right about… now, “Cowrie shells have intrinsic value as you’ve said, that’s why they are money”. Yes, I did say that cowrie shells, at least on that island, has some intrinsic value — they are pretty enough that everybody wouldn’t mind keeping them around just to look at them.

But you see, that doesn’t make cowrie shells money. It just makes cowrie shells pretty. There are a lot of things that are pretty, yet are not used as money — a medium of exchange, a scoreboard for tracking how much you owe the world, or how much the world owes you.

Part of the reason why cowrie shells is money on your remote island, is because everyone agrees they are money, and everyone agrees to accept or offer them as representations of value transferred. The fact that they are pretty is mostly irrelevant — the prettiness is a useful property for bootstrapping the economy, but beyond that has no real relevance to the day to day use of cowrie shells.

Similarly, a fiat currency can be bootstrapped into money by, well, fiat — a government can decree that within the borders under its control, some currency needs to be accepted and offered as legal tender for goods and services offered or rendered. The currency need not be pretty in this case for the bootstrapping — the credibility of the government, and how much people believe the government is able to enforce its legal tender laws, is the criteria for bootstrapping the currency. And once the currency is in wide circulation, and everyone agrees to use it as money, then it will be money, and it will, as before, track debt owed to (or by) each individual person.

Hyperinflation

Now, let’s say that for whatever reason a large portion of the population of the island decide not to use cowrie shells anymore at any point in time. They stop accepting cowrie shells, and start using their existing cowrie shells to quickly buy up goods or services from those who still use cowrie shells.

In time, more and more people will recognize that cowrie shells cannot be used to buy certain goods and services, and even though the shells are just as pretty, their “value”, how much each cowrie shell can buy, will start to drop. As more and more people recognize this, they will be more and more willing to exchange cowrie shells for less and less, resulting, eventually, in hyperinflation — the value of money essentially drops to, or close to, 0.

Now, I want to be clear here — hyperinflation and inflation are not the same thing. Inflation is just the regular ebb and flow of the value of money vs goods and services. Hyperinflation, on the other hand, is a loss in confidence in the value of money by a large portion of the populace, which then feeds on itself, becoming a death spiral for the value of money (1). The former is a measure of relative supply and relative demand, while the latter is a loss in confidence of money — two very different things.

You can have very, very high inflation (say 10-20% a year), without actually getting hyperinflation. There are countries with poorly managed currencies with such high inflation numbers for prolonged periods of time, but because enough people still believe in the currency (even if that belief means mentally adjusting by 10-20% a year), that hyperinflation simply does not set in.

In short, high inflation is a crisis of relative supply vs relative demand. Hyperinflation is a crisis of confidence in money.

Another way of looking at it, is that hyperinflation is one way how money stops being money.

Forgeries

Let’s say instead of losing confidence in the cowrie shells, someone stumbled upon a little cove on a remote part of the remote island, where cowrie shells are just all over. They secretly take these cowrie shells and start using them to buy things, and entirely stop working. If they do this at a small scale, most people may not notice, and while inflation may set in (prices will go up a bit to reflect the relative value of money vs goods and services has shifted), confidence in cowrie shells won’t be loss, and life goes on without hyperinflation. If, however, they do it on a large enough scale, effectively introducing a level of supply of money that’s so large that society (the rest of the island) can never repay the debt as symbolized by the new supply cowrie shells, then things will likely go haywire and hyperinflation will likely set in.

To counter the demise of cowrie shells, you found something else, a shiny yellow rock, that is, again, very rare, but because it wasn’t money, nobody has been really collecting it, and so you are the only person with a lot of it. Can you just unilaterally demand everyone use the yellow rock as money? Maybe! Obviously everyone else will be at a severe disadvantage to you, and clearly they won’t like that very much. Some other people can probably find other things, maybe a leaf scribbled with an arcane math problem only they managed to solve, or a series of auditable numbers carved on a giant stone, things that are also hard to forge, but that they themselves have a lot more of than the rest of the island. Those people will also make the same demand that their thing is the new money.

So why yours and not theirs?

Ultimately, the choice of what to use as money depends on the interplay of 2 things:

  1. Who has the clout, the ability (by persuasion or by force) to convince more people to accept their choice
  2. What is the thing most people agree to use

Essentially, being hard to forge, even impossible to forge, does not automatically make something money. Humanity has known for decades about cryptography and how to make essentially unforgeable artifacts. Yet none of these have become money in and of themselves — instead, they are used to secure existing money, by encrypting transactions made in USD, EUR, GBP, etc.

Summary

To become money, having the properties that are necessary for being money is not enough. You also need that bootstrap, and you need that bootstrap to morph into popular support by the populace. Finally, to prevent your money from stopping being money, you also need to maintain the people’s confidence in your money, essentially in perpetuity.

But underlying all of these, is the basic premise, that money is, simply, debt. Money represents debt owed, and is the unit of accounting so that society can decouple the 2 parts of a barter trade — instead of you and Alex trading a fire pit for berries, you get the fire pit now, and Alex gets the berries later, with money acting as a measurement of the debt you owe Alex in between.

Edit:

The key, then, to remember, is that the value of money does not come from within — it comes from without. Money is money not because it has intrinsic value. Instead, money is money because it has extrinsic value — its value is entirely bestowed by the willingness of others to take that money as payment for their goods and services. Claiming something is hard to forge or highly divisible is necessary, but not sufficient. Claiming something has intrinsic value because it can be used in industries, or looks pretty, is mostly irrelevant. Claiming something is backed by something else, is irrelevant, unless that backing is either a form of widely accepted money, or that backing involves the ability to persuade others (again, either by persuasion or force) to accept the backed asset as money.

Footnotes

  1. Wikipedia defines hyperinflation here, which includes a mathematical definition of hyperinflation, which is basically 50% increase in prices of general goods and services on a month over month basis, over a prolonged period of time, essentially the death spiral mentioned above. On a year over year basis, 50% month over month translates to roughly 129x increase in prices per year.