The new landscapes vs. the new eyes

Recently, I read two books one after the other by coincident: one entitled “The Birth of Plenty: How the Prosperity of the Modern World was Created” by William Bernstein, and the other “Talking to My Daughter about the Economy: A Brief History of Capitalism” by Yanis Varoufakis. 

What I found interesting is that despite both going through the same fact pattern in economic history, they seem to take very different viewpoints and come to diametrically opposing conclusions. Having read the books, combined with my own personal life experiences, I have come to the realization that the facts and realities do not matter as much as the lenses through which we allow ourselves to observe the world. 

Indeed, “[t]he real voyage of discovery consists not in seeking new landscapes but in having new eyes”, selon Monsieur Proust.

Apparently, what counts is not what we see, but how we see it. So, let’s be careful in choosing our lenses.

On the Tenth Anniversary of the Bitcoin Whitepaper

Today (depending on where on earth you are) is the 10th anniversary of the release of the Bitcoin whitepaper.

I invite my tech-oriented friends, lawyers, and economists to carefully read it at least once and to contribute to bettering the Bitcoin network. As far as I am concerned, bitcoin is one of the most promising experiments in money in our lifetime, however, it is a work-in-progress and needs more and more dedicated contributors with diverse backgrounds to overcome its imperfections.

For our part, I and my coauthor have tried to shed some light on some of its idiosyncratic features and raise awareness among regulators to help them view Bitcoin as an evolving, work-in-progress, open-source protocol that warrants a nuanced light-touch regulatory approach which is data dependent, defers to the virtues of experimentation, spontaneous discovery process and evolutionary dynamics in the financial system.

For now, I raise my hat for bitcoin’s spectacular success in its first decade and salute Satoshi for his/her/their ingenious work.

PS: Stay tuned! Within a few days, our new paper on central banks and the regulation of cryptocurrencies may see the light of day. More is forthcoming within the next few months.

Ignorance, Debt and Cryptocurrencies

Decentralized, permissionless and blockchain-based cryptocurrencies and their underlying technology are said to have as transformative an impact on value as the invention of the internet had on information. For decades, the double-spending problem was the main roadblock to the emergence of cryptocurrencies. The Bitcoin Blockchain eventually solved this problem in a highly secure, decentralized, consensus-based, and censorship-resistant manner without relying on third parties. This has harbingered the advent of a whole variety of different cryptocurrencies, with varying degrees of societal risk-reward payoffs. Although regulators on both sides of the Atlantic have taken a passive approach to regulating cryptocurrencies, with the increasing popularity and potential success of cryptocurrency experiments, it is likely that governments will take interest and involve in regulating them in the foreseeable future.

In our recent paper titled “ignorance, debt and cryptocurrencies”, building on the seminal work of Holmstrom (2015), we analyze how information economics of Bitcoin, which is built on symmetric (common) knowledge, trumps that of central bank money, commercial bank money and shadow bank money, which is built on symmetric ignorance as to the underlying collateral. We argue that this informational distinction can potentially make Bitcoin a new ‘safe’ asset, holding the promise of maturing into a viable store of value, a potential medium of exchange, and a unit of account. By comparing the information economics of central, commercial and shadow bank money with that of Bitcoin, we highlight important aspects of information economics of Bitcoin that can inform any pending regulatory intervention in the cryptocurrency ecosystem.

In fiat currency context, A is willing to accept a piece of paper as a method of payment in anticipation of B willing to accept it from A, and C willing to accept it from A and B, ad infinitum. For this to happen, the settlement asset should not give rise to any adverse selection problem arising from the information asymmetry as to the value of the settlement asset. In transactional terms, the more adverse-selection proof an asset, the better it is for transactional purposes (medium of exchange). To be adverse-selection proof, the asset should be information-insensitive and its information insensitivity should be common knowledge.

Fiat money, including commercial and shadow bank money, is legally constructed as a debt contract. Finance literature suggests that debt instruments have traditionally been superior to equity instruments in addressing informational problems between the borrowers (issuers) and lenders (shareholders). Debt-on-debt (debt used as collateral for another debt contract) minimizes financial market participants’ incentives to produce private information about the ultimate payoffs (Dang, Gorton, Holmstrom, 2012). This makes debt the least information-sensitive instrument in financial markets. This near-information insensitivity removes adverse selection problems, contributes to the liquidity of debt instruments, helps public adoption and thereby makes them a viable instrument for both market and funding liquidity.

However, no debt instrument, including central bank money, is entirely free from adverse selection problems. There are different methods to mitigate adverse selection. Signaling and screening have traditionally been the two well-known mechanisms to mitigate information asymmetry; the root cause of adverse selection. Another way to address the adverse selection problem is to basically do away with information asymmetry by either shedding sunlight on the settlement asset so that its value would be symmetrically evaluated by both parties to a transaction (common knowledge), or by obscuring and hiding all information so that neither party to a transaction would be able to or would have an incentive to acquire information about the underlying collateral of the debt instrument (symmetric ignorance).

Since an ultimate means of payment and settlement needs to be the most information insensitive asset and be completely free from the adverse selection problem, we argue that for such an asset (money) neither signaling nor screening mechanisms provide complete information insensitivity. Instead, for such an asset to best perform its function as an ultimate means of settlement, its value and underlying mechanisms should be either common knowledge or should not be known to any financial market participant at all (symmetric ignorance). It is no surprise that governments have chosen the latter path. The residual information insensitivity of central bank money (arguably the safest asset in a given market) has been eliminated by making all financial market participants ‘symmetrically ignorant’ of the value of the underlying collateral (a vague promise based on the full faith and credit of the government). This symmetric ignorance of all market participants as to the value and nature of that collateral removes all incentives for participants to acquire any information about the underlying collateral (hence a state of blissful symmetric ignorance).

Commercial bank and shadow bank money use different techniques to create money, but ultimately, all those techniques explicitly or implicitly fall back on the government safety net (government credit and liquidity puts). The main techniques used to create information insensitive assets in the banking and shadow banking system are insurance, (over)collateralization, imposing prudential requirements on issuing entities, and granting preferential regulatory treatment to quasi-money instruments (bankruptcy safe harbors for repos). In all these cases, the value of a safety-enhancing external element (eg, collateral in repos, government credit and liquidity puts in deposits) removes the depositors’ or investors’ incentives to acquire information about the underlying debt contract, making it information insensitive.

The information economics and potential information insensitivity of Bitcoin, however, stands at stark contrast to that of fiat money, as Bitcoin relies on the common (symmetric) knowledge as to the underlying inner workings of the Bitcoin Blockchain. The proposition that ignorance can be turned into knowledge, but knowledge cannot be reversed back into ignorance, is central to the information insensitivity of Bitcoin. Full transparency in the Bitcoin Blockchain eliminates incentives to acquire new information, thereby eliminating the adverse selection problem as to the value of Bitcoin as a medium of exchange. This superior informational feature of Bitcoin can potentially transform it into a potential safe asset, a good store of value, a medium of exchange, and a unit of account.

Given the superior quality of Bitcoin as compared to fiat money and the absence of market failures in Bitcoin in terms of information economics, regulatory intervention would not be warranted. More importantly, since the cryptocurrency industry in general is in its infancy, a hard-touch regulatory approach can hinder the potential welfare-enhancing innovations coming from this ecosystem. However, this suggestion should not be mistaken for an advocacy of regulatory faineance, as the ecosystem suffers from legal uncertainty. To the contrary, this approach is a defense of regulatory sobriety, data dependency, and a deference to the virtues of experimentation, permissionless innovation, the spontaneous discovery process and evolutionary dynamics in the financial system. This being said, the fast and ever-changing cryptocurrency ecosystem should put regulators on alert as market failures and potential for abuse will likely develop swiftly.

This post has been originally published in the Oxford Business Law Blog. 

Some early observations on New York City

• The city never sleeps, and it does not let you sleep. There is so much noise in the air. Perhaps it is part of the vibe and vigor of the city.

• Pedestrians often do not respect traffic lights, and this makes some drivers to blow the horn contributing to a noisier environment. Not surprisingly, sirens are the integral part of the background noise.

• The subway is not very impressive, but very efficient. It’s amazing how many taxi cabs are on the streets in spite of such an efficient subway system.

• The city is great for the young, but not fit and friendly at all for the elderly and people with disability. Only a handful of subway stations are equipped with lifts. Perhaps, that may explain the abundance of taxi cabs. By the way, early-morning subway commuters look pretty tired and depressed.

• If you are coming from Europe, you will be disappointed in how people dress.

• People are straightforward, they do not care who you are and what you think of them, a feature of big-city dwellers. They are by and large themselves.

• The use of smart phones is pervasive and almost everybody is looking at screens all the time, no matter what they are doing. Unlike Europe, commuters do not read much.

• NYC is deeply diverse. So many languages are spoken in public places. Compared to Europe, there are fewer Muslims on the streets. Perhaps they are already integrated in the bigger community/culture.

• NYC is naturally colorful especially at night.

• People are helpful and do not hesitate to offer extra help and information at their own initiative.

• People are humorous, they try to joke around even with strangers.

• Woody-Allen-like characters abound. I used to think Woody was making comedies, but it seems like he was simply filming the realities of the every-day life in New York.

• Compared to Europe, cafes and public spaces are a bit less tidy and neat and more chaotic.  

• People tend to talk a lot to strangers. Everywhere, you have to have a small talk. Overall, this is a good thing.

• Condos and big apartment buildings have doormen! It came as a surprise to me to see doormen opening the door for the residents and greeting them each time they want to enter the building. An 18^th-century-England phenomenon, not fitting my image of NYC at all.

• So far, the internet speed has not impressed me.  

• The universities are superb. Lots of events, amazing lectures, great infrastructure and facilities to bring students together and to allow for teamwork. Of course, it comes with a high price tag.

• Food in Europe is healthier than it is in the U.S., especially in university cafeterias.

• NYC is more expensive than most cities in Europe. If you are shopping or eating out, pay attention to taxes and tips.

• My limited experience suggests that one should be patient with American cities, they always fail to make a good first impression. It takes time for NYC and some other U.S. cities to reveal their beauties. 

On Brexit

Europe, a continent that midwifed the birth of globalization, foster-mothered its infancy, and nurtured it into its prime age, now seems to be retreating into its shell with increasing number of parties and movements in all its corners tilting toward protectionism. Indeed, this time it is not the globalization’s discontents, but its ardent advocates who are pushing globalization off the precipice by pulling the rug from under the EU. But why is it so?

It seems that at the heart of the idea of Europe lies a confusing conundrum. The more centralized and European it becomes, the less transparent and democratic it gets. The bigger the union, the farther away from its alienated citizens.

The forces that push for creation of a centralized union, away from the every-day business of the rank and file, inevitably lead to alienation of citizens from the centralized institutions. And perhaps the Brexit vote could be understood in light of this ever-deepening gap between European citizens and institutions.

Fortunately, the legal and institutional framework of the EU has the capacity to avoid the aforementioned dilemma by taking advantage of the principles of subsidiarity and proportionality and Meroni doctrine in its constitutional arrangements. However, the vicissitudes of crises seem to erode the importance of such counterbalancing provisions and upset this equilibrium in favor of the EU institutions vis-a-vis the Member States and their citizens.

One of the central ideas pushing for centralization at the EU level is the pronounced emphasis on the need for a unified European governance and regulation; the underlying reason being the fact that a European single market necessitates a single governance and regulation. By highlighting the gap between EU-wide governance and regulation, and European integrated markets, new policy proposals are incessantly pushing for harmonization, centralization and consolidation of regulatory regimes: a move from economic union to political union.

For example, in financial regulation, we have witnessed policies pushing for a Banking Union, which have given shape to new ideas for a single supervisory mechanism, a single resolution mechanism, a single European deposit insurance scheme (under construction), and different single rulebooks and handbooks. In stove is yet another union (i.e., the capital markets union), which will be accompanied by a whole host of new mechanisms and perhaps handbooks and rulebooks with the word single preceding them.

Although the push toward having all these single institutions in place is understandable against the backdrop of the financial and sovereign debt crisis, it seems that not only would not these single mechanisms achieve the objectives of stability and growth, but also the EU markets would be as prone to crises in the presence of such institutions as in their absence, if not more.

This is mainly because a move toward regulatory and governance harmonization and consolidation (regulatory monopoly) would diminish diversity, which can lead to lower levels of competition among different institutional forms and models. In other words, establishing an EU-wide regulatory and governance authority may contribute to heightened fragility because in a harmonized regime, which is free from the market or downward accountability, a monopolistic regulator is more likely to adopt one-size-fits-all regulatory strategies and perhaps inadvertently encourage homogeneity and correlated business strategies.

Deprived of the benefits of diversity and heterogeneity, a harmonized regulatory regime, in which the risks of regulatory and governance errors can be easily amplified, could be more prone to failure and collapse than its decentralized regulatory counterpart. A more localized and diversified regulatory and governance design, within which there is a healthy level of regulatory arbitrage, which encourages regulatory competition, would minimize the risks of catastrophic large-scale regulatory errors. Therefore, a move toward regulatory monopoly (harmonization) can hardly be justified as a mechanism for achieving stability.

However, this note is not intended to downplay the positive role of the EU in improving the lot of the EU citizens by supporting the single market and the four freedoms, nor is it an advocacy of regulatory faineance at the EU level, but it is intended to highlight the importance of principles of subsidiarity, proportionality, and deference to the virtues of local experimentation, incremental and evolutionary transformations, and leaving sufficient room for crosspollination of diverse views on important policy issues. With a tunnel vision towards centralization at the EU level, one would be reasonably wary of dreary prospects of impending great disasters as a result of a Great Leap Forward towards the Unites States of Europe.

Although the urge for betterment and perfection is a deeply-engrained human desire, it comes with huge pitfalls and perils; the perils that often remind me of Adam Smith’s recount of an epitaph on the tombstone of a perfectionist mason reading: “I was well, I wished to be better, here I am.”

On Cannes 2016 and the Iranian Cinema

It seems that recent achievements in the Iranian cinema have dethroned some long-lasting stereo-typical Iranian products in representing the country in international fora. In my conversations with people of different nationalities in the last 2-3 years, I can hardly remember a dialogue in which the Iranian cinema was not mentioned.

As someone without any expertise in the film industry, I have two modest (and perhaps crude) observations about cinema.

There seems to be an antifragile aspect to cinema. The more you suppress it and put it under constraints, the more it thrives. That might explain why some of the best movies I have seen were made in an era during which the directors’ political views were suppressed or were dominated by the opposing political ideologies, or were about an era during which individual and political freedoms did not fare very well.

The second observation, which to a certain degree flows from the first one, is that the best movies of all times were made by the artists belonging to the left side of the political spectrum (Marxists, communists, lefties or whatever label you prefer). These movies are exceptionally effective at casting some light on certain genuine concerns and poignant aspects of human life which cannot be captured by the narrow calculus of an economist or a policy maker. But the caveat is that a movie is probably the last thing by which a policy maker or an economist should be inspired. Though these genres of movies and their artists are incredibly powerful at highlighting ‘some’ problematic aspects of the status quo or reality, they often are as hopeless as economists or policy makers in explaining what to do about it.

Anyway, off-topic basta! I just wanted to congratulate the Iranian artists on their recent success and I hope that the Iranian cinema will continue to contribute to human civilization and its wealth of cultural heritage.

I take my hat off to these Iranian artists and salute their achievement.