CFA Society Chicago Book Club:

Blockchain Revolution: How the Technology Behind Bitcoin is Changing Money, Business, and the World by Don Tapscott and Alex Tapscott

BlockchainRevolution-674x1024Blockchains are simultaneously feared as a disruptive threat and lauded as a technological panacea, often with little understanding of how they actually work and often with little practical consideration of how they might be implemented. Don Tapscott and Alex Tapscott (father and son, respectively) assist the layperson in understanding how blockchains work and how they could be used in Blockchain Revolution (2016). The authors also, unfortunately, further delude the technological utopians by proposing seemly endless possible uses of blockchain technology while failing to address some of the practical considerations of implementation.

Starting with the positive, Blockchain Revolution is one of the first resources to both explain blockchain technology and to fully explore its potential uses beyond the now somewhat familiar bitcoin. Bitcoin is the digital currency created by “Satoshi Nakamoto” in 2009. Satoshi Nakamoto was the name that was used in internet chat rooms and the like by a person or group of persons who claimed credit for creating the cryptocurrency. Soon after creating bitcoin, Satoshi Nakamoto disappeared and the identity or identities behind the name never have been revealed. Replete with a dubious creation story, bitcoin maintains a religious, cult-like following despite scant uptake and usage. The history of bitcoin has been told elsewhere, including in Paul Vigna’s and Michael J. Casey’s The Age of Cryptocurrency (2016), which was the book of the month for the CFA Society of Chicago’s Book Club in February 2016.

What hasn’t been told widely until now are the other possible applications of the technology underlying bitcoin, the blockchain. A blockchain is nothing more than a ledger for recording transactions. The double-entry bookkeeping system that forms the foundation of modern accounting is widely attributed to Luca Pacioli, a Franciscan Monk and mathematician who lived in the 14th and 15th centuries. There are earlier claims to the discovery, which probably have some merit. There are probably undiscovered cave scribbles that merchant cavepeople used to record exchanges of spears and mastodon parts. As long as there’s been commerce, there’s been the need to record exchanges, and ledgers in some hasty form have probably served the part from time immemorial. The difference between blockchains and most previous ledgers is that previous ledgers resided with a trusted central party to the transaction, whereas blockchain ledgers are distributed, meaning that every member of a network retains a copy of the ledger. When there is a new transaction in the blockchain, members of the network that maintain the ledger verify the authenticity of the new transaction, append it to the chain of all previous transactions, and transmit the updated chain to the network.

That distributed feature is what poses the disruptive threat to numerous businesses that are based on intermediating markets. For example, the Uber business model is based on a central party that sits between drivers and passengers, links the two, and takes a slice of the profits in transaction fees. Similarly, Airbnb disrupted the hotel industry by intermediating the market for lodging by linking people who have spare capacity in their homes with travelers looking for a place to stay. Blockchains could further disrupt the disruptors by allowing those parties to transact directly and take out the middleman.  The Tapscotts mention several other less obvious areas where blockchains could be used to intermediate markets or keep records, such a land and property deeds, personal medical and financial information, stock and bond offerings, contracts, and wills. The authors even argue that intellectual property such as music and other artwork could benefit from blockchains by allowing artists to control access to their works and charge a royalty fee directly to end users when they access them.

The oldest and largest business based on intermediation is, of course, banks. The primary function of banks always has been to intermediate the market of lenders and borrowers. Without banks, potential borrowers could find themselves having to go door-to-door, pleading for loans and negotiating the amount and the terms of the loans with each potential borrower. Banks have always done that legwork primarily by taking deposits and issuing those deposited funds as loans. Add credit and debit cards, foreign exchange, settlement, custody, and clearing to the mix and banks make considerable profits just by sitting between market participants, recording transactions, and taking fees. The Tapscotts and other blockchain utopians contend that all such businesses based on market intermediation will become unnecessary and disappear due to blockchain technology.

The CFA Society Chicago Book Club members who met to discuss Blockchain Revolution during their March 2017 meeting agreed that the range of possible blockchain uses was enlightening but found the tone of the book overly optimistic and found the treatment of implementation challenges lax. Take contracts, for example. The Authors seem to presume that blockchains will obviate the need for traditional contracts and courts to enforce them. A hypothetical blockchain contract might look as follows: A stadium owner engages a vendor to fix the plumbing in his stadium. When a credible party who has access to verify that the work has been completed confirms successful completion of the work in the blockchain, payment is automatically distributed. But what if the stadium owner contests the quality of the work? Was the vendor merely to fix the plumbing so that it didn’t leak or was the vendor supposed to restore the plumbing to like-new status? What if the stadium owner was relying on the repairs being completed by a certain time so that he could host a concert? If the vendor doesn’t complete the repairs, is it liable for the foregone revenue due to the stadium owner’s inability to host the concert? These are not far-flung hypotheticals. Contract law deals with those issues constantly. It’s not clear how blockchain-based contracts will be any better than paper-and-pencil contracts in terms of interpretation and adjudication.

Safety and security of blockchains is given similarly little treatment. Assuming for the sake of argument that the double key encryption technology that blockchains use makes them impenetrable to hackers, they could always just access blockchains using stolen passwords. And unlike when someone fraudulently uses a credit card, there is no legal department at bitcoin to contest the fraudulent transaction or IT department to reset the password.

Blockchain usage will undoubtedly increase. Even without blockchains, market intermediation for a variety of products and services has become increasingly automated and that trend will continue whether by blockchains or by other means. The consequence of that for banks and financial institutions is that they won’t be able to rely as much on the simple act of intermdiation for revenue and will instead have to increasingly compete on knowledge and customer service. Even now customers no longer need banks to purchase a variety of financial products and services, but retail and commercial customers still come to banks and financial institutions for sound advice and financial planning—and to reset their passwords.

Despite its shortcomings, Blockchain Revolution is an important contribution to understanding rapidly evolving blockchain technology, and hopefully others will step up to fill in the missing parts of the puzzle concerning how blockchains will be implemented and administered.

CFA Society Chicago Book Club:

The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore by Michele Wucker

thegrayrhino-3D-coverOverlooking or underestimating obvious dangers is a timeless tradition. A man is terrified of planes but gets in his car every day and drives with no seat belt. A woman pays the fire insurance premium on her home religiously but doesn’t floss her teeth. People play the lotto but don’t take advantage of their employers’ 401(k) matching contributions. Organizations, including governments, are as bad or worse.  Passengers remove their shoes at airports to prevent a shoe bombing, which has been attempted once in human history—unsuccessfully—while infrastructure is allowed to crumble to the point of collapse, such as the I-35W Bridge in Minneapolis, Minnesota, that collapsed under the weight of normal traffic and killed 13 people. That catastrophe didn’t occur because it was rare, hard to predict or even unpredictable, a black swan in modern parlance from Nassim Nicholas Taleb’s 2007 classic of the same name.  Instead, those dangers are obvious and imminent; much like the danger of a charging gray rhino, from which Michele Wucker’s The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore (2016) derives its name.

In February of 2017, the CFA Society Chicago’s Book Club had the privilege of hosting Ms. Wucker in person to discuss her Book. The conversation was wide ranging and included water shortages, global warming, the Challenger Shuttle disaster, and many other topics. Why do we spend resources worrying about and preventing rare events but ignore or do nothing about obvious, preventable dangers? Ms. Wucker has several explanations from the social sciences: taboos about raising alarms, groupthink, anchoring and confirmation biases. She notes the origins of the sobriquet Cassandra, an unflattering term used to describe people who warn others about potential dangers. The original Cassandra was given the power of prophecy from the god Apollo. When she didn’t reciprocate Apollo’s affections, he threw a curse on her that prevented others from believing her prophecies, including her prophecy that the Greeks would attack Troy, which is what ultimately happened. The negative connotations that are associated with the name of someone who correctly warned others about impending danger speaks to deep seated cultural aversions to raising alarms. That negativity combined with the fact that Cassandra was a woman who was punished for shunning the advances of a male superior is a similarly depressing statement about society.

With the manifold existence of Gray Rhinos and their causes firmly established, the question turns to their taxonomy and life-cycle. Ms. Wucker identifies eight types and five stages of a Gray Rhino.  The eight types include the “Inconvenient Truth” Gray Rhinos that are widely recognized but not acted upon due to denial, including manufactured denial, and high costs to fix.  Global warming is the classic example of an Inconvenient Truth Gray Rhino. There are also the “Creative Destruction” Gray Rhinos such as Kodachrome, where acceptance and orderly unwinding are the only tenable solutions. It was not mama but the inevitable march of time that took our Kodachrome away. For each of the eight types in the taxonomy, all follow a life cycle of five stages. The first stage is denial, the second is muddling or kicking the can down the road, followed by haphazard diagnostic exercises, the third, panic, the fourth, and finally action.

Ms. Wucker’s Taxonomy and Stages are invaluable contributions to the ongoing policy discussion. The Taxonomy and Stages also need to be viewed in the context of organizational motivations and individual incentives, though. A good example is the Challenger disaster that Ms. Wucker opens her book with.  When making go/no-go decisions, it’s helpful to look at data from previous failures as well as data from previous successes. Space shuttles relied on re-usable solid rocket boosters for their initial launch. The boosters were built in segments and each segment had o-rings that were supposed to keep hot gas from escaping. When o-rings get too cold, they become brittle and fail allowing hot gasses to escape, which is what caused the Challenger disaster. On the morning of the launch, one engineer spoke up against the launch. The coldest successful launch took place when the temperature was 53 degrees. In that launch, gas escaped passed the first ring and caused corrosion on the backup ring, but the backup ring contained the gases. Below 53 degrees, there were no data. On the morning of the Challenger launch, the temperature was 35 degrees.

On January 28, 1986, NASA got an additional data point. The backup ring failed and seven astronauts died.  The Challenger disaster didn’t happen because the world’s smartest people didn’t understand the threat of cold weather to the proper function of o-rings. It happened because of the tremendous pressures on NASA to proceed with the launch. The space shuttle was originally conceived as a way to easily and cheaply launch people into space and return them in a re-usable ship.  The term “space bus” was even used. In practice, the program proved to be more costly and inefficient than the shuttle’s predecessors. NASA was under tremendous pressure to demonstrate the viability of the program.  In addition, the Challenger was going to launch the first teacher, Christa McAuliffe, into space. Millions of people were tuned to their television sets to see a launch that had already been delayed several times.  The organizational and public relations pressure to proceed with the launch overwhelmed good judgement.

Organizational pressures and incentive structures are that root of several Gray Rhinos. Scarce public funds either can be used to pay teachers or fix bridges that seem to work fine (until they don’t). Publicly traded companies struggle to look past obstacles beyond meeting quarterly numbers. Politicians aren’t incentivized to deal with any problem such as global warming whose most detrimental effects are likely to occur after a two, four, or six year term.

The assembled Book Club members and Ms. Wucker did offer several solutions to the Gray Rhino problem.  First, align incentives. Executive compensation should vest fully over a period of years or even decades.  Investors should similarly hold companies to account for long term performance and be more forgiving of short term volatility. Allowing US banks to hold stocks as banks do in Japan and Germany might allow more steady capital into capital markets and reward longer term performance, too. Second, break the problem into small pieces. There’s an old expression: “How do you eat an elephant? One bite at a time.” The same logic applies to Rhinos. Instead of trying to fix all the nations crumbling infrastructure, prioritize. Fix one bridge at a time, starting with the most dilapidated. Third, to combat groupthink and denial, include diverse perspectives in one’s circle and allow multiple channels of access to leaders and decision makers.  Related to that third point, the group discussed the competing leadership styles of Presidents Reagan and Kennedy. President Kennedy’s administration followed a spokes-on-a-wheel format where multiple influencers had direct access to the President, which could explain his successful resolution of the Cuban Missile Crisis. President Reagan, on the other hand, had a more linear chain of command with multiple bottlenecks and chokepoints, which could explain how in the Iran-Contra Affair a few rogue elements of his administration where able to conduct arms sales and a covert war without knowledge or involvement from either the State or Defense Departments.

The Gray Rhino is a welcome addition to current policy debates and compliments established organizational behavior and social science literature well. At 304 pages, it’s also a manageable and enjoyable read. The Society is very grateful to Ms. Wucker for her book and for her attendance at our meeting.

CFA Society Chicago Book Club:

The Accidental Superpower: The Next Generation of American Preeminence and the Coming Global Disorder by Peter Zeihan

superpowerGeography is destiny.  Demography is second.  Everything else is a distant third.  That’s the takeaway from Peter Zeihan’s The Accidental Superpower: The Next Generation of American Preeminence and the Coming Global Disorder, which was the book of the month for the CFA Society Chicago’s Book Club in January 2017.  From settling the Nile Valley to deep water navigation and the shale oil revolution, Mr. Zeihan explains how geography influences almost every aspect of civilization from formation to eventual demise.  Landlocked countries tend not to have navies of any consequence.  Countries with neighboring threats tend not to have excess resources to project military power beyond their borders.  Countries lacking internal resources are more likely to engage in trade.  The fact that the US is facing two oceans and has no neighboring threats coupled with its need to secure energy and goods explains how she can—and has—projected her power abroad for decades in part to secure global trade.  The shale revolution and ample food supplies coupled with the rising costs of extra-continental labor and domestic supply chain alternatives such as 3D printing explain why she might no longer need or care to.  The conclusion is that a newly self-sufficient and relatively young US will withdraw from participating in global trade and security while the rest of the world collapses under the weight of its aging populations and competition for scarce food and energy.  How’d we get here?

To answer that question, rewind to the beginning of the book, which starts at the end of World War II, the most destructive war in human history, and the agreement that helped in part to ensure that it never happened again, the Bretton Woods Agreement, signed by 44 countries at the Mount Washington Hotel in Bretton Woods, New Hampshire.  In addition to the consequences of that momentous agreement, we learn that its namesake town and the Hotel at which it was signed were so overwhelmed the 730 delegates that descended upon it that the Hotel’s manager locked himself in his office with a case of whiskey at one point during the gathering and refused to come out.  Those anecdotes along with Mr. Zeihan’s wry sense of humor alone made the book well worth reading.  The Agreement’s consequences were threefold: (1) all the signatories’ currencies were to be freely convertible into US dollars at a fixed rate, and the US dollar was likewise to be exchangeable for gold at a fixed rate, (2) the US would protect maritime shipping, and (3) the signatories would be part of a “strategic umbrella” of protection against the common Soviet threat.

Just as geography had ordained that the WWII belligerents compete militarily to secure markets, resources, and shipping, the Bretton Woods Agreement with the stroke of a pen ensured that they would no longer need to.  Being freshly ravaged by war and facing a common Soviet threat further ensured their assentation to the agreement.  In addition to Bretton Woods, there was one more ingredient in the elixir that spawned the post-war boom: demography.  The signatories boasted youthful populations.  Few variables in economics are known with near certainty for any extended period of time.  Demographic variables are an exception.  At any given time in any given country, one can tell with reasonable certainty how many skilled young workers will be entering the workforce.  Skilled workers don’t magically fall from the sky ready to leave home and acquire gainful employment, as much as their parents may wish it. There is a pipeline from birth to school to adulthood.  Once in the workforce, laborers again follow a predictable life cycle. As they begin working, they begin paying taxes and saving.  As their savings grow, they deploy their savings into capital markets until they finally retire, spend down their savings, and increasingly rely on the next generation of tax payers for their welfare.  Here again the US, while still aging, is relatively young and demographically well positioned relative to the rest of the World, Mr. Zeihan argues.

The book club members welcomed Mr. Zeihan’s geographic and demographic analysis as a compliment to traditional economic and financial modes of analysis. The members did, however, cast doubt on some of his conclusions and predictions.  The first was the premise and title of the book, Accidental Superpower.  One member noted that the Founders were quite deliberate in their desires to build the US into a military and economic superpower, the subject of a recent popular musical.  No one gave serious credence to Mr. Zeihan’s prediction that Alberta, Canada, might become the 51st state.  If Mr. Zeihan had cast a critical eye towards the US and applied some of the same analysis that he applied to the rest of the world, he might have found similar fissures.  Many Western and Southern US States are net beneficiaries of federal aid and lament the federal government’s intrusions in their lives.  If armed standoffs like 2014 one with Amon Bundy in Nevada become more commonplace, it’s at least as plausible as some of Mr. Zeihan’s other claims that net-contributor states might leave those states to fend for themselves.  More importantly, Mr. Zeihan’s arguments about geography and physical capital didn’t seem as relevant to the Members as the author claimed them to be in the internet age, and one certainly doesn’t have to be a naval power to wreak havoc in the cyberwar era, as the US again learned in the 2016 election of Mr. Trump as President.

Alberta, Canada, might indeed become the 51st and prove the Club Members wrong, and even with its other potential omissions and shortcomings, Accidental Superpower was an eminently enjoyable and worthwhile read.

CFA Society Chicago Book Club:

The Only Game in Town by Mohamed El-Erian

the-only-game-in-townExtraordinary central bank interventions during economic crises aren’t new.  In his Pulitzer Prize-winning Lords of Finance, Liaquat Ahamed mentions Emperor Tiberius injecting one million gold pieces into the Roman economy to keep it from collapsing in 33 AD.  Extraordinary central bank policy coordination similarly isn’t new, as Mr. Ahamed notes with the frequent meetings between the heads of British, French, US, and German Central Banks and the resulting coordinated policy actions during the First World War and the Great Depression.  What is new is the extent and duration of those interventions and the absence of any corresponding fiscal or structural reforms. After Tiberius’s intervention, Rome soon returned its focus to commerce, conquest, and imperial assassination.  Roman merchants and farmers didn’t sit idly waiting for the next round of monetary stimulus and then dispose of their wares and crops in panicked fire sales when cheap money didn’t materialize.  Contrast that with our times.  Six years into an economic expansion, interest rates remain at historic lows—even negative in several major economies—with little hope of fiscal or structural reform.  A small uptick in volatility can elicit calls for further quantitative easing (college campuses apparently aren’t the only places where people are clamoring for safe spaces).  Central banks have become The Only Game in Town, the title of Dr. El-Erian’s book and the subject of the CFA Society Chicago’s July 19, 2016, Book Club meeting.

Dr. El-Erian brings uniquely diverse cultural, educational, and professional perspectives to the financial crisis and the ensuing central bank interventions.  His mother is French and his Father is Egyptian, and he spent time growing up in Egypt, in France, where his father was the Egyptian Ambassador to that country, and in New York City, where his father worked at the United Nations.  His enrichment continued in the United Kingdom where he attended boarding school, Cambridge, and finally Oxford, where he earned a doctorate in economics.  His professional resume is equally diverse and impressive.  It includes the International Monetary Fund (IMF), Harvard University’s endowment, and PIMCO, one of the world’s largest bond investors with approximately $2 trillion under management.  It’s there where Dr. El-Erian served as co-CIO along with PIMCO-founder Bill Gross.  That’s in addition to his numerous publications, boards and committees, and his previous book, When Markets Collide, which won the Financial Times and Goldman Sachs Business Book of the Year Award as well as The Economist’s Book of the Year Award in 2008.

In addition to his qualifications to write on the subject, Mr. El-Erian served as CFA Society Chicago’s keynote speaker at its 2015 Annual Dinner, which further piqued Book Club members’ interest.  In his exposition of the issues facing global markets and central banks’ responses to them, Dr El-Erian didn’t disappoint the assembled Book Club Members.  In the plain-spoken fashion that made When Markets Collide a classic, he explained complex, interdisciplinary phenomenon in simple terms with the assistance of helpful metaphors.

For example, he explained the collapse in confidence and liquidity during the crisis in terms of a drive through: Customers pay at the first window and receive their food at the second.  When customers aren’t confident that they’ll receive their food at the second window, they’ll demand it at the first window.  When restaurants don’t relent, both parties that otherwise wish to transact will walk away – market failure.  As another example, he explained that trying to push certain products and activities out of the banking system was like pushing on a waterbed.  Rather than remove the activity, pushing simply displaces the activity to elsewhere in the bank and non-bank financial sectors.

Dr. El-Erian also noted the increase in the size and power of the end-users of capital, the buy-side, relative to financial intermediaries, the sell-side.  The phenomenon has been noted, among others, by John Rogers, the former CEO and President of the CFA Institute, in A New Era of Fiduciary Capitalism? Let’s Hope So, which appeared in the May/June 2014 edition of the Financial Analysts Journal.  Dr. El-Erian explained the consequence of that transformation, namely that the growing end-users are trying to force more transactions through the shrinking pipes of the financial intermediaries.  The result in the financial world is as calamitous as the result in the plumbing world.

In all, Dr. El-Erian noted nine challenging trends in global economies related to extraordinary extended central bank interventions, the subject of Part Three of his book: inadequate growth models, high unemployment, increased inequality, decreased institutional credibility, political gridlock, increased trade imbalances and tensions between the core and the periphery of the global economy, the rise of shadow banking, decreased liquidity (the pipes mentioned above), and finally the increased complacency among market participants due to a perceived central bank put.  In that exposition Dr. El-Erian touched on several insightful points.  For example, he noted the Bank of International Settlements (BIS) meetings allowing for back-channel discussions and problem solving between the monetary authorities of different economies.  A similar mechanism for averting armed conflicts through international organizations such as the United Nations has been noted in Bruce Russett and John O’Neal’s Triangulating Peace.  Perhaps a longer book would have allowed those points to be developed further.  The Only Game in Town is only 296 pages, including appendix.

That largely concluded the exposition of the problem, where Book Club Members gave Dr. El-Erian high marks.  The remainder of the book was a meandering attempt to solve the problems noted in the first part of the book, which left members disappointed.  The desultory journey covered bi-modal distributions, behavioral finance, several other topics, and even a section on diversity in the workplace.  One member quipped that the last chapter of the book was probably a last-gasp effort to fulfill a contractual minimum page requirement with the publisher.  Dr. El-Erian had a similar chapter on organizational leadership at the end of When Markets Collide.  In that book he also noted the failure of macro-prudential regulators such as the IMF, his former employer, to balance their academic training with technical knowledge gleaned from actual market participants.  Perhaps better institutional leadership and reforms, including more diversity, could foster economic stability and growth, but Dr. El-Erian failed to argue the point persuasively, at least in the judgement of the participating Book Club members.

The Only Game in Town is a worthwhile addition to the discussion about the continued role of central banks in the current economy and the potential pitfalls of continuing down the current path.  Even though Dr. El-Erian ultimately failed to solve the problems he elucidated, he’s hardly alone in that regard.