Too Big To Fail And The Ethereum DAO Hack

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Includes: AIG, BAC, BCS, BLK, C, GE, GS, JPM, MET, PRU, WFC
by: Kurt Dew

Summary

The myth of Too Big to Fail (TBTF) is that of a government knight riding to the rescue.

But in fact, after so many rescues, caring for TBTF institutions has become a 24/7 job.

Cryptocurrencies were designed to escape the miseries of TBTF.

But now a cryptocurrency, Ethereum, has a big failed financial institution.

Will Ethereum bite the bullet or ride to the rescue?

If you wanna make the world a better place
Take a look at yourself, and then make a change

—Michael Jackson

Many would like to see a financial system that competes with the creaky old dealer banking network: Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM). There are many ways this could come about - most obviously the dealer banking network could consider that it is creaky and old, and decide to fix itself.

The Financial Crisis was an opportunity, but that event was seized upon by the government as an opportunity to stuff some problem financial institutions into the existing creaky old banks, making them creakier and older.

Thus the big banks let Washington take on the issues. The result was predictable. The dealer system is quickly becoming calcified and fossilized. This has led many, including myself, to look for cures to the inefficiencies of financial entrepreneurship outside the existing dealer bank structure.

One of the least attractive things about our dealer banks is that they are Too Big to Fail (TBTF). The government likes to oversimplify that concept. The government claims it only rescues banks during liquidity crises.

Now politicians seek to win the favor of the electorate by frequently stating that they will never, ever, again rescue a big bank, or many banks, that have gotten into a liquidity crisis. They have made that promise three times; broken it, twice. If they need to, I hope they break this promise again because the alternative - a collapse of the system - would be truly grave.

Actually though, in reality, the government has made rescuing the dealer banks a full time occupation, 24/7. If the government were to treat the TBTF banks' dealer repo and swaps positions as ordinary claims in bankruptcy, instead of escorting the dealers and their dubious debts straight to the front of the line, ahead of the scrutiny of even the bankruptcy court itself, the dealer banks would be gone by next week.

But the issue of government protection of derivatives' risk is beyond the ken of the average voter. Thus only experts are aware which of the banks are so risky that without a government respirator, they would fail. And the politicians are never asked to explain why they provide these free credit-enhancement services to publicly despised institutions that nevertheless are generous lobbyists.

However, there are symptoms of being truly TBTF, that the average investor may observe. If the TBTF financial institution doesn't want that designation - institutions that seek to escape TBTF, such as GE (NYSE:GE), and the three US TBTF insurers, AIG (NYSE:AIG), MetLife (NYSE:MET), and Prudential Financial (NYSE:PRU); then these institutions are probably not in need of constant government preservation as are the dealer banks.

And among the large banks, Wells Fargo (NYSE:WFC) should be let off the hook as well. Wells Fargo is a particularly interesting case. Since there is no possibility that Wells will not be designated TBTF, they might actually choose to get involved in otherwise too risky government-protected activities, like repo.

I would like to see Wells sue to be counted out of TBTF instead, on the grounds that the size of the bank is irrelevant - it's the bank's lines of business. That would be a really interesting case.

If you look outside the decrepit existing dealer bank community, there are several possible sources of a healthier, more competitive, risk-taking, financial system:

  • There are smaller banks: regionals and even groups of community banks. They are merging and growing. And they have not been force-fed other failing banks by the government, as the big dealers have. They have a fighting chance of being efficient.
  • There are a few big banks - Barclays (NYSE:BCS), Goldman Sachs, and Wells Fargo, for example; that exhibit an evident awareness that there is a future beyond next quarter and that institutional growth and change will be necessary to survive it. They seek ways around their regulatory moat.
  • There are non-bank financial institutions such as Blackrock (NYSE:BLK), Berkshire Hathaway (NYSE:BRK:A) and Citadel, who attempt entrepreneurial activities.
  • There are non-bank entrepreneurs like the new exchange, IEX.
  • There is FinTech - an IT-oriented group of startups that anticipate conducting financial functions more efficiently, involving varying degrees of cooperation with financial institutions and their regulators.

This article focuses on what may be described as the biggest mistake the TBTF banks have made - a mistake that they make so often that it has become their signature. The TBTF banks' greatest mistake is to solve their problems by lobbying a higher authority for favors and protection. In the case of the TBTF banks, this is bank regulators and elected officials.

I bring this mistake into focus because one of the hopefuls, in fact until now one of the brightest stars among the hopefuls, is about to repeat the TBTF banks' greatest mistake - dependency on a benevolent benefactor.

This hope for the future is the cryptocurrency, Ethereum. For those of you who are new to cryptocurrencies in general, cryptocurrencies are not easy to explain. Try Wikipedia or Investopedia, for serviceable definitions, or read on. The details are not important here. A cryptocurrency is a sort of electronic money transfer system run by IT professionals, based on a store of value or currency.

Ethereum is second largest among the two major cryptocurrencies. The other is bitcoin. Bitcoin, the largest, has a several strikes against it:

  1. In its early days it was associated with some shady users - notably The Silk Road, an online dealer specializing in illegal merchandise such as drugs and automatic weapons; and MtGox, a bitcoin currency exchange run by scam artists who eventually ran off with users' money.
  2. Bitcoin has no one willing to represent it to the public. Bitcoin is an impressive performer for an entity with nobody in charge. But its anonymity is off-putting to government regulators and their ilk, as you might imagine. But it has great appeal to the government-weary among us.
  3. Bitcoin's code is too basic to permit users to design bitcoin contracts. Individual receipts and payments and their recordkeeping is its sole capability.

Etherium, when introduced, showed promise to deliver what many considered to be the "best features" of bitcoin, while avoiding the worst.

  1. The writers of the Etherium code revealed their names, addresses, and the other aspects of identity that were missing from disturbingly anonymous bitcoin developers.
  2. Ethereum had no bad actors in its history. Perhaps in part because it had very little history.
  3. Ethereum was "smart." Complex agreements including the kind of conditional future performance at the heart of most financial contracts, appeared to be possible to construct with the Ethereum code.

For the special new players of finance, from IEX to cryptocurrencies, care is needed. Financial innovation is a dangerous business. Past innovators have experienced the pitfalls for themselves - such as Michael Milken and John Meriwether - who had bad experiences with the unexpected twists and turns of the unknown, and were subsequently vilified in the eyes of some.

This is perhaps less of a concern at IEX. The young managers there are Wall Street vets and probably aware of the uncomfortable realities of their vulnerability. But I am strongly suspicious that the IT professionals at Etherium have a lesser awareness that, when they crossed the Rubicon and started to pursue things financial, they entered a far more hazardous world than the world of writing code.

I believe, for example, that Ethereum code developers have no legal advisors. You might as well try to cross the Pacific in a leaky rowboat as create an investment fund without legal advice.

This issue came to a head on Friday, June 17 th. There is a somewhat naively conceived and executed crowdfunding entity resident on Ethereum, called DAO. It has an IT feel to it. In concept - but impossible in the real world - it claims to be simply code. But it accepts investor funds. Under the law, of course, code cannot accept investor funds. Only people can do that. And if said people have not incorporated or hired quality legal counsel, yet have also not bought open airline tickets to a country without a US extradition treaty, they are people in deep trouble.

DAO, apparently to its own surprise, received value from investors apparently in the tens of millions of dollars. The alarm bells should have sounded at that point. Indeed, more experienced observers pointed out the danger, but to deaf ears it seems.

As it stands, the DAO has been hacked, in amounts reportedly in the tens of million dollars. This hack is going to be messy, because someone has diverted these funds in a manner not anticipated by the founders of DAO, but apparently using instructions from DAO's code. And this someone does have a lawyer.

The accused hacker claims that the hack is not a hack. In fact, if the alleged hacker has the proceeds of his activities taken away, that, the hacker claims, would be a hack. It would cause the hacker to sue.

And immediately, on this news, a bigger issue surfaced. In the minds of people who, until this weekend, were simply writers of the code that operates DAO, this first "hack" must be undone and the ether that has been "lost" by other DAO owners returned to them. This idea seems entirely reasonable until you realize that to accomplish this, it must be done in the ethereum code outside DAO.

This is different from what happened with the MtGox fail on the Bitcoin system. MtGox was viewed as an application operating on Bitcoin which was responsible for its own misfortunes. The remedy to the MtGox problems was to be found in the courts, not in the reprogramming of Bitcoin.

In other words, DAO seems to be "too big to fail" and Ethereum code developers take themselves to have the role of resolving this dispute. The damage done by the DAO hack to the wider Ethereum community is so significant that these Ethereum developers believe the Ethereum code itself must be modified to undo any damage done to DAO participants. So DAO is not a failed firm resident on Ethereum, as was MtGox on Bitcoin. DAO is essential to the very heartbeat of Ethereum, according to these developers.

Unfortunately, many of the Ethereum powers-that-be also have an investment in DAO. The decision to invest in something you administer might also have been more carefully considered. Now, it seems a conflict of interest, without any clear legal authority behind it, to modify Ethereum to solve the problems of DAO.

The moral of this cautionary tale is clear. Innovation is great, but read some history and hire a good lawyer first; before you wander out of the code kiddie pool and dip your toe into the shark-infested financial waters.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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