29 Oct 2016 by Ann Rutledge

The ABS coins in your wallet

If Bitcoin is a “coin,” could securitizations (“ABS” for short) be coins too?

A coin is a “small, flat, round piece of metal or plastic used primarily as a medium of exchange or legal tender. [Coins] are standardized in weight, and produced in large quantities at a mint in order to facilitate trade. They are most often issued by a government.” (https://en.wikipedia.org/wiki/Coin)

If all these attributes make a coin a coin, Bitcoin isn’t.

To start with, it’s digital, not physical. New bitcoins aren’t produced in a mint; they are issued to bitcoin IT experts (“miners”) as a reward for IT breakthroughs. Bitcoins in the secondary market are sold person-to-person or in exchanges.

Importantly, bitcoin is not legal tender: Governments do not backstop its value, which is determined by supply and demand, and exhibits a level of volatility we do not ascribe to the coins jangling in our pockets. To illustrate just how volatile, the graph below shows the time series price data of Bitcoin between March 2015 and October 19, 2016: https://bitcoinaverage.com/en/bitcoin-price/btc-to-usd

bitcoinavg

At about 13:00 EST on October 19, 2016, the spread between the day’s high ($640.41) and low ($629.34) was $11.07, or 175 BPS. This spread is comparable to one-year (not intraday!) spreads at the high end of AAA-rated loan-backed securities. Meaning, although nominally standardized, Bitcoin value is marked by high volatility–orders of magnitude higher than cash or securities considered money-good. So, what makes Bitcoin a coin is that we say it is; and so saying, we free Bitcoin from the rules and regulations imposed on securities.

If the Bitcoin example blurs the conventional boundary between coins and securities, cash and credit, or money and finance, let us now consider another class of financial instrument: ABS. By convention, and under securities law, it is a security. But ABS securities are more coin-like, not less, than Bitcoin. All performing ABS “coins” eventually turn into pure cash.

ABS “securities” have less in common with corporate debt securities than we imagine. Corporate debts are repaid from unidentified future earnings. ABS, from dedicated collateral and contingent capital, the risk and value of which become crystal clear with amortization. Conceptually, it is really no more of an exaggeration to call an ABS with a one-year remaining term “near-money” than to speak of ABS “issuers” instead of calling them what they actually are: ledgers

And that is why I believe our understanding of ABS is exactly backwards. We don’t call ABS a security because it’s like a security. It looks to us like a security because we view it through the lens of securities

Rating agencies originally domesticated the ABS market using their same corporate rating nomenclature to “help” investors to understand the risks (see Chapter 1, http://bit.ly/2e2ht8l) while they ignored the very fundamental risk differences between the two financial assets. Although ABS is under SEC jurisdiction, much of the risk architecture is a poor fit for coin. In a very real sense, the more mainstream and “regulated” ABS has become, the further it has moved away from fundamentals. This isn’t good for markets or economies.

We can blame many parties for the Crisis of 2007-8, but the square-peg-round-hole problem of the ABS paradigm has not received much attention. One reason may be asymmetric information. Not many people know much about sui generis ABS analysis, which is based on cumulative data sets, not data with one-year thresholds. Special training is needed to be able to discern whether ABS risk has been properly measured and reported.

Another reason may be the stifling weight of convention. More than we could possibly imagine falls apart when the artificial one-year boundary in risk reporting is removed. Some deeply held myths that prop up market trust and liquidity begin to unravel, such as whether the efficient market hypothesis applies to debt (it doesn’t) and whether updating ratings every year improves their predictiveness (it doesn’t). Casual conversations on technical points like these can get the speaker into a lot of hot water, especially in academic circles where they run counter to modern financial theory.

Coming back to the proposed paradigm-inversion: In classic financial terms, ABS is much nearer to money than bitcoin or debt securities. ABS assets are made up of countable cash flow streams where counting gets easier as time rolls forward and the pool pays down. As maturity approaches, ABS morphs from a risky digital coin into cash. Think about the good that could be done if new payment systems embedded in blockchain technologies could also finance near-term ABS spectrum!

A perfect use-case would be SME loan-backed ABS in markets like Kenya’s, where private investment is a main source of new money creation. There is a tendency to charge a high risk premium on credits the First World deems “poor” or “exotic.” But, in reality, the First World needs to get a grip on complacency about its own aging financial architecture. It may be the biggest risk of all.


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Ann Rutledge By Ann Rutledge

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