Note: This is part 1 in a multi-part series exploring the dangers of rehypothecation and commingling in bitcoin and other cryptocurrency assets that could occur once Wall Street begins offering crypto products. Part 1 is an interview with Caitlin Long and subsequent parts will ask the question, "How did we get to a place that where laws look like this?" Stay tuned for part 2.
Caitlin Long is a 22-year Wall Street veteran with an impressive career inside of and outside of the cryptocurrency space. She started out as an associate at Salomon Brothers (now Citigroup) before becoming a managing director at Credit Suisse and finally heading up Morgan Stanley's Pension Solutions Group. As it turns out, Long's extensive experience on Wall Street (in addition to her Harvard Law degree) give her some unique insight into things that most cryptocurrency investors aren't going to have top of mind but that institutional investors have been dealing with for years. At the beginning of our conversation, Long says that everyone's "backgrounds bring them to who they are today and bring them the knowledge base for recognizing trends." It is Long's impressive background, combined with a unique recognition of the opportunity to make Wyoming a "crypto haven" and a passion for doing what was necessary to achieve this goal, that put her in the unique position of understanding everything that is wrong with our current system and the opportunity blockchain -- and specifically bitcoin -- give the financial services industry to ameliorate its past mistakes.
Note: The following has been edited for clarity
CCN Interviews Caitlin Long
CCN: How did you get into cryptocurrencies and how has your background allowed you to enter the space?
CL: Well, like everyone, their backgrounds bring them to who they are today and give them the knowledge base for recognizing trends, and I just happen to have a slightly maybe a typical background because I'm not a technologist but I actually have the legal background as well as having worked on Wall Street for 22 years, most recently running the pension business at Morgan Stanley [where I] really got into the weeds of how assets are custodied, cleared, and settled when they transfer.
The system that we have is very unstable. It's not fair to investors, and I've learned from experience not to trust my brokerage account. My brokerage account itself is not inaccurate, but there's so much that goes on in these commingled pools of assets behind the scenes that you can't see. In other words, if you own 100 shares of Apple stock you don't know that the leveraged institutions of Wall Street haven't promised those very same 100 shares out to someone else too -- and they also show up on that person's brokerage statement. That kind of stuff really hit me in the gut as just unfair and morally wrong and there's a lot to be said for pension fiduciaries upping their game and for the investor protection regulation to up its game because frankly, regular investors are the losers from all of these issues in the system.
CCN: Would you talk a little bit about the crypto problem? How the regulations allow that to happen?
CL: Well, there's fault tolerance in the system. It stems from the fact that trades are not required to be settled instantly, which, for your crypto listeners is going to sound really strange because your trades literally go in the next block. If you're talking about the bitcoin blockchain, you can see them within minutes, on the ethereum blockchain, your actual trades are right there, and that's not the way Wall Street works.
Wall Street just settles trades. When I started in 1994, the industry was five days after the trade date [T+5] and now it's two days after the trade date. We just went from T+3 to T+2 this year, but it's still two days. Obviously, [delayed settlement is] not a technology problem. It's long since not been a technology problem anymore. So why is it that Wall Street is stuck with this crazy practice of not settling trades in near real time? The answer is it has to do with the market structures.
Now all these crazy market structures that we've let been left with, that were designed to do -- to try to help Wall Street settle the increasing trading volumes on the New York Stock Exchange in the 1970s -- which essentially said, "Why don't we immobilize shares, instead of literally running share certificates back and forth across all the brokerage firms?," which is why if you go down to the New York Stock Exchange in New York, that's why all the brokerage firms were located right there because they literally were running paper securities back and forth to each other every day. And then they got overwhelmed it and they said, “Why don't we just immobilize them in a vault somewhere, and everybody will actually own a certificate. That's a claim against that share.” So instead of owning the real thing, everybody now owns a paper claim against the real thing, and the real thing is immobilized in a vault at a company called the DTC, a big huge company that is the legal owner of 99.9 percent of the securities issued and outstanding in the United States.
Most people don't realize that if you don't own the actual paper certificate, you don't own your securities, the DTC [Depository Trust Company] does. What you own is an IOU, and that IOU is from a leveraged financial institution that might default. So behind the scenes, all of these different institutions that were designed to clear and net settle transactions that gave rise to this settlement delay, those institutions haven't been done away with, even though the technology problem that created them long ago was solved.
CCN: It's just crazy to think, here we are in 2018, and it's still taking, two -- recently, three -- days to settle these trades. So I guess there's got to be a market advantage to the brokerage firm and I guess they’re lobbying to kind of keep that open?
CL: Well, it's interesting they did when we went down to T+3. I remember that was in the late 90s from T + 5, the industry fought it tooth and nail. They didn't fight it as much when we went from T+3 to T+2, but they will fight it tooth and nail if we ever go T+1, and here's why: because the industry makes a lot of money on securities lending. This is the hypothecation word that I wrote about on Forbes.com, that's one of those phrases that crypto enthusiasts are going to know and understand just like they know and understand the phrase fiat currency.
Ten years ago it was only the Austrian School economists that were talking about fiat currency; no one ever talks about [U.S.] dollars as a fiat currency. Now everybody talks about it that way to the point that even Fiat -- the car company -- had this hilarious tweet about two weeks ago that asked why everybody was criticizing their money. It was a play on the name of the company, the Italian car company Fiat. It's now in the regular vernacular, and I think the word application we have going is going to be in the regular vernacular of industry very soon because that is one of those insidious and subtle things that happen behind the scenes in these in these commingled collateral accounts behind the scenes that you can't see from your brokerage statement.
For instance, in the MF Global bankruptcy a lot of people, unfortunately, learned what rehypothecation was and learned that it was legal and learn that their brokerage firm got them to agree to it. The remedies to our default are pretty limited if you've agreed to it, and it was right there in the fine print. I've very publicly been campaigning against this for a while, and it's not new just because this has been something I wrote about recently. It's only because it burst on the scene in the crypto sphere due to the entry of Intercontinental Exchange (ICE).
They’re the parent of the New York Stock Exchange, which is one of the largest operators of central clearinghouses and counterparties in the world. So they are a major rehypothecator of collateral. This is one of those things that I love about bitcoin because you actually can own your asset. It's the same as if you were actually owning that paper stock certificate, except it's just in digital form and it's not as easy as paper is to counterfeit or lose. In the case of bitcoin, if you have your private keys and you haven't lost them and they haven't been hacked, then you really own your bitcoin. I would love to get back to that in the financial markets as a whole.
CCN: How did the institutional investors let this happen, let the brokerage firms take this amount of power so the pension fund managers and -- why [aren't] all those people kind of lobbying to do away with that old system?
CL: That is a great question and I don't know the answer -- I wish I did. Having better pension fiduciaries and having negotiated some of these agreements ,I knew I was an outlier when we were asking for title collateral terms and one-day collateral posting. We went for intraday collateral posting on our interest rate contracts and nobody would give it to us. When we first started asking, I think it was T+3 collateral posting. You can have a major move in interest rates and the counterparty wouldn't have to give you any additional collateral for three days.
Well, in the intervening three days, of course, they can go bankrupt. I was pushing for that and it was the experience of the financial crisis that made me learn that I needed to ask for that. Why did many others not? I actually had that conversation with a couple of people in the pension business at a recent Free State Project picnic. So they, like me, are opposed to fractionally reserved assets and fractional reserve banking in general. And I said, “God, why are the fiduciaries not digging into this?,” and they said it's two things: they think that they're powerless to change the system, which on an individual basis may be correct, but if they were to work together, I don't think that's correct at all.
I think they do have the power to force positive change. Indeed, there's a terrific speech called The Block Chain Plunger: Using Technology to Clean Up Proxy Plumbing and Take Back the Vote that was given by a Delaware court judge back in 2016, his name is Vice Chancellor Travis Laster. I strongly encourage your listeners to read his speech because it gives a tremendous amount of detail about all the problems in the clearing and settlement system of Wall Street, and he like me, is trying to encourage the fiduciaries to take the reins, take the control back in the markets, because it's their investors and their clients that are losing as a result of all the issues in the system. Lastly, I'll add I hope the plaintiffs’ bar starts to come into some of these issues and litigate.
I don't know the outcome of the Dole Foods situation. I have not seen any FCC enforcement actions in the Dole Food situation, which means somebody lost money there. Why has there not been litigation? Why have there not been enforcement actions? It's the sort of thing that regular mom and pop investors out there look at this kind of thing and just think the system is rigged against them. And guess what? In a lot of ways it is!
CCN: How common is the over-issuance of shares as it happened in the Dole Foods situation in the traditional stock market?
CL: It's very common, it happens every day. But it is a matter of degree and so essentially it all gets back to the delayed settlement that we talked about earlier, plus securities lending and the fact that these brokers and clearinghouses and custodians are making money off securities lending and they're allowed to, and again, it's in the legal agreements.
In most cases, the pensions for these shares have agreed to it or the clearinghouse, the Commodity Futures Trading Commission (CFTC), and FTC (Federal Trade Commission) allow the clearinghouses to do it. What I've experienced is that failures to deliver in securities lending can happen on almost a daily basis, especially for something that is a hard-to-deliver security. A hard-to-deliver security would be something that is very scarce and very difficult to find a borrower in the security. There are failures to deliver every day.
Here's the other shocking statistic: The market where this happens the most is the U.S. Treasury bond market, and the Federal Reserve actually encourages all of this. It is the means by which the Fed institutes its monetary policy. It used to be that monetary policy was instigated through the traditional banking system, it’s how a lot of us learned it in school, the Fed injects a dollar of a monetary base into the traditional banks, they typically had about an 8 percent capital requirement. And that would turn into $12 of M2 if you've ever taken an economics class and learned about the difference between M0 and M2 the multipliers, and those similar multipliers exist in the securities industry as well, and it happens through rehypothecation.
CCN: Wow, it just almost sounds corrupt. If you're advising Bakkt, what are you telling them to do?
CL: Well, I'm not advising Bakkt, to be clear. They put out an interesting statement today and it directly spoke to some of the critiques that I and others have made about the fact that they're creating more paper claims to bitcoin then they have real bitcoin in their warehouse, and they didn't actually answer the question. They did actually say something very positive, which I gave them credit for, which is that they're not going to allow any margin on the physically-settled bitcoin contracts and no leverage in the contracts. But based on what I just walked you through, the devil is always in the details, right?
It’s the analogy that your broker statement isn't incorrect. It's just what's going on behind your brokerage statement that you don't have any visibility into and you don't know how many times they've promised that those very same Apple shares out to different people. That is the same thing happens in these clearinghouses; you don't know how many times the collateral has been promised out to different people, and I will give -- I sent back credit if they actually released their documents and indeed they absolutely are not commingling the collateral and they are not rehypothecating the collateral, and again, in this case what I'm talking about is physical bitcoin. If they are not playing those games, then I will be the first to stand up and congratulate them for doing it right.
Then, if they don't play those games the only thing that I think probably is outstanding the question posed by Andreas Antonopoulos, which is related but different which is the power of these large custodians to influence the software upgrades in the bitcoin network in the future. He raised this issue related to the big exchanges last summer when we were going through what happened in the control of bitcoin related to the scaling debate.
He's saying it, rightfully so, that that's going to be even more pronounced when Wall Street comes in and you start to get institutional quantity money in these markets. I think he would probably be in favor of is to enabling the actual owners of collateral to vote with their feet as opposed to Bakkt essentially voting on behalf of the entire pool that it controls. So we know if you control all your keys it’s your bitcoin, if you don't control your keys it's not your bitcoin, and that is going to become an issue with the [bitcoin] ETF as well. Gigantic “not-your-keys-not-your-bitcoin” pools of bitcoin where the people who really control them and therefore control the influence over the future of the software are those who are not necessarily aligned with the individual users.
CCN: Being able to make decisions for you, how is that currently handled with stocks where you have a big vote?
CL: It's not handled well; you would think that there would be one-for-one, one share-one vote. And that is indeed what the system appears to be. In fact, actually, if you go back and read that blockchain plunger speech by Vice Chancellor Travis Laster, that I referred to earlier, he talks about just how awful the proxy voting mechanism is in U.S. capital markets.
Laster should know because all the proxy laws are governed by state laws, and, of course, most corporations are domiciled in Delaware and so they are subject to Delaware law. All the proxy laws are governed by state laws. State law says you've got to have one share-one vote. Well, you don't have one share-one vote, and you don't have one share-one share even because of the way the shares are owned under indirect basis.
Anyway, he said that a big corporate attorney advised him that if there is a proxy vote that's closer than 55/45 that it's just a sheer guess, finger in the air as to who actually won the vote. We saw that in the Procter and Gamble proxy contest, which happened at the end of 2017, and in the Dole Foods case which was a 2017 case.
These examples are not old. They're very recent, but [in] the Proctor Gamble case the first vote count was plus 6.2 million for the Procter and Gamble candidate for the board seat. Then they did a recount and it came out negative 449,000 some odd votes. So the challenger in the recount actually won. Then it's swung back to positive 498,000 votes for Procter and Gamble. So you had two votes swinging by as many as 6.2 million in those vote counts. It just goes to show you how inaccurate the proxy system is, and the reason it's that inaccurate is the same reason that I don't trust my brokerage statements, which is that what's going on behind the scenes on Wall Street is not required to be accurate either. There's a lot of fault tolerance and estimation of ownership that happens in the system, and they count on the fact that not everybody wants to withdraw their shares at the same time, they count on the fact that there's not going to be a run on the bank. If there ever is you could have a situation like the Dole Foods situation where you discover they’re actually one-third more shares outstanding in people's brokerage statements then there were actual shares issued. In Dole Foods there were 49.2 million brokerage statements for 36.7 million shares outstanding.
CCN: If a bank starts handling these shares, and then there is a run on the bank because maybe there's going to be a hard fork, they can't even handle that. What usually happens in those cases in traditional markets?
CL: Well, in traditional markets you don't have something like a hard fork. You have stock splits and stock dividends. There are very clear rules if somebody is selling a stock short to govern what happens if there's a dividend or something that they have to actually pay the long investor the dividend. But because there is rehypothecation, it does create an interesting question like in a Dole Foods case. This is why I know there were losses because there were people who were owed money in the Dole Foods case that were not paid because I know that the brokers would not have been able to go back and collect what was paid out to the hedge funds, it took three years for this court case to find its way through the system.
What's happened in the intervening three years is every single hedge fund that owned Dole Foods shares is probably not open, and a lot of those hedge funds were specialist merger arbitrage hedge funds, many of them are still around, but not every one of them. I virtually guarantee that there are a couple of them that are just -- that wound up and they are not there anymore. So how's the broker going to go back to them and get the money to pay for the rightful owner? This is swept under the rug and there were some pensions and long-only owners of Dole Food that did not get their class action consideration in that case. It's a good question. I think that's something I can't answer. Only Wall Street can answer that question.
CCN: I just think one of the other interesting things about bitcoin is the hard cap on the amount of shares. I think you said this previously, the FTC should just come out and put you can't have more than 18 million shares at the moment. And then up that to 21 million. Is there any reason they're not doing that just because it's not really a concern right now? Have you heard anything there and are you willing to speculate on that?
CL: It all comes back down to the fact that the clearing and settlement system is where things get lost, so this is why this judge in Delaware who has to deal with these situations like Dole Foods and like Procter and Gamble and he talks about a Yahoo proxy contest and the Dell -- there was an issue with Dell shares a couple years ago, where he's got to try to reconcile the fact that Wall Street ends up saying that there's a different number of shares outstanding than is actually legally issued and outstanding under Delaware law and because corporate law is state law even though securities law is federal law, the corporate law is state law, so it ends up in litigation in the state courts.
This judge has been advocating for years that these are major issues being ignored and they have to be fixed, and it's the fiduciaries of pension funds and mutual funds, the boards of mutual funds, these are the guys that really should be looking out for regular investors and they're either -- they don't understand the issues because they are subtle. This rehypothecation is subtle. It may seem like how is it that the accounting system of Wall Street can create all these extra paper claims? Aren't they required to settle up and foot the balances every single night? Well, you actually do have these failures to deliver which creates, more shares outstanding than legally issued.
There is naked short selling, even though it's illegal and the SEC is supposed to be going after it again, I haven't seen them go after it in the Dole Foods situation and that doesn't mean they didn't, but I would have thought they would have made it public because that was such a public court case. There was black and white naked short selling that happened. I think the corporations are doing everything they can do to ensure that their shares are not over issued. It's the clearing and settlement infrastructure of Wall Street that doesn't have an interest in fixing the system. Unfortunately, the SEC, which has an investor protection mandate today is the one that really should be on this, but an interesting question is why they haven’t been.
Stay tuned for part 2 of CCN's interview with Caitlin Long.
Note: This interview is part of the CCN Podcast. The podcast and this interview are also available on iTunes, TuneIn, Stitcher, Google Play Music, Spotify, SoundCloud, YouTube or wherever you get your podcasts. Make sure you rate and subscribe!
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