he current times are fantastic opportunities for a new generation of economists to cut their teeth, albeit in studying the misery of us all. Here's some of that, cutting of teeth or gnashing, you decide. H/t to Arthur, here is the punchline from "Banks, government bonds, and default: What do the data say?" from Nicola Gennaioli, Alberto Martin, Stefano Rossi:
The transmission mechanism
Our results support the notion that banks’ holdings of public bonds are an important transmission mechanism from sovereign defaults to bank lending. These findings are broadly consistent with the following narrative. Public bonds are very liquid assets (e.g. Holmstrom and Tirole 1998) that play a crucial role in banks’ everyday activities, like storing funds, posting collateral, or maintaining a cushion of safe assets (Bolton and Jeanne 2012, Gennaioli et al. 2014a). Because of this, banks hold a sizeable amount of government bonds in the course of their regular business activity, especially in less financially developed countries where there are fewer alternatives. When default strikes, banks experience losses on their public bonds and subsequently decrease their lending. During default episodes, moreover, some banks deliberately hold on to their risky public bonds while others accumulate even more bonds. This behaviour could reflect banks’ reaching for yield (Acharya and Steffen 2013), or it could be their response to government moral suasion or bailout guarantees (Livshits and Schoors 2009, Broner et al. 2014). Whatever its origin, this behaviour is largely concentrated in a set of large banks, and is associated with a further decrease in bank lending.
There you have it. In short human words, the need for banks to hold the bonds of their government becomes a limit on their lending activity. As they enter crisis (the banks, the government or the economy), the banks are incentivised to hold more bonds. As they hold more bonds, their lending decreases.
Reducing lending confirms the recession, and indicates why we now see full depression in Southern Europe.
I've oft ruminated on the failure of economics that is central banking; it works until it doesn't. Central banking works thusly:
Notice that part 7 -- the cost of central banking always ends up with the citizen through either bailout (taxpayer) or inflation (money-holder). One destroys the middle classes, the other penalises the poor through their cash holdings. (The rich know that the safe money is now in owning and running the banks, who win always because they are rarely forced into real bankruptcy.)
One thing that strikes from that is the history of banking (c.f. Dowd especially) suggests that the requirement to hold state bonds is what brought the end to free banking in the USA. Now fast forward to Europe, and what brought the end was banks and governments over-extended in a deadly embrace.
The common factor is the lack of ability to inflate. The individual states in the USA weren't able to issue their own dollar, because money was competitive. The individual states in Europe are likewise unable to inflate away their trouble, because they gave that up to ECB.
What's left is bailouts.
I called the end of Central Banking many moons ago, which of course went down like a lead balloon. Now, in the post-Cyprus era, we see that one of the legs of Central Banking -- the rescue of the failed bank -- is being unwound:
BERLIN--Germany's cabinet Wednesday approved plans to force creditors into propping up struggling banks beginning in 2015, one year earlier than required under European-wide plans that set rules for failing financial institutions.
The new bail-in rules are part of a package of German legislation on the European banking union--an ambitious project to centralize bank supervision in the euro zone and, when banks fail, to organize their rescue or winding-up at a European level.
Germany "leads the way" in Europe by implementing European rules quickly and "creates instruments that allow the winding-down of big systemically relevant institutions without putting the financial stability at risk," the country's finance ministry said in its draft bill seen by The Wall Street Journal.
"This ensures that in times of crisis mainly owners and creditors will contribute to solving the crisis, and not taxpayers."
It is probably clear to most Euro-skeptics that the (a) nothing has been fixed, and (b) the troika cannot handle anymore bailouts. At least, it's more clear to the Germans, who have their own problems:
I have warned that about 50% of the German municipalities are on the verge of bankruptcy. The pensions have been unfunded and are absorbing everything. As we saw in Detroit with more than 50% of current revenue going to pensions, taxes either rise, the borrow more, or they are out of business. We are in a giant bull market for taxes increases on every level. This is the real downside of Marxism – they theory that just keeps taking.
Central Banking is unsustainable in our interconnected world. It's also unnecessary, as the invention of securitization, and other financial cryptography inventions to come are removing the fundamental economics need for the banking charter.
However, the way Central Banking dies is difficult to predict. The behemoths that they allowed to grow and devour still have much fat to carry them forward, and the Central Banks themselves aren't ready to call it a day. The carnage will continue for a while.
There's a fascinating signalling opportunity going on with US politics. As we all know, 99% the USA congress seats are paid for by contributions from corporate funders, through a mechanism called PACs or political action committees. Typically, the well-funded campaigns win the seats, and for that you need a big fat PAC with powerful corporate wallets behind.
Lawrence Lessig decided to do something about it.
"Yes, we want to spend big money to end the influence of big money... Ironic, I get it. But embrace the irony."
So, fighting fire with fire, he started the Mayday PAC:
"We’ve structured this as a series of matched-contingent goals. We’ve got to raise $1 million in 30 days; if we do, we’ll get that $1 million matched. Then we’ve got to raise $5 million in 30 days; if we do, we’ll get that $5 million matched as well. If both challenges are successful, then we’ll have the money we need to compete in 5 races in 2014. Based on those results, we’ll launch a (much much) bigger effort in 2016 — big enough to win."
They got to their first target, the 2nd of $5m will close in 30th June. Larry claims to have been inspired by Aaron Swartz:
“How are you ever going to address those problems so long as there’s this fundamental corruption in the way our government works?” Swartz had asked.
Something much at the core of the work I do in Africa.
The signalling opportunity is the ability to influence total PAC spending by claiming to balance it out. If MayDay PAC states something simple such as "we will outspend the biggest spend in USA congress today," then how do the backers for the #1 financed-candidate respond to the signal?
As the backers know that their money will be balanced out, it will no longer be efficacious to buy their decisions *with the #1 candidate*. They'll go elsewhere with their money, because to back their big man means to also attract the MayDay PAC.
Which will then leave the #2 paid seat in Congress at risk ... who will also commensurately lose funds. And so on ... A knock-on effect could rip the funding rug from many top campaigns, leveraging Lessig's measly $12m way beyond its apparent power.
A fascinating experiment.
The challenge of capturing people’s attention isn’t lost on Lessig. When asked if anyone has told him that his idea is ludicrous and unlikely to work, he answers with a smile: “Yeah, like everybody.”
Sorry, not this anybody. This will work. Economically speaking, signalling does work. Go Larry!
Last month, I launched a rocket at those who invest in Bitcoin as the Coin or the Currency. It's bad, but I won't repeat the arguments against it.
For those of you who've survived the onslaught on your sensitivities, and are genuinely interested in how to make an investment into the cryptocurrency world, here is part B: the Business! The good news is that it is shorter.
If one was to look for a good Bitcoin investment in a business, what would it be? I think you should be asking questions like these:
Signs of a bad investment:
Part of laying the groundwork is bringing the establishment on board, Malka said. “We need more banks participating in this. We need regulators. I’m part of the Bitcoin Foundation – we are out there trying to educate regulators.” Getting regulators on board will help get the banks to come along, Liew predicted. “If the regulators explicitly set forth rules that say, ‘Bright line, do this, you will find a bank that is willing to take on bitcoin customers,’” Liew said.
That's my B list so far. You'll note that it includes no conventional things, because you already have those. All it includes is pointers to the myths-of-doom peddled in the current bitcoin world as business talk. It's designed to separate out the happy hopefuls from the actual business possibilities, in a world where talking is deeper than walking.
Next up, when I get to it, is my A list: a point I believe so important I saved it for another post. Watch this space.
Preamble. In the last recent months I've seen a lot of interest in the question of what makes a good Bitcoin investment. I may not be the best person to make this call, but as I'm a reluctant skeptic, I may not be the worst person either. Most of the people I speak to are either confirmed believers, or they are people who are afraid of missing the boat. In either case, they haven't got a lot of critical analysis to offer, and as I've been there several times already, it seems I might have. I've been speaking on this issue at the moment in multiple fora, so I've been forced to put my thoughts in order. (Fair Warning. Long post ahead...)
Call this my ABC of Bitcoin investment. In reverse order, C for Currency. Put your coin on the table, and read on!
The first decision that hits the erstwhile investor in Bitcoin is this: to bet on the currency or to bet on the business?
Currency or business ?
can be seen as a diversification question. If you buy the coin, you are investing in the entire market, because, as the theory goes, it goes up with the fortunes of everyone, and comes down alike.
Diversification is a good strategy, and according to the efficient market hypothesis it is the only strategy that makes sense to a non-insider. In the stock market, this means buying a stock index fund, which is hated by the banks because they can't push your trades around and make fees off you. Which alone tells you diversification is a winner, and for these and other reasons, index funds typically perform in the top half of funds.
The strategy could be considered a good thing. Buying the currency could make you a smart investor!
It is also rather unique. For example, when you bought into that Internet boom in a big way in the 1990s, or the social networking of the 2000s, it wasn't possible to "buy the net!" Then, you had to make a more precise investment decision e.g., B for Business, which I leave to another post.
This time around, you can buy the coin literally, and see afar from everyone else's tall shoulders. What could make more sense?
I would however like to raise a bit of a red flag. Buying the coin might actually make a lot less sense than at first blanche. Let's work it through.
Unlike the stock market, the Bitcoin unit hasn't got the same longevity. The LSE, NASDAQ, Nikkei, etc will be around next year, in 10 years, and in some form in 100 years. Bitcoin might not be. It might be the Ripple or the Ethereum or the Bitcoin2.0 or any other strange and interesting name. Or Bitcoin might be a totally regulated thing, or it might be only traded in China, or it might be illegal or ...
The point being that there are a lot of potential futures. Which leads to issue number 1:
it's more a speculation than an investment
That part is obvious, but if it is so short-term, why does it gain in value? Bitcoin is rising in value rapidly because people are piling money into it on the expectation of future rewards.
We have a word for this: bubble.
Then, the second problem with investing in the currency, and holding it, is that you are now participating in the expectation of a rise of value for no work put in. Indeed, by deciding to invest, you are confirming that it is a bubble. Hence, caveat #2:
you are now part of the bubble!
Being part of a bubble isn't necessarily bad, yet. People participate in the stock market bubble or the real estate bubble all the time, and life goes on. Entire countries participate in the pension bubble, and nobody blinks!
As long as you don't lose money, you're fine. And, as long as you have no explaining to do, you're fine. If you're in a fund where risk taking is the idea, then this is a good thing. If however you feel that you need to explain to your upstream investors how you made your decisions on investment, and bubbles do not form part of that explanation, you might want to try an alternate strategy. Institutional or pension money might want to steer clear, whereas VC and hedgefund money might see this as the green light.
Let's assume today I am writing to angels and VCs, and let's pursue those bubble rewards.
There is, excitingly or sadly, more to come. Bitcoin is currently in a sort of early life crisis. As lifecycles go, it's discovered limbs and crawling and attempts at walking. And typically we get a lot of flailing and yelling and falling. Mt Gox is the canonical case, and it looks just like that, a toddler getting a few steps down the hall before collapsing in a heap. Then, tears.
Which highlights a particular difficulty. It is easy to buy Bitcoin, but it is harder to sell it. It turns out that the market is perhaps more illiquid than the glossy website stats indicate, for reasons of depth (lack of big buyers), fraud (which is what Mt Gox probably is) and gross mismanagement (ditto).
Unlike stock markets, if you've just put $75m of VC cash into Bitcoin currency, you have just purchased yourself a rather nasty little problem #3:
you can't sell out!
At an absolute minimum, you may not be able to shift the value without moving the market so far it loses your value, an issue investors in the HFT game know well. In practice, you may not be able to sell it at all, or you may have to wait months, or you may watch the value go down the tubes, to the point where you're left with pennies on the coin.
Or you may discover it was for sale, but now it's nowhere to be found.
Now you have more explaining to do. If you hold a cash instrument that can't be shifted, you can't mark it to market, you can't book it as liquid. You haven't got cash, it's starting to look just as liquid as holding startup stock (that is, not liquid), but without the business rationale backing it.
Did we say speculation or investment?
Worse, your upstream investors aren't going to buy that story, as they'll be watching the price on exchanges and ask you why you didn't shift it? They'll give you plenty of advice about who has the hottest exchange this month, but it will be you who is hitting the send button and relying on the promises of that shiny new website with the street address you can't pronounce.
Which leads us to the next problem:
can you pick the burst of the bubble?
Bubbles always burst. You the venture capitalist might be measured more on the fall from the peak than the rise from original investment, which will be booked as profit well before you get lucky on that score. So you are now on a very wild ride, where your decision will cast your future in an entirely positive light, or a disaster.
Let's cut to the chase: the only theory that we know of about picking the bursting of the bubble is the one of being lucky. Someone always sells just before the peak, and close investigation reveals that those people are often saying the same thing that everyone else is saying. When we strip out the factors we can scientifically identify, we're left with mostly luck.
Are you lucky?
To avoid the curse of excessive luck we typically suggest ... wait for it ... Diversification! And therein lies the rub. Although you've diversified from the risk of business collapse, you've just picked up other risks, being bubble popping, liquidity and fraud. Indeed, given the nature of Bitcoin, I think we can pretty much dismiss /buying the coin/ as a diversified strategy across the business of Bitcoin.
We are talking then not about a diversified strategy at all. Rather, buying the coin is a precise investment on a particular instrument -- the herd. Which means two things.
Firstly, blowing the bubble, as opposed to pricking the bubble. This is the pernicious issue of the mechanics of a bubble -- ever wonder why everyone in the Bitcoin community is a total believer? Now you're about to find out.
You've staked your future on the Bitcoin bubble. The only way that a bubble grows is if more people come in than go out. Or, more money, in than out.
As you are now invested in a bubble this means your incentives are now aligned with growing the bubble.
Where do those people and their money come from, once you personally are "all in"? Well, as it's not an economics simulation or a government policy, these new people do not exist in isolation or as mere statistics. You can't just push a button or wind up a knob or make a campaign promise, now you have to make it happen.
New investors are probably people you know, in your world. If you're a VC, new people are other VCs you chat to at the bar. If you're an angel, it's all the others in the angel meetup.
As you're now aligned to growing the bubble, *you want your friends in* !
And that's the crux. Having invested in a bubble, you now want people to pump up your investment. Which leads to two paths in your life:
Path one is the believer. You decide that there is no bubble, and therefore no bursting, or you consider it isn't relevant or will pass or it's a momentary hiccup or somesuch. You can comfortably turn your entire philosophy over to Bitcoinmania, and this is the future. You are a believer, and no analysis to the contrary is necessary or applicable.
Path two is the opportunist. You agree there is a bubble, and it will burst, but you are gambling that you can get out before it bursts.
Either way, in the meantime, the fundamental is true:
you have to recruit all your friends, relatives, partners, contacts, school buddies, pastor, teachers, mentors, ... EVERYONE!
This choice is a disastrous one for integrity. Every person you are selling into the market is a new victim to the eventual bubble burst. You're choice is dire. Dispose of all analytical skills and simply believe, in which case you'll never spot the top because you cannot believe and not believe at the same time;
OR, know that the top is coming, watch it ferociously, plan its every snap up and your flip out, but have to sell everyone else around you on a lie.
Sounds a bit drastic? Over the top?
Well, yes. It is drastic. But here's the clanger: the history of pyramid schemes, bubbles and ponzis predicts exactly that. We've been here before, hundreds of times. It doesn't matter where bubbles come from, when they get going, the herd phenomena is frightening. Friends trick each other, families consume themselves, businesses get sucked in, investment blows out.
And generally, what we find when we investigate the complaints is that everyone knew it was a bubble. Everyone believed. Everyone knew it was the opportunity of a life time. And everyone turned on their friends and families and pulled them into it.
This might be the sort of risk appetite that you like. If so, holding on to the currency as an investment is for you. If for example, you are a VC and you see 9 other VCs thinking seriously about going in, then there's an easy call for you -- in you go, quicker than them, and out you go if you can spot the top. You might see this as the bread and butter of your work.
And the scare reasons above might actually be just ranting or philosophising and can be ignored. Let's give it one more go.
There is one final reason why investing in the currency might actually be a bad bet. It is this: by investing in the currency, you are actually de-investing in the global Bitcoin community. Unlike buying the stock market index, by taking currency and hoarding it, it is no longer available to circulate and to provide new capital to the new business. As new capital is the only fundamental way, sans bubble, of making future investment returns, such a choice, buying the bubble, is reducing the float in the economy, and therefore reducing the overall growth, and the aggregate returns. Buy holding the currency, you are ensuring the bubble pops earlier rather than later.
Which is to say, your apparent prisoners' dilemma result of cheating not only rides on the backs of others' work, it also makes it harder to develop the market in the long run with /fundamental returns/. Only new value circulating as capital in the market can make it grow. It is a mathematical certainty that if you take money out of the market by hoarding it, you are reducing its ability to grow, and this is repeatedly demonstrated every time the central bank winds the knob to strip the cash out of the currency in order to cool it down.
Indeed, this force is so dramatic that when you as investor announce your intention to hold currency, positive investors should leave the room. They should ostracize you, they should shout at you, they should do all but shoot you! How dare you call yourself an investor when you are de-investing in Bitcoin? While everyone else is working hard to make the market work, you're dragging it down by withdrawing capital?
You are a negative investor.
You're actually doing more damage to the returns of the Bitcoin world than any government can.
I personally think that the investment in the currency is the worst of all options. In short sweet summary, it's lowering overall returns, it's not diversified at all, and it creates incentives to turn off the one thing I thought I valued above all else -- my brain. Indeed it is the sort of approach where you might have to hide your strategy because serious Bitcoiners -- those who've understood the potential of cryptocurrencies without losing sight of the reality of business investment -- are going to blackball you. And if I've learnt one thing in two decades in the financial cryptography game, it is this: In the money game, dirty hidden secrets have a way of biting you, hard.
If this all makes sense, then I'd suggest you look at the opportunity in investing directly in Bitcoin businesses, and not the currency. More on that in another post, labelled B for Business.
Bitcoin UK has done two podcasts on the cryptocurrency history before Bitcoin:
These podcasts were done at the same time as my rant as posted on the blog a little while ago, "A very fast history of cryptocurrencies BBTC -- before Bitcoin." Interesting for those that prefer to listen more than read.
New paper for circulation by Ken Griffith and myself:
Bitcoin Verification Latency
The Achilles Heel for Time Sensitive Transactions
Abstract.Bitcoin has a high latency for verifying transactions, by design. Averaging around 8 minutes, such high latency does not resonate with the needs of financial traders for speed, and it opens the door for time-based arbitrage weaknesses such as market timing attacks. Although perhaps tractable in some markets such as peer to peer payments, the Achilles heel of latency makes Bitcoin unsuitable for direct trading of financial assets, and ventures seeking to exploit the market for financial assets will need to overcome this burden.
As with the Gresham's paper, developments moved fast on this question, and there are now more ventures looking at the contracts and trading question. For clarification, I am the secondary author, Ken is lead.
Many systems are built on existing trust relationships, and understanding these is often key to their long term success or failure. For example, the turmoil between OpenPGP and x509/PKI can often be explained by reference to their trust assumptions, by comparing the web-of-trust model (trust each other) to the hierarchical CA model (trust mozilla/microsoft/google...).
In informal money systems such as LETS, barter circles and community currencies, it has often seemed to me that these things work well, or would work well, if they could leverage local trust relationships. But there is a limit.
To express that limit, I used to say that LETS would work well up to maybe 100 people. Beyond that number, fraud will start to undermine the system. To put a finer point on it, I claimed that beyond 1000 people, any system will require an FC approach of some form or other.
Now comes some research that confirms some sense of this intuition, below. I'm not commenting directly on it as yet, because I haven't the time to do more than post it. And I haven't read the paper...
'Money reduces trust' in small groups, study shows
By Melissa Hogenboom Science reporter, BBC News
People were more generous when there was no economic incentive
A new study sheds light on how money affects human behaviour.
Exchanging goods for currency is an age old trusted system for trade. In large groups it fosters co-operation as each party has a measurable payoff.
But within small groups a team found that introducing an incentive makes people less likely to share than they did before. In essence, even an artificial currency reduced their natural generosity.
The study is published in journal PNAS.
When money becomes involved, group dynamics have been known to change. Scientists have now found that even tokens with no monetary value completely changed the way in which people helped each other.
Gabriele Camera of Chapman University, US, who led the study, said that he wanted to investigate co-operation in large societies of strangers, where it is less likely for individuals to help others than in tight-knit communities.
The team devised an experiment where subjects in small and large groups had the option to give gifts in exchange for tokens.
- Participants of between two to 32 individuals were able to help anonymous counterparts by giving them a gift, based solely on trust that the good deed would be returned by another stranger in the future
- In this setting small groups were more likely to help each other than the larger groups
- In the next setting, a token was added as an incentive to exchange goods. The token had no cash value
- Larger groups were more likely to help each other when tokens had been added, but the previous generosity of smaller groups suffered
They found that there was a social cost to introducing this incentive. When all tokens were "spent", a potential gift-giver was less likely to help than they had been in a setting where tokens had not yet been introduced.
The same effect was found in smaller groups, who were less generous when there was the option of receiving a token.
"Subjects basically latched on to monetary exchange, and stopped helping unless they received immediate compensation in a form of an intrinsically worthless object [a token].
"Using money does help large societies to achieve larger levels of co-operation than smaller societies, but it does so at a cost of displacing normal of voluntary help that is the bread and butter of smaller societies, in which everyone knows each other," said Prof Camera.
But he said that this negative result was not found in larger anonymous groups of 32, instead co-operation increased with the use of tokens.
"This is exciting because we introduced something that adds nothing to the economy, but it helped participants converge on a behaviour that is more trustworthy."
He added that the study reflected monetary exchange in daily life: "Global interaction expands the set of trade opportunities, but it dilutes the level of information about others' past behaviour. In this sense, one can view tokens in our experiment as a parable for global monetary exchange."
Sam Bowles, of the Santa Fe Institute, US, who was not involved with the study, specialises in evolutionary co-operation.
He commented that co-operation among self-interested people will always occur on a vast scale when "helping another" consists of exchanging a commodity that can be bought or sold with tokens, for example a shirt.
"The really interesting finding in the study is that tokens change the behavioural foundations of co-operation, from generosity in the absence of the tokens, to self-interest when tokens are present."
"It's striking that once tokens become available, people generally do not help others except in return for a token."
He told BBC news that it was evidence for an already observed phenomenon called "motivational crowding out, where paying an individual to do a task which they had already planned to do free of charge, could lead people to do this less".
However, Prof Bowles said that "most of the goods and services that we need that make our lives possible and beautiful are not like shirts".
"For these things, exchanging tokens could never work, which is why humans would never have become the co-operative species we are unless we had developed ethical and other regarding preferences."
In comments to the last post, Glyph poses a hard question:
I'm curious: why, at this point, would you be a fan of Alan Greenspan?
He's the epitome of everything that went wrong with our financial system: a demagogue who substituted ideology for critical thought. He spoke as if he were an entrepreneur who understood the creation of real wealth by use of the free market, but whose real power and influence came from being a bureaucrat with the keys to the largest fiat money machine in the history of mankind.
A simple answer is found in rephrasing the question -- what is the alternative?
Let me expand on that. I'm not a fan of Central Banking, as many readers will know from my frequent posts. I see Central Banking as inevitably enslaved to the banks, the regulated consumes the regulator (something known in economic literature as the Stigler Conjecture).
But the realpolitik of the 20th century was that Central Banking was the structure of finance. Granted, that we have a central bank, who then is best to lead it?
In the trade, knowledge of monetary policy would probably stand out as the first and highest metric. But, also known as important to Central Banking is the quality of "independence".
Alan Greenspan was a notorious goldbug who became a boutique investment banker. He retained his suspicion of all fiat currencies until the end, and it is this skepticism of Central Banking that established his credentials as an independent thinker. In my book, picking someone who was already suspicious of Central Banking was probably an inspired choice, and this is borne out by his incredibly long career.
If we look for example at Mark Carney, the current most-talked about Central Banker who last month took post at the Bank of England, we see something of the same flavour. He is suspicious of banks by nature, as well as having been a banker with Goldman-Sachs. As I hear it, his time in Canadian public service was marked by keeping the banks on a tight leash, while those south of the border ran roughshod.
To paraphrase the above, Mark Carney thus represents a least bad choice among many worse choices. Need we present examples of the worse choices?
The fundamental problem is still the failure of Central Banking, and its history of protecting the TBTFs and allowing them to bring the system down.
It would be far better if we as a society and economy could ease away from Central Banking, TBTF and all that, but that is likely to take decades. In the meantime, who better to lead Central Banks than people naturally suspicious of banks?
If you, like me, are a fan of Alan Greenspan, you'd also be wondering what went wrong in the 2000s. His book is enlightening, but not conclusive. Observations that there were a series of heart-starting adrenalin injections into the economy -- the dotcom crash, 9/11, Fannie Mae, Bear-Stearns and Lehman Brothers, 2007, etc -- are illuminating but again not conclusive.
The train not only ran off the tracks, it left the reservation. The beauty of these graphs is that you don't even have to understand them to realise that something really crazy happened after 2000.
But that said, let's try and interpret them. The graph shows accelerating USA housing prices beyond the norm. The pre-2000 blob(s) on the bottom left corner shows stability over the long run, which is to say that housing prices were stable across the USA, over time. For the norm, housing prices were a direct reflection of the rest of the economy, and in stability.
Then, movement to the right shows rapidly increasing prices, as it measures the index of prices for a given year over 4 years before. Movement to the left shows rapid collapse, the reverse. Movement up&right shows overall (sustained?) increase in prices, movement down& left shows overall (sustained?) lowering.
I think then, this is compelling evidence. There was a bubble blown from the year 2000 to 2006 of epic proportions. It then collapsed between 2006 and 2013, still on-going (we're still 20 points above long run stability).
Only the Federal Reserve could blow such a bubble. And, it was done on Alan Greenspan's watch.
I'm still a fan of the magician. He did, overall, a far better job than Bernanke is doing right now. But, there is no doubt that the Federal Reserve lost the plot while under Greenspan's watch.
Which, for future economic historians, leaves a compelling research project: what went wrong? And for the rest of us, a mess.
(I’m a bank teller at a large national bank. A customer in her mid-twenties comes up to my till.)
Me: “Welcome to [bank name]! How can I help you today?”
Customer: “Yeah, can I find the total amount I owe for my student loans?”
Me: “Sure, what is your full name?”
(She gives me her name, and I give her the amount owed. It is a fairly large amount.)
(With a large smile, she hands me a cashier check from another bank, for the exact amount, totally paying off all loans she has with this bank. I enter the info, and print her receipt. I quickly run to the back to see my manager.)
Me: “Can I give this customer a couple of the promotional items that we usually give to people that open checking accounts?”
(My manager see the amount that she is paying, and that this means the customer has totally paid off the loans.)
Manager: “You can give her whatever you want!”
(I grab some items, and bring them back up to the till.)
Me: “Congratulations on paying off all your loans. Here’s your receipt, and a few gifts for paying off such a large loan amount.”
Customer: “Thank you very much! What I’m about to say has nothing to do with you; you are a great person, and thank you very much for the free gift. So, just go with everything I’m about to do.”
(She holds up the receipt above her head, and speaks in a loud voice.)
Customer: “Ha! Six years ago I sold my soul to this bank! But after going through the nine circles of hell, I have finally gotten free of it! I now owe you nothing, zip, zero, nada! I am free; no more bills, payments, fees, nothing. I’M FREEEEEEE!”
(Even as she walks out the doors, she’s yelling and dancing. The dozen or so other customers and workers watch her the whole time. Another customer speaks loud enough so just about everyone can hear him.)
Customer #2: “Raise your hand if you wish you could do that.”
(Just about everyone else in the bank raises their hand.)
Strange and contradictory notions, indeed. In contrast, the impatient bears over at ZeroHedge point to Iceland:
Iceland Debt Forgiveness Reaches $2 Billion Since Crisis By Omar R. Valdimarsson - 2013-06-24T15:26:26Z
Iceland’s lenders have forgiven household debt equal to about 12.4 percent of gross domestic product since the island’s 2008 financial collapse.
Lenders had written off 212.2 billion kronur ($1.7 billion) in household debt through the end of 2012, the Icelandic Financial Services Association said in a letter to parliament. The group estimated a further 35.3 billion kronur will be forgiven this year after they recalculate loan agreements to meet a Supreme Court ruling.
About 141.2 billion kronur of that follows a ruling from the island’s top court stating that mortgage loans indexed to foreign exchange rates were illegal, it said.
The island’s biggest banks failed in October 2008, after defaulting on about $85 billion in debt. The collapse plunged the island’s economy into a crisis that sent unemployment surging nine-fold and triggered a recession.
The association said that of the total, 45.8 billion kronur in private debt was forgiven as part of an agreement that stipulated that debts exceeding 110 percent of a property’s value must be written off.
This is germane because, as ZeroHedge do not hesitate to remind us, "Iceland is so far the only success story in the continent of Europe, which continues sliding into an ever deeper depressionary black hole, as a result of the complete destruction of its financial sector and its subsequent rise from the ashes..."
If you're still interested, here's Chris's generational perspective and his gentle reminders that Britain has a "a £27.1 billion capital shortfall in the UK banking system" and a few random other troubled bank reports. Probably unimportant in the scheme of things.
Wait, one of those is a third way to get out of crushing debt:
Taped telephone recordings (from the bank's own systems) from inside doomed Anglo Irish Bank reveal for the first time how the bank's top executives lied to the Government about the true extent of losses at the institution. ...
Anglo itself was within days of complete meltdown – and in the years ahead would eat up €30bn of taxpayer money. Mr Bowe speaks about how the State had been asked for €7bn to bail out Anglo – but Anglo's negotiators knew all along this was not enough to save the bank.
The plan was that once the State began the flow of money, it would be unable to stop. Mr Bowe is asked by Mr Fitzgerald how they had come up with the figure of €7bn. He laughs as he is taped saying: "Just, as Drummer (then-CEO David Drumm) would say, 'picked it out of my arse'."
And a picture makes 4. I should change the title, but who cares about numerical accuracy these days?
A series of posts over on Chris Skinner's Financial Services Club has amounted to a whistleblowing expose par excellence!
First up, a victims organisation called BullyBanks has collected over a thousand cases of mis-selling of Interest Rate Swap Agreements (IRSAs) to small / medium businesses (SMEs). To dispose of the essentials quickly, these were complex derivatives that were mis-sold to businesses that had no clue what they were about:
You can see the details on the posts. Chris estimates the potential damage as such:
Jeremy was a victim of the process and has been championing the cause ever since. He now counts 1,200 companies in his group, Bully Banks, out of the 40,000 cases that have been identified so far.
It does not sound like much, but if each case averages £2.5 million compensation, this is a £100 billion exposure and is far bigger than the PPI mis-selling scandal we all know about already.
Did the banks do anything wrong? Chris asks exactly that, rhetorically:
BullyBanks lays it out:
The substantial majority of the complaints of the business men and business women who are members of Bully-Banks have most of the following elements:
- The complainant is dependent upon finance provided by their Bank. Without that finance they could not continue in business.
- Their Bank sold them the IRSA when loan facilities were being granted or extended.
- Their Relationship Manger advised that the Bank believed interest rates were at an historic low and were going to rise in the medium term.
- Their Relationship Manager warned that the Bank was concerned about the complainant’s ability to finance their loan if interest rates were to rise significantly.
- The Relationship Manager introduced the concept of the IRSA to the complainant – an IRSA is normally outside the knowledge or experience of the complainant.
- The Relationship Manager stated that the IRSA was something that the Bank wanted the complainant to enter into and either made this recommendation as part of the grant of the loan facilities or stipulated it as a requirement as part of the grant of the loan facilities.
- The Relationship Manager then introduced an expert from the appropriate division of the Bank to arrange the IRSA. The expert was introduced as an advisor. No mention was made of the fact that in fact the expert was a salesman earning significant levels of commission on the sale of the IRSA. (No mention was made of the fact that in many cases the Relationship Manager also had annual targets to sell IRSAs.)
- The Bank typically booked a significant profit on the sale of the IRSA even though no mention of this profit to the Bank was made at the time the complainant was advised that the Bank wanted the complainant to enter into an IRSA.
Those are claimed facts from BullyBanks, and the presentation at the Financial Services Club was even harsher.
Rhetorically, we can look at it from a perspective of law. The high-bar charge here would be fraud. In order to show fraud, prosecutors would generally test on three elements: Intent, deception & damages.
In reading all of the information so far published by BullyBanks and FSC, I would say either there is a charge of fraud to be answered, OR, BullyBanks is simply wrong, barking mad and up its tree. Whether their claims were sustainable in court, before a jury, would answer which of the two.
“I wonder when the banks will be taken to court for not protecting customers from interest rate rises?”
The question was asked in sarcasm, but it is precisely on point. BullyBanks has made a claim, in effect, that the banks told the customer the IRSA was to protect them from interest rate rises, but their evidence suggests it was a rort to sell the customer an explosive derivative.
In short, a deception, one of the three elements of fraud.
So why didn't the banks get taken to court? Well, it turns out that the above poster is not the only one mystified:
Mainly because of the Parliamentary investigation, the Financial Services Authority was kicked into action and, on June 29 2012, announced that it had found "serious failings in the sale of IRSAs to small and medium sized businesses and that this has resulted in a severe impact on a large number of these businesses.”
So it seems that the FSA initially ignored the complaints. Then because of parliamentary bullying, it investigated, and agreed there was a case to answer for. What did it do next?
However, [the FSA] then left the banks to investigate the cases and work out how to compensate and address them.
Promptly handed the case back to the banks to deal with! Are those words for real? What we have here is ... fraud. Now, either the FSA lied and there wasn't any mis-selling, or there was a bona fide case to be answered.
Worse, the banks agreed:
The banks response was released on January 31 2013, and it was notable that between the June announcement and bank response in January that the number of cases rose from 28,000 to 40,000. It was also noteworthy that of those 40,000 cases investigated, over 90% were found to have been mis-sold. That’s a pretty damning indictment.
Even then the real issue, according to Jeremy, is that the banks are in charge of the process
Even if there is no case found in court, it is still the prosecutor's job to try it. It is not the FSA's job, not the banks' job, and it is certainly not the FSA's role to hand the mess across to the perpetrators.
BullyBanks also smells a rat:
Our lobbying campaign is now focused on addressing this failure by the FSA. ... Bully-Banks has already made a substantial contribution to the raising of this issue in the UK. Bully-Banks is now working hard on the next phase of its campaign in the UK: a submission to the Treasury Select Committee and further lobbying of Members of Parliament. It is also beginning to address a number of legal issues in the UK which have arisen in connection with the mis-selling of IRSAs.
Which reminds me of the mess the Reserve Bank of Australia got into. In short: they were formally advised of a serious suspicion of crime by one of their executives. RBA decided to take legal advice on this claim, and the advice from a notable law practice was that no Australian crime had been committed. So, armed with a legal opinion, the RBA did ... nothing. Fast forward to a media expose, the police investigated, and laid charges against some 8 or 9 people.
It transpires in Australia at least, a federal agency has to by law refer suspicion of crimes to the police. It doesn't have an option of deciding itself.
One wonders then if the FSA knows what it is doing? Open question for British readers: is it a requirement in the UK for Crown Agencies to refer crimes to the prosecutor? Or is the FSA in possession of some magical get-out-of-jail card?
Back to the rhetorical question:
Have banks behaved badly or are customers a little bit stupid?
If, still by way of rhetorical evidence so far presented, fraud were indicated, then the customer doesn't need to be a little bit smart - they are entitled to rely on the banks for banking expertise and fair dealing.
So it seems pretty clear: the banks behaved badly. QED. (If you are still not convinced, check out the bad behavior in the other whistleblowing post ... combine the two!)
But what is more disturbing still is that the FSA behaved even worse. This is a rather damning indictment that British Banks are unregulated. Penultimate word to Chris:
...the industry is known for selling you an umbrella when the sun is shining, only to find the umbrella full of holes when it rains. Is this true? Are we working in an industry purely focused upon ripping off our customers or do we work in a business that is customer focused and honestly trying to help?
I believe it is the latter and, for all the shenanigans of LIBOR, swaps, PPI and more, it is purely a few rotten eggs and ill-judged deeds that have resulted in where we are today, and not a systematically focused industry trying to rip off their customers.
Don’t you agree?
For me: No.
Yes, it's the first of May, also known as May Day, and the communist world's celebration of the victory over capitalism. Quite why MayDay became the international distress message over radio is not known to me, but I'd like to know!
The bank went through their customer base and identified which businesses were asset rich and cash poor.
Typically, the SME (small to medium enterprise) would require funding for expansion or to cover short term exposures, and the bank’s relationship manager would work with the business owner on a loan funding cover.
The loan may be for five or ten years, and the relationship manager would often call the client after a short time and say “congratulations, you’ve got the funding”.
The business owner would be delighted and would start committing the funds.
This would start the process of the disturbance sale of the IRSA.
The rest you can imagine - the bank sold an inappropriate derivative with false information, and without advising the customer of the true costs. This time however the costs were more severe, as it seems that many such businesses went out of business in whole or in part because of the dodgy sale.
In particular, the core issue is that no-one has defined whether the bank will be responsible for contingent liabilities.
The liabilities are for losses made by those businesses that were mis-sold these products and, as a result, have now gone into bankruptcy or been constrained so much that they have been unable to compete or grow their business as they would have if they had not taken these products.
Ouch! I have to applaud Chris Skinner and the Financial Services Club here for coming forth with this information. It is time for society to break ranks here and start dealing with the banks. If this is not done, the banks will bring us all down, and it is not clear at all that the banks aren't going to do just that.
Meanwhile back to the scandal du jour. We are talking about 40k businesses, with average suggested compensation of 2.5 million quid - so we are already up to a potential exposure of 100 billion pounds. Given this, there is no doubt that even the most thickest of the dumbest can predict what will happen next:
Mainly because of the Parliamentary investigation, the Financial Services Authority was kicked into action and, on June 29 2012, announced that it had found "serious failings in the sale of IRSAs to small and medium sized businesses and that this has resulted in a severe impact on a large number of these businesses.”
However, it then left the banks to investigate the cases and work out how to compensate and address them .
The banks response was released on January 31 2013, and it was notable that between the June announcement and bank response in January that the number of cases rose from 28,000 to 40,000. It was also noteworthy that of those 40,000 cases investigated, over 90% were found to have been mis-sold. That’s a pretty damning indictment.
Even then the real issue, according to Jeremy [of Bully Banks], is that the banks are in charge of the process.
Not only is the fox in charge of the chickens, it's also paying off them off for their slaughter. Do we really need to say more? The regulators are in bed with the banks in trying to suppress this scandal.
Obviously, this cunning tactic will save poor banks money and embarrassment. But the emerging problem here is that, as suggested many times in this blog (e.g., 2, 3, 4, ...) and elsewhere, the public is now becoming increasingly convinced that banks are not healthy, honest members of society.
But I see an issue emerging in the next systemic shock to hit the financial world: if the public's patience is exhausted, as it appeared to be over Cyprus, then the next systemic shock is going to cause the collapse of some major banks. For right or wrong, the public is not going to accept any more talk of bailouts, taxpayer subsidies, etc etc.
The chickens are going to turn on the foxes, and they will not be satisfied with anything less than blood.
One hopes that the old Lady's bank tear-down team is boned up and ready to roll, because they'll be working hard soon.
The Economist talks about corruption in sport, and how to deal with it:
For sponsors like ING, disassociating the company or a brand from corruption in sport simply makes good business sense, protecting reputation and image from the negative perceptions of consumers. For banks, this matters especially. Domestic banking is built upon customer trust; how then could such an organisation be associated with a team that was demonstrably untrustworthy? It is such incongruence that is at the heart of the newly emerging market-driven morality: sponsors do not want to be associated with corruption and hence recoil from it.
That was easy...
Now, what about those within? Front-running, Libor, PPI over-selling, robo-signing, MBS pushing, bonuses, off-balance sheet liabilities, risk-free sovereign debt, audit failures, secret bailouts, ... plenty of life left in this game!
Chris says Image sourced from Catholic in Brooklyn
We've all seen the various rumours of digital and electronic attacks carried out over the years by the USA on those countries it targets. Pipelines in Russia, fibre networks in Iraq, etc. And we've all watched the rise of cyber-sabre rattling in Washington DC, for commercial gain.
What is curious is whether there are any limits on this behaviour. Sigint (listening) and espionage are one thing, but outright destruction takes things to a new plane.
Which Stuxnet evidences. Reportedly, it destroyed some 20% or so of the Iranian centrifugal capacity (1, 2). And, the tracks left by Stuxnet were so broad, tantalising and insulting that the anti-virus community felt compelled to investigate and report.
But what do other countries think of this behaviour? Is it isolated? Legal? Does the shoe fit for them as well?
Now comes NATO to opine that the attack was “an act of force”:
The 2009 cyberattack by the U.S. and Israel that crippled Iran’s nuclear program by sabotaging industrial equipment constituted “an act of force” and was likely illegal under international law, according to a manual commissioned by NATO’s cyber defense center in Estonia.
“Acts that kill or injure persons or destroy or damage objects are unambiguously uses of force,” according to “The Tallinn Manual on the International Law Applicable to Cyber Warfare.”
Michael N. Schmitt, the manual’s lead author, told The Washington Times that “according to the U.N. charter, the use of force is prohibited, except in self-defense.”
That's fairly unequivocal. What to make of this? Well, the USA will deny all and seek to downgrade the report.
James A. Lewis, a researcher at the Center for Strategic and International Studies, said the researchers were getting ahead of themselves and there had not been enough incidents of cyberconflict yet to develop a sound interpretation of the law in that regard.
“A cyberattack is generally not going to be an act of force. That is why Estonia did not trigger Article 5 in 2007,” he said, referring to the coordinated DDoS attacks that took down the computer networks of banks, government agencies and media outlets in Estonia that were blamed on Russia, or hackers sympathetic to the Russian government.
Cue in all the normal political tricks to call white black and black white. But beyond the normal political bluster and management of the media?
Under the U.N. charter, an armed attack by one state against another triggers international hostilities, entitling the attacked state to use force in self-defense, and marks the start of a conflict to which the laws of war, such as the Geneva Conventions, apply.
What NATO might be suggesting is that if the USA and Israel have cast the first stone, then Iran is entitled to respond. Further, although this conclusion might be more tenuous, if Iran does respond, this is less interesting to alliance partners. Iran would be within its rights:
[The NATO Manual] makes some bold statements regarding retaliatory conduct. According to the manual's authors, it's acceptable to retaliate against cyberattacks with traditional weapons when a state can prove the attack lead to death or severe property damage. It also says that hackers who perpetrate attacks are legitimate targets for a counterstrike.
Not only is Iran justified in targetting the hackers in Israel and USA, NATO allies might not ride to the rescue. Tough words!
Now is probably a good time to remind ourselves what the point of all this is. We enter alliances which say:
Article 5 of the NATO treaty requires member states to aid other members if they come under attack.
Which leads to: Peace. The point of NATO was peace in Europe, and the point of most alliances (even the ones that trigger widespread war such as WWI) is indeed peace in our time, in our place.
One of the key claims of alliances of peace is that we the parties shall not initiate. This is another game theory thing: we would not want to ally with some other country only to discover they had started a war, to which we are now dragged in. So we all mutually commit to not start a war.
And therefore, Stuxnet must be troubling to the many alliance partners. They see peace now in the Middle East. And they see that the USA and Israel have initiated first strike in cyber warfare.
This is no Pearl Harbour scenario. It's not even an anticipatory self-defence, as, bluster and goading aside, no nation that has developed nuclear weapons has ever used them because of the mechanics of MAD - mutually assured destruction. Iran is not stupid, it knows that use of the weapons would result in immediate and full retaliation. It would be the regime's last act. And, as the USA objective is regime change, this is a key factor.
So it is entirely welcome and responsible of NATO -- in whatever guise it sees fit -- to stand up and say, NO, this is not what the alliance is about. And it can't really be any other way.
Cypriot President Nicos Anastasiades agreed to shut the country’s second-largest bank under pressure from a German-led bloc in a night-time negotiating melodrama that threatened to rekindle the debt crisis and rattle markets.
The revised accord spares bank accounts below the insured limit of 100,000 euros. It imposes losses that two EU officials said would be no more than 40 percent on uninsured depositors at Bank of Cyprus Plc, the largest bank, which will take over the viable assets of Cyprus Popular Bank Pcl (CPB), the second biggest.
Cyprus Popular Bank, 84 percent owned by the government, will be wound down. Those who will be largely wiped out include uninsured depositors and bondholders, including senior creditors. Senior bondholders will also contribute to the recapitalization of Bank of Cyprus.
This is how it should be. In order to avoid moral hazard - the laziness from complete insurance - the people responsible must suffer the consequences of their judgement. The bond holders must be left short. The creditors -- uninsured depositors  -- must lose. The shareholders must be wiped out. The employees must be sacked, and officers in positions of material decision making must be pursued.
Only when that message gets out across Europe, and the world, will the people who choose to do business with their bank begin to regulate their bank.
Or withdraw their funds; which is the safety mechanism in a sound system against bad banking :
Second, the commitment to the convertibility would provide an effective discipline against goldsmith-bankers who issued an excess of notes. When banks issued convertible notes, their circulation would be limited by the demand to hold them. That demand would depend on such factors as the precise features of the convertibility contract (for example, whether the depositor had to give notice when he wanted to withdraw his deposit), the bank's reputation, the familiarity of its notes, the number of branches it maintained, and so on. Any notes issued beyond the demand to hold them would be returned for redemption.
The law for banks might have changed, but the laws of banking do not.
 This is not the end to the Cyprus story. Although the remedy is correct there are still questions to ask. Who owns the bonds? It turns out that a large part of the bonds have been put as collateral for emergency lending to the ECB. Which is then guaranteed by the national central bank. Oops. Story yet to unfold.
The Cyprus news flows in, thick and fast. There are only a few major points. As expected from any nation made of /ellos con cajones/, the Cypriots slapped down the European offer, 36 to nothing (much). The problem here can be seen as the curse of a small democratic nation -- which is to say, the representatives probably still have to answer to their constituency, unlike their more sophisticated northern counterparts.
Meanwhile, the Europeans are perhaps left bemused at the fail of the bid. They gave it their best shot, non? What now?
Cypriot Finance Minister Michael Sarris flew to Moscow on Tuesday to seek Russian financial assistance. He denied by text message reports that he had resigned, which rattled nerves as lawmakers were poised to vote.
Let's sum up the friendship. The Russians already loaned in 2.5bn, sans Eursury. They're hopping mad at being excluded from the conference of debtors. They're also a bit red faced -- slap slap -- at repeated allegations of hot money. Further, although the media plays shy on this one, it turns out that Cyprus has become a nice little center for serious, legal, solid Russian business. As well as a destination for that soon to be listed endangered species: English common law.
The din of criticism from Moscow signaled the importance of Cypriot offshore financing for the Russian economy. The island has long served as an escape valve for Russian businessmen. Some are surely dodging local taxes. Others, paradoxically, are seeking better courts in the British law system practiced in Cyprus.
Offshore domiciles are so ingrained in the post-Soviet way of doing business in Russia that Cypriot shell companies are linked not only with money launderers and organized crime, but well-established companies like the metals giant Norilsk Nickel.
H/T to naked capitalism and Lynn in comments on that one. Naked capitalism does not go so far on this, but I wonder: This is one hell of a friendship.
For some number around 10bn, plus/minus, perhaps the Russians get to buy into Europe. As long as they (a) respect the english common law tradition, (b) leave the islanders to live out their happy sun-kissed lives, and (c) sort out the banks, what objection could there be, nyet?
Not to mention, Nota bene to students of long Russian strategy & short Middle Eastern futures, pay no attention to the hands,... Cyprus is a warm weather port.
Cypriots woke up on March 16 to find bank transfers frozen as the country’s authorities prepared to remove the tax from accounts before banks were scheduled to reopen on March 19. The Cypriot central bank has since declared bank holidays until March 21 to avert the prospect of account-holders withdrawing all their savings.
The economics term 'bank holiday' is historically synonymous with the banking system being bankrupt, at least.
Meanwhile, the European Finance Ministers have held strong on the need for Cyprus to raise the cash, but left open flexibility in just who for the Cypriots.
What a dilemma! The obvious answer is "just deposits over 100k" but that will cause massive withdrawals of those same massive deposits from the massive Russian Oligarchs, and put the banking sector into crisis as its revenues and profits are pretty much dependent on those things. (e.g.) The more subtle answer is they have to move broader afield ... and hit the bond holders.
Which will not please the Europeans. Why not? Same reason different channel: the bond holders are the European banks. And the root asset failure of the banking sector is that they are all left holding each others' junk bonds. Wipe out a class of bonds anywhere, and contagion is an issue.
The Europeans have fought to keep the bonds good, but it is an open question how long the game of Russian Roulette goes on. This is exactly how Cyprus got into this mess in the first place: Greek bonds. Which, as all who have studied real banking (a.k.a. free banking) know well, points to the root cause of most banking crises: state intervention in the quality of banking reserves:
One of the US's major criticisms of IFRS (International Financial Reporting Standards) is that it is subject to political intervention.
They're right to be concerned, said Mr Andrew. "We had regulators and governments telling us not to write down Greek debt in certain countries. They were refusing to allow accounting firms to adjust, saying they would underwrite a portion of the debt but refusing to put [that commitment] in writing," he said.
In short, banks are required to list state bonds as risk-free. When they are not. Cyprus is one step closer to leaving the euro zone, and declaring default on its bonds. Like Iceland.
News over the weekend has it that Cyprus has agreed to a bailout, but in exchange for the most terrible of conditions: Cypriot depositors are to be taxed at rates from 6.75% to 9.9% of their deposits.
This is utter madness, and the reasons are legion. Speaks the Economist:
EVERYONE agrees that taxpayers should be protected from the cost of bailing out failing banks. But imposing blanket losses on creditors is still taboo. Depositors have escaped the financial crisis largely unscathed for fear of sparking panic, which is why the idea of hitting uninsured depositors in Cypriot banks has caused policymakers angst.
You muck around with deposit holders or your own people at your peril. There is now a fair chance of a bank run in Cyprus, and a non-trivial chance of riots.
Further, the bond holders don't get hit. Not even the unprotected ones!
Worse, yet, the status of deposit is enshrined in a century of law, decisions and custom. It is not going to be clear for years whether the law will sustain ahead of legal challenges. Consider the mess about Greek bonds in London, and that allegedly big powerful Russian oligarchs are involved? A legal challenge is a dead certainty.
Finally, and what is the worst reason of all - the signal has been sent. What happened to the Cypriots can and will happen to the Spanish. And the Italians. And if them, the French. And finally, those safe in the north of Europe will now see that they are not safe.
The point is not whether this will happen or not: the point is whether you as an individual saver wish to gamble your money in your bank that it won't happen?
The direction of efforts to improve banks’ liquidity position is to encourage them to hold more deposits; the aim of bail-in legislation planned to come into force by 2018 is to make senior debt absorb losses in the event of a bank failure. The logic behind both of these reform initiatives is that bank deposits have two, contradictory properties. They are both sticky, because they are insured; and they are flighty, because they can be pulled instantly. So deposits are a good source of funding provided they never run. The Cyprus bail-out makes this confidence trick harder to pull off.
Other than that, it is a really good deal.
In short words, Cyprus bail out means: start a run on European banks. Only time will tell how this goes on.
What's to take solace? Perversely, there is an element of justice in this decision. Moral hazard is the problem that has pervaded the corpus bankus for a decade now, and has laid low the financial system.
Moral hazard has it that if you fully insure the risk, then nobody cares. And indeed, nobody in the banking world cares, it seems, since they've all acquired TBTF status. None of the people care, either, as they happily deposited at those banks, even knowing that the financial sector of Cyprus was many times larger.
Go figure ... here comes a financial crisis, and our banks are bigger than our country? What did the Cypriot people do? Did they join the dots and wind back their risk?
However the figures are massaged down, the nub of the problem will remain: a country with a broken banking model. Unlike Greece, brought low by its unsustainable public finances, Cyprus has succumbed to losses in its oversize banks. By mid-2011 the Cypriot banking sector was eight times as big as GDP; its three big commercial banks were five times as large.
No. Moral hazard therefore has it the stakeholders must be punished for their errors. And the stake holders of last resort are the Cypriot people, or at least their depositors. And their pensioners, it seems:
In practice the main answer will be to dragoon Cyprus’s pension funds and domestic banks into financing the €4.5 billion of government bonds due to be redeemed over the next three years.
It is highly likely that Cypriot pensioners will lose the lot, as it worked for Spain.
Which does nothing to obviate the other arguments listed above. Regardless of this sudden and surprising display of backbone by the Troika, it is still madness. While we may actually be on the cusp of cure to the disease, the patient might die anyway.
European leaders could at long last bite the bullet and insist on a bail-in of bank creditors to cover expected losses. The snag is that any such action would set alarm-bells ringing for investors with serious money at stake in banks elsewhere in the euro area. Mario Draghi, the ECB’s president, said on March 7th that “Cyprus’s economy is a small economy but the systemic risks may not be small.”
Watch Cyprus with interest, as if your future depends on it. It does.
The obvious problem with TBTF - too big to fail - is that banks that successfully manoeuvre governments into awarding them with the honoured right of printing money for nothing (aka bonuses, and chicks for free) also set the governments up for the eventual fall.
Although bank failure is traumatic, the alternate is far worse, at every possible level. Economic theory has it quite simply: if a bank fails, then all the directors must be punished, all the shareholders be set to zero, and the creditors must lose. No other reminder is sufficient to instill in the public's minds the need to treat their banks with skepticism.
But western, socialist or community minded governments often fall into the Misean trap of thinking they can do better than the market. And at times, they can -- central banks have successfully taken over many banks, fixed them, and returned them to the market. At a profit, even.
But the market always reasserts in time. They only thing that changes is who pays for the folly. And so comes Icesave - against who's creditors a European court has ruled:
The ruling, delivered in Luxembourg by the European Free-Trade Association Court, dealt with the collapse of Icesave, an online subsidiary of Iceland’s Landsbanki. Before the crisis Icesave had used a European “passport” to open branches abroad and collected deposits in Britain and the Netherlands with almost no oversight from regulators in those countries. One condition of its passport was that it promised that its deposits were backed by a national deposit-insurance scheme in Iceland. Yet when the bank collapsed Iceland’s deposit scheme was overwhelmed. Icelandic depositors in the bank ended up getting their money back; the British and Dutch governments both had to step in to compensate depositors in their countries.
Many observers had expected the court to rule that Iceland was obliged to stand behind its national deposit-protection plan and not to discriminate against foreign depositors. Instead the court found that Iceland was obliged only to make sure that it had a deposit-insurance scheme. The state was not required to pay out if the scheme had no money because of a banking crisis. Oddly, the court also found that Iceland had not breached an obligation not to discriminate between domestic and foreign depositors, even though it made only the domestic ones whole.
As an individual who had lost money in such a case, I would be yelling for blood. But as an economist, this is the wrong approach -- I the individual should be yelling for blood at the shareholders' meeting while the bank is still solvent, not after it is obviously dead.
The way the Economist writes the above story is common sense, and can get no better. Obviously, a national deposit-insurance only insures the nationals, or more precisely the residents. It's that word - "national" - which was curiously not extended to "community".
Obviously, such a scheme was in place. What is not clear is, in the sad event that it failed, why would one imply that there was another scheme behind it? Or why would one imply that a given "national deposit scheme" was a bottomless pit of value for tapping? A scheme has a value, right?
The SoFFin (Sonderfonds Finanzmarktstabilisierung - Special Financial Market Stabilization Funds) is a program of the German government with the purpose to stabilize and restore confidence in the financial system. .... The SoFFin may grant guarantees of up to 400bn euros and recapitalize or purchase assets for an additional 80bn euros.
Only if one can suspend any judgement as to the credibility and creditworthiness of the players, can one assume that a fund would never fail, but this is what people typically do. If Wikipedia knows the number for Germany, why don't the people?
This assumption flies in the face of evidence that is presented daily. Well, yesterday at least: Six of the big Canadian banks are now downgraded:
"Today's downgrade of the Canadian banks reflects our ongoing concerns that Canadian banks' exposure to the increasingly indebted Canadian consumer and elevated housing prices leaves them more vulnerable to unpredictable downside risks facing the Canadian economy than in the past," said Moody's vice president David Beattie.
We need more of it. Meanwhile, in not so sensible news, the Greeks have gone precisely backwards and declared war on themselves:
Any transaction in excess of 500 euros will soon only be allowed via credit or debit card or by check, according to a plan by the Finance Ministry aimed at combating tax evasion.
The ceiling for cash transactions is to be lowered from 1,500 euros today to 500 euros and could be reduced further over in the course of 2013. Ministry sources say that in the first quarter of the new year all companies and certain self-employed individuals will have to obtain the POS (point-of-sale) terminals that provide for card transactions.
The problem with this is that, although the Greek problem of taxation failure is well known, there is another larger problem: the Greek economy is dying. And this is a problem for the whole population, not just the sub-sector know as "the government".
People need to eat. If the economy is failing, they need to resort to themselves, their local communities, their families and their long standing local trade relationships. They need small trades, efficient trades, hand to hand and barter.
Trust at a local level, because there is nothing else. It is no longer a question of savings, or deposit schemes, or even taxation - it's about survival. People need the cash.
Instead of assisting this process, and serving the very survival of their People, the government of Greece is assisting the banks which everyone knows to be bankrupt. Which then is a shot across the bows of the Greek People.
So one has to ask a question - are the People of Greece irretrievably stupid? Will they rush in droves to place their cash in banks, and trust in the Greek Government to make them whole if there are any failures? Is their national deposit scheme a bottomless pit of value?
Or, are they possibly like the now chastened British and Dutch - a little more skeptical of offers endorsed by a regulator who's best idea for repairing an economy is to strip raw circulating cash out of the economy. Or, the Spanish, who are moving (their cash and sometimes themselves).
Coincidentally, stripping the cash out of the economy is an idea championed to great effect in the 1930s by none other than the USA Federal Reserve.
When banks are bankrupt, we need them to fail. What other language will get the message through?
In yet another "that's a bad gender term" debate somewhere, this article popped up: "Evidence for a Collective Intelligence Factor in the Performance of Human Groups," Woolley et al, Science 2010. Massacring it to extract its core message:
"However, three factors were significantly correlated with c [Group Intelligence]. First, there was a significant correlation between c and the average social sensitivity of group members.... Second, c was negatively correlated with the variance in the number of speaking turns by group members.... In other words, groups where a few people dominated the conversation were less collectively intelligent than those with a more equal distribution of conversational turn-taking.
Finally, c was positively and significantly correlated with the proportion of females in the group (r = 0.23, P = 0.007). However, this result appears to be largely mediated by social sensitivity (Sobel z = 1.93, P = 0.03), because (consistent with previous research) women in our sample scored better on the social sensitivity measure than men [t(441) = 3.42, P = 0.001]. In a regression analysis with the groups for which all three variables (social sensitivity, speaking turn vari- ance, and percent female) were available, all had similar predictive power for c, although only social sensitivity reached statistical significance (b = 0.33, P = 0.05) (12)."
The lobby for women may simply be missing a few marketing tricks. Instead of detecting "differences" and assuming them to be discrimination, there are positive things that can be highlighted.
Maybe it is as simple as coming up with a slogan or aphorism that captures the positive? That article suggests in a very solid and cohesive way that women make groups more intelligent. This is a message that could make even the most hardened geeks and misogynists take pause.
I think I have already predicted the apogee of Central Banking in claiming that the 20th century was theirs. It is not entirely clear what happens next; we won't know that until we (or they) build that future, and CBs themselves lose all their power such that they step aside and allow banks to fail.
That said, it is a rather dramatic prediction. So it behoves to review it from time to time. And to seek other opinion! With that in mind, I present a long essay from BullionVault's Paul Tustain, who starts out by saying:
I'VE ALWAYS been fairly sure you can't print money and get away with it indefinitely. But I couldn't well answer the question "Why not?"
It turns out the recent head of the British financial services regulator is similarly uncertain. He recently suggested the Bank of England write off half of the government's debt, which comes to exactly the same thing as printing money. How wonderfully simple. Of course it must be wrong, but why?
You can read the whole thing for the fuller answer. I'm just going to cherry pick. Firstly, show that a reminder that we need money:
CHIMPANZEES don't barter, but they trade a variety of delayed favours we won't go into here. South American vampire bats are more sophisticated, and run a small credit economy. The little darlings have such a need for blood that they lend, borrow and pay back amongst themselves rather than let a relative go bloodless for a whole night. They somehow manage to do the whole thing without plastic cards. A credit card – of course – is a device which creates both credit and debt, and you can spend the credit bit, which unfortunately leaves the debt bit overhanging, though oddly absent from the device's name.
Pure, distilled credit usually arises from us doing some work (labour), or transferring our property to someone else (selling goods). Either way, we generate an unreturned favour. So I'm going to call a unit of credit an 'Uf', and wherever possible I'll use the word 'Uf' instead of credit. Somehow it makes it much easier to understand what the hell is going on.
Chimps and vampires show that credit occurs naturally, just as it would have for the earliest humans. Beyond the smallest number of transactions it would have quickly become hard to agree who owed unreturned favours (Ufs) and to whom. Then somebody had the smart idea of using tokens to represent Ufs.
It is quite an important observation that money is simply an accounting system for favour returns. If we were to formalise this notion, money would be an accounting system that works in a world of many parties, where each are individual actors. (Some would say byzantine actors, others would say crooks.) In contrast, the accounting systems we actually call accounting systems, the ones we normally have occasion to use, are more simply which work well with only one party, self or or our employer, and there is a reasonable expectation that self does not steal from self.
The point here is that when we create money we are building an accounting system. And we might have different ways of doing that... Indeed we might set up an accounting system where someone stands in the center and lets users pay each other:
Vampires bats can't do what we can which is to formalise our simple transaction onto an account by booking two payments through the bank. If your friend were to pay you through the bank for the original favour you did then you could spend your Uf anywhere. Banking is useful, like Uf tokens are, because an Uf you earn from your friend, then record at your bank, becomes available for you to pay anyone who's got a bank account.
And now I'd like to step in and reveal a crucial distinction. Where Paul has started talking about banks, he has now drifted to payment systems. Pin this point on your wall above your monitor or laptop - there are banks and there are payment systems.
Banks happen to have payment systems, but banks also have credit. Why and how does credit exist? He explains it in some detail, but here's a succinct para:
It is pure nonsense to say that a gold standard means all money should be backed by vaulted gold. Suppose it was. It would prevent a man with a paid up £100 million property portfolio from borrowing £10,000 from his bank to pay someone £10,000 to build a garden shed. A monetary obstruction to this deal just isn't going to be tolerated, and it's a stupid idea to suggest the deal should be blocked simply because the consumer (rich property owner) or his bank currently has no gold at hand. It was precisely this sort of economic blockage that caused people to create money in the first place, and if you try to stop willing and credible exchangers from using one type of money they'll simply abandon your money, and either use someone else's or create their own.
Which is to say - people with wealth will work with credit, and credit will arise naturally to assist those people, in exactly the same way that money itself arose (which is nothing more than a credit system for favours done in the past).
Credit is natural. Now the question turns to how we deal with the industrialisation of credit in a banking system, and the more particular point of what happens when a bank over-extends. In a stable banking system, other banks knock on the door and get their agreed collateral back. In a Central Banking system, the banks pass their combined position to the CB who nets it. Paul introduces Brad's bank, one that acts badly, and is enouraged to act more badly:
....When his bank deposits its balance at Brad's bank to Central, then it clears away its risk of Brad's bank's failure. It is Central which will now be exposed to the failure of Brad's bank.
The role of Central Banking is (or has become) to take on the risk of any bank failng.
....It also explains that the last bank in the chain is accepting the risk that Brad's bank can't return the Ufs, and because banks can get off that risk by drawing a cheque on Brad's bank and depositing it into Central, the Ufs created by Brad's bank usually end up owed by Brad's bank directly to the Central Bank.
And banks take on that role with relish.
These days Central is feeble, and frightened of the political consequences of any bank failure, so it lets Brad's bank run up an ever growing balance on ever weaker collateral. Other banks can deposit any of Brad's bank's junk at Central. Central's bluff (that it might close down a dodgy bank like Brad's) has been well and truly called. If you are a sound bank you can now do stupid business with a bad bank which you know can never pay you properly, and it won't hurt you.
Because Central's Governor has made it known he won't let banks fail, he has set himself up as the patsy.
To ground this story, Paul puts it in today's financial speak:
The resulting huge Uf balances at Central can be made grand and confusing by saying "The Bank of England's Balance Sheet is expanding" which I'm sure makes everyone think it's doing a remarkably important job. What it really means is that the Governor won't demand that a busted bank pays up or shuts down, so Central just runs up an ever bigger deposit balance at an ever weaker bank. While Central permits this Brad's bank really is being allowed to 'create money out of thin air'.
In short: Banks ran ever bigger loan exposures, because they had to compete on dividends. They cleared them through the Central Banks, which declined to shut any down. Therefore the Central Banks expanded their balance sheets to hold the risk, thus further encouraging the banks to do more and more.
Indeed the current set up – where banks are not allowed to fail – turns out to be even worse than I previously thought. It does much more than offer succour to the odd unfortunate bank which steps over the limit of safety. It actually forces banks to be dumb. They have no choice but to approach the safety limit until they are bound to step over it. Any bank which does not step up to the plate will underperform all the others, and be subsumed by a more aggressive competitor. It's how evolution works; the survival of the fittest, where fitness means adapted to the prevailing environment. If you do not compete in the skewed environment where the Central Bank is a wimp you will expire because of it.
That's why banks are forced to make rosy judgments on the value of collateral.
Precisely. The regulatory environment *requires* banks to compete in badness. They cannot innovate (take on risk not understood by the CB), and they cannot seek to avoid being commoditised. Thus the only thing they can do is compete on dividends to their shareholders, who are guaranteed by the CB patsy.
If all of them act like this, they must all overstep the bounds, and the system must fail.
Central Banking is thus the problem NOT the solution. And therefore has grave difficulty in being any part of the solution, even if all the actors in the Central Banking world are honest, hard-working and try their darndest to avoid the inevitable.
Once we understand the theory of why Central Banking must fail, in the end, we all naturally reach for predictions and solutions. That's tough. Nobody who is in control has an interest in stopping the rot, all of us outside have no power. So the result will be unpredictable.
But maybe some good things can be snuck through to prepare for the inevitable.
Let's now return to the events of 2007-2008 because it brings forth a singular lesson. When the crisis of Lehman Brothers hit Britain, panic spread through the banks, and in a knee-jerk reaction to protect themselves, they refused to deal with each other.
Bad idea. In an effort to keep the banks working, some banks turned to new teams. E.g., sack the executives. But, as the story is widely told in private banking circles, one man held a gun to the banks' collective head and refused to go.
So long did he hold that gun that it was estimated that his bank was 2 hours from shutting down their ATM network. And if that bank's ATM network was shut down, all the others follow suit.
The entire British payments systems were 2 hours from freezing solid.
So we now see the real fear behind the deadly embrace that Paul outlined: Central Banking will fail and take the banks with them, the banks operate the payment systems and the failure of them will cause society to screech to a halt.
The silver lining that can be brought out of this is that payment systems, and indeed other innovations, can be allowed to emerge out of society. Payment systems can be divorced from banks, and to a large extent this direction can be see in the European monetary regulations of the last decade (PSD and eMoney directive).
Central Banks cannot get off their rollercoaster ride to credit-fueled doom, but they can ensure that newer innovations are not coupled to their journey to destruction.
Consider Kenya and Tanzania, countries that now have THREE mostly independent payment systems: cash, banks and mPesa. If all banks were to fail, shut the doors and the ATMs were to go broke, then the people can turn to the other two. Cash transactions will suddenly be king. And as long as the mPesa system is able to operate divorced from the banks, it will become queen.
mPesa already handles something like 20-30% of the GDP of Kenya, and something similar in Tanzania; if it can pick up more load, then this society might survive. As long as cash and electronic can still circulate, people can eat. Credit will be frozen, the middle classes will be screwed, but as long as people can eat, the bloodshed will be less pronounced.
A country like Britain which has long handed the monopoly of payments to the banks will not have this option, and remains in its deadly banking embrace. Hence, their better bet would be nurture and encourage the innovations: BullionVault and their close cousin GoldMoney. Zopa. Alternative payments systems under the eMoney directive, and independent systems under PSD. They should pray for an mPesa.
The question then to the Bank of England is not how much governance they wish to load onto these innovations, but rather do you dare run the risk without them?
In another outstanding development in the new normal of the post-GFC world, a bad actor has been brought to task:
The ruling in the Federal Court of Australia on November 5th held Standard & Poor’s (S&P) jointly liable with ABN AMRO, a bank, for the losses suffered by local councils that had invested in credit derivatives that were designed to pay a high rate of interest yet were also meant to be very safe.
What in effect does this mean? If you put your name on something as good, then you have to carry the consequences of it being bad. And the courts will hold you to it, or, they did in this case. As shareholders held Deloitte accountable in at least one Auditor case recently.
This is one of the essential, unavoidable causes of the GFC (marks I and II) -- that powerful players may take the upside of profitable participation in risky trades, but declare themselves non-liable for the downsides.
Was, in this case, S&P just caught out by a statistical bad apple, or was it raking it in? The Economist goes on to report:
The derivatives in question were “constant proportion debt obligations” (CPDOs). These instruments make even the most ardent fans of complex financial engineering blush: they are designed to add leverage when they take losses in order to make up the shortfall. S&P’s models, which the court said blindly adopted inputs provided by ABN AMRO, gave the notes a AAA rating, judging they had about as much chance of going bust as the American government.
That's a slam dunk. Adding that local councils are unsophisticated investors (and generally can't tell their elbow from their posterior) it is no surprise that they routinely invest in AAA ratings, and only AAA ratings. Hence, they rely on AAA.
Hence, S&P must be held liable for their good word on the meaning of AAA, assuming of course that the Economists' reporting is fair representation of the evidence presented.
Further, as S&P clearly did not do the diligence due to a statement with the gravitas of "as safe as the American government," the question of gross or criminal negligence looms large.
Seen on the net, copied as is, from James A. Donald:
On 2012-11-01 7:18 PM, CodesInChaos wrote:
> 3) You need to figure out an appropriate price. In the simplest case
> the uploaders simply send to the offer with the highest payment
That just offloads the problem of price discovery somewhere else in the system.
Price discovery is hard.
Price discovery in micro transactions needs to be substantially automated - at both ends. People will not invest the effort needed for manual price discovery.
Bad, incompetent, or buggy price discovery has killed every previous effort to solve this group of problems.
Price information is probabilistic, thus a price discovery mechanism has to support a full Bayesian model, recursive probabilities estimating the probability that the true probability is p, performing maximum entropy modeling. This is the sort of work that gets very smart engineers hired at astronomical salaries by wall street.
[James A. Donald]
I have struggled to write this story for a long time, and now Business Insider has written it for us:
In a world where you can watch cyberattacks happen in real-time, it's no wonder that nation-states are doing little to hide the cyber arms race and low-grade cyberwar that's taking place. However, what's surprising is that the country leading the charge — the U.S. — may also be the one with the most to lose.
"There is a world of bytes and a world of atoms, and increasingly the world of bytes is driving the world of atoms," Dr. Jarno Limnell, director of cyber security at Stonesoft, told us. "This is a whole new capability for these state-actors — previously there was no way to touch the U.S."
(fast forward to the crux of the issue)
Capabilities vary. China, which began its Information Warfare (IW) plan in 1995, has been stealing America's business secrets for more than a decade. Russia recently stated that it's "not making a secret of their plans to gain offensive [cyber] technologies."
The U.S. isn't in the best position to invite cyberwar. As RedSeal Chief Technology Officer Dr. Mike Lloyd told us when he described how easy it would be to attack the physical U.S. infrastructure: "People in glass houses shouldn't throw stones. [And] unfortunately, it's not just that—very simple stones can break our glass windows. We have very thin defenses."
OK, I'll spell it out - the USA has the most developed computer base of all countries, and is also the most attractive target. It is also as badly defended as anyone else, and may be the worst. E.g., it is the home of phishing, DDOS, breaching, and BotNet nodes. In particular, the record of breaches and phishing suggest that the USA is the country that was most at risk and had most losses from these attacks. (Question for all - Europe missed out on phishing, Russia got Kaspersky - why did USA get the worst of it?)
So in this environment, what is the Pentagon thinking? Good question. Here's an example of what the Pentagon is thinking:
The big question is whether a cyberattack can trigger a "real world" attack. Last year the Pentagon concluded that cyberattacks would justify a traditional military response. And in August BBC reported on a leaked Israeli memo that spelled out the hybrid use of cyber and military warfare in a proposed assault on Iran.
"This is the most troubling aspect of developing these weapons," said Limnell. "What is the action of the president if an attack happens, does it immediately become kinetic?"
Limnell said the difference between traditional warfare and cyberwarfare is that often cyberwarfare includes, indeed even prioritizes, civilian targets. And like the situation with the nuclear weapons in the 50s and 60s, there are no international rules for how we can use these weapons.
"Cyberwarfare is like Wild West right now, there’s a huge lack of norms and rules," Limnell said. "We will experience some type of major problem before we learn how to use weapons in the cyber domain."
Dumb. We already know that cyber attacks are mostly unattributable - the Chinese have been spying using these techniques for decades and China has not been caught. We now know the Pentagon generals are justifying their position by saying "it's cool, we'll just go kinetic if they dare throw a packet our way."
Dumber. So who do they throw their bombs at? Other than a country, their stuck - they have to go to the world and say "bad Iranians hurt us with packets, now we want to bomb them back into the stone age." That doesn't work, because the world saw the Iraqi debacle and won't play stupid again, but it seems that the Pentagon didn't get the memo. Worse - their casus belli is already known to be outright fraud because the USA has admitted launching StuxNet against the Iranians.
Can it possibly get any dumber?
The U.S. isn't in the best position to invite cyberwar. As RedSeal Chief Technology Officer Dr. Mike Lloyd told us when he described how easy it would be to attack the physical U.S. infrastructure: "People in glass houses shouldn't throw stones. [And] unfortunately, it's not just that—very simple stones can break our glass windows. We have very thin defenses."
Oh yeah -- it gets leveraged dumb. It's because the equation is stacked against the USA. The Pentagon have launched what is probably the dumbest attack of all time. The Stuxnet attack that they might see as an exchange of a pawn, letting their kinetic queen rove free, is actually exposing their entire board. Dumbest of all.
The reason for this is politely called the equity question in NSA circles. When it came to cyber defence, the NSA decided in the early 1990s that it was more important to make the Internet weak and vulnerable to spying, than to let the Internet be able to defend itself. This decision was prosecuted publically through crypto export regulations -- remember the crypto wars -- but also through a host of other interventions into the IETF, corporates, critical infrastructure (to them) and other places. When thinking about why USA banking suffered the brunt of phishing and breach losses, a large part of the big picture goes back to the NSA.
So the biggest dumb mistake of them all is that the Pentagon wants any excuse to go kinetic against the Iranians, but they've not defended their home ground over the last 20 years. The gates to the cyber-kingdom are not only wide open, they're 6 inches high and guarding a line of warning signs.
Long time readers of this blog will recall that I predict that the era of Central Banking is now over. We are now in the process of watching the Central Banks destroy their legacy from within. Here is more evidence:
A review of evidence into Quantitative Easing (QE) has shown that the Government's hope that it will pull the UK out of recession may be unfounded.
Professor Chris Martin, from the University of Bath's Department of Economics, has looked at the impact of QE not just on financial markets but also the 'real' economy of jobs, inflation and output and concluded that there is no lasting benefit in continuing to pursue the policy.
He concludes that QE has produced a limited but temporary gain for the financial sector, but it has been of no help to the wider business community or individuals and families struggling against inflation and unemployment.
His review has looked at studies of the performance of QE by central banks, including numerous historical studies of small scale QE purchases and studies of the large contemporary QE programmes.
Now, it may be that the Central Banks find themselves convinced of having to prop up the financial sector, in order to save the rest of industry. But this logic doesn't impress for very long because (a) they are only succeeding in undermining the financial sector, rather than making banks more robust for the future, and (b) the populace isn't comfortable with paying the price of this worsening.
Realpolitik will reassert itself. As more time goes on, and more trouble is stored for the future, the potential for massive systemic failure increases. And it is the Central Banks themselves that are driving that systemic risk higher and higher, so they necessarily have to pay the cost when it comes around.
Still, the problem with predicting that the Central Banks are diligently removing themselves from the game is that we do not know what happens next. The end of the century of Central Banking is then a prediction of only small value. The far better question is what arises to re-structure finance in the future?
There are now all the preliminary planks in place for the next step in evolution in the business of browser security.
A federal judge has rejected BancorpSouth's plan to use contractual agreements with customers as a shield against liability claims stemming from an online heist of some $440,000 that was illegally wire-transferred from the account of one of the bank's commercial customers in March 2010.
The first plank was an aggressive environment, this turned up in 2011 (by my reckoning).
The second plank was the decision by participants to avoid liability issues and to document that they had avoided liability issues.
The third plank was recognition by experts (as determined by courts) that online banking was insecure. Although I've pointed at this advice for years ("use another browser") courts don't recognise bloggists as experts. However, e.g., Lynn points in comments to USA federal regulatory advice that a single-purpose dedicated PC be used. That's recognised!
The fourth plank was sufficient clarity on how the courts would deal with the question, by means of actual rulings. This was never in doubt, because the courts always go that way in the long run, but while there were no rulings, people could "reasonably" argue that it was cool.
In his four-page ruling, Magistrate Judge John Maughmer says he based his decision about contractual obligations between banks and commercial customers on his interpretation of the UCC. And he acknowledges the waters are murky. "The court, having read the briefing of the parties, finds this to be a very close call," he says.
Nevertheless, Maughmer finds that the UCC does not provide blanket protections for banking institutions, in spite of indemnity noted in the contract.
"As enacted in Missouri and other jurisdictions, the Funds Transfers Act (UCC 4A) was not intended to preempt or displace all causes of action between a bank and its customers engaging in money transfers," Maughmer writes. "The uniformity and certainty sought by the statute for these transactions could not possibly exist if parties could opt to sue by way of pre-Code remedies where the statute has specifically defined the duties, rights and liabilities of the parties."
Other Cases. Inherent in the magistrate judge's findings is the question "What is reasonable?" regardless of whether that reasonableness comes from the bank or the commercial customer. What's contained within the contract and what is deemed "commercially reasonable" often are at odds, Navetta says.
The point being that the courts will find fault with an unreasonable contract. Those rulings we are now seeing, as quoted. As somewhat less than coincidentally, close analogues will inform the courts as to how to deal with liability in other browsing security issues. E.g., PKI certificates.
Smarter participants have seen the writing on the wall. VeriSign sold their CA to Symantec, correctly IMHO judging that the business was going to face increasing risks, while not generating the synergies across to other areas of its business to take on those risks. This confirms the truism of the industry - Others acquired market share, VeriSign understood the market.
All that remains is a headline high-value target to serve as the channel of forces. All of the trouble in the marketplace for certificates - a.k.a. secure browsing - has so far been against non-monetary uses of certificates. Paradoxically, the saving grace for the business may be that it never really got used for such high commercial value things as to be relied upon.
Stories about new ideas in social networking are like snails after rain. Here's "Between," a smartphone app that works for couples only:
"So we turned our eyes to unmarried couples who need such a private relationship platform more than any other groups."
Between lets them share photo timelines, send messages and mark anniversaries, birthdays and other dates on each other's calendars.
Connection to the service is completed when both parties enter each other's phone numbers after registering.
However what gets interesting is when the sparks of anger not romance fly:
If a couple breaks up, one of them may disconnect the service and all the data will be deleted.
¡Olé! Stories about the hard problems in privacy are as rare as bullfighting at the RSPCA's annual garden party.
If there is a privacy and security problem that has so bedevilled the worlds thinkers -- even to the extent of most of them not recognising the problem -- it's this: if a couple shares stuff in the purest essence of romantic privacy, what happens when the alliance flips and the lovers-until-death become plaintiffs-to-the-death?
"Between in a way represents a commitment made by couples, so we rarely see teenagers using the service...their relationship usually doesn't last long enough to take full advantage of it," said Park.
That is why VCNC's engineers plan to develop a system which backs up data for up to one month after a breakup, just in case lovers decide to reunite and reopen their accounts.
"Think of it as an adjustment period for couples," said Park, adding users quite often complain when data is wiped under the current system.
"users quite often complain" must be evidence of Korean shyness -- if launched in America, the complaints would take hard filed copy form, at STBX's local court.
Still, notwithstanding that date with reality, my hat's off to this brave effort to deal with the *hard problems* of privacy - ¡Olé!
Several cases in USA are resolving in online theft via bank account hackery. Here's one:
Village View Escrow Inc., which in March 2010 lost nearly $400,000 after its online bank account with Professional Business Bank was taken over by hackers, has reached a settlement with the bank for an undisclosed amount, says Michelle Marsico, Village View's owner and president.
As a result of the settlement, Village View recovered more than the full amount of the funds that had been fraudulently taken from the account, plus interest, the company says in a statement.
And two more:
Two similar cases, PATCO Construction Inc. vs. Ocean Bank and Experi-Metal Inc. vs. Comerica Bank, raised questions about liability and reasonable security, yet each resulted in a different verdict.
In 2010, PATCO sued Ocean Bank for the more than $500,000 it lost in May 2009, after its commercial bank account with Ocean Bank was taken over. PATCO argued that Ocean Bank was not complying with existing FFIEC requirements for multifactor authentication when it relied solely on log-in and password credentials to verify transactions.
Last year, a District Court magistrate found the bank met legal requirements for multifactor authentication and dismissed the suit.
In December 2009, EMI sued Comerica after more than $550,000 in fraudulent wire transfers left EMI's account.
In the EMI ruling, the court found that Comerica should have identified and disallowed the fraudulent transactions, based on EMI's history, which had been limited to transactions with a select group of domestic entities. The court also noted that Comerica's knowledge of phishing attempts aimed at its clients should have caused the bank to be more cautious.
In the ruling, the court required Comerica to reimburse EMI for the more than $560,000 it lost after the bank approved the fraudulent wire transfers.
Here's how it happens. There will be many of these. Many of the victims will sue. Many if the cases will lose.
Those that lose are irrelevant. Those that win will set the scene. Eventually some precedent will be found, either at law or at reputation, that will allow people to trust banks again. Some more commentary.
The reason for the inevitability of this result is simple: society and banks both agree that we don't need banks unless the money is safe.
Online banking isn't safe. It behoves to the banks to make it safe. We're in the phase where the court of law and public opinion are working to get that result.
A friend proposed a problem with international trust - how do Alice and Bob swap currencies where trust in trade has broken down. Both parties want to complete the transaction, but have no support from 'the system'.
Ordinarily the parties could go to their banks and ask for e.g., letters-of-credit, but in this particular case banking services are frozen or drying up or unreliable. How then to do a swap of value when the only thing left is the basic payments system (one assumes that the banks have managed to keep that running...).
Imagine Alice has 1m of A$ to swap with Bob's 1m of B$. The quantities and currencies are uninteresting. What is interesting is that both parties have committed, but one will lose their head if the other does not follow through.
To borrow an idea from cryptographic bit-commit protocols, they could do it in tranches, which is what financial people call bits. It would go like this: Alice sends 10k to Bob. Bob returns with his 10k. And so on, until it is all done, 200 transactions in all.
This would work, but it might be possible to do better. Notice above that Alice is always neutral or at risk, while Bob is always neutral or positive. Also, Bob is learning to trust Alice, but Alice has no such reward.
Overall, we are talking about both risk & trust. On taking a risk, successfully, trust is built. With equal tranches, we have reduced the total risk overall, and increased trust, but we've done it in an asymmetric fashion. We could talk about balancing and benefiting from this.
How about this: Alice goes first, and this puts Bob in the driver's seat, so right now he is taking no risk! So Bob could return the favour. To do that, he could return with 20k. Bob now has matched Alice's contribution, and has now taken on the same risk as Alice had in her first round.
What does Alice return? She is now ahead by 10k. But she has received 20k, so her risk is actually not so bad. If she were to likewise double up, she could send 20k. Alice and Bob have now entered tit-for-tat, each taking on a risk of half their tranche.
Perhaps we could ramp it up more? Consider taking each risk position and rewarding it by ramping it up by a positive multiplier:
From the above, a formula emerges. Each round (except first and last) should transmit (H - S) * R where H is the sender's holdings, S is the receiver's holdings, and R is the risk multiplier.
Risk multipliers are interesting. With R of 1, the initiator is always at risk, the follower is always with zero risk, catching up. But with R of 2, the follower matches her risk, not however extending it, so it quickly moves to balanced, symmetric exposure - tit-for-tat in a positive way. This is perhaps the comfortable compromise.
With R of 3, Bob extends and rewards Alice's initial risk, by taking on new risk that goes well beyond what he need do. This has the advantage of reducing the transactions from o(100) to o(10), and giving the economists an enjoyable chance to show the precise logarithmic reduction that applies.
Some comments on wider issues.
Each exchange could agree on what R or risk parameter they desire. And here we reach some interesting questions in negotiation -- who goes first? Who selects R? Also who selects the initial amount I? Mechanism design might suggest that out of such a negotiation, a fair split in parameters might emerge. E.g., like cut & choose. Or maybe it is a matter for parties to choose.
Also, there is a last round issue. The person who sends the last payment has an incentive to hold. Therefore the formula above might be modified to take account of the ceiling in payments, perhaps reducing the penultimate payments so as to require more trust as it gets closer. Especially for R = 3. It could also be balanced such that Alice as initiator is also the last to send.
This would be the game theory way of looking at it. It is important to recognise that contractual aspects would bring in protection as well. For example, I would be looking to publish any parties who do not complete, perhaps making this compulsory with a 3rd party agency. Also one might refer the thing to binding Arbitration, with rights to full publication and fines, including liens on any future transaction on any other member.... Finally, there should be clauses to include the players and their executioners - names and all - so as to limit the cuts in case the other party begs off.
Of course, the game theory aspects should be as strong as we can make them ... leaving the final exceptions to a short sharp dispute resolution process.
The 'new idea' is not difficult. The idea of Convergence is for independent operators (like CAcert or FSFE or FSF) to run servers that cache certificates from sites. Then, when a user browser comes across a new certificate, instead of accepting the fiat declaration from the CA, it gets a "second opinion" from one of these caching sites.
Convergence is best seen as conceptually extending or varying the SSH or TOFU model that has already been tried in browsers through CertPatrol, Trustbar, Petnames and the like.
In the Trust-on-first-use model, we can make a pretty good judgement call that the first time a user comes to a site, she is at low risk. It is only later on when her relationship establishes (think online banking) that her risk rises.
This risk works because likelihood of an event is inversely aligned with the cost of doing that attack. One single MITM might be cost X, two might be X+delta, so as it goes on it gets more costly. In two ways: firstly, in maintaining the MITM over time against Alice costs go up more dramatically than linear additions of a small delta. In this sense, MITMs are like DOSs, they are easier to mount for brief periods. Secondly, because we don't know of Alice's relationship before hand, we have to cast a very broad net, so a lot of MITMs are needed to find the minnow that becomes the whale.
First-use-caching or TOFU works then because it forces the attacker into an uneconomic position - the easy attacks are worthless.
Convergence then extends that model by using someone else's cache, thus further boxing the attacker in. With a fully developed Convergence network in place, we can see that the attacker has to conduct what amounts to being a perfect MITM closer to the site than any caching server (at least at the threat modelling level).
Which in effect means he owns the site at least at the router level, and if that is true, then he's probably already inside and prefers more sophisticated breaches than mucking around with MITMs.
Thus, the very model of a successful mitigation -- this is a great risk for users to accept if only they were given the chance! It's pretty much ideal on paper.
Now move from paper threat modelling to *the business*. We can ask several questions. Is this better than the fiat or authority model of CAs which is in place now? Well, maybe. Assuming a fully developed network, Convergance is probably in the ballpark. A serious attacker can mount several false nodes, something that was seen in peer2peer networks. But a serious attacker can take over a CA, something we saw in 2011.
Another question is, is it cheaper? Yes, definately. It means that the entire middle ground of "white label" HTTPS certs as Mozilla now shows them can use Convergence and get approximately the same protection. No need to muck around with CAs. High end merchants will still go for EV because of the branding effect sold to them by vendors.
A final question is whether it will work in the economics sense - is this going to take off? Well, I wish Moxie luck, and I wish it work, but I have my reservations.
Like so many other developments - and I wish I could take the time to lay out all the tall pioneers who provided the high view for each succeeding innovation - where they fall short is they do not mesh well with the current economic structure of the market.
In particular, one facet of the new market strikes me as overtaking events: the über-CA. In this concept, we re-model the world such that the vendors are the CAs, and the current crop are pushed down (or up) to become sub-CAs. E.g., imagine that Mozilla now creates a root cert and signs individually each root in their root list, and thus turns it into a sub-root list. That's easy enough, although highly offensive to some.
Without thinking of the other ramifications too much, now add Convergance to the über-CA model. If the über-CA has taken on the responsibility, and manages the process end to end, it can also do the Convergence thing in-house. That is, it can maintain its set of servers, do the crawling, do the responding. Indeed, we already know how to do the crawling part, most vendors have had a go at it, just for in-house research.
Why do I think this is relevant? One word - google. If the Convergence idea is good (and I do think it is) then google will have already looked at it, and will have already decided how to do it more efficiently. Google have already taken more steps towards ueber-CA with their decision to rewire the certificate flow. Time for a bad haiku.
Google sites are pinned now / All your 'vokes are b'long to us / Cache your certs too, soon.
And who is the world's expert at rhyming data?
Which all goes to say that Convergence may be a good idea, a great one even, but it is being overtaken by other developments. To put it pithily the market is converging on another direction. 1-2 years ago maybe, yes, as google was still working on the browser at the standards level. Now google are changing the way things are done, and this idea will fall out easily in their development.
(For what it is worth, google are just as likely to make their servers available for other browsers to use anyway, so they could just "run" the Convergance network. Who knows. The google talks to no-one, until it is done, and often not even then.)
As we all know, it's a right of passage in the security industry to study the SSL business of certificates, and discover that all's not well in the state of Denmark. But the business of CAs and PKI rolled on regardless, seemingly because no threat ever challenged it. Because there was no risk, the system successfully dealt with the threats it had set itself. Which is itself elegant proof that academic critiques and demonstrations and phishing and so forth are not real attacks and can be ignored entirely...
Last year, we crossed the Rubicon for the SSL business -- and by extension certificates, secure browsing, CAs and the like -- with a series of real attacks against CAs. Examples include the DigiNotar affair, the Iranian affair (attacks on around 5 CAs), and also the lesser known attack a few months back where certificates may have been forged and may have been used in an APT and may have... a lot of things. Nobody's saying.
Either way, the scene is set. The pattern has emerged, the Rubicon is crossed, it gets worse from here on in. A clear and present danger, perhaps? In California, they'd be singing "let's partly like it's 2003," the year that SB1386 slid past our resistance and set the scene for an industry an industry debacle in 2005.
But for us long term observers, no party. There will now be a steady series of these shocks, and journalists will write of our brave new world - security but no security.
With one big difference. Unlike the SB1386 breach party, where we can rely on companies not going away (even as our data does), the security system of SSL and certificates is somewhat optional. Companies can and do expose their data in different ways. We can and do invent new systems to secure or mitigate the damage. So while SB1386 didn't threaten the industry so much as briskly kicked it around, this is different.
At an attacks level, we've crossed a line, but at a wider systems level, we stand on the line.
Which brings us to this week's news. A CA called Trustwave has just admitted to selling a sub-root for the explicit purpose of MITM'ing. Read about that elsewhere.
Now, we've known that MITMing for fun and profit was going on for a long time. Mozilla's community first learnt of it in the mid 2000s as it was finalising its policy on CAs (a ground-breaking work that I was happy to be involved with). At that time, accusations were circulating against unknown companies listing their roots for the explicit purpose of doing MITMs on unwitting victims. Which raised the hairs, eyebrows and heckles on not a few of us. These accusations have been repeated from time to time, but in each case the "insiders" begged off on the excuse: we cannot break NDA or reputation.
Each time then the industry players were likewise able to fob it off. Hard Evidence? none. Therefore, it doesn't exist, was they industry's response. We knew as individuals, yet as an industry we knew not.
We are all agreed it does exist and it doesn't. We all have jobs to preserve, and will practice cognitive dissonance to the very end.
Of course this situation couldn't last, because a secret of this magnitude never survives. In this case, the company that sold the MITM sub-root, Trustwave, has looked at 2011, and realised the profit from that one CA isn't worth the risk of the DigiNotar experience (bankruptcy). Their decision is to 'fess up now, take it on the chin, because later may be too late.
Which leads to a dilemma, and we the players have divided on each side, one after the other, of that dilemma:
That is the question. First the case for the defence: On the one hand, we applaud the honesty of a CA coming forward and cleaning up house. It's pretty clear that we need our CAs to do this. Otherwise we're not going to get anywhere with this Trust thing. We need to encourage the CAs to work within the system.
Further, if we damage a CA, we damage customers. The cost to lost business is traumatic, and the list of US government agencies that depend on this CA has suddenly become impressive. Just like DigiNotar, it seems, which spread like a wave of mistrust through the government IT departments of the Netherlands. Also, we have to keep an eye on (say) a bigger more public facing CA going down in the aftermath - and the damage to all its customers. And the next, etc.
Is lost business more important than simple faith in those silly certificates? I think lost business is much more important - revenue, jobs, money flowing keeping all of the different parts of the economy going are our most important asset. Ask any politician in USA or Europe or China; this is their number one problem!
Finally, it is pretty clear and accepted that the business purpose to which the sub-Root was put was known and tolerated. Although it is uncomfortable to spy on ones employees, it is just business. Organisations own their data systems, have the responsibility to police them, and have advised their people that this is what they are going to do. SSL included, if necessary.
This view has it that Trustwave has done the right thing. Therefore, pass. And, the more positive proponents suggest an amnesty, after which period there is summary execution for the sins - root removal from the list distributed by the browsers. It's important to not cause disruption.
Now the case for the Prosecution! On the other hand, damn spot: the CA clearly broke their promise. Out!
Three ways, did they breach the trust: It is expressed in the Mozilla policy and presumably of others that certificates are only issued to people who own/control their domains. This is no light or optional thing -- we rely on the policy because CAs and Mozilla and other vendors and auditors and all routinely practice secrecy in this business.
We *must rely on the policy* because they deny us the right to rely on anything else!
Secondly, it is what the public believe in, it is the expectations of any purchaser or user of the product, written or not. It is a simple message, and brooks no complicated exceptions. Either your connection is secure to your online bank, and nobody else can see it *including your employer or IT department*. Or not.
Try explaining this exception to your grandmother, if the words do not work for you.
Finally, the raison d'être: it is the purpose and even the entire goal of the certificate design to do exactly the opposite. The reason we have CAs like TrustWave is to stop the MITM. If they don't stop the MITM, then *we don't need the heavyweight certificate system*, we don't need CAs, and we don't need Mozilla's root list or that of any other vendor.
We can do security much more cost-effectively if we drop the 100% always-on absolutist MITM protection.
Given this breach of trust, what else can we trust in? Can we trust their promises that the purpose was maintained? That the cert never left the building? That secret traffic wasn't vectored in? That HSMs are worth something and audits ensure all is well in Denmark?
There being two views presented, it has to be said that both views are valid. The players are lining up on either side of the line, but they probably aren't so well aware of where this is going.
Only one view is going to win out. Only one side wins this fight.
And in so-doing, in winning, the winner sews the seeds for own destruction.
Because if you religiously take your worldview, and look at the counter-argument to your preferred position, your thesis crumbles for the fallacies.
The jaws of trust just snapped shut on the players who played too long, too hard, too profitably.
Like the financial system. We are no longer worried about the bankruptcy of one or two banks or a few defaults by some fly specks on the map of European. We are now looking at a change that will ripple out and remove what vestiges of purpose and faith were left in PKI. We are now looking at all the other areas of the business that will be effected; ones that brought into the promise even though they knew they shouldn't have.
Like the financial system, a place of uncanny similarity, each new shock makes us wonder and question. Wasn't all this supposed to be solved? Where are the experts? Where is the trust?
We're about to find out the timeless meaning of Caveat Emptor.
As an aside to the old currency market currently collapsing, in the now universally known movie GFC-2 rolling on your screens right now, some people have commented that perhaps online currencies and LETS and so forth will fill the gap. Unlikely, they won't fill the gap, but they will surge in popularity. From a business perspective, it is then some fun to keep an eye on them. An article on Facebook credits by George Anders, which is probably the one to watch:
Facebook’s 27-year-old founder, Mark Zuckerberg, isn’t usually mentioned in the same breath as Ben Bernanke, the 58-year-old head of the Federal Reserve. But Facebook’s early adventures in the money-creating business are going well enough that the central-bank comparison gets tempting.
Let's be very clear here: the mainstream media and most commentators will have very little clue what this is about. So they will search for easy analogues such as a comparison with national units, leading to specious comparisons of Zuckerberg to Bernanke. Hopeless and complete utter nonsense, but it makes for easy copy and nobody will call them on it.
Edward Castronova, a telecommunications professor at Indiana University, is fascinated by the rise of what he calls “wildcat currencies,” such as Facebook Credits. He has been studying the economics of online games and virtual worlds for the better part of a decade. Right now, he calculates, the Facebook Credits ecosystem can’t be any bigger than Barbados’s economy and might be significantly smaller. If the definition of digital goods keeps widening, though, he says, “this could be the start of something big.”
This is a little less naive and also slightly subtle. Let me re-write it:
If you believe that Facebook will continue to dominate and hold its market size, and if you believe that they will be able to successfully walk the minefield of self-issued currencies, then the result will be important. In approximate terms, think about PayPal-scaled importance, order of magnitude.
Note the assumptions there. Facebook have a shot at the title, because they have massive size and uncontested control of their userbase. (Google, Apple, Microsoft could all do the same thing, and in a sense, they already are...)
The more important assumption is how well they avoid the minefield of self-issued currencies. The problem here is that there are no books on it, no written lore, no academic seat of learning, nothing but the school of hard-knocks. To their credit, Facebook have already learnt quite a bit from the errors of their immediate predecessors. Which is no mean feat, as historically, self-issuers learn very little from their forebears, which is a good predictor of things to come.
Of the currency issuers that spring up, 99% are destined to walk on a mine. Worse, they can see the mine in front of them, they successfully aim for it, and walk right onto it with aplomb. No help needed at all. And, with 15 years of observation, I can say that this is quite consistent.
Why? I think it is because there is a core dichotomy at work here. In order to be a self-issuer you have to be independent enough to not need advice from anyone, which will be familiar to business observers as the entrepreneur-type. Others will call it arrogant, pig-headed, too darned confident for his own good... but I prefer to call it entrepreneurial spirit.
*But* the issuance of money is something that is typically beyond most people's ken at an academic or knowledge level. Usage of money is something that we all know, and all learnt at age 5 or so. We can all put a predictions in at this level, and some players can make good judgements (such as Peter Vodel's Predictions for Facebook Credits in 2012).
Issuance of money however is a completely different thing to usage. It is seriously difficult to research and learn; by way of benchmark, I wrote in 2000 you need to be quite adept at 7 different disciplines to do online money (what we then called Financial Cryptography). That number was reached after as many years of research on issuance, and nearly that number working in the field full time.
And, I still got criticised by disciplines that I didn't include.
You can see where I'm heading. The central dichotomy of money issuance then is that the self-issuer must be both capable of ignoring advice, and putting together an overwhelming body of knowledge at the same time; which is a disastrous clash as entrepreneurs are hopeless at blindspots, unknowns, and prior art.
There is no easy answer to this clash of intellectual challenges. Most people will for example assume that institutions are the way to handle any problem, but that answer is just another minefield:
If Facebook at some point is willing to reduce its cut of each Credits transaction, this new form of online liquidity may catch the eye of many more merchants and customers. As Castronova observes: “there’s a dynamic here that the Federal Reserve ought to look at.”
Now, we know that Castronovo said that for media interest only, but it is important to understand what really happens with the Central Banks. Part of the answer here is that they already do observe the emerging money market :) They just won't talk to the media or anyone else about it.
Another part of the answer is that CBs do not know how to issue money either; another dichotomy easily explained by the fact that most CBs manage a money that was created a long time ago, and the story has changed in the telling.
So, we come to the the really difficult question: what to do about it? CBs don't know, so they will definately keep the stony face up because their natural reaction to any question is silence.
But wait! you should be saying. What about the Euro?
Well, it is true that the Europeans did indeed successfully manage to re-invent the art and issue a new currency. But, did they really know what they were doing? I would put it to you that the Euro is the exception that proves the rule. They may have issued a currency very well, but they failed spectacularly in integrating that currency into the economy.
Which brings us full circle back to the movie now showing on media tonight and every night: GFC-2.
And so it came to pass that, after my aggressive little note on GFC-1's causes found in securitization (I, II, III, IV), I am asked to describe the current, all new with extra whitening Global Financial Crisis - the Remix, or GFC-2 to those who love acronyms and the pleasing rhyme of sequels.
Or, the 2nd Great Depression, depending on how it pans out. Others have done it better than I, but here is my summary.
Part 1. In 2000, European countries joined together in the EMU or European Monetary Union. A side-benefit of this was the Bundesbank's legendary and robust control of inflation and stiff conservative attitude to matters monetary. Which meant other countries more or less got to borrow at Bundesbank's rates, plus a few BPs (that's basis points, or hundredths of percentage points for you and I).
Imagine that?! Italy, who had been perpetually broke under the old Lira, could now borrow at not 6 or 7% but something like 3%. Of course, she packed her credit card and went to town, as 3% on the CC meant she could buy twice as much stuff, for the same regular monthly payments. So did Ireland, Portugal, Greece and Spain. Everyone in the EMU, really.
The problem was, they still had to pay it back. Half the interest with the same serviceable monthly credit card bill means you can borrow twice as much. Leverage! It also means that if the rates move against you, you're in it twice as deep.
And the rates, they did surely move. For this we can blame GFC-1 which put the heebie-jeebies into the market and caused them to re-evaluate the situation. And, lo and behold, the European Monetary Union was revealed as no more than a party trick because Greece was still Greece, banks were still banks, debt was still debt, and the implicit backing from the Bundesbank was ... not actually there! Or the ECB, which by charter isn't allowed to lend to governments nor back up their foolish use of the credit card.
Bang! Rates moves up to the old 6 or 7%, and Greece was bankrupt.
Now we get to Part 2. It would have been fine if it had stopped there, because Greece could just default. But the debt was held by (owed to) ... the banks. Greece bankrupt ==> banks bankrupt. Not just or not even the Greek ones but all of them: as financing governments is world-wide business, and the balance sheets of the banks post-GFC-1 and in a non-rising market are anything but 'balanced.' Consider this as Part 0.
Now stir in a few more languages, a little contagion, and we're talking *everyone*. To a good degree of approximation, if Greece defaults, USA's banking system goes nose deep in it too.
So we move from the countries, now the least of our problems because they can simply default ... to the banks. Or, more holistically, the entire banking system. Is bankrupt.
In its current today form, there is the knowledge that the banks cannot deal with the least hiccup. Every bank knows this, knows that if another bank defaults on a big loan, they're in trouble. So every bank pulls its punches, liquidity dries up, and credit stops flowing ... to businesses, and the economy hits a brick wall. Internationally.
We saw something similar in the Asian Financial Crisis, where countries were forced to accept IMF loans ... which paid out the banks. Once the banks had got their loans paid off, they walked, and the countries failed (because of course they couldn't pay back the loans). Problem solved.
This time however there is no IMF, no external saviour for the banking system, because we are it, and we are already bankrupt.
Well, there. This is as short as I can get the essentials. We need scholars like Kevin Dowd or John Maynard Keynes, those whos writing is so clear and precise as to be intellectual wonders in their own lifetimes. And, they will emerge in time to better lay down the story - the next 20 years are going to be a new halcyon age of economics. So much to study, so much new raw data. Pity they'll all be starving.
In a short cycle on banking(I, II, III, IV), I point the crooked finger of blame for the first great financial crisis at securitization, as the contractual and markets innovation that gave the USA property bubble the legs to consume society. Now, it seems that I'm just one guy, and everyone has their favourite theory, leading to a fairly long list of hopeful causes. By way of example, Roger Garrison crooks the Austrian finger unwaveringly at central banking:
As my colleague Leland Yeager puts it, “Each cyclical episode is a unique historical event.” True enough, but my attention to the central bank as turbocharger helps to keep separate the particulars and the commonalities of the different cyclical episodes.
True enough, although I think it will take a decade or two before the economists sort through the contenders and come to consensus. Garrison wrote the above in a review of a new book from Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System, which claims to be a comprehensive treatment of the many causes. Here's one that was new to me:
As Dowd and Hutchinson make clear, the redistribution of wealth and income away from business and industrial families meant the demise of the “old partnerships” and the rise of “managerial capitalism.” It meant the separation of ownership and control. In an earlier time and without the limited liability that virtually defines the modern corporation, the owners of large-scale industrial and business concerns had plenty of “skin in the game.” They had a strong incentive to watch the bottom line, all things considered, and they were in it for the long run. Individual businesses, both large and small, could rise and fall with changing circumstances, but for the economy as a whole the underlying concern for preserving capital value over the long run translated into a degree of macroeconomic stability. Precisely this critical source of stability has been continuously eroded over the years by the federal tax code and regulatory schemes.
So with the atrophy of the partnership form of business enterprises, the incentives to maintain long-run profitability have been continuously weakened. It follows, almost as a corollary, that the window for exploiting short-run profit opportunities at the expense of long-run viability has been continuously widened. Managerial capitalism has given rise to a whole class of traders in securities markets and especially in derivatives markets who get in and out of markets in pursuit of short-run gains. The opportunity for these cumulative short-run gains would not have been available (or would have been available on a much smaller scale) had it not been for the absence of “old partnerships” whose vigilance and long-run perspective would have provided an effective counterbalance.
This aspect of Dowd and Hutchinson’s storyline rings true. ...
My Audit cycle (I, II, III, IV, V, VI, VII) hints at the very same effect, as the entire Audit industry moved from meticulous to loss-leader in the same 2 decades that mirrored the death of the partnership model. Further, as Professor Dowd's long and prolific career in Free Banking will testify, the disappearance of robust long-term retail banking and the rise of central banking is inherently tied up with the end of partnership banking (c.f., White's Free Banking in Britain).
Why did we as society replace the owner-manager with the salaried managerial trader?
Dowd and Hutchinson date the origins of modern finance to a theorem that Franco Modigliani and Merton Miller introduced in 1958, demonstrating the underlying equivalence of debt financing and equity financing, and to Harry Markowitz’s ground-breaking work (a 1952 University of Chicago Ph.D. dissertation) that formalized the relationship between risk and rate of return. Modern financial theory became operational during the 1960s in the form of the Capital Asset Pricing Model (CAPM) and allowed for significant leveraging in the 1970s after Fischer Black and Myron Scholes extended the approach to the pricing of options. Still later developments in information technology and the strategic placement of computer hardware gave rise to flash trading, putting CAPM-based trading strategies on steroids.
Outside the context of booms and busts, modern financial theory can be the basis for an overall gain to society. Apart from flash trading, which appears to have no socially redeeming features, trading on the basis of a comprehensive assessment of alternative investment portfolios allows the risks that are inherent in a market economy to be borne by those who are most willing to bear them. A risk/rate-of-return assessment more generally can help tailor an investment portfolio to an individual’s risk preferences. The problem, as Dowd and Hutchinson point out, is that the risks that the CAPM takes into account do not include systemic risks. The risk metric that was widely adopted in the 1990s, called “Value-at-Risk” (VaR), quantifies the riskiness of a particular portfolio—on the assumption that the market as a whole is stable. With this metric, you may assure yourself, for example, that you have a 95 percent chance that this portfolio will suffer no greater one-day loss than the calculated VaR (Dowd and Hutchinson 2010, 113). But what if the market as a whole is not stable? And what if the use of the CAPM, the reliance on the VaR, and the proliferation of derivatives serve to leverage both short-run profits and the market’s instability?
Boom! Cycle back into the /volatility & ignorance/ theory of financial markets, and we seem to be taking our first steps towards understanding where we are today. To summarise, the elimination of the partnership allowed short-termism to dominate in the modern bonus-fuelled trading enterprises, and it was precisely this worldview that supported the rise of VaRism. Or, systemic risk ain't my problem, boss, now about that bonus...
That's a hell of a contribution. Still, it's early days yet, and to be fair, reviewer Garrison reminds us:
The dot-com crisis of the 1990s occurred because a credit expansion took place during a time when technological innovations associated with the digital revolutions created a strong demand for investment funds in that sector. The housing crisis in 2008 occurred because a credit expansion took place during a time when the federal government was pushing hard for increased home ownership for low-income families. We understandably identify these different cyclical episodes (the dot-com crisis, the housing crisis) with “what was going on at the time.” The common denominator, however, is the Fed’s propensity to expand credit.
At this point, we might ask, “Will the real Alchemist please stand up?”
Which brings us full circle: Systemic Risk is the central bank's problem! So where were the central banks when the partners were selling out of the investment banks and the VaRists were running rampant on bonus steroids? They were pumping up the machine in mini-crisis after mini-crisis, so setting the stage for the mother of all systemic collapses.
From an academic point of view, this is a lot of fun! Aside from the fact that we're so deep in it we can only poke our nose above the smelly brown stuff, I would suggest the next 20 years will be a grand time to be an economist.
I spent over a decade building the snappiest financial system around. In that time I pursued one goal of efficiency: reduction of complexity. This wasn't only goodness in an angelic sense, it was a pragmatic goal to reduce my own costs in building systems.
The result was pretty spectacular: we were settling trades in seconds and doing so with every leg firmly fastened to the ground. That is, the whole thing was running with direct concrete ties to assets.
But, the big players weren't interested. Indeed they were more than uninterested, they were highly interested in making sure this would never ever happen. Time after time, the message was delivered: Never. Other companies received the same message, so after a few years, I started to take it seriously.
At the time I hypothesised that the reason for this was insider fraud, or at least profits capture. The complexities were endemic and there were very few people who could see the whole picture. So, I theorised that those who could understand the complexities were cashing in on their advantage; from the inside. And some very few who cashed in were also driving the information agenda, as their success made them both wealthy and influential:
Of course such a hypothesis is unlikely to find proof. By its very nature, how do you prove such a tendency towards chaos? Here comes an alternate perspective from ZeroHedge, citing two papers (1, 2):
And the punchline: "Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization." Reread the last statement as it explains perhaps better than anything, the true functioning of modern capital markets and why they are terminally broken: in order to preserve the system, the banking cartel need to make everything of virtually infinite complexity so that no one has a clear understanding of what is going on!
Consider the perfect market hypothesis: the market already has all the information priced in, so you yourself cannot beat the market. Or, more politely, you get to earn the market rate of return, so you may as well invest in a unit fund that covers the entire market.
Although this hypothesis is proven, and proved time and time again (look at the averaged hedge fund returns against stock market returns over time), it is also clear that, at the limit, the hypothesis is impossible: if the market already knows, no new information will come to the market. In which case it gums up. (Leaving aside temporal arguments for now.)
So, the market also defends itself by creating reasons to bring in new information. ZeroHedge highlights Gorton & Metrick's punchline:
"Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization."
The market promotes impenetrable securities, which promotes Ignorance, which generates symmetric information, and hence liquidity. QED.
Well, we're all on the same page. Banks support e.g., OTC or over-the-counter market, and will kill to preserve it, because it creates symmetric information. a.k.a ignorance, leading to profits. Meanwhile, I invented the Ricardian Contract which created an excessively visible and tangible chain of contract. These two concepts are at war, opposite poles of complexity versus transparency.
Which is where sites like Zero Hedge step in - to expose "shadowy" places where things are best left unseen.
Yeah. That's what I thought, too. As we watch the complexity-driven system implode it would be easy to assume that now is the time for transparency to rise from the ashes of Europe, thus to be renamed Phoenix.
But, such a thought would be facile and naive in the extreme. A forlorn hope. The implosion of the world financial system doesn't make people any wiser, just poorer. Since when has the world responded to a crisis by getting smart?
What Zero Hedge is really discovering is that rewards are there if you participate in being aware of the complexity. It is a proof of the hypothesis: wisdom emerges in understanding where the masses, the herd, have it wrong. It is not in itself an absolute, nor a way to save them. For anything good to arise, something else is needed.
Over the Atlantic, where the Americans struggle with their own financial crisis, we have a real case of money laundering:
LAREDO — The high walls of Alexander Estates, an affluent development nestled near this border city’s country club and golf course, were supposed to keep the narcotics world at bay. But when federal agents raided the stately home of a downtown perfume salesman in January, it reinforced a notion that is feared by Texas leaders: the drug war spillover from Mexico is much broader than shootouts and kidnappings — it is cloaked in the seemingly routine business transactions of the border economy.
In this case, the alleged crime was the back-wash of dollars from drugs sales, laundered through a perfume dealer.
The Black Market Peso Exchange has been on the federal government’s radar for years. The system was perfected by Colombian drug lords and later adopted by Mexican drug cartels: When drugs are sold in the United States, the proceeds, in American dollars, are smuggled back into Mexico or Colombia, where they are exchanged for pesos at a discounted rate.
The peso-exchange businesses then use the dollars to buy products in the United States — in Mr. Datta’s case, millions of dollars worth of perfume — and have them shipped to purchasers in Mexico or Colombia.
Yeah. Of course, they have the money to corrupt any business (see Lynn's comments about drugs money and CDOs) and now that times are tight, they can find plenty of incentive.
I've previously written of the process of mexicanization. It begins with an aggressive prosecution by police of drug business; then the value of the illicit business rises, creating profits for the "businessmen" which leads them to fight the authorities. Pretty soon they realise the best way is to corrupt them.
This starts with the police. But pretty quickly spreads. In Mexico, bringing in the soldiers to police the police was a monumental step, and a mistake. Now the Mexican Army is criminalised. With the loss of the judiciary, civil society moves to collapse.
Think it can't happen here? Think again:
The FBI has released a new gang assessment announcing that there are 1.4 million gang members in the US, a 40 percent increase since 2009, and that many of these members are getting inside the military (via Stars and Stripes).
The report says the military has seen members from 53 gangs and 100 regions in the U.S. enlist in every branch of the armed forces. Members of every major street gang, some prison gangs, and outlaw motorcycle gangs (OMGs) have been reported on both U.S. and international military installations. ...
The report notes that while gang members have been reported in every branch of service, they are concentrated in the U.S. Army, Army Reserves, and the Army National Guard.Many street gang members join the military to escape the gang lifestyle or as an alternative to incarceration, but often revert back to their gang associations once they encounter other gang members in the military. Other gangs target the U.S. military and defense systems to expand their territory, facilitate criminal activity such as weapons and drug trafficking, or to receive weapons and combat training that they may transfer back to their gang. Incidents of weapons theft and trafficking may have a negative impact on public safety or pose a threat to law enforcement officials.
Make no mistake: the mexicanization of the USA is happening, and will keep happening. What's it about?
US-based gangs have established strong working relationships with Central American and MDTOs to perpetrate illicit cross-border activity, as well as with some organized crime groups in some regions of the United States. US-based gangs and MDTOs are establishing wide-reaching drug networks; assisting in the smuggling of drugs, weapons, and illegal immigrants along the Southwest Border; and serving as enforcers for MDTO interests on the US side of the border.
One word: Drugs. One acronym: MDTO stands for Mexican Drugs Trafficking Organization.
Violence in Mexico—particularly in its northern border states—has escalated with over 34,000 murders committed in Mexico over the past four years.
One policy: the war on drugs. For brutal comparison with real wars, USA lost 53,402 combat deaths in WWI and 47,424 in Vietnam.
The USA no longer has an option of exporting its miserable war on people south of the border. They're sending it back.
Another sign of strain may be found in demand for €500 bills. These are too large for everyday transactions and are mainly used for mattress-stuffing or money laundering, say bankers. Demand for them surged after the collapse of Lehman Brothers in 2008, and it has ticked up again in recent months (see chart 2).
I don't know about you, but use of these unfortunate and economically nonsensical terms by bankers against their customers has always troubled me. Now however, I sense more than a slight cognitive dissonance with the suggestion that money launderers or mattress stuffers are surging.
During the Lehman Brothers Affair, the people lost a huge amount, possibly $150 billion.
The shockwave triggered all sorts of issues; one observer put it that, due to the response of banks like RBS to the crisis, the British ATM network was only hours from being shut down. And, that could have led within a day or to an outbreak of 'shopping with violence'.
In this sense, the people are not so much stuffing mattresses or money laundering, as unstuffing the bank's mattress or getting the money out before the financial system launders it down the tubes. The Lehmans uptick looks to be about 15bn, which looks pretty tame compared to the losses. Or if you take the financial community in Europe who potentially knew 1st hand about the meltdown, and divide by the size of the Lehman Brothers uptick, it's only a handful of supernotes for each aware banker...
To spell out what the Economist didn't put in words: we're looking at a run on the banks.
Even if we take it broader, by eyeball, the period of that chart shows an increase of 40% in demand for the supernote, from say 210 billion euros in 2007 to 295 now. Crudely put, we could imagine the initial starting value as a normal and stable state, and attribute any increase to a shift by the people into safer money stores.
40% is a pretty significant vote against the banks of Europe. Demand for the supernote might just be an inverse signal of confidence in banking.
In this sense, the euphemisms such as 'mattress stuffers' and 'money launderers/ backfire: although bankers in the past were keen to apply these terms to their cash-using customers, it now appears that the shoe is on the other foot. The bankers need to explain to the people in which mattress is the missing trillion euros, or whatever the final bill for Europe's financial meltdown ends up being.
Saving the euro requires more pain for some, more generosity from others and fundamental change for all. Is it worth it? Sooner or later, citizens must be asked. Without their support, no reform can last. And a real choice must include the option of leaving the euro. Now that this taboo has been breached, the euro zone should start thinking about how best to arrange the departure of those that cannot, or will not, live by Germanic rules.
Else, if this explanation isn't provided, and the money found, demand for supernotes is likely to increase as confidence in the banking system suffers from more 'strain', to use another euphemism. Or, in other words, we're all money launderers now, and the only question left is who runs fastest to who's fat mattress, the bankers or the people?
Either way, one to watch!
If you want some view on the future, James Turk reviews a new book: Currency Wars, by Jim Rickards:
.... the first part being almost surreal because it reads more like a novel than non-fiction. It details Rickards’ participation in an exercise at the Warfare Analysis Laboratory near Washington D.C. This group is one of the Defense Department’s leading venues for war games and strategic planning, but in a first-ever event, the game in which Rickards joined was not a war-fighting simulation. Rather, several dozen people from the military, academic and intelligence communities fought a global financial war using currencies and capital markets to support national interests. Rickards and two colleagues were invited to give the simulation some real-world, Wall Street expertise about markets, which they certainly did.
I guarantee that when you start reading this part, you won’t put the book down until you learn the outcome of the war. It reads better than a suspense novel, even though the ending is somewhat anti-climactic and predictable. While I won’t spoil it for you by divulging the ending, I will note that gold has a big role to play. In fact, gold reappears throughout the whole book.
In the second section, Rickards analyzes the first two currency wars (CWI and CWII). ...
From the "you read it here first" department:
The final section of the book explains why the world is now fighting Currency War III, which Rickards believes began in 2010. He speculates that there are three possible outcomes from CWIII – paper, gold or chaos. Each of these alternatives is analyzed in detail, providing readers with much food for thought.
Actually, the scenes of this war go back to the issuance of the Euro as a credible alternative, and play their part in the great Financial Crisis of the 21st century. For confirmation of the thesis, Goldmoney's blog also pointed at The Real Contagion Risk which makes the same point: watch for the Central Banks to shift out of US Treasuries:
Step 1: As the global growth story frays, global trade decelerates, and the sovereign and total debt burdens of various countries drag at economic growth, fewer and fewer dollars will be accumulated and stored by various foreign central banks. The typical way dollars are stored is in the form of Treasury holdings. Because of this, several years of record-breaking Treasury accumulation by these foreign banks will grind to a halt and foreign Treasury holdings will begin to decline.
So what's our prediction? Well, it'll be a long slow decline from the dollar as reserve currency. The Euro looked good for a decade, but that's off it's shine now. Expect Central Banks to get back into the currency trading game -- and keep reserves of their bigger partners. And, the next shot in the war will be related to energy -- which is typically priced in dollars.
Gold? Well, everyone expects that to come up. James Turk says:
The harmful effects from abandoning gold still impair economic activity today because the necessary discipline has been removed from the monetary system, creating the global imbalances, debt loads, insolvent banks, risky derivatives and other problems that plague our world. So as economic activity sinks ever deeper into an abyss, think about the cause.
Yeah, and we used to say that governments should go back to the gold standard because we don't trust them with their own units.
Very proven true, no doubt, these days, but there has been a bit of a shift in thinking of late. For me, it was signalled by Alan Greenspan as far back as 1995 (?) when he said "nobody's listening any more." (In response to being asked why he didn't talk about gold anymore.) Fact is, governments will issue their own currencies, whether we trust them or not:
Namely, governments have created this mess, so we cannot rationally expect governments to get us out of it, which is something I have intuitively understood for some time but was also the main conclusion I reached from Rickards’ book.
And, the clanger is this: We don't trust governments, period. We don't trust them to issue their own inflation-protected currency, and we don't trust them to issue a gold-based unit either.
So, gold goes free. Economists are no longer advising governments to base off gold, because we know it won't work. Gold therefore will remain the independent watchdog it has since the closing of the gold window by Nixon; a three-way tussle between central bankers, gold banks and the buying public.
The future is a world of competitive currencies, USD, Euros, Yen, the Chinese unit ... and gold. With a very slow long decline of the power of the USD.
Disclosure: Author is long gold, and short fingernails.
Two Microsoft researchers have published a paper pouring scorn on claims cyber crime causes massive losses in America. They say it’s just too rare for anyone to be able to calculate such a figure.
Dinei Florencio and Cormac Herley argue that samples used in the alarming research we get to hear about tend to contain a few victims who say they lost a lot of money. The researchers then extrapolate that to the rest of the population, which gives a big total loss estimate – in one case of a trillion dollars per year.
But if these victims are unrepresentative of the population, or exaggerate their losses, they can really skew the results. Florencio and Herley point out that one person or company claiming a $50,000 loss in a sample of 1,000 would, when extrapolated, produce a $10 billion loss for America as a whole. So if that loss is not representative of the pattern across the whole country, your total could be $10 billion too high.
Having read the paper, the above is about right. And sufficient description, as the paper goes on for pages and pages making the same point.
Now, I've also been skeptical of the phishing surveys. So, for a long time, I've just stuck to the number of "about a billion a year." And waited for someone to challenge me on it :) Most of the surveys seemed to head in that direction, and what we would hope for would be more useful numbers.
So far, Florencio and Herley aren't providing those numbers. The closest I've seen is the FBI-sponsored report that derives from reported fraud rather than surveys. Which seems to plumb in the direction of 10 billion a year for all identity-related consumer frauds, and a sort handwavy claim that there is a ration of 10:1 between all fraud and Internet related fraud.
I wouldn't be surprised if the number was really 100 million. But that's still a big number. It's still bigger than income of Mozilla, which is the 2nd browser by numbers. It's still bigger than the budget of the Anti-phishing Working Group, an industry-sponsored private thinktank. And CABForum, another industry-only group.
So who benefits from inflated figures? The media, because of the scare stories, and the public and private security organisations and businesses who provide cyber security. The above parliamentary report indicated that in 2009 Australian businesses spent between $1.37 and $1.95 billion in computer security measures. So on the report’s figures, cyber crime produces far more income for those fighting it than those committing it.
Good question from the SMH. The answer is that it isn't in any player's interest to provide better figures. If so (and we can see support from the Silver Bullets structure) what is Florencio and Herley's intent in popping the balloon? They may be academically correct in trying to deflate the security market's obsession with measurable numbers, but without some harder numbers of their own, one wonders what's the point?
What is the real number? Florencio and Herley leave us dangling at that point. Are they are setting up to provide those figures one day? Without that forthcoming, I fear the paper is destined to be just more media fodder as shown in its salacious title. Iow, pointless.
Hopefully numbers are coming. In an industry steeped in Numerology and Silver Bullets, facts and hard numbers are important. Until then, your rough number is as good as mine -- a billion.
Liability is increasing slowly for cyber-exposed companies. We're in an exploratory court phase as litigants try different things. For a while, we'll see these filings in USA courts, which won't get far ... but then one will find the formula, and a company will be hit by a huge judgement.
"The US Department of Defense has been hit with a $4.9 billion (£3.1 billion) lawsuit over a recently disclosed data breach involving TRICARE , a healthcare system for active and retired military personnel and their families."
Meanwhile, pressure for breach disclosure increases. Now the SEC is in on the act:
"The SEC guidance clarifies a long-standing requirement that companies report 'material' developments, or matters significant enough that an investor would want to know about them. The guidance spells out that cyberattacks are no exception.
For example, the SEC says, a company probably will need to report on costs and consequences of material intrusions in which customer data are compromised. The company's revenue could suffer, and it could be forced to spend money to beef up security or fight lawsuits. In addition, if a company is vulnerable to cyberattack, investors may need to be informed of the risk, the SEC said."
This is also a first step that has increasing and more costly ramifications. May as well get used to it: disclosure will be part of the future. Liabilities are coming.
Perhaps the great age of software freedom is coming to an end, in more ways than one?
Blast from the past. The Economist talks about the great economic problem of our time. No, not global warming but global jobbing.
To understand why these changes are so exciting for some people and so scary for others, a good place to start is the oConomy section on the website of oDesk, one of several booming online marketplaces for freelance workers. In July some 250,000 firms paid some 1.3m registered contractors who ply their trade there for over 1.8m hours of work, nearly twice as many as a year earlier.
ODesk, founded in Silicon Valley in 2003, is a “game-changer”, says Gary Swart, its chief executive. His marketplace takes outsourcing, widely adopted by big business over the past decade, to the level of the individual worker. According to Mr Swart, this “labour as a service” suits both employers, who can have workers on tap whenever they need them, and employees, who can earn money without the hassle of working for a big company, or even of leaving home.
It is still small, but oDesk shows how globalisation and innovation in information technology, the two big trends that have been under way for some time, are moving the world nearer to a single market for labour. Much of the work on oDesk comes from firms in rich economies and goes to people in developing countries, above all the Philippines and India. Getting a job done through oDesk can bring the cost down to as little as 10% of the usual rate. So the movement of work abroad in search of lower labour costs is no longer confined to manufacturing but now also includes white-collar jobs, from computer programming to copywriting and back-office legal tasks. That is likely to have a big impact on pay rates everywhere.
It puts the whole thing into context of the current 2nd dip in USA and Europe. My first contribution to this debate was to predict the above in a paper & implementation of a jobs market in 1997, here: iang.org/papers/task_market.html. Because this used a sort of variation on Ricardian Contracts, and turned the global jobbing market into a financial system, it qualifies as FC.
(My second contribution was equally exciting, built in 2009-2010, and I guess someone will overtake it in 14 years as well. If you are in the angel business, you can find out about it sooner...)
Oh, and in case you didn't quite understand the oTalk above ... here's some hard econ data:
Michael Spence, another Nobel prize-winning economist, in a recent article in Foreign Affairs agrees that technology is hitting jobs in America and other rich countries, but argues that globalisation is the more potent factor. Some 98% of the 27m net new jobs created in America between 1990 and 2008 were in the non-tradable sector of the economy, which remains relatively untouched by globalisation, and especially in government and health care—the first of which, at least, seems unlikely to generate many new jobs in the foreseeable future. At the same time, says Mr Spence, the mix of jobs available to Americans in the tradable sector (including manufacturing) that serves global markets is shifting rapidly, with a growing share of the positions suitable only for skilled and educated people.
(Readers will recognise Prof. Spence as the man who wrote the paper that inspired the silver bullets hypothesis.)
Long term readers will know that I have often written of the failure of the browser vendors to provide effective security against phishing. I long ago predicted that nothing will change until the class-action lawsuit came. Now signs are appearing that this is coming to pass:
That's changing rapidly. Recently, Sony faced a class action lawsuit for losing the private information of millions of users. And this week, it was reported that Dropbox is already being sued for a recent security breach of its own.
It's too early to know if these particular lawsuits will get anywhere, but they're part of a growing trend. As online services become an ever more important part of the American economy, the companies that create them increasingly find that security problems are hitting them where it really hurts: the bottom line.
See also the spate of lawsuits against banks over losses; although it isn't the banks' direct fault, they are complicit in pushing weak security models, and a law will come to make them completely liable. Speaking of laws:
Computer security has also been an area of increasing activity for the Federal Trade Commission. In mid-June, FTC commissioner Edith Ramirez testified to Congress about her agency's efforts to get companies to beef up their online security. In addition to enforcing specific rules for the financial industry, the FTC has asserted authority over any company that makes "false or misleading data security claims" or causes harm to consumers by failing to take "reasonable security measures." Ramirez described two recent settlements with companies whose security vulnerabilities had allowed hackers to obtain sensitive customer data. Among other remedies, those firms have agreed to submit to independent security audits for the next 20 years.
Skip over the sad joke at the end. Timothy B. Lee and Ars Technica, author of those words, did more than just recycle other stories, they actually did some digging:
Alex Halderman, a computer science professor at the University of Michigan, to help us evaluate these options. He argued that consumer choice by itself is unlikely to produce secure software. Most consumers aren't equipped to tell whether a company's security claims are "snake oil or actually have some meat behind them." Security problems therefore tend not to become evident until it's too late.
But he argued the most obvious regulatory approach—direct government regulation of software security practices—was also unlikely to work. A federal agency like the FTC has neither the expertise nor the manpower to thoroughly audit the software of thousands of private companies. Moreover, "we don't have really widely regarded, well-established best practices," Halderman said. "Especially from the outside, it's difficult to look at a problem and determine whether it was truly negligent or just the kind of natural errors that happen in every software project."
And when an agency found flaws, he said, it would have trouble figuring out how urgent they were. Private companies might be forced to spend a lot of time fixing trivial flaws while more serious problems get overlooked.
So what about liability? I like others have recognised that liability will eventually arise:
This is a key advantage of using liability as the centerpiece of security policy. By making companies financially responsible for the actual harms caused by security failures, lawsuits give management a strong motivation to take security seriously without requiring the government to directly measure and penalize security problems. Sony allegedly laid off security personnel ahead of this year's attacks. Presumably it thought this would be a cost-saving move; a big class action lawsuit could ensure that other companies don't repeat that mistake in future.
Still, Halderman warned that too much litigation could cause companies to become excessively security-conscious. Software developers always face a trade-off between security and other priorities like cost and time to market. Forcing companies to devote too much effort to security can be as harmful as devoting too little. So policymakers shouldn't focus exclusively on liability, he said.
Actually, it's far worse. Figure out some problem, and go to a company and mention that this issue exists. The company will ignore you. Mention liability, and the company will immediately close ranks and deny-by-silence any potential liability. Here's a variation written up close by concerning privacy laws:
...For everything else, the only rule for companies is just “don’t lie about what you’re doing with data.”
The Federal Trade Commission enforces this prohibition, and does a pretty good job with this limited authority, but risk-averse lawyers have figured out that the best way to not violate this rule is to not make explicit privacy promises at all. For this reason, corporate privacy policies tend to be legalistic and vague, reserving rights to use, sell, or share your information while not really describing the company’s practices. Consumers who want to find out what’s happening to their information often cannot, since current law actually incentivizes companies not to make concrete disclosures.
Likewise with liability: if it is known of beforehand, it is far easier to slap on a claim of gross negligence. Which means in simple layman's terms: triple damages. Hence, companies have a powerful incentive to ignore liability completely. As above with privacy: companies are incentivised not to do it; and so it comes to pass with security in general.
Try it. Figure out some user-killer problem in some sector, and go talk to your favourite vendor. Mention damages, liability, etc, and up go the shutters. No word, no response, no acknowledgement. And so, the problem(s) will never get fixed. The fear of liabilities is greater than the fear of users, competitors, change, even fear itself.
Which pretty much guarantees a class-action lawsuit one day. And the problem still won't be fixed, as all thoughts are turned to denial.
So what to do? Halderman drifts in the same direction as I've commented:
Halderman argued that secure software tends to come from companies that have a culture of taking security seriously. But it's hard to mandate, or even to measure, "security consciousness" from outside a company. A regulatory agency can force a company to go through the motions of beefing up its security, but it's not likely to be effective unless management's heart is in it.
It's completely meaningless to mandate, which is the flaw behind the joke of audit. But it is possible to measure. Here's an attempt by yours truly.
What's not clear as yet is how is it possible to incentivise companies to pursue that lofty goal, even if we all agree it is good?
How to cope with a financial system that looks like it's about to collapse every time bad news turns up? This is an issue that is causing a few headaches amongst the regulators. Here's some musings from Chris Skinner over a paper from the Financial Stability gurus at the Bank of England:
Third, the paper argues for policies that create much greater transparency in the system.
This means that the committees worldwide will begin “collecting systematically much greater amounts of data on evolving financial network structure, potentially in close to real time. For example, the introduction of the Office of Financial Research (OFR) under the Dodd-Frank Act will nudge the United States in this direction.
“This data revolution potentially brings at least two benefits.
“First, it ought to provide the authorities with data to calibrate and parameterise the sort of network framework developed here. An empirical mapping of the true network structure should allow for better identification of potential financial tipping points and cliff edges across the financial system. It could thus provide a sounder, quantitative basis for judging remedial policy actions to avoid these cliff edges.
“Second, more publicly available data on network structures may affect the behaviour of financial institutions in the network. Armed with greater information on counterparty risk, banks may feel less need to hoard liquidity following a disturbance.”
Yup. Real time data collection will be there in the foundation of future finance.
But have a care: you can't use the systems you have now. That's because if you layer regulation over policy over predictions over datamining over banking over securitization over transaction systems … all layered over clunky old 14th century double entry … the whole system will come crashing down like the WTC when someone flies a big can of gas into it.
The reason? Double entry is a fine tool at the intra-corporate level. Indeed, it was material in the rise of the modern corporation form, in the fine tradition of the Italian city states, longitudinal contractual obligations and open employment. But, double entry isn't designed to cope with the transactional load of of inter-company globalised finance. Once we go outside the corporation, the inverted pyramid gets too big, too heavy, and the forces crush down on the apex.
It can't do it. Triple entry can. That's because it is cryptographically solid, so it can survive the rigours of those concentrated forces at the inverted apex. That doesn't solve the nightmare scenarios like securitization spaghetti loans, but it does mean that when they ultimately unravel and collapse, we can track and allocate them.
Message to the regulators: if you want your pyramid to last, start with triple entry.
PS: did the paper really say "More taxes and levies on banks to ensure that the system can survive future shocks;" … seriously? Do people really believe that Tobin tax nonsense?
Many people are asking me about BitCoin, and I've put off writing about it because I need to be clear on why I think it is not a long term player. Of course, I've been wrong before ... Anyway, it looks like John Levine has done the job for me:
Bitcoin and tulip bulbs
Bitcoin, for anyone who's not up on their techno-trends, is this year's hot trendy digital payment system. Its main claim to fame is that it is peer-to-peer, not depending on a central bank to issue or validate the "coins", actually blobs of cryptographically signed bits. This makes it both fairly anonymous and hard to manipulate (at least in the ways that real money is manipulated), making it a darling of anarcho-libertarians.
A lot of people have opined on its merits, most notably this Quora message.
I took a look at the design of Bitcoin, which is credited to "Satoshi Nakamoto". Nobody seems to know who he is (or who they are), but he definitely knows his crypto. As a piece of cryptographic software design, it's quite clever. As a system you might want to use to pay for stuff, it's hopeless.
To somewhat adapt the arguments in the Quora message, Bitcoins suffer from two problems, one technical and the other economic. [techo-issue elided]
The other problem is economic. A year ago, you could buy bitcoins for about 1¢ apiece. In January, they cost about $1. Now they're about $10. We have a name for that -- it's a bubble. (Bitcoin fans tend to assume that bitcoins are money, and describe what's happending as deflation, but you'll have to look pretty hard to find any real-world examples of 1000 to 1 deflation.) Since there's no central bank to manage exchange rates, nor can you pay your taxes with them, which is the practical definition of money, a bitcoin is only worth what the next sucker thinks it's worth. So what we have here is a system that lets you pay for stuff with tulip bulbs, or perhaps shares of stock in theglobe.com.
John's rant mostly covers it, but for the hardcore monetarists I'll add: money is expected to be a store of value. BitCoin doesn't speak to value at all, and it is the antithesis of the Ricardian Contract, which describes its value in glorious and legal detail. So it's whatever value we as holders want it to be.
Typically such a bubble bursts when we run out of speculators who agree on its appeal. In this case, it is eerily familiar with history of last decade. It shares something of the media hype of DigiCash, and also the user-base of e-gold. So it will burst when we run out of cypherpunks, and when the user base reaches a tipping point.
And, as Lynn Bell pointed out, last decade was the decade of the alternative issuers. This decade, facebook, apple and google will try it, and may succeed (if that is they can keep the geeks at a distance and build an integrated team with some monetarists in it)...
More grist for the mill -- where are we on the security debate? Here's a data point.
In May 2009, PATCO, a construction company based in Maine, had its account taken over by cyberthieves, after malware hijacked online banking log-in and password credentials for the commercial account PATCO held with Ocean Bank. ....
There are two ways to look at this: the contractual view, and the responsible party view. The first view holds that contracts describe the arrangement, and parties govern themselves. The second holds that the more responsible party is required to be <ahem> more responsible. PATCO decided to ask for the second:
A magistrate has recommended that a U.S. District Court in Maine deny a motion for a jury trial in an ACH fraud case filed by a commercial customer against its former bank. According to the order, which must still be reviewed by the presiding judge, the bank fulfilled its contractual obligations for security and authentication through its requirement for log-in and password credentials. ....
At issue for PATCO is whether banks should be held responsible when commercial accounts, like PATCO's, are drained because of fraudulent ACH and wire transfers approved by the bank. How much security should banks and credit unions reasonably be required to apply to the commercial accounts they manage?
"Obviously, the major issue is the banks are saying this is the depositors' problem," Patterson says, "but the folks that are losing money through ACH fraud don't have enough sophistication to stop this."
David Navetta, an attorney who specializes in IT security and privacy, says the magistrate's recommendation, if accepted by the judge, could set an interesting legal precedent about the security banks are expected to provide. And unless PATCO disputes the order, Navetta says it's unlikely the judge will overrule the magistrate's findings. PATCO has between 14 and 21 days to respond.
"Many security law commentators, myself included, have long held that *reasonable security does not mean bullet-proof security*, and that companies need not be at the cutting edge of security to avoid liability," Navetta says. "The court explicitly recognizes this concept, and I think that is a good thing: For once, the law and the security world agree on a key concept."
My emphasis added, and it is an important point that security doesn't mean absolute security, it means reasonable security. Which from the principle of the word, means stopping when the costs outweigh the benefits.
But that is not the point that is really addressed. The question is whether (a) how we determine what is acceptable (not reasonable), and (b) if the Customer loses out when acceptable wasn't reasonable, is there any come-back?
In the disposition, the court notes that Ocean Bank's security could have been better. "It is apparent, in the light of hindsight, that the Bank's security procedures in May 2009 were not optimal," the order states. "The Bank would have more effectively harnessed the power of its risk- profiling system if it had conducted manual reviews in response to red flag information instead of merely causing the system to trigger challenge questions."
But since *PATCO agreed to the bank's security methods when it signed the contract*, the court suggests then that PATCO considered the bank's methods to be reasonable, Navetta says. The law also does not require banks to implement the "best" security measures when it comes to protecting commercial accounts, he adds.
So, we can conclude that "reasonable" to the bank meant putting in place risk-profiling systems. Which it then bungled (allegedly). However, the standard of security was as agreed in the contract, *reasonable or not*.
That is, *reasonable security* doesn't enter into it. More on that, as the observers try and mold this into a "best practices" view:
"Patco in effect demands that Ocean Bank have adopted the best security procedures then available," the order states. "As the Bank observes, that is not the law."
(Where it says "best" read "best practices" which is lowest common denominator, a rather different thing to best. In particular, the case is talking about SecureId tokens and the like.)
Patterson argues that Ocean Bank was not complying with the Federal Financial Institutions Examination Council's requirement for multifactor authentication when it relied solely on log-in and password credentials to verify transactions. Navetta agrees, but the court in this order does not.
"The court took a fairly literal approach to its analysis and bought the bank's argument that the scheme being used was multifactor, as described in the [FFIEC] guidance," Navetta says. "The analysis on what constitutes multifactor and whether some multifactor schemes [out of band; physical token] are better than others was discussed, and, to some degree, the court acknowledged that the bank's security could have been better. Even so, it was technically multifactor, as described in the FFEIC guidance, in the court's opinion, and "the best" was not necessary."
Navetta says the court's view of multifactor does not jibe with common industry understanding. Most industry experts, he says, would not consider Ocean Bank's authentication practices in 2009 to be true multifactor. "Obviously, the 'something you have' factor did not fully work if hackers were able to remotely log into the bank using their own computer," he says. "I think that PATCO's argument was the additional factors were meaningless since the challenge question was always asked anyway, and apparently answering it correctly worked even if one of the factors failed. In other words, it appears that PATCO was arguing that the net result of the other two factors failing was going back to a single factor."
This problem has been known for a long time. When the "best practices" approach is used, as in this FFIEC example, there is a list of things you do. You do them, and you're done. You are encouraged to (a) not do any better, and (b) cheat. The trick employed above, to interpret the term "multi-factor" in a literal fashion, rather than using the security industry's customary (and more expensive) definition, has been known for a long long time.
It's all part of the "best practices" approach, and the court may have been wise to avoid further endorsing it. There is now more competition in security practices, says this court, and you'll find it in your contract.
Just when you thought it couldn't get any worse for infosec, there's more bad news on the horizon.
WASHINGTON—The Pentagon has concluded that computer sabotage coming from another country can constitute an act of war, a finding that for the first time opens the door for the U.S. to respond using traditional military force. ....
In part, the Pentagon intends its plan as a warning to potential adversaries of the consequences of attacking the U.S. in this way. "If you shut down our power grid, maybe we will put a missile down one of your smokestacks," said a military official.
Recent attacks on the Pentagon's own systems—as well as the sabotaging of Iran's nuclear program via the Stuxnet computer worm—have given new urgency to U.S. efforts to develop a more formalized approach to cyber attacks. A key moment occurred in 2008, when at least one U.S. military computer system was penetrated. This weekend Lockheed Martin, a major military contractor, acknowledged that it had been the victim of an infiltration, while playing down its impact.
Cyberwarfare is becoming more than just another talking point for the US Military, it's becoming a plank in government policy.
How significant is this? Well here's a data point. Lieutenant-General David Hurley has just been appointed as the new Chief of the Australian Defence Force. In a TV interview that night, he stated that one of the top four priorities for his term is cyberwarfare . He called each of the other three as gamechangers (to which I concur) but did not elaborate on his one-word declaration of cyberwar.
What does that mean, other than a scurrilous lead for Australia's infosecarrazi press to follow up on? *Cyberwarfare is now top drawer stuff*. While us infosec types are scrabbling around trying to figure out what all the fuss is about (theories including:
the military has put it on the agenda. On the *top of the agenda* of a force of 58,000 permanent warmakers, now with new improved government sanction to go out and bomb some electrons.
If the normally sensible Australians have bought into cyberwarfare, that means typically that the Americans are long gone down that path, and the British and Canadians have their walking shoes on as well. NATO won't be far behind, and NZ will join after their routine decade of protest.
The future of information security may well travel down a government / compliance path as we're squeezed between the 363kg gorilla of cyberwarfare on the one side, and the general incompetence of vendors on the other side. This will see all the vendors drawn over to cyberwar side, and an inevitable loss of innovative work on in the private sector. Not that we saw a lot, but there was always hope.
The end result will be more wrong threat models leading to more best practices and ultimately more compliance directed out of a military/political agenda. The compliance cycle that we saw stifling the American anti-phishing efforts will be the beginning, not the end, it will become the sad norm, not the upsetting exception.
Curiously however, there may be new common sense over on the other side of the Pacific. Lt Gen Hurley's opposite number in USA has also just been appointed as the new Chair of the Joint Chiefs of Staff:
[General Martin] Dempsey is “deeply skeptical” of technology being able to alter the basic nature of combat. He wrote recently in the introduction to the Army’s main operating concept, “We operate where our enemies, indigenous populations, culture, politics, and religion intersect and where the fog and friction of war persists.” In the end, it comes down to boots on the ground performing their jobs under competent command leadership.
His critics claim he doesn’t think as much as he should about future warfare and that he is too narrowly focused on the wars in Iraq and Afghanistan. ...
If anything's clear, the entry of the war machine into civilian cybersecurity affairs is likely to be bad news. Business and trade is far too delicate a thing to clobber with the heavy, blunt weapon of state responses. Maybe we need an old soldier to remind the futurists that war is actually a brutal thing?
No matter what the futurists have said over the last several centuries, it is always the grunts on the ground who are called upon to go in and make the job real. And it is always the people who bear the brunt of desk-flying futurists.
The third priority was equally big, but I don't recall it because I was too busy picking my jaw off the ground from hearing him slide that single neoligism into the middle of his conservative and comprehensive priorities.
In July 2009, President Medvedev illustrated his call for a supranational currency to replace the dollar by pulling from his pocket a sample coin of a “united future world currency.” The coin, which bears the words “Unity in Diversity,” was minted in Belgium and presented to the heads of G8 delegations.
In September 2009, the United Nations Conference on Trade and Development proposed creating a new artificial currency that would replace the dollar as reserve currency. The UN wants to redesign the Bretton Woods system of international exchange. Formation of this currency would be the largest monetary overhaul since World War II. China is involved in deals with Brazil and Malaysia to denominate their trade in China’s yuan, while Russia promises to begin trading in the ruble and local currencies.
Additionally, nine Latin American countries have agreed on the creation of a regional currency, the sucre, aimed at scaling back the use of the US dollar.
Question of some pondering for me was, then, why is this *the number 1 censored story* ? Well, if one thinks about it some, the connection is clear.
In order to maintain the powerbase of Washington DC, the USD must remain supreme, because it is by the power of the dollar that economic force is wielded around the world, and it is the power of the dollar that buys the military machine at the pointy end of Ferguson's comment.
Except, this party's over. Outside the media eye, for a decade now, the world has been easing gently over to a multicurrency future. Here's just more latest news:
Mexico has quietly purchased nearly 100 tons of gold bullion, as central banks embark on their biggest bullion buying spree in 40 years. The purchase, reported in monthly data published by Mexico’s central bank, is the latest in a series of large gold buys by emerging market economies intent on diversifying reserves away from the faltering US dollar. China, Russia and India have acquired large amounts of gold in recent years, while Thailand, Sri Lanka and Bolivia have made smaller purchases.
*Central banks became net buyers of gold last year after two decades of heavy selling* – a reversal that has helped propel the price of bullion to a series of record highs. On Wednesday gold was trading at about $1,510 a troy ounce, down 4 percent from a nominal record high of $1,575.79 reached on Monday.
As a result of Mexico’s purchase, central banks, sovereign wealth funds and other so-called “official sector” buyers are on track to record their largest collective purchase of gold since the collapse of the Bretton Woods system, which pegged the value of the dollar to gold, in 1971. GFMS, a precious metals consultancy, had predicted that the official sector would make net gold purchases of 240 tons this year, compared with a post-Bretton Woods peak of 276 tons in 1981.
Because every day this story is unknown is another day without currency flight, and another day the current regime avoids the tough questions. It buys more time for *everything else* that is going on. E.g., one supposes, Obama's efforts to balance his budget, contain inflation, withdraw forces from land wars in Asia, and other tasks in the struggle for peace.
So, it's the number one story to censor because it is the number one story to those who are in a position to censor. For the rest of us, it isn't, it's just more humdrum and drone and 1 percent this and 2 percent that.
"And," as my local TV station closes every day without fail, "that's finance."
The idea is that you put cash in and get gold out.
I plumped for the cheapest gold nugget priced at £100 and inserted my MasterCard.
Oh no, it didn’t work.
I guess that’s because you need to go to the other ATM to get cash to come back and get your gold.
With gold now enjoying its resurgence in notoriety as the alternate world currency, it's probably time to refresh our memory of the May Scale, reproduced below.
|Street cash, US dollars|
|Street cash, euro currencies, japan|
|Street cash, other regions|
|Interbank transfers of various sorts (wires etc), bank checks|
|Consumer-level electronic account transfers (eg bPay)|
|Business-account-level retail transfer systems|
|Paypal and similar 'new money' entities, beenz|
Fig. 1. The May Scale
With such a scale at hand, it is easy to see why the gold ATM doesn't take credit cards. Even without the May Scale tucked in your wallet, just in case you thought to whip it out and read out the laws of economics to your ATM, this one gives you handy instructions:
This headline struck my attention:
Data Breaches Feared More than Hackers
The majority of compliance professionals feel that their organizations are well or very well prepared to fend off hacker attacks, however, their confidence wanes significantly when assessing other data breach threats. This according to a survey conducted by the Society of Corporate Compliance and Ethics (SCCE) and the Health Care Compliance Association (HCCA).
This mirrored my results in The Market for Silver Bullets, in that the cost of the loss to intangibles and indirects such as reputation and compliance reviews would far outweigh the direct losses to the individuals. Consequently, this would have perverse effects on the treatment of risks.
I didn't really go into what those perverse effects were. Suffice, I thought at the time, to say, security's really screwed up, there is no way you can expect a rational result from this mess. But one thing struck me on reading that heading.
If the indirect effects of the data breach are feared more than the direct effects of the hacker's impacted damages, then there is an easy solution. Simply share the results, and generate a win-win for both. E.g., if the hacker manages to breach, and steal X data sets, he now has two opportunities. He can either exploit the breach set for some gain X*y where y is the average gain per identity, or he can settle with the lead victim.
Because we know that the indirect costs to the victim will far outweigh the direct gain to the attacker, there is an easy settlement. The victim is easily incentivised to pay for the breach to be settled without additional costs. And the attacker gains too as he has less work to do. Negotiation will find a convenient price between the two bounds.
Thus, this state of affairs predicts that the market for silver bullets leads to a market for extortion. Hack citibank, sell them their data back. I have no firm data, but I am comfortable with predicting that the difference is an order of magitude. That is, the costs to the victim are around 10 times the benefit to the attacker. Plenty of room there for a win-win solution.
(For those who are worried about the impact of an illegal contract, it is easy enough to put a silk dress on the pig and sell the breach techniques, with an NDA attached. This of course is the worry behind those breach markets. How close to extortion does it take us? Where do the morals stop and where does the crime start? A topic for another day...)
As a slight footnote, to confirm my prediction of this particular perverse result, I followed the article. Here's the relevant section found on the survey provider's site, two groups called Society of Corporate Compliance and Ethics and Health Care Compliance Association.
Fears of an accidental breach far outweigh fears of an intentional breach. Respondents were asked how likely they felt that data would be released through hacking attacks, intentional breaches by employees and third party vendors, and accidental breaches by employees and vendors. In general the feeling was that accidental breaches were far more likely. Just 8% felt that it was somewhat or very likely a hacker would gain access to the system, When it came to breaches by employees, 61% thought an accidental breach was somewhat or very likely, but just 30% thought the same of an intentional breach. Likewise 41% thought an accidental breach by a third party vendor was somewhat or very likely but only 13% thought an intentional breach was somewhat or very likely.
Unfortunately, no such luck. Right crowd, different story :) Oh well. So markets in extortion won't happen, right?
The Economist summarises who the Financial Crisis Inquiry Commission of USA's Congress would like to blame in three tranches. For the Democrats, it's the financial industry and the de-regulation-mad Republicans:
The main report, endorsed by the Democrats, points to a broad swathe of failures but pins much of the blame on the financial industry, be it greed and sloppy risk management at banks, the predations of mortgage brokers, the spinelessness of ratings agencies or the explosive growth of securitisation and credit-default swaps. To the extent that politicians are to blame, it is for overseeing a quarter-century of deregulation that allowed Wall Street to run riot.
For the Republicans:
A dissenting report written by three of the Republicans could be characterised as the Murder on the Orient Express verdict: they all did it. Politicians, regulators, bankers and homebuyers alike grew too relaxed about leverage, helping to create a perfect financial storm. This version stresses broad economic dynamics, placing less emphasis on Wall Street villainy and deregulation than the main report does.
Finally, one lone dissenter:
A firmer (and, at 43,000 words, longer) rebuttal of the report by the fourth Republican, Peter Wallison, puts the blame squarely on government policies aimed at increasing home ownership among the poor. Mr Wallison argues that the pursuit of affordable-housing goals by government and quasi-government agencies, including Fannie Mae and Freddie Mac, caused a drastic decline in loan-underwriting standards. Over 19m of the 27m subprime and other risky mortgages created in the years leading up to the crisis were bought or guaranteed by these agencies, he reckons. These were “not a cigarette butt being dropped in a tinder-dry forest” but “a gasoline truck exploding” in the middle of one, Mr Wallison says.
Yessss..... That's getting closer. Not exactly a gasoline truck, as that would have one unfortunate spark. More like several containers, loaded with 19m fully-loaded zippo lighters driven into the forest of housing finance one hot dry summer, and distributed to as many needy dwellers as could be found.
Now, who would have driven that truck, and why? Who would have proposed it to the politicians? Ask these questions, and we're almost there.
In a long series of essays on the topic of Audit, I asked the question, why didn't the Audit firms pick up the disasters of the global financial crisis? Not all of those failed firms, as that would be too much to ask, but not even one?
As far as I know, no audit firm rang any alarm for any impending disaster for any business that consequently ran into trouble in the GFC. Not a single one!
Which raises the question: not even accidental combinations of misfortunes are being noticed by Auditors? What would it take to get an auditor to ring the alarm bell?
We have a statistically significant sample -- all the world's big firms. By some statistical hypothesis, either some alarm bells should have rung, or, no alarm bells were ever going to ring.
Some might be asking the same thing. Ernst & Young have now been sued by the New York Attorney General, Andrew Cuomo:
NEW YORK (Reuters) – Accounting firm Ernst & Young was sued by New York prosecutors over allegations it helped to hide Lehman Brothers' financial problems, in the first major government legal action stemming from the Wall Street company's 2008 downfall.
The civil fraud case contends that Ernst & Young stood by while Lehman used accounting gimmickry to mask its shaky finances. The lawsuit says Lehman ran "a massive accounting fraud," but it did not name as defendants any former top executives at the investment bank whose September 2008 collapse helped spark the global financial crisis.
You can read the indictment here. Now, it's hard to speculate reliably as to where this will go, other than to a quiet settlement. What is more interesting to me at the systemic level is that an audit firm is being brought to account.
People close to Cuomo said one factor in bringing the case was that he knows that the U.S. Securities and Exchange Commission already is investigating former Lehman chief Richard Fuld and other former top Lehman executives.
Cuomo "wants to go after the one party he knows isn't being sued," said John Coffee, a professor of corporate law at Columbia University.
Whatever that means. Ernst & Young predictably say they did nothing wrong and all transactions were "by the book." Could well be, and the court will no doubt audit that very statement, as well as the statements of the bankrupcy court:
The lawsuit comes nine months after a court-appointed examiner in the Lehman bankruptcy concluded that Ernst & Young was "professionally negligent" in its audit duties.
The report by examiner Anton Valukas also said that Lehman could also have claims against Fuld and former chief financial officers Chris O'Meara, Erin Callan and Ian Lowitt for negligence or breach of fiduciary duty related to the use of Repo 105 transactions.
For me, the big question remains: if we can't expect an audit firm to pick up any signs of trouble, what can we expect of them? Perhaps we could save our money and do our due diligence another way?
The lawsuit seeks more than $150 million in fees that Ernst & Young received from 2001 to 2008 as Lehman's outside auditor -- less than 1 percent of its global annual revenue -- plus other unspecified damages.
However it turns out, the result will be important.
I've been watching an odd series of posts over in UK's Finanser site with amusement:
All along the lines of,
It's time to change the music, but I've predicted that nobody's going to be the first to say that.
I spoke too soon. Last month, Hasan pointed to Mervyn King again, who's just come out and said:
"One might well say that a financial crisis occurs when the Basel risk weights turn out to be poor estimates of underlying risk. And that is not because investors, banks or regulators are incompetent. It is because the relevant risks are often impossible to assess in terms of fixed probabilities. Events can take place that we could not have envisaged, let alone to which we could attach probabilities. If only banks were playing in a casino then we probably could calculate appropriate risk weights. Unfortunately, the world is more complicated. So the regulatory framework needs to contain elements that are robust with respect to changes in the appropriate risk weights, and that is why the Bank of England advocated a simple leverage ratio as a key backstop to capital requirements."
In short, what the Governor is saying is that Basel III is not the answer. It might be part of the answer, but he's raising some skepticism. Then, he discusses solutions:
"Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009).
Blink and you missed it! The end of fractional reserve banking? On the table?
In essence these proposals recognise that if banks undertake risky activities then it is highly dangerous to allow such “gambling” to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure. And eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.
So there we have the reversion to Glass-Steagall and removal of deposit taking from risk-making, or as he puts it, kicking the payments system out of banks' jurisdiction. My words fail, so back to his:
We certainly cannot rely on being able to expand the scope of regulation without limit to prevent the migration of maturity mismatch. Regulators will never be able to keep up with the pace and scale of financial innovation. Nor should we want to restrict innovation. But it should be undertaken by investors using their own money not by intermediaries who also provide crucial services to the economy, allowing them to reap an implicit public subsidy. It will not be possible to regulate all parts of the financial system as if they were banks. ...
Which in effect is a fall-back to Glass-Steagal, but this time there is a recognition of something called the migration of maturity mismatch. Innovation might be the cassus belli above, but securitization is firmly in Mr King's sites.
But, wait, there's more! Across the pond, Mr King reports that they're talking about redeeming the implied public subsidy of lender of last resort:
As Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, has argued, “merely expanding the scope of regulation to chase those firms that extract implicit guarantees by engaging in maturity transformation would be an interminable journey with yet more financial instability in its wake” (Lacker, 2010).
For "implicit guarantee" read lender of last resort. For "maturity transformation" read securitization, CDOs and the shift from banking to market.
It's happening. Jeffrey Lacker of the Fed has called for a stop to the lender of last resort, and the Governor of the world's first central bank has put it on the table for negotiation. In effect, they're throwing in the towel. In speech celebrating the inventor of the central bank, Mervyn King has called the beginning and the end of an era of financial history.
Central banking is on its last legs, the Old Lady of Threadneedle Street is on her deathbed.
What remains is to give her a decent burial, and preserve our economy in her wake. The shift from Banking to Markets continues, apace.
In the last couple of weeks I posted a thesis on what caused the global financial crisis. In technical terms it is the invention and usage of securitization, a.k.a., the market for mortgage-backed securities. In economic and policy terms, it is the shift from banking to markets .
It sounds too simple to be true, but I'll stick to my guns. So, how to show this? Scientifically this is a difficult one to show. Instead, I'll just do this: make observations on big things happening, and interpret them from the theory.
Let's look at the EU who are currently dealing with Ireland. Here's the Economist summary:
The decision by finance ministers in the EURO ZONE to create a European Stabilisation Mechanism as a permanent system for resolving future sovereign-debt difficulties did little to soothe markets, at least at first. The mechanism distinguishes a "solvency" crisis from a "liquidity" one, with bondholders in insolvent countries expected to take the brunt of losses, but does not come into force until 2013. However, markets were encouraged by a hint of more immediate help from the European Central Bank. Jean-Claude Trichet, the ECB's president, advised that people were "tending to underestimate the determination" in Europe to solve the debt crisis. - See article
What does that tell us? Well, the EU went in with a big fat cheque book and acted as lender of last resort, one of the primary functions of central banks. They bailed out Ireland (the country, the banks, the economy, whichever). And the markets weren't impressed.
Europe’s policymakers are crying foul. “The speculation on international financial markets can’t be explained rationally at all,” declared Wolfgang Schäuble, Germany’s finance minister.
It's entirely rational: lender of last resort is appropriate to banking, but not appropriate to markets. The markets themselves have figured out the first part, the politicians, not.
(OK, so this skims past the second part, how to deal with markets, and all the pointed questions of what EU should do right now; and how to get themselves out of the mess -- see the article for more on that. I'm simply concentrating on the core, underlying, fundamental systemic cause of failure. Without understanding that, there is no foundation in discussing policy or rescue prescriptions.)
Let's now turn to the USA. There, the highly successful Federal Reserve has now revealed more details about how it managed the crisis:
The numbers are staggering, encompassing more than a dozen emergency programs set up starting in 2007 or 2008. In one program alone the Fed doled out nearly $9 trillion in funds to borrowers such as Morgan Stanley and Merrill Lynch, largely at interest rates below 1 percent. (This program involved overnight loans, so the amount of Fed credit outstanding at any single point in time was much smaller.)
Other programs, with longer-term loans also measured in the trillions of dollars.
The Fed actions were just part of a larger array of government bailouts for the financial industry, which were deeply unpopular with most Americans. Rescue programs run outside the Fed included insurance-style backstops for bank debts and the investments from the Treasury's $700 billion TARP (Troubled Asset Relief Program).
At the same time, it's possible that the release of details will end up largely vindicating the Fed for the massive financial support that it gave the economy at a time of severe stress. The emergency loans, in the view of many finance experts, helped to avert a much deeper economic slump. And those loans have now been largely paid back without losses to the central bank.
The Fed therefore scores top points as lender of last resort, and the obvious complaint is that the EU isn't spending enough. However, there is a rider or caveat on that:
"My view is that the Fed has done an excellent job since the crisis started, but they didn't do a very good job before the crisis started," says Pete Kyle, a finance expert at the University of Maryland. He says the central bank, as a key financial regulator, should have ensured that US banks had plenty of capital on hand to weather a storm.
Some other economists echo that view, arguing that the Fed and other bank regulators should have done much more to safeguard against a surge in high-risk mortgage lending during the years leading up to the crisis, at a time when US home prices were soaring.
Once a crisis is under way, however, the standard view among economists is that a central bank should act as a "lender of last resort," providing credit as freely as possible to prevent widespread bank failures at a time when ordinary investors are in a panic.
When people resort to language like "the standard view" we know something's wrong. The economists are wobbling: they know the standard view, they see the lender of last resort is facing bankrupcy under its own rules, and they're feeling quite bad and conflicted about it.
Whatever is happening to the skepticism of the markets and the economists, this still doesn't tell the ordinary people what went wrong. We're so used to conflicting signals from economists and markets, we'll discount them all without a second thought.
Let's get a little bit more haptic. Let's reach in and touch the problem. Here it is:
Dan Edstrom is a guy who is in the right place at the right time. His profession? He performs securitization audits (Reverse Engineering and Failure Analysis) for a company called DTC-Systems.
The typical audit includes numerous [stuff, snipped]. The following flow chart reverse engineers the mortgage on the Ekstrom family residence. It took Dan over one year to take it this far and it clearly demonstrates what happens when there are too many lawyers being manufactured.
Dan went in and documented the mortgage on his house. Think of this as who owns Dan and Teri's house? or from an accountant's pov, who owns the cash flow?
Do you understand it? Of course not. Be not ashamed, the real point is, nobody else understands it either, and that includes the banks.
When the banks found themselves masters of the mortgage-backed securities market, they were holding onto a poisoned chalice. The value that was released in this method was immense: the entire risk premium of banking was delivered into their hands within days, but in exchange for selling off the banking risk, they took on a complexity risk as graphically suggested in that above diagram (or tabulated by ProPublica).
The first premium was large enough to overshadow the second negative premium; can you say appetite for risk? What inevitably occurred was a ponzi-like feeding frenzy on mortgage-backed securities, while complexity created a powder keg with a slow-burn fuse under the castle.
Quite how the spark gradually ate its way along the slow-burn fuse to the powder keg within is a fascinating subject, and one that many will discuss. Many causes and effects within. However, the key issue is this: switching from long term loans to the mortgage-backed securities market, a.k.a. securitization not loans, was the crux.
Now, if we see that, and we recognise there is no turning back, then the big question is, how are the central bankers going to deal with the shift from banking to markets ?
Another month, another mini-crisis. Many banks remain in trouble, many countries too, adding weight to the claim that we're not through yet. Say hello, double dip, or depression. Whatever the economists end up calling it, it will be with us for a few years yet.
For what it's worth, I'd suggest this will be a 10 year story. Today's news is about Ireland, yesterday we were in Greece, tomorrow it will be another fun travel destination, where our money will buy more, as long as it's not us.
Each of those countries are looking at scenarios that will be a decade minimum to work through, to pay off their debt.
What does that make a citizen think?
Whatever you think about your national profits for the next decade being expropriated for the sins of your fathers, it seems to make sense to take more than ordinary care, and to sort it out properly this time. This one isn't the localised moral hazard of the S&L crash, it isn't the Asian Financial story of dominos too cozy, it isn't the Russian panic, nor LTCM.
Those were regular, this one's exceptional. This is more like the Japanese experience, on an OECD scale, or the Great Depression. Both things which were at their root central banking crises.
So what's the cause? It does all seem to be a bit bemusing as theory after damnable theory goes wafting by, and still we don't see the end of the crisis. Theories I've seen and dismissed as mere symptoms:
There is one and only one underlying cause for this crisis. It's the thing that answers everything, and the thing that nobody wants to talk about. It's the massive shift in structural nature of the business that took 30 years to develop, and suddenly everyone's caught by surprise.
It's banking, or more precisely, it's
the end of banking, as we know it
(Which is why I wrote a long post on what banking is.) Banking is no longer essential to society because there is now another method to achieve what banking achieves. That is, we now have two methods to distribute society's savings on the stage of the economy: from small-left to big-right, as it were. Both methods work, but the new method has advantages that will make it dominate over time.
The new method is called:
It's new, because it was invented in the USA in 1970 (hence the Z). While it is pretty simple to describe, it is (arguably) complex to see:
I'll leave it as an exercise for the reader to compare how that relates to banking, and just skip to the essence of the shift from the definition of banking: term. The bank can "originate" these loans to the 1000 customers, aggregate them into a fund, slice the fund into shares, and sell the shares.
Here's the clanger: At this point, the bank has sold off the loans to other investors, which means the bank has sold off the risk.
After this point, the bank is no longer in the risk business! What's more, it can do this in 100 days and under. Which means it is no longer in the term business either.
Which means, the bank and those loans are no longer at risk of the economy. Nor a run. In fact, the bank need no longer be in the risk business at all, because it can sell off all its risk. To a market. As the ever-popular Prof Ferguson puts it:
These changes swept away the last vestiges of the business model depicted in It’s a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
Which means, anyone doing business in securitization is not doing banking.
Now go back to the structure of the banking industry. I showed that the structure, and the regulation, was predicated on the risk inherent in the term structure of banking loans.
As banks are no longer taking on that risk, the structure is no longer required. That is, central banking is no longer useful to the economics of banking, and regulation based on public policy interests and lender of last resort issues is therefore unfounded.
Which further means the regulation is probably (almost certainly) wrong, the incentives are mismatched, the risk analysis is unnecessary, ... on and on it goes. Add in a dash of technology like the Internet, cryptography, and disintermediation (think Zopa or microfinance) and the mix is heady, and unstoppable.
Banks are not doing banking any more, so trying to make them act like they were doing banking is not helpful, it is harmful. In economics terms, there is a fundamental shift:
from banking to markets
But the world is still treating banks as if they do banking. From Basel-3 on down:
But on one point Pandit [Vikram Pandit, CEO of Citigroup] cannot be challenged. Since the promulgation of Hammurabi’s Code, in ancient Babylon, no advanced society has survived without banks and bankers. Banks enable people to borrow money, and, today, by operating electronic-transfer systems, they allow commerce to take place without notes and coins changing hands. They also play a critical role in channelling savings into productive investments.
When the banking system behaves the way it is supposed to—as Pandit says Citi is now behaving—it is akin to a power utility, distributing money (power) to where it is needed and keeping an account of how it is used. Just like power utilities, the big banks have a commanding position in the market, which they can use for the benefit of their customers and the economy at large.
So the regulators are making mistakes, a steady series of them. Says TheFinanser's Chris Skinner in evident disgust at the BIS's numberitis:
Hmmm ... HBOS had a higher Tier I Capital Ratio than Lloyds TSB in 2008; Alliance & Leicester and Bradford & Bingley were well above the BIS requirements; RBS is particularly well capitalised; and Northern Rock appeared to have no issue in 2007, as mentioned.
And yet, these are all the failed banks of Britain!
This Tier I Capital Ratio measure ain't that good is it?
The rules of the financial world have changed, the structures have not.
In particular, banks are off-the-hook for term failures, but they still make money as if they were on-the-hook. Hence, as banks and other participants discovered that securitization was a licence to print money (because the risk had been sold off to others in the funds markets) what happened?
Everyone dived madly into subprime. Everyone made money! Appetite for risk went sky high, because ... the risk was sold off to the market, and all that was left was the fees! Hence, we had a bubble of risk off-selling in many forms which ultimately led to the global financial crisis.
(You're probably wondering why the banks got so stuck when they had sold off their risk. It may be because <drumroll> they also bought securitized assets from the same markets that they'd sold into! </tara> Outstanding shift from Banking to Speculators, further exercise left for reader, look to the definition of banking again!)
Mervyn King, governor of the Bank of England, called on Tuesday night for banks to be split into separate utility companies and risky ventures, saying it was “a delusion” to think tougher regulation would prevent future financial crises.
Mr King’s call for a break-up of banks to prevent them becoming “too important to fail” puts him sharply at odds with the direction of domestic and international banking reform.
What's the new world, where banks are no longer needed to do banking? Well, smaller, more purpose-limited ventures is one good start. "Utilities" is a good word. Expect to see more of this sort of proposal.
But, don't expect to see anyone agree that it's the end of banking, as that is still too politically untenable.
To understand what's happening today in the economy, we have to understand what banking is, and by that, I mean really understand how it works.
This time it's personal, right? Let's starts with what Niall Ferguson says about banking:
To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants. Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, “essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed.”
As much as the good Prof's comments are good and fruitful, we need more. Here's what banking really is:
Banking is borrowing from the public on demand, and lending those demand deposits to the public at term.
Sounds simple, right? No, it's not. Every one of those words is critically important, and change one or two of them and we've broken it. Let's walk it through:
Banking is borrowing from the public ..., and lending ... to the public.
Both from the public, and to the public. The public at both ends of banking is essential to ensure a diversification effect (A to B), a facilitation effect (bank as intermediary), and ultimately a public policy interest in regulation (the central bank). If one of those conditions aren't met, if one of those parties aren't "the public", then: it's not banking. For example,
So now we can see that there is actually a reason why the Central Banks are concerned about banks, but less so about funds, S&Ls, etc. Back to the definition:
Banking is borrowing ... on demand, and lending those demand deposits ... at term.
On demand means you walk into the bank and get your money back. Sounds quite reasonable. At term means you don't. You have to wait until the term expires. Then you get your money back. Hopefully.
The bank has a demand obligation to the public lender, and a (long) term promise from the public borrower. This is quaintly called a maturity mismatch in the trade. What's with that?
The bank is stuck between a rock and a hard place. Let's put more meat on these bones: if the bank borrows today, on demand, and lends that out at term, then in the future, it is totally dependent on the economy being kind to the people owing the money. That's called risk, and for that, banks make money.
This might sound a bit dry, but Mervyn King, the Governor of the Bank of England, also recently took time to say it in even more dry terms (as spotted by Hasan):
3. The theory of banking
Why are banks so risky? The starting point is that banks make heavy use of short-term debt. Short-term debt holders can always run if they start to have doubts about an institution. Equity holders and long-term debt holders cannot cut and run so easily. Douglas Diamond and Philip Dybvig showed nearly thirty years ago that this can create fragile institutions even in the absence of risk associated with the assets that a bank holds. All that is required is a cost to the liquidation of long-term assets and that banks serve customers on a first-come, first-served basis (Diamond and Dybvig, 1983).
This is not ordinary risk. For various important reasons, banking risk is extraordinary risk, because no bank, no matter where we are talking, can deal with unexpected risks that shift the economy against it. Which risks manifest themselves with an increase in defaults, that is, when the long term money doesn't come back at all.
Another view on this same problem is when the lending public perceive a problem, and decide to get their money out. That's called a run; no bank can deal with unexpected shifts in public perception, and all the lending public know this, so they run to get the money out. Which isn't there, because it is all lent out.
(If this is today, and you're in Ireland, read quietly...)
A third view on this is the legal definition of fraud: making deceptive statements, by entering into contracts that you know you cannot meet, with an intent to make a profit. By this view, a bank enters into a fraudulent contract with the demand depositor, because the bank knows (as does everyone else) that the bank cannot meet the demand contract for everyone, only for around 1-2% of the depositors.
Historically, however, banking was very valuable. Recall Mr Rothschild's goal of "facilitating the movement of money from Point A, where it is, to Point B, where it is needed." It was necessary for society because we simply had no other efficient way of getting small savings from the left to large and small projects on the right. Banking was essential for the rise of modern civilisation, or so suggests Mervyn King, in an earlier speech:
Writing in 1826, under the pseudonym of Malachi Malagrowther, [Sir Walter Scott] observed that:“Not only did the Banks dispersed throughout Scotland afford the means of bringing the country to an unexpected and almost marvellous degree of prosperity, but in no considerable instance, save one [the Ayr Bank], have their own over-speculating undertakings been the means of interrupting that prosperity”.
Banking developed for a fairly long period, but as a matter of historical fact, it eventually settled on a structure known as central banking . It's also worth mentioning that this historical development of central banking is the history of the Bank of England, and the Governor is therefore the custodian of that evolution.
Then, the Central Bank was the /lender of last resort/ who would stop the run.
Nevertheless, there are benefits to this maturity transformation – funds can be pooled allowing a greater proportion to be directed to long-term illiquid investments, and less held back to meet individual needs for liquidity. And from Diamond’s and Dybvig’s insights, flows an intellectual foundation for many of the policy structures that we have today – especially deposit insurance and Bagehot’s time-honoured key principle of central banks acting as lender of last resort in a crisis.
Regulation and the structure we know today therefore rest on three columns:
That which we know today as banking is really central banking. Later on, we find refinements such as the BIS and their capital ratio, the concept of big strong banks, national champions, coinage and issuance, interest rate targets, non-banking banking, best practices and stress testing, etc etc. All these followed in due course, often accompanied with a view of bigger, stronger, more diversified.
Which sets half of the scene for how the global financial crisis is slowly pushing us closer to our future. The other half in a future post, but in the meantime, dwell on this: Why is Mervyn King, as the Guv of the Old Lady of Threadneedle Street (a.k.a. Bank of England), spending time teaching us all about banking?
Lynn points to a long story in The New Yorker that gives a well-written and strong story by Seymour M. Hersh on the origins of the current Cyber War propaganda push by the US Department of Defence. I and many others of the community called this a budgetary war, not a real threat, and it is good to see that there are many in the USA administration that have called "bull" on the Cyber War claim.
Picking up from page 7:
Why not ignore the privacy community and put cyber security on a war footing? Granting the military more access to private Internet communications, and to the Internet itself, may seem prudent to many in these days of international terrorism and growing American tensions with the Muslim world. But there are always unintended consequences of military activity—some that may take years to unravel.
Of particular note for those who subscribe to the "heavy" approach to secure systems, and poo-poo the doctrine of risk management in favour of absolute security, is an example of the Law of Unintended Consequences, and how complicated it is when you push the envelope at so many levels.
Ironically, the story of the EP-3E aircraft that was downed off the coast of China provides an example. The account, as relayed to me by a fully informed retired American diplomat, begins with the contested Presidential election between Vice-President Al Gore and George W. Bush the previous November. That fall, a routine military review concluded that certain reconnaissance flights off the eastern coast of the former Soviet Union—daily Air Force and Navy sorties flying out of bases in the Aleutian Islands—were redundant, and recommended that they be cut back.
“Finally, on the eve of the 2000 election, the flights were released,” the former diplomat related. “But there was nobody around with any authority to make changes, and everyone was looking for a job.” The reality is that no military commander would unilaterally give up any mission. “So the system defaulted to the next target, which was China, and the surveillance flights there went from one every two weeks or so to something like one a day,” the former diplomat continued. By early December, “the Chinese were acting aggressively toward our now increased reconnaissance flights, and we complained to our military about their complaints. But there was no one with political authority in Washington to respond, or explain.” The Chinese would not have been told that the increase in American reconnaissance had little to do with anything other than the fact that inertia was driving day-to-day policy. There was no leadership in the Defense Department, as both Democrats and Republicans waited for the Supreme Court to decide the fate of the Presidency.
The predictable result was an increase in provocative behavior by Chinese fighter pilots who were assigned to monitor and shadow the reconnaissance flights. This evolved into a pattern of harassment in which a Chinese jet would maneuver a few dozen yards in front of the slow, plodding EP-3E, and suddenly blast on its afterburners, soaring away and leaving behind a shock wave that severely rocked the American aircraft. On April 1, 2001, the Chinese pilot miscalculated the distance between his plane and the American aircraft. It was a mistake with consequences for the American debate on cyber security that have yet to be fully reckoned.
For what went wrong after that, read the rest of the story!
Chit-chat around the coffeerooms of crypto-plumbers is disturbed by NIST's campaign to have all the CAs switch up to 2048 bit roots:
On 30/09/10 5:17 PM, Kevin W. Wall wrote:> Thor Lancelot Simon wrote:<...snip...>
> See below, which includes a handy pointer to the Microsoft and Mozilla policy statements "requiring" CAs to cease signing anything shorter than 2048 bits.> These certificates (the end-site ones) have lifetimes of about 3 years maximum. Who here thinks 1280 bit keys will be factored by 2014? *Sigh*.No one that I know of (unless the NSA folks are hiding their quantum computers from us :). But you can blame this one on NIST, not Microsoft or Mozilla. They are pushing the CAs to make this happen and I think 2014 is one of the important cutoff dates, such as the date that the CAs have to stop issuing certs with 1024-bit keys.
I can dig up the NIST URL once I get back to work, assuming anyone actually cares.
The world of cryptology has always been plagued by numerology.
Not so much in the tearooms of the pure mathematicians, but all other areas: programming, management, provisioning, etc. It is I think a desperation in the un-endowed to understand something, anything of the topic.
E.g., I might have no clue how RSA works but I can understand that 2048 has to be twice as good as 1024, right? When I hear it is even better than twice, I'm overjoyed!
This desperation to be able to talk about it is partly due to having to be part of the business (write some code, buy a cert, make a security decision, sell a product) and partly a sense of helplessness when faced with apparently expert and confident advice. It's not an unfounded fear; experts use their familiarity with the concepts to also peddle other things which are frequently bogus or hopeful or self-serving, so the ignorance leads to bad choices being made.
Those that aren't in the know are powerless, and shown to be powerless.
When something simple comes along and fills that void people grasp onto them and won't let go. Like numbers. As long as they can compare 1024 to 2048, they have a safety blanket that allows them to ignore all the other words. As long as I can do my due diligence as a manager (ensure that all my keys are 2048) I'm golden. I've done my part, prove me wrong! Now do your part!
This is a very interesting problem . Cryptographic numerology diverts attention from the difficult to the trivial. A similar effect happens with absolute security, which we might call "divine cryptography." Managers become obsessed with perfection in one thing, to the extent that they will ignore flaws in another thing. Also, standards, which we might call "beliefs cryptography" for their ability to construct a paper cathedral within which there is room for us all, and our flock, to pray safely inside.
We know divinity doesn't exist, but people demand it. We know that religions war all the time, and those within a religion will discriminate against others, to the loss of us all. We know all this, but we don't; cognitive dissonance makes us so much happier, it should be a drug.
It was into this desperate aching void that the seminal paper by Lenstra and Verheul stepped in to put a framework on the numbers . On the surface, it solved the problem of cross-domain number comparison, e.g., 512 bit RSA compared to 256 bit AES, which had always confused the managers. And to be fair, this observation was a long time coming in the cryptographic world, too, which makes L&V's paper a milestone.
Cryptographic Numerology's star has been on the ascent ever since that paper: As well as solving the cipher-public-key-hash numeric comparison trap, numerology is now graced with academic respectability.
This made it irresistible to large institutions which are required to keep their facade of advice up. NIST like all the other agencies followed, but NIST has a couple of powerful forces on it. Firstly, NIST is slightly special, in ways that other agencies represented in keylength.com only wish to be special. NIST, as pushed by the NSA, is protecting primarily US government resources:
This document has been developed by the National Institute of Standards and Technology (NIST) in furtherance of its statutory responsibilities under the Federal Information Security Management Act (FISMA) of 2002, Public Law 107-347. NIST is responsible for developing standards and guidelines, including minimum requirements, for providing adequate information security for all agency operations and assets, but such standards and guidelines shall not apply to national security systems.
That's US not us. It's not even protecting USA industry. NIST is explicitly targetted by law to protect the various multitude of government agencies that make up the beast we know as the Government of the United States of America. That gives it unquestionable credibility.
And, as has been noticed a few times, Mars is on the ascendancy: *Cyberwarfare* is the second special force. Whatever one thinks of the mess called cyberwarfare (equity disaster, stuxnet, cryptographic astrology, etc) we can probably agree, if anyone bad is thinking in terms of cracking 1024 bit keys, then they'll be likely another nation-state interested in taking aim against the USG agencies. c.f., stuxnet, which is emerging as a state v. state adventure. USG, or one of USG's opposing states, are probably the leading place on the planet that would face a serious 1024 bit threat if one were to emerge.
Hence, NIST is plausibly right in imposing 2048-bit RSA keys into its security model. And they are not bad in the work they do, for their client . Numerology and astrology are in alignment today, if your client is from Washington DC.
However, real or fantastical, this is a threat model that simply doesn't apply to the rest of the world. The sad sad fact is that NIST's threat model belongs to them, to US, not to us. We all adopting the NIST security model is like a Taurus following the advice in the Aries section of today's paper. It's not right, however wise it sounds. And if applied without thought, it may reduce our security not improve it:
> At 1024 bits, it is not. But you are looking
> at a factor of *9* increase in computational
> cost when you go immediately to 2048 bits. At
> that point, the bottleneck for many applications
> shifts, particularly those ...
> ...and suddenly...
> This too will hinder the deployment of "SSL everywhere",...
When US industry follows NIST, and when worldwide industry follows US industry, and when open source Internet follows industry, we have a classic text-book case of adopting someone else's threat, security and business models without knowing it.
Keep in mind, our threat model doesn't include crunching 1024s. At all, any time, nobody's ever bothered to crunch 512 in anger, against the commercial or private world. So we're pretty darn safe at 1024. But our threat model does include
*attacks on poor security user interfaces in online banking*
That's a clear and present danger. And one of the key, silent, killer causes of that is the sheer rarity of HTTPS. If we can move the industry to "HTTPS everywhere" then we can make a significant different. To our security.
On the other hand, we can shift to 2048, kill the move to "HTTPS everywhere", and save the US Government from losing sleep over the cyberwarfare it created for itself (c.f., the equity failure).
And that's what's going to happen. Cryptographic Numerology is on a roll, NIST's dice are loaded, our number is up. We have breached the law of unintended consequences, and we are going to be reducing the security of the Internet because of it. Thanks, NIST! Thanks, Mozilla, thanks, Microsoft.
 For detailed work and references on Lenstra & Verheul's paper, see http://www.keylength.com/ which includes calculators of many of the various efforts. It's a good paper. They can't be criticised for it in the terms in this post, it's the law of unintended consequences again.
 Also, other work by NIST to standardise the PRNG (psuedo-random-number-generator) has to be applauded. The subtlety of what they have done is only becoming apparent after much argumentation: they've unravelled the unprovable entropy problem by unplugging it from the equation.
But they've gone a step further than the earlier leading work by Ferguson and Schneier and the various quiet cryptoplumbers, by turning the PRNG into a deterministic algorithm. Indeed, we can now see something special: NIST has turned the PRNG into a reverse-cycle message digest. Entropy is now the MD's document, and the psuedo-randomness is the cryptographically-secure hash that spills out of the algorithm.
Hey Presto! The PRNG is now the black box that provides the one-way expansion of the document. It's not the reverse-cycle air conditioning of the message digest that is exciting here, it's the fact that it is now a new class of algorithms. It can be specified, paramaterised, and most importantly for cryptographic algorithms, given test data to prove the coding is correct.
(I use the term reverse-cycle in the sense of air-conditioning. I should also stress that this work took several generations to get to where it is today; including private efforts by many programmers to make sense of PRNGs and entropy by creating various application designs, and a couple of papers by Ferguson and Schneier. But it is the black-boxification by NIST that took the critical step that I'm lauding today.)
In terms of value at risk, this has to be the winner in the monthly "most outrageous post across my desk" competition:
According to attorney Ellen Brown, author of "Web of Debt", a California bankruptcy court has followed what are now being called "landmark cases in other jurisdictions" in ruling that as many as 62 million mortgages may not be foreclosed on.
The result could force the biggest banks into bankruptcy because having millions of homeowners get title to their homes with no further mortgage payment would decimate the asset portfolio. As pointed out in a San Francisco Chronicle article in 2007:
"The loans at issue dwarf the capital available at the largest U.S. banks combined, and investor lawsuits would raise stunning liability sufficient to cause even the largest U.S. banks to fail…."
This is an issue that I knew about. We tried to solve it. Blame me. Which makes it much harder to write about.
What's going on here? And why the chicken-little panic? How much truth is in this? Unfortunately, some:
The problem is that at the height of the real estate bubble, mortgages were sliced and diced into investment products -- securities -- that changed hands frequently.
Whoa! Stop right there! This was not a problem constrained to the height of the bubble, but a structural innovation that has dominated the last 30-40 years. Permit me to set the record straight:
The problem is that
at the height of the real estate bubblesince the invention of securitization in the 1970s or so, mortgages wereare sliced and diced into investment products -- securities -- that change dhands frequently.
If you wish to understand anything about the financial crisis, understand this:
securitization was a game-changer.
It was invented in the 1970s or so, and it set the scene for the massive boom we saw in the 2000s, and the massive collapse 2007-2009. Most confusing still, it's a good thing. Moving right along...
As a convenience for the mortgage industry, many of these mortgages were recorded electronically by a system called MERS (Mortgage Electronic Registration System).
At issue was when Citibank tried to foreclose on a property in California, the homeowner's defense was that the actual deed was held by MERS and yet since MERS could not offer a homeowner signed documentation to a mortgage agreement, they could not prove ownership and since they couldn't prove ownership, the Deed of Trust could not be transferred and Citibank's note was therefore uncollectible.
Basically, throughout the securitisation process that created the global financial collapse, the issue that was staring us in the face was that the various transactions were not being perfected. That is, the contracts were not being adequately backed up according to the standards of the day. That standard is ultimately measured in court, or not as Citibank has discovered above.
I saw this when I designed my system, and set out to resolve it. The Ricardian Contract form solves the above problem, in part because it is signed, and in other part because it solves a lot of other issues lurking in the mess above. And, when Jim and I filed it into the SEC, they realised that it addressed their concerns, too.
But like this blog post, the problems brought about by securitization's success were put off until tomorrow. And tomorrow's tomorrow. And ... then came 2007. Some singularity somewhere caused systemic ripples throughout the system, which caused all contracts to shake and wobble. But it is important, nay, essential to realise: the fundamental structural feature was securitization. The systemic wobble event was not important. Keep your eye on the securitization ball as it rolls on unchallenged through the USA financial quagmire.
Now they've gone to court, and:
The California bankruptcy court concluded:
"Since the claimant, Citibank, has not established that it is the owner of the promissory note secured by the trust deed, Citibank is unable to assert a claim for payment in this case."
So that's what is meant by a contract not being perfected. You can talk about it. You can sell it, slice & dice it, derive it and steal it. Start a boom, pay outrageous bonuses, watch the bubble burst. But you can't get a court to back all these things up. Which matters not one jot if everyone believes the boom will go forever...
Which leads to somewhat of an observation over modern finance... heck, all finance, and probably all business!
Finance is an inverted pyramid that sits on the apex of dispute resolution. Somewhere in a middle layer are contracts. Somewhere up top on the mesa are mortgages and loans and prosperity and the happiness of owning your own home. Down the bottom is dispute resolution.
If the apex collapses, don't be standing nearby with a camera.
The dark side of Intellectual Property is this: the structure of the market encourages theft, and more so than the more polite in society would predict. It's something that has really annoyed both sides of the debate; those who want to steal grumble about owners making it hard, while owners grumble that they need the help of their government for terrorising the first lot into financial dependency.
Two of the most abject victims of wikinomics are the newspaper and music industries. Since 2000, 72 American newspapers have folded. Circulation has fallen by a quarter since 2007. By some measures the music industry is doing even worse: 95% of all music downloads are illegal and the industry that brought the world Elvis and the Beatles is reviled by the young. Why buy newspapers when you can get up-to-the-minute news on the web? Why buy the latest Eminem CD when you can watch him on YouTube for free? Or, as a teenager might put it: what’s a CD?
Now, if it does that, if IP is structured that way, we can ask a number of searching questions. Was that what we intended? Is this a good thing or a bad thing? Can we improve it?
An interesting case of a company called Zynga (mentioned in last week's story) seems to make the case. First off, theft seems to be part & parcel of intellectual property:
In the latest SF Weekly cover story, multiple former employees of Zynga, speaking on condition that their names not be published so that they could discuss their work experiences candidly, tell us that studying and copying rivals' game concepts was business as usual. One senior employee who has since left the company describes a meeting where Zynga CEO and founder Mark Pincus said, "I don't fucking want innovation. You're not smarter than your competitor. Just copy what they do and do it until you get their numbers."
There's two ways of looking at this. Maybe Pincus has perfected a novel use of the perfect market hypothesis in innovation? Outstanding! In brief, the perfect market hypothesis as applied would say that the market has already acquired all the information, hence there is no point in trying to beat it, hence we should simply acquire the market.
Or maybe he has developed a new theory of creative destruction in innovation, following Schumpeter? It's certainly not my grandmother's definition of innovation, and some would call it by worse names (Guernica springs to mind, if I can bring in an IP link).
|The Creative Destruction Theory of Innovation|
On the other hand, the artists have a different take on the topic:
One of the more common complaints among former Zynga employees is about Pincus' distaste for original game design and indifference to his company's applications, beyond their ability to make money. "The biggest problem I had with him was that he didn't know or care about the games being good -- the bottom line was the only concern," a former game designer says. "While I'm all for games making money, I like to think there's some quality there."
Above, the "former game designer" suggests that his view of "goodness" should override the market's view, as expressed by the bottom line. The clear statement of his boss is the other way around.
Such a disdain for the message of the users is somewhat typical of fields of artistic endeavour where artists create their own shared, internal sense of goodness, and seek to avoid the market's view as insufficiently enlightening or overly opaque (etc). From where I sit, this is a view that artists can hold in a greenfield design where there simply isn't a market, and/or where the artist is also the investor.
But that latter point is troubling. Innovators are like artists, as a whole. One could suggest that innovators won't monetarise, because they'll be focussed on "goodness" and we might well be wasting our time supporting them to the extent of actually listening to them (I speak as an innovator, but prefer you not to mention it today). One could also suggest that they can't monetarise because that trap makes them perpetually too poor to invest.
What then happens if the innovatory process is really stacked in this direction? What happens if most innovators can't monetarise? How do we support a rationale whereby we as society should continue to support innovators with intellectual property rights at all? Why patents, brands, ideas, copyright, etc?
Another former employee recalls a meeting where Zynga workers discussed a strategy for copying a gangster game, Mob Wars, and creating Zynga's own Mafia Wars application. "I was around meetings where things like that were being discussed, and the ramifications of things like that were being discussed -- the fact that they'd probably be sued by the people who designed the game," he says. "And the thought was, 'Well, that's fine, we'll settle.' Our case wasn't really defensible." (Mob Wars' creator, David Maestri, proprietor of Psycho Monkey, did sue Zynga for copyright infringement. The case was settled for an undisclosed amount.)
So let's stop doing upfront licensing and sales of IPR. The point being that as long as the innovator keeps innovating, and product gets to market, it matters not to everyone else whether he's paid for it before or after its use. Everyone wins.
Just not the way we thought. Not what the brochure said. The goal of intellectual property rights then might not be to save the rights, but to lose them. And, the more you lose, the better, as the the better the theft, the more you can claim back.
(On the search for a good aporism here! Comments welcome.)
If that were so, if we were to assume IP theft as a goal of public policy, we'd be switching our emphasis to making IP easier to prove and recover in litigation. Registrations might deal with the first part (but are arguably too too cumbersome and expensive).
What deals with the second part? How do we improve the rate of recovery in IP litigation? By all accounts, the victim in any litigation is typically the small guy, so the innovator has it stacked against him or her there, too.
Facebook is making a play to become the dominant player in virtual currency — the funny money you use to everything from digital magazines to Farmville turnips. It’s already a billion-dollar business in which Facebook, the world’s largest social network, will face stiff competition from other behemoths like Apple, Google and PayPal.
Facebook already has a big advantage over those companies: a virtual currency, Facebook Credits, that works across different apps rather than being tied to one specific app or another.
Sales of virtual goods are projected to reach $1.6 billion this year in the United States alone, according to an Inside Network report. About half of that will be spent on social games, and the majority of that in Facebook games such as Farmville.
Facebook claims 30 percent of revenue when people buy these credits — the same cut Apple and Google slice off when users buy virtual goods within their apps — but is already the number one app across all smartphone platforms according to Nielsen.
This means that Facebook will earn its investors the return demanded. Because it has an active market place of many thousands of suppliers, it has gained control of the monetisation within its world, and it takes significant margin of that activity, this means that Facebook has cracked the revenue model in a way that few others have.
However, other big Internet players will notice the success, will revisit their flawed models, and will move to adopt the one that Facebook has worked out for them.
Apple has yet to create a cross-app virtual currency, but offers other virtual goods — iTunes songs, for instance — through pre-paid gift cards. Users may start wondering why they can’t use iTunes credits to purchase goods within iPhone apps like Farmville — and vice versa. And because so much money will be spent in this way, this problem could become a source of annoyance for users and app developers alike.
This is of interest to financial cryptography players as it establishes the basic business rules to play in this market. It's also of interest to regulators and incumbents (read: banks) who want to squash the market:
The U.S. has strict laws against creating new forms of currency, but there’s enough wiggle room for Apple (iTunes), Google (Checkout, Android), Paypal, individual developers, and others to join Facebook in creating virtual currencies that work in apps across their respective platforms, even those beyond games — music, movies, productivity apps, and so on. And that’s when things could get tricky, in the huge and expanding market for virtual goods.
Unfortunately the signs auger badly for them. As frequently commented here in this blog, the European Union tried to beat this one back in the 1990s and succeeded so well it lost. Meanwhile, the USA supported, and partly won with Paypal, but then reversed course and is now set to lose. And, unless the banks wave the get-out-of-jail-free card, they won't be getting as much attention as before. Curiously, their favourite "save me" card might be more justified this time (you know your banking, right?) but it's already been spent, and the results weren't good. Patience should be thin.
Perhaps it is time to roll out Goodhart's law as this blog's aphorism ad nauseum? Meanwhile, bringing the two battles together, this means that while the B-list is moving to copying, the A-list now starts its regulatory response phase.
Good luck on that immense strategic battle! Interesting times ahead.
Evgeny Morozov and a whole lot of other media-savvy people have a silver bullets moment when analysing Haystack, a hopeful attempt at bypassing censorship for citizens in countries like Iran. The software was released, lauded by the press, and got an export licence from the USA government.
By all media-validated expectations, Haystack should have been good to go on and wreak merry havoc against Iranian censorship. Until Jake Appelbaum and his team took a poke at it and discovered it permitted tracking of the dissidents. Then the media flipped and attacked. Familiar story, right?
I want to know why the media was so quick to push this tool. I want answers.
Morozov asks, in various ways, what went wrong? Here's a breakdown of what I think are his essential points, and my answers.
Why didn't the security community come in and comment? That's easy. The security community is mostly a commercially minded group of people who work for food. It includes a small adjunct rabble who make a lot of noise breaking things. Not for money, but for fun & media attention. Allegedly, Appelbaum said:
Haystack is the worst piece of software I have ever had the displeasure of ripping apart. Charlatans exposed. Media inquiries welcome.
If Jake's deep sarcasm isn't slapping you on the forehead, here it is in plain writing: we break the tools because it's cool, because the media write about it, and because it's fun. But the presence of the crowd-pleasing infosoc vigilantes doesn't mean that anyone is going to fix the broken efforts. Or provide good advice. No, that costs money:
UPDATE #1: I just received information that "Haystack has been turned off as of ~19:00 PST, Sept 10/2010", with Austin Heap agreeing that "Haystack will not be run again until there is a solid published threat model, a solid peer reviewed design, and a real security review of the Haystack implementation."
Look at for wider example, the fabled OpenPGP encryption system. In its long history, the major providers emerged as PGP Inc and GnuPG. Both of these groups had substantial funding or business reasons to carry on, to build, at one time or another. Which meant that their programmers could eat. As an alternate case in point, my own efforts in Cryptix OpenPGP went up and down to the tune of money and business need, not to the tune of crackers or bugs or media attention. The hoi polloi took their best shot at these products, and a few cracks were found, but the real story is how the builders built, not how the cracks were found.
So in essence we have in the security community an asymmetric relationship with the world. We are happy to break your product for our fun; but we won't be fixing it. For that, put your money on the table. If you want to change that, get the media to make building secure apps more sexy than breaking them. Simple, but the opposite of how the Haystack story went.
Next. Why did the State Department endorse Haystack with a license to export? The best way of seeing this is a case of "the enemy of my enemy is my friend." It has been evident since the start of the Bush administration (1990?) that the US government has a policy of taunting the Iranians when and how they can. So, of course, the Haystack product fit with the policy.
One could look at the technical merits of the product, and come to some sort of hopeful case. The license is not an endorsement of any strong security, it's actually the reverse. It is an endorsement that the security isn't strong enough to worry the USA. There is one further aspect: the exporting organization has a way to avoid any hard discussions: simply open source the product.
From that perspective, the State department has no benefit from not issuing the license, and every reason to issue it.
What is probably more interesting is to ask: what do we do about a product that puts Iranian lives at risk? The easy answer is to not put lives at risk. Let's not do that, it would seem undeniable to think otherwise, right?
Wrong. It is wrong, at three levels.
Firstly, this is clearly against the policy and practice of the various governments in this space, who routinely put foreign lives at risk in order to pursue local objectives. (We already established some alignment there, above.) According to the count of lives next-door in Iraqi, we're seemingly running at a 100:1 ratio, order of magnitude, of putting their lives at risk, compared to our lives. We might talk about "undeniable value of human life" but the facts make that a difficult assumption.
We could simply say that we the Internet, we the Intellectuals shouldn't adopt the low tactics and cavalier attitude of our governments. We are better than them!
Except, that's unfounded as well. Secondly: Consider the OpenPGP community: this community distributed encrypted software that was frequently used by the same target audience as Haystack. I know because I was part of that community (proudly) and I heard some of the stories.
Stories of success, and stories of failure. People used OpenPGP product and people disappeared and people died.
So why this apparent contradiction? Why is OpenPGP so secure, but people still die, whereas we don't accept Haystack which is insecure and might lead to deaths? The answer is risk.
All security is risk-based. Adi Shamir put it best:
Security is relative to everything, and the "black box" called Haystack or OpenPGP is only a part of that context. The security of Haystack may be sufficient in one context, OpenPGP may be hopeless in another context.
And it takes quite a lot of experience, and fairly difficult analysis of the overall context to establish whether the risk of a tool is worth taking. For example, we deep in the security community know that all OpenPGP products can be utterly defeated with equipment worth about five bucks.
Which should make the point: we can't easily say that the use of Haystack will be absolutely safer or less safe. We can only take on risk, or expose others to risk through our efforts, which is why Haystack may well have deserved the Entrepreneur award: the team went where others were too afraid to go, the true spirit of an Entrepreneur.
Finally, thirdly, and to close on risk, we must always consider the null option: we do nothing, therefore we cannot put lives at risk. Right?
No, wrong again. The Null option, do nothing, doesn't work either. If we do not supply OpenPGP secure communications to the Iranian dissidents (or Haystack or whoever, or whatever) then they will use less secure techniques. Because of our actions to limit the availability of secure tools, our actions of denial will increase risk for some others.
That's because we can assume that the dissidents will diss, and we can either help them by providing better tools, or stand idly by while they die for want of better tools. We have to negate the easy implication of "causality & responsibility," there is no simple binary responsibility here; people die if we act, and they die if don't act. Our risk might go down if we do nothing, their's may go up.
What in summary do we have? How to answer the blogsphere angst of "how did this happen to us? Why can't you fix it? The government must do something?"
That's leading to the final question. Why is it that this is so hard, when it seems so easy? Who can we blame for the hype? Why have the expectations of the media been so truly flipped over in the blink of an eye?
The security market is a market in silver bullets.
In other words, in a silver bullets market, there is an absence of well-agreed solid practice & theory. There are lots of producers, and there are lots of products, and lots of theories and lots of practices. But, within the security community, these theories are at war with one-another, and for every apparently sustainable argument, you'll be able to find someone to trash it. And the data to prove it trash-worthy.
In this sense, security is about as well understood as freedom. Just to give a case in point: this article quotes the misnamed and misunderstood Kerckhoffs' Principle:
"Although we sincerely wish we could release Haystack under a free software license, revealing the source code at this time would only aide the authorities in blocking Haystack."
That’s a statement in direct conflict with Kerckhoffs' Principle, a cornerstone of security philosophy. The Principle states that the only security worth doing is that which remains secure even if your enemy knows the totality of how it works. Haystack’s refusal to publish the software is an enormous red-flag to security practitioners, suggesting strongly that some aspect of the security it provides somehow hinges on a parlour trick that - once known - becomes useless or potentially hazardous.
This is a reference to Kerckhoffs 6 principles of secure communications which fails for a too-simple reading of one of them. It's a common problem.
Kerckhoffs' second principle states "It must not be required to be secret, and it must be able to fall into the hands of the enemy without inconvenience;" Unfortunately, this is not strictly true. K2 remains a principle and not a law, and yes, when people talk about Kerckhoffs' law, they are wrong.
It's perhaps easier to show this by a hypothetical: if for example Haystack had been built as a Skype plugin, or had used RIM's Blackberry enterprise layer, etc, would we then be able to rely on it? Yes, remembering our risk discussion, because it would be better than the alternate. But these things are secret, breaking K2. Or for more realworld example, if the NSA were to mount Haystack, now with new-improved-secret-crypto!, do you think they would be publishing the source?
Why then does K2 work for us, or as Shannon's maxim, "the enemy knows the system" ? Because revealing the internal design generally makes it much harder to hide behind incompetence. And the silver bullet aspect of the entire security world makes it almost a given that an incompetent result is ensured. In this, Haystack has proved the general incompetence principle of secrecy: that a secret system is likely to hide a great deal of incompetence.
But, that can still be a good risk to take. It all depends. There is no absolute security, so where you draw the line, depends. On everything. Now perhaps we see why Adi's words above, and Kerckhoffs principles, *all of them*, have sustained over time. Knowing the Principles and Hypotheses of security engineering is a given, that's the job of a protocol engineer. That which separates out engineering from art is knowing when to breach a hypothesis.
All this by way of showing that one man's security wisdom might be another man's folly, and in such a world, a silver bullet is a seemingly valuable thing.
Now, imagine you want to do a better job. Feel scared and queasy? Yup, in the climate generated by the media, the security folk and the political agenda, today, there are relatively few incentives to take on this task. Instead, there are much greater incentives to build a social network and really monetarise the potential for massive abuses in privacy than to muck around with democracy and freedom of speech and all that.
Secondly, consider the open security community. We will break it for you, but we won't help you fix it. Like the media, our attention is slanted dramatically against you.
So, in practice, it should be no surprise that groups such as the Haystack team are few and far between. It's almost as if we have the devil's choice: a dodgy system or no system at all. A good security model is not a cheap option, it's not a practical option, nor an economic option. Security will kill your dreams, the structure of the industry makes it so.
If your objective is to help freedom of speech, then delivering crypto systems will help, even ones with known leaks. That's assuming they will do some good, in the balance. There is one final advantage, it is also a lot easier to fix broken tools than to fix absent tools. In contrast to accepted wisdom, writing the solid security model up front, with no customer base, is a fool's errand.
It is fairly normal to hear people talk about innovation, but it doesn't take much experience to realise there is a gulf between the reality and the buzzword. Innovation is not something we can bring to the company just by talking about it. Here's some cold water poured on popular notions by Govindarajan and Trimble (G&T):
The fashion these days is to focus on the supply side of innovation: for example, by encouraging everyone to think big thoughts. 3M, the maker of Post-it notes, ...
Fashion in innovation thinking is an oxymoron if ever I saw one! When did 3M invent Post-it notes? No matter, let's carry on:
...expects its workers to spend 15% of their time on their own projects. Google expects them to spend 20%. This approach is attractively democratic: by giving everyone a chance to innovate, it makes everyone feel special. Or so the theory goes. G&T are ready with the cold water. The let-them-loose approach spreads resources thinly and indiscriminately. Companies dissolve into a thousand small initiatives rather than focusing on a few big problems. It also produces far too many ideas: managers have to spend weeks sorting through the chaff to find a few grains of wheat.
I've seen the 20% idea in operation, and it doesn't work. Calling it democratic is a good approximation, so there is some value to it in a tight bureaucracy seeking to "empower" its people. But innovation-driving it isn't, and doing it in a technology company like google reveals a profound misunderstanding of the techie's human psyche. I'd even suggest that the approach quite possibly hides the sources of true innovation.
G&T say that you need to start by recognising that innovation is unnatural.
Hallelujah! Now, ask your boss whether she'd like something unnatural to happen to her this week ... and we'd be getting close to why that it isn't going to happen.
Established businesses are built for efficiency, which depends on predictability and repeatability—on breaking tasks down into their component parts and holding employees accountable for hitting their targets. But innovation is by definition unpredictable and uncertain. Bosses may sing a pretty song about innovation being the future. But in practice the heads of operational units will favour the known over the unknown.
Right. But it is also not just companies that are obsessed with these things. People are scared, scared for their jobs. Mundane is safe, innovation gets you fired, or if you are lucky the credit will be lost to others. Far safer to talk the buzzwords, only.
So how to to turn big corporations or departments into innovation factories? Well, it's probably unreasonable because we are likely in that statistical impossibility space. Either people will talk about it, and not do it (for fear of their jobs), or people will do it and lose their jobs. So every lesson will be an anti-innovation lesson, and any accidental slippage into innovation will be dismissed as a statistical outlier.
Annecdote: I recall presenting on the fundamentals of why innovation is impossible in banking, to a big british bank's Head of Innovation. Of course, he argued I was wrong. But after he left, two of his employees told me that while he talked the talk very well, he did everything possible to avoid innovation. He was the head of Innovatory Capture & Suppression, and he served the bank well.
The only way to crack the anti-innovatory structure of business is to change the rules.
Many would-be innovators deal with the trade-off between efficiency and innovation by rejecting traditional management entirely. They repeat mantras about “breaking all the rules” and “asking for forgiveness rather than permission”. They set up skunk works (small, autonomous units with a remit to innovate) and mock the boring corporate types who write their pay-cheques. But again this is counter-productive.
However, not the rules written on paper, but the meta-rules of the operation! (People who talk about breaking the rules are generally using this as a cover to get their own way.)
G&T argue that companies need to build dedicated innovation machines. These machines need to be free to recruit people from outside (since big companies tend to attract company men rather than rule-breakers). They also need to be free from some of the measures that prevail in the rest of the company.
Right! But! That gets us back to the same dilemma:
But they must avoid becoming skunk works. They need to be integrated with the rest of the company—they must share some staff, for example, and they must tap into the wider company’s resources as they turn ideas into products. And they must be tightly managed according to customised rather than generic rules. For example, they should be held accountable for their ability to learn from mistakes rather than for their ability to hit their budgets.
We can talk about it but we won't actually do it. Or, what we do will not be it. Or what we do will be captured or dispersed, so not learnt.
Innovation in big corporates, as a turnaround, /has been done/. But the cases are relatively rare, and the conditions are hard to duplicate. Innovation happens in the startup sector, and the word innovation is never used there, it's just business, or survival, or the founder's omniscience. That is, the natural state of the startup is to write the meta-rules, so it is totally natural that the unnatural takes place.
Which perhaps confirms that the only successful strategy for innovation a large company has is to buy out small successful startups ... Sorry about that!
Niall Ferguson spoke a few weeks ago at something called the CIS, supposedly a right-wing thinktank in Australia. He's well known for his Ascent of Money series, which is the thing you buy on DVD if you want to tell your Mum about economics and the way the world works. He's also that rarest breed in economics - he's not an economist at all, he's a historian.
Other writings on the same theme can be found in An Empire at Risk and America, the Fragile Empire. But frankly, the words in print don't do justice. It's a great presentation, both in terms of the picture it draws, the evidence assembled, and how well it was presented.
(The introduction of around 8-9 minutes is very skippable...) (Slightly edited to incorporate new links.)
Clive Robinson writes in comments, and I can do little more than post it as a special Friday 13th edition. Good luck:
The problem of spend too little, get hurt, spend too much, waste resources unprofitably is older even than money.
It is the basic problem with all defensive behaviour. If you go back to the times of the "hunter-gather" the gathers had an issue (as do all prey): if you put all your resources into gathering then you will not see the predator stalking you. If all gathers spend their time looking for predators, then no gathering will occur and they will starve. Thus there is some trade-off towards an optimum value of lookouts for any given predator, terrain or group size of gathers.
Interestingly the optimum is usually less than four, for all predators and group sizes that fit within a moderate shout range in open terrain. For larger groups, it is usually the number of watchers that will go around the edge of the group and remain within moderate shout range in open terrain. In closed terrain it depends not on shout distance but visual distance. Which is why you get very large groups (antelope, etc) in the open savanna, but much smaller-sized groups (monkeys) in closed areas such as scrub and forest, etc.
Now the important thing to notice is that the number of watchers goes up at a very very small fraction of the number of gathers.
All of which is why traditionally we have looked at perimeter defence. However it has a "physical assumption" underlying it which is "locality" which further assumes "visibility". In a network environment with 0-day attacks, everywhere that is connected is local. Thus perimeter defence only works with visible attack vectors (i.e. those that are known or exhibit behaviour that is sufficiently different from the norm to be detected).
Thus there are three basic classes of attack vector,
Within reason the Known Class can be correctly defended against with up-to-date Anti-malware, without effecting the day-to-day activities of a host (within the network perimeter). A simple measurand for this class is the number of attacks stopped.
Again within reason, the Visible Class may be mitigated against using various probabilistic techniques. This however may well involve considerable delay (with respect to attack time, not human time) and require "isolation" or "quarantining" hosts within the network perimeter which will usually negatively impact day-to-day activities of a host (within the perimeter). A simple measurand for this class is the number of events detected, a more difficult but more useful measurand is to distinguish between the "positives" (i.e. those that are seen and are proven to be attacks, those that are seen and assumed to be attacks and those that are seen and proven to be false alarms).
At first sight the Unknown Class cannot be defended against because there is "nothing to see" thus detect. Therefore the only perimeter possible is a "perfect air gap" which in current times makes a significant impact on some day to day activities of the hosts on such networks. Because there is "nothing to see" it could be argued that there is no measurand.
Setting the resource line should place it between the Visible and Unknown classes, but in most cases, resource restrictions actually puts it between the Known and Visible classes.
The question then arises, is the Unknown class really unknown?
The answer is probabilistic or a "Qualified No".
If an attack does not copy any host data and does not modify any host or its data and does not impact a hosts day-to-day activities, then its impact inside the perimeter is negligibly small at that point in time (it might for arguments sake use spare CPU cycles and memory to crack password files from another location).
Such activity might be very difficult but not impossible to spot. Currently, with monolithic executable files and current operating systems, it is effectively not possible to spot.
However there is a way that this problem can be resolved but it requires a different computing platform methodology both in hardware and software.
One of the things that has been pretty much standard in infosec is that the risks earnt (costs incurred!) from owning a Mac have been dramatically lower. I do it, and save, and so do a lot of my peers & friends. I don't collect stats, but here's a comment from Dan Geer from 2005:
Amongst the cognoscenti, you can see this: at security conferences of all sorts you’ll find perhaps 30% of the assembled laptops are Mac OS X, and of the remaining Intel boxes, perhaps 50% (or 35% overall) are Linux variants. In other words, while security conferences are bad places to use a password in the clear monoculture on the back of the envelope over a wireless channel, there is approximately zero chance of cascade failure amongst the participants.
I recommend it on the blog front page as the number 1 security tip of all:
Why this is the case is of course a really interesting question. Is it because Macs are inherently more secure, in themselves? The answer seems to be No, not in themselves. We've seen enough evidence to suggest, at an anecdotal level, that when put into a fair fight, the Macs don't do any better than the competition. (Sometimes they do worse, and the competition ensures those results are broadcast widely :)
However it is still the case that the while the security in the Macs aren't great, the result for the user is better -- the costs resulting from breaches, installs, virus slow-downs, etc, remain lower . Which would imply the threats are lower, recalling the old mantra of:
Business model ⇒ threat model ⇒ security model
Now, why is the threat (model) lower? It isn't because the attackers are fans. They generally want money, and money is neutral.
One theory that might explain it is the notion of monoculture.
This idea was captured a while back by Dan Geer and friends in a paper that claimed that the notion of Microsoft's dominance threated the national security of the USA. It certainly threatened someone, as Dan lost his job the day the paper was released .
In brief, monoculture argues that when one platform gains an ascendency to dominate the market, then we enter a situation of particular vulnerability to that platform. It becomes efficient for all economically-motivated attackers to concentrate their efforts on that one dominant platform and ignore the rest.
In a sense, this is an application of the Religion v. Darwin argument to computer security. Darwin argued that diversity was good for the species as a whole, because singular threats would wipe out singular species. The monoculture critique can also be seen as analogous to Capitalism v. Communism, where the former advances through creative destruction, and the latter stagnates through despotic ignorance.
A lot of us (including me) looked at the monoculture argument and thought it ... simplistic and hopeful. Yet, the idea hangs on ... so the question shifts for us slower skeptics to how to prove it ?
Apple is quietly wrestling with a security conundrum. How the company handles it could dictate the pace at which cybercriminals accelerate attacks on iPhones and iPads.
Apple is hustling to issue a patch for a milestone security flaw that makes it possible to remotely hack - or jailbreak - iOS, the operating system for iPhones, iPads and iPod Touch.
Apple's new problem is perhaps early signs of good evidence that the theory is good. Here we have Apple struggling with hacks on its mobile platform (iPads, iPods, iPhones) and facing a threat which it seemingly hasn't faced on the Macs .
The differentiating factor -- other than the tech stuff -- is that Apple is leading in the mobile market.
IPhones, in particular, have become a pop culture icon in the U.S., and now the iPad has grabbed the spotlight. "The more popular these devices become, the more likely they are to get the attention of attackers," says Joshua Talbot, intelligence manager at Symantec Security Response.
Not dominating like Microsoft used to enjoy, but presenting enough of a nose above the pulpit to get a shot taken. Meanwhile, Macs remain stubbornly stuck at a reported 5% of market share in the computer field, regardless of the security advice . And nothing much happens to them.
If market leadership continues to accrue to Apple in the iP* mobile sector, as the market expect it does, and if security woes continue as well, I'd count that as good evidence .
 Perhaps because Dan lost his job, he gets fuller attention. The full cite would be like: Daniel Geer, Rebecca Bace, Peter Gutmann, Perry Metzger, Charles P. Pfleeger, John S. Quarterman, Bruce Schneier, "CyberInsecurity: The Cost of Monopoly How the Dominance of Microsoft's Products Poses a Risk to Security." Preserved by the inestimable cryptome.org, a forerunner of the now infamous wikileaks.org.
 Proof in the sense of scientific method is not possible, because we can't run the experiment. This is economics, not science, we can't run the experiment like real scientists. What we have to do is perhaps psuedo-scientific-method; we predict, we wait, and we observe.
 On the other hand, maybe the party is about to end for Macs. News just in:
Security vendor M86 Security says it's discovered that a U.K.-based bank has suffered almost $900,000 (675,000 Euros) in fraudulent bank-funds transfers due to the ZeuS Trojan malware that has been targeting the institution.
Bradley Anstis, vice president of technology strategy at M86 Security, said the security firm uncovered the situation in late July while tracking how one ZeuS botnet had been specifically going after the U.K.-based bank and its customers. The botnet included a few hundred thousand PCs and even about 3,000 Apple Macs, and managed to steal funds from about 3,000 customer accounts through unauthorized transfers equivalent to roughly $892,755.
 I don't believe the 5% market share claim ... I harbour a suspicion that this is some very cunning PR trick in under-reporting by Apple, so as to fly below the radar. If so, I think it's well past its sell-by date since Apple reached the same market cap as Microsoft...
 What is curious is that I'll bet most of Wall Street, and practically all of government, notwithstanding the "national security" argument, continue to keep clear of Macs. For those of us who know the trick, this is good. It is good for our security nation if the governments do not invest in Macs, and keep the monoculture effect positive. Perverse, but who am I to argue with the wisdom in cyber-security circles?
Luther Martin asks this open question:
I have a quick question for you based on some recent discussions. Here's the background.
The first was with a former co-worker who works for the VC division of a large commercial bank. He tells me that his bank really isn't interested in investing in security companies. Why? Apparently foreach $100 of credit card transactions there's about $4 of loss due to bad debt and about only $0.10 of loss due to fraud. So if you're making investments, it's clear where you should put your money.
Next, I was talking with a guy who runs a large credit card processing business. He was complaining about having to spend an extra $6 million on fraud reduction while his annual losses due to fraud are only about $250K.
Finally, I was also talking to some people from a government agency who were proud of the fact that they had reduced losses due to security incidents in their division by $2 million last year. The only problem is that they actually spent $10 million to do this.
So the question is this: are we not spending enough on security or are we spending too much, but on the wrong things?
Things I've seen that are encouraging. Bruce Schneier in Q&A:
Q: We've also seen Secure Sockets Layer (SSL) come under attack, and some experts are saying it is useless. Do you agree?
A: I'm not convinced that SSL has a problem. After all, you don't have to use it. If I log-on to Amazon without SSL the company will still take my money. The problem SSL solves is the man-in-the-middle attack with someone eavesdropping on the line. But I'm not convinced that's the most serious problem. If someone wants your financial data they'll hack the server holding it, rather than deal with SSL.
Right. The essence is that SSL solves the "easy" part of the problem, and leaves open the biggest part. Before the proponents of SSL say, "not our problem," remember that AADS did solve it, as did SOX and a whole bunch of other things. It's called end-to-end, and is well known as being the only worthwhile security. Indeed, I'd say it was simply responsible engineering, except for the fact that it isn't widely practiced.
OK, so this is old news, from around March, but it is worth declaring sanity:
Q: But doesn't SSL give consumers confidence to shop online, and thus spur e-commerce?
A: Well up to a point, but if you wanted to give consumers confidence you could just put a big red button on the site saying 'You're safe'. SSL doesn't matter. It's all in the database. We've got the threat the wrong way round. It's not someone eavesdropping on Eve that's the problem, it's someone hacking Eve's endpoint.
Which is to say, if you are going to do anything to fix the problem, you have to look at the end-points. The only time you should look at the protocol, and the certificates, is how well they are protecting the end-points. Meanwhile, the SSL field continues to be one for security researchers to make headlines over. It's BlackHat time again:
"The point is that SSL just doesn't do what people think it does," says Hansen, an security researcher with SecTheory who often goes by the name RSnake. Hansen split his dumptruck of Web-browsing bugs into three categories of severity: About half are low-level threats, 10 or so are medium, and two are critical. One example...
Many observers in the security world have known this for a while, and everyone else has felt increasingly frustrated and despondent about the promise:
There has been speculation that an organization with sufficient power would be able to get a valid certificate from one of the 170+ certificate authorities (CAs) that are installed by default in the typical browser and could then avoid this alert ....
But how many CAs does the average Internet user actually need? Fourteen! Let me explain. For the past two weeks I have been using Firefox on Windows with a reduced set of CAs. I disabled ALL of them in the browser and re-enabled them one by one as necessary during my normal usage....
On the one hand, SSL is the brand of security. On the other hand, it isn't the delivery of security; it simply isn't deployed in secure browsing to provide the user security that was advertised: you are on the site you think you are on. Only as we moved from a benign world to a fraud world, around 2003-2005, this has this been shown to matter. Bruce goes on:
Q: So is encryption the wrong approach to take?
A: This kind of issue isn't an authentication problem, it's a data problem. People are recognising this now, and seeing that encryption may not be the answer. We took a World War II mindset to the internet and it doesn't work that well. We thought encryption would be the answer, but it wasn't. It doesn't solve the problem of someone looking over your shoulder to steal your data.
Indeed. Note that comment about the World War II mindset. It is the case that the entire 1990s generation of security engineers were taught from the military text book. The military assumes its nodes -- its soldiers, its computers -- are safe. And, it so happens, that when armies fight armies, they do real-life active MITMs against each other to gain local advantage. There are cases of this happening, and oddly enough, they'll even do it to civilians if they think they can (ask Greenpeace). And the economics is sane, sensible stuff, if we bothered to think about it: in war, the wire is the threat, the nodes are safe.
However, adopting "the wire" as the weakness and Mallory as the Man-In-The-Middle, and Eve as the Eavesdropper as "the threat" in the Internet was a mistake. Even in the early 1990s, we knew that the node was the problem. Firstly, ever since the PC, nodes in commercial computing are controlled by (dumb) users not professional (soldiers). Who download shit from the net, not operate trusted military assets. Secondly, observation of known threats told us where the problems lay: floppy viruses were very popular, and phone-line attacks were about spoofing and gaining entry to an end-point. Nobody was bothering with "the wire," nobody was talking about snooping and spying and listening [*].
The military model was the precise reverse of the Internet's reality.
To conclude. There is no doubt about this in security circles: the SSL threat model was all wrong, and consequently the product was deployed badly.
Where the doubt lies is how long it will take the software providers to realise that their world is upside down? It can probably only happen when everyone with credibility stands up and says it is so. For this, the posts shown here are very welcome. Let's hear more!
Seen on the net, by Dan Geer:
The design goal for any security system is that the number of failures is small but non-zero, i.e., N>0. If the number of failures is zero, there is no way to disambiguate good luck from spending too much. Calibration requires differing outcomes.
I've been trying for years to figure out a nice way to describe the difference between 0 failures, and some small number N>0 like 1 or 2 or 10 in a population of a million.
Dan might have said it above: If the number of failures is zero, there is no way to disambiguate good luck from spending too much.
Has he nailed it? It's certainly a lot tighter than my long efforts ... Once we get that key piece of information down, we can move on. As he does:
Regulatory compliance, on the other hand, stipulates N==0 failures and is thus neither calibratable nor cost effective. Whether the cure is worse than the disease is an exercise for the reader.
An insight! For regulatory compliance, I'd substitute public compliance, which includes all the media attention and reputation attacks.
Gunnar posts on the continuing sad saga of infosec:
There's been a lot of threads recently about infosec certification, education and training. I believe in training for infosec, I have trained several thousand people myself. Greater knowledge, professionalism and skills definitely help, but are not enough by themselves.
We saw in the case of the Great Recession and in Enron where the skilled, certified accounting and rating professions totally sold out and blessed bogus accounting practices and non-existent earning.
Right. And this is an area where the predictions of economics are spot on. In Akerlof's seminal paper "the Market for Lemons," he predicts that the asymmetry of information can be helped by institutions. In the economics sense, institutions are non-trading, non-2-party market contractual arrangements of long standing to get stuff happening. Professionalism, training, certifications, etc all are slap-bang in the recommendations.
So why don't they help? There's a simple answer: we aren't in the market for lemons! There's one key flaw: Lemons postulates that the seller knows and the buyer doesn't, and that simply doesn't apply to infosec. (Criteria #1) In the market for security, the seller knows about his tool, but he doesn't know whether it is fit for the buyer. In contrast, the salesman in Akerlof's market assumed correctly that a car was good for the buyer, so the problem really was sharing the secret information from the seller to the buyer. Used car warranties did that, by forcing the seller to reveal his real pricing.
The buyer doesn't really know what he wants, and the seller has no better clue. Indeed, it may be that the buyer has more of a clue, and at least sometimes. So professionalism, certification, training and warranties isn't going to be the answer.
Another way of looking at this is that in infosec, in common with all security markets (think defence, crime) there is a third party: the attacker. This is the party that really knows, so knowledge-based solutions without clear incorporation of the aggressor's knowledge aren't going to work. This is why buying the next generation stealth fighter is not really helpful when your attacker is a freedom fighter in an Asian hell-hole with an IED. But it's a lot more exciting to talk about.
Which leads me to one controversial claim. If we can't get useful information from the seller, then the answer is, you've got to find it by yourself. It's your job, do it. And that's really what we mean by professionalism -- knowing when you can outsource something, and knowing when you can't.
That's controversial because legions of infosec product suppliers will think they're out of a job, but that's not quite true. It just requires a shift in thinking, and a willingness to think about the buyer's welfare, not just his wallet. How do we improve the ability of the client to do their job? Which leads right back to education: it is possible to teach better security practices. It's also possible to teach better risk practices. And, it can be done on an organisation-wide basis. Indeed, this is one of the processes that Microsoft took in trying to escape their security nightmare: get rid of the security architecture silos and turn the security groups into education groups .
So from this claim, why the flip into a conundrum. Why aren't certifications the answer? It's because certifications /are an institution/ and institutions are captured by one party or another. Usually, the sellers. Again a well-known prediction from economics: institutions to protect the buyer are generally captured by the seller in time (if not in the creation). I think this was by
Stiglitz or Stigler, pointing to finance market regulation, again.
A supplier of certifications needs friends in industry, which means they need to also sell the product of industry. It's hard to make friends selling contrarian advice, it is far more profitable selling middle-of-the-road advice about your partners . "Let's start with SSL + firewalls ..." Nobody's going to say boo, just pass go, just collect the fees. In contrast:
In short, the biggest problem in infosec is integration. Education around security engineering for integration would be most welcome.
That's tough, from an institutional point of view.
 E.g., I came across a certification and professional code of conduct that required you to sign up as promoting /best practices/. Yet, best practices are lowest-common-denominator, they are the set of uncontroversial products. We're automatically on the back foot, because we're encouraging an organisation to lower its own standards to best practices, and comply with whatever list someone finds off the net, and stop right there. Hopeless!
In a paper Certified Lies: Detecting and Defeating Government Interception Attacks Against SSL_, by Christopher Soghoian and Sid Stammby, there is a reasonably good layout of the problem that browsers face in delivering their "one-model-suits-all" security model. It is more or less what we've understood all these years, in that by accepting an entire root list of 100s of CAs, there is no barrier to any one of them going a little rogue.
Of course, it is easy to raise the hypothetical of the rogue CA, and even to show compelling evidence of business models (they cover much the same claims with a CA that also works in the lawful intercept business that was covered here in FC many years ago). Beyond theoretical or probable evidence, it seems the authors have stumbled on some evidence that it is happening:
The company’s CEO, Victor Oppelman confirmed, in a conversation with the author at the company’s booth, the claims made in their marketing materials: That government customers have compelled CAs into issuing certificates for use in surveillance operations. While Mr Oppelman would not reveal which governments have purchased the 5-series device, he did confirm that it has been sold both domestically and to foreign customers.
(my emphasis.) This has been a lurking problem underlying all CAs since the beginning. The flip side of the trusted-third-party concept ("TTP") is the centralised-vulnerability-party or "CVP". That is, you may have been told you "trust" your TTP, but in reality, you are totally vulnerable to it. E.g., from the famous Blackberry "official spyware" case:
Nevertheless, hundreds of millions of people around the world, most of whom have never heard of Etisalat, unknowingly depend upon a company that has intentionally delivered spyware to its own paying customers, to protect their own communications security.
Which becomes worse when the browsers insist, not without good reason, that the root list is hidden from the consumer. The problem that occurs here is that the compelled CA problem multiplies to the square of the number of roots: if a CA in (say) Ecuador is compelled to deliver a rogue cert, then that can be used against a CA in Korea, and indeed all the other CAs. A brief examination of the ways in which CAs work, and browsers interact with CAs, leads one to the unfortunate conclusion that nobody in the CAs, and nobody in the browsers, can do a darn thing about it.
So it then falls to a question of statistics: at what point do we believe that there are so many CAs in there, that the chance of getting away with a little interception is too enticing? Square law says that the chances are say 100 CAs squared, or 10,000 times the chance of any one intercept. As we've reached that number, this indicates that the temptation to resist intercept is good for all except 0.01% of circumstances. OK, pretty scratchy maths, but it does indicate that the temptation is a small but not infinitesimal number. A risk exists, in words, and in numbers.
One CA can hide amongst the crowd, but there is a little bit of a fix to open up that crowd. This fix is to simply show the user the CA brand, to put faces on the crowd. Think of the above, and while it doesn't solve the underlying weakness of the CVP, it does mean that the mathematics of squared vulnerability collapses. Once a user sees their CA has changed, or has a chance of seeing it, hiding amongst the crowd of CAs is no longer as easy.
Why then do browsers resist this fix? There is one good reason, which is that consumers really don't care and don't want to care. In more particular terms, they do not want to be bothered by security models, and the security displays in the past have never worked out. Gerv puts it this way in comments:
Security UI comes at a cost - a cost in complexity of UI and of message, and in potential user confusion. We should only present users with UI which enables them to make meaningful decisions based on information they have.
They love Skype, which gives them everything they need without asking them anything. Which therefore should be reasonable enough motive to follow those lessons, but the context is different. Skype is in the chat & voice market, and the security model it has chosen is well-excessive to needs there. Browsing on the other hand is in the credit-card shopping and Internet online banking market, and the security model imposed by the mid 1990s evolution of uncontrollable forces has now broken before the onslaught of phishing & friends.
In other words, for browsing, the writing is on the wall. Why then don't they move? In a perceptive footnote, the authors also ponder this conundrum:
3. The browser vendors wield considerable theoretical power over each CA. Any CA no longer trusted by the major browsers will have an impossible time attracting or retaining clients, as visitors to those clients’ websites will be greeted by a scary browser warning each time they attempt to establish a secure connection. Nevertheless, the browser vendors appear loathe to actually drop CAs that engage in inappropriate be- havior — a rather lengthy list of bad CA practices that have not resulted in the CAs being dropped by one browser vendor can be seen in .
I have observed this for a long time now, predicting phishing until it became the flood of fraud. The answer is, to my mind, a complicated one which I can only paraphrase.
For Mozilla, the reason is simple lack of security capability at the *architectural* and *governance* levels. Indeed, it should be noticed that this lack of capability is their policy, as they deliberately and explicitly outsource big security questions to others (known as the "standards groups" such as IETF's RFC committees). As they have little of the capability, they aren't in a good position to use the power, no matter whether they would want to or not. So, it only needs a mildly argumentative approach on the behalf of the others, and Mozilla is restrained from its apparent power.
What then of Microsoft? Well, they certainly have the capability, but they have other fish to fry. They aren't fussed about the power because it doesn't bring them anything of use to them. As a corporation, they are strictly interested in shareholders' profits (by law and by custom), and as nobody can show them a bottom line improvement from CA & cert business, no interest is generated. And without that interest, it is practically impossible to get the various many groups within Microsoft to move.
Unlike Mozilla, my view of Microsoft is much more "external", based on many observations that have never been confirmed internally. However it seems to fit; all of their security work has been directed to market interests. Hence for example their work in identity & authentication (.net, infocard, etc) was all directed at creating the platform for capturing the future market.
What is odd is that all CAs agree that they want their logo on their browser real estate. Big and small. So one would think that there was a unified approach to this, and it would eventually win the day; the browser wins for advancing security, the CAs win because their brand investments now make sense. The consumer wins for both reasons. Indeed, early recommendations from the CABForum, a closed group of CAs and browsers, had these fixes in there.
But these ideas keep running up against resistance, and none of the resistance makes any sense. And that is probably the best way to think of it: the browsers don't have a logical model for where to go for security, so anything leaps the bar when the level is set to zero.
Which all leads to a new group of people trying to solve the problem. The authors present their model as this:
The Firefox browser already retains history data for all visited websites. We have simply modified the browser to cause it to retain slightly more information. Thus, for each new SSL protected website that the user visits, a Certlock enabled browser also caches the following additional certificate information:
A hash of the certificate.
The country of the issuing CA.
The name of the CA.
The country of the website.
The name of the website.
The entire chain of trust up to the root CA.
When a user re-visits a SSL protected website, Certlock first calculates the hash of the site’s certificate and compares it to the stored hash from previous visits. If it hasn’t changed, the page is loaded without warning. If the certificate has changed, the CAs that issued the old and new certificates are compared. If the CAs are the same, or from the same country, the page is loaded without any warning. If, on the other hand, the CAs’ countries differ, then the user will see a warning (See Figure 3).
This isn't new. The authors credit recent work, but no further back than a year or two. Which I find sad because the important work done by TrustBar and Petnames is pretty much forgotten.
But it is encouraging that the security models are battling it out, because it gets people thinking, and challenging their assumptions. Only actual produced code, and garnered market share is likely to change the security benefits of the users. So while we can criticise the country approach (it assumes a sort of magical touch of law within the countries concerned that is already assumed not to exist, by dint of us being here in the first place), the country "proxy" is much better than nothing, and it gets us closer to the real information: the CA.
From a market for security pov, it is an interesting period. The first attempts around 2004-2006 in this area failed. This time, the resurgence seems to have a little more steam, and possibly now is a better time. In 2004-2006 the threat was seen as more or less theoretical by the hoi polloi. Now however we've got governments interested, consumers sick of it, and the entire military-industrial complex obsessed with it (both in participating and fighting). So perhaps the newcomers can ride this wave of FUD in, where previous attempts drowned far from the shore.
A wave of stupidity is flooding through the USA mediawaves. Here's an example:
A cyberattack disabled US cell phone networks, slowed Internet traffic to a crawl and crippled America's power grid Tuesday -- all in the interest of beefing up US security. Dubbed "Cyber ShockWave" and organized by the Bipartisan Policy Center (BPC), the event was held at a Washington hotel room transformed for the day into the White House Situation Room, where the president and his advisers typically meet to address national emergencies.
In the simulation, former top US officials debated how to respond as the power grid in the eastern United States was virtually shut down by a stealth cyberattack and a pair of bombings, cutting electricity to tens of millions of homes.
This is an "exercise" conducted by something called the Bipartisan Policy Group. The confusion between officialdom and lobbying could be forgiven, because it was intentional. Consider this list of Washington DC rock stars:
Then we have the amazing spectacle of Google complaining about being attacked by China!? Is there -- can there be -- any credence to this story? To me, it doesn't pass the laugh test, it is clearly a propaganda story with a hidden message. A little clicking and we find this:
Second, we have evidence to suggest that a primary goal of the attackers was accessing the Gmail accounts of Chinese human rights activists. Based on our investigation to date we believe their attack did not achieve that objective. Only two Gmail accounts appear to have been accessed, and that activity was limited to account information (such as the date the account was created) and subject line, rather than the content of emails themselves.
Oh. 2 activists... that's two, the number between one and three ... gmail accounts of alleged activists. Not hacked but probed. This is below underwhelming, this is quintessence of underwhelming, the very quantum of underwhelming!
One glance and it's gone. If you read more, the contradictions just keep rolling in. Apparently it is related to copyright theft, or, no it's not. Related to a concerted attack on 30 big companies, or not. It's caused by a horrifying new technique called "man-in-the-mailbox" or it's caused by phishing, or a virus, not. It's China, or it's Taiwan! It's a school, or it's the Red Army?
What's going on? What is curious is why a group so historically sensible and focussed as Google fell to such a stupidity as announcing this in a blather of hype. Well, read a bit further:
These attacks and the surveillance they have uncovered--combined with the attempts over the past year to further limit free speech on the web--have led us to conclude that we should review the feasibility of our business operations in China. We have decided we are no longer willing to continue censoring our results on Google.cn, and so over the next few weeks we will be discussing with the Chinese government the basis on which we could operate an unfiltered search engine within the law, if at all. We recognize that this may well mean having to shut down Google.cn, and potentially our offices in China.
Ah. So, google are under pressure from the Chinese government. This is *nothing* to do with cyber-hacks, activist, freedom of speech, intellectual property, APTs, and everything to do with the access to the Chinese market. On terms appropriate to Google. They needed a casus belli to convince someone (shareholders? own employees?) of the need to rattle sabres, and a hack is a great catch-all. But, in the process of feeding the media craving for new heights in gullibility, google might have drunk a little too deeply of the kool-aid, because they then negotiated with the NSA to cut a secret deal; if there is ever a sign that it's all over for independence, that's the one!
Google approached the NSA shortly after the attacks, sources said, but the deal is taking weeks to hammer out, reflecting the sensitivity of the partnership. Any agreement would mark the first time that Google has entered a formal information-sharing relationship with the NSA, sources said. In 2008, the firm stated that it had not cooperated with the NSA in its Terrorist Surveillance Program.
Sources familiar with the new initiative said the focus is not figuring out who was behind the recent cyberattacks -- doing so is a nearly impossible task after the fact -- but building a better defense of Google's networks, or what its technicians call "information assurance."
Getting out of China, to maintain independence, then signing up with the NSA, doesn't present a consistent message. I love the quote about how they don't want to break any laws on spying on Americans...
Back to China. The rhetoric has spread further than expected. Over in Mozilla's groups, the anti-China faction has stirred up another little hate campaign over a Chinese CA called CNNIC.
With this background in mind, let's unpack the Mozilla debate. What set off the debate was the addition of the China Internet Network Information Center (CNNIC) as a trusted CA in Firefox. CNNIC is not part of the Chinese government but many people assert that it would be willing to act in concert with the Chinese government.
To see why this is worrisome, let's suppose, just for the sake of argument, that CNNIC were a puppet of the Chinese government. Then CNNIC's status as a trusted CA would give it the technical power to let the Chinese government spy on its citizens' "secure" web connections. If a Chinese citizen tried to make a secure connection to Gmail, their connection could be directed to an impostor Gmail site run by the Chinese government, and CNNIC could give the impostor a cert saying that the government impostor was the real Gmail site. The Chinese citizen would be fooled by the fake Gmail site (having no reason to suspect anything was wrong) and would happily enter his Gmail password into the impostor site, giving the Chinese government free run of the citizen's email archive.
Which offends them mightily, because CNNIC is likely to follow the Chinese government's rules on ... well, everything, as did a veritable stampede of popular western companies (Microsoft, Sun, Cisco, Skype spring to mind, and don't forget google who did, and don't and won't and might stop and want to take their bat and ball and go home). The problem for Mozilla is, CNNIC seems to offend them in more or less legal ways, in more or less policy ways, and in more or less the ways of every other view we can objectively apply.
The crime, after all the evidence is assembled (not a single credible fact that I have seen), is pretty thin, and as thin as the accusations levelled against every other CA from time to time.
But, this matters not at all if the real objective is popular manipulation (propaganda, by some). Note the clear linkage above from google to gmail to Mozilla... What might be called governance and protection of 250 million users in Mozilla technical circles might also politely be called nationalism by others.
But. Silly as it is, the message meshes in nicely with the current global geopolitical aspirations of some in Washington, at top. Back to the silk-dress appeal for pork-barrel funds by the "BPG":
An operation dubbed "Cyber ShockWave" has spanked the U.S.'s cyberdefenses -- hypothetically. Under the scenario organizers dreamed up, virus-infected smartphones spread malware to their owners' PCs. From there, the attackers DDoSed telecommunications networks into submission, brought down electrical grids and bombed a gas pipeline. The verdict: America's cyberdefenses are wanting.
What's the connection between the Mozilla skirmish, the Google retreat, and the unaffiliated-affiliated NGO above?
These are all the same war, the war on China. And, the battleground isn't anywhere near China (indeed they are probably as bemused as anyone else), it's happening in the American media. Although Mozilla do not think they are political and although Google would like not to be political, both of these agents are being dragged into an anti-China rhetoric by a much more media-savvy player, anciently called the military-industrial complex, at times called "the hawks," more recently called the Neocons, and now wielding the pathetic title of Bipartisan Policy Group:
"You're going to see planes being grounded now. You're going to see trains not moving," said Fran Townsend, former president George W. Bush's one-time Homeland Security advisor, who was promoted to Homeland Security secretary for the simulation.
The "cabinet members" debated how to respond to the situation and what advice to give the president, with suggestions ranging from calling out the National Guard, nationalizing the power companies and retaliating once the attackers' identities were known.
"If this is an attack on the United States the president, as commander-in-chief, has the authority to use the full powers at his disposal," said former deputy attorney general Jamie Gorelick, playing the role of the US attorney general.
"We're in good shape from a command and control standpoint," said "Secretary of Defense" Charles Wald, a retired general and the former deputy commander of US European Command. "We can take action offensively if we know where to go," Wald said. "Problematically, we don't know where that is."
That crowd doesn't know the difference between a bit and a bomb, but they don't need to because the warfront is the media front, and they certainly know a thing or two about using the media to prepare you for their next big adventure. You might thing this is a small thing, but the propaganda just keeps on rolling. The British version of the NSA, called GCHQ, is also infected:
"A successful cyber attack against public services would have a catastrophic impact on public confidence in the government, even if the actual damage caused by the attack were minimal," [Cheltenham spy agency's new Cyber Security Operations Centre (CSOC) says].
The warning forms part of a preliminary "horizon scanning" report produced by the new unit, which is scheduled to begin operations next month. Its job will be to continually monitor internet security, producing intelligence on botnets, denial of service attacks and other digital threats to national security.
Such a level of FUD has rarely been seen outside the information security industry and wartime. This is awful news for just about everyone. What most of these players want is to shake China down. Google wants "in" on comfortable USA competition rules, where it gets the preferential treatment that allows its business model to shine. No bad thing for the Google shareholder, but the Chinese government wants to reserve that market for a local player (for obvious & easy reasons):
In the last two decades, China's economic reform programs and its citizens' entrepreneurial flair have lifted hundreds of millions of Chinese people out of poverty. Indeed, this great nation is at the heart of much economic progress and development in the world today.
Google wants a piece of that action, plain and simple. Mozilla wants "in" on far more vague grounds that can't really be tied down, but they probably feel an interest in preserving the ability of activists in China to browse securely. Given my crypto history, it should be no surprise that I'm sympathetic to that argument as are many readers, but China isn't. If we think of it in legal terms, this puts Mozilla squarely against the current anti-democratic, anti-freedom-of-speech laws of one quarter of the planet. As google said:
We have taken the unusual step of sharing information about these attacks with a broad audience not just because of the security and human rights implications of what we have unearthed, but also because this information goes to the heart of a much bigger global debate about freedom of speech.
Meanwhile, the last-war-generals in Washington DC want "in" to China on a geophysical control basis, whereas the Chinese government wants to reserve the supply of commodities to itself. That is, China has a long term strategic mission of securing the supply of commodities to its industries. Washington DC disagrees. Hence, we find a lot of strange bedfellows all agreeing on the same objective, but for wildly different reasons.
At this point, most readers will think I'm short a few marbles. All can I say in my defence is this: the rise of China in the thought-processes of the Washington DC set is pretty easy to see, if you look. It's been there for at least a decade to my knowledge; it pops up in any serious scandal from Middle East, looking eastwards to some watery point well west of Japan. You'll have to take it on faith that when you're in a tussle with China, suddenly you'll find an 800lb gorilla in the room as your ally. Slashdot knows it, from many examples here's just one:
While I don't disagree that we could do more in the area of computer security, one needs to look closely at the affiliations of the people running this "exercise."
They're both loyal Neocon insiders. John Negroponte [wikipedia.org] is the former Bush Director of National Intelligence. Michael Chertoff [wikipedia.org] is the former Director of Homeland Security, and co-author of the Patriot Act. And both of these positions were just the last in a string of appointments by Bush/Cheney.
And as career neoconservatives, they've been at the forefront of fearmongering and prevarication in order to lead the US to war and erode civil liberties. These are not opinions, these are well-documented facts [google.com].
The neocons are a one trick circus; this is just their newest pony. If you've been paying attention the past nine years, how can you possibly doubt that this is anything else?
A gorilla you really don't want in your living room, because the cost of the alliance is probably a house re-build. The danger lurking within is this: the hawks' theory is that China will take over the USA militarily sometime in the next few decades. Whatever you think about geopolitics (last 20 years of small proxy wars, etc) this has led a not-insignificant group within the Beltway into wanting a war of some form with China. Their theory is that they have to do it now or soon, or else it will be too late.
And this may explain the flush of rhetoric out of Washington DC: the hawks are scared they are running out of time for a war, and for that, the next step is simple: they have to swing the American public behind them, into a bellicose, anti-China mood (recall how they did this with Iraq 2).
Which brings us back to the cyber-war nonsense. This is the perfect cassus belli because there is no embarrassing evidence to show they are lying; indeed we can't even get it right or clear or agreed in the open market because the electrons won't sit still after the attack. As cassus bellis go, it's got more mileage than historical ones such as Iraqi nukes or Saddam's mate Osama or the North Vietnamese torpedoe boats in the Gulf of Tonkin, because in the end, the physical evidence spoke up.
From now on in, cyber-war will be a central plank of the war on China. The only problem is, it's a lie, a casus belli, and it's more or less unprovably false and unprovably true and very very scary, all at the same time. The American Public are being set up, again. Same as it ever was, but this time the entire Internet, security, communications and interactions world is being dragged in.
That effects every one of us. This time it's personal.
(As an aside, the hawks' strategy is doomed to failure. It worked in Iraq 1 & 2 because of many factors that were easily predictable. Arguably, it failed or worked in Talibans 1, 2. It failed in Iran, but there's still hope. Unlike Iraq & Iran, who supply lots of *commodity* oil, and Afghanistan which supplies commodity opium, China supplies manufactured goods to USA. If oil or drugs slow down, the price goes up, and the market adjusts. The traders love that, it's called volatility.
On the other hand, if Walmart is emptied, we've got bigger problems, nobody benefits from that. But this easily predictable failure of strategy won't stop the hawks, possibly because their experience in economics is limited to slopping at the pork-barrel trough. As far as policy goes, this is the same stupid crowd that chose to hollow out its nearest and dearest southern neighbour in the so-called _war on drugs_. The stupidity virus has gone deep.)
It has been clear for a long time that information security was more about perception than any other factor than was good for it, a concept I tried to turn into a theory in the market for silver bullets, based on some solid thinking by others on the economics of insufficient information. Here are some random snippets that seem to anecdotally support that security is dominated by perception.
Gunnar reports on Google who were apparently subject to a cyber-attack by China. I didn't notice, probably because it doesn't pass the laugh test, but he collects all this security-blog-o-sphere stuff into a nice package:
Of course cyberattacks and the other issues raised by Google as rationale have been around for a long time, so why did they choose now as the time to threaten to pull out? ... First, we know that Google has been getting its butt kicked by Baidu.com. Baidu's search market share in 3Q09 was 77%. ... Google was in need of some positive PR to correct its worsening image (especially in Europe, where concerns about privacy are mounting on a daily basis). Google.cn is the goat that would be sacrificed ... It's no surprise than NSA is getting interested in the story. One doesn't need to know much about US politics to realize that framing this as a national security issue is going to make Google's case for US government's pressure on China much stronger ... No wonder Google has been hiring all those smart policy types with government experience ...
While Google is bandying around the phrase "national security" as a commercial weapon, Bruce Schneier is earning lots of airmiles by talking not about security but about what he calls *magical thinking*: TSA rules to make you safer from the last attack:
Of course not, the attacks are designed to get through whatever we're doing. The liquid bombers used liquid so now we screen liquids. This is a powder bomber using powders. They will look at what we do and do something different. There's sort of a bit of magical thinking about the last hour, its not a more dangerous hour, its the hour this guy happened to choose. I am not sure why the next guy can't choose the first hour or a different material or maybe even not an airplane. Focusing on the tactic might make us feel a little better but its not going to make us any safer.
Or, what military types refer to as fighting the last war, or, building the Maginot Line. Which would support the notion that the real enemy that TSA is fighting is the home front, and perception is the weapon of choice.
Adam has a nice collection of the latest TSA madness, including this quote:
'It became necessary to destroy the town to save it,' a TSA major said today. He was talking about the decision by allied commanders to shock and awe the public regardless of civilian casualties, to rout al Qaeda.
Which I can't tell if it is a spoof or not, but it seems to be on point. Here is more evidence of the perceptional nature of security: news that Microsoft's browser had a flaw in it has finally caused governments to sit up and do the unthinkable: warn people not to use a Microsoft product.
Nobody would ever notice if a government said "we don't use Linux because of security issues" or "we don't permit Apple because of ..." Microsoft's browbeating of the press and governments has been so successful that for 2 decades, nobody dare say "don't use Microsoft." Remember "Nobody every got fired for buying IBM?"
Which unfortunately has been a great loss to Microsoft (as it was to IBM) because it hid the danger from them, too, until 1992. Now they are facing the long-term decline, shackled with their chains of past insecurity. Perception-wise, they will probably never be able to shake off the the real public opinion, now that it's shifted, even with the great work listed at bottom.
Too late for their future shareholders, but maybe their past shareholders had the right idea? Markus Kuhn reports on a placebo bomb detector for the BBC, and discovered it is testably indistinguishable with any other random appliance purchased at the local Dixon's (consumer electronics store):
There is no way in which this device could be programmed to distinguish the many different substances that the ADE651 manufacturer claimed it could, not to mention that any useful interaction with such an LC circuit would require a transmitter antenna, a power source, and lots of other components that the ADE651 appears to lack.
These things sell for around 40,000 sterling each, in quantity, and the Iraqi government swears by them. OK, whatever. Compelling proof ... that the power of the placebo is essential to unlock the minds of the (human) bomb detectors that do the real job? You be the judge. What has not as yet been answered to me is why the TSA has not purchased them -- if they are America's department for magical thinking, why not purchase such things?
The devices contain no power source (”powered by the user’s static electricity”, no battery), resemble very much a dowsing rod, and generally leave much to be desired regarding a plausible operating principle or performance in repeatable double-blind trials. There are several such military dowsing rods on the market.
And they won't contribute to global warming! So real security (where "real" means, we have evidence that this is how people think, act and purchase) is as much about placebo devices as anything else. Here's the most magical question of all: why is an entire generation of crypto/security/geeks fixated on the technical workings of a device? Insisting that it operate to lab specs? When all the evidence from the field indicates that it doesn't matter much if at all?
Here's another outstanding example: Last month there was a series of crypto break news in GSM phones. Here's a summary from emergentchaos's Mordaxus.
Orr Dunkelman, Nathan Keller, and Adi Shamir have released a paper showing that they've broken KASUMI, the cipher used in encrypting 3G GSM communications. KASUMI is also known as A5/3, which is confusing because it's only been a week since breaks on A5/1, a completely different cipher, were publicized. So if you're wondering if this is last week's news, it isn't. It's next week's news.
(Except it's last month's news.) OK, joking aside, so what? GSM phones use encryption to stop the papparazzi recording your love-chat, stop neighbours hearing your shopping list, and spoofers stealing GSM minutes. As long as they do that, why aren't we happy with a 40 bit crypto response to the 20 bit crypto threat?
(In 1994 numbers, etc, just add water for 16 years of crypto-flation.)
It will be interesting to see the response from the GSM Association. They have the opportunity to show leadership. If they recognize that this is a real problem, reassure us that it's not a catastrophe, and show that they're taking it seriously, then this can be an all-around good thing for them and us.
We're all adults (well, okay, most of us are adults and act like adults some of the time), and if we know that there will be an upgrade in a few years, then that's great. We lived through the WEP issues. We are living through the SSL evil proxy issues. This is less acute than either of those. But we need to have some assurance that in a few years, we'll just get wireless devices with a safety net.
I don't mean to pick on mordaxus here, but this typifies an entire security industry: absolute obsession with an apparent security rating (measured in bits of crypto strength) and an almost willful blindness to the environment of choice. Let's list how safe we are because of GSM's fine security design:
What is the "real problem" that Mordaxus expects them to spot? What catastrophe? It's not as if we need to speculate here, we actually have real evidence: We know that when they were broken 12 years ago by Lucky Green ... nothing happened. It didn't change our security situation one iota.
Their challenge is to have a response before this news metastasizes into a common perception that 3G crypto is worthless.
Right. If we have no security argument, we also are left arguing on perception.
There are some out there that think they can use psychology to assess our current security thinking. Perhaps they can answer the most magical question of all: why are the world's top security sellers so quick to damn a crypto algorithm that has lost of few bits, like MD5, when the world's top security buyers are happily purchasing Placebo devices with 5km ratings? Or Cell-phones with 40 bit crypto? And, apparently happy with their choice?
Let's face it. Security thought as a science is failed, it is all marketing, all perception, all religion. The good news is that this meme seems to be finally getting some traction in the scientific community: "So Long, and no thanks for the Externalities: The Rational Rejection of Security Advice by Users" by Cormac Herley, who works for, of all people, Microsoft Research. Finally, we have the paper that says what we all knew:
It is often suggested that users are hopelessly lazy and unmotivated on security questions. They chose weak passwords, ignore security warnings, and are oblivious to certificates errors. We argue that users’ rejection of the security advice they receive is entirely rational from an economic perspective. The advice offers to shield them from the direct costs of attacks, but burdens them with far greater indirect costs in the form of effort. Looking at various examples of security advice we find that the advice is complex and growing, but the benefit is largely speculative or moot. For example, much of the advice concerning passwords is outdated and does little to address actual threats, and fully 100% of certificate error warnings appear to be false positives.
Read that if you think there is a place for science in information security. On the other hand, if you think information security is something else, better off to go read something on creative journalism, public relations, politics, marketing, ...
In the very sad story of the Justice System as we know it, a British courts has ruled the beginning of the end.
He went to jail this week, protesting his innocence. Speaking to The Times, he said: “There are no missing millions, there’s no villa in the Virgin Islands, there has been no fraud. I am not allowed to earn any money, my assets were restrained so I couldn’t use them to defend myself — it’s a relentless, never-ending, vicious, cruel and wicked system.
Of course, all mobsters say that. So what was the crime?
Bowles was convicted by a jury in June of cheating the Revenue of £1.2 million in VAT but sentencing had been adjourned on three previous occasions. He had been found guilty of failing to pay VAT on a BIG land sale and diverting money due to the taxman to prop up Airfreight Express, his ailing air-freight company.
Now we have come full circle, and the evidence is presented: the Anti-money-laundering project of the OECD (known as the Financial Action Task Force, a Paris-based body) is basically and fundamentally inspired by the desire to raise tax. Hence, we will see a steady progression of government-revenue cases, occasionally interspersed with Mr Big cases. This is exactly what the OECD wanted. Not the mobsters, murderers, drug barons and terrorists pick up, but:
Bowles is a divorced, middle-aged company director from Maidenhead who has been transformed from successful entrepreneur to convicted fraudster.
A businessman, from the very heartland of English countryside. Not a dangerous criminal at all, but someone doing business. Not "them" but us. POCA or Proceeds of Crime Act is now an important revenue-raising tool:
It was not suggested that Bowles, who has no criminal record, had used the money to fund a luxury lifestyle. Nevertheless, when the Revenue began a criminal investigation into his affairs in 2006 all his assets were frozen under the powers of the Proceeds of Crime Act.
Bowles was required to live on an allowance and rely on legal aid for his defence rather than pay out of his own resources. Defence lawyers claimed that preparation of Bowles’s defence case was hampered further because his companies’ financial records were in the hands of administrators.
The accounts were not disclosed until a court hearing in February this year, at which point Bowles sought permission to have a forensic accountant examine them to determine the VAT position. He was refused a relaxation of the restraint order to pay for a forensic accountants’ report. The Legal Services Commission also declined to fund such a report from legal aid.
After the court was told that the records “could be considered by counsel with a calculator” the trial went ahead. Bowles was cleared of two charges but found guilty of a third.
It works this way. First the money is identified. Then, the crime is constructed, the assets are frozen, legal-aid is denied, and the businessman goes to jail. By the time he gets out of that, he probably cannot mount a defence anyway, and rights are just so much confetti. This stripping of rights is a well-known technique in law, as only 1 in 100 can then mount a recovery of rights action, it is often done when the job of the prosecutor is more important than rights.
Let's be realistic here and assume that Bowles was guilty of tax fraud. His local paper certainly thinks he was guilty:
A tax cheat from Maidenhead who dodged paying £1.3m in VAT has been jailed for three-and-a-half years. ... The court heard between October 2001 and July 2006 Bowles failed to submit VAT returns to HM Customs and Excise (HMCE) and then HM Revenue & Customs (HMRC). The VAT related to the sale of land for commercial development in Cardiff worth £7.5m.
Following an HMRC criminal investigation Bowles, from Sandisplatt Road, was charged on three counts of ‘cheating the revenue’. Peter Avery, assistant director, HMRC Criminal Investigations, said: "This sentence will serve as a deterrent to anyone who thinks that tax fraud is a risk worth taking."
Firstly, this is quite common, and secondly, tax is the most complicated thing in existance, so complicated that most ordinary lawyers don't recognise it as law by principle. It's the tax code, it's special. It's actually very hard not to be guilty of it, when you have a fair-sized business (whoever heard of a value-added-tax on a land sale?)
But even assuming that the guy was guilty, there was rather stunning evidence to the contrary, which underscores the point that this was revenue raising, not the bringing down of a Mr Big:
A financial report has since been prepared, free of charge, by a firm of chartered accountants. A draft copy was presented to the judge two months ago and a full version handed to him this week. Its analysis concludes that rather than owing tax, Bowles’s companies had actually overpaid their taxes.
The report stated: “In our opinion, none of the evidence points to Philip Bowles fraudulently evading or concealing VAT due to HMRC ... It would have been reasonable to conclude that no fraud has taken place.”
Lawyers for Bowles claimed in court that matters were compounded by a failure to explain VAT law properly. They alleged the jury were wrongly informed that companies in the same group could not asssign tax liabilities and credits between each other.
When a firm of *chartered accountants* utters _an opinion_ over finances, this is a legally imposing evidence. It is given a special status in court, in that the court may rely on it, and so might all others; this special status is awarded for the purposes of public companies that need to impress others such as creditors and shareholders that the company is sound. This form of reliance is not available outside the accounting profession, and only available in an accounting context (e.g., when a firm of accountants audits a certification authority, we do not get a special right to rely on it without further ado).
When a firm of chartered accountants does this for free, this is beyond surprising, this is a shock. The natural order of things is now upset. When the accountants are working for free, this might mean that the professions are mounting a last-ditch effort to preserve the Justice System in Britain, as I predicted:
It took 20 years to hollow out Mexico, we have a bit longer in other countries, because the institutions are staffed by stiffer, better educated people.
Those stiffer, better educated institutions realise that we all are poorer when the justice system is used to raise revenue. Or perhaps they realise their turn is next?
One of the brief positive spots in the last decade was the California bill to make breaches of data disclosed to effected customers. It took a while, but in 2005 the flood gates opened. Now reports the FBI:
"Of the thousands of cases that we've investigated, the public knows about a handful," said Shawn Henry, assistant director for the Federal Bureau of Investigation's Cyber Division. "There are million-dollar cases that nobody knows about."
That seems to point at a super-iceberg. To some extent this is expected, because companies will search out new methods to bypass the intent of the disclosure laws. And also there is the underlying economics. As has been pointed out by many (or perhaps not many but at least me) the reputation damage probably dwarfs the actual or measurable direct losses to the company and its customers.
Companies that are victims of cybercrime are reluctant to come forward out of fear the publicity will hurt their reputations, scare away customers and hurt profits. Sometimes they don't report the crimes to the FBI at all. In other cases they wait so long that it is tough to track down evidence.
So, avoidance of disclosure is the strategy for all properly managed companies, because they are required to manage the assets of their shareholders to the best interests of the shareholders. If you want a more dedicated treatment leading to this conclusion, have a look at "the market for silver bullets" paper.
They also target corporate executives and other wealthy public figures who it is relatively easy to pursue using public records. The FBI pursues such cases, though they are rarely made public.
Huh. And this outstanding coordinated attack:
A similar approach was used in a scheme that defrauded the Royal Bank of Scotland's (RBS.L: Quote, Profile, Research, Stock Buzz) RBS WorldPay of more than $9 million. A group, which included people from Estonia, Russia and Moldova, has been indicted for compromising the data encryption used by RBS WorldPay, one of the leading payment processing businesses globally.
The ring was accused of hacking data for payroll debit cards, which enable employees to withdraw their salaries from automated teller machines. More than $9 million was withdrawn in less than 12 hours from more than 2,100 ATMs around the world, the Justice Department has said.
2,100 ATMs! worldwide! That leaves that USA gang looking somewhat kindergarten, with only 50
ATMs cities. No doubt about it, we're now talking serious networked crime, and I'm not referring to the Internet but the network of collaborating, economic agents.
Compromising the data encryption, even. Anyone know the specs? These are important numbers. Did I miss this story, or does it prove the FBI's point?
One of the interesting things about the financial system we built back in the late 1990s is that the design was pretty much spot on, and that keeps getting confirmed. I recently found out that the PKI infrastructure used the design in a CA-to-CA protocol, so they do know how to do it :)
Slowly, the knowledge inches its way up to the level needed to appreciate and duplicate the work of the early pioneers (insert long list of names here...). Over on the Harvard Business blog, Umair Haque muses on what "finance 2.0" would be like and looks at google.
Every day, you handle more searches than the NYSE handles trades — and that difference, I'm guessing, is about to hit an order of magnitude more. Every day, you connect people, businesses, and communities in deeper and tighter ways than besuited beancounters do. From my tiny perspective, it seems that you just might be in the best position of any organization in the world to take on Finance 2.0.
It's an inspirational question; and we know where the inspiration came from. But it is not exactly spot on. Google is a good fit for the market data side and search ("market"), as seen above. But not for the trade side, or more particularly the settlement side. If you know the difference, you're half way there. They *could be* a good fit because that side is just a matter of acquiring the right skills, the right mentality. But it takes a job of work and some tearing down of assumptions, because those things aren't easy to look up on wikipedia. Been there, spent the money, and only by luck and hard work did I figure it out. Not, I assure you, because "I'm smarter."
After money, the first great financial innovation was bills of exchange. What's interesting about bills of exchange is that they're just, well, information. Their example makes the point: money, debt, derivatives — all are just information.
Oh, big mistake, and this makes the point. Finance isn't "just information," it's information built on a foundation of transactions, which is built on a foundation of contracts, which is built on ... well, you get the point. And these many floors, each a foundation for the next, are widely and deeply misunderstood even, or especially in the building known as finance.
In my experience, when I talk to deep industry experts, they almost universally focus on the elevator ride and consequently bumble around with great authority in a 2 x 4m box within a huge edifice. I guess this point shouldn't be controversial, as we've now seen this great financial crisis, so we know that the industry is competitive with Hollywood when it comes to the mythology and starstruckedness.
Google Finance is nice. I like using it a lot. But if it created thick value — by really slashing search costs in finance — it would have prevented people, communities, and society from investing in toxic CDOs in the first place. It didn't. It's a pair of reading glasses, when what the world needs (to begin with) is the financial equivalent of an electron microscope.
What would a Googlier finance industry resemble? What would a more Googly set of capital markets look like? That's the $12 trillion dollar question. After all, markets are just search engines — remember?
See how people are getting closer? So much hope, still far from the solution, but getting closer. Given the amount of desire for solutions right now, there is an outside chance that the creativity needed could take off around 2015, where it didn't in 1995.
Let's get serious. Markets are just search engines, but only at one level of abstraction. This is where google fits, where information is searchable. At other abstractions they are exchanges of information, and this widely-studied topic is full of nuance, full of deception. Google doesn't fit here at all, and many have broken themselves on it.
What does it look like? It looks like financial cryptography; finance with a delicate touch of cryptography, but also larger doses of software, rights, accounting, governance stuffed in between. If you want to know what it looks like in more detail than a windmilling blog post, study Digicash for inspiration, AADS for the complications, Systemics for the transactions, the gold issuance business for the governance.
But beware; it's not about awesome, nor is it about marketing blah blah, nor is it about huge data capabilities. If anything, the core skill you need is demythologisation; the stripping away of fairy tales, until you can see the core.
What company is best for that? I have my views, but it ain't google.
Better than freedom?
Nov 12th 2009 | BAGHDAD
From The Economist print edition
Why Iraqis cherish their mobile phones
ASKED to name the single biggest benefit of America’s invasion, many Iraqis fail to mention freedom or democracy but instead praise the advent of mobile phones, which were banned under Saddam Hussein. Many Iraqis seem to feel more liberated by them than by the prospect of elected resident government.
In the five years since the first network started up, the number of subscribers has soared to 20m (in a population of around 27m), while the electricity supply is hardly better than in Mr Hussein’s day....
Good news for them! It gets better:
During recent years of civil strife, when many stayed indoors, mobile phones were the lifeline. They also became a tool of commerce. Reluctant to risk their lives by visiting a bank, many subscribers transferred money to each other by passing on the serial numbers of scratch cards charged with credit, like gift vouchers. Recipients simply add the credit to their account or sell it on to shops that sell the numbers at a slight discount from the original. This impromptu market has turned mobile-phone credit into a quasi-currency, undermining the traditional informal hawala banking system.
Practically every financial cryptographer I know has made this observation. Phones can be used to ship money. Mobile minutes are a fantastic demand base for money. They've been traded at face value for a long time. And, visiting banks is dangerous in some contexts, something we rich fat&happy westerners often forget.
This is pure financial cryptography: the turning of a simple technical architecture based on some security (some crypto) into a network capable of moving value for people. If there is any doubt left...
The market’s growing size is making some bankers wonder if phone credit should be traded on a public exchange. This may not be practical, but more regulation would be welcome. ... Prostitutes get regular customers to send monthly retainers to their phones, earning them the nickname “scratch-card concubines”, while corrupt government officials ask citizens for $50 in phone credit to perform minor tasks.
We got it all: markets to trade phone credit, crime, so we've crossed that GP thing, and booming trade where the worry-worts in government would normally blush and ban.
Of course, those same people will rant on about how this is promoting crime, and it must be banned.
Criminal rings are among the parallel currency’s busiest users. Kidnap gangs ask for ransom to be paid by text messages listing a hundred or more numbers of high-value phone cards. ... Viewed as cash substitutes, scratch cards have also drawn the attention of armed robbers. In one case, a gang emptied out the card storage of Iraq’s biggest mobile operator, Zain, which is based in neighbouring Kuwait.
Serious architects of money systems know that *all* such electronic systems also work to seriously track the crook (even the much-hyped DigiCash was not exactly as it seems). The notion that you can send a ransom over a phone is just press-headlines and FUD. Remember, the cell towers can track the phone bearer to 10m or so, so if you do that, it's because the police aren't doing their job.
Still, it remains popular political policy to shoot the messenger, as was done in Europe in the 1990s, and now is popular in other countries. But we've also learnt that when a need is big enough, even the normal worries are swept away:
Not to be left out of the bonanza, Iraq’s cash-strapped government now says it will sell a fourth mobile-operating licence, after raising $1.25 billion from each of the last three. That is less than its vast oil reserves promise to put into the state’s coffers but a lot easier to negotiate. And Baghdad is not the only place where mobile-phone commerce thrives. The UN says it has plans to deliver aid to Iraqi refugees in Syria in the same way.
Is the mobile phone better than freedom? Only when free enough to allow freedom to develop. In this case, financial cryptography is the general rubik, but economists would recognise the real linkage here: Free trade is freedom; the ability of Iraqis to avoid "going to the bank" when there's shooting outside is a life saver.
Literally, phone money saved their lives. In our fat&content western society, freed up payments won't save anyone's life, we're not in Mexico yet. But financial cryptography can shave a percentage point or two off of the price of *everything* because payments cost money and FC delivers those same things for a fraction of the costs.
And that you can take to the bank, or more importantly, back to the economy. Got a problem with growth? Install an FC plugin into your economy, and watch.
The decision to conduct a war on drugs was inevitably a decision to hollow-out Mexico. The notion of hollowing-out states is a time-honoured tradition in the Great Game, the way you control remote and wild places. The essential strategy is that you remove the institutions that keep places strong and stable, and bring them to a chaos which then keeps the countries fighting each other.
While they fight each other they are easier to control and extract value from. This is the favourite conspiracy theory behind the middle east and the famous Kissinger Deal: The Sheiks are propped up and given control of weak states as long as they trade their oil in dollars, and use the money to buy American goods. Of course we only speculate these details, and sometimes things look a little loose.
There are weaknesses in the strategy. Obviously, we are playing with fire when hollowing out a state ... so this is quite a lot of danger to the nearby states. (Which of course leads to the next part of the strategy, to play fire against fire and undermine an entire region.)
Beheadings and amputations. Iraqi-style brutality, bribery, extortion, kidnapping, and murder. More than 7,200 dead—almost double last year’s tally—in shoot-outs between federales and often better-armed drug cartels. This is modern Mexico, whose president, Felipe Calderón, has been struggling since 2006 to wrest his country from the grip of four powerful cartels and their estimated 100,000 foot soldiers.
So, quite obviously if one understands the strategy, don't do this nearby. Do it far away. Reagan's famous decision to do this must have been taken on one his less memorable days ... no matter how the decision was taken on Mexico, now Reagan's chickens have cross the border to roost in mainland USA:
But chillingly, there are signs that one of the worst features of Mexico’s war on drugs—law enforcement officials on the take from drug lords—is becoming an American problem as well. Most press accounts focus on the drug-related violence that has migrated north into the United States. Far less widely reported is the infiltration and corruption of American law enforcement, according to Robert Killebrew, a retired U.S. Army colonel and senior fellow at the Washington-based Center for a New American Security. “This is a national security problem that does not yet have a name,” he wrote last fall in The National Strategy Forum Review. The drug lords, he tells me, are seeking to “hollow out our institutions, just as they have in Mexico.”
Quite what is going on in these people's minds is unclear to me. The notion that it "has no name" is weird: it's the standard strategy with the standard caveat. They overdid the prescription, now the disease bounces back stronger, more immune, with a vengeance! Further, I don't actually think it is possible to ascribe this as a deliberate plot by the Mexican drug lords, because it is already present in the USA:
Experts disagree about how deep this rot runs. Some try to downplay the phenomenon, dismissing the law enforcement officials who have succumbed to bribes or intimidation from the drug cartels as a few bad apples. Peter Nuñez, a former U.S. attorney who lectures at the University of San Diego, says he does not believe that there has been a noticeable surge of cartel-related corruption along the border, partly because the FBI, which has been historically less corrupt than its state and local counterparts, has significantly ratcheted up its presence there. “It’s harder to be as corrupt today as locals were in the 1970s, when there wasn’t a federal agent around for hundreds of miles,” he says.
But Jason Ackleson, an associate professor of government at New Mexico State University, disagrees. “U.S. Customs and Border Protection is very alert to the problem,” he tells me. “Their internal investigations caseload is going up, and there are other cases that are not being publicized.” While corruption is not widespread, “if you increase the overall number of law enforcement officers as dramatically as we have”—from 9,000 border agents and inspectors prior to 9/11 to a planned 20,000 by the end of 2009—“you increase the possibility of corruption due to the larger number of people exposed to it and tempted by it.” Note, too, that Drug Enforcement Agency data suggest that Mexican cartels are operating in at least 230 American cities.
By that I mean, the drug situation has already corrupted large parts of the USA governance structure. I've personally heard of corruption stories in banks, politics, police and as far up the pecking order as FINCEN, intel agencies and other powerful agencies. As an outside observer it looks to me like they've made their peace with the drugs a long time ago, heaven knows what it looks like to a real insider.
So I see a certain sense of hubris in these writings. This feels to me that the professional journalist did not want to talk about the corruption that has always been there (e.g., how else did the stuff get distributed before?). What seems to be happening is that now that Mexico is labelled in the serious press (*) as hollowed-out, it has become easier to talk about the problem in mainstreet USA because we can cognitively blame the Mexicans. Indeed, the title of the piece is The Mexicanization of American Law Enforcement:
And David Shirk, director of the San Diego–based Trans-Border Institute and a political scientist at the University of San Diego, says that recent years have seen an “alarming” increase in the number of Department of Homeland Security personnel being investigated for possible corruption. “The number of cases filed against DHS agents in recent years is in the hundreds,” says Shirk. “And that, obviously, is a potentially huge problem.” An August 2009 investigation by the Associated Press supports his assessment. Based on records obtained under the Freedom of Information Act, court records, and interviews with sentenced agents, the AP concluded that more than 80 federal, state, and local border-control officials had been convicted of corruption-related crimes since 2007, soon after President Calderón launched his war on the cartels. Over the previous ten months, the AP data showed, 20 Customs and Border Protection agents alone had been charged with a corruption-related crime. If that pace continued, the reporters concluded, “the organization will set a new record for in-house corruption.”
Well, whatever it takes. If the US-Americans have to blame the Mexican-Americans in order to focus on the real problems, that might be the cost of getting to the real solution: the end of Prohibition. Last word to Hayden, no stranger to hubris:
Michael Hayden, director of the Central Intelligence Agency under President George W. Bush, called the prospect of a narco-state in Mexico one of the gravest threats to American national security, second only to al-Qaida and on par with a nuclear-armed Iran. But the threat to American law enforcement is still often underestimated, say Christesen and other law enforcement officials.
* Mind you, I do not see how they are going to blame the Mexicans for the hollowing-out of the mainstream press. Perhaps the Canadians?
I don't normally follow the gold talk because on the one hand it is the goldbugs saying "gold is set to explode" and on the other is a bunch of bankers that insult the noble metal, while on the backside buying & selling it short, naked and happy as fast as they can. That is, the story never changes.
Which in some senses is good. There has always been an expectation that gold would survive. So far nothing has changed to keep that expectation solid, with gold at $1000 an ounce, up from around $250 8 or 9 years ago.
But there is another aspect beyond the price: the market itself. As it happens, this is founded on a thing called "good delivery" bars run by LBMA (London Bullion Market Association), London being the center of the physical gold trading world. This is a good efficient and simple system which works like this: once your gold is "in" the LBMA good delivery programme, you can reliably ship it to any one of the vaults that are in, and sell it within. Deliver it out of LBMA-territory, and your gold loses its status. To put it in, it has to be tested, at some cost.
So, most of the physical retail gold that is traded (in bars) is inside the LBMA system. It's just easier to buy and sell when someone guarantees it. Which brings me to the point: Obviously, the guarantee can be wrong.
About 10 years ago the debate of unreliable LBMA bars erupted in the digital gold community, and we discovered at that time that the gold is not routinely checked in any way once it is in the system (not this). At all! I predicted then that this would mean the gold would slowly lose its integrity, as insiders raided it sliver-by-sliver, over the many many decades of its operation. It looks like I was right, from this post that JPM sent:
C) In an Asian depository, they've found "Good Delivery" bricks that had been gutted and filled with tungsten.
And predictably, the writer goes on to report "B) A number of large interests have demanded audits of gold stored in London."
If you hold gold in the LBMA system, be worried. If you are an issuer of digital gold be very worried. Why? Because it looks like the gold markets are about to be tested. Not in price terms but in delivery terms. To summarise the long anti-markets rant by "marketskeptics" (a.k.a. Eric deCarbonnel):
Have we got the message that physical gold now counts? If so, then one could wonder why open interest in gold trading on COMEX has since exploded? From August this year, it's jumped from a stable 1000-1100 tons band to around 1450. That's 40% up in a virtually traded commodity that is increasingly being demanded to convert to physical delivery! And, according to their reserves, it cannot be delivered: COMEX only holds 250t.
I wouldn't rule out a run on COMEX, and if so, it will likely collapse. That's because its reserves are a fraction of the open interest, so it looks highly vulnerable to being squeezed by the open traders (the "shorts") on one hand and the retail demands for physical delivery. Why won't the former deliver? Because for the most part they haven't got it; a short sale is generally a promise to acquire it when needed. In trading parlance, a lot more of the shorts are "naked shorts" which means they rely on a falling market (it's supposed to be illegal to be naked in a public trading, but a lot of markets look more like a nudist convention than a church meeting).
And we have a rising demand for physical, and a rising price in gold. So the squeeze happens this way: first the COMEX warehouse gets cleaned out. Then COMEX puts the squeeze on the short sellers to deliver their promise. Gold, physical, now. Which shorts then suddenly fold their cards, reveal their nakedness and declare mea culpa, I'm a nudist, so chase me. At some point, when enough of this goes on and is reported, the whole pyramid of cards collapses.
What's the likelihood of this happening? I feel it is being tested at the moment. It will probably take a rash of more bad financial news to make it happen, faster than we can react. E.g., a couple of months of CITs or European unemployment figures. But it is possible, because the gold markets have not been divorced from the decades of corruption that brought down the other markets. More likely we will see a gradual shift out of COMEX, out of London and across to other gold exchanges; preferably ones outside the western/toxic asset belt, and ones that can more easily prove their reserves. Meanwhile, those who hang on will lose value. Someone has to pay for the frauds of the past.
It's definitely not easy to predict when something will happen. But it is possible to point to fundamental and powerful contradictory forces. And that's the situation right now with the markets in gold, if that post is reliable (it might not be, it's from a goldbug, after all!). I would suggest that if people want to speculate in the gold of any form right now, hold physical only. The rest is ... too uncertain in value. That's beyond speculation, that's gambling, only do that if you really enjoy the thrill of losing bar-worths of value.
(Note: one thing I loosely follow is goldmoney's blogs and posts from founder James Turk. He's just announced that Turk's long-running newsletter is now migrated online only, and for free.)
How the war on drugs has become the war on you is an ongoing topic. However, ordinary people would generally dismiss this as more ranting blogs and kooksterising. Until it happens, in which case we simply present the evidence and hope we don't get caught in the cross-fire. From Britain, spotted by Charon QC and noosphere:
Councils get ‘Al Capone’ power to seize assets over minor offences
Draconian police powers designed to deprive crime barons of luxury lifestyles are being extended to councils, quangos and agencies to use against the public, The Times has learnt. The right to search homes, seize cash, freeze bank accounts and confiscate property will be given to town hall officials and civilian investigators employed by organisations as diverse as Royal Mail, the Rural Payments Agency and Transport for London.
The measure, being pushed through by Alan Johnson, the Home Secretary, comes into force next week and will deploy some of the most powerful tools available to detectives against fare dodgers, families in arrears with council tax and other minor offenders. The radical extension of the Proceeds of Crime Act, through a Statutory Instrument which is not debated by parliament, has been condemned by the chairman of the Police Federation. ...
My reading of the article is that this is a done deal. In a new rendition of that old Chinese curse, be careful what you wish for, it seems that the police (Federation) are now opposed to the ill-thought-out extensions of seizure powers.
Paul McKeever said that he was shocked to learn that the decision to hand over “intrusive powers” to people who were not police was made without consultation or debate.
“The Proceeds of Crime Act is a very powerful tool in the hands of police and police-related agencies and it shouldn’t be treated lightly,” Mr McKeever said. “There is a behind the scenes creep of powers occurring here and I think the public will be very surprised. They would want such very intrusive powers to be kept in the hands of warranted officers and other law enforcement bodies which are vetted to a very high standard rather than given to local councils.”
His concerns are shared by leading legal figures, who believe that there is a risk of local authorities abusing the powers to search people’s homes, seize their money, freeze their accounts and confiscate their property. They also see parallels with the spread of counter-terrorist surveillance powers to monitor refuse collections and school catchment areas.
They're shocked now, but wait until the councils ask them for advice on how to meet new and rising Home Office profitability targets. Wait, I know! A new role for the FATF: business development for County Police, Local Councils and other stationary Princes.
Wideranging confiscation powers were given to police and law enforcement bodies in 2003 to seize the cash and property from drug dealers, people-traffickers and money launderers. They were viewed as “Al Capone powers” — a means of getting at the Mr Bigs of organised crime by seizing wealth accrued from criminality. David Blunkett, then Home Secretary, said law enforcement was targeting “the homes, yachts, mansions and luxury cars of the crime barons”.
The expansion of seizure powers is part of a Home Office plan to “embed” financial seizure across the criminal justice system. Ministers set a target to recover £250 million in criminal assets by 2010, rising to £1 billion per year soon after.
Three weeks ago I wrote where this was heading: Mexico. I gave it 20 years, and now it's 20 days later.
Put yourself in the shoes the Mr Bigs that this targets; do you think they are trembling in their evil boots at the thought of the rubbish police coming after them? Or, are they seeing new opportunities for corporate expansion? Or, are they worried they need to move fast to stake out the territory before the Mr Not-So-Big from across town gets a jump on them?
In the aftermath of the failure of Vista, there is of course a lot of hand-wringing. Some talk about security, notably following CEO Steve Ballmer's admission:
Mr Ballmer said: "We got some uneven reception when [Vista] first launched in large part because we made some design decisions to improve security at the expense of compatibility. I don't think from a word-of-mouth perspective we ever recovered from that."
Let's go back to the basics. As I described in previous posts, the problem is that Microsoft is sitting on a 20 year legacy of insecurity (e.g., 1). Bill Gates recognised that the pre-Internet design assumption was heading into stormy weather, and to his credit tried to turn it around.
But, it turns out that it is easier to turn around a Blackbird than a supertanker, and even Ballmer's legendary energy didn't substantially challenge the Newtonian physics. I have to hand it to them, at least they tried!
The point isn't whether Vista was sunk by security issues (Schneier), or whether it was sunk by marketing & direction failures (as suggested by Mordaxus). This is backwards thinking. The strategic picture is that security issues had to succeed in order to save Microsoft's dominant position.
The fact now clear is that Vista failed, and this has consequences for Microsoft. Firstly the security problem is still there; so they will still have to figure that one out. But secondly, it still means that anyone concerned with security over the last decade has now had a long time to discover the solution. For the most part it is a mixture of (a) stick with old/simpler Microsoft systems, (b) switch to Mac as highlighted on this blog, or (c) switch to other more reliable (==secure) technologies like web-based, cloud,, smart-phone etc. Thirdly, while Microsoft was grappling with the problem, the PC-to-Internet equation of the 1990s has shifted. It is now a much different place.
Ultimately, it means the end of dominance for Microsoft. Like the year 1989 for IBM, the emergence of the credible alternates is no longer just hopeful talk, it is concrete. And a big correction is needed, and as seen in the chart on market caps, the market has done that over the last decade.
But unlike IBM in 1989, Microsoft does seem to know its fate. Bill Gates is the King, and he sealed his legacy by signalling this pain in a really big way back in 2002. So instead of a mass riot, a run for the bank, a complete collapse of confidence as we saw in 1989, it looks like we are now heading to a more regularised market in IT. The big players are now all within striking distance of each other. They all have some particularly strong territory, they all can defend their territory, and they can all look a the new stuff and wonder if they can get in for some of it. The IT market is now interesting again.
Welcome to the next decade!
The issue is critical because at the NSA, electrical power is political power. In its top-secret world, the coin of the realm is the kilowatt. More electrical power ensures bigger data centers. Bigger data centers, in turn, generate a need for more access to phone calls and e-mail and, conversely, less privacy. The more data that comes in, the more reports flow out. And the more reports that flow out, the more political power for the agency.
And it isn't just the NSA. The Economist points out that the cash that 3 big players have to go to war with will be spent on data centers (and what you do in them, called Cloud computing in the current buzzword):
Full war chests
This means that all three will have ample resources to spend in the main areas of the fight: data centres, cloud services and the periphery. In data centres, Google is ahead, but Microsoft is catching up in size and sophistication. Apple has most to learn, but this, too, seems only a question of time and money. Just as much of hardware has become a commodity, knowing how to build huge data centres may not be a big competitive advantage for long. And data centres can get only so big before scale ceases to be an advantage.
So you need lots of them, like google's three dozen. Where to build? You build them where the tech people are (because you want lots of technical employees who can drive in and press reset buttons on google's 2 million servers...) and you build them where energy is cheap. E.g., the cutely-named Apple-Google Power Corridor is located in North Carolina's "Research Triangle", a tech-university area located at twin cities of Raleigh/Durham. So they've got the personnel base, and:
“We’ve been working together with pofficials [sic?] from Caldwell County to market this idea for several years,” said Millar. “Duke Energy serves both sites, and is competitive with its pricing,” which is typically between 4 and 5 cents a kilowatt hour for industrial customers.
“One of the things that’s driving the competitiveness of our area is the power capacity built for manufacturers in the past 50 years,” said Millar. “Having that capacity and those redundancies has helped the region. We’ve got other sites and other buildings ready to go as well.”
They've got the energy! Power, of the energy form, underpins the new economy. Energy economics might not be a new idea: it supports China's booming economy (see chart at bottom). So whatever one thinks about the USA's politics of dabbling around from the Middle East to China, playing the Great Game in the energy belt, there are correlations of importance there.
The negotiations are part of a longstanding effort by the West to try to halt Iran’s nuclear program, which many in the West say is geared toward producing weapons. Iran says the program is designed to generate energy.
Geographically, politically and economically, a new currency based on the kWh is not an outlandish idea.
I just had to write about this one:
The greenback is heading for the trough of a super-cycle that started in August 1971, Uno said, referring to the Elliot Wave theory, which holds that market swings follow a predictable five-stage pattern of three steps forward, two steps back.
The dollar is now at wave five of the 40-year cycle, Uno said. It dropped to 92 yen during wave one that ended in March 1973. The dollar will target 50 yen during the current wave, based on multiplying 92 with 0.764, a number in the Fibonacci sequence, and subtracting from the 123.17 yen level seen in the second quarter of 2007, according to Uno.
The Elliot Wave was developed by accountant Ralph Nelson Elliott during the Great Depression. Wave sizes are often related by a series of numbers known as the Fibonacci sequence, pioneered by 13th century mathematician Leonardo Pisano, who discerned them from proportions found in nature.
! Well, I'll bet all the technical traders are packing up their books and retiring, now that they've heard this news.
More seriously, the problem with fundamental analysis (like the above) is that although it can be very right, it can also be very hard to time. Point in fact, I predicted the shift in the dollar (and so did a lot of others). But I predicted it around 2001, and it just didn't happen according to any schedule I could see. So this information is interesting but relatively worthless on a daily basis.
On the other hand, the technical trader works to patterns. To scientists this seems more like voodoo or interpreting the future from chicken entrails, and to all objective metrics it is like that. But the technical traders swear by it, and they promise it makes them money.
What's the truth? I think it is clear that complexity is such that fundamentals can't be time-predicted so easily. Which means that day-to-day is unpredictable, being the random walk. But something has to happen (never forget the Stiglitz observation), and it happens in the minds of the traders. Ideas for patterns emerge: cat droppings & bouncings, peaks & troughs, decision points. The ideas that are consistent over time are probably decided by the efficiency of meme-spreading more than anything else, which then leads to the patterns becoming self-confirming.
So where are we heading? Well, the dollar is no longer the undisputed champion. But it will still retain leadership for some time, a steady decline into a more dispersed market. People talk about alternates:
Uno said after the dollar loses its reserve currency status, the U.S., Europe and Asia will form separate economic blocs. The International Monetary Fund’s special drawing rights may be used as a temporary measure, and global currency trading will shrink in the long run, he said.
But that doesn't make sense; as Chris says:
As a bear of little economic brain but with market experience approaching 25 years, I prefer to deal with the practical, rather than the theoretical. I observe that the transaction currency is relatively unimportant, because the foreign exchange market allows an alternative currency to be used in a microsecond. What matters is, for a consumer, the capability to make future payments in the transaction currency; and for a producer, where and in what currency and asset class the proceeds of sale may be invested.
I propose an entirely different approach, and that is to distinguish between the value standard we use, and the currencies we exchange by reference to the standard.
Firstly, a fixed amount of energy - for instance the energy value of a liter of gasoline, or its equivalent in kilowatt hours - would be intuitively obvious as a pricing reference. Most people could relate to that, and whether the unit is called a petro, electro, or an energy dollar is irrelevant.
Secondly, there is the need for nationally and globally acceptable units of currency as a store of value. A unit redeemable in land rental value could perhaps be a nationally acceptable currency, but for international acceptance or "fungibility" the obvious candidates are electricity, which is pure energy, and carbon-based fuels, such as natural gas, gasoline, kerosene, heating oil and fuel oil.
If a new force is to emerge, it won't be a political unit like the IMF's accounting thing, nor will it be a historical thing like gold, but will be backed by something substantial. Energy is one universal, and if anything it is going up in value and demand, not down (so it doesn't equate to Moore's law or technology reductions, nor to natural commodity pricing).
But also, we should be very important not to attach the dollar's pain to the American Economy. Although it will suffer one hell of a hangover, bear in mind this observation from the Economist:
Only one thing seems sure about the future of the digital skies: the company or companies that dominate it will be American. European or Asian firms have yet to make much of an appearance in cloud computing. Nokia, the world’s biggest handset-maker, is trying to form a cloud with its set of online services called Ovi, but its efforts are still in their infancy. Governments outside America may harbour ambitious plans for state-funded clouds. They would do better simply to let their citizens make the most of the competition among the American colossi.
Practically all new value is created in North America. They may have sacrificed their dollar over the irrational exuberance, but the attitudes in creating new value run deep; Europe can't do it, and most all other new countries copy the essential model of post WWII Japan: copy and out-perform.
(So much for a quick post!)
Steven Englander, chief U.S. currency strategist at Barclays ( BCS - news - people ) Capital says it is the culmination of what currency traders have feared for some time now. In the second quarter central banks put just 37% of assets into dollars. Typically, banks invest 70% of their assets in the greenback.
"No one wants to be caught holding too many dollars," Englander said, "and this rising reluctance is increasing pressure on the U.S. dollar." Englander noted that the second quarter was the only time that central banks have accumulated more than $100 billion of reserves in the quarter, and the dollar's share of this accumulate has been less than 40%.
He also noted that this period was also the only time the euro has accounted for more than 50% of the accumulation when central banks, in aggregate, have accumulated more than $80 billion. Furthermore, the yen's share of the increase in reserves was 12%, by far the highest incremental share since 2005. "The drop in aggregate reserves in the fourth quarter of 2008 and the first quarter of 2009 was almost all U.S. dollar, but the recovery has been primarily in non-U.S. dollar reserves," Englander said.
From Bloomberg and the "picture is worth a 1000 words" school:
The CHART OF THE DAY shows the percentage of allocated world currency reserves in dollars has fallen as holdings in euros increased in the past decade, according to quarterly data compiled by the International Monetary Fund.
But you have to click and go there ... for the chart. It shows that euro reserve has risen from 18% to 29% over the last decade, meaning that dollar reserve has shrunk from 70% to 60%. Very approx, eyeball method. Elsewhere it says that chart covers 63% of the total reserves of central banks, as some reserves such as China's aren't reported.
In summary, it seems that most of the shift occurred around 2002 to 2003, but now there is a sudden leap in this last quarter.
“Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it,” said Steven Englander,
Well, not quite all. The Europeans are still just talking:
The economies of both Japan and Europe depend on exports that get more expensive whenever the greenback slumps. European Central Bank President Jean-Claude Trichet said in Venice on Oct. 8 that U.S. policy makers’ preference for a strong dollar is “extremely important in the present circumstances.”
Here's an idea: why don't Japan and Europe trade with each other, and avoid the problem? Gosh.... Finally, to remind us that sentiment is an issue:
“People didn’t like the dollar in 1995,” said Taylor, whose firm has $9 billion under management. “That was very stupid and turned out to be wrong. Now, we are getting to the point that people’s attitude toward the dollar becomes ridiculously negative.”
To live contrarian, buy the dollar. Postscript from FC in 2006 for some old predictions of what this means:
Let's do the maths, so as to explain why this is significant. If we take the shift as from 60% to 50%, allowing euros to rise from 30% to 40%, then we see a relative shift in USD demand of say 20%. Call it over 2 years, and we can guess at a shift of 10% per year in the total international currency use of USD.
If all countries are doing this - and there are good game theory, trade and geopolitical reasons to suspect this - then we see a massive washing around the world of some 10% of the USD during the space of a year. This will go on until we reach a new stability, a level which is anyone's guess at the moment
Just in case you're sacking your fundamentals analysts at the moment and need help...
So it is with some satisfaction that our civilisation has worked for a 1000 years to suppress the criminal within; going back to the Magna Carta where the institution of the monarch was first separated from the money making classes, and the criminal classes, both. Over time, this genesis was developed to create the rights of the people to hold assets, and the government as firmly oriented to defending those rights.
One of those hallowed principles was that of consolidated revenue. This boring, dusty old thing was a foundation for honest government because it stopped any particular agency from becoming a profitable affair. That is, no longer government for the people, but one of the money making or money stealing classes mentioned above.
Consolidated Revenue is really simple: all monies collected go to the Treasury and are from there distributed according to the budget process. Hence, all monies collected, for whatever purpose, are done so on a policy basis, and are checked by the entire organisation. If you have Budget Day in your country, that means the entire electorate. Which latter, if unhappy, throws the whole sorry group out on the streets every electoral cycle, and puts an entirely new group in to manage the people's money.
This simple rule separates the government from the profit-making classes and the criminal classes. Break it at your peril.
Which brings us to the FATF, the rot within modern civilisation. This Paris-based body with the soft and safe title of "Financial Action Task Force" deals with something called money laundering. Technically, money laundering exists and there is little dispute about this; criminals need a way to turn their ill-gotten gains into profit. When criminals get big, they need to turn a lot of bad money into good money. So part of the game for the big boys was to set up large businesses that could wash a lot of money. It is called laundering, and washing because the first large-scale money-cleansing businesses were launderies or launderettes: shops with coin-operated washing machines, which took lots and lots of cash, in a more or less invisible fashion. Etc etc, this is all well known, undisputed, a history full of colour.
What is much more disputable is how to deal with it. And this is where the FATF took us on the rather short path to a long stay in hell. Their prescription was simple: seize the money, and keep it. It is indeed as simple as the law of Consolidated Revenue. Which they then proceeded to break, as well, in their innocence and goodliness.
The Economist reports on how far Britain, a leader in this race to disaster, has come in 30 short years it has taken to unravel centuries of governance:
The public sale of criminals’ property, usually through auction houses or salvage merchants, has been big business for a long time. The goods are those that crooks have acquired legitimately but with dirty money, as opposed to actual stolen property, which the police must try to reunite with its rightful owners. Half the proceeds go to the Home Office, and the rest to the police, prosecutors and courts. The bigger police forces cream off millions of pounds a year in this way (see chart).
So if a crook steals goods, the police work for the victim. But if a crook makes money by any other means, the police no longer works for the victim, but for itself. We now have the Home Office, the prosecutors, the courts, and the humble British Bobby well incentivised to promote money laundering in all its guises. Note that the profit margin in this business is *well in excess of standard business rates of return* and we will then have no surprise at all that the business of legal money laundering is booming:
Powers to confiscate criminals’ ill-gotten gains have grown steadily. A drugs case in 1978, in which the courts were unable to strip the traffickers of £750,000 of profits, caused Parliament to pass asset-seizure laws that applied first to drug dealers, and then more widely. The 2002 Proceeds of Crime Act expanded these powers greatly, allowing courts to seize more or less anything owned by a convict deemed to have a “criminal lifestyle”, and introducing a power of civil recovery, whereby assets may be confiscated through the civil courts even if their owner has not been convicted of a crime.
Everyone's happy with that of course! (Read the last two paragraphs for a good, honest middle-class belly laugh.) Of course, the normal argument is that the police are the good guys, and they do the right thing. And if you oppose them, you must be a criminal! Or, you like criminals or benefit from criminals or in some way, you are dirty like a criminal.
And such it is. This is the sort of thought level that characterizes the discussion, and is frequently brought up by supporters of the money laundering programmes. It's also remarkably similar to the rhetoric leading up to most bad wars (who said "you're either with us or against us?"), pogroms and other crimes against civilisation.
Serious students of economics and society can do better. Let's follow the money:
Since then, police cupboards have filled up fast. Confiscations of criminal proceeds in 2001-02 amounted to just £25m; in 2007-08 they were £136m, and the Home Office has set a goal of £250m for the current financial year. To meet this, new powers are planned: a bill before parliament would allow property to be seized from people who have been arrested but not yet charged, though it would still not be sold until conviction. This, police hope, will prevent criminals from disposing of their assets during the trial.
This is the standard evolution of a new product cycle in profitable business. First, mine the easy gold that is right there in front of you. Next, develop variations to increase revenues. Third, institute good management techniques to reduce wastage. The Home Office is setting planning targets for profit raising, and searching for more revenue. The government has burst its chains of public service and is now muckraking with the rest of the dirty money-grubbing corporates, and is now in a deadly embrace of profitability with the dirty criminal classes.
Can the British electorate possibly reel in this insatiable tiger, now they've incentivised it to chase and seize profit? Probably not. But, "surely that doesn't matter," cry the middle-class masses, safe in their suburban homes? Surely the police would never cross the NEXT line and become the criminals, seizing money and assets that was not ill-gotten?
Don't be so sure. There is enough anecdotal evidence in the USA (1) that this is routine and regular. And unchallenged. It will happen in Britain, and if it goes unchallenged, the next step will become institutionalised: deliberate targetting of quasi-criminal behaviour for revenue raising purposes. Perhaps you've already seen it: are speeding fines collected on wide open motorways, or in danger spots?
The FATF have broken the laws of civilisation, and now we are at the point where the evidence of the profit-making police-not-yet-gang is before us. The Economist's article is nearly sarcastic .. uncomfortable with this immoral behaviour, but not yet daring to name the wash within Whitehall. Reading between the lines of that article, it is both admiring of the management potential of the Home Office (should we advise them to get an MBA?), and deeply disgusted. As only an economist can be, when it sees the road to hell.
Britain stands at the cusp. What do we see when we look down?
We see Mexico, the country that Ronald Reagan hollowed out. That late great President of the USA had one massive black mark on his career, which is a cross for us all to bear, now that he's skipped off to heaven.
Ronald Reagan created the War on Drugs, which was America's part in the FATF alliance. It was called "War" for marketing reasons: nobody criticises the patriotic warriors, nobody dare challenge their excesses. This was another stupidity, another breach of the natural laws of civilisation (separation of powers, or in USA, this might be better known as the destruction of the Posse Comitatus Act). This process took the "War" down south of the border, and turned the Mexican political parties, judiciary, police force and other powerful institutions into victims of Ronald Reagan's "War". From a police perspective, Mexico was already hollowed out last decade; what we are seeing in the current decade is the hollowing out of the Army. The carving up of battalions and divisions into the various gangs that control the flow of hot-demand items to from the poor south to the rich north of the Americas.
When considering these issues, and our Future in Mexico, there are several choices.
The really sensible one would be to shut down the FATF and its entire disastrous experiment. Tar&feather anyone involved with them, run them out of town backwards on a donkey, preferably to a remote spot in the Pacific, with or without speck of land. The FATF are irreparable, convinced that they are the good guys, and can do no wrong. But politically, this is unlikely, because it would damn the politicians of a generation for adopting childish logic while on duty before the public. And the FATF's influence is deep within the regulatory and financial structure, everyone will be reminded that "you backed us then, you don't want people to think you're wrong..." Nobody will admit the failure, nobody will say «¡Discuplanos!» to the Mexican pueblo for depriving them of honest policing and a civilised life.
The simple choice is to go back to our civilised roots and impose the principle of Consolidated Revenue back into law. In this model, the Home Office should have its business permit taken away from it, and budget control be restored. The Leicestershire Constabulary should be raided by Treasury and have its eBay and Paypal accounts seized, like any other financial misfits. This is the Al Capone solution, which nobody is comfortable with, because it admits we can't deal with the problem properly. But it does seem to be the only practical solution of a very bad lot.
Or we choose to go to Mexico. Step by step, slowly but in our lifetimes. It took 20 years to hollow out Mexico, we have a bit longer in other countries, because the institutions are staffed by stiffer, better educated people.
But not that long. That is the thing about the natural laws: breach them, and the policing power of the economy will come down on you eventually. The margins on the business of sharing out ill-gotten gains are way stronger than any principled approach to policing or governance can deal with. I'd give it another 20 years for Britain to get to where Mexico is now.
Compelling evidence that FinancialCryptography.com is not deeply read in Washington DC arrived with this fascinating article:
It’s the biggest mystery in global finance right now: Who conducted a sneak attack on the U.S. dollar this week?
It began with a thinly sourced but highly explosive report Monday in a British newspaper: Arab oil sheiks are conspiring with the Russians and Chinese to quit using the dollar to set the value of oil trades — a direct threat to the global supremacy of the greenback.
Is it true? Everyone from the head of the Saudi central bank to U.S. officials scrambled to undercut the story, but no matter.
Wakeup America? The collapse of the dollar was first heralded around 2001. The clue was the weaker-than-deserved crash after the dotcom era. Then, as evidence continued to pile in that the Fed was managing the US crises and economy too nicely, and the President was spending too many of the toys chasing towelheads and oil in Asia, the idea of a shift from dollar hegemony to multiple leading units went from theory to inevitability.
War Against the Dollar, the Pillar of United States Power
Whatever happens, Washington can no longer backtrack. In fact, the survival of the U.S. is menaced - not by an external enemy, but by internal economic weakness and tensions running between its communities. Many are becoming conscious of the fact that U.S. power is based upon a mirage, the dollar. These are only pieces of paper, printed when more are needed, while the rest of the world feels obliged to use them.
For the past three years, Jacques Chirac and Gerhard Schroder have engaged France and Germany in a pitiless war against the United States. They have sent emissaries world wide to convince other States to convert their monetary reserves to euros. The first to accept were Iran, Iraq and North Korea. Precisely the countries described by George W. Bush as those of the "axis of evil".
Meanwhile, Vladimir Putin has begun restoring the economic independence of the Russian Federation. He has reimbursed - ahead of time - the debts that Yeltsin had contracted with the International Monetary Fund and will also make an early repayment, before the end of the year, of the remaining debts to the Club of Paris.
That was 2003. It was reported here, not because we like poking fun at the Yanks, but because a monetary shift of this proportion is HUGE. Such a shift passes as news, except in Washington DC of course, where it's a sneak attack! The evidence in monetary terms was compelling enough to make it not only hypothesis but a clear progression; this blog reported it at least a dozen times back to 2003 (when the blog started. E.g.: 2008, x, x, x, x, The Coming Collapse of the Dollar, x, x, x, x, x, 2004).
Meanwhile, back in Washington DC, where the brightest and best are analysing this surprising development:
For American officials, the possibility of the dollar losing its long-term dominance in global commerce is a nightmare scenario because it would likely mean sharply higher interest rates at home and a declining ability to finance the U.S. debt. No one believes it could really happen right now, but stories like the British report this week make it seem incrementally more likely.
Reading the article, I get the feeling that because the report is British, it isn't credible. And Fisk, the author, is apparently a radical who consorts with Osama bin Laden. That's good news for us here in financialcryptography. That means it is not personal, the people in Washington DC don't read anything from outside their borders....
And so the USA seals its fate. With analysis like that, American policy is apparently immune from forces beyond the board, even when triggered from within.
In other news, President Obama was awarded the Nobel Peace Prize, which comes with a gold medal. Going up in value every day...
If he can save the dollar, he could be in line for another gold coin. He's probably too late this year as the Prize in Economics, in memorium of Alfred Nobel, will be awarded this Monday. But there's always next year.
I got some good criticism on the post about accounting as a profession. Clive said this which I thought I'd share:
As an engineer who's father was an accountant I will give you three guesses as to what he told me not to do when I grew up... Oddly it is the same for engineers, we tend to tell our children to do other things. As I've said before if you want to get on in life you should learn to speak the language that the man who cuts your cheque at the end of the month does, or more correctly his boss ;)
So even if you are just a humble team leader get yourself three courses,
- Vocal training,
- Psychology or Method acting.
And no I'm not joking about 3.
He's talking about what we do when we get to 30 and beyond, e.g., most readers of this blog. For us older folks looking back, it is depressing that the world looks so sucky; but this is a time-honoured thing. The myths have been stripped away, the rot revealed.
But the youth of today is perpetually optimistic, and the question they ask is eternal and (Spence-like) opinionated: what to study, first?
What then do we recommend for a first degree for someone near 20? It seems that nobody promotes the accountancy field, including the incumbents. Accountants don't practice accountancy, if they are any good. The only accountant I ever knew well committed suicide.
An MBA doesn't work, this is something that should be done after around 5-10 years of experience. Hence, I'm not convinced a straight business degree ("Bachelors in Business Studies" ?) makes sense either, because all that additional stuff doesn't add value until experience is there to help it click into place.
I wouldn't suggest economics. It is like law and accounting, in that it helps to provide a very valuable perspective throughout higher business planes. But it doesn't get you jobs, and it is too divorced from practical life, too hard to apply in detail. Engineering seems far too specialised these days, and a lot of it is hard to work in and subject to outsourcing. Science is like engineering but without the focus.
To my mind, the leading contenders as a first degree are (in no particular order):
⇒ computer science,
⇒ biotech, and
Firstly, they seem to get you jobs; secondly, law, compsci and marketing are easy to apply generally and broadly, and pay dividends throughout life. I'm not quiet sure about Biotech in the "broad" sense, but it is the next big thing, it is the wave to ride in.
Comp sci was the wave of the 1980s and 1990s. Now it is routine. Any technical degree these days tends to include a lot of comp sci, so if there is a tech you enjoy, do that degree and turn it into a comp sci degree on the inside.
Law is in my list because it is the ultimate defensive strategy. Headline Law tends to offend with its aggressively self-serving guild behaviour ("a man who represents himself has a fool for a client and a fool for a lawyer") and as a direct practice (courts) the field seems made for crooks. More technically, all disputes are win-lose by definition, and therefore litigation is destructive by definition, not productive. This is offensive to most of humanity.
But litigation is only the headline, there are other areas. You can apply the practical aspects of law in any job or business, and you can much more easily defend yourself and your business against your future fall, if you have a good understanding of the weapons of mutual destruction (a.k.a. lawsuits). About half of the business failures I've seen have occurred because there was no good legal advisor on the team; this is especially true of financial cryptography which is why I've had to pick up some of it; what one person I know calls "bush lawyering."
The downside to studying law is that you can lose your soul. But actually the mythology in law is not so bad because it is grounded in fundamental rights, so keep those in mind, and don't practice afterwards. It's nowhere near as bad as the computing scene (no grounding at all, e.g., open source) or the marketing blah blah (your mission is to unground other's perceptions!).
Marketing is there because every successful business needs it, and you can only be successful with it. MBAs are full of marketing, which reflects its centrality (and also gives a good option for picking it up later). But marketing is also dangerous because it gives you the tools to fool yourself and all around you, and once you've become accustomed to the elixir, your own grounding is at risk.
I don't advise any of the arts (including Clive's points 2,3) as a primary degree for youth, because businesses hire on substance, so it is important to have some to offer. E.g., people who study psychology tend to end up doing HR ("human resources"), badly, perhaps because they lack the marketing sense to make HR the most important part of the business.
Likewise, avoid anything that is popular, soft, fun, nice and that all your touchy-feely friends want to do. When there are too many people and too little substance, the competition suppresses everyone and makes you all poor. That's the best result because at least it is honest; a very few dishonest ones become rich because they figure out the game. The notion that you can study acting, media, history, photography or any of the finer arts, and then make a living, doesn't bear talking about. It is literally gambling with lives, and has no place in advice to young people.
So, if they are not doing audits and accounting, where does the accounting profession want to go? Perhaps unwittingly, TOdd provided the answer with that reference to the book Accounting Education: Charting the Course through a Perilous Future by W. Steve Albrecht and Robert J. Sack.
It seems that Messrs Albrecht and Sack, the authors of that book, took the question of the future of Accounting seriously:
Sales experts long ago concluded that “word of mouth” and “personal testimonials” are the best types of advertising. The Taylor Group1 found this to be true when they asked high school and college students what they intended to study in college. Their study found that students were more likely to major in accounting if they knew someone, such as a friend or relative, who was an accountant.
So they tested it by asking a slightly more revealing question of the accounting professionals:
When asked “If you could prepare for your professional career by starting college over again today, which of the following would you be most likely to do?” the responses were as follows:
Type of Degree % of Educators Who Would % of Practitioners Who Would Who Would Earn a bachelor’s degree in something other than accounting and then stop 0.0 7.8 Earn a bachelor’s degree in accounting, then stop 4.3 6.4 Earn a Master’s of Business Administration (M.B.A.) degree 37.7 36.4 Earn a Master’s of Accountancy degree 31.5 5.9 Earn a Master’s of Information Systems degree 17.9 21.3 Earn a master’s degree in something else 5.4 6.4 Earn a Ph.D. 1.6 4.4 Earn a J.D. (law degree) 1.6 11.4
These results are frightening,...
Well indeed! As they say:
It is telling that six times as many practicing accountants would get an M.B.A. as would an M.Acc., over three times as many practitioners would get a Master’s of Information Systems degree as would get an M.Acc., and nearly twice as many practitioners would get a law degree instead of an M.Acc. Together, only 12.3 percent (6.4% + 5.9%) of practitioners would get either an undergraduate or graduate degree in accounting.2 This decrease in the perceived value of accounting degrees by practitioners is captured in the following quotes:We asked a financial executive what advice he would give to a student who wanted to emulate his career. We asked him if he would recommend a M.Acc. degree. He said, “No, I think it had better be broad. Students should be studying other courses and not just taking as many accounting courses as possible. ...
My job right now is no longer putting numbers together. I do more analysis. My finance skills and my M.B.A. come into play a lot more than my CPA skills.
.... we are creating a new course of study that will combine accounting and
information technology into one unique major….
...I want to learn about information systems.
(Of course I'm snipping out the relevant parts for speed, you should read the whole lot.) Now, we could of course be skeptical because we know computing is the big thing, it's the first addition to the old list of Reading, Arithmetic and Writing since the dark ages. Saying that Computing is core is cliche these days. But the above message goes further, it's almost saying that Accountants are better off not doing accounting!
The Accounting profession of course can be relied upon to market their profession. Or can they? Todd was on point when he mentioned the value chain, the image in yesterday's post. Let's look at the wider context of the pretty picture:
Robert Elliott, KPMG partner and current chairman of the AICPA, speaks often about the value that accountants can and should provide. He identifies five stages of the “value chain” of information. The first stage is recording business events. The second stage is summarizing recorded events into usable data. The third stage is manipulating the data to provide useful information. The fourth stage is converting the information to knowledge that is helpful to decision makers. The fifth and final stage is using the knowledge to make value-added decisions. He uses the following diagram to illustrate this value chain:
This five-stage breakdown is a helpful analysis of the information process. However, the frightening part of Mr. Elliott’s analysis is his judgment as to what the segments of the value chain are worth in today’s world. Because of the impact of technology, he believes that:
- Stage 1 activity is now worth no more than $10 per hour
- Stage 2 activity is now worth no more than $30 per hour
- Stage 3 activity is now worth $100 per hour
- Stage 4 activity is now worth $300 per hour
- Stage 5 activity is now worth $1,000 per hour
In discussing this value chain, Mr. Elliott urges the practice community to focus on upper-end services, and he urges us to prepare our students so they aim toward that goal as well. Historically, accounting education has prepared students to perform stage 1- and stage 2-type work.
Boom! This is compelling evidence. It might not mean that the profession has abandoned accounting completely. But it does mean that whatever they do, they simply don't care about it. Accounting, and its cousin Audits are loss-leaders for the other stuff, and eyes are firmly fixed on other, higher things. We might call the other stuff Consulting, and we might wonder at the correlation: consulting activities have consumed the major audit firms. There are no major audit firms any more, there are major consulting firms, some of which seem to sport a vestigial audit capability.
Robert Elliot's message is, more or less, that the audit's fundamental purpose in life is to urge accountancy firms into higher stages. It therefore matters not what the quality (high?) is, nor what the original purpose is (delivering a report for reliance by the external stakeholder?). We might argue for example whether audit is Stage 2 or Stage 3. But we know that the auditor doesn't express his opinion to the company, directly, and knowledge is the essence of the value chain. By the rules, he maintains independence, his opinion is reserved for outsiders. So audit is limited to Stages 3 and below, by its definition.
Can you see a "stage 4,5 sales opportunity" here?
Or perhaps more on point, can you avoid it?
It is now very clear where the auditors are. They're not "on audit" but somewhere higher. Consulting. MBA territory. Stage 5, please! The question is not where the accounting profession wants to go today, because they already got there, yesterday. The financial crisis thesis is confirmed. Audits are very much part of our problem, even if they are the accounting profession's solution.
What is less clear is where are we, the business world? The clients, the users, the reliers of audit product? And perhaps the question for us really is, what are we going to do about it?