The Janet Jackson Transaction Vexation

Malt Liquidity 82

Dark Money

In transactions, as in clothing, too much transparency can be a bad thing. In the many, many discussions over the years that I’ve had over centralization vs. decentralization, the “new financiers” talk about full transparency of transactions like it’s irrefutably a good thing, while any student of central banking history knows that there’s more than meets the eye. Tools such as Etherscan and the availability of public ledgers fueling due diligence as seen from ZachXBT are undoubtedly remarkable. Yet, regardless of whether a currency is centralized or not, the ability of it to fuel a transaction system depends on its stability. The sole purpose of a central bank, for example, is to prevent the tail risk of a crippling bank run. As such, over-transparency of assets is counter-productive when you are trying to stem contagion during banking-afflicted events.

There’s a reason I bring this up post-FTX, though I have been theorizing about it for a long time, as it seems that the crypto élite seem to be coming around to this realization:

Ethereum co-founder Vitalik Buterin has proposed a new system that would allow the blockchain’s users to generate obfuscated addresses and receive funds privately on the network.

The new system can provide more privacy for user activities ranging from money and financial transactions as well as non-fungible token transfers by allowing users to create “stealth addresses” where they can conduct private transactions with a special code. 

Sounds kind of similar to dark crossing, doesn’t it?

I don’t bring this up post-FTX to rub people’s faces in not catching a massive fraud — indeed, FTX’s issues were more related to them just straight up stealing money. The fallout from FTX, however, is why a little less transparency is not a bad thing. Everyone knew how everyone else was transacting, so at the first warning signs, everything turned into a massive rush for the gates, which blew up multiple billion dollar firms due to the hot potato borrowing nature from firm to firm. It’s akin to everyone rushing to withdraw their money during the Great Depression, which was the subject of much of Bernanke’s research, and why it was so perfectly timed that he was there to stem the flood of this happening in 2008. When banks received bailout funds, he made a point to not openly reveal which banks were receiving assistance to not spark chaos — though we later found out most banks were receiving assistance, the bailouts, in a sense, worked, as the Treasury eventually made a profit on their TARP assistance, and most banks survived. (Though profit is not necessarily the best way to judge liquidity backstops — it’s never about the “profit” these manipulative operations generate, because if you are taking action and not making money, the market is fucked anyway. Rather, the frequency of interventionist operations is assessed as a ‘canary’ as to whether things are broken.)

One could then argue that if fully transparent proof of reserves were available, none of the contagion would have spread either. This is also flawed because overemphasizing proof of reserves runs into a weirdly goldbug-ish situation, where you are unable to fully utilize lending and borrowing against your resources to create value, because highly capitalized players can blow up your system when they know what your margining is (a la Soros.) A certain level of agency needs to be surrendered to the system to allow it to provide liquidity. Here, there are multiple tiers of liquidity — think of layer 1 liquidity as immediacy of the transaction layer, and layer 2 liquidity as solvent, but less liquid resources that are held and duly allocated to foster productivity (aka debt facilitation.) Overemphasis of layer 1 reduces the efficacy of fractional reserves, which is how layer 2 liquidity is distributed through the system to fuel growth.

People who do not follow market flows don’t fully realize how big of a problem showing a position of size in a market is. Dark pools, dark crossing, delayed filings, below-screen liquidity, and more all serve to obfuscate positioning, but this is so that any sizable sale doesn’t induce massive front-running to “beat someone to the punch.” Too much transparency of your size induces a Bank of Japan problem on any large player:

The BOJ held 535.62 trillion yen ($3.92 trillion) in Japanese government bonds by market value at the end of September, excluding treasury discount bills, according to its Flow of Funds Accounts report published Monday [Dec 19, 2022 ~ed].

This represented 50.3% of the outstanding balance of nearly 1.07 quadrillion yen -- up from 49.6% at the end of June.

The figure came to around 10% a decade earlier.

If they ever decided they wanted to downsize this position, who the hell would buy it knowing that another massive % of the market is due to follow? Their transparency is their own demise — they will never be able to liquidate their position.

The core problem with having transactions consistently front-run is that it artificially heightens volatility. Reposting from a twitter thread I wrote over the weekend regarding crypto market movement:

While tokens are built on 'hot air' — there isn't an underlying business involved with cash flow generation/accrual of debt for coins — the fact that there is liquidity is fundamental value. I think of tradable crypto as essentially a put on central bank stability — <1 delta in, say, the U.S., much higher delta in, say, Turkey. Specifically, they are far dated, far otm puts. This would imply that the extrinsic 'value' crypto has (bc there's no intrinsic for these options, obviously) is almost entirely IV (given that they're on the extremes of the volatility smile), and there is no 'exercisability'. As a result, crypto "inflows and outlows" are more akin to rapid bidding/crushing of the implied volatility of an option rather than normal delta one products, which exponentiates the nature of the move when it comes due to the nonlinearity of option movement itself.

This is why crypto pops and then slowly deflates/stagnates over time — the vol bid is always more rapid than the deflation because deflation of IV has to coincide with a lower forward realized vol, meaning it happens over time, while bid is pure flow, unless there is a “mass sell” event. What triggers that mass sell event? Well, when you can see on chain that everyone is looking to get out!

The people at the forefront of crypto seem to realize that something needs to be done to prevent the edge probability of mass exodus from the system and the tail risks of contagion. Since the biggest facilitators of transactions don’t want to provide transparency of their reserves (due to the obvious nature of what would happen if their positioning was found to have holes), allowing some privacy of transactions seems to be the inevitable next progression. Given the regulatory attention on the space right now, though, I highly doubt regulators will approve of more shadow banking/dark transactions — while they probably don’t understand how the mechanics I just described would stabilize the ecosystem, surely they see it as legitimizing what I described as a “put on central bank stability.”

On a more abstract level, a government’s role is essentially “short society vol” to maintain it, and it uses the central bank and a system of laws to control the tails. A mature society wants its range of outcomes to be between the -2/2 sigma level — you don’t want sub -2 sigma outcomes for obvious reasons, and you don’t want 2+ sigma outcomes in case the society is pushed into a new paradigm that overrules your ability to maintain the society. This is why inflation targeting is so powerful — it’s signaling that the government is not looking to hockey-stick society. Leaving the tails exposed, however, leaves you open to “Brad” risk — the edge case where the absolute freak occurrence happens and you’re left to pick up the pieces. With a “zero hedge”, the survival rate of all systems over time drops to zero.