Caitlin Long on Bitcoin, Blockchain And Rehypothecation (#GotBitcoin?)
Caitlin Long is the Co-Founder of the Wyoming Blockchain Coalition
She spent over 2 decades working for big banks, and was one of the leading voices advocating for the use of blockchain technology in the financial services community. While president of Symbiont she jointly led its index data project with Vanguard. Caitlin is a Wyoming native, and recently launched the Wyoming Blockchain Coalition which helped pass five bills into law. These bills are laying the foundation to make Wyoming the epicenter for cryptocurrency firms and blockchain technology companies.
How Did You Get Into The Crypto / Blockchain Industry?
In 2012 I came across bitcoin in Austrian School economics circles. But I didn’t act on it right away, just as most people don’t when they first hear about bitcoin. It’s bewildering at first, and it takes time and repetition to sink in. Then, in February 2013, I was flat on my back for days recovering from surgery when an article by Jeffrey Tucker hit my inbox. It contained some “how to” advice about bitcoin, and I remember thinking “it’s finally time to figure this thing out.” That day I set up my first wallet.
What Did You Do Before You Got Sucked Down The Blockchain Rabbit Hole?
Before jumping to blockchain full-time in 2016, I’d spent 22 years on Wall Street in various senior roles (most recently as head of Morgan Stanley’s pension business). Initially I felt pressure to keep my bitcoin interest quiet, as a manager inside an investment bank — but gradually felt more comfortable and started participating in an internal bitcoin forum. Morgan Stanley’s CTO saw that, and out of the blue in 2014 he called to ask me to join his blockchain working group. From there it wasn’t long before I had one foot out the door to pursue blockchain full-time — it was a gradual process, but by 2016 I was all-in.
What Was Your Motivation In Starting The Wyoming Blockchain Coalition, And Why Do You Feel Passionate About This?
My passion is honest ledgers. That must sound odd and tremendously boring to your readers. But most folks don’t realize that the financial system’s ledgers are not honest. When I figured this out, it was like a betrayal — a punch to the gut — that made me question my chosen profession. But it’s true. We do not have a fair and honest financial system. One reason is that Wall Street’s accounting systems are rarely in sync with each other and smart actors have figured out how to exploit these inconsistencies to their advantage. Some of this is nefarious, but much of it is just systemic sloppiness. We will only have a fair financial system when we restore property rights back to the owners of assets in the financial system, and account for them using honest ledgers.
I witnessed some of these issues first-hand, but publicly can point to the Dole Food case as one of many examples. In February 2017 a Delaware court case detailed how 49.2 million valid claims were filed for Dole Food shares in a class-action lawsuit, but there was a problem: only 36.7 million Dole Food shares existed! All 49.2 million claims were backed up by valid brokerage statements proving that the shareholders owned the shares, but there were only 36.7 million shares outstanding. When the financial system can create 12.5 million real claims to phantom shares that don’t exist, it’s the same as if your county clerk issued someone else a valid deed to your house. It’s dishonest and shocking.
Here’s another example. The vote tally in the 2017 Procter & Gamble proxy fight was laughably inaccurate, three times, and no one really knows who won because the parties simply agreed to stop fighting and settle. The first count found P&G won by 6.2 million votes. The second count found the challenger, Nelson Peltz, won by 42,780 votes. The third and final count found P&G won by 498,312 votes. Do these wildly different vote counts give you confidence that Wall Street keeps accurate track of the securities in your brokerage account? The Wall Street Journal’s headline captured the exasperation,: “P&G Concedes Proxy Fight, Adds Nelson Peltz to Its Board,” even though P&G actually won that latest count!
All of this inaccuracy is unacceptable to me, as it should be to anyone who believes in free and fair markets. Wall Street’s ledgers are not honest. Blockchain can make them so!
What’s Been The Most Inspiring Experience You’ve Had In Blockchain-Land Thus Far?
By far the most meaningful project on which I’ve worked was the Wyoming Blockchain Coalition’s passage of five blockchain bills in 2018 that make Wyoming a crypto haven. This was a purely volunteer project and was a labor of love for me, as I was born and raised in Wyoming and care deeply for my native state. Had someone been paying us for the time we spent on the ground in Cheyenne making it happen, they would have paid a fortune! But for me it was a service project, both for my native state and the blockchain community. The opportunity came at the right time for Wyoming, and fit the state’s needs like a glove. It was the most intense and gratifying project I’ve worked on in years — and I hope everyone in the community can find and make a similar contribution during their careers!
What Are Some Ideas You’re Excited About In The Blockchain Ecosystem?
I’m most excited by the idea of making securities markets a lot fairer to regular folks by issuing and trading securities on a blockchain. This idea was originally that of Symbiont, my former company — and it’s a great one. The insight is that if a company registers its shares on a blockchain at its genesis moment — which is when it registers with the Secretary of State in its state of incorporation — then its stock ledger will be accurate, honest and tamper-proof. No more phantom shares of Dole Food or inaccuracies in the P&G proxy vote! Blockchains can clean this up.
We Always Overestimate What Will Happen In Five Years And Underestimate What Will Happen In Twenty. Where Do You See This All Going?
I believe we will all be using bitcoin for payments in 20 years. I’m a bitcoin maximalist, but believe it will take 20 years for bitcoin to become pervasive.
Unfortunately, I believe the financial system will crack hard when the West hits the proverbial debt ceiling and our lenders stop lending to us — no one knows exactly when that will happen — and that’s when the rubber will hit the road for cryptocurrencies. Bitcoin used to be countercyclical (e.g., it rose during the financial crisis in Cyprus), but recently its trading pattern has been procyclical (i.e., it rises when stock markets rise) as institutional money flows into it. But I believe it will eventually prove to be powerfully countercyclical again.
I used to worry about the instability of the traditional financial system — but bitcoin makes me optimistic about the future because it provides a viable alternative!
What Is Unique About The City Of London’s Laws Regarding Rehypothecation?
Good question – except there aren’t any. There aren’t any laws about rehypothication in the City of London. The City of London is an
‘offshore’ jurisdiction with regard to regulation (the so-called “Euromarkets”)
As you know rehypothication (simplified) is the ability to re-use and re-use assets as collateral ad infinitum… Many Wall St. banks have established subsidiaries there, to shift assets off their books.
The reports below indicate that this was the main reason behind the demise of MF Global, Lehman, AIG, etc..
Zerohedge: Why The UK Trail Of The MF Global Collapse May Have “Apocalyptic” Consequences For The Eurozone, Canadian Banks, Jefferies And Everyone Elseand Shadow Rehypothecation, Infinite Leverage, And Why Breaking The Tyranny Of Ignorance Is The Only Solution and Has The Imploding European Shadow Banking System Forced The Bundesbank To Prepare For Plan B?
Dole Food Had Too Many Shares
In 2013, tropical-fruit tycoon David Murdock, who was the chairman, chief executive officer and biggest shareholder of Dole Food Co., took it private for $13.50 a share. A lot of shareholders felt that that price was way too low, and that Murdock had sandbagged the shareholders by driving down the value of the company so he could buy it cheaply for himself. So they sued, and they won. In 2015, the Delaware Chancery Court ordered Murdock to pay shareholders another $2.74 a share, plus interest. There was a class action on behalf of shareholders, covering 36,793,758 shares, and after the court ruled in their favor, the class lawyers informed the shareholders and asked them to submit a form to claim their $2.74 a share.
They got back claims from 4,662 shareholders for a total of 49,164,415 shares. “That figure substantially exceeded the 36,793,758 shares in the class,” Delaware Vice Chancellor Travis Laster drily noted in an opinion Wednesday. Oops! Somehow shareholders owned 33 percent more Dole Food shares than there were Dole Food shares.
Huh. So. The simple explanation would be “a quarter of those people were lying,” but nope. Almost all the claims were valid, 2 or at least, “facially eligible.” So the lawyers sheepishly went back to Vice Chancellor Laster to explain what happened and ask what to do about it.
What happened? Two things. The first one is just a pure pointless mess. Essentially the way everyone owns stock is:
- Cede & Co., a nominee of the Depository Trust Co., owns all the stock in all the companies.
- DTC keeps a list of its “participants” — banks and brokers — who “really” own that stock, and how much each of them own.
- The participants, in turn, keep lists of “beneficial owners” — people and funds — who really really own the stock, and how much each of them own.
So if you own stock, what you really have is an entry in your broker’s database, and your broker in turn has an entry in DTC’s database, and DTC (well, Cede) has an entry in the company’s database of shareholders of record. If you sell the stock, your broker takes it out of your account (at your broker), and DTC takes it out of your broker’s account (at DTC), and DTC adds it to the buyer’s broker’s account (at DTC), and the buyer’s broker adds it to the buyer’s account (at the buyer’s broker). As far as the company is concerned, Cede owned the stock the whole time.
If this all makes your head hurt, you are not alone. Sometimes it makes DTC’s head hurt too, and it needs to lie down for a while in a dark room and listen to soothing music. DTC calls this a “chill.” I am not kidding. 3 So when there’s a merger that’s about to close, it’s too crazy for DTC to both keep track of trades and deal with getting the merger payment to shareholders. So DTC will place a chill on the stock, and just not record trades for the three days leading up to the closing. From Wednesday’s opinion 4 :
DTC placed “chills” on its records for its participants’ positions in Dole common stock as of the close of business on November 1. A “chill” restricts a participant’s ability to deposit or withdraw the security. Once DTC initiated the chills, the participants’ positions in Dole common stock were locked in and could not change.
Nov. 1, 2013, was the closing date, 5 but the chill effectively covered the three previous days:
DTC’s centralized ledger did not reflect all of the trades in Dole common stock on the day of the merger or during the two days preceding it. Under the current standard of T+3 for clearing trades, DTC did not receive information about all of the transactions that took place on October 30, October 31, or November 1.
This doesn’t actually mean that you couldn’t trade Dole stock in the three days leading up to the merger closing. You could, and lots of people did. About 32 million shares traded in those last three days. 6 It just means that DTC doesn’t want to hear about it. DTC was chilling. Instead:
The DTC participants who facilitated transactions that had not yet cleared when the merger closed were responsible for properly allocating the merger consideration among the parties to the transactions.
As far as DTC was concerned, whoever owned shares as of the close on Oct. 29 owned the shares at the time the merger closed. If you sold your shares after that time, your broker and the buyer’s broker — the DTC participants — had to sort that out themselves.
You can see why this would be a problem for the current Dole lawsuit. If you owned a share of Dole stock as of Oct. 30, DTC thinks you owned it at closing. If you sold the share to me on Oct. 31, my broker (and your broker) thinks that I owned it at closing. It’s just one share, but it has turned into two shares as far as “facially eligible” claims go. 7 This is a weird problem: If you owned the stock on Oct. 30, and then sold it before the closing, you’re kind of a jerk for submitting a claim pretending that you owned the stock at closing. 8 But this all happened a pretty long time ago and maybe you forgot.
Fortunately this problem is solvable. The solution is simultaneously trivial and extremely difficult. The key thing to realize is that those trades in the last three days happened, and somehow the original merger consideration — the $13.50 a share paid on Nov. 4, 2013 — found its way to the people who really owned the stock at the end of Nov. 1. DTC might not have had a complete and up-to-date list of them, but DTC’s participants had mechanisms to get the money to the right place. (Intuitively: If Broker A sold shares to Broker B on Oct. 31, DTC would send the merger money to Broker A on Nov. 4, and Broker A would pass it along to Broker B, etc.) Whatever voodoo they did back then, they could probably do again. The problem of distributing the $2.74 can be reduced to a previously solved problem, the problem of distributing the $13.50. So it is trivial.
It’s also kind of hard, in that the brokers have to go back and figure out who actually owned the shares at the time, but that’s their problem. The Delaware vice chancellor concludes that for him to figure out who actually owned the shares, or for the lawyers to figure it out, “would be lengthy, arduous, cumbersome, expensive, and fundamentally uncertain,” and “functionally impossible” to do “in a practical or cost-effective manner.” That sounds hard! So the lawyers suggested, and the judge approved, letting the brokers figure it out instead:
Under this method, it will be up to the DTC participants and their client institutions to resolve in the first instance any issues over who should receive the settlement consideration. Shifting the burden to them is efficient because they already had to address these issues for purposes of allocating the merger consideration. If new issues arise, the DTC participants and their client institutions have access to their own records, and they have visibility into the terms of their contractual relationships, such as the terms on which shares are borrowed. Any ensuing disputes are between the beneficial owners and their custodial banks and brokers. Those disputes should be resolved pursuant to the contractual mechanisms in the governing agreements or, if necessary, through a judicial proceeding limited to the parties.
There might be lots of issues, but they won’t be the court’s problem. Good solution.But there is another problem that created extra Dole shares. This is also a mess, but not a pointless one. It’s a real economic issue, and also one that people seem to get emotional about. It is: short-selling.
Some quick background. The way short-selling works is:
- Mr. A owns a share of stock.
- Mr. B borrows Mr. A’s share of stock.
- Mr. B sells the share to Mr. C.
But now Mr. A and Mr. C each own one share of stock. Where there was only one share, now there are two. A “phantom share” has been created. Well, not really. The trick to balancing the books is to remember that Mr. B owes Mr. A a share of stock. So Mr. B now owns negative one share of stock. There’s a total of one share: one for A, and one for C, and negative one for B. One plus one minus one is one. It’s no problem. 9
“But what if …,” you start to ask, and I reply: Shh, shh. It just works. What if the company pays a dividend? Well, Mr C. physically possesses the share — don’t think too hard about that metaphor — so the company pays the dividend to Mr. C. But Mr. A also owns the share, and he wants the dividend too. But it’s OK, because Mr. B owns negative one share, so he has to pay a dividend. So he pays the dividend to Mr. A. 10 In practice, this is all intermediated through brokers, and Mr. A is unlikely to ever find out that his share was borrowed or that he got his dividend from Mr. B. For Mr. A, the whole thing just works quietly and seamlessly. It’s magic.What if the company is acquired in a management buyout for $13.50 in cash? Same thing. The company sends $13.50 to Mr. C. Mr. B sends the $13.50 to Mr. A. The two owners of the one share of stock each get the full $13.50 merger price for that one share of stock. Mr. B, who is short one share of stock, pays one merger price. Everything works. 11 It just works. It’s still magic.
What if the company is acquired in a management buyout for $13.50 in cash and then, three years later, a court adds another $2.74 in cash to the merger price? Same … wait. I have no idea. The magic might break down here. As the court points out:
The shorting resulted in additional beneficial owners who received the merger consideration, who fell within the technical language of the class definition, and who could claim the settlement consideration. Meanwhile, the lenders of the shares, not knowing that the shares were lent, also could claim the settlement consideration. This is another means by which two different claimants could submit facially valid claims for the same underlying shares.
That’s basically true of the original merger consideration, too. There, brokers would owe merger consideration to people who owned more shares than actually existed, and they’d go get that extra consideration from the short sellers. Everything balanced out. Maybe that will happen here too. But it’s harder. If you were short Dole Food stock on Nov. 1, 2013, you were doing it in an account with a broker. You posted collateral in that account. When it came time to collect the $13.50 from you, the broker had no problem collecting it. But that was three years ago. If the broker comes back to you now for the extra $2.74, you might feel entirely within your rights to reply “new phone who dis?” You might not have an account with that broker any more. You might not even exist any more. (People die; hedge funds close.) You certainly haven’t been posting collateral against your Dole Food short position for the last three years. That position was closed out ages ago.
Anyway this could account for millions of the phantom shares:
As of October 31, 2013, traders had shorted approximately 2.9 million shares of Dole common stock. Because the price of Dole common stock traded above the merger price through closing, it is likely that traders shorted additional shares on November 1, resulting in even more shares in short positions as of closing.
So that’s a fun one! I don’t know how the brokers will deal with this problem, but I will just quote the court and say: “Any ensuing disputes are between the beneficial owners and their custodial banks and brokers.” Let us wash our hands of them.
Isn’t this such a delightful muck? As Vice Chancellor Laster writes:
This problem is an unintended consequence of the top-down federal solution to the paperwork crisis that threatened Wall Street in the 1970s. Through the policy of share immobilization, Congress and the Securities and Exchange Commission addressed the crisis using the 1970s-era technologies of depository institutions, jumbo paper certificates, and a centralized ledger.
It’s enough to drive even a sensible vice chancellor to talk about blockchains 12 :
Distributed ledger technology offers a potential technological solution by maintaining multiple, current copies of a single and comprehensive stock ownership ledger. The State of Delaware has announced its support for distributed ledger initiatives.
I want to push back on that a little. There are two problems in this case. One is mechanical: figuring out who actually owned Dole stock as of the closing date three years ago. A blockchain would presumably solve that problem, without requiring the court and the lawyers to embark on a “lengthy, arduous, cumbersome, expensive, and fundamentally uncertain” dive through the records to figure out who owns what. But the current system also solves the problem, without requiring the court and the lawyers to do anything arduous or expensive. They just send the problem off to the current ledgering system — DTC and the custodian brokers and so forth — and that system deals with it. It’s like a blockchain, only it’s made up of hundreds of humans and computer systems at dozens of banks, glued together in a way that somehow more or less works. It’s not even expensive. “DTC advised class counsel that this process is feasible and requires payment of a base fee to DTC of $2,250, with the potential for additional consultation fees if difficulties arise.” 13 That’s like 0.002 percent of the amount being distributed. It does seem like a half-competent blockchain would be faster and cheaper and more transparent. But the idea that the current system can’t solve this problem is wrong. The current system can solve it fine. Just not in a way that any individual human can see or understand. The solution is, let’s say, distributed.
The other problem is economic: People owned more Dole shares than actually existed, because they bought them from short sellers, and now if you want to pay off all the owners, you have to track down the short sellers to make them pay up. That problem is hard, and it seems like the current system might have real problems with it: If the short sellers died, or went out of business, or closed their accounts, or just really don’t want to pay some extra merger consideration three years after the fact and yell a lot when their brokers ask them to, then the brokers will have a hard time finding all the money. Would a blockchain fix this? I don’t know. A blockchain would make it easy to identify the short sellers, three years later. (That’s what blockchain immutability is good for.) But then what? They could still have died, or closed their accounts, or yell.
But, sure, Delaware, and Vice Chancellor Laster, are not wrong that a distributed ledger system to keep track of who owns what shares in real time would make all of this a lot easier. 14 And I can see why Delaware is thinking about it. This is not the first time we have talked about the antique goofiness of the current system, and how it messes with mergers. Dell Inc. also did a management buyout, and a Delaware court also found that its shareholders should have gotten paid more. But some of those shareholders who should have gotten paid more didn’t, because of two separate failures to grapple with the convoluted registry system. (Some of them failed to own their shares the right way. Others failed to vote them the right way. Neither was entirely the investors’ fault.) That system has worked pretty well for 40 years. But it is starting to show its age. There are little cracks that give us brief glimpses of the abyss below. Why not cover them up with a fresh, cool coat of blockchain?
- I’m eliding some details here. The 2015 decision combined class action and appraisal claims for a class including all of the Dole shareholders other than Murdock and his affiliates. That was a total of about 54.1 million shares. “This decision likely renders the appraisal proceeding moot,” the vice-chancellor found then. But the subsequent class-action settlement excluded the appraisal claimants, who had their own lawyers and took care of themselves separately. They had about 17.3 million shares. The other 36.8 million shares, covered by the class action, are what we’re talking about here. Their payout comes to about $115.8 million, including interest (but before deducting attorneys’ fees).
- They did kick out 48,758 shares after double-checking.
- I mean, I am about the lying down in a dark room with soothing music. But not about the “chill.”
- Citation omitted.
- It was a Friday; the merger consideration was paid out on Monday, Nov. 4.
- Most of them in the last two days. By comparison, the average daily volume over the previous year was about 1.3 million shares.
- From the opinion:For purpose of the settlement, multiple owners could submit claims for shares involved in trades that had not cleared. A DTC participant who continued to hold the shares as reflected on DTC’s records could submit a claim, but so could the beneficial owner who was a client of the DTC participant that acquired the shares and therefore owned them as of closing. Both claims could appear facially valid even though they involved the same underlying shares.
- Though I mean I see your point. Murdock paid $13.50 in cash in the merger; the court ultimately found that he should have paid $16.24. If I owned the stock at the closing, I got $13.50, and am now entitled to get the extra $2.74. But if I bought it from you the day before the closing, I paid you about $13.55 (the closing price on Oct. 31). The extra $2.74 (or $2.69) is kind of a windfall to me. You, on the other hand, might have been a long-term shareholder who thought Dole was destined for great things, who voted against the underpriced merger, and who finally sold in disgust the day before it closed. In a real sense Murdock’s underpayment harmed you, not me. But, whatever, the deal is that the people who owned stock at closing are the ones who get the extra payment. And to be fair that was priced in: The stock closed at $13.55 the day before the merger closed, and a whopping $13.65 the Friday of the closing. And then the next Monday all those buyers got cashed out for $13.50, as they knew they would be. Presumably they only paid over the merger price because they thought they might get a second chance in court.
- People sometimes complain about “naked short selling” creating “phantom shares,” which they demonstrate by pointing to the fact that people own more shares of Company XYZ than there are shares outstanding. But this is no problem at all, is true of every company, and has nothing to do with naked short selling. “Naked” short selling means selling stock short without borrowing it. That is mostly illegal. It would indeed create “phantom shares.” But so does regular, clothed short selling. Either way, the trick is that the person doing the short selling — naked or otherwise — now owns a negative number of shares, which precisely balances out the “phantom shares” that the short selling creates.
- This is covered by Section 8 of the Master Securities Loan Agreement. But for our purposes let’s just pretend it happens by the operation of magic.
- This also seems to be covered by Section 8 of the MSLA, though … less clearly? Everyone seems to think it works, though.Again this all happens through DTC, brokers, etc. Like realistically what happens is:
- There are like 1000 shares outstanding.
- The company pays $13,500 to Cede & Co.
- DTC looks at its books and sees that Broker X owns 100 shares.
- Cede pays $1,350 to Broker X.
- Broker X looks at its books and sees that it has customers who own 150 shares, and other customers who are short 50 shares.
- Broker X bills those short customers for $675.
- Broker X takes that $675 from the shorts, and the $1,350 from Cede, and gives it to the long customers.
- Everything checks out.
- Albeit in a footnote.
- The lawyers “have budgeted $10,000 for additional consultations.”A de- centralized ledger to keep track of who owns what shares in real time would solve these issues. (The move to T+2 settlement will also help) The key thing is updating the share registry in real time on the blockchain.