Wonderful Monetary Policy and Beautiful Deleveragings

Doug Nolan

“Generally speaking (depending on the country), it is appropriate for central banks to lessen the aggressiveness of their unconventional policies because these policies have successfully brought about beautiful deleveragings. In my opinion, at this point of transition, we should savor this accomplishment and thank the policy makers who fought to bring about these policies. They had to fight hard to do it and have been more maligned than appreciated. Let’s thank them.” Ray Dalio, July 6, 2017

I find his choice of words inflammatory, but I guess when you’re worth $16.8bn (Forbes) you can write what and how you please. In past CBBs I took strong exception with Ray Dalio’s “beautiful deleveraging” thesis. Data these days speak incontrovertibly to the fact that from a systemic standpoint there has been a huge accumulation of additional debt – at home and globally. The notion of deleveraging is a myth. It is the unprecedented inflation of “money” at the very foundation of global finance that is real. As for “wonderful monetary policy,” at best the jury’s still out. I’ll be shocked if we look back in five or ten years and tag this period’s monetary management in a positive light.

Dalio is somewhat of an enigma. Highly intelligent and hugely successful in the markets ($160bn hedge fund empire), he is one of this era’s foremost “deep thinkers”. I enjoy reading his analysis and share his concerns for social and geopolitical instability. But I see flawed monetary management - and resulting Bubbles/busts and wealth redistribution/destruction - as a major agent to these instabilities. Dalio sees “wonderful monetary policy” as a positive force, while I see radical policy experimentation with disastrous consequences.

It’s what Dalio doesn’t address that I find most intriguing: How much financial sector leverage has accumulated over the past nine years of near-zero rates and unprecedented central bank market liquidity injections and backstopping? How has the expansion of global financial sector leverage (including central bank balance sheets and speculative leveraging) distorted traditional indicators of systemic stability – such as corporate and household debt, debt service capacity and market risk premia.

Monetary policy and associated financial leveraging have significantly reduced debt service burdens for going on a decade, in the process lessening overall debt growth for households and businesses alike. I would also argue that Trillions of liquidity injections into the markets have flowed into real economies, again working to mitigate private-sector debt accumulation. The massive inflation of central bank and government balance sheets has indeed improved the outward appearance of private-sector finances. This has superficially “brought about balance sheet repairs” for traditional weak-link household and corporate borrowers. I’m just not convinced these remain the most germane structures for gauging global Bubble systemic fragilities.

Dalio has been a hedge fund “risk parity” pioneer. “Risk parity is a portfolio allocation strategy based on targeting risk levels across the various components of an investment portfolio… Risk parity considers four different components: equities, credit, interest rates and commodities, and attempts to spread risk evenly across the asset classes. The goal of risk parity investing is to earn the same level of return with less volatility and risk, or to realize better returns with an equal amount of risk and volatility…” (Investopedia).

Few strategies have so greatly benefited from nine years of radical monetary management. A portfolio of diversified asset classes (most notably equities, bonds and corporate Credit) - all enjoying simultaneous central bank-induced price inflation - has been a huge and surefire winner. The more leverage the better. And, importantly, no drag on performance from hedging or de-risking during recurring bouts of market instability, not with the inherent market “hedge” from managing a diversified portfolio with a significant bond component. It’s just been the best of all worlds.

“Wonderful Monetary Policy” has ensured that any successful strategy is inundated with financial inflows. Dalio’s Bridgewater has seen assets under management swell to $160 billion. Hundreds of billions more have gravitated to similar strategies. The proliferation of diversified multi-asset class strategies (leveraged and otherwise) has been a powerful force behind the synchronized inflation of prices for securities and corporate Credit across the globe. As central banks prepare to remove aggressive stimulus, I would expect many strategies that have enjoyed long (nine years!) and consistent success to now face significant challenges.

July 7 – Bloomberg (Dani Burger): “Hawkish signals from central bankers have punished stocks and bonds alike in the past week. Also punished: investors who make a living operating in several asset classes at once. They’ve been stung by the concerted selloff that lifted 10-year Treasury yields by 25 bps and sent tech stocks to the biggest losses in 16 months. Among the hardest-hit were systematic funds who -- either to diversify or maximize gains -- dip their toes in a hodgepodge of different markets all at the same time. Losses stand out in two of the best-known quant strategies, trend-following traders known as commodity trading advisers, and risk parity funds. CTAs dropped 5.1% over the past two weeks, their worst stretch since 2007, according to a Societe General SA database of the 20 largest managers. The Salient Risk Parity Index dropped 1.8%, the most in four months.”

Dalio: “Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered rather than increased—i.e., that the directions of policy are reversing so we are at a) the end of that nine-year era of continuous pressings down on interest rates and pushing out of money that created the liquidity-fueled moves in the economies and markets, and b) the beginning of the late-cycle phase of the business/short-term debt cycle, in which central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn. Recognizing that, our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.”

Fascinating analysis. “Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered… that the directions of policy are reversing… Our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.”

The problem is that tea leaves reading “head for the exits” risk inciting a stampede. These fund complexes and speculative strategies have become gigantic within an overall marketplace structure more vulnerable than ever. In what will now be a common theme, who will take the other side of the trade when the enormous “risk parity” crowd moves to de-risk. Who will have the wherewithal to step up and buy when asset prices across the board come under pressure? How quickly will perceived low-risk strategies face major redemptions when performance turns sour? This has become a systemic issue, recognizing the massive flows into equities, bonds and corporate Credit – with the ETF complex surpassing $4.0 TN of assets. There has never been anything similar to trend-following (speculative) finance so dictating market dynamics.

This is not some nebulous issue going unexplored by market players. There are, however, three key aspects to this issue that are unknowable – and have, to this point, been easily dismissed in the exuberance of a central bank-administered marketplace: First, how much leverage has been employed throughout the securities markets – in the U.S. and globally? Second, how much embedded leverage has accumulated in global derivatives markets? And third, what is the scope of market risk that has (or expects to be) offloaded to dynamically hedged derivatives trading strategies (that will be forced to sell into declining markets to hedge exposures)?

And a few thoughts on Dalio’s, “The beginning of the late-cycle phase of the business/short-term debt cycle, in which central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn.”

I have issues with such analysis. “Central bankers” trying to get things “exactly right”? The next downturn comes when they “don’t get it right”? Well, let’s not lose sight of the reality that central bankers are nine years into an unprecedented reflationary experiment. To this point, rightly or wrongly, they’ve orchestrated historic securities and asset market inflation. Yet central banks will at some point lose control of the global financial Bubble, at which time they will have fully lost control of inflation and growth dynamics. The notion that this continues so long as they “get it right” really suggests that central bankers must remain pro-Bubble.

It’s these days not difficult to explain how the structure of the U.S. household balance sheet appears in good shape (net worth approaching $100 TN!). The structure of the corporate balance sheet is surely solid as well, at least from the perspective of strong earnings and cash-flow. With rates so low and markets abundantly liquid, it’s easy to argue that the federal government balance sheet, while having ballooned massively, remains quite manageable. Conventional analysis, then, views the entire structure of the greater U.S. balance sheet as solid and immune to crisis dynamics.

Yet traditional analysis misses the prevailing vulnerability that emanates from this most unusual of Credit and Speculative Cycles: The Structure of Global Financial Market Risk. 
 
Central banks inflated an unprecedented market Bubble, slashing rates, adding Trillions of liquidity and repeatedly intervening to stem fledgling “Risk Off” Dynamics. Perceptions of low risk have over years stoked the accumulation of unprecedented systemic risk (including price, liquidity, Credit, counterparty, policy, economic, social, political, geopolitical and so on)

Over nine years, this has led to deeply embedded market misperceptions, perhaps most importantly that risk assets enjoy money-like attributes of liquidity and safety. Moreover, that central banks will ensure rising asset prices. These misperceptions have spurred Trillions of flows, with a major chunk jumping aboard the equity and fixed-income bull markets via the ETF complex.

Within the leveraged speculating community, hundreds of billions flowed into “risk parity,” CTAs (“a CTA fund is a hedge fund that uses futures contracts to achieve its investment objective”) and other trend-following strategies. Meanwhile, zero rates and central bank control over securities markets have ensured a derivatives boom like no other – derivatives to leverage securities, to employ international “carry trade” speculations, to exploit Credit spreads, to write myriad variations of market “insurance,” to hedge risk and to implement about whatever strategy imaginable.

I would posit that global market Bubbles today rest tenuously upon the false premise that central banks can get it right when it comes to managing market risk and liquidity. In reality, central banks have created an Unsustainable Market Structure with increasingly acute latent fragilities. It’s impossible to “get it right,” because Bubbles are by their nature unsustainable.

Today’s global Bubble works only so long as securities values continue to inflate. Market inflation is dependent upon unrelenting central bank stimulus and backstops. It will all falter badly in reverse. And all the “money” that has chased central bank-induced market returns – from “risk parity” to corporate bond and equity index ETFs to derivatives strategies – creates vulnerability to an abrupt shift in perceptions, followed by illiquidity and market dislocation.

Markets this week were again showing indications of vulnerability. Global yields remain on the rise. German bund yields jumped 11 bps to an 18-month high 0.57%. French yields rose 13 bps to 0.94%. The largest yield spikes, however, were at the “periphery.” Italian and Spanish 10-year yields surged 19 bps to 2.34% and 1.73% - with Italian yields near two-year highs.

It’s also worth noting that emerging bond markets faced increased selling (EM bond ETF down 1.3% this week). Local EM bond markets were under heavy selling pressure. Ten-year yields surged 28 bps in Turkey, 21 bps in Indonesia, 21 bps in Russia, 22 bps in Colombia, 12 bps in Brazil and 11 bps in South Africa. Dollar-denominated EM bonds were not spared. Yields rose 20 bps in Turkey, 19 bps in Argentina, 13 bps in Brazil, 12 bps in Mexico, 15 bps in Colombia and 10 bps in Russia.

July 6 – Bloomberg (Liz McCormick and Lananh Nguyen): “With yields surging across major economies as more central banks hint at joining the Federal Reserve in tightening policy, strategists are pointing to a likely loser: emerging-market currencies. The fallout is already being felt in the foreign-exchange market as investors eye the end of an era of unprecedented stimulus. An MSCI index of emerging-market currencies hovered near a seven-week low Thursday as yields on Treasuries and bunds rose to fresh highs. In 2006, the last time investors braced for steeper borrowing costs in the biggest economies, the index lost almost 5% of its value in a span of weeks, while developing-market stocks plunged.”

When it comes to Market Structures vulnerable after nine years of runaway global monetary stimulus, look no further than EM. Despite all the corruption, fraud, political turmoil and nonsense that one would anticipate from a prolonged period of egregiously easy “money,” finance has nonetheless flowed lavishly to EM (with its relatively high-yielding debt markets and growth opportunities). Over recent months, with blow-off dynamics enveloping risk markets worldwide, huge flows gravitated to EM. Much of this “money” was intermediated through the ETF complex. How much was purely trend-following?

While traditional analysis would look first to U.S. economic fundamentals (including household and corporate debt, earnings, employment and inflation) for indications of underlying market vulnerability, I would point instead to Global Market Bubble Dynamics – while reminding readers that the current backdrop is distinct to previous Bubble experiences. As such, market indicators this week at the periphery – EM as well as European – were flashing heightened susceptibility to de-risking/de-leveraging and the potential for liquidity challenges. Considering the enormity of recent flows, perhaps EM will provide an early test for the thesis of Market Structural Vulnerabilities.

Here at home, 10-year Treasury yields rose eight bps to 2.39%. In equities, there was more of this choppy topping-action rotation away from tech/high-flyers and into financials/laggards. Corporate debt markets are beginning to feel the strain of rising global yields. High-yield bond funds saw another $1.1bn of outflows, though investment-grade corporates are still attracting large inflows. The high-yield ETF (HYG) traded near a two-month low. Commodities, as well, seemed to support the thesis of fledgling “Risk Off” and waning liquidity. With crude down almost 4%, the GSCI Commodities Index dropped 1.8%. Copper fell 2.4% and gold lost 2.3%. But it was wild trading in silver (down 7.2%) that might have provided a harbinger of more general market liquidity issues to come.

That Treasuries, equities, corporate Credit and commodities all seem to be indicating a (thus far subtle) shift in market liquidity, we can look to “risk parity” - and similar multi-asset class strategies that incorporate leverage – as a possible weak link in a Vulnerable Global Market Structure. And we’re supposed to savor this moment and pay a debt of gratitude to courageous central bankers? Strange world.


Additive manufacturing

3D printers start to build factories of the future

Recent advances make 3D printing a powerful competitor to conventional mass production
 
SLOWLY but surely the sole of a shoe emerges from a bowl of liquid resin, as Excalibur rose from the enchanted lake. And, just as Excalibur was no ordinary sword, this is no ordinary sole. It is light and flexible, with an intricate internal structure, the better to help it support the wearer’s foot. Paired with its solemate it will underpin a set of trainers from a new range planned by Adidas, a German sportswear firm.

Adidas intends to use the 3D-printed soles to make trainers at two new, highly automated factories in Germany and America, instead of producing them in the low-cost Asian countries to which most trainer production has been outsourced in recent years. The firm will thus be able to bring its shoes to market faster and keep up with fashion trends. At the moment, getting a design to the shops can take months. The new factories, each of which is intended to turn out up to 500,000 pairs of trainers a year, should cut that to a week or less.

As this example shows, 3D printing has come a long way, quickly. In February 2011, when The Economist ran a story called “Print me a Stradivarius”, the idea of printing objects still seemed extraordinary. Now, it is well established. Additive manufacturing, as it is known technically, is speeding up prototyping designs and is also being used to make customised and complex items for actual sale. These range from false teeth, via jewellery, to parts for cars and aircraft. 3D printing is not yet ubiquitous. Generally, it remains too slow for mass production, too expensive for some applications and for others produces results not up to the required standard. But, as Adidas’s soles show, these shortcomings are being dealt with. It is not foolish to believe that 3D printing will power the factories of the future. Nor need the technology be restricted to making things out of those industrial stalwarts, metal and plastic. It is also capable of extending manufacturing’s reach into matters biological.

Adding it up
 
There are many ways to print something in three dimensions, but all have one thing in common: instead of cutting, drilling and milling objects, as a conventional factory does, to remove material and arrive at the required shape, a 3D printer starts with nothing and add stuffs to it. The adding is done according to instructions from a computer program that contains a virtual representation of the object to be made, stored as a series of thin slices. These slices are reproduced as successive layers of material until the final shape is complete.

Typically, the layers are built up by extruding filaments of molten polymer, by inkjet-printing material contained in cartridges or by melting sheets of powder with a laser. Adidas’s soles, however, emerge in a strikingly different way—one that is, according to Joseph DeSimone, the result of chemists rather than engineers thinking about how to make things additively. Dr DeSimone is the boss of Carbon, the firm that produces the printer which makes the soles. He is also a professor of chemistry at the University of North Carolina, Chapel Hill.

Carbon’s printer uses a process called digital light synthesis, which Dr DeSimone describes as “a software-controlled chemical reaction to grow parts”. It starts with a pool of liquid polymer held in a shallow container that has a transparent base. An ultraviolet image of the first layer of the object to be made is projected through the base. This cures (ie, solidifies) a corresponding volume of the polymer, reproducing the image in perfect detail. That now-solid layer attaches itself to the bottom of a tool lowered into the pool from above. The container’s base itself is permeable to oxygen, a substance that inhibits curing. This stops the layer of cured polymer sticking to the base as well, and thus permits the tool to lift that layer slightly. The process is then repeated with a second layer being added to the first from below. And so on. As the desired shape is completed, the tool lifts it out of the container. It is then baked in an oven to strengthen it.

Dr DeSimone says that digital light synthesis overcomes two common problems of 3D printing.

First, it is up to 100 times faster than existing polymer-based printers. Second, the baking process knits the layers together more effectively, making for a stronger product and also one that has smooth surfaces, which reduces the need for additional processing.

All this, he reckons, makes digital light synthesis competitive with injection moulding, a mass-production process which has been used in factories for nearly 150 years. Injection moulding works by forcing molten plastic into a mould. Once the plastic has solidified, this mould opens to eject the part. Injection moulding is fast and extremely accurate, but making the moulds and setting up the production line is slow and expensive. Injection moulding is therefore efficient only when making thousands of identical things.

The usual economies of scale, however, barely apply to 3D printers. Their easy-to-change software means they can turn out one-off items with the same equipment and materials needed to make thousands. That alters the nature of manufacturing. For example, instead of having vast warehouses packed with spare parts, Caterpillar and John Deere, two American producers of construction and agricultural equipment, are working with Carbon on moving their warehouses, in effect, to the online cloud, whence digital designs can be downloaded to different locations for parts to be printed to order.

Printers made by established producers are improving, too. They are speeding up, enhancing quality and printing more colours and in a wider variety of polymers, including rubbery materials. Two of the biggest firms in the business, 3D Systems and Stratasys, were joined last year by a third American company when HP, well known for conventional printers in offices, entered the market with a range of 3D plastic printers costing from $130,000. According to the latest report by Wohlers, a consultancy, the number of firms manufacturing serious kit for 3D printing (ie, not hobby printers, but systems priced from $5,000 to $1m and more) rose to 97 in 2016 from 62 a year earlier. Nor is purchase always necessary. Whereas many producers sell their machines outright, Carbon follows a “software” model and leases them to customers at a price starting from $40,000 a year. And, like software firms, it updates its machines over the internet.

New metallica
 
Printing polymers, which have low melting-points and co-operative chemistry, is reasonably easy.

Printing metals is another matter entirely. Metal printers use either lasers or electron beams to reach the temperatures needed to melt successive layers of powder into a solid object. This takes place in multiple stages: depositing the powder, spreading it and, finally, fusing it.

Such printers can produce extremely intricate shapes, but may need to run for several days to make a single item. For high-end components used in low-volume products, such as supercars, aircraft, satellites and medical equipment, this can, nevertheless, be worth the wait. 3D printing, which is able to create voids inside objects far more easily than subtractive manufacturing can manage, increases the range of possible designs. There are cost savings, too. Addition, which deposits metal only where it is needed, generates less scrap than subtraction. That saving matters. Many of the specialist alloys used in high-tech engineering are exotic and expensive.

These advantages have been enough to persuade GE, one of the world’s biggest manufacturers, to invest $1.5bn in 3D printing. In Auburn, Alabama, for example, the firm has spent $50m on a factory to print fuel nozzles for the new LEAP jet engine, which it is building with Safran of France. By 2020, the plant in Auburn should be printing 35,000 fuel nozzles a year.

A kilo saved is a trophy won


Each LEAP uses 19 nozzles, which have new features, such as complex cooling ducts, that GE says can be created in no other way. The nozzles are printed as single structures instead of being welded together from 20 or more components as previous versions were. The new nozzles are also 25% lighter than older designs, which saves fuel. And they are five times more durable, which reduces servicing costs.

More such developments are coming. GKN Aerospace, a British firm, recently signed a five-year agreement with Oak Ridge National Laboratory, in Tennessee, to find new ways to print large structural aircraft parts in titanium. The intention is to reduce waste material by as much as 90% and to cut assembly time in half.

Existing metal printers can be as big as a car, and some cost $1m or more. What, though, might companies achieve if they had smaller, cheaper metal printers? Ric Fulop thinks he can make such machines. Mr Fulop is the boss of Desktop Metal, a firm he co-founded in 2015 with a group of professors from the Massachusetts Institute of Technology and nearly $100m in cash from investors that include GE, Stratasys and BMW. The firm’s first printers are now coming to market.

Instead of zapping layers of powder with a laser or an electron beam, Desktop Metal’s machines use a process called bound-metal deposition. This also involves a bit of cooking. First, the machine extrudes a mixture of metal powder and polymers to build up a shape, much as some plastic printers do. When complete, the result goes into an oven. This burns off the polymers and compacts the metal particles by sintering them together at just below their melting point. The outcome is a dense metallic object, rather like one that has been cast the old-fashioned way as a solid chunk of metal. The sintering causes the object to shrink. But this can be compensated for by printing it a little larger than required, because the shrinkage occurs in a predictable way.

Desktop Metal makes two sorts of machine. Its Studio system, priced at around $120,000, is designed for prototypes and small production runs. A full-scale system costs just over $400,000. By incorporating a conventional metal printer’s multiple production stages into a single “sweep” of the print head, Desktop Metal’s machines are fast. According to Mr Fulop, they can build and bake objects at the rate of 500 cubic inches (8,194cm3) an hour. That compares with about 1-2 cubic inches with a conventional laser-based metal printer, or 5 cubic inches with an electron-beam machine.

On top of all this, because the materials used by Desktop Metal’s printers are already employed in other industrial processes they are, according to Mr Fulop, 80% cheaper than some specialist 3D-printing powders. And they require less finishing to remove rough surfaces. Improvements such as these can change the economics of manufacturing.

Printing a bit of you
 
One of the earliest adopters of additive manufacturing was the medical industry. For good reason; everybody is different, and so, therefore, should be any prosthetics they might need. As a result, millions of individually sculpted dental implants and hearing-aid shells are now printed, as are a growing number of other devices, such as orthopaedic implants. The big prize, however, is printing living tissue for transplants. Though this idea is still largely experimental, several groups of researchers are already using bioprinters to make cartilage, skin and other tissues.

Bioprinters can work in several ways. The simplest use syringes to extrude a mixture of cells and a printing medium, a method similar to that used by a desktop printer in plastic. Others employ a form of inkjet printing. Some medical researchers are trying a form of 3D printing called laser-induced forward transfer. In this, a thin film is coated on its underside with the material to be printed. Laser-pulses focused onto the film’s upper surface cause spots of that material to detach themselves and land on a substrate below. Sometimes, though, the third dimension needs a helping hand. Certain printers therefore impose the desired shape by printing cells directly onto a pre-prepared scaffold, which dissolves away once the cells have proliferated sufficiently to hold their own shape.

Anthony Atala and his colleagues at the Wake Forest Institute for Regenerative Medicine, in North Carolina, have printed ears, bones and muscles in this way, and have implanted them successfully into animals. The crucial part of the process is ensuring the printed tissue survives and then integrates with the recipient when transplanted. Some types of tissue, such as cartilage, are easy to grow outside the body. Infusing nutrients into the medium they are kept in is sufficient to sustain them, and they tend to take well when transferred to a living organism.

More complex structures, though, like hearts, livers and pancreases, require a blood supply to grow beyond being tiny slivers of cells. Dr Atala and his colleagues therefore print minute channels through their structures, to let nutrients and oxygen diffuse in. This encourages blood vessels to develop. The next step, probably within a few years, will be to test such bioprinted material on people.

All clever stuff. But what was missing in bioprinting, reckoned Erik Gatenholm and Hector Martinez, two biotechnology entrepreneurs, was some form of standardised “bio-ink”. So, in January 2016, they founded a firm called Cellink to commercialise bioprinting materials developed at the Chalmers University of Technology, in Gothenburg, Sweden.

Cellink’s ink is made from nanocellulose alginate, a biodegradable material containing wood fibres and a sugary polymer found in seaweed. Researchers first mix their cells into the bio-ink and then extrude the result as a filament from which the desired shape is constructed. The company has gone on to develop tissue-specific bio-inks that contain growth factors needed to stimulate particular types of cells, including stem cells. These are cells that can proliferate to produce any of the cell types that form a particular tissue. If the stem cells in question are obtained from the patient into whom the transplant will later be inserted, that will reduce the risk that the transplant will be rejected.

In addition to making bio-ink, Cellink has also launched its own range of printers. These are sold at a discount to universities in return for research feedback. That provides a good picture of what is going on. In particular, says Mr Gatenholm, advances are being made in printing tissues for drug testing.

One is to employ a patient’s own cancer cells to print multiple versions of his tumour. Each can then be challenged with a different drug, or mixture of drugs, to help determine what treatment will work best. For actual transplantation, Mr Gatenholm suggests that cartilage, followed by skin, are likely to be the first tissues printed for such use. Organs that need blood vessels will follow.

Bioprinting, then, looks set to become a new manufacturing industry—albeit one located at medical centres and operating in sterile conditions that more resemble a laboratory than a production plant.

But even the less esoteric forms of 3D printing, those involving plastics and metals, will transform what a factory is. The 3D print shops of the future will still have some workers. But those will mainly be hardware and software engineers. And they are more likely to be wearing white coats rather than overalls.


Lasting Questions from Hamburg

Was the G-20 Summit Really Worth It?

By Florian Gathmann and Philipp Wittrock
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REUTERS Chancellor Angela Merkel and Hamburg Mayor Olaf Scholz with G-20 security personnel



The Hamburg summit is over. Overshadowed by the violence on the streets outside, Angela Merkel and the rest of the G-20 leaders managed to find mini-compromises on major issues.

But the question remains: Was it worth it?

Unfettered violence. Unbridled brutality. Outside our democratic community. When Angela Merkel held her closing address on Saturday afternoon at the G-20 summit in Hamburg, she used clear words to denounce what had taken place on the streets of Hamburg during the preceding day and night.

Cars and barricades ablaze, shops plundered, water cannons in constant operation, injuries, devastated city quarters, heavily armed special police units: The images of the violence in Hamburg have circled the globe. And they stood in stark contrast to those of the 20 heads of state and government who, at the same time, were listening to Beethoven's "Ode to Joy" in Hamburg's chic new Elbphilharmonie concert hall. Classical music inside, clashes outside.

The question that must now be asked, which the chancellor must also answer, is this: Was it all worth it? Or was the price too high?

At first glance, the political results and messages presented by the club of global economic powers leave room for doubt. The arduously negotiated closing declaration is so weakly formulated that, as usual, all participating countries can live with it. (Click here for the full declaration.)
  • Trade: The G-20 declares its opposition to protectionism. But it is still not a clear commitment to free trade. In the declaration, unfair trade practices are criticized and the "role of legitimate trade defense instruments" is recognized, the latter being a concession to U.S. President Donald Trump's tendency to further isolate his country. But it is not clarified what unfair trade practices might be, nor are trade defense instruments further elucidated. And the steel dispute with the U.S. has been postponed to a later date.

  • Climate: On climate protection, the G-20 essentially agreed that they don't agree. The end result was 19 to 1 when it came to the express commitment in favor of the Paris climate agreement. The U.S. is the odd country out. But shortly after the end of the summit, Turkish President Recep Tayyip Erdogan indicated that his country had no intention of ratifying the Paris climate agreement, even if he signed his name to the G-20 closing declaration.

  • The Fight against Terror: The G-20 countries intend to work more closely together to fight terrorism, with the goal of putting a stop to the financing of extremists as well as their propaganda on the internet and their communication among themselves. Companies, law enforcement agencies and international finance organizations are to deepen their cooperation to better uncover transactions aimed at financing terrorism.

  • Supporting Women in Developing Countries: A pet project of Donald Trump's, because it was initiated by his daughter Ivanka. Around 300 million euros will be made available for micro-loans to assist women in developing nations build up their own businesses and escape poverty. Ahead of the summit, Merkel too threw her support behind the project.
The results hardly constitute a debacle. But they aren't a breakthrough either. Merkel nevertheless expressed satisfaction with the results. With Trump now in the White House, which has made progress on many issues more difficult, Merkel had sought to lower expectations ahead of the summit. Still, government officials remain convinced that such large-scale meetings are worth the effort - and worth the massive security measures necessary, even if they weren't able to prevent excessive violence in this case.

And despite the massive, and partly justified, criticism levied against it, the G-20 forum does have value. When so many heads of state and government come together, alliances become possible on all manner of different political issues while pressure can be exerted on others - even if, as the case of Trump shows, it doesn't always work. Such events also provide the opportunity for personal discussions on the sidelines.

A Few Nice Words

Who knows, for example, when and under what circumstances Donald Trump and Russian President Vladimir Putin would otherwise have met. In Hamburg, they ended up talking for so long that they almost missed the concert at the Elbphilharmonie concert house. Their conversation even produced a ceasefire in southern Syria, even if it had actually been negotiated previously.

Trump had a few nice words for the chancellor on Saturday. "It's been really incredible the way things have been handled and nothing's easy, but so professionally, without much interruption despite quite a few people, and they seem to follow your G-20s around," Trump said.

Merkel, though, can't afford to be quite as light-hearted about the riots as the American president. She had hoped, with German elections approaching in just over two months, that the summit would produce a few nice images - not unlike the images from the 2015 G-7 meeting in Bavaria, with the stunning Alps in the background. Following that meeting, she was accused of isolating herself from the people - so this time she resolved to host the leaders of the world's most powerful economies in the heart of a big city. But did it have to be Hamburg, a metropolis notorious for its active left-wing radical scene? On the other hand, why should the state buckle in the face of predictable militancy from summit opponents?

A Campaign Issue

These are the questions that the chancellor must now face, right in the middle of her re-election campaign. She can't duck responsibility. But then, neither can her primary opponents from the Social Democratic Party (SPD). Hamburg's Mayor Olaf Scholz, after all, is a member of the SPD. And his assurance in the run up to the G-20 summit - "Don't worry, we can guarantee your safety" - has already entered the pantheon of misguided political pledges in Germany.

It's no wonder, then, that representatives of the SPD and of Merkel's conservatives have been trying to outdo each other in condemning the violence that took place. Merkel's Chief of Staff Peter Altmaier has referred to it as "left-wing extremist terror" while Martin Schulz, the former European Parliament president who is running as the SPD's candidate for chancellor, called the rioters "murderous arsonists."

The chancellor, for her part, sought on Saturday to assuage the anger of those affected by the violence. Together with the city of Hamburg, she announced, the Finance Ministry will come up with a plan to quickly and straightforwardly help victims repair the damage.

lunes, julio 10, 2017

JAPANESE EXCEPTIONALISM / GEOPOLITICAL FUTURES

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Japanese Exceptionalism

By George Friedman


Japan is a quiet place, at least from a geopolitical standpoint. It makes few political demands on other nations, and no military ones. Article 9 of its constitution forbids it from maintaining any military force. Article 9 has been reinterpreted to mean that it can maintain a substantial military for self-defense, under the principle that self-defense is a natural right, but that force cannot engage in offensive military operations – and it certainly can’t do so unilaterally. Since its banking crisis in the late 1980s and early 1990s, global financial markets have expected that Japan will face a financial crisis that will create domestic upheaval. It hasn’t happened. Instead, Japan grows slowly and sometimes not at all, but compared to much of the rest of the world, it is seemingly at peace with itself.

It has not always been this way. In the first half of the 20th century, Japan sought to take control of the Western Pacific and China. It had defeated the Russian navy in 1905, and then challenged the United States and European powers in the Pacific. It temporarily claimed an empire in China and in the littoral islands of Asia, ranging from Taiwan to the Dutch East Indies to the gates of India. This lasted for only three years, but for the first part of those years it appeared that Japan had permanently reshaped the balance of power in the Pacific and in Asia.

Nor was it a quiet power in the decades leading to its economic crisis. Japan was the China of the 1960s, 1970s and 1980s, paying low wages and enjoying remarkable growth. The Japanese were well educated and experienced in industrial processes, and the process of rebuilding Japan’s economy kicked off a wave of low-cost exports that flooded Western, and particularly American, markets. During the 1980s, this created substantial political crises with Japan, with Americans seeking both to limit Japanese exports and to emulate Japanese management techniques, and the Japanese clinging to free trade principles and hinting that the problem with American workers was that they were lazy.

The Japanese surged into American markets, dominating many, until the economics of high exports took their toll on the rate of return on capital. Huge exports and diminishing profits can go hand in hand.

Internally, Japan wasn’t at peace for most of the 20th century either. After World War I, the Japanese army became a political force and sought to control foreign and domestic policy, tied to an ideology that purported to represent the military ideas of historical Japan. Whether that was true or not, Japanese internal politics were poisonous in between the two world wars, with assassinations, coups and threats. It was as far from contemporary Japan as posible.

Unique Adaptability

Japan is remarkable for its ability to change its behavior. It did so after its surrender in 1945 and was thoroughgoing in almost every respect. But this wasn’t the first time it had remade itself. In the 1850s, when Europe and America were probing the country, Japan lacked any powered tools. It was an agrarian society of farmers and craftsmen, with clans waging a perpetual war of all against all while their leaders engaged in endless political maneuvering. Japan seemed ripe for the picking by Western imperialism.

Between 1860 and 1900, Japan transformed itself even more radically than the United States had. It went from being a war-torn agrarian country to a rapidly industrializing one, with a navy that it purchased from Britain and an army trained by Germans. It absorbed the technology and the knowledge of the Europeans to build a navy that defeated the Russians in 1905 and that challenged the world for control of the Pacific. The speed with which Japan industrialized was stunning. Equally stunning was the political shift from barons who ruled themselves to a centralized government under the guardianship of an emperor, who, although considered a descendent of a goddess, was not decisive until industrialization required national unity and a symbol. Politics continued, but the country united, overcoming regional differences sufficiently that a modern national government could be created.

In 1945, Japan underwent its second massive change in less than a century. It shifted from being an aggressive power, politically dominated by the military, to being institutionally opposed to a military-based foreign policy. With the military banished from political life, Japan adopted a liberal democracy.

This is worth repeating. In less than 100 years, Japan went from an economically backward but culturally advanced nation on the edge of the world, to a nation that challenged everyone around it, to a peaceful mercantile state. What is most important here is that for all the changes and all the political friction, it did this without any significant social upheaval.

Industrial Feudalism

The Industrial Revolution in England accompanied the decline of power of the nobility and the rise of industrial and commercial power, along with the rise of demands from the masses for social adjustment and political participation. France did the same, with the addition of Maximilien Robespierre’s Reign of Terror. Russian industrialization involved this plus a holocaust. In almost all industrialized nations, industrialization was accompanied by social upheaval. The transition from agrarian feudalism to industrialism came with blood.

Japan is the one major exception. It never underwent a social revolution, despite the speed of its transformation and the massive discontinuities that came with it. In Japan, the nobility became the industrialists and advocates of war. The industries they created continue today to support the policy of mercantilism and increasing domestic consumption – as well as embracing Japanese democracy.

The great Japanese agglomerations, the keiretsu, trace their heritage to nobles in the 19th century who founded businesses. These nobles did not hesitate to engage in commerce as some of Europe’s nobility did. They eased Japan from agrarianism to industrialism, and from feudalism to capitalism.

To be more precise, the Japanese feudal system remained, changing along the way. But in essence, the feudal estates became feudal industries, and the feudal industries treated their workers in many ways as serfs. The workers were supposed to give their loyalty to the company, and in turn, the company was supposed to take care of the worker. In Japan, it was not simply an economic relationship; it was a social relationship of mutual obligation. Japanese workers pride themselves on the prestige of the company they work for, and they work for that company, in many cases, for a lifetime. The industries, in turn, have as a policy retaining workers even in hard times, even at the cost of maximizing profit. But if austerity is needed, the workers share in the austerity.


A construction site is seen at Tokyo’s Shibuya shopping district on June 8, 2017. KAZUHIRO NOGI/AFP/Getty Images


Economists have been surprised at how Japan has avoided collapse, but it is explained at least in part by the fact that there was never a social upheaval in the country. Much of Japan’s national debt is held by the public, in part as savings, in part as duty. Sluggish growth does not translate into ruthless cuts, even if this turns into even more sluggish performance. Imagining Japan as industrialized feudalism – in the full and not pejorative sense – gives us a hint of how it has sustained itself through its dramatic rises and falls.

This isn’t to say that the Japanese are incapable of agitation. There was great agitation in 2011 after the earthquake, tsunami and nuclear leaks. But it was deflected to the state. The Japanese state appears to be a liberal democracy, but it is more complicated than that. The bureaucracy that evolved from the old imperial bureaucracy remains in place and works in concert with other ministries, private banks and other institutions. The democratic institutions serve an important purpose of absorbing the passion of the public on various issues, the ministries of finance and foreign affairs have a hold on what Japan does, and the public accepts their authority. What binds the ministries together are the universities that their personnel graduated from. Japan is a meritocracy with universities informally but rigorous ranked, and the graduates work together throughout their careers. It is what the British civil service used to be.

This has meant three things. First, Japan is able to make sudden shifts as necessity requires, and then remain on a new course for a very long time. Apart from occasional passion, the system has a degree of trust and acceptance not found in Euro-American society. Second, the financial crisis of the 1980s could be navigated without the expected social and political upheaval. Sluggish growth was accepted and even welcomed, since flat growth and a declining population means higher per capita income. And third, the idea that the Japan of today is the one that we will know for the rest of the century is possible but unlikely. It’s as unlikely as the idea in 1860 that Japan would be a major economic power in 50 years, or that it would take Singapore from Britain in 80. It has been 72 years since the end of World War II, and Japan has followed a clearly defined road. Do not assume that another 72 years will pass before it changes.

Change Will Come Again

The United States caused both of Japan’s radical changes. It was the approach of U.S. Adm. Matthew Perry that triggered the frantic industrialization. It was the defeat by the United States in World War II that triggered the shift to mercantile pacifism. That isn’t unreasonable. The U.S. and Japan entered modernity at about the same time. And as they touched, they both feared and fascinated each other.

No one had dominated the Pacific in history – it was much too large and empty. But Japan and the United States were both nations built on hubris, on the idea that they were ordained by God and history to rule. In time, it was inevitable that they would wage a desperate war that one – most likely the United States – would win. It was in its way certain that the United States would help resurrect Japan, leaving much of it alone. The Americans had a new enemy, the Soviets, and they wanted Japan to help. Besides, the Americans were always interested in commercial relations.

Japan suffers from the disease bred by industrialism. It needs oil and other industrial minerals that it cannot supply domestically. Those come from far away. Since 1945, Japan has happily relied on the United States to protect Japan’s access to them. Japan prefers this by far. But in this world, relying on any other nation is risky, and without the U.S. keeping open the sea lanes, Japan’s industry grinds to a halt. Facing China, and the persistent danger of North Korea, Japan continues to put its trust in the United States. So once more a change in Japanese direction will depend on the United States. If the U.S. changes interests or falters or becomes hostile, Japan will, with sincere regret, change direction again. It will change with the same national unity that has been its strength ever since its industrial revolution.


Barron's Cover

Beyond Bitcoin: How Blockchain Is Changing Banking

The digital currency has taken off this year, nearly tripling in price.

By Avi Salzman  

Barron's Graphics    


The hottest investment of the first half of the year wasn’t Amazon.com, Netflix, or even Tesla.

In fact, your broker probably isn’t pitching it, and it is barely even recognized by the Securities and Exchange Commission. Yet cryptocurrencies—the most famous of which is Bitcoin—are shooting out the lights.

Investors who bought Bitcoin for $5 or less just five years ago are millionaires today, as its price has soared above $2,500. Unlucky ones have lost small fortunes simply by misplacing a password, much like leaving a suitcase full of cash at the train station. Bitcoin, which has nearly tripled in price this year alone, is blamed for fueling drug sales and for helping hackers wreak havoc on businesses and governments. On some days, its price swings 20% up or down, often on a whim or a rumor. (See related story: “How to Invest in Bitcoin.”

It’s easy to dismiss the digital currency as an outlandish, even dangerous, fad. Don’t.

Even if Bitcoin ultimately falls apart or crashes, its underlying technology—known as “blockchain”—is likely to disrupt financial markets for years to come.
 
A blockchain is a digital ledger that is kept and validated simultaneously by a network of computers, almost like a shared Excel document that no one person can change without the agreement of the others.
 
Importantly, it allows deals to be made without the blessing of a “trusted intermediary,” such as a clearinghouse.
 
Companies are already using blockchain technology to send payments and redesign how trades are settled.
 
Financial giants like JPMorgan Chase (ticker: JPM) and Bank of America (BAC) could save billions by standardizing their record-keeping for all sorts of financial processes—at a time when they have come under increasing pressure to raise margins and cut costs. And it shows promise in other areas, from insurance to medical record-keeping to energy trading. Even traditionally conservative financial companies are speaking of the technology in world-changing terms.
 
“Blockchain technology isn’t just a more efficient way to settle securities,” said Fidelity Investments Chairman and CEO Abby Johnson at a blockchain conference in May. “It will fundamentally change market structures—and maybe even the architecture of the internet itself.” Johnson has a unique viewpoint: She’s even “mined” Bitcoin herself.
 
BITCOIN IS MORE THAN CASH you can trade over the internet. Unlike traditional currencies, the supply of which is controlled by central banks, new Bitcoins are mined about every 10 minutes by a global network of computers that maintain a constantly updated list of Bitcoin transactions. (The network itself is also called Bitcoin.)
 
 
Illustration Jay Zehngebot

  
Theoretically, anyone can become a Bitcoin miner by hooking their computer into the Bitcoin market, but there’s little chance they’ll win many Bitcoins. The mining business is dominated by Chinese operations that use specialized equipment to quickly complete the complicated mathematical tasks of verifying transactions.

There is no physical token involved—Bitcoin owners get codes, or “keys,” to access their money. The keys that each party enters allow the system to verify the transaction and memorialize it in a block.

Only 21 million Bitcoins will ever be created (16.4 million of them have already been mined), so no central authority can devalue the currency.

Bitcoin was not the first idea for a digital, or “crypto,” currency. For at least a decade before it was created, libertarian-minded tech enthusiasts had dreamed of inventing a digital token that would allow them to trade directly with each other and avoid interference from central banks and regulators. Yet early efforts failed to catch on.

In 2008, in the heat of the financial crisis, a programmer or programmers using the name Satoshi Nakamoto shared an idea for a currency called Bitcoin on an online message board. Bitcoin’s key innovation is that it allows people to trade with each other without relying on a trusted intermediary, a strong selling point at a time when a growing number of people distrusted the institutions that were supposed to protect their money.

For some people, finding Bitcoin was a eureka moment. “I felt like I had stumbled across a really big idea that had the potential to be really important, but I also realized it would take years for something like Bitcoin to prove itself worthy of people’s trust,” wrote Gavin Andresen, a very early Bitcoin proponent, in an email to Barron’s. Andresen, a Massachusetts software developer, quickly became one of Bitcoin’s most prominent figures. In 2011, Nakamoto, just before ending public communication, appointed him as Bitcoin’s lead developer.



Bitcoin was beset by controversy and fraud from early on. People who didn’t want to mine Bitcoin by connecting their computers to the Bitcoin network often bought and traded them on exchanges, which were easily corruptible. The largest of them, named Mt. Gox, “lost” 850,000 Bitcoins (some were recovered), worth $450 million at the time and $2.2 billion today, and filed for bankruptcy in 2014.

Criminals quickly realized Bitcoin’s potential, too. A vast Bitcoin-fueled drug-dealing operation called Silk Road briefly thrived, then imploded. Hackers and blackmailers have demanded ransom in it.

All this could have destroyed Bitcoin, particularly if the U.S. government had stepped in to regulate it. But the Bitcoin network itself proved resilient to hacking and other chicanery—and its core users were in it for the long haul. “Most of us expected (and still expect) that Bitcoin would be a long-term project, not a get-rich-quick scheme,” Andresen writes.

IN THE EARLY DAYS, Andresen literally gave away Bitcoins in order to spur interest. Not anymore. One Bitcoin fetched eight cents in 2010. Last week, Bitcoins were trading for $2,550, up 170% since the start of the year. Clearly, investors are speculating on Bitcoin; many view it as an asset that, like gold, has a low correlation to the rest of the economy.

But Bitcoin is also rising because it has gradually gotten more useful and accepted. Stephen Pair, the CEO of Bitcoin payment-processor BitPay, says he was “happy to get five or 10 transactions a day” when he co-founded the company in 2011. “Today, we’re doing around 8,000 per day, on average.” Expedia (EXPE) and Overstock.com (OSTK) accept Bitcoin, and people sometimes use it to buy houses and cars. In general, though, your local grocery clerk or tailor isn’t accepting it, and perhaps never will.

In the U.S., about 0.5% to 0.75% of the adult population—roughly 1.2 million to 1.9 million people—have used Bitcoin, according to Scott Schuh, director of the Consumer Payments Research Center at the Boston Federal Reserve. “We’re not finding that the adoption rate is growing very fast,” he says. Bitcoin has gotten a better reception in some places overseas, where central banks have devalued the local currency. In fact, BitPay pays its employees in Argentina in Bitcoin.

Lately, Bitcoin has been suffering growing pains. Its network is too slow to handle the number of transactions people are attempting to process, forcing users to pay fees if they want their payments to go through. Only five to eight blockchain transactions can be processed per second, while credit-card networks process 10,000 times as many, according to a Goldman Sachs report. Absent a major change to the underlying Bitcoin code, the subject of a fierce debate among adherents, the cryptocurrency will be too illiquid to use for daily purchases, and will mostly be a store of value—a bar of gold instead of a Visa card.

 
 
The government, for its part, hasn’t even settled on what Bitcoin is. The Internal Revenue Service considers it an asset; the Commodity Futures Trading Commission says it’s a commodity; and Treasury Department regulators have described it as a “virtual currency.”
Fed Chair Janet Yellen has said the agency has no authority to oversee Bitcoin, but has encouraged central bankers to study it. The SEC didn’t respond to Barron’s question about how the new administration will handle cryptocurrencies.

FOR INVESTORS, buying Bitcoin is a major gamble. There are few options beyond purchasing Bitcoins themselves or shares of the Bitcoin Investment Trust (GBTC), an over-the-counter security that tracks the price of Bitcoin (see “How to Invest in Bitcoin”). The SEC rejected an application by Cameron and Tyler Winklevoss, famous for suing Mark Zuckerberg over Facebook, to create a Bitcoin exchange-traded fund—the Winklevoss Bitcoin Trust—though the decision is being reviewed.

Meanwhile, entrepreneurs have come out with other digital coins that mimic Bitcoin’s structure, with some differences. The value of the most popular offshoot, a cryptocurrency called Ethereum, has risen to $300 from about $10 at the start of the year—a 3,000% rise. (Its market value is about $27 billion, versus $42 billion for Bitcoin.) Like Bitcoin, it’s extremely volatile, and even had a “flash crash” last month, when it briefly traded for 10 cents.

Yet Ethereum is much more than a coin. The blockchain network it runs on allows people to embed complicated information, including “smart contracts” that turn contractual terms into computer code and govern how they are executed.

“The sky is the limit in what I can express” with a smart contract, said Grainne McNamara, who runs financial blockchain programs for PwC, at an SEC conference in November. “I can write a check that says, ‘Look, I’d like to fund your Kickstarter, I’d like to give you $5,000, but only if you have raised the $5 million that it’s going to take you to shoot your new indie film. Otherwise, the money reverts back to me.’”

The Ethereum platform is so useful that JPMorgan Chase, Microsoft (MSFT), and dozens of other companies have formed an Enterprise Ethereum Alliance—yes, it sounds like something out of DC Comics—to explore its potential.

THE SUCCESS OF BITCOIN AND ETHEREUM has convinced others to launch their own “initial coin offerings,” some of which have raised tens of millions of dollars on little more than promises. The new coinmakers often say they’ll create a product tied to the coin and give coinholders preferential treatment. But there’s no guarantee a product will ever appear, and it’s starting to resemble a mania—Massachusetts Institute of Technology Professor Christian Catalini warns that we’re headed for a “dot-coin bubble.”  

“Given the enthusiasm and the levels and amount of money that have been raised, it’s almost inevitable,” he said in an interview.

BUBBLES? DRUG MARKETPLACES? Malicious hackers? How is it possible that anyone in the traditional banking industry is interested in this stuff?

In the post-Napster, post-Uber world, Wall Street no longer has the option of ignoring technologies whose legality or utility isn’t immediately clear. That doesn’t mean that U.S. banks have started trading Bitcoin. Few, if any, will touch it, in part because they can’t effectively comply with “know your customer” laws.

The financial institution that has seemed most interested in experimenting with Bitcoin is Fidelity, which allows employees to use the currency in its cafeteria and invites guest Bitcoin lecturers to its Bits + Blocks Club. Fidelity Charitable helps clients turn their Bitcoins into tax-advantaged charitable donations.

Fidelity will soon allow people who hold Bitcoin through a company called Coinbase to see their balances in their Fidelity account, although the customers will have to leave the Fidelity site to actually transact in it.

STILL, FEW EXPECT that Bitcoin will find a place in the traditional finance system anytime soon.

Instead, entrepreneurs are harnessing the underlying technology to change finance.

By 2014, startups were already designing financial products that used blockchain technology with no direct connection to Bitcoin. Their pitch to bank executives: The new tech could speed up several back-office operations, such as settling trades or making cross-border payments, and make these activities cheaper. And unlike Bitcoin—whose users need no permission to enter the network—blockchains can also be closed to the public, creating a system that users can access only with explicit permission. That makes it secure enough to operate in the tightly regulated world of finance. Also, while Bitcoin transactions can be anonymous, blockchains can be designed to be transparent, so every transaction is easily linked to a person or corporation.

“That was the tipping point,” says Julio Faura, an executive at Banco Santander (SAN) who first became aware of blockchain’s promise in 2014. Faura got his Ph.D. in electrical engineering and designed computer chips before getting his M.B.A. He is now the head of research and development at Santander, leading the bank’s blockchain efforts.

“The rails on top of which the financial system was built—those rails are not broken,” Faura says. “They do work. It’s just that they are old. Our job was to see how this could help build a better financial infrastructure, rather than disrupting the world of finance.”

Santander has been a leader in testing and adopting the new technology. It has partnered with a company called Ripple that allows employees to send cross-border payments, an innovation that cut processing times to hours from days.

Bank of America Merrill Lynch and others are also partnering with Ripple.

While financial trades happen virtually instantaneously, the process to settle them remains slow and cumbersome. It often takes days to actually exchange assets, and financial counterparties tend to use different systems to settle accounts, which can make disputes particularly thorny.

Speeding up transactions and encasing them in a shared blockchain could save financial institutions $15 billion to $35 billion per year, according to Bain & Co. And it could actually make those transactions more secure, because the true record is kept by all participants.

“Architecturally, it does not depend on just one, but on a community of people,” says Faura.

“There is no single point of failure.”

THE DEPOSITORY TRUST & Clearing Corp., or DTCC, and its precursors have been settling trades since the 1970s, giving brokers a central clearinghouse to exchange securities.

The DTCC is now working with IBM (IBM) and two startups named Axoni and R3 to put the $11 trillion credit-default-swap market on a distributed ledger similar to a blockchain. (A distributed ledger is an umbrella term for technologies, including blockchain, where computers certify transactions in a shared record.)
 
That credit-default-swap ledger should be operational by next year. The DTCC is also redesigning the $3-trillion-a-day U.S. Treasury repo market after completing a successful test with tech firm Digital Asset.

There have also been some experiments in share-trading. Overstock.com announced late last year that it had issued public securities on a blockchain. Nasdaq, too, has created a blockchain to trade shares, although its experiment was in the private market. Under Nasdaq’s system, developed with a company called Chain, private companies transferred shares without having to keep a literal paper trail, as many do today.
 
The pilot program was successful, says Fredrik Voss, who oversees the blockchain programs at Nasdaq. The exchange is now considering whether to open this option up to more clients. “The tech is there,” he adds in an interview.
 
Nasdaq’s experiments are not limited to trading shares: The company is also creating an exchange using blockchain that allows advertisers to buy, sell, and trade ad inventory. And it has put together a proxy voting platform in Estonia that lets shareholders vote on the internet, which “successfully demonstrated how a blockchain could be used for something other than transaction settlement.”
 
Other companies are embarking on similarly ambitious projects.
 
IBM last week announced that it will work with seven European banks, including Deutsche Bank (DB), to conduct trade-finance transactions—which now can take weeks and reams of paper—on a blockchain.
 
Elsewhere, blockchains are being tested to store medical records. The technology has even been employed in esoteric smaller-scale projects, like a solar electricity trading platform in one Brooklyn, N.Y., neighborhood.
 
VOSS IS OPTIMISTIC that blockchains will gain wider adoption, but he says that financial firms need more guidance from regulators. How will different governments treat cross-border payments made over closed networks? What information needs to be embedded in each trade or contract? What’s the right balance between security and privacy? “The world is full of these legal questions right now,” Voss says.
 
“For people to commit billions to this, we need more guidance.”
 
More market players need to become involved in blockchain-powered exchanges to make them worthwhile. “This is a technology that’s not about building a faster engine for us,” he adds. “It’s about building a new road. If no one else is using it, there’s no use in having it.”
 
Banks are also reluctant to commit too many staff members or too much hardware to the projects, knowing that the first movers in blockchain—the ones who create the rails—will absorb most of the initial risk and upfront costs.
 
Indeed, much of Wall Street remains reticent. Bain surveyed executives at financial firms and found that about 80% expected the technology to be transformative and see their firms using it in some form by 2020.
 
Still, they’re sketchy on where exactly they’ll deploy it at a time when older technologies still work.
 
One executive in a blockchain consortium with other companies told Bain that “half of the people in the group are looking for a solution; the other half are there uniquely to obstruct progress.”
 
“If there’s a consortium working on some sort of new cool solution, but that will threaten your existing business, people will try to steer it one way or the other or potentially delay it while they work on their own solution,” Thomas Olsen, a Bain blockchain expert, said in an interview. “There’s some of that going on right now.”
 
EXECUTIVES KNOW they need to understand blockchain, but not everyone is clear yet on how exactly it will help their business. Payment-processing company WEX surveyed 500 chief financial officers, and nearly two-thirds said they had a strong understanding of the technology. But only six explained how they were actually putting it into practice.
 
Nonetheless, Olsen expects blockchain to gain wider acceptance soon, spreading in a “piecemeal” fashion, rather than a “big bang” like how Uber changed taxi service.
 
What’s true of Bitcoin—and really all money—is true of blockchain too: It has value only inasmuch as everyone believes it has value. Then, perhaps, the sky’s the limit.
 
 
NICHOLAS JASINSKI contributed reporting to this story.