Tottenham Report: Crypto revisited

June 13, 2023 11:00 PM
Photo: Shutterstock
  • Andrew Tottenham — Managing Director, Tottenham & Co
June 13, 2023 11:00 PM
  • Andrew Tottenham — Managing Director, Tottenham & Co

Joint stock companies were created in the middle of the 16th century. This allowed people to invest in a company and own a share of the equity, giving them the rights to a share in the profits and the ability to sell. These companies proved hugely popular.  

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One of the most famous was the East India Company, a private enterprise that was given a monopoly by the English Crown to plunder the world to the east of the Cape of Good Hope. 

For three centuries, the East India Company was an enormously profitable enterprise, sucking the wealth out of a number of Asian countries, backed up by their own private army. 

Not all joint stock companies were successful. Some failed spectacularly. The South Sea Company, formed in 1711, was effectively a Ponzi scheme backed by the Crown and the British government (the South Sea Bubble is a great story). When it failed in 1720, its share price plummeted from over £1,000 to around £120. Fortunes were made and lost.  

Following that bust, the investment community and parliamentarians took a paternalistic attitude toward investing. They thought only the skilled and knowledgeable should be allowed to invest; they understood the risks and knew how to control their losses, so as not to lose all their investment. For “skilled and knowledgeable,” read “wealthy.” 

People with little disposable income were viewed as ignorant and the powers that be believed that their purchases and sales of shares would upset the “orderliness” of the market. If you did not know what you were doing when you made an investment, investing was akin to gambling.  

In order to stop investing being seen as speculation or gambling, they sought to prevent people from making small investments. Rules were established to set a minimum sale and purchase price for shares on the stock exchange.   

This did not stop those with little money from investing; a side business grew allowing people to bet pennies on the movement of a particular stock.  

It appears to me that in the minds of the investment community and parliamentarians, the distinguishing features that separated “investment” from “gambling” were: 

  • a lack of knowledge about the investment and the risks involved 
  • a lack of skill in making the investment 
  • a lack of wealth on the part of the people making the investment 
  • and the ability to lose a large amount of money, relative to personal wealth 

What has this got to do with crypto? Everything! 

Governments are grappling with what to do about cryptocurrency trading. The high volatility, scams, endless scandals, and tales of woe from people losing their life savings as crypto prices crashed have given governments a sense of urgency to do something about it.  

The UK government is no different. HM Treasury published a consultation document earlier this year, Future financial services regulatory regime for cryptoassets, setting out how the Financial Conduct Authority (FCA), the UK’s financial-services regulator, might regulate the sector. In response, the UK Treasury Select Committee, one of the more powerful parliamentary committees investigated crypto assets, in May issued a report titled Regulating Crypto. 

The Committee’s report quotes research from the Bank of International Settlements estimating that 73% to 81% of those who invested in cryptocurrencies between 2015 and 2022 were nursing losses. The same research stated, “In periods of price increases, small Bitcoin holdings tend to increase, while especially the largest Bitcoin holders – the humpbacks – tend to sell. This […] is consistent with a market sustained by new entrants, allowing early investors and insiders to cash out at their expense.” Was it ever thus! 

The surprising thing about this report is that it criticized the UK government for rushing headlong into embracing all forms of crypto assets and the proposal that they should be regulated by the FCA.  

They did not think that the FCA regulating cryptocurrencies was a good idea. Due to the “halo” effect, it would make the general public think that their investment would be safe and they would have someone to turn to if things went very wrong.  

Did the investors in Enron, Wirecard, and many other companies that have gone spectacularly bankrupt, wiping out all of their equity, believe that their investments were safe? 

The Committee came to the conclusion that “unbacked crypto assets” (cryptocurrencies) have “no intrinsic value,” “expose consumers to substantial gains and losses,” and “serve no useful social purpose.” And because of this, they determined that “investing” in cryptocurrencies was the same as gambling and therefore the buying and selling of cryptocurrencies should be regulated by the Gambling Commission. 

Let’s get serious about this.  

Every day, about 15% of all of the world’s money supply is traded on the Forex exchanges. This has little to do with someone needing a foreign currency to pay an invoice or for going on holiday, but everything to do with currency traders, most of which is algorithmic, trying to make a profit with thousands of micro trades daily.  

Contracts For Difference (CFDs) are a means whereby you can have a contract between two people about the movement of the price of an asset without owning the underlying asset. It is a method of making or losing a lot of money very quickly. It is not for the faint-hearted. CFDs have no intrinsic value. 

Please explain to me the why these two examples of financial services, and there are many others, do not expose investors to substantial gains and losses and serve a useful social purpose.  

The financial community argues that their traders and mutual-fund managers are knowledgeable and skilled and can always make money; thus, it is all skill and therefore not gambling.  

Let’s take the second group first. Mutual-fund managers do not always make money for their funds over a period of time; they quite often lose money. But their marketing materials point only to the few funds of many that have made money over a certain period of time. They do not point out all of the funds that have lost money as well.  

The only parties that make money consistently are the mutual-fund management companies through the fees they charge and those fees are not related to the success of the fund, nor do they give them back when the fund loses money. In a static market, as much money is “made” as is “lost.” It is a zero-sum game. 

With regards to the first group, financial traders do make considerable sums of money for their employers, for which they are rewarded handsomely. Until they don’t! 

Their trading strategies are very similar to some gambling strategies: They make money consistently, until it all goes horribly wrong, and then they lose everything and more. At which point the taxpayer has to bail them out. 

I concluded years ago that most of the financial-services industry is nothing other than gambling. If we put the financial products on offer today through the “is it gambling test?”, I think many products would be classified as gambling. 

Nearly all jurisdictions have a legal definition of what constitutes gambling. Made up of a three-legged stool, provided the three “legs” exist and the stool stands, it’s considered gambling. The legs are prize, consideration, and chance; a person pays consideration of value for the possibility of obtaining a prize with the outcome being dependent on chance. 

Each jurisdiction weights these three legs differently. For example, some require that the amount being paid needs to exceed a certain amount, some that the size of the prize needs to be above a certain limit, and some that it depends on the extent that chance affects the outcome, and/or some a combination of all of these. Some jurisdictions state that if any element of chance can affect the outcome, it is considered gambling. 

I think a case could be made that in many jurisdictions, all financial products are gambling and should be regulated as such. Perhaps removing the “halo” effect is not such a bad idea. Caveat emptor!