Coining it…or just Untethered?

The Awbury Team’s members have been around long enough to have observed, lived through and survived multiple financial bubbles, crazes and crashes. However, we have looked on at the current frenzy surrounding the rise in the value of bitcoin (lower case, as opposed to the upper case Bitcoin payment system) with bemusement, which we shall use as a proxy for analogous “crypto-currencies”.

While the company behind the South Sea Bubble was a fraud, one could at least plant tulip bulbs and console one’s self with the beauty of the flower after that mania ended (Fun fact: in 1637, the Dutch East India Company was worth USD 7.9TN in today’s terms). In the case of bitcoin, it seems that what was once considered a curiosity and subsidiary component on a blockchain-based system has become the focus of the most extreme rise in “value” in recorded history. Having started life with what, in hindsight, is probably the most expensive pizza purchase in history in May 2010, and reaching a price of USD 1 in April 2011, bitcoin was supposedly quoted at a price of over USD 19,000- in early December. To say that the price is volatile is a serious understatement, as it becomes increasingly difficult to discern what, if anything, is “real” about it.

This begs the questions of what exactly bitcoin is; what purpose it serves; and what impact it is having or will have on the financial system, including (re)insurance. Classically, a currency is a medium of exchange, (one hopes!) a store of value and a unit of account. How does bitcoin measure up?

Frankly, as bitcoins are simply entries in a Bitcoin blockchain ledger and there is no-one who guarantees that a bitcoin has any particular value, such value depends entirely on supply and demand. Given that bitcoin is designed in such a way that there are only ever supposed to be 21 million of them in existence, and that creating new ones (up to the limit) costs increasing amounts of both computing power and (literally) energy, one can see how, as the desire to own a seemingly scarce item increase, demand can lead to the sort of frenzy seen in the past few weeks.

In theory, one can transact using bitcoin, assuming that the other party has both the desire and ability to accept them. However, the frictional cost of doing so keeps rising, and the time required to complete and validate a transaction also continues to increase, leading to the risk of “double-spending” of the same bitcoin. So, as a medium of exchange, bitcoin is far from optimal; and, of course, the volatility in its price also militates against that use. While, theoretically, bitcoin could be used as a unit of account for book-keeping purposes (and after all, Bitcoin is supposed to be a distributed ledger), that purpose seems to have become obscured by the frenzy surrounding whether or not bitcoin can be considered a store of value.

Of course, the “bitcoin billionaires” (yes, they now exist) would argue that it most certainly does. However, in reality, one can only realize that value in the real world by converting it into a more conventional and widely accepted currency, such as the US Dollar. Couple this with the thinness of the market; the fact that it would appear that holdings are quite concentrated; and the continuing reluctance of major banks to become involved in trading and clearing bitcoin transactions (in particular the newly-minted CME and CBOE futures markets), and one begins to wonder when and how bitcoin will become anything more than a speculators’ plaything and one more opportunity for the less salubrious fringes of illegal businesses to try to shield their profits from discovery and confiscation.

So, why, one might ask, should (re)insurers care about all this?

Well, consider the current obsession for growing revenues from cyber-risk coverages. Crypto-currencies are supposed to be free from the risk of “hacking” or misappropriation because of the underlying technology. Yet there are already numerous reported instances (and probably many more unreported) of bitcoins and their analogues “disappearing”, being misappropriated or simply stolen. If a (re)insurer had written a cyber-risk or even a standard theft and fraud coverage for a client who owned bitcoin, quantifying and pricing that risk might prove rather challenging, as might defining exactly what had been lost. Or consider covering risks relating to the default of a clearing broker or exchange involved with bitcoins. In theory, initial and variation margins should cover all but the most extreme loss scenarios; but, given the lack of reliable data and the brief history of the “asset”, what exactly is an “extreme loss scenario”.

At Awbury, we aim to maintain an understanding of complex risks and the opportunities they may bring, so we shall, of course, continue to monitor the evolution of the blockchain and crypto-currencies, while remaining a healthy skepticism about whether there is, as yet, sufficient data and market understanding to qualify and quantify the true nature and level of the underlying risks.

However, if you have a blockchain or crypto-currency risk that needs a solution, give us a call

When is an “unknown unknown” really unknown? And have all the Black Swans gone Grey?

Donald Rumsfeld was once much mocked for his parsing of risks into categories such as “known knowns”; “known unknowns” and “unknown unknowns”. Yet he had a point. There is really no excuse for allowing known risks to overwhelm one’s capital or business model; while accepting risks one can identify, but which are difficult to assess or quantify, is somewhat inadvisable, as many financial institutions have found out the hard way through misaligned incentives and imperfect models.

So, what about “unknown unknowns”? Objectively, one does not even know that one does not know. Consider “cyber risk”. Fifty years ago, that would have probably counted as an “unknown unknown”, because the products, systems and software that have created the risk did not exist- even if some might have been foreshadowed in the works of various science fiction authors. And what of the still-running asbestos saga? One could lay reasonable odds that none of the original underwriters foresaw what would happen, or that the risk existed.

In a broader context, into which category should the recent actions of the Saudi Crown Prince “MbS” be placed? Expropriation for political or financial gain is nothing new, but the event was considered unforeseen, as could be gauged by the reactions. So, a Grey Swan perhaps, being charitable?

The point of all this sophistry is that the ability to survive and prosper in any business, including (re)insurance is based upon being able to detect, avoid and mitigate risks before they reach unmanageable proportions. However, the quality of risk detection capabilities appears to vary widely: it requires a willingness to be proactive in “thinking the unthinkable”; which, frankly, many find difficult because it can lead to some uncomfortable conclusions and requires being both contrarian and disciplined. FOMO is not a viable approach!

Consider the risk of nuclear confrontation- most likely involving North Korea (altho’ both India and Pakistan are nuclear powers, with muddled military doctrines and a long history of enmity and mistrust). Lobbing the odd low-yielding ICBM across the Pacific Ocean is not likely to be a good survival technique for the Kim dynasty, which leads into a consideration of the potential behaviours of other actors as they try to gauge responses. The risks of miscalculation are probably higher than they have been for more than a decade, made more dangerous by the rapidly-increasing nuclear weapons capabilities of the regime in North Korea, and they are no longer negligible. This then requires thinking about the consequences of a nuclear weapons exchange. MAD (Mutually Assured Destruction) might not apply in this case in the literal sense, although tens of millions of Koreans would rather not see the hypothesis tested, but the increased probability might cause underwriters to take another look at the wording of their Nuclear Exclusion clauses.

Of course, this is a “known known” risk, but it requires mental effort that many may not wish to take, which practically speaking could push it into another category.

Turning back to “unknown unknowns”, worrying about them is counter-productive. They are, by definition, currently “unknowable”. One should instead focus on risks that can be detected and then decide where they sit upon the spectrum of probability and severity; and whether they are sufficiently capable of being measured, and so priced and managed. At Awbury, while we are always surveying our environment for new and unexpected risks, we continue to emphasis our ability to provide our clients with products and techniques for managing their “known knowns” and “known unknowns”.

The Awbury Team